Sentiment as Signal: Forecasting with Alternative Data and Generative AI

How to Use Alternative Data and LLMs to Generate Alpha

Quantitative trading based on market sentiment is a less developed area compared to traditional approaches. With the explosion of social media, advances in computing resources, and AI technology, sentiment-based trading is making progress. In this issue, I will explore some aspects of sentiment trading.

Web-only posts Recap

Below is a summary of the web-only posts I published during last week.

Volatility Spillover Between Developing Markets

Decomposing the Variance Risk Premium: Up and Down VRP

An Options Pricing Model for Non-Frictionless Markets

Use of the Real-World Measure in Portfolio Management

Can AI Trade? Modeling Investors with Large Language Models

Credit Risk Models for Cryptocurrencies

Using ChatGPT to Extract Market Sentiment for Commodity Trading

A Large Language Model (LLM) is an advanced AI system trained on vast amounts of text data to understand, generate, and analyze human language. In finance, LLMs are used for tasks like analyzing earnings reports, generating market sentiment analysis, automating financial research, and enhancing algorithmic trading strategies.

Reference [1] examines the effectiveness of ChatGPT in predicting commodity returns. Specifically, it extracts commodity news information and forecasts commodity futures returns. The study gathers over 2.5 million articles related to the commodity market from nine international newspapers across three countries, covering a diverse set of 18 commodities.

Findings

-A novel Commodity News Ratio Index (CNRI) was developed using ChatGPT, derived from the analysis of more than 2.5 million news articles from nine international newspapers across 18 commodities.

-The CNRI effectively forecasts commodity futures excess returns over 1- to 12-month periods, demonstrating significant predictive power in both in-sample and out-of-sample regression analyses.

-ChatGPT was used to classify sentiment in commodity-related news as either positive or negative, based on headlines, abstracts, or full article content.

-The CNRI shows stronger forecasting accuracy during specific macroeconomic conditions—particularly economic expansions, contango market phases, and periods of declining inflation.

-This ChatGPT-based approach outperforms traditional text analysis methods, including BERT and Bag-of-Words, in predicting future returns in commodity markets.

-The study controlled for various business variables and economic indicators, confirming the independent predictive significance of the CNRI.

-Results indicate that the CNRI also holds macroeconomic insight, offering valuable signals on broader economic performance beyond commodity markets.

-Findings affirm the utility of ChatGPT in financial forecasting, showcasing the broader potential of LLMs in understanding and extracting actionable intelligence from complex financial text data.

-This research highlights the growing role of AI in finance, illustrating how LLMs can enhance decision-making for investors, analysts, and risk managers alike.

In short, ChatGPT proves useful in forecasting commodity market dynamics and provides valuable insights for investors and risk managers.

Reference

[1] Shen Gao, Shijie Wang, Yuanzhi Wang, Qunzi Zhang, ChatGPT and Commodity Return, Journal of Futures Market, 2025; 1–15

Using the Number of Confirmed Covid Cases as a Sentiment Indicator

COVID-19, the novel coronavirus, was a source of anxiety for markets and individuals around the world since its outbreak in December 2019. Many traders looked for ways to use the information on the spread of the virus to predict market movements.

In Reference [2], the authors established an intraday algorithmic trading system that would open a short position in the Eurostoxx 50 futures market if the number of new confirmed cases of Covid-19 increased in the previous day (suggesting that fear of the epidemic rises), and close by afternoon. The system will open a long position if the new confirmed cases of Covid-19 have decreased from the previous day. The trading system achieved an annual return of 423% and a Sharpe ratio of 4.74.

Findings

-Daily confirmed COVID-19 cases were used as a sentiment proxy, reflecting public fear and uncertainty in financial markets during the pandemic.

-Researchers built an intraday trading system for Eurostoxx 50 futures, responding to increases or decreases in new Covid-19 cases reported the previous day.

-The system opened short positions after rising case counts and long positions after declines, closing trades by the afternoon to reduce overnight exposure.

-This simple rule-based strategy delivered an annual return of 423% and a Sharpe ratio of 4.74, suggesting strong performance under extreme market stress.

-The study demonstrated that pandemic-related health data could serve as a reliable short-term predictor of market direction, especially during crisis periods.

-Results reinforce the idea that emotional triggers—like health fears—can impact trading behavior just as much as traditional economic indicators or financial models.

-During high-uncertainty environments, metrics that reflect collective anxiety, such as COVID-19 cases, can outperform classic sentiment tools like the VIX index.

-The strategy showed how non-financial data can be directly translated into market actions, offering practical tools for risk-aware investors and quant traders.

-Overall, the research contributes to behavioral finance by quantifying the influence of fear on asset prices in moments of extreme public concern.

The article presented new evidence that emotions have an impact on financial markets, especially in situations of extreme uncertainty. In these situations, investors may utilize a variety of investment techniques based on metrics reflecting the progression of fear.

Reference

[2] Gómez Martínez, R., Prado Román, C., &CachónRodríguez , G. (2021). Algorithmic trading based on the fear of Covid-19 in Europe, Harvard Deusto Business Research 10(2), 295-304.

Closing Thoughts

Together, these studies highlight the growing role of alternative data and AI-driven sentiment analysis in financial forecasting. From pandemic case counts to millions of news articles, both fear and information flow can shape markets in measurable ways. Whether through rule-based trading or LLM-powered indices, the findings underscore how emotion, uncertainty, and unstructured data are becoming key inputs in modern investment strategies.

Educational Podcast

Trading on Sentiment with Richard Peterson

In this video, Richard Peterson offers a deep dive into the world of sentiment-driven trading, blending neuroscience, behavioral psychology, and market data. His insights reveal how emotions, social media chatter, and even environmental cues can shape market movements in subtle but powerful ways.

Richard Peterson has been analyzing sentiment for over 20 years. He started what was probably the world’s first fund specializing in sentiment trading, and now runs a company called MarketPsych, specializing in the collection and analysis of sentiment data.

Around the Quantosphere

-Quantitative hedge funds on track for worst month in five years, says Goldman Sachs (Tradingview)

-It's business as usual for Jane Street, at least globally; hiring mode on, no mention of SEBI order on site (Moneycontrol)

-How to get a risk management job in banking and finance (Efinancialcareers)

-How to get a job in a hedge fund (Efinancialcareers)

-Bitcoin's Volatility Index Shows Record 90-Day Correlation with S&P 500 VIX (Ainvest)

-Quant Hedge Funds Are Losing Money — And No One’s Quite Sure Why (businessinsider)

-The man behind a Toronto hedge fund that revived meme mania (yahoo finance)

Recent Newsletters

Below is a summary of the weekly newsletters I sent out recently

-Behavioral Biases and Retail Options Trading (10 min)

-The Rise of 0DTE Options: Cause for Concern or Business as Usual? (11 min)

-How Machine Learning Enhances Market Volatility Forecasting Accuracy (11 min)

-Predicting Corrections and Economic Slowdowns (11 min)

-Rethinking Leveraged ETFs and Their Options (12 min)

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