Sentiment Analysis: What is it? Why do you need it?

It's not unusual for a trader to have a hunch – to feel as if the market or the price of an asset is about to move. But is a hunch enough to make fully informed decisions about any investment? Using sound logic, reasoning, and analysis gives you the best chance of achieving returns. And sentiment analysis is one of those tried and tested methods that investors use.

To some investors, the idea of using analysis based on 'sentiment' may not seem that different from trusting their hunches or a 'feeling'. And they aren't necessarily wrong in that assessment. But there's much more to sentiment analysis than meets the eye. The key is to first get to grips with it – what is market sentiment, how can you use it, and what are its benefits?

What is sentiment analysis?

In technical analysis, traders use historic price data to inform their next move. In fundamental analysis, tangible numbers and the reputation of the security supply that grounding. But, when it comes to market sentiment analysis, the information is more abstract. Specifically, it's based on the mood of the market as a collective.

For the most part, trading is a human activity. As such, it is impossible to eliminate all emotion from the equation. Investors can make decisions according to the data and information they've taken from other analysis. But each one will still have their personal opinions or interpretations that will influence their decision. And, when multiplied, this fuels a collective 'sentiment'.

If the mood of the market is bullish, the price of that security – be it a forex pair or commodity – is expected to rise. If the mood is bearish, the opposite is expected. And the reason why this idea of market sentiment is important is that you alone cannot influence that movement. It comes from the greater sentiment in the market – and the collective mood of the market.

How does it work with fundamental and technical analysis?

It can be argued that a well-rounded trading strategy will benefit from a mix of all three forms of analysis. You could, for example, use fundamental analysis to put good foundations in place for your trading decisions. Next, you might layer on top the technical data that shows whether recent movements give credibility to your expectations.

The next step would then be to explore what the prevailing mood is towards a specific security or market. Here, sentiment analysis gives you two options. The first is to trade in line with the consensus. Or you can adopt a contrarian approach – going against the grain and selling where other investors are buying, for example, on the belief that current sentiment is misplaced.

Above all, your risk appetite and overall goals will determine the success of your strategy. But the type or combination of analysis can play an important part in enhancing your prospects.

How does sentiment analysis work?

The concept of sentimental analysis is rooted in the market's perception of a particular security or asset class. The two positions that can be taken are either "net long" or "net short".

In the case of a position being "net long", the conclusion is that more traders than not (even if only 51% to 49%) are in a bullish mood and expect the price to increase – therefore buying. In the case of being "net short", the opposite applies. The majority view is bearish and the belief is that an asset's price will decrease – thus prompting investors to sell.

The use of sentiment analysis is perhaps best applied in short-term scenarios. Emotions – much like prices – can be volatile. And it's entirely possible that a market could go to bed one evening in one frame of mind, before waking up the next morning in another.

Emotion is an integral part of sentiment analysis (and, indeed, trading) in that respect. After all, taking decisions on pure empirical data would surely end up with every trader acting the same.

Sentiment analysis examples

Let's take some examples of sentiment analysis in action.

• The UK's mini-budget of September 2022 saw a collapse in confidence when announced. Foreign investors "dumped" government bonds at the fastest pace on record, with forex traders pushing the British Pound to generational lows. It took a reorganisation of the UK's government and fiscal policy to restore the confidence of investors.
• On a theoretical level, bullish market sentiment towards one asset can lead to a bearish outlook in another. In times of uncertainty, therefore, the market can show a decline in confidence in stock markets. At the same time, however, sentiment towards safe-haven currencies or commodities will strengthen.
• Fear and greed are important ingredients in fuelling market sentiment. As such, you can spot points at which an asset's value becomes unduly inflated or deflated. If the price of Tesla shares is trading in a consistent band and then suddenly lurches up (or down), it is evident that fear and greed are at play in the market.

What signs can guide your market sentiment analysis?

You might still be unsure how trading using this form of analysis differs that much from trusting a gut feeling. The answer lies in the sentiment analysis tools, signs, and indicators that you can use to better gauge the prevailing mood. Some of the most prominent include:

Commitments of Traders Report (COT)

Each Friday, the Commodity Futures Trading Commission publishes the COT. This highlights the current net long and net short positions of all speculative and commercial traders. With it, you'll be able to see how the biggest traders in the market are positioning themselves. If you can see signs these traders are becoming bearish in a bullish market, things may be about to change.

Volatility Index (VIX)

The Chicago Board Options Exchange's (CBOE) VIX is fuelled by the price of options and subsequently tracks the volatility present in the market. It is sometimes referred to as the 'fear index' because it can help traders react to any perceived increase in volatile trading conditions. And the increase in volatility may be a sign that any current trends are about to reverse.

Bullish Percent Index (BPI)

This index is an explicit measure of stocks with a bullish pattern as indicated by point and figure charts. For traders using this as one of their sentiment analysis tools, the output is presented as a percentage. A score of 50% can indicate a neutral sentiment, whereas a reading of 70+% is a sign that the sentiment is bullish. On the flip side, a score of 30% or less suggests a bearish view.

High/Low Ratio

This is another index-based data point that can enhance your sentiment analysis. It provides a comparison between the stocks moving to their highest point in 52 weeks to those moving in the opposite direction. Traders can then get a snapshot of the average direction in which things are moving. Like the BPI, an index score below 30 is bearish and above 70 is bullish.

What are the advantages of sentiment analysis?

The art of successful trading doesn't depend on one exclusive set of rules or methods. A trader can use any strategy that works best for them – influenced by uniquely personal attributes like risk aversion, available time, and capital resources. So, of course, you may find there are some advantages of sentiment analysis that make it an integral part of your trading journey.

One main benefit is the presence of proven indicators to help you grasp the mood of a market. A hunch? That's based on little real evidence – if anything at all. But market sentiment can be evidenced in tools such as the COT, VIX and BPI.

As the VIX is based on the options market, there's a forward-looking element to sentiment analysis that other forms can't replicate. Those options, for instance, are future-dated. So, if there are more 'puts' (rights to sell) in play, it can hint at a trader's belief that prices are about to become unstable. Similarly, other indicators can point towards potential reversals ahead.

What are the potential drawbacks?

It can undoubtedly be useful to incorporate sentiment analysis into your trading strategy. At the same time, there needs to be an acceptance that sentiment is abstract and guided by emotion.

The spectrum of emotions that can exert collective forces on the market can range from fear to greed. And this brings the potential for trends or prices to be unduly skewed – if only in a short window of time. Market sentiment also has the potential to be stubborn; trading on an idea that something will come to pass regardless of what other data may be suggesting.

With this in mind, knowing how to use sentiment analysis often means knowing how to spot anomalies. Just because the market is showing itself to be in a particular mood, there can be no reliable guarantee that it's justified. After all, most retail traders don't turn a profit. Applied on a broader scale, can you really trust the general mood?

That said, it can lead to contrarian opportunities where you go against the market.

It's also worth noting that some indicators are non-transferable. The BPI, for example, looks at share prices. It can't easily translate into useful learnings when trading forex or other securities.

What can sentiment analysis be used for?

In practice, market sentiment can be applied to trading decisions no matter the asset class. The concept can work with forex, share, index, and commodities trading among others. At FXCM, we offer opportunities to trade in each of those asset classes using CFDs or spread betting. So, that can be an ideal starting point for using your analysis to positive effect.

Due to its forward-looking nature, sentiment analysis can be used to get you ahead of the curve when it comes to trading opportunities. The tools and indicators you use – plus the observations – can give a good indication of what your fellow investors are thinking. From this, you can make reasoned judgements on whether a bearish trend will continue – or a bullish trend will reverse.

As such, it can leave you with the option of making a contrarian trade. And doing so correctly is one way you could make a profit where most others end up in a losing position.

Sentiment analysis methods explored

There are perhaps two main sentiment analysis methods that could work if you feel this should be part of your trading journey. The first is in real-time and the other is a longer-term activity.

As far as real-time analysis goes, it is what the name suggests. Looking at your chosen security, use the sentiment analysis tools at your disposal to understand what is happening to its value – and why now. One example scenario is a sudden spike in the value of a currency that had been slowly retreating, thus lacking the technical and fundamental reasons for acting that way.

It's equally possible to perform this type of analysis over a longer timeframe if you prefer. This can make it more cohesive with fundamental analysis because you have the space to view any emotional reactions to things like the publication of financial results. In turn, this can influence periodic trading decisions based on the expectation of similar market sentiment in the future.

Put your analysis to the test with FXCM

Are you looking for an online trading experience that allows you to explore all possibilities?

Our award-winning platform at FXCM gives you all the tools to analyse the markets, execute trades and build your portfolio. Adding sentiment analysis into your trading strategy could be the key that unlocks your profit-making potential across thousands of popular instruments.

So, why not sign up for an FXCM account today? Use everything you've learned from examining the mood of the market to your advantage. No matter if you opt to go with the flow or follow a different path, it's your trading experience – and we're here to help make it a fulfilling one.