Every trader participating in the forex market has his or her own opinion about the direction the market is likely to take. And, the decisions they make—whether to place buy or sell orders—is based on these views.

Ultimately, the predominant direction the market is going to take is based on the combination of the opinions of all the market participants.

For example, if the dominating sentiment is bullish for a currency pair, it will rise in value. Note that using sentiment analysis will not provide you with specific entry and exit places for every trade—but it will assist you to know whether to ride with the flow or not.

Certainly, you can use sentiment analysis with technical analysis and fundamental analysis to siphon your signals and improve entry and exit decisions.

Importance of Sentiment Analysis

Knowing how to use sentiment analysis can be a vital tool in your toolbox. Sentiment forms a significant component of what drives movements in the forex market.

For example, if 90 traders have placed buy orders on the GBP/USD and 10 traders have placed sell orders on the currency pair, it shows the sentiment to be 90% overall in favor of buy positions.

In the forex market, if traders have a positive attitude on a currency pair, the sentiment can also be positive. On the other hand, if the attitude is poor, then the sentiment is likely to be negative.

As a trader, it should be your responsibility to determine the predominant emotions in the market. Are investors bullish about the economic situation of a country? Are the indicators suggesting positivity for the currency?

Remember that you cannot dictate to the market what it should do. However, what you can do is make a calculated response to what is taking place in the market.

Including sentiment analysis in your trader’s toolbox will assist you to decide whether to ride on the same bandwagon with everybody or wait for your turn.

If you decide to ignore sentiment analysis, you may make losses. It is what you need to become profitable in your trading.

Forex Sentiment Tools

Forex sentiment analysis entails identifying traders’ positions so that you can try to know how they are thinking and make appropriate trade decisions.

In other financial markets, like the stocks market, participants can assess the volume traded to gauge the prevailing sentiment.

If a stock price has been on an uptrend, but volume is decreasing, it could indicate overbought market conditions.

Likewise, if a plummeting stock abruptly reversed its move because of increased volume, it could point to shifting market sentiment, from bearish to bullish.

However, because forex trading takes place over-the-counter, the absence of a centralized market complicates knowing the volume of every currency traded.

Nonetheless, here are two common tools that forex traders can use to measure market sentiment.

• Contrarian indicators
• Commitment of Traders report

1. Contrarian indicators

The contrarian trading strategy involves placing orders that are against the present market sentiment. Contrarian traders mostly place long orders when a currency is weak and short orders when it’s strong.

These traders take advantage of situations when the market has attained a level of saturation. If traders are propelling prices higher, it could result in overpriced assets. Similarly, if the market is enjoying a selling spree, it could present opportunities to buy at a lower price.

Essentially, the contrarian approach posits that whenever market sentiment reaches extreme levels—such as when the number of long positions overwhelmingly exceed short positions and vice versa—then the trend is regarded as exhausted and thus a price reversal is imminent.

For instance, a trader can place a buy order on a currency pair when growing pessimism has made its price to plummet to extremely low levels.

On the other hand, when the price has increased to unsustainable levels because of diminishing bullish pressure, the trader can place a sell order.

Contrarian traders usually go against the basic rule of trading: always trade according to the predominant trend. If the market has been strongly trending in a particular direction, contrarians believe that it is now time to reverse its move—and therefore will not place trades according to the trend.

However, when trading using this strategy, you should remember that sometimes the market shows extreme conditions but continues with the primary trend, without any reversal in sight.

Therefore, you need to be disciplined and carry out a comprehensive analysis of the market before using this approach for trading.

Several technical contrarian indicators are available for gauging the market sentiment. For example, a typical technical indicator that can identify overbought and oversold market conditions is the Relative Strength Index RSI.

The RSI comprises of a single line, which fluctuates within a scale of 0 to 100. The scale is usually categorized as follows:

• 0 to 30: Oversold territory
• 30 to 70: Neutral territory
• 70 to 100: Overbought territory