Sentiment analysis: The key trading fresh sentiment
Sentiment, like food, is best enjoyed fresh
Firstly, what is sentiment?
Sentiment is, quite simply, the present mood of the market. The market, like people, has different moods depending on what has just happened. As traders, we are always wanting to know what the current sentiment is. Now, trading sentiment is a basic market skill as we try to make sure we are always trading in line with market sentiment (Unless of course we are fading market sentiment, which is a valid pursuit, but a different subject). So, what are the keys to trading fresh sentiment? In this article, we will briefly present the case that the two key concepts to trading fresh sentiment are as follows:
- Picking which sentiment change to focus on and;
- Trading that sentiment while it is still fresh.
Look at the previous two sessions for significant events
Thankfully, analyzing sentiment is not a mysterious skill. At the start of every session, the latest sentiment will be obvious. If you read a previous session summary you will usually become aware of the most significant events that took place. So, if you are coming to your desk at the start of the US session, read through the highlights for the previous two sessions. What significant events have just happened? What was a surprise for the markets? For example, perhaps the UK’s CPI data was released in the London session and it was a surprise beat to the upside. In this scenario, GBP would be considered to have a positive sentiment since traders would look to buy up the GBP. Or maybe there was a political development that weighed on a particular currency. For example, perhaps a Eurozone state is having an election, and an anti-European party is found out to be leading in the polls. This would have a negative sentiment for the Euro.
Pair currencies with positive sentiment against currencies experiencing negative sentiment
Continuing with the example above, you would have discovered the market’s mood on two currencies. Firstly, the GBP. The beat in CPI data would mean the GBP will almost certainly be bought up in the coming session, pullbacks in the GBP would most likely find buyers. The Euro would most likely be being sold as the market fears another country pulling out of the Eurozone. Any rally would be sold. So, by analyzing the sentiment or mood of the currencies you have a good pair to trade: EUR/GBP short.
Picking which sentiment to focus on
The very best time to trade sentiment is when we notice the sentiment change. Sentiment can change on a number of different issues. It could be a surprise data point, a political development, or some other unexpected event that causes a currency to move. The point is, that we have our opportunity to change sentiment.
Not all sentiment is equal
One of the challenges of trading sentiment is that every day there is a plethora of different data points and comments that flow across feeds. Not all of those data points move the market, so the first thing to realize is that sentiment varies in importance.
Now, this is obvious in that a central bank interest rate decision holds far more sway over a currency than a retail sales release. However, aside from the stark and self-evident differences, it is important to recognize which sentiment is going to be important ahead of the event. Let’s take a worked example.
Canadian CPI as a case study from August 2019
The Canadian CPI data release was a key focus in August as it was widely known, prior to the CPI release, that the Bank of Canada was in a unique position amongst its central bank peers as the Bank of Canada remained the only major central bank to not turn explicitly dovish. However, in an increasingly bearish central bank world, the pressure was increasing on the Bank of Canada to follow suit. This meant that the market was just waiting for a reason to sell CAD as the expectations were that the BoC would follow their central bank peers. They just needed a data reason to nudge them in that direction. Also, we knew that the BoC are not reluctant to cut interest rates and surprise the markets, as they did in 2015.
So, that sets the expectation for the potential of a strong CAD sell off if the CPI print was a negative read. That would be the ammunition to fuel increased expectations of a coming BoC dovish tilt, the sentiment change. This would have resulted in a strong sell off for CAD. In the event, the release was a positive uptick in inflation, so the chances of a September rate cut from the BoC faded into the background. The trade was not there. Move on to the next opportunity. The principle remains the same for future sentiment shifts.
The key takeaway
The key point is that the market moving event, with the most force behind it,
would have been the negative CPI print. In this way, we could be poised and ready to take an immediate CAD short out of the event. It would have been a high conviction trade. So, you need the following elements for a decent sentiment trade:
- A clear bias going into the event
- A data release or event that clearly confirms or contradicts that bias. In other words, the market will respond in a certain way.
Now let’s move on to the next principle, trading sentiment while it is still fresh.
Trade the sentiment while it is still fresh
Let’s say, for the sake of argument, that you took a similar trade like the one outlined above that actually played out. Now, you missed trading out of the event because you were away from your desk, at sleep, or at work, etc.
There is often a second chance to enter a trade on that sentiment in the next 24-48 hours. Now, you don’t want to just chase the price of selling or buying at the market. So, in these scenarios wait for a retracement to a key level. Then trade back down to those prior lows. Below is an example of a trade we took on the AUD/NZD pair that illustrates this.
AUDNZD: An example of trading sentiment while still fresh
The AUDNZD longs were based on the growing diverging outlook between the RBA and the RBNZ. The RBA minutes from that week further confirmed that divergence and the market chances of a rate cut from the RBA went down to ~12% from ~50% the previous week. So, having missed the release of the minutes overnight we set orders to buy on stop around the 50% Fib level and took profits at the prior’s high. Check out the details below. Our entry is the small blue arrow and our exit is the small red arrow. Our order was filled about 12+ hours after the minutes, but we got it while it was still fresh
So, there you have it. A simple high conviction sentiment based trade. Sentiment is a dish best served fresh. What sentiment trades are you looking at for the coming week? Please post in the comments section below and help reinforce this concept.
Use sentiment to anchor stops
So, let’s assume you have analyzed the sentiment of two opposing currency pairs. In this case the EUR/GBP pair. How can you use that sentiment knowledge to place your stops in an intelligent place? Again, this involves quite a simple approach. Place your stops above the price before the sentiment catalyst is released. So, for example, let’s say that before the UK’s CPI data release the EUR/ GBP was trading at 0.8800. If you placed your stops above that level then you would know that, for that price to be breached, your sentimental analysis would have to be wrong. In the example below the GBP/JPY pair rallied into Friday’s close on the 6th of July 2018 on some positive Brexit news.
Different ways of using sentiment
Sentiment comes in different varieties and here is a brief list of some of the most common types of sentiment:
Buying the rumor, selling the fact
When positive data is released the currency falls. This happens when the market has been expecting a certain outcome for some time. As soon as the data release is confirmed the market simply ‘sells the fact’. Watch out for this sentiment when a certain outcome is expected and happens just as forecasted.
This is when you use the short-term sentiment to get into a trade at a better price in line with the fundamentals of a currency. So, you are said to ‘fade’ the move.
If something can’t rally on good news
Another market maxim is that if something can’t rally on good news it is a good indicator that lower prices are ahead. This is linked to the heading above – fading sentiment – as traders take advantage of all positive sentiment to fade in line with the broader direction of the market
Overbought and oversold conditions in the Commitment of Traders Report
The COT report indicates the positions of traders. Whenever you see a fundamental shift in monetary policy that catches traders unawares you can have quick adjustments in price.
When you have traders heavily positioned to one side of a trade buying a certain position and then monetary policy shifts, many of those traders will be unwinding their positions. This is a sentimental shift that you can take advantage of. A similar sentiment trade would be with traders taking profit on overbought or oversold positions.
Risk-on and Risk-off markets
In a risk-on environment, traders rush to buy the traditional safe haven currencies like JPY, CHF, and the USD. Conversely, AUD and NZD will not be bought. If you come to the market and find a risk-on sentiment is in play, then you will want to make sure you are not entering any short JPY trades.
Sentiment is simply the mood of the market. Understanding that mood will help you not only stay on the right side of the market but also help you to have the correct expectations of what is influencing the mood of the market right now.