Can we trust market sentiment?
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Brokers have developed many trading tools that highlight their clients' market sentiment on each asset. Market sentiment, for example, tells you that 70% of its customers are buying on the EUR/USD or that 10% of traders have gone bullish since the previous day. Unlike a consensus, the market sentiment is based on the positions held by individuals, it is not a simple survey. Can we trust market sentiment?
For me, the answer is clear, it's NO! These tools are designed to lure novice traders into believing that trading is easy. If everyone is bullish, it means that assets will rise, so you can buy. Whatever happens, do not fall into the trap! Here's why.
In the financial markets, individuals account for a tiny share of the volume of transactions. For example, in Forex, this share is about 1%. It should also be added that market sentiment is based solely on the broker's clients. Even if your broker is the biggest in the sector, he may capture 10 to 20% of all individuals. The broker's market sentiment tool will therefore represent 0.10 to 0.20% of total trading volume on Forex.
In the financial markets, it is not individuals who make the trends! It is hedge funds, banks, etc. Market sentiment for these players would be relevant, but the one on individuals is useless!
On the financial markets, not all players have the same investment horizon. Some are short term, others medium or long term. Market sentiment makes no distinction between these different investors.
If 70% of individuals are bullish on EUR/USD 90% of them might be long term traders. If you deal short term, market sentiment will therefore be totally distorted. A trend can be bullish in the long term and bearish in the short term.
With Forex, an average of 50% of individual traders win their trades. A study conducted on a large number of investors revealed this. So by copying individual trades, you have a 50/50 chance of winning. It's like flipping a coin.
Even if market sentiment indicated that 100% of traders are bullish on an asset, this does not increase the probability of making your trade a winner. It is important not to forget that in the end, it is always the market that decides! You can do the best analysis, your trade will lose if the market has decided. That's why even the best traders have losing trades. It's part of trading and you have to accept it.
On the financial markets, there are good and bad traders! Good traders are those who have taken the time to train well and bad traders are the others. With a market sentiment tool, a bad trader has as much weighting as a good trader. There are more bad than good traders. Using market sentiment, you might therefore copy the positions taken by bad traders.
Most of the time, a bad trader takes a position without having a real buy or sell signal. Either he has not done any analysis (and takes his position on a personal feeling), or he has done some analysis which is not good or is incomplete. For example, he will forget to analyse the upper time unit to identify the asset’s trend.
If after all these arguments you still want to take market sentiment into account that is your right. But don't come crying to me when you've lost all your money. You should neither base your investment decisions on it, nor even include it as an indicator in your trading strategy.
In trading, you have to learn to make up your own mind. The best trading strategy is yours. It is the one that suits you, adapts to your investor profile and that you are able to apply over the long term. Market sentiment is still a sentiment, it is subjective and it will never replace analysis.
For me, the answer is clear, it's NO! These tools are designed to lure novice traders into believing that trading is easy. If everyone is bullish, it means that assets will rise, so you can buy. Whatever happens, do not fall into the trap! Here's why.
1 - Market sentiment is based on a tiny sample of investors
In the financial markets, individuals account for a tiny share of the volume of transactions. For example, in Forex, this share is about 1%. It should also be added that market sentiment is based solely on the broker's clients. Even if your broker is the biggest in the sector, he may capture 10 to 20% of all individuals. The broker's market sentiment tool will therefore represent 0.10 to 0.20% of total trading volume on Forex.
In the financial markets, it is not individuals who make the trends! It is hedge funds, banks, etc. Market sentiment for these players would be relevant, but the one on individuals is useless!
2 - Market sentiment does not take into account the investment horizon
On the financial markets, not all players have the same investment horizon. Some are short term, others medium or long term. Market sentiment makes no distinction between these different investors.
If 70% of individuals are bullish on EUR/USD 90% of them might be long term traders. If you deal short term, market sentiment will therefore be totally distorted. A trend can be bullish in the long term and bearish in the short term.
3 - Market sentiment is based on individuals
With Forex, an average of 50% of individual traders win their trades. A study conducted on a large number of investors revealed this. So by copying individual trades, you have a 50/50 chance of winning. It's like flipping a coin.
Even if market sentiment indicated that 100% of traders are bullish on an asset, this does not increase the probability of making your trade a winner. It is important not to forget that in the end, it is always the market that decides! You can do the best analysis, your trade will lose if the market has decided. That's why even the best traders have losing trades. It's part of trading and you have to accept it.
4 - Market sentiment does not distinguish between good and bad traders
On the financial markets, there are good and bad traders! Good traders are those who have taken the time to train well and bad traders are the others. With a market sentiment tool, a bad trader has as much weighting as a good trader. There are more bad than good traders. Using market sentiment, you might therefore copy the positions taken by bad traders.
Most of the time, a bad trader takes a position without having a real buy or sell signal. Either he has not done any analysis (and takes his position on a personal feeling), or he has done some analysis which is not good or is incomplete. For example, he will forget to analyse the upper time unit to identify the asset’s trend.
Conclusion
If after all these arguments you still want to take market sentiment into account that is your right. But don't come crying to me when you've lost all your money. You should neither base your investment decisions on it, nor even include it as an indicator in your trading strategy.
In trading, you have to learn to make up your own mind. The best trading strategy is yours. It is the one that suits you, adapts to your investor profile and that you are able to apply over the long term. Market sentiment is still a sentiment, it is subjective and it will never replace analysis.
