The Argument for Sentiment Based Approach to Trading

Sentiment based trading is an approach to trading which rather than trading based on the fundamental and technical analysis, prefers an approach where trades should be made based on the dominant market psychology. Those who extol this approach trading believe what really causes  big movements in the markets is not analysts and traders taking a look at fundamentals and technical charts but rather the instinct of people to follow the crowd. Often those who argue for a sentiment based approach argue that both technical and fundamental analysis is fatally flawed. 

Arguing instead that participants in markets in fact do not make rational objective decisions but rather follow their psychological impulses. Examples where the market has moved against what you would expect from Economic forecasts and figures, they claim are rationalized in order to make it appear that such movements where based on objective facts. Whether these arguments are in fact valid are questionable, though some swear by the sentiment based approach to trading.  

While I agree with some aspects of the sentiment approach to trading, I have some concerns. The increasing rise of algorithmic trading which is not affected by human psychological factors raises some problems for this approach to trading. Plus Sentiment based traders point to examples where news and economic figures have led to counter intuitive results, but seem to largely ignore the times when economic news and figures have lead to results that would be expected. But it is clear that human psychology does play a role in the movements of markets and arguably make the swings more dramatic and for this reason in further posts I’m going to evaluate some of the arguments made those who favor this approach. To examine what is to be learned and to what extent a trader should adopt (if to any extent) a sentiment based approach to trading. 

Part 2  

Part 3


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