According to market sentiment, traders are currently inclined to trade specific currency pairs. As a result, spot Forex traders typically have to use the sentiment meters provided by big brokers when trading sentiment. In contrast, futures exchange-based sentiment meters (the Commitment of Traders report) show different numbers for different traders.
Getting an accurate picture of retail sentiment requires combining information from several brokers because brokers’ sentiment values are derived from their client base, which is limited, even at big companies. Therefore, market sentiment is described in this article, along with the most important sentiment indicators related to forex trading.
What is market sentiment?
It is a measure of the mood of investors toward a particular market or financial instrument. The sentiment increases over time as the market becomes more bullish. However, if market participants start to behave negatively, sentiment can also deteriorate.
Thus, traders determine a market’s sentiment based on its price movements. A bear market is characterised by asset prices going down, and a bull market is characterised by asset prices going up. With the help of tools such as sentiment indicators and simply by watching the market’s movement, traders can gauge market sentiment. They then use this information to determine what to do next.
How do sentiment indicators work?
The sentiment indicator displays the raw data, or percentage, of how many traders or trades have been made on the currency pair. For example, suppose 100 traders trade a currency pair; if 60 are extended, and 40 are short, 60% of the traders long the currency pair.
The sentiment indicator is useful when the number of trades or traders in a particular position reaches an extreme level. For example, consider our currency above pair rising steadily over time, and eventually, 90 out of 100 traders are long (10 are short); few traders are left to push it upwards.
How to trade
We need to start watching for a price reversal now that sentiment is changing. The sentiment trader enters short when the price drops and indicates a top has formed, assuming that those long need to sell to avoid further losses as the price drops.
The sentiment indicator does not provide actual purchase or sale signals. Act only on sentiment signals after the price confirms the reversal. There is no guarantee that a reversal will materialise quickly when currencies are at extreme levels.
The degree of extremeness will vary from pair to pair. For example, assume that historically, the price of a currency pair reversal occurs when the number of longs reaches 75%; when the number of longs reaches that level again, you should watch for signs of a reversal. In contrast, if another pair reversed historically at 85% of short positions, you will watch for this limit of 85% of short positions to be crossed.
Bottom line
There are several types and sources of sentiment indicators for forex. When combined with fundamental and technical analysis, multiple sentiment indicators can provide a broad view of what is happening in the market. In addition, using sentiment indicators can inform you when a reversal is likely to happen due to extreme readings and confirm current trends. Before acting on sentiment indicator readings, look at the price to see what sentiments indicate. Sentiment indicators are not bought or sold signals on their own. Trading losses are still possible when sentiment is used. Price reversals may be smaller or larger than sentiment readings suggest when extreme levels persist for a long time.
