the gestalt shift

What is sentiment and how to profit from it

How price and events show sentiment

Most macro instruments follow sentiment rather than fundamental factors such as supply and demand. The problem with strict fundamental analysis is that the economic data is very noisy and doesn’t provide a clear relationship of cause and effect between information and exchange rates. Furthermore, the efficient nature of such markets as foreign exchange makes it difficult to trade based on this information when everyone else knows it as well. It is often touted that currencies trend for very long times and thus we can stick to the fundamental trend and be profitable. Well, we all know what happens to those who follow the crowd (especially those souls who did so in Q3 2008).

The trader’s job is to anticipate what the focus of the market could potentially become. Events and information entering the world will cause the major drivers of the market (hint: central banks) to make decisions which will move the market. When information and events begin to suggest that the focus as evidenced by the current positioning of the market may change to a new concern, a stronger than 50 % chance that price will adjust presents itself.

Enter the concept of sentiment. Any macro trader worth his salt will tell you that timing the market is rather difficult because of the randomness that pervades price movement. However, we can come close by using sentiment as an indicator. Suppose that the Euro has been climbing due to good news coming out of Europe and dismal economic figures coming out of the U.S. Eventually, even as more good news comes out of Europe, the single unit simply ranges at current levels. Before long, one piece of good data comes out of the US such as a Chicago PMI (Purchasing Manager Index) and then the Euro falls quickly. What happened? Shouldn’t good news be good for the currency? This is sentiment in action. Every piece of information that enters the market is discounted long ago by instiutional traders and their research teams. What matters is how they “feel” the rate of return on a currency position could be. This depends on what their focus is. The focus shifted entirely in the above example, and we could see this by observing how the market reacted to the same, recurring information. This is the gestalt shift on a small scale.

A sentiment change can be gauged by several means:

• If price falls on good news the sentiment is negative
• If price spikes up on good news but cannot breach an important level and comes back down, sentiment could become negative
• If news headlines start to change focus to something that could affect the health of the economy but price is just ranging after a big steady rally, sentiment is worried and could easily become outright negative
• If an event or statement ocurrs that devastates the currency and then occurs again except worse, but the currency unit does not make a new low, sentiment is positive and the market is looking for a catalyst to drive up price.

I hope this helps explain sentiment better. This is an important topic and I’ll write more on it later. In the mean time I’ll leave you with some market wisdom. John Maynard Keynes once remarked,

“we devote our intelligence to anticipating what average opinion expects the average opinion to be”

Wednesday, April 8th, 2009, by kristophm and is filed under "Uncategorized ". You can leave a response here, or send a Trackback from your own site.