Sentiment analysis: what it is and how it works

There are many ways to level up your Forex skills, and identifying trends is one of those methods needed to place successful orders. So, how do you identify a trend? That's where Forex sentiment analysis comes in handy.

Forex requires attention to many details and a thorough analysis of the current market situation. Investors use fundamental and technical analysis to help achieve an ideal balance of being informed while making their own trading decisions. However, there is a third type of analysis—a bit more vague yet just as important.

Forex sentiment analysis plays a crucial role in helping you grasp the overall market sentiment toward a specific asset. In simple terms, it provides a summary of what traders believe about the currency pair—will the price rise or fall? This understanding is key to making informed trading decisions.

Forex sentiment analysis doesn't provide the exact information on when to enter and exit the market, but it does give you extra context to empower actions that best fit your trading strategy. So, how do you identify the Forex sentiment?

What is sentiment analysis?

Sentiment analysis is defined as an attempt by traders to determine how other traders, investors, etc., feel about a particular market or asset. In other words, it's the collective consensus of market participants on the direction of the market, either bullish or bearish.

For example, if traders and investors have a positive sentiment on the Dollar index (DXY), they feel the index should go long. In a similar manner, the pairs that are impacted directly by the dollar index, such as GBPUSD, ought to fall. Therefore, it is vital to gauge the overall market mood beyond technical and fundamental analysis.

Why is sentiment analysis critical?

For decades, market sentiment has been identified as a significant influence on the general direction of a financial instrument. The general collective mood of market participants is vital as it reflects the overall flow of the market. Thus, traders should avoid trading against this general flow of the market. Sentiment analysis helps them stay aligned with the market.

Let's consider a market such as GBPUSD to understand the magnitude of sentiment analysis. Sometimes, the market moves against the outcome of red folder news, such as the FOMC or NFP.

If the general market sentiment for the dollar index is bearish and the major news released, such as NFP, indicates that the data is positive, the traders might anticipate a bullish momentum in the market–dollar index.

However, due to the negative sentiment of the dollar index, the news may have an insignificant impact or even drop against the news outcome. Therefore, it is vital for traders to focus not only on technical analysis but also on other factors, such as the sentiment of the market.

Types of sentiment analysis

Sentiment analysis is like figuring out how people feel about something, and there are different ways to do it. One way is to look at people's words, like whether they say something is good or bad. Another way is to check how people are reacting on social media, like if they're sharing posts that convey excitement or a more worried tone. Understanding these different SA methods helps us know what Forex traders think and feel.

Fine-grained sentiment analysis

Think of it as looking closely at individual opinions. Instead of just saying something is good or bad, fine-grained SA breaks down the feelings into more specific categories. For example, if someone concludes that they love the new trading app, though it crashes sometimes, this analysis looks at both the positive feeling (love) and the negative one (criticism of the crashes). Forex trading helps traders understand the nuances of opinions about a currency or market.

Aspect-based sentiment analysis

This type focuses on specific parts or 'aspects' of a topic. Imagine you're reading reviews about a video game. Some people might love the graphics but hate the storyline. Aspect-based sentiment analysis would identify these features (graphics vs. storyline) and how people feel about each. Forex means analysing different factors affecting a currency, like economic news or political events, to see how traders think about each aspect.

Emotion detection

This is all about figuring out the emotions behind the words. Instead of just saying whether something is good or bad, emotion detection tries to identify feelings like happiness, anger, fear, or excitement. For example, if traders are expressing fear about a currency dropping, that can signal potential market movements. Understanding emotions can help traders anticipate how others might react in the market.

Intent analysis

Intent analysis is a method that looks at what people intend to do based on their sentiments. It's like reading between the lines to see if someone is likely to buy or sell a currency. For instance, if many traders express concern about a currency's future, intent analysis can help predict that they might be planning to sell it soon. This allows traders to make informed decisions based on the anticipated actions of others.

How does sentiment analysis work

In 2016, the UK voted to leave the European Union (Brexit), a decision that surprised many people. The British pound (GBP), compared to the U.S. dollar (USD), dropped significantly after the vote. It hit its lowest point in 31 years because many traders felt pessimistic about what would happen next.

Before the vote, traders used sentiment analysis tools to monitor how people felt about the pound. They noticed that as the vote approached, more and more people were anticipating a negative outcome (negative sentiment). Those traders who paid attention to this negative sentiment could anticipate that the pound would likely drop after the vote. So, they were prepared for the significant changes in the market.

After the initial drop, there were some ups and downs in how people felt about the pound over the next few years. In 2018, negative feelings returned, but by 2019, things started to look better again. Sentiment analysis helped traders understand how people felt about the pound during a big event (Brexit), which allowed them to make better trading decisions. By knowing that many were worried, they could prepare for the pound's drop before it happened.

Sentiment analysis tools

In the world of market analysis, there are numerous sentiment indicators that both day traders and swing traders rely on to gauge the market mood. Some of the widely used tools include:

• VIX 'Fear Index'
• Commitment of Trader (COT Report)

VIX 'Fear Index'

VIX, a sentimental indicator for options traders, is called the 'Fear Index.' The tool measures 30-day expected volatility based on options premiums paid in the popular S&P 500 index. The VIX indicator ranges from 0 to 100. Although the VIX value does not represent a percentage, they are interpreted as such. VIX traders usually look at the 20-level as the market basis; any value below 20 forecasts a healthy and non-volatile market. However, values above 20 indicate higher-risk trading.

Commitment of Trader's report

The Commodity Futures Trading Commission (CFTC) provides the Commitment of Traders (COT) report every Friday.

This report shows the positions opened by three types of traders:

• commercial traders
• non-commercial traders
• small traders

Commercial traders are financial institutions that want to protect their funds from market uncertainties. Their most distinctive characteristic is that they tend to open bearish positions when the price reaches its peak and vice versa.

Non-commercial traders are all about making a profit. They are trend followers and always have open bullish positions when the price is rising and bearish when the price goes down.

Small traders are hedge funds and individual traders who often ignore significant trends and might even go against them.

You can use the COT indicator to help you see the correlation, which usually has three lines for those traders. Non-commercial traders are excellent indicators of trends, while commercial traders can help you identify pivot points.

This indicator won't signal you to enter the market at the exact time, but it will help you tailor your trading strategy and define your trading style.

Forex market sentiment is a great way to analyse the market and help you shape your future actions. Knowing other traders' positions can be a game-changer, so use this information wisely and have very successful trading!

Pros and cons of sentiment analysis

In Forex trading, SA is like reading the mood of the market. Here's why it's helpful:

• Just like you might notice when your friends are about to change their strategy in a game, sentiment analysis helps traders see when the market might change its direction, meaning they can make intelligent moves before everyone else catches on.
• If you already have a trading plan, sentiment analysis can confirm that you're on the right track. If the market's mood matches your strategy, you can be more confident about going ahead with your trades.
• Sentiment analysis helps traders figure out how other people feel about the market. Just like understanding how your friends react to game updates can help you strategise, knowing the market's mood helps traders predict what might happen next.
• Knowing when to jump into or out of a trade is essential, like knowing when to attack or defend in a game. SA helps traders find the best moments to make their moves.
• If everyone is doing the same thing, it might be risky. Sentiment analysis can show if too many traders are buying or selling, which could mean the market is about to change, helping traders avoid getting caught in a bad situation.
• When traders combine sentiment analysis with other tools, they get a clearer picture of the market's activity, which helps them make better decisions about their trades.

While sentiment analysis can be efficient, it has some downsides that traders need to be aware of:

• Sometimes, regular traders (called retail traders) get too excited or too worried about the market, leading to wrong conclusions about how the market will move. If everyone thinks a currency will rise and doesn't, it can mislead other traders.
• Significant events, like economic news or political issues, can happen suddenly and quickly change the market. Sentiment analysis might not catch these sudden changes, making earlier predictions useless.
• Understanding sentiment data can be challenging. If someone is new to trading, they might need to understand the data and make better decisions. It takes practice to read sentiment correctly.
• When too many traders follow each other without thinking for themselves, it can create a situation where everyone is betting in one direction. If that direction suddenly changes, it can lead to significant losses for those traders.
• Sometimes, sentiment data takes time to show what's happening in the market. When traders see a change in sentiment, the market may have already moved in a different direction.
• For some sentiment tools, more historical information is needed to see how well they work over time. With enough past data, it is easier to know if a sentiment indicator is reliable.

Final thoughts

• To be good at Forex trading, you must know how the market feels about different currencies. It is like constantly checking the mood of a group of people talking about money.
• This is called sentiment analysis, which shows if traders are excited (wanting to buy) or worried (wanting to sell) about a currency. If everyone thinks a currency will go up, they're 'net long,' and if they think it'll go down, they're 'net short'.
• Some traders go against the crowd, selling when others buy, thinking the hype will die.
• Tools like the Relative Strength Index (RSI) help you determine whether a currency is overbought or oversold and hint at possible price changes.
• Another helpful resource is the Commitment of Traders (COT) report, which shows what different traders do each week.
• Understanding these feelings and trends lets you make smarter trading choices before others catch on.