Forex Market Sentiment Indicators Explained

In the volatile and fast-paced forex market, there are various types of analysis that can be used to inform your trading decisions such as Sentiment Indicators, or Trading Simulators.

Fundamental analysis can be used to deliver a broad overview of a currency pair’s movements, for example, whereas technical analysis helps to define relevant trends in the real-time marketplace.

While they may not be as well-known, so-called “sentiment indicators” can also be used to help guide forex traders and highlight more extreme market conditions. But what exactly are sentiment indicators and are they relevant to you?

What are Sentiment Indicators?

Sentiment plays a critical role throughout the financial market, especially in volatile markets that deal in derivative assets such as currency.

In simple terms, they display a percentage of how many traders have assumed a particular position within a specific currency pair.

For example; let’s say that you analyse 100 traders who are speculating on the popular and highly liquid EUR/USD pairing. In this case, if 60% are going long on the asset and the remaining 40% are shorting their pair, you’re witnessing a relatively even split that’s indicative of largely positive sentiment (suggesting that the asset will appreciate in value).

However, what happens if this percentage changes and moves towards a more extreme outcome? Well, if 90% of the same demographic of traders suddenly go long and just 10% continue to short the EUR/USD, it’s statistically unlikely that this trend can continue on the same trajectory indefinitely.

At this stage, sentiment suggests that traders should start to prepare for a price reversal, before the price begins to move lower and sentiment suddenly shifts.

When the price does eventually begin its descent and signals that the trend has topped, you’ll enter the market by shorting the EUR/USD in the belief that the vast majority of traders who are long will have to sell quickly to minimise their losses.

Using Sentiment Indicators in the Real-time Market

Because sentiment indicators aren’t exact buy or sell signals, you’ll need to showcase patience as a trader and wait for the price trend to confirm before taking direct action.

After all, currency prices can stay at extreme levels for extended periods of time, and rushing to the market may make the same mistakes as those who have driven a particular trend in the first place!

It’s also important to note that sentiment indicators vary from one asset to another, as will the definition of “extreme levels”. This rule even applies to different types of currency pairs, so you’ll need to perform historical price analysis of assets to ensure that you use sentiment indicators effectively.

The question that remains, of course, is how can you access the data that drives sentiment indicators?

Well, many novices use the ‘Position Summaries’ published by their online trading platform, with this data feartring the aggregate percentage of traders who are currently short or long on a particular currency pairing.

However, this data only covers the data pertaining to a particular broker, creating a very narrow few of a broad and global marketplace. So, although the information is relatively easy to read, this may create misleading sentiment indicators, which are completely at odds with the wider marketplace.

A more all-encompassing tool is ‘The Commitment of Traders’ (COT) report, which is released every Friday and provides data based on decisions based on positions held on the previous Tuesday.

While this contains huge swathes of data that can be hard to decipher (especially with any trade or accuracy), it provides a far greater and more detailed insight into the positions held by a broader range of traders across the marketplace.

So, if you are able to interpret this data, it’s an incredibly effective way to gauge sentiment via the OTC reports, potentially improving the success of this strategy going forward.