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CO08 - What is Sentiment Analysis?

"When you look at the general price of a security, what you see is not just price but also the sentiment among the investors. Typically, when investors are optimistic, this is reflected by higher asset prices. Conversely, when investor sentiment is pessimistic, this is reflected by weaker or lower asset prices. In the same way, assets tend to behave differently depending on the prevailing sentiment. Therefore, sentiment analysis is a study of the different markets, the risky and the safe haven assets. Using sentiment analysis and the different markets, investors are able to tell whether the general sentiment is positive or negative. Depending on the sentiment, certain assets perform better compared to the others. The same holds true in the forex markets as well. There are some currencies and securities that perform better when the market sentiment is negative and there are some currencies that perform better when the market sentiment is positive. In this article, we show you what is sentiment analysis and how to use it."

You might have heard about fundamental analysis and technical analysis in forex. These are the two main approaches to understanding price of the currency pair that you are trading.

However, there is another type of analysis known as sentiment analysis. As the name suggests, sentiment analysis deals with understanding the investor sentiment. Emotions, as you know play a big role in the markets.

The price of a security basically changes and reflects the investor or trader sentiment behind the security. For example, when investors are bullish, meaning that they expect the price of the security to rally, or to appreciate in value, they tend to push the price higher.

Similarly, when the investor sentiment on a security is bearish, it means that they expect the price of the security to fall or depreciate in value. But sentiment analysis is not just about understanding whether the markets are bullish or bearish.

Sentiment analysis requires investors or traders to analyze different asset classes. As you might know, the financial markets are broadly divided into two categories:

Risk assets: The risk assets are generally comprised of stocks and other derivatives. These are risk assets. But at the same time, the risk assets also have a higher return. Therefore, when investors are feeling bullish or optimistic about the markets, they prefer to buy or hold the risk assets. This will give them the option to get higher returns.

Safe haven assets: The safe haven assets on the other hand comprise of securities that are not very risky. A good example of safe haven assets includes bonds or fixed income markets.

Bonds are basically debt instruments issued by governments and corporates. Among the two, the government bonds are the safe haven assets because they are backed by the credibility of the government. Thus, such bonds are known as safe haven or risk free assets.

Besides bonds, you also have some other assets such as gold and silver which act as a safe haven asset. Among currencies, the Japanese yen and the Swiss franc are two currencies known as safe haven currencies.

Sentiment analysis requires traders to be adept in using inter market relationships. This helps traders to know what securities can outperform depending on the sentiment in the market.

Risk on Risk Off Sentiment

There is a term called the risk on or risk off sentiment in the markets.

A risk on sentiment is where the markets or the investors are bearish on risk assets. When the market sentiment is inclining towards a risk off, it means that investors prefer to buy the safe haven assets rather than hold the risky equity assets.

A risk off sentiment is generally very bullish and, in this scenario, investors prefer to buy the risky equities. In most cases, the risk off sentiment occurs more than the risk on sentiment.

Markets tend to switch between these two modes of risk. The market sentiment is usually triggered by some external factors such as news that wasn’t discounted already or some unforeseen event. Even weather which can damage one’s economy can influence whether the markets are in risk on or risk off.

Therefore, with sentiment analysis, traders try to ascertain the general state of the investors. When investors are happy and optimistic, they prefer to take on more risk, meaning that the risk is on and the equity and other risky assets perform much better.

As a trader, when you understand the sentiment in the market, you can expect certain currencies and assets to behave in a certain way.

Below is a quick table for some currencies and assets that perform based on whether the market sentiment is in a risk on or a risk off mode.

   Market Sentiment//Asset 

   Risk on 

   Risk off 

   Gold 

   Underperforms 

   Outperforms 

   Equities 

   Outperforms 

   Underperforms 

   Bonds 

   Underperforms 

   Outperforms 

   JPY, CHF 

   Underperforms 

   Outperforms 

An interesting thing to note about the U.S. dollar is that it behaves as general safe haven currency. This is usually the case when the market sentiment is influenced by events outside the United States.

For example, if there was an economic crash in some country outside the U.S., you can expect the USD to outperform and behave as a safe haven asset currency. On the contrary, when there are internal events within the United States, the USD acts the opposite, meaning that the USD behaves as risky asset.

Market sentiment is a unique way to trade the financial markets. It makes use of the inter market relationship and gives insights into how the sentiment of the general investor is. Using this information, traders can find opportunities in the safe haven or the risy assets.

Read 964 times Last modified on Thursday, 04 July 2019 11:19

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