Combining Market Sentiment with Technical Analysis

Have you ever executed a trade that seemed ideal based on your chart analysis—clean break of a trendline, substantial volume—but it nonetheless failed, because you were in the wrong market mood? Technical analysis provides you with structure (patterns, levels, indicators), but if you do not have a grasp of how others feel and how it can create unseen turns, then you fail to see the whole picture.

To have the right mindset, you need to combine yourself with market sentiment to see both the skeleton and the soul of the market. In this article, I will discuss why combining these two offers better signals, how to read the two, and how to develop those signals without falling into traps.

What Is Market Sentiment & Why Is It Important

Before we combine, let's clarify the existing two parts as to their meaning.:

• Market Sentiment is the collective feelings of participants regarding a market—Bullish/Bearish/Fearful/Greed. It is the measure of expectations, emotions, and collective psychology.

• Technical Analysis involves the study of historical price action (charts, indicators, patterns, support/resistance) to find the most probable outcome, either a move or a reversal.

Sentiment often leads us, or exaggerates moves, which the technicals then reflect. When sentiment gets too bullish or bearish, technical levels will bust through or violently reverse. Understanding sentiment tells you in advance if a technical setup has a better chance of working—or failing!

Standard Sentiment Tools & Indicators

To combine sentiment with technicals, you need a reliable feed on how traders are positioned. Here are some common sentiment tools based on traders' positions and what others are saying:

• Retail positioning data: Reports from brokers about how many traders are long vs short.

• COT (Commitment of Traders) report: Information about hedgers, speculators and significant funds' positions.

• News sentiment/headlines: What the financial press and social media are talking about.- Surveys and investor polls: These can be slow to show up, but can give a sense of the larger mood.

- Volatility and implied volatility (e.g. the VIX in equities): When fear rises, this can also lead to increased levels of volatility.

Key Components of Technical Analysis

While sentiment deals with the feel of the market, technical analysis is about giving you a little structure. Some key components are:

- Trendlines, Support & Resistance: Key levels that act as zones where price will often stall or reverse. 

- Chart Patterns: Double tops and bottoms, head and shoulders, flags and pennants.

- Momentum Indicators: RSI, MACD and Stochastic oscillators showing strength or exhaustion.

- Volume: Viewing volume levels as a means of confirming the move; a price break under a support level with high volume is a more likely reversal.

- Moving Averages: Moving averages can give clearer trend direction and dynamic support/resistance.

How to Incorporate Sentiment with Technical Analysis

Here is the way in which you can effectively combine the sentiment and technical analysis:

1. Technical Set Up

Start analyzing any potential trading setup as a first step with technical analysis and a focus on trend reversals, breakouts, zones of support and resistance and so on.

2. Sentiment Context

Once the technical level has been found, you will then check the sentiment context using those sentiment tools to see if traders are heavily bullish or bearish, or if the sentiment context is more positive than would usually be expected, or negative than would usually be expected based on media commentary.

3. Confirmation/Divergence

o Confirmation: In this case, sentiment aligns with the technical level found (e.g. price at resistance + turning sentiment bearish).

o Divergence: In this case, sentiment, in comparison to price levels, is not aligned with the current price trend (e.g., there is bullish price action happening, but sentiment is now softening or contrary signals are being found), thus signalling a weakening trend or possible reversal.

4. Be Precise When Placing Orders

Avoid placing trades solely because of technical analysis. Sentiment could provide far greater advantages over time, depending on sentiment extremes, changes in positioning, or a candle/pattern confirming the level.

5. Use Risk Management

Sentiment can change on a dime. Be sure to always have a stop loss in place. You also want to limit your trade size and have an exit plan for any changes in sentiment.

Example Situations

To clarify sentiment extremes, consider two made-up situations:

Bullish Breakout with Bearish Sentiment

• Imagine that a currency pair breaks above a resistance line, while the RSI also indicate momentum is breaking to the upside.

• The only problem is that the sentiment shows that small retail traders are too long on that currency pair and commercial hedgers are starting to add shorts to the position (COT sentiment).

• The technical picture is robust and bullish. The sentiment picture diverges from the bullish breakout. The cautious trader is likely to pause for the bullish breakout to reroute as a retest of resistance, adjusting the trade with a smaller position size, or watching for signs of reversals, such as a large bearish candle to write off the breakout.

Support Test with Oversold Conditions

• Price is dropping into a known support area. In addition to price falling into a support zone, technical indicators, such as the RSI, are indicating that the market (price drop) is becoming oversold.

• Observing sentiment tools, they are indicating extreme bearishness in the news, retail positioning, and sentiment. Perhaps the only involvement in the market is speculative traders, and only a few short positions were opened in the trading environment.

• Therefore, combining the oversold condition with technical analysis and the extreme negative sentiment of traders, their odds of a bounce higher or a potential bottom are the foundation for a reversal trade. The trader would take a reversal trade here with a tight stop or partial entry, all the while looking for indicators of increased market participation, e.g. increased volume while price increases, bullish candle, etc.

Tools & Platforms That Assist

There are many tools provided below, utilizing sentiment, as well as technical analysis, which will be easier to use with the tools below:

•  Your charting software of choice (TradingView, MetaTrader, Thinkorswim) or similar that will allow you to overlay technical indicators and can import sentiment data (or lack of) for all trades.

• A sentiment dashboard that is either provided by your broker/or vendor that offers long/short ratios of retail or professional positioning, like the COT reports.

• News aggregator tools, news sourced from professionals, are less defined and track social sentiment (and comments of the news—counting comments is MANDATORY).

• Back-testing tools that will allow you to back-test the sentiment and technical setup—how many of the trades were winners, how many of the trades were losers, the average pool of drawdowns, etc.

Common Mistakes & Solutions

The ability to blend sentiment in the realm of technical analysis is a valuable tool. Yet, based on our personal experience, some common mistakes can demote or lose their edge to other traders:

• Putting Too Much Weight on Sentiment: When trend trading utilizes sentiment, disregarding everything (even pricing structure), providing overweighting, you could be entering a position too early or being impacted by false sentiment.

• Neglecting Technical Context: Then, even if the market sentiment is "too extreme" in one direction, the price may be firm, trending in the same direction. Technical analysis can push to a price reversal.

• Outdated Sentiment Info: Some of the indicators of sentiment are sentiment indicators (surveys, retail positioning, etc.), you can only measure them daily (weekly, maybe), the market could have already moved, and you missed it.

• Confirmation Bias: If you are "right, I believe the market is bullish (in price), you might read the sentiment data as an additional confirmation even when it wasn't, simply because you believe it, i.e., you really think there is enough "enough...

Best Practice Workflow

To provide a structured workflow and workable example, you looked at a workflow area that many professional traders would find below:

Often, the question comes up, "Why does this work better?"

• Sentiment analysis provides you with psychological value that charts can't offer. It will inform you about what the crowd (investors) believes to be true and where current price levels are expected to head.

• Technical analysis provides you with structure - levels at which price may logically stop, reverse or continue.

• Together, the combination will reduce the occurrence of false breakouts, help you better time the market, and provide a more effective risk-management plan.

Closing

Combining market sentiment with technical analysis does not have to make your signals immediately more complicated; instead, the signals will become easier to interpret. Market sentiment will help you decide if traders are getting crowded into their positions, whether fear or greed is driving the market, and if the current technical setup is being trustworthy, or if the technical setup is likely to fail.

So, the next time you see the chart pattern, do not just mark the line - see what the crowd is saying. If the market sentiment aligns, the trade becomes stronger. If the sentiment isn't in line, then a cautious approach should be a signal for action. By approaching the trade with stricter risk control and looking at sentiment combined with technical analysis, you will have a sturdy edge; half psychology, half structure combined is something to consider to make a more confident investment.