Sentiment trading uses retail trader data to measure sentiment and forecast trends based on trader market positions. The sentiment is the mood or tone of the market and a measure of how traders expect prices to move soon.
Experienced traders combine technical and sentiment analysis to make trading decisions. They often take a contrarian approach, trading against the trend. This typically happens when sentiment indicators show that a change in market direction is imminent. A trading strategy that uses data gleaned from technical analysis with insights from forex sentiment could be a winning combination.
How Do Forex Market Sentiment Indicators Work?
Forex market sentiment indicators gauge market sentiment and show how investors are positioned. Sentiment indicators are grounded in the belief that traders’ sentiment drives market trends. They quantify trader sentiment, presenting the figures graphically for easy visualization. Forex indicators look at several areas, including news, social media and put and call options. Traders combine forex sentiment with technical analysis when buying and selling forex. It is a strategy that enhances profits and mitigates risk.
How to Apply Forex Sentiment Indicators
Sentiment indicators are easy to use. Here is how it is done.
- Select a sentiment indicator: Choose one or more indicators to suit your trading strategy.
- Analyze the sentiment indicator: Use these to understand current market sentiment.
- Consult other market analysis tools: Use sentiment indicators to confirm trading decisions. Traders should make trading decisions based on technical analysis.
The Commitment of Traders Report
A weekly report published by the Commodity Futures Trading Commission (CFTC), the Commitment of Traders (COT), provides traders with data about the futures positions of large traders. COT helps traders to gauge market sentiment and understand market dynamics. It can help to identify upcoming market trends.
The report has three categories, showing the net positions of each group in various futures markets. The net position is the difference between the number of long and short positions. Traders identify potential market trends by analyzing the changes in the net positions.
Contrarian Methods with Sentiment Indicators
If you’ve chosen to follow a contrarian position, you’ll trade contrary to the market sentiment. When the market is overly bullish, contrarian traders take a bearish stance. They do this believing that the market is overbought and due for a correction.
Contrarian trading with sentiment indicators requires discipline, patience and risk management.
Volatility Index (VIX)
A measure of S&P 500 index volatility, the VIX is also known as the Fear Index because the VIX rises when there is market uncertainty and falls when markets are stable.
The VIX shows the weighted average of S&P 500 options. The numbers are shown as a percentage based on the prices of options contracts. The VIX represents the expected annualized change in the S&P 500 index over the next 30 days.
Traders can use the VIX to identify opportunities where the VIX and the S&P 500 index diverge. If, for example, the S&P 500 index is rising, but the VIX is also rising, it may indicate market uncertainty with a potential reversal imminent.
Example of Successful Use of Forex Market Sentiment Indicators
The Brexit referendum took place in June 2016 in the U.K. The prevailing market sentiment was that the U.K. would remain in the European Union. Still, the COT report and currency option pricing showed rising numbers of investors betting on the "Leave" vote.
As the referendum drew closer, the sentiment indicators showed a clear shift towards the "Leave" vote. Contrarian traders watching the sentiment indicators took a bullish stance on the British pound. They believed the market underestimated the likelihood of a "Leave" vote.
The U.K. vote to leave the EU caused a significant drop in the pound’s value. Contrarian traders who had taken a bullish stance profited.
Advantages of Using Forex Market Sentiment Indicators
Forex market indicators can help traders make sensible decisions and maximize profits. Here are some of the advantages.
- Insight into market sentiment: Traders can make more informed decisions based on the prevailing mood.
- Early warning: Potential market corrections may be revealed.
- Confirmation of technical analysis: Sentiment indicators can validate the technical analysis
- Identify trading opportunities: By identifying when market sentiment is overly bullish or bearish, traders can take a contrarian stance and profit from the market correction.
- Risk mitigation: Traders can better manage their risks when they understand market sentiment.
Limitations of Forex Market Sentiment Indicators
Like all trading tools forex market sentiment indicators also have limitations.
- Lagging indicator: Based on historical data, sentiment indicators lag the trend. They reflect past rather than current or future sentiment.
- Subjective interpretation: The sentiment indicator interpretation may vary among traders.
- Limited market coverage: Some sentiment indicators focus on specific currency pairs or markets.
- Market noise: Volatility and noise make it difficult to get an accurate view of market sentiment.
- False signals: Like any technical analysis tool, sentiment indicators can provide false signals. Traders who rely solely on sentiment indicators could lose money.
Make Better Trading Decisions with Forex Sentiment Indicators
Take your forex trading success up a notch. Validate your technical analysis using forex sentiment indicators. These trading tools are not infallible, but they are useful for traders concerned about market direction. Choose from various forex indicators to match your trading style and techniques. To maximize profits, it’s smart to use all the charting and analysis tools at your disposal.
Frequently Asked Questions
How do you find the market sentiment in forex?
You can use several ways to find market sentiment in forex, including sentiment analysis, news analysis and broker sentiment data.
What is the best sentiment analysis for forex?
No single sentiment analysis is best for forex. Of the many forex indicators, each has its pros and cons.
How accurate is market sentiment analysis?
Market sentiment analysis is not always accurate and should be used in conjunction with other tools.