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Why Should Forex Traders Use Sentiment Analysis for Trading

The foreign exchange market, or forex, is the largest and most liquid market in the world, with a daily move over $6 trillion.

Trading currencies is highly profitable, but it also involves high risks. Apart from using diversified strategies and tools to forecast the markets, forex traders may also overlook using sentiment analysis.

In short, sentiment analysis studies the broader emotional opinion or behaviors of participants in the market, which can range from ones trading a specific currency to millions of traders.

What is Sentiment Analysis?

The sentiment background impacts the currency pair value by suggesting whether it will rally or tumble based on the collective sentiment of traders, brokers, analysts, as well as all the other players.

Forex traders can monitor news, social media, broker reports, and other sources to check the overall market sentiment. A positive sentiment will indicate that the traders are optimistic about the currency while a negative one mostly bearish. Both qualitative and quantitative methods exist alongside sentiment analysis, with the former being the reading of news as well as posts to analyze the entire attitude more subjectively.

Quantitative approaches use specially designed software to read the text through keywords organizing it into positive, negative, or neutral scoring.

Why Use Sentiment Analysis for Forex Trading?

There are several reasons why incorporating sentiment analysis can give forex traders an edge:

  • It provides a unique perspective. Even though both technical and fundamental analyses are based entirely on objective data and statistics, sentiment analysis focuses on human psychology and emotions. As a result, it provides traders with a broad spectrum of information not covered in the other analyses .
  • Sentiment Analysis Indicates Turnpoints. Moreover, sentiment analysis’ most incredible feature is its ability to detect changes. What is challenging for other indicators and analysis is manageable for this one; it will alert a trader to an overly moody mood that is working against the forecast or suggests that the forecast will be accurate .
  • It complements the standard forex analysis. Although it, by no means, is sufficient to drive forex analysis on its own, combining sentiment analysis data with other standard forex analysis indicators and metrics helps traders improve their read of the markets. This is possible because when several different types of analysis indicate the same trend, there is a higher likelihood of the trend being accurate. Therefore, sentiment analysis provides a greater variety of analysis combinations, increasing the likelihood of the final forecast being right.
  • It gives an information edge Most retail traders don’t employ sophisticated sentiment models and end up simply chasing price momentum. But tracking composite sentiment data gives traders a potential information advantage by allowing them to position trades ahead of major sentiment shifts.

How to Apply Sentiment Analysis

There are several ways through which forex traders can include a sentiment analysis in their trading:

News Monitoring

Follow major economic, geopolitical, and other news that have an impact on currencies. Seek analyst consensus forecast and position of traders to discover sentiment extremes that are about to form prior to the release of major news. Make a collection of primary news sources to check daily.

Social Monitoring

Get into popular forex trading forums, chat rentals, and social networks’ channels. Keep an eye on general sentiment themes, issues that are hot topics, rumors and comments from traders plus expert opinions. Look for bullish vs. bearish keyword ratios that relate to particular currencies and pairs.

Broker Reports

Most brokers as well as major banks make regular trader surveys and publish sentiment indicators as an analytical tool to their clients. Always subscribe to these reports and use them to evaluate sentiment perspective for specific currencies and pairs.

Paid Sentiment Tools

Now there are a lot of paid software services that conduct news monitoring from major sources, monitor social trading networks in real time and analyze tweet sentiments. They also include the analysis of forex orders flows.

These types of tools get a score based on how intricate they derived it. This can help save time and make it consistent compared to manually monitoring multiple targets for every couple.

Combined with other technical and fundamental analysis, sentiment data should be used to determine optimal entries, exits, and position sizing. It can help traders buy currencies with strong positive sentiment after a pullback or short currencies when sentiment turns overly frothy.

For example, a currency pair may have positive buy signals from the technical chart patterns, favorable fundamental factors, and growing bullish sentiment from news and social sources. This convergence of analysis could present a high-probability, low-risk buying opportunity.

Limitations of Sentiment Analysis

Like any analytical approach, there are some potential pitfalls and limitations to using sentiment analysis that traders need to be aware of:

  • It is hard to fully quantify sentiment as it is tautological and subjective to an extent.
  • In price lingo, and because markets are mass psychology, sentiment can be more resilient to mean reversions.
  • The inputs into sentiment such as news, data, social media do not always capture the “smart money” or the large money. *Extremes do not always trigger reversals and sentiment is meaningless when there is uncertainty.
  • Subtle sentiment changes are not sufficient to adjust trading positions as it would lead to overtrading.

However, to truly derive the most utility from sentiment analysis, traders should continue refining their sentiment models and sentiment-based strategies over the long term. This includes developing, testing, and backtesting strategies that use sentiment across various market cycles and environments.

Case Study

Example To demonstrate how a forex trader might use sentiment analysis to great effect, let’s create a fictional scenario:

In early 2023, the Japanese yen had been falling steadily against the U.S. dollar due to a combination of rising U.S. interest rates and the extremely accommodative policies of the Bank of Japan . USD/JPY had rallied from the 110s to 140 since the start of the year. By Mid-March, despite the continued strong dollar sentiment, extreme bearish yen sentiment was at least near its maximum for contrarian traders on various measures.

The yen sentiment was overwhelmingly negative on trading forums, financial news websites, and hedge funds. International traders and Japanese citizens alike had borne the brunt of the consumer price and economic data for well over half a year.

Yen short positioning from hedge funds was at multi-year highs, based on CFTC data. Quantitative sentiment models gave their most bearish readings for yen in years. But the USD/JPY pair was at a multi-year major resist zone, forming a double top.

USDJPY had rallied into 140 resistance. But it had failed to break through despite such a strong dollar sentiment.

Key momentum indicator RSI and others had reached very overbought. For a contrarian trading sentiment, the confluence of gravity was enough for a strong dollar trade sentiment from yen to near an overextended bearish ultra sentiment for position.

After briefly cracking above 140, USDJPY reversed hard into the following weeks over the next two months. The yen would end up rallying over 8% from those highs when short positions were covered hard. A sentiment trader could have played out the overextended trade with this kind of major sentiment reversals using the sentiment analysis platform.

Does Sentiment Analysis Really Work?

The most critical question for traders is whether sentiment analysis works and helps increase trading performance. A study published in 2015 by a group of researchers from Hong Kong investigated whether sentiment data could be advantageous in forex trading over a multi-year horizon .

This research team built sentiment scores for eight currency pairs on the basis of news and Twitter posts through several complex classification models. They discovered that the intraday trading strategy and the sentiment indicators produced statistically higher yields over the test phase.

It was not only due to more frequent trading either: the sentiment models cut trading intensity and transaction expenses. As the researchers observed, currencies with the most positive sentiment scores were rising over the next several days, while those with negative scores were dropping .

Thus, their findings support the concept of employing new sources of sentiment data to develop vital trading strategies.

The Bottom Line

As with most investments and trading strategies, using sentiment analysis offers potential benefits and risks that need to be carefully considered.

It may be simply another source of noise and data overload if used indiscriminately. However, for the disciplined forex trader who can track and model sentiment in a mechanistic manner with other technical and fundamental factors, it becomes a useful complementary tool.

Forex traders who monitor and analyze the dominant mood among other traders, investors, specialists, and the general market herd can even get ahead of the major market sentiment moves.

When combined with a solid risk management strategy and used in the proper framework, sentiment analysis provides a significant information advantage in an ultracompetitive forex environment.

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