The Role Of Sentiment Analysis In Forex Trading – According to a recent Bank for International Settlements (BIS) report, there is, on average, nearly $6 trillion in foreign exchange transactions daily. With so many participants – most of whom are trading for speculative reasons – gaining an edge in the forex market is crucial.
Fundamental analysis provides a broad view of a currency pair’s movements and technical analysis defines trends and helps to isolate turning points. Sentiment indicators are another tool that can alert traders to extreme conditions and likely price reversals, and can be used in conjunction with technical and fundamental analysis.
The Role Of Sentiment Analysis In Forex Trading
Sentiment indicators come in different forms and from different sources. One is not necessarily better than the other, and they can be used together or specific strategies can be tailored to whatever information you find easier to interpret.
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Sentiment indicators show the percentage, or raw data, of how many trades or traders took a given position on a currency pair. For example, suppose there are 100 traders trading a currency pair; if 60 of them are long and 40 are short, then 60% of traders are long on the currency pair.
When the percentage of trades or traders in a position reaches an extreme level, sentiment indicators become very useful. Suppose our aforementioned currency pair continues to rise, and eventually 90 out of 100 traders are long (10 are short); there are too few traders left to continue pushing the trend higher. The sentiment indicates that it is time to start watching for a price reversal. When the price moves lower and shows a sign that it has reached a top, the sentiment trader goes short, assuming that those who are long will need to sell to avoid further losses as price falls.
Sentiment indicators are not exact buy or sell signals. Wait for price to confirm the reversal before acting on sentiment signals. Currencies can remain at extreme levels for long periods of time and a reversal may not materialize immediately.
“Extreme levels” vary from peer to peer. Let’s say the price of a currency pair has historically reversed when the buy reaches 75%; when the number of longs reaches that level again, the pair is likely to be at an extreme and you should watch for price reversal signals. However, if another pair has historically reversed when around 85% of traders are short, you will watch for a reversal at or before that percentage level.
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A popular tool used by futures traders to get a sense of sentiment is also applicable to spot forex traders. The Commitment of Traders (COT) report is released every Friday by the Commodity Futures Trading Commission (CFTC). The data is based on positions held on the previous Tuesday, which means the data is not real-time but is still useful.
Interpreting the actual publications released by the Commodity Futures Trading Commission can be confusing and somewhat artistic. Therefore, mapping the data and interpreting the levels shown is an easier way to assess sentiment through the COT reports.
Barchart.com provides an easy way to plot COT data along with a specific futures price chart. The chart below shows the Daily Continuous Euro FX futures contract with a Traders Commitment Line Chart indicator added. COT data is not displayed as a percentage of the number of short or long traders, but rather as the number of short or long contracts.
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Large speculators (green line) trade for profit and are trend followers. Traders (red line) use the futures markets to hedge and are therefore countertrend traders. Focus on large speculators; although these traders have deep pockets, they cannot resist losing trades for long. When many speculators are on the same side of the market, there is a high probability of a reversal.
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During the time period shown, when large speculators were short around 200,000 contracts, at least a short-term rally soon followed. This is not a definitive or “timeless” extreme level and may change over time.
Another way to use COT data is to look for crosses. When large speculators move from a net short position to a net long position (or vice versa), it confirms the current trend and indicates that there is still more room to move.
Although the crossover method is prone to giving some false signals, over the years several big moves have been caught using the method. When speculators move from net short to net long, look for the euro futures price, and by extension the EUR/USD, to appreciate. When speculators move from net long to net short, look for the price of futures and related currency pairs to depreciate.
The forex market is “over-the-counter” with independent brokers and traders across the world creating a non-centralized market. Although some brokers publish the volume produced by their clients’ orders, it does not compare to the volume or open interest data available on a centralized exchange such as a futures exchange.
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Statistics are available for all futures traded, and open interest can help gauge sentiment. Open interest, simply defined, is the number of contracts that have not been settled and open positions remain.
If, say, the AUD/USD currency pair is trending up, looking at the open interest in Aussie dollar futures provides additional information about the pair. Increased open interest as price rises indicates that the trend is likely to continue. Leveling off or declining open interest signals that the uptrend may be coming to an end.
The data then must be applied to the forex market. For example, strength in euro futures (US dollar weakness) will likely continue to push EUR/USD higher. Weakness in Japanese yen futures (US dollar strength) is likely to push USD/JPY higher.
Information on futures volume and open interest is available from the CME Group and is also available through trading platforms such as TD Ameritrade’s
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To provide transparency to the over-the-counter forex market, many forex brokers publish the aggregate percentage of traders or trades that are currently long or short on a given currency pair.
The data is only collected from the clients of that broker and therefore provides a microcosmic view of market sentiment. The sentiment reading published by one broker may or may not be similar to numbers published by other brokers. Small brokers with few clients are less likely to accurately represent the sentiment of the entire market (composed of
Brokers and traders), while larger brokers with more clients make up a larger share of the entire market and are therefore likely to give a better indication of overall sentiment.
Many brokers provide a sentiment tool on their website for free. Check multiple brokers to see if sentiment readings are similar. When multiple brokers show extreme readings, it is highly likely that a reversal is near. If the sentiment numbers vary significantly between brokers, this type of indicator should not be used until the numbers line up.
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For example, it publishes a free customer opinion report combined with analysis and ideas on how to trade the data.
Forex sentiment indicators come in many forms and from many sources. Using various sentiment indicators in conjunction with fundamental and technical analysis provides a broad view of how traders are maneuvering in the market. Sentiment indicators can alert you when a reversal is near due to an extreme sentiment reading, and they can also confirm a current trend.
Sentiment indicators are not buy or sell signals on their own; look to the price to confirm what sentiment it is indicating before acting on the sentiment indicator readings. Losing trades still occur when using sentiment. Extreme levels can last a long time, or a price reversal can be much lower or higher than sentiment readings indicate.
Does not provide tax, investment or financial advice and services. The information is presented without regard to the investment objectives, risk tolerance or financial circumstances of any particular investor and may not be suitable for all investors. Investing involves risk, including the possible loss of principal.
What Is Market Sentiment? Definition, Indicator Types, And Example
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