Sentiment Indicators are basically indicators of crowd behavior in the Forex market. In other words, they measure the market’s pulse or the outlook of traders on various market conditions. Forex market sentiment indicators are a very useful tool that traders can utilize to improve their performance in the Forex market.
Unfortunately, many investors don’t give much attention to these indicators. Most focus mainly on either fundamental analysis or technical analysis, or a combination of both.
There is nothing wrong with using either of these analysis techniques. In fact, they are very effective tools for aiding in making trade decisions. But for sure, you can improve the outcome of your positions by adding forex market sentiment indicators into your trading arsenal.
What Are Forex Market Sentiment Indicators?
Forex market sentiment indicators are tools that tell you the percentage of traders holding certain positions in a given currency pair. Let’s say in a particular currency pair, there are 200 traders with open positions. Of these, 120 traders are holding long positions and 80 are short. The sentiment indicators will say that 60% of traders are long and 40% are short on that specific currency pair.
Although the outcome and the general principle are the same, forex market sentiment indicators come in different forms. There are those that are volume-based, which is good for personal securities. However, the majority of sentiment indicators take their information from broad market data.
It is quite interesting to know that some sentiment indicators were developed based on common trader mistakes. For instance, there is a belief that traders can make errors like buying when the price is high. Similarly, these traders might sell when the price is low. Such are the indicators that are based on odd-lot statistics.
Further on in this article, we will talk about some of the more frequently used sentiment indicators in the forex market today.
How Are Forex Market Sentiment Indicators Used for Forex Trading?
It’s not very remarkable if the values returned by the indicators are in the middle range. But if the percentages get close to 0 or to 100, that’s a different matter. The relevance of the forex market sentiment indicators increases considerably. These values mean that you have to be very alert because price reversals are likely.
In our previous example, let’s say more traders go long until the indicator shows a value of 90%. There are just 10% of traders left to push the price up. A price reversal has a very good chance of taking place pretty soon. When this happens and the price starts to go down, you will enter a short position if you are watching the sentiment indicators. Other traders are likely to sell in order to cut their losses while the price decreases.
As with other indicators, the signals produced by sentiment indicators are not always very accurate. There is a chance that the suggested price reversal may not emerge. You can avoid possible trading errors by monitoring the price movements. If the price confirms the signal, then you can go ahead and act on it.
Past price movements are also important when watching out for extreme levels using sentiment signals. A particular currency pair may have historical price reversals at around 80%. When the current value gets close to this percentage, it is time to start looking for the reversal. This is the extreme level for that particular currency pair. For other pairs, the level can be higher or lower.
Different Forms of Forex Market Sentiment Indicators
There are different forms of forex market sentiment indicators. Each one has its own distinct characteristics, as well as pros and cons. It’s not easy to tell if one is better than the other. In fact, these sentiment indicators are frequently used with each other, as well as with other trading tools.
- Volume Indicators
- Commitment of Traders Report
- Futures Open Interest
- Position Summaries
Keeping track of market volume makes perfect sense for the goal of measuring market sentiment. The general movement of the large volume of the market is a good indication of how the market feels toward a particular security.
In using volume indicators, experts advise traders to focus on the high volumes or spikes. When spikes occur, it could be due to important security updates or major news about a company. In this case, it would be best to take a peek at the economic news. If it is indeed due to significant news, the nature of the news can tell whether the current trend will reverse or extend, or if a completely new trend will begin.
You can also use tools like order flow to look at the volumes of sells and buys at particular pivot points or trend reversal zones. You can also determine this through the demand and supply zones, where the institutions pumped in enough liquidity or where they are taking out the liquidity.
Commitment of Traders (COT) Reports
This tool is very popular among futures speculators but is also quite helpful in spot forex trading. These reports are weekly releases from the Commodity Futures Trading Commission. They contain an abundance of data that, when charted, can effectively measure the sentiment of the forex market.
In contrast to the typical sentiment indicators that show the percentage of traders, COTs show the number of short and long contracts. The same concept applies when looking for extreme levels in COTs. When the value approaches either the low or high extreme, a price reversal is imminent. This is then a good time to enter a trade. Some traders also use the cross-over method when interpreting COTs.
Futures Open Interest
Open interest refers to how many contracts are yet unsettled at a given time. In other words, this is the number of positions that are still open. Open interest can help measure forex market sentiment.
For example, if the price of a particular currency pair is on an uptrend, you will find it helpful to check open interest in the currency’s futures. As the open interest gets higher while the price also increases, this is an indication of a continuing trend. If the price is still increasing but the climb of open interest is slowing down, it might be the end of the trend.
It is customary for brokers to provide information on the total percentage of long and short trades on any currency pair. While practically all brokers do this, their individual lists contain only data from their own clients. This is obviously a very small part of the market and by themselves, hardly enough to gauge sentiment.
You can, however, analyze the lists from several brokers. Position summaries of multiple brokers can be good forex market sentiment indicators if you examine them collectively. This is because you will be able to get a more accurate reading of the market sentiment.
If several brokers display extreme levels, there could be a potential market reversal just around the corner. However, if the data from multiple brokers is very diverse, it will be impossible to get an accurate measure of sentiment. In this case, it is best to wait until the figures become more similar.
Deciding on Which Forex Market Sentiment Indicators to Use
The sentiment indicators explained above are all quite different and each has its good and not-so-good points. You might be asking, which of these indicators is the best to use? At the end of the day, it all just boils down to personal preference. Pick the indicators that you are most comfortable using. But it is imperative that you choose more than one. This will give you a better indication of market sentiment than if you just use a single one.
Keep in mind that indicators are not 100% accurate. False signals do emerge from time to time. It is necessary to use other tools to confirm the signals first before you act on them. It is therefore very important that you use other technical indicators along with your chosen Forex market sentiment indicators. Adding a bit of fundamental analysis will also be very good for making better trade decisions. When you find the right combination of these indicators, you will definitely be able to trade better and earn bigger profits.
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