What Is Market Sentiment, Risk Aversion, Risk Appetite? How Can They Impact Your Trading

May 14, 2020
This post is a detailed market sentiment breakdown in Forex Trading. It covers all areas from sentiment indicators, sentiment measurement, risk aversion and risk appetite and their bearing on Forex Trading.
What Is Market Sentiment, Risk Aversion, Risk Appetite? How Can They Impact Your Trading

Every investor in the forex trading community always has a market sentiment and some opinion about the forex market. This includes an opinion as to why the market is shifting in a direction and this is often revealed in the trades they make. Regardless of all these opinions, it is important to understand that the forex market is a conglomerate of different opinions, views, and ideas.

This discipline is all about predicting the probable shifts of the market while utilizing the right indicators. Having a good idea of where a huge number of stockholders have positioned themselves can give you a pretty chance to earn significant profits.

Therefore, it is all about learning to position yourself where the market sentiment is likely strongest by equipping yourself with the necessary information. This post is meant to shed light and provide you with more information on this issue and how it can impact on your trading.

What is market sentiment?

market sentimentTo put this into perspective, think about how we respond with our emotions to certain events. The same applies to forex trading. Essentially, market sentiment, otherwise referred to as investor sentiment, in forex trading is the overall attitude of market stockholders towards any market price or asset at a given time.

In other words, it is a collective emotion or crowd psychology. The price movement and activity of the assets traded in a market is always a revelation of collective emotion.

If the market sentiment becomes more positive, the ripple effect will be a more positive general market consensus. On the other hand, if the market stockholders begin having a negative attitude towards the securities, the general market sentiment becomes negative.

That is why forex traders use to measure market sentiments through sentiment analysis to know the bullish sentiment or bearish sentiment of a market.

Bearish sentiment is indicative of assets plummeting while a bullish sentiment shows prices of assets going up. However, stockholders can always employ a range of tools to measure market sentiment like indicators or watching the market movements then utilize the results to make an informed trading decision.

Measurement of Market Sentiment

In theoretical terms, price action should reflect every available information on the market. Unfortunately, this is not the case in a practical sense, especially for stockholders. These forex markets do not just reflect all the available information there is because then all the investors will act in the same fashion. This is where sentiment analysis comes in.

Sentiment analysis is a type of analysis that primarily functions to measure market sentiment. It strives to quantify the percentage of the investors that are bearish or bullish. Upon successful identification of the market sentiment, an analyst will then take up an opposite position that the collective emotion is mistaken.

You must take note that trading on sentiment is a rather contrarian approach that heavily relies on bull and bear ratios among other indicators. That is it is important to frequently measure sentiment to help you add more depth to your understanding of the forex market.

Sentiment Indicators

Market sentiment is an especially important aspect when trading in financial markets. As an investor, it is imperative to employ the tool to measure market shifts and at the same time read the mood of the market to have an idea of where the market is headed. This way you will be able to capitalize from the shifts. To know how best to utilize market sentiment in forex trading, you need to understand this concept.

An indicator is a graphical or numerical indicator that shows the raw data or percentage of the number of traders or trades occupying a position in a currency pair. These indicators become especially useful when stockholders or trades reach an extreme level.

It is important to note that these indicators are not particular signals for buy or sell. It is imperative that you wait for the price confirmation of the reversal before you act on the sentiment signals. In some cases, currencies can stay at an extreme point for extended periods and it may take some time before the reversal materializes.

There are different forms of indicators coming from different sources. No one indicator is better than the other. You can apply these indicators together to achieve the best results. The following are the best indicators to employ.

  1. CBOE Volatility Index/ VIX Index

forex calculatorsThis is the most vastly used indicator. The index is responsible for recording the implied volatility of the S&P index options. In this case, if you are a trader, you can buy options to only hedge but also protect your portfolios.

In the event the volatility is expected to rise, you bid your options higher and the index will rise. It is also referred to as the Fear Index because it can give investors a good indication of the levels of fear in the prevailing market. A rising VIX calls for an increasing need for insurance.

  1. A commitment of Trader’s Reports (COT)

This is a quite popular tool among futures investors. Every Friday, COT is released, and it contains data based on the held positions on the preceding Tuesday. Even though the data is not real-time, it is especially useful. Sometimes interpreting these publications can be very confusing.

To better understand them, you need to chart the data to easily interpret them.

  1. High/Low Index

It is a ratio of the stock number in the stock market making new 52-week highs against the stocks making the new 52-week lows. If the reading is below 30, it is bearish and if it is over 70, it implies bullish market sentiment.

  1. CNN’s Fear and Greed Index

This index combines 7 different indicators that ultimately produces a reading between 1 and 100. On the reading, 1 indicates extreme fear while 100 indicates extreme greed. It can use all other listed indicator in this post including market momentum.

  1. Stock Price Breadth

The indicator compares the traded volumes of the declining stock with that of the rising stock numbers in the stock market. The thinking behind it is that the information may show whether there is a flow of money into the stock market, despite the number of stocks rising.

  1. Moving Average

Investors in the financial market’s typical employ the 50-day simple moving average (SMA) plus the 200-day when they want to determine the investors’ sentiment. When a 50-day SMA rises above the 200-day SMA, it is known as a golden cross.

This means that the market momentum has moved to the upside thus resulting in a bullish.

Conversely, a death cross is when the 50—day SMA moves to below the 200-day SMA. The result is bullish because it is suggestive of lower prices.

  1. Put/Call Ratio

It is a measure of the number of put options divided by the call options. The put options are measured when the price is expected to go down whereas the call options are measure when the price is set to rise.

If the ratio goes below 1, it is an indication that stockholders are placing more call options. This means more stockholders are anticipating a market bounce. However, of the ratio is over 1, traders feel that the market is set to fall or slow. It is a good tool to identify possible bottoms.

  1. Bullish Percentage Index (BPI)

If you want a clear way to find out just how bullish a financial market is, this is the tool to use. It makes use of point and figures buy signals. It does this by listing the stock in an index responsible for generating a buy signal.

The readings are in percentages ranging between 0% and 100%. In general, of 70-80% of stocks in the market have buy signals, then investors regard the market as overbought and seemingly ready for a downturn. Nonetheless, you can always apply your threshold. On the other hand, 30-20% shows that the market stock is oversold and are set to rise.

Risk Appetite Vs. Risk Aversion

position size calculatorAnytime we are talking about market sentiment about forex trading, we are essentially laying a distinction between risk appetite and risk aversion. They are a state of mind of investors.

Risk Appetite

it is indicative of the ‘greediness’ of people and just how the economic patterns are. In terms of risk appetite, an investor always prefers to choose a riskier investment. It could a riskier commodity, currencies with high interests or stock.

Risk Aversion

Risk aversion has more to do with ‘fear’ and uncertain economic patterns. In this case, investors will choose to distance themselves from any form of risky investment like stocks, commodities, and high-interest rates currencies. They choose to invest in ‘safe investments’ like haven currencies.

The Impact of Risk Appetite and Risk Aversion on Forex Trading

In instances where the global market is either recovering from an unfavourable period or when it is performing well, what comes into play is risk appetite.

However, if the prospects are all and there are all indications that the global economy is going to experience agitation like wars or pandemic like the recent coronavirus, risk aversion will come into play but the situation may not always be black and white.

Consequences of Risk Aversion and Risk Appetite on Currencies

These two aspects of market sentiment are heavily impacted by interest rates. For instance, in the case of risk appetite, currencies having high-interest rates will rise whereas currencies with low-interest rates will rise in the case of risk aversion.

Therefore, there is always a rise in the demand for save haven currencies in case of risk aversion. This is because many investors consider these currencies as safe investments. For instance, during this time, the US Dollar, Japanese yen and Swiss Franc were mostly on demand because many investors considered them as safe investments.

Their interest rates are particularly low. However, the Swiss Franc has always been considered as a haven currency because of the country’s protection of investments, privacy, and stability.

Final Thoughts

It is now clear that market sentiment plays an instrumental role in forex trading. As an investor, you can always rely on it as an identifier of the market direction.

It is also evident that it is important to consider what other investors are talking about and apply the analysis to help you predict the future movements of markets. If you found this material useful, you can always share with your friends and colleagues on Facebook, Twitter, and other social media platform for more engaging conversations.

Disclaimer: This article is not investment advice or an investment recommendation and should not be considered as such. The information above is not an invitation to trade and it does not guarantee or predict future performance. The investor is solely responsible for the risk of their decisions. The analysis and commentary presented do not include any consideration of your personal investment objectives, financial circumstances or needs.

Risk Warning: Our products are traded on margin and carry a high level of risk and it is possible to lose all your capital. These products may not be suitable for everyone and you should ensure that you understand the risks involved.

Categories: Education

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