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Track Market Sentiment to Understand Price Cause and Effect

I’m willing to bet that a lot of newer traders are having a hard time understanding the cause and effect relationships that seem to be taking place in the markets these days. I’ve seen questions asking things like “Why did the dollar fall when the economic data was positive?”. Today”s moves by the European Central Bank (ECB) and Bank of England (BOE) probably caused some confusion as well. The ECB cut rates but the BOE held steady, yet the euro rallied sharply while the pound fell. Someone who looked only to those headlines with the view that lower rates = weaker currency would have missed what the market was really focused on – the quantitative easing.

The Relationship Between Data/Events and Price Action is Not Fixed or Logical
I’m not about to spend this post talking about the ins and outs of currency rates and central bank policies. That’s a discussion for another venue. The point I want to make is that new traders often take things very literally when it comes to data and news. Good data means better prices. Bad data means lower prices. While this is sometimes the case, often it isn’t, which I know can be very confusing. Sometimes even experienced professionals do really know why the market is moving a certain way. Logic doesn”t always seem to apply to the way the market reacts to things, and those reactions can vary, so while positive figures today could be taken bullishly, tomorrow they might be bearish.

Keep foremost in your mind that the market is an anticipatory mechanism. The press loves to say that stocks lead the economy by 6-9 months. It works that way on a more micro day-to-day level as well.

Markets are Foward Looking
Think about the trading or investing process. It is basically one where someone makes a positioning decision based on expected prospects for the future. That could be a rate cut by the central bank, quarterly earnings for a company, a merger, a new drug getting approved, a projection coming from a technical pattern break, or any one of a thousand other things. All of them involve a look into the future in some fashion or another.

The market basically aggregates the forecasts of participants. That means if the majority of players and/or positions reflect a view that the Fed is going to cut rates by 25 basis points then when the Fed cuts that much it probably won’t have a major impact on the market. If the Fed doesn’t cut, or cuts by 50bps then there is a reaction because folks have to adjust to the new information.

Keep Track of Sentiment
Of course you can never really know how everyone is positioned relative to a certain data release or news item, and there are always cross-currents between trader timeframes, existing positions, and strategies. Having a general idea of the sentiment of the market, however, can help avoid getting caught by surprise with the market doesn’t react the way logic would suggest.

Tracking sentiment, though, isn’t about following some index. It’s about listening to what people are saying about the markets and what kind of forecasts are being made for a specific data item or event, like company earnings. The more tightly forecasts are around a central point, the more likely the market will probably not react with much vigor if the data comes in at or near that point.

By John

Author of The Essentials of Trading

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