Sentiment-oriented technical traders trade in response to predictable price patterns (“judge market sentiment”) and are similar to front runners or even effectively act as dealers or order anticipators because they try to trade before other traders. If they offer liquidity to the uninformed traders they are essentially dealers. They therefore accelerate the impact that other traders will have on the price.
Since sentiment-oriented technical traders try to trade before uninformed traders, their trading tends to make prices more erratic - high or low - which then tends to misrepresent a true market price of the instrument in question. This is especially true when they trade into a rising asset bubble.
In many cases sentiment-oriented technical traders tend to decrease market liquidity as follow-on traders then tend to view the increase or decrease in a stock price with concern. Although sentiment-oriented technical traders sometimes improve prices, the additional transaction costs they impose on their victims more than offset the price improvements that they offer to the traders with whom they trade.
Sentiment-oriented technical trading
Sentiment-oriented technical trading can be quite risky because it involves front running uninformed traders. The impacts that uninformed traders have on prices often move prices away from their fundamental values. Such movements attract value traders to the other side of the market. If the value traders trade aggressively, sentiment-oriented technical traders will then lose. Therefore sentiment-oriented technical traders must know when to close their positions. If they hold their positions too long, they will lose when prices revert to fundamental values.
Since sentiment-oriented technical traders tend to lose to value traders, sentiment-oriented technical trading will be most profitable in instruments that are not easily valued. Value traders trade less aggressively in hard-to-value instruments than in instruments that they know well.
Perhaps the best examples of hard-to-value instruments are stocks in developing industries such as the Internet. Their values are hard to estimate because they depend on uncertain technologies and on the development of unknown markets. Since these stocks tend to attract many uninformed traders, sentiment-oriented technical traders may occasionally identify profitable trading opportunities in them. Also, the stocks and bonds of companies in emerging markets may provide such opportunities for similar reasons. - Larry Harris, Author of Trading and Exchanges: Market Microstructure for Practitioners.
Successful sentiment-oriented technical traders
Successful sentiment-oriented technical traders may trade successfully in instruments whose values depend on difficult-to-measure fundamental factors. The three most important factors are:
- Expected inflation
- Future political uncertainty
- The equity risk premium
Stock, bond and precious metal values depend crucially on these factors. Since these factors are very hard to measure, value traders do not know well the fundamental values of instruments whose values depend on them. Therefore, uninformed traders may significantly affect prices in these instruments. Traders who can predict what uninformed traders will do may therefore be able to trade these instruments profitably.
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