Market sentiment refers to the collective mood of the market you’re trading.

When sentiment is “negative”, then it can be said that investors in the market are either uncertain, nervous or fearful. When sentiment is “positive” this means that investors are confident and optimistic regarding the future prospects of these investments.

Generally, market sentiment pivots on large-scale events that are likely to have short to medium-term consequences.

For example, a recession in the economy of the EU will likely have a detrimental impact on jobs and growth, which will cause sentiment to turn negative. 

When Is Sentiment Relevant?

Sentiment can be identified by investors when they look at the way in which prices are moving.

Every asset has its predicted behaviours, whether its trending (going up or down) or ranging (where prices generally trade between a specific high and low). Investors try to judge when sentiment is turning by looking at expected behaviour of the markets versus what the market is currently experiencing. When price action is irregular, it can often be indicative of turning sentiment. 

How To Spot A Change In Sentiment

Assets that are considered “safe-haven” assets are great examples of how investors detect a change in sentiment.

Safe-haven assets are considered safe because they are expected to retain or even gain value in times of market uncertainty.

The US dollar is a perfect example of this.

When sentiment is negative, the US dollar tends to rise as investors flock to the greenback because of its perceived safe-haven status. When the US dollar seems to be strengthening without a strong underlying cause related to the US economy, this can often be a clear sign that investor sentiment is turning negative. 

Another gauge of market sentiment is the news cycle, especially the coverage from popular financial papers and business channels. Often, these outlets will tend to pick up on the same themes that they think will influence the markets, and can be both a mirror of market sentiment and a driver of it.

Taking a big-picture view of what is being covered (and how) by news outlets is another important way to gauge market sentiment. 

How Can You Trade Based On Market Sentiment?

The first step to trading based on market sentiment is to identify what you think is the prevailing feeling in the markets, perhaps using the methods described above.

You can then attempt to identify price trends that are in line with what you think the market sentiment is. For example, if you think market sentiment is negative (good for USD) and you also see a possible upwards trend in the price of the dollar, you can look for opportunities to get in long on USD. 

Sentiment can change rapidly, and it’s important to always be on the lookout for events on the ground that could swing sentiment one way or the other. 

How Long Does Sentiment Last?

There is no hard and fast rule that tells investors how long market sentiment is going to last.

The best investors will learn to get a “feel” for the markets, making it second nature to pick up on market moods and behaviours. Investors will then use their knowledge of market patterns, and deviations from those patterns, as an added method of gauging how long sentiment is likely to last. 

What To Look Out For

Market sentiment is a powerful force. It can often take market prices a long way away from what the fundamentals dictate should be the “natural” price of an asset.

Fundamentals will always win out in the very long term, but it’s in between those periods where many traders make their money, and for that, it’s important to understand sentiment.

TIO Staff
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