Combining Sentiment and Technical Analysis for a Swing Trade

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Combining Sentiment and Technical Analysis for a Swing Trade

There is a wide of array of sentiment indicators which you can use to generate trade ideas and confirm trades. One of the most popular ones is the long-short ratio. It shows the percentage of traders who are long and short a particular currency pair. Over time we can see how a currency pair’s price has acted in relation to the percentage of traders who are long or short.

Figure one shows the GBPUSD price (black line) over the last year. The blue graph marks the percentage of long positions.

Figure 1. GBPUSD %Long (left scale) vs. Price (right scale)

Back in December and early January of 2020 the percentage of longs was quite small–in the 30% area. The price makes a double top and then proceeds to head to lower and the number of longs begins to climb again.

Currently, the same circumstances are materializing in the GBPUSD. The long percentage is near 30, but in this case it has been for some time. There is a potential double top in the price, which is very close the price area of the last double top.

This is all evidence that a significant drop is forthcoming in the GBPUSD.

Yet, as traders we don’t have the luxury of just making predictions, we also need a way to enter and exit this trade in a risk controlled way.

I took a short position on November 11 (small red bar third from the right in figure two) as the price made a lower high and began to move to the downside indicating a downtrend had possibly begun.

Figure 2. GBPUSD Daily with Trade, Stop and Target Marked – November 13

The price then proceeded to make a lower low, which helped confirm the outlook.

A sharp rebound on November 13 is putting the trade somewhat at risk though. If this was the start of a downtrend, the price should have fallen a bit further and the rebound should not have been quite as strong. In other words, the pair isn’t acting quite right. Therefore, I’ll need to see how this trade continues to play out. If the rebound continues I may look for an early exit, as it is highly likely I can find another short entry at a different price once (and if) the price is shows signs of weakness again.

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As it stands now though I am short at 1.6014, with a stop loss above the recent swing high, and a target at 1.5775.

The target is based on a Fibonacci Extension, but also provides a reward to risk ratio of about 1.7:1.

This target area is chosen because it allows for a good profit, but there is also a possibility that the downtrend (if it materializes) will experience a pullback around that level. If the price is indeed in for a significant move lower as the sentiment indicates, I can then look for another short entry on pullbacks.

When I took the trade I was expecting a little more immediate strength to the downside to develop. But in trading, you need to roll with the punches and trade what the market gives you. While the trade is currently just in the money, there hasn’t been much follow through to the downside as of yet. In order for this trade to work out, and for me to stick with, I will need to see that selling pressure come in relatively soon.

Also, the long percentage as been near 30% for the last couple months as this potential double top has been forming in the price. Therefore, it is quite possible that the price could continue to channel here for another couple weeks. This is why caution is still warranted even though sentiment and the dropping price indicated the short-side was where to be.

If the price keeps moving higher, I will actively manage the trade, therefore neither the stop nor target are set in stone at this point. If the price does start dropping, it may not be possible to get the same entry point I have, which potentially increases risk the lower the price drops since it will be further from the stop level.

This is not a recommendation to buy or sell. It is simply how I have constructed a current trade and the thought process and tools I used to come up with a game plan. The stop on this position is quite large; therefore, pay special attention to position size. No trade should expose your account to more than 1% risk if your stop is hit (see Determining Binary Options Position Size).

How to Combine Fundamental and Technical Analysis

Fundamental and technical analysis can complement one another

Fundamental and technical analysis can be combined to provide a holistic trading strategy. Traders often compare the differences between fundamental and technical analysis , however blending the two can have positive benefits. Although there are no hard facts as to which style of analysis is superior, combining the two may lead to more definitive trade choices. This article will explore various ways how to combine fundamental and technical analysis using practical examples.

Ways to combine fundamental and technical analysis

There are numerous ways of combining fundamental and technical analysis. Below are examples of how three different technical analysis methods can be combined with fundamental analysis to provide richer insights including:

  1. Combining range bound trading with fundamental analysis
  2. Combining breakout trading with fundamental analysis
  3. Using oscillators with fundamental analysis

Range bound trading with fundamental analysis

Range bound trading attempts to identify a price channel of a market, by which a trader uses to buy at the lower trendline support and sell at the higher trendline resistance.

The chart below shows a strong bullish (upward) trend on EUR/USD . In a strong up-trending market, traders are looking to enter or buy at the lowest possible level to maximize on the strategy. However, news events can disrupt a range bound market. In this case, the trader would look to avoid open trades around the time of the news release (poor ‘retail sales’ and ‘durable goods orders’ figures). The chart shows clearly this disruption as indicated, after which the price level returns to preceding range bound levels.

Breakout trading with fundamental analysis

A breakout trade strategy involves capitalising on prices of an instrument moving outside of a predefined trading range; often catalysed by news events.

While range traders should remain cautious when going into news releases (since additional volatility could pierce support and/or resistance with which they are using to set their stops), they can still look to take advantage of overreactions to news. Traders in these situations would want to wait for news or data to cause price to reach support and/or resistance – and once a test of either of these levels are put in – could look to buy or sell accordingly. Traders can look to trade breakouts with any of the prescribed mechanisms of support and resistance, with the anticipation that news releases could bring in the wanted volatility to a) trigger into the trade b) move the trade closer to the trader’s profit target (limit).

Using oscillators with fundamental analysis

Oscillators are a frequently used technical instruments, usually to discover short-term overbought/oversold conditions. In the chart above, I have included an example of using an RSI indicator (technical indicator) in conjunction with a Non-farm Payroll (fundamental indicator) data release, one of the most significant fundamental indicators in US history. The NFP figure was lower than estimates, which caused the USD to weaken as depicted by the strong bullish move on EUR/USD . When NFP is due to be released and you expect it to be lower than estimates based on recent events in the US, then this would mean EUR/USD could become more volatile so potentially a good choice to sell and vice versa. Oscillators can further assist with entry and exit points and their respective timing.

Blending Technical and Fundamental Analysis

People often ask if technical analysis can be used as an effective substitute for fundamental analysis. Although there is no definitive answer whether technical analysis can be used as a whole substitution for fundamental analysis, there is little doubt that combining the strengths of both strategies can help investors better understand the markets and gauge the direction in which their investments might be headed. In this article, we’ll look at the pros and cons of technical analysis and the factors that investors should consider when incorporating both strategies into one market outlook.

The Best of Both Worlds

Some technical analysis methods combine well with fundamental analysis to provide additional information to investors. These include:

1) Volume Trends: When an analyst or an investor is researching a stock, it’s good to know what other investors think about it. After all, they might have some additional insight into the company or they might be creating a trend.

One of the most popular methods for gauging market sentiment is to take a look at the recently traded volume. Large spikes suggest that the stock has garnered much attention from the trading community and that the shares are under either accumulation or distribution.

Volume indicators are popular tools among traders because they can help confirm whether other investors agree with your perspective on a security. Traders generally watch for the volume to increase as an identified trend gains momentum. A sudden decrease in volume can suggest that traders are losing interest and that a reversal may be on its way. (See also: Gauging The Market’s Psychological State.)

Intraday charting is growing in popularity because it enables traders to watch for spikes in volume, which often correspond with block trades and can be extremely helpful in deciphering exactly when large institutions are trading. (See also: Volume Oscillator Confirms Price Movements and The Pros And Cons Of Institutional Ownership.)

2) Tracking Short-Term Movements: While many fundamental investors tend to focus on the long haul, the odds are that they still want to obtain a favorable buy-in price and/or a favorable selling price upon liquidating a position. Technical analysis can be handy in these situations as well.

More specifically, when a stock punches through its 15- or 21-day moving average (either to the upside or the downside), it usually continues along that trend for a short period of time. In other words, it is largely an indicator of what to expect in the coming term. Incidentally, 50- and 200-day moving averages are often used by chartists and some fundamental investors to determine longer term breakout patterns. (See also: Moving Averages.)

For those looking to time a trade or to solidify a favorable entry or exit price in a given stock, these types of charts and analyses are invaluable.

3) Tracking Reactions Over Time: Many fundamental analysts will look at a chart of a specific stock, industry, index or market to determine how that entity has performed over time when certain types of news (such as positive earnings or economic data) has been released.

Patterns have a tendency to repeat themselves, and the investors who were lured (or put off by) the news in question tend to react in a similar manner over time.

For example, if you take a look at the charts of various housing stocks, you’ll often see that they react negatively when the Federal Reserve chooses to forgo a cut in interest rates. Or check out how home improvement stores tend to react when reports of new and existing home sales decline. The reactive move lower is pretty consistent each time.

In short, by analyzing historical trends, investors can ballpark the possible reaction to a future event. (See also: Why Do Stock Prices Change following News Reports?)

The Downside to Blending

Technical analysis may also provide an inaccurate or incomplete perspective on a stock because:

1) It’s History: While it is possible to decipher and anticipate certain movements based on patterns or when a particular stock crosses a major moving average, charts cannot usually predict future positive or negative fundamental data—instead they are heavily focused on the past.

However, if news leaks out that a company is about to release a good quarter (for example), investors might be able to take advantage of it and this good news will be apparent in the chart. A simple chart cannot provide the investor with crucial long-term fundamental information such as the future direction of cash flow or earnings per share.

2) The Crowd is Sometimes Wrong: As mentioned above, it’s nice to buy into a stock that has upside momentum. However, it is important to note and understand that the crowd is sometimes wrong. In other words, it is possible that a stock that’s being accumulated en masse this week may be under heavy distribution the next. Conversely, stocks that are being heavily sold this week may be under accumulation in the weeks to come.

A terrific example of the “crowd is wrong” mentality can be found in the large amount of money that went into technology shares at the turn of the millennium. In fact, money kept flowing into shares of companies such as CMGI or JDS Uniphase, as well as a number of other high-tech issues. When the bottom dropped out, the money flow into these stocks and the stock markets on which they traded dried up almost overnight. The charts did not indicate that such a harsh correction was coming. (See also: The Madness of Crowds.)

3) Charts Don’t Typically or Consistently Forecast Macro Trends: Charts also are generally unable to accurately forecast macroeconomic trends. For example, it is nearly impossible to look at a major player in the oil and gas sector and decipher definitively whether OPEC intends to increase the amount of oil it pumps, or whether a fire that just started at a shipping facility in Venezuela will affect near-term supplies.

4) There is Subjectivity: When it comes to reading a chart, a certain amount of subjectivity comes into play. Some may see a chart and feel that a stock is basing, while another person might see it and conclude that there is still more downside to be had.

So who is right? Again, there’s no calculation that can be done to solve the argument, as might be the case with fundamental analysis. When it comes to charting, only time will tell which way the markets will actually go.

Bottom Line

Technical analysis can be a valuable tool, but it is important to realize the benefits as well as the limitations before diving in. There is no definite answer about whether technical analysis should be used as a substitute to fundamental analysis, but many agree that it has its merits when used as a compliment to other investing strategies. (See also: The Basics of Technical Analysis.)

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