Sentiment indicators in the Forex market1

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Sentiment indicators in the Forex market1

 

According to the report of the U.S. FX Market Committee, as of April 2012, the daily volume of trading on Forex is almost 4.3 billion U.S. dollars. Profiting on the market with huge competition because of the huge number of traders, most of whom are speculators, can only be gained by having a serious advantage. Fundamental analysis allows you to assess the overall movement of the currency pair, and technical analysis helps to identify reversal points and the current trend. Critical market conditions and possible reversal points can be determined with the help of the mood indicator, which, together with technical and fundamental analysis, sheds more light on the market situation.

Mood indicators

The sentiment indicator shows the percentage or number of trading operations performed by traders in a certain direction on a particular currency pair. As an example, let’s suppose that 100 traders participate in the trades on a certain currency pair. If 60 traders occupy long positions, and 40 – short, the mood indicator will show that there are 60% of bulls and 40% of bears on the market.

If the percentage of orders opened in one direction reaches critical values, the mood indicator informs the trader about it. Let’s assume that in the above example, the currency pair continues to grow, and the long positions are occupied by 90 traders out of 100 (and the remaining 10 traders, respectively, are short). In this case, there are very few market participants who can support the upward movement of the currency pair, the values of mood indicators become critical, and the trader needs to prepare for the market reversal. If the price of a currency pair begins to fall, and the indicator values become maximum, the trader takes a short position, assuming that the bulls will start to fix profits, fearing further price decline.

The mood indicator itself does not generate buy or sell signals. Wait for confirmation of the turn before opening the position. Currency pairs may be at critical price levels for a long time, so there may not be an immediate reversal. “Critical levels” for different currency pairs are different. If a currency pair has been reversed in the past when the 75% value of the number of long positions was reached, this value is most likely a critical level for it, and it is necessary to monitor the signals of a possible reversal when it is reached. If another currency pair was reversed at the 85% value of the number of long positions, it is necessary to monitor the reversal signals exactly when this value is reached. The mood indicators have a different look and are formed by different sockets. One indicator does not necessarily have an advantage over the other – it can be used together or adapted to a specific strategy, allowing for easy interpretation of the incoming information

Reports about the involvement of traders

This instrument is popular in the futures market, but can also be used among currency traders. The Trader Engagement Report (COT) is published by the U.S. Derivatives Exchange Commission every Friday. The report is based on the data of the previous Thursday and is an extremely useful tool for a trader, despite its relative irrelevance. Correct interpretation of the published numerical data is quite a complicated task, so the graphical display is used, which allows you to easily assess the moods of traders. The Barchart.com website provides graphical price data for futures along with charts of traders’ involvement. Below is the chart of the euro futures (December 2012) with an indicator of the involvement of traders. The data are displayed not as a percentage, but as the number of long and short contracts.

Figure 1: December Euro futures chart

Source: Barchart.com

Large speculators (green line) try to profit from market movements and follow the current direction of the market. Commercial organizations (red line) use futures markets for hedging and, accordingly, trade against the market. Focus on the large speculators, as they do not withstand long loss-making positions. When there are too many speculators on one side of the market, there is a high probability of a reversal. In the above example, as soon as the number of short contracts reaches 200,000, a short-term rally is observed.

This level is not fixed and may change over time. On the Trader Engagement Chart you can search for the so-called “transitions”. When large speculators close net short positions and open net long positions (or vice versa), it is a confirmation of the current trend and indicates the existing space to continue the market movement in the current direction.

Figure 2: Weekly chart of December euro futures

Source: Barchart.com

Despite the fact that this method generates a large number of false signals, its use in 2010-2012 allowed to “catch” a number of large movements. When speculators close net short positions and open net long positions, the signal to action may be an increase in the value of the base currency. If speculators close net long positions and open net short positions, the signal of trend change may be a decrease in the value of the base currency

Amount of existing fixed-term contracts

The Forex market is over-the-counter and decentralized because it is operated by independent brokers and traders from all over the world. Despite the fact that some brokers publish information about the volume of client orders, it is not as useful as information about the amount of valid futures contracts in the futures market.

Information on all futures contracts awarded is available for analysis and can be used to assess current moods. The sum of open positions is the number of unfulfilled contracts, which at the moment remain open. If the value of the AUD/USD currency pair grows, analyze the sum of open positions on the Australian dollar futures. If the sum of open positions grows, it is likely that the upward movement of the currency pair will continue. If the sum of the open positions decreases, it is likely that the uptrend is nearing its end.

Futures price

Amount of open positions

Interpretation
Growing upGrowing upThe strength of the underlying asset
Growing upIt’s going downWeakness of the underlying asset
It’s going downGrowing upWeakness of the underlying asset
It’s going downIt’s going downThe strength of the underlying asset

Table 1: Interpretation of data on the sum of open positions

The same data applies to the Forex market. For example, the growth of futures on the euro (the fall of the U.S. dollar) will most likely lead to the growth of EUR/USD. Fall of futures on the yen (growth of the U.S. dollar) will most likely lead to growth of USD/JPY.

Information on the volume and amount of open positions is provided by CMEGroup and is also available on some trading platforms, such as TDAmeritrade’s Thinkorswim.

Brokerage information about open positions

Many brokers in the Forex market publish summary information on the percentage of short and long positions currently opened by traders for a particular currency pair. The data are provided by brokers only for their clients, which is a tiny piece of information on a market scale. Indicators of current moods of traders of one broker may not coincide with similar data provided by other brokers. Small brokers working with a small number of clients provide data that less accurately reflect the overall market situation. Large brokers occupy the most part of the market and, accordingly, the data they provide is a more accurate assessment of the current market sentiment.

Many brokers place free sentiment information on their websites. Choose a broker if you have not already done so, and compare the data from different brokers and make sure they are similar. If data from several brokers show critical values, we can conclude that the trend reversal probability is high. If the traders’ sentiment data differs significantly among brokers, do not rely on this indicator. Swiss bank Dukascopy provides a whole set of mood indicators. Below is an example of one of these indicators.

Figure 3: Dukascopy Bank Customer Sentiment Index (2 November 2012)

Source – Dukascopy

Some online providers have developed their own mood indicators. For example, DailyFx weekly publishes a free Speculative Sentiment Index (SSI), which contains data on speculative sentiment, as well as their analysis and ideas on possible trading operations.

Results

Sentiment Indicators for the Forex market are published by different sources in different forms. The use of several sentiment indicators in combination with fundamental and technical analysis allows you to better understand the actions of traders in the market. Sentiment indicators can warn of an impending reversal or confirm the strength of the current market movement. Mood indicators do not generate buy or sell signals on their own – you should wait for additional confirmation of reversal before opening a position. When using mood indicators, losing trades are possible, because the period of critical indicator values may be prolonged, or the reversal force may be stronger or weaker than the predicted values.