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Exploring the role of Sentiment Analysis in Day Trading

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Originally Posted On: Exploring the role of Sentiment Analysis in Day Trading – Stockgeist


Stock market sentiment analysis provides day traders with the tools necessary to understand the attitude of investors towards specific companies, sectors and markets. The recent boom of GME and AMC is testament to the importance of sentiment in determining the price movements of a stock, especially when the price movements appear contradictory to the fundamentals.

Sentiment has a limited life span. It is impossible to predict exactly when it will change. It can last in a particular phase anywhere from a few seconds to several weeks.

The emotions and actions of traders are not always driven by reasoned and sound logic. Market sentiment indicators prove to be invaluable as an investment tool because of the irrationality of traders, whose corresponding responses to fundamental changes aren’t necessarily proportional to the initial movement.

The fundamental value of a stock refers to company-specific business performance, and is typically associated with a long-term buy-and-hold strategy.

Sentiment analysis provides an alternative perspective when analysing a stock performance, and is often associated with short-term trading methods.

Stock sentiment consists of analysing the feelings, emotions and reactions that surround a stock. Analysing this crowd psychology provides sentiment traders with the opportunity to profit from short-term price movements caused by investor reactions. Whilst it is the fundamental foundations that will dictate the long-term price potential for stocks, it is the emotional reaction of traders that typically drives the immediate market into either bullish or bearish territory.

A bearish market sees stock prices sliding, whereas when the bulls are in control, stock prices are on the rise.

Types of Stock Sentiment

Risk-on is when traders and investors are not greatly concerned about any economic or geo-political issues relating to the financial markets. This results in market participants ‘profit hunting’ by taking more risk. They move their capital from safer assets into riskier assets to seek these greater rewards. This is due to the typical inverse relationship between risk and reward. In general, the more risk one takes, the more reward one can expect to receive.

Risk-off is simply the opposite of risk-on. It is where traders and investors are concerned about one or multiple economic or geo-political issues. This causes them to move their capital from riskier assets into safer or ‘safe haven assets. A ‘safe haven’ is an asset that investors typically flock to in times of uncertainty and thus they tend to appreciate in price in these scenarios.

Effect of sentiment on different asset classes

Risk-on and risk-off effects different asset classes in typically predictable ways. In times of risk-on sentiment, equities markets (such as the S&P 500 equity index) tend to go up since equities are seen as a riskier asset. Fixed income (such as T-notes, the US government 10-year bonds) go down because they are seen as a safe haven. Safe haven currency pairs, including the US Dollar (USD), the Swiss Franc (CHF) and the Japanese Yen (JPY), decrease when risk-on sentiment is present. Whilst currencies that are seen as riskier, such as the Pound Sterling (GBP) and the Euro (EUR) appreciate.

Gold typically goes down due to it acting as a safe haven, however it should be noted that a key factor that influences the price of gold is the movement of the US Dollar. At times, for example during periods of 2020 and 2021, the main factor impacting gold was USD movement. So if risk-on sentiment caused USD to decrease, gold would in fact increase because gold and the USD have an inverse relationship. This relationship comes about from the fact that if USD depreciates, USD denominated assets (which includes gold) become relatively cheaper to international (non-US) market participants, thus incentivising them to buy gold in light of the USD depreciation.

Oil is largely unaffected by changes in risk-on and risk-off sentiment as it tends to move more on oil-specific factors. However, sometimes risk-on sentiment can impact its price if that sentiment is caused by a relevant factor. For example, in 2020 when investors started to become positive about the prospects of the global economy re-opening, they not only held a general risk-on sentiment but also a bullish view on oil. This was because the global economy reopening would result in a greater use of and therefore demand for oil, hence the risk-on and bullish oil sentiment were intertwined in this scenario.

Risk-off sentiment tends to result in the opposite directional movement to that described above for risk-on for each of the asset classes discussed.

Real time sentiment analysis

There are many different stock sentiment features available to view for greater, in-depth insights on a particular stock using the dashboard. Real-time sentiment analysis helps traders to understand current discussions regarding stocks, helping them to understand why the market is reacting as it is to recent updates and changes. This appreciation for the current mindset of investors provides a useful tool when attempting to understand the nature and extent of short-term price changes to expect. It is this understanding that often dictates whether sentiment traders will enter or leave the market at any given time.

From a fundamental analysis perspective, there were no obvious drivers for the 1700% gain in the GME share price in January 2021. The video game and consumer electronics high street shop had seen sales falling 30% over the previous two years, racking up over $1 billion in losses. The flailing video game outlet market combined with the pandemic that closed malls all over the country presented a bleak trading future for the retailer. However, as a result of the coordinated and well-executed short squeeze of the reddit r/wallstreetbets ‘apes’, the GME stock price soared exponentially, despite the bleak fundamentals.

Long Term Sentiment Analysis

Sentiment analysis over a lengthier period of time is often undertaken by traders looking to spot trends in the emotional reactions to fundamental changes. By spotting these trends, traders seek to gain a competitive advantage when reacting to short-term price changes in the wake of news, updates or fundamental changes for publicly listed companies.  The desired competitive advantage is fuelled by the expectation that past emotional reactions can be used to plot future reactions. Investors are assumed not to be perfectionaly rational in their activities. However, by spotting trends in their emotion-led trading activities, especially in times of high volatility, it is expected that future patterns can be predicted and that profitable trading opportunities will present themselves as a result of the bullish or bearish reactions from fellow traders.

The Role of Sentiment Analysis in Trading

Sentiment analysis data is subject to interpretation from the trader, and should not be taken in isolation as a timing signal to take action. When used in conjunction with fundamental analysis of factors such as the price/earnings ratio, sentiment analysis can help to provide a holistic understanding of the current trends that dictate market price changes.

Without sentiment analysis, the human aspect of traders can prove to be an intangible factor when analysing stock performance. By offering analytical and statistical measures of emotion, sentiment analysis provides traders with an opportunity to trade rationally in amongst a sea of hysteric investors responding frenetically.

Markets driven by fear or greed offer greater short term profitable opportunities in comparison to stable and rational markets to traders who can separate the wheat from the chaff when it comes to discussions surrounding stocks.

Sentiment analysis is not a binary advisory tool that offers quick-money opportunities to the layman trader. When utilised effectively, stock sentiment analysis provides expert day traders with the ability to cut through the general noise to get access directly to the real-time investment opportunities.

Whilst it is difficult to master, sentiment analysis should form part of every day trader’s analytical toolkit. Understanding the driving motivators behind the current market movements provides the best footing to predict what the market will do next.

StockGeist provides traders with real-time stock sentiment data, helping users to understand the discussions surrounding 2200+ publicly listed companies on social media and within news articles. Sign up for an account to get ahead of the competition and to start understanding the market in real-time.

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