When Does A Sentiment Trade Become Invalid?

Trading sentiment can be very rewarding, but it can also be challenging as short-term sentiment can change very quickly and be quite fickle.
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Trading Sentiment – The Switch From A Valid Trade To No Longer Valid

Just a quick question here from Amir, asking when exactly does a sentiment trade become invalid?

So Amir said that he entered into an Aussie/Australian dollar trade this morning. He was in a winning trade before oil prices moved lower and caused the U.S. dollar to spike. So he closed out the trade for a loss, only to see the price move higher later in today’s session.

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So looking at sentiment, Amir, we need to keep in mind that sentiment can be fickle sometimes. It can change very quickly, and often with lots of momentum. So it’s always good to remember that risk oftentimes happens slowly, and then all at once, which can be tricky to navigate.

So the easiest way to analyze when sentiment has changed, is if there is a catalyst that changes the sentiment or goes against the reason for entering the trade in the first place. That’s usually the clearest signal that the bias has changed, and we should get out of that trade, and look for other opportunities. The more tricky part comes in when there aren’t any major clear catalysts changing the sentiment, but just price action or inter-market movements distorting the current buyers.

So looking at the example, you would have noticed in our video for today, our dominant theme was when upside bias in the Australian dollar versus the Swiss franc. However, our bias for the Australian dollar versus the U.S. dollar signaled a neutral bias, as we saw a lot of strength coming into the safe havens like the U.S. dollar as well as the Japanese yen, with that downside we saw in oil prices.

So the main reason for the strength that we saw in the U.S. dollar and the Japanese yen wasn’t clear. But based on the reaction that we saw across asset classes, the most probable cause for that, was the weakness that we saw across the board in the oil complex, with both WTI and Brent Crude breaking through those important support areas.

Now, with this upside bias seen in the U.S. dollar in a very short space of time, let’s quickly have a look at the dollar index. We saw a massive move to the upside in a very short space of time. The prudent thing in that environment was to expect a neutral bias in the risk zone, until we got a clearer driver or a stronger risk flow coming back into the market. So that only occurred of course, later in the session as the dollar completely reversed its move that it made earlier in the session and we saw the Aussie dollar heading higher in the session, as well as the Kiwi dollar actually leading the fact to the upside and for the rest of the session.

So on days like today, it is more tricky to gauge exactly when the sentiment is shifted, but it’s always best to stay on the prudent and the careful side, instead of holding on to something, when there are clear signs that the market might be trading the other way, or at least when we have strong moves against our expectations, showing that the sentiment might have moderated.

So of course, in hindsight, after seeing how price reacted, you could say that, okay, yes but you should have kept that trade on in terms of the Aussie dollar versus the U.S. dollar, the position that you had. But personally, with all the counter signals that we were seeing in the market, I think that you made the right decision to cut that trade.

But on another trading day, you know with similar environments, we might have seen a complete reversal of the risk zone, with this move just continuing to the downside. Which means you might have taken a much bigger loss in another trading day, compared to today’s smaller loss that you took by closing out that position.

So it all does come back to probabilities and always sticking with a predefined process whenever you have a specific bias in a pay, and something happens in the market and everything moves against it. If nothing changes, obviously hold onto that position if there’s no clear catalyst.

In the case of today, we had a very strong move to the downside in oil prices, which caused that move to the upside in safe havens and downside in the commodity based currencies which was enough reason for us to take a neutral stance on that. So personally, I think you made the right decision there.

Obviously as I said in hindsight, it’s always easier to say that you know, you maybe should have held onto it, but again in another environment, it might not have been that case.

 

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