Forex sentiment: An introduction

Forex sentiment refers to how the market feels about the way a currency pair is performing. For example, a currency pair will rise in value if the main sentiment for it is bullish. Sentiment doesn’t show you where to exit or enter a trade, but it does indicate whether you should stay with a pair or ditch it. To get more specifics, such as entry and exit points, you can always combine sentiment with technical analysis as well as fundamental analysis.

Why sentiment analysis is valuable

Sentiment analysis is one of the basics you must get to grips with when you learn how to trade CFDs or forex pairs. If traders are positive about a pair of currencies, the sentiment can be positive. If the attitude is poor, the sentiment is likely to also be negative. You cannot direct a sentiment in the market, but you can formulate an informed response to the benefit of your trade. If you ignore sentiment, you do so at your own peril, and it could lead to losses.

The tools

Because forex trading happens over-the-counter with no central market to regulate it, this complicates matters because you don’t know the volume of each currency being traded. The two common tools used to help are contrarian indicators and the Commitment of Traders report.

Contrarian indicators

In a contrarian trading strategy, you place orders that go against the current market sentiment. Contrarian traders usually place long orders while a currency is weak and place short ones when it’s strong.

When a market has reached a certain level of ripeness, that is when contrarian traders strike by taking advantage. If traders are pushing prices up, it may result in overpriced assets. If the market is on a selling spree, this could be your chance to buy at lower prices.

When is a price reversal coming up in a contrarian strategy? You need to know this to avoid getting caught off guard. The general trading tips state that any time market sentiment reaches extreme levels, like when the number of long positions exceeds short positions by a mile and vice versa, the trend is likely exhausted, and price reversals are expected. The challenge is that this doesn’t always hold true and a trend continues unabated.

Commitment of Traders (COT) report

This is provided by the Commodity Futures Trading Commission (CFTC) each Friday. It is compiled according to the net long and short positions traders are holding in the Chicago IMM exchange on the previous Tuesday. The report may not be accurate in real time, but the data still provides deep insights. You can take intermediate long and short term positions based on this as you get a clear insight into sentiment and market activity.

On the COT report, you’ll find the positions taken by three types of traders:

  • Commercial traders, or hedgers such as financial institutions that are mostly interested in protecting investments from market volatility.
  • Non-commercial traders, or big speculators who follow trends – for example, if sell-outs are happening, they will keep selling too.
  • Small traders, or hedge funds and individual traders with smaller retail trading accounts. They may trade without paying too much attention to the main trends in the market. They often look for market tips or bottoms to enter or exit trades.

One technique for using the COT report is identifying extreme net long or short positions. Spotting these could indicate that a trend is weakening and a reversal is on the horizon, making the report very handy. You can use an indicator in conjunction with the report for the best results

By revealing the positions of other traders, sentiment analysis is therefore a valuable trading insight. If you study how to extract the best from it and its associated tools, such as the two we’ve discussed, it could mean succeeding in a trade as opposed to failing.