Two forms of analysis dominate the market place as you may very well know; Technical and Fundamental Analysis. Those in favor of a sentiment based approach to trading believe that fundamental analysis is fundamentally flawed. But rather state that it is emotions or sentiment that lead the markets.
Some of those that have promoted the sentiment based approach point to the fact that 90% of Forex trades involve the US dollar, so you would suppose that it would be possible to work out a clear correlation between US economic indicators and the value of the US dollar against other currencies. But it appears that no such link exists, if such a link did exist we could correctly assert that are decisions were led by rational thought rather than emotion. In my opinion the US dollar is not just effected by US economic indicators but it is also effected by US indicators relative to the indicators in other countries. Though it is clear that sentiment does play a role in the movements of currencies.
Those in favor of sentiment based trading have used scientific evidence to back there claims. Claiming that is evidence shows that the rational parts of are brain overridden by our emotional urges and that this can be clearly explained by evolutionary biology quoting works in the field.
The Argument for Sentiment Based Approach to Trading: What’s Wrong With Fundamental Analysis
”As a primitive tool of survival, emotional impulses from the limbic system
impel a desire among individuals to seek signals from others in matters of
knowledge and behavior and therefore to align their feelings and convictions
with those of the group.”1
The claim lies that even if we do understand what the economic indicators seem to suggest, we are led by our brains to follow the lead of the market place. As we naturally follow the herd and align are convictions with the rest of the group (the group being the trend in the market place).
Through analysis of historic data many who argue for adopting a sentiment based approach to trading have shown what would normally be considered key indicators of how an financial instrument may move do not have the kind correlation you would expect. If decisions were made on a truly rational basis. It is often the case that there is no consistent correlation between one economic indicator and currency prices, it would seem that those arguing for a sentiment based approach are onto something. But it is important to remember not to be blind to such indicators as sometimes these news about these indicators will move the market much in the way expected. Understanding and using sentiment can be one of the tools in your trading arsenal and in further posts we will explain some of the things those in favor sentiment based trading suggest you look for.
1.R. R. Prechter, Jr., The Wave Principle of Human Social Behavior
(Gainesville, GA: New Classics Library, 1999), 152
