In trying to decipher the likely movement of foreign exchange rates, traders gratefully embrace a wide myriad of technical and fundamental analysis tools. Each have their uses – fundamental analysis help to provide traders with hard numbers, while technical analysis provide dynamic and visual analytics on price momentum, trends, volatility and more.
There’s one more type of analysis that can provide astute traders with an insight into the likely tendencies of foreign exchange rates – sentiment indicators. Market sentiment as a price driver simply cannot be underestimated, and understanding periods of extreme sentiment can help pinpoint likely price turnarounds. Used with other established technical and fundamental indicators, sentiment tools can be a real ace up the forex traders sleeve.
Using Sentiment Tools To Predict Foreign Exchange Rate Movement
Sentiment indicators provide traders with information on how many traders have taken a particular position within a currency pair. For example, if 7 out of 10 traders have gone long the Euro Dollar, this would hint at a highly bullish market sentiment for the currency pair. However, it’s when trader position placements take on extremes that sentiment tools come into their own. If for example, the number of traders going long on the Euro Dollar rises to 9 out of 10, this is unlikely to be a sustainable bull trend. There would simply be no buyers left to maintain the buying pressure, and the storming Eur/USD price would inevitably face a reversal at some point.
While sentiment indicators can be extremely valuable to suggest likely reversal scenarios, they unfortunately fail to provide actual signals that we can use for timing our entry and exits. Therefore, we need to use sentiment indicators in conjunction with our other technical indicators to identify actual reversals. For instance, a sentiment indicator that suggests that a reversal is bound to happen might be powerfully combined with a double moving average – when a moving average crossover is seen, this could be a signal that the trend has indeed reversed.
Interestingly, currency pairs often demonstrate a certain memory for sentiment turning points. That means, when sentiment reaches a particular point (eg 80% long) the currency pair often will have a track record of reversing price direction in and around this sentiment level. It’s therefore possible to use this sentiment level as a resistance point, bringing awareness that a price reversal could be hovering excitedly on the horizon. Traders can then use this sentiment memory to either close off profitable positions, or get ready to open new contradictory ones.
Popular Sentiment Indicators
Without question, the most popular sentiment tool used to predict a reversal in foreign exchange rates is the Commitment Of Traders (COT) report. This report is released every Friday by the Commodity Futures Trading Commission, and contains data on the positions of traders as of the previous Tuesday. While the COT is not real time, it’s still highly potent in getting a generic overview on market sentiment for each currency pair.
Another sentiment based indicator that can help to predict possible foreign exchange rates turnarounds include the Futures Open Interest report which reveals how many futures contracts have not been settled. Additionally, some brokers will also provide an in house sentiment tool which can assist their clients in understanding whether traders are largely buyers or sellers for any currency pair.
In many ways, market sentiment works in somewhat the same fickle way that fashion trends do. Just like clothes and styles go in and out of vogue, so too do currency pairs. Crucially, as forex traders, if we don’t take market sentiment into account, we risk the trading equivalent of wearing a pair of Flares and having a mullet for a haircut!