Forecasting price storms with market sentiment

When it comes to forecasting the direction of a price move, traders use multiple tools and techniques that take the guesswork out of the equation. But there is one powerful influence on every investment market in the world that cannot be analyzed, and often renders even the most robust trading strategies useless. It’s called market sentiment.  Traders who understand what fuels sentiment can get a front seat for both rallies and crashes and maximize their trading performance.

What is sentiment?

Market sentiment, AKA investor sentiment, refers to the general feeling or expectations that traders have toward popular investment opportunities. It can be divided into three categories, it is always present, and it moves markets massively, even in the absence of a concrete reason.  Whether optimistic, uncertain, or pessimistic, sentiment can be a powerful addition to your forecasting strategies.

How sentiment works

Let’s use the weather as an analogy. Before you leave your home, you might like to forecast the weather and dress appropriately.

You can go to a meteorological website and measure the barometric pressure and check satellite imagery. This is a technical analysis of coming conditions.

Or, you can switch on the weather channel and listen to a weather reporter. A more fundamental approach to deciding how the day will go.

Or you can look out the window and see what everyone else is wearing. Sentiment.

The assumption is that the majority of people on the street have done their forecasting and concluded how the day will be. If you see a trend for umbrellas, expecting rain is a natural conclusion. But, this opens the door to manipulation. What if a small group of people walks the streets wearing raincoats, sporting a large bright umbrella, even though technical analysis doesn’t suggest rain?

Trendsetting

Unlike the weather, trend-setting traders can influence prices on the financial markets. If a sudden increase in Buy volumes spikes the price of a particular instrument, traders checking the “window” are likely to react to the trend and follow. As traders follow the forming trend, the prices react. 

This behavior is well known in psychology and is often referred to as herd mentality. There is sense in the behavior, but it is not a reliable method of forecasting, especially as market sentiment can be manipulated by large investors and hedge fund firms who pump prices to start a trend. By doing so, they are buying early at low prices, then dumping the asset after the herd has raised the price.

Using sentiment in forecasting

Consider using sentiment as an early warning system, and a great way to isolate instruments that deserve investigation. Technical analysis can confirm that the trendsetters have good reason to trade the trend, but check to see if financial news doesn’t contradict the direction, and be ready for a rapid fall at any time. Setting a trailing stop order can be a useful tool to take advantage of the rally and close the order at the first sign of a reversal.

If all your forecasting strategies are aligned, you might be sitting on a coming price storm worthy of investment.