What No One Tells You About Markets Sentiment ?

After gaining a knowledge base in fundamental analysis has to be converting that knowledge into action. A key weakness often mentioned in using fundamental analysis is that it is thought of as being too macro a viewpoint. Fundamental forces are perceived to not be actionable for day-to- day and minute-to-minute trading. This is a false viewpoint. Fundamental forces are not abstract concepts. They act on prices through a transmission mechanism: sentiment. Sentiment acts like gravity and exerts a force shaping price direction.

Applying the concept of sentiment provides a necessary increase in granularity to detect what is actually happening with price action. For example, the conventional description of a currency pair is that it is bullish or bearish. Traders describe prices as being in an uptrend, downtrend, or in consolidation. Further frequent descriptions are that the trend is being probed or broken. Moreover, the price may be in a bullish trend but retracing. All these descriptions are not inaccurate, but they are incomplete. These descriptions share a major weakness; they are low resolution and need a great deal more confirmation to become actionable in creating trading signals. A better approach is understanding sentiment as the energy behind the price action. The price action rides the sentiment.

First, let us clarify what is meant by sentiment in this context. Sentiment is defined as containing a set of emotions. For example, a person can have a positive sentiment about an upcoming vacation. A trader can have a bullish sentiment about the direction of a price. Sentiments contain emotions which are about something. When we try to assess the sentiment that is being reflected in a currency pair, the trader needs to be careful in attributing the correct emotion to the price action. The currency pair, or market, does not have any emotion. Currency pairs have no goals. Currency pairs are not conscious entities. But they have a function, which is rather a reflection of emotions. Bullish or bearish patterns are caused by different sentiments or emotions result in the pushing and pulling of the price. It is a tug-of-war. Sideways patterns reflect a balance of expectations waiting for new catalysts to skew the sentiment. Currency pairs are seesaws of emotions reflecting an ongoing battle of expectations.

When sentiment analysis is used it brings an unprecedented depth of insight into price action. The language of sentiment analysis is itself different from the language and expressions emerging from candlestick analysis. With sentiment analysis one perceives markets. There are no bullish or bearish trends. Rather, there are bullish or bearish emotions and expectations. We can also call them bullish or bearish waves (or wavelets?). How these emotions are expressed will, of course, be detailed. This vantage point allows the trader to focus precisely on what the price is doing rather than where it may be going. Sentiment analysis filters out subjective factors and variables that would only distract the trader. With sentiment analysis the most important time frame is the now.

This focus on sentiment has a profound impact on trading tactics. The traders become like surfers; they spot a wave and jump on at the optimal point. They ride it without any predefined notion of how far they will ride that wave. This is hard to achieve psychologically. In fact, if the surfer had any a priori intentions on what that particular wave would be doing and how it would be moving, he would not last long. Another similar instructive example for forex traders is the western rodeo. Yes, watching a rodeo cowboy riding a bull and trying to last eight seconds without being thrown off is a remarkable example of sentiment-based tactics. The fact is that the cowboy is thrown off when he wrongly anticipates which way the animal will sway, and as a result is left on the floor. In a similar way, the forex sentiment trader can be understood as participating in a virtual forex rodeo, where putting on a trade is riding the bullish or bearish currency pair!

The forex trader who uses sentiment as the framework for trading is in every sense surfing forex sentiment waves or riding in an FX Rodeo! The exact trading tactics for sentiment trading are detailed in Set-Up link. For now, let us get a handle on visualizing sentiment.

1. Visualizing Sentiment

If currency pairs reflect sentiment, just how can the trader diagnose and detect the prevailing sentiment? Let us start with candlesticks; the commonly used representation of price action. Candlesticks (similarly, bar charts) show open, close, high and low, price points at any time slice (one minute, one hour, etc.). Candlesticks, when grouped together, do provide a signature of a variety of emotions at that point in time. But they also generate a lot of noise. A famous candlestick, the Doji, provides a signature of hesitation. Yet it is not clear whether that emotion of hesitation is predictive of the coming moves. 

Candlesticks

The problem with candlesticks is that they generate a great deal of noise and a wide range of possible interpretations. Where is resistance? Is it above the high wicks or at the candle body close? Likewise, where is the support? Is it below the low wick, or is it at the low close? Subjective conclusions are clearly needed. An additional challenge of candlesticks is the difficulty in mastering all of the patterns and then converting that knowledge into tradeable action. Sentiment analysis presents an alternative to using candlesticks. The objective in using sentiment analysis is to filter the noise and to measure, more objectively, the degree of sentiment in the market. This alternative charting is known Line Break, and Renko charting. Let us explore some of the key features of these charts.

Line Chart

Line charts only show the close of the price and are like maps outlining boundaries in the price action. 

Price Break Charting

Price break charting filters the price action in a specific way.

Here is how it works. The trader selects a slice of time, for example, one hour. Unlike candlesticks, the chart will only show whether the price has closed at a new high, or a new low. The chart system will check every hour. If there is a new low or a new high close, a line is added. This creates a block. If the price has not registered a new low or new high close, then no new line is added. So, we see in chart that the white blocks represent a new high close. 

Generic price break chart

All of the black blocks represent a new low close. Remember, it does not show how high or how low the price actually went (as the wicks in candlesticks do), it only shows the successful close. All we care about knowing is whether the price has had an ability to close higher or lower. Attempts by a price to go higher or lower, but only to close below the previous high or low close, are not recorded. Only successful attempts to achieve new high closes or new low closes are what these charts will show. We care about successful attempts at closing new high or new lows because this inherently represents a level of strength in the sentiment.

2. Reversal of Sentiment

Another key property of line break charts is the cause of a color change in the block. A block will switch colors when a reversal of sentiment is triggered. A bullish reversal of sentiment (black is followed by a white block; Chart, Point B), occurs when the price closes above the three previous high closes. A bearish reversal of sentiment (white is followed by a black block; Chart , Point A), occurs when the price closes below the three previous low closes. Line break charts are defaulted at three and therefore the trader does not have to count the blocks.

A legitimate question is why is three lines the threshold used to trigger a reversal confirmation? The answer is that number three is common criteria for measuring a stable event. For example, three confirmations in technical analysis is considered sufficient to confirm a failure to break resistance or support. A triangle, with its three vertices, offers great stability. Three lines back provides a reasonable assurance that a reversal is strong enough and is in fact occurring. Setting the reversal threshold to four makes it a stronger confirmation because the price has to go further to trigger a reversal. However, it will require more time. Going down to two lines increases choppiness. Three lines is in the Goldilocks zone.

3. Why are line break charts so impactful?

By showing only whether the price is achieving a sequence of new high closes, or new low closes, the trader can instantly assess the strength of the sentiment. A strong bullish sequence will mean that the energy in the market has made it possible for the price to progressively and sequentially achieve new high closes. A strong bearish sequence, where there are several new low closes, instantly reveals that bearish emotions are in control. There is no ambiguity. Candlesticks are not necessary.

Line breaks provide a quick and objective view of bullish and bearish and reversal conditions, for any time frame, from a day to one minute, sentiment can be measured.

Let us explore the following example of a multi-time frame sequence of line break visuals for the currency pair USDJPY. We will evaluate and compare the day, four-hour, one-hour, 15-minute, five-minute, and one-minute line break charts.

Day 3 Line Break Chart

Starting with the day time frame (Chart), we see that the three-line breaks clearly show a sequence of bearish new low day closes, followed by a larger reversal (white block). The bullish sentiment is therefore strong. The trader looking for a direction has permission to look for a buy. Remember that each block is NOT registering one day. It only registers when a new day high or low close has occurred or reversed.

Four-Hour 3 Line Break Chart

The next step is to scroll down a time frame to a slightly lower slice of time than one day. Some traders can choose eight hours, six hours, or even four hours. The point is to get some further confirmation of the sentiment that is dominating the market. Did the sentiment shift? Let us look at the four-hour, three-line. 

This time frame visualizes whether the price is able to be persistently closing new four-hour highs, or new four-hour lows. This four-hour three-line shows a strong sequence of new high closes. In fact, there were eight sequential new four-hour high closes, which is very powerful! The trader can conclude that the sentiment is sustaining a bullish move. There is no strong evidence of any bearish sentiment at this point. A willingness to buy is supported.

JUST when would a trader look to be buying? Not yet. We need to drill down to a shorter time frame that allows us to diagnose the more near term sentiments that are acting upon the prices. Let us drill down further to a one-hour, three-line. 

The one-hour chart shows an interesting dynamic. We see that there was a bearish push down with five consecutive one-hour new low closes. But the bullish sentiment was countered and was strong enough to cause a reversal back towards the direction of the four-hour bullish sentiment. This is very significant. A one-hour reversal into the direction of the four-hour line break chart can be an immediate buy order! We have an alignment of a lower time frame with the direction of the higher time frame! Such an alignment is a key principle of trading with sentiment analysis. Does the trader stop at the 1 hour 3 line break chart, or should there be further magnification of the sentiment at lower time slices such as the 5 minute or 1 minute 3 line break charts? The answer depends on whether one is trading intra-week, intra-day, or even intra-hour. As the trading duration reduces, the time frame appropriate to use can be lower than 1 hour. But the key principle is an alignment of a lower 3 line break time frame with a higher 3 line break time frame.

Line break charts are powerful detectors of sentiment conditions and effectively guide traders to being on the right side of the direction.

4. Renko Bricks

A visualization of sentiment is not complete without detecting whether the price can move in persistent distances. While a line break shows only movements of new high, new low closes, and reversals, Renkobricks show the capabilities of the price to move a predetermined measured distance. The question that Renko bricks answer is whether the price is able to move in a sequence of five, or ten bricks. The time setting recommended is one minute to achieve a high resolution of whether the direction is changing. If the feed is a tick feed, then the setting can be at a tick level. The reason for a 10-pip setting as a default is to obtain evidence at a micro level of what the sentiment is and whether there is a gathering threat.

For gold, oil, and other indexes, the settings should be a percentage of the price, such as 1%.In the example of Chart one can immediately see, without the noise of candles, that the price action is persisting in a bullish direction. It’s important to note that this is a snapshot, and in real time a Renko brick will not form until there is movement in either direction of the prescribed distance (10 pips). 

There are several benefits of looking at Renko charts. First, they filter out the noise within a time frame that is considered quite noisy using candlesticks. For example, look at the comparison of the one minute candlesticks with the one minute Renko bricks at a 10-pip size setting. The candlestick chart shows swings and gives the impression of uncertainty in the bullish move up. Whereas, in contrast, the Renko charts show no interruption of the bullish persistence. They filter out the noise. A more accurate depiction of sentiment strength of the price movement is being shown and quantified. Sentiment becomes understood as the ability of a currency pair to move a predetermined size, per minute !

5. Comparison of Candles and Renko

Let us explore, from a biological perspective, why sentiment analysis using Renko bricks is effective. If one went to the doctor and had an infection, a lab test by measuring the white cell count would show if the infection was declining or increasing. Similarly, Renko bricks provide a visualization of the sentiment against an existing trade. It is a virtual lab test of the threat to the health of the trade! Consider the situation where a trader is long a currency pair and has reached a level of profits in pips that causes the trader to want to take the profits. Most traders would exit a position once it has reached a predetermined take profit target, only to see that the position continued to higher levels of profits. With Renko bricks the trader can easily determine if the micro-sentiment was, in fact, in the trader’s direction. The trader would stay in until the bricks showed movement the other way!

6. The Fundamental Knowledge Grid

By combining fundamental with sentiment analysis, we can now complete the Fundamental Knowledge Grid (Table). This is inspired by the work of Abraham Maslow. He is famous for his hierarchy of needs describing the priorities that humans face, from needing food to actualizing their personalities. Likewise, our claim is that there is a hierarchy of knowledge currency traders need to actualize on their path to professional trading. We can call it the Fundamental Knowledge Grid. It describes the core components of fundamental analysis and tops it off with understanding sentiment conditions and sentiment alignments, leading to the trading signal. Navigating this hierarchy of knowledge about fundamentals and sentiment the trader will be ready for trading the currency markets.

Hierarchy of sentiment analysis	Key questions
Trading signal confidence	What is your ranking of the alignment from a scale of 1–5
Sentiment alignment	Is the lower line break chart aligned with the higher line break chart and with the Renko bricks?
Sentiment conditions	Are equity markets risk-on, or risk-off?
Balance of fears	Is there a fear of inflation, stagflation, deflation, recession? Or geopolitical risks?
Central bank policies	Is the central bank in an easing, neutral, or tightening mode?