What Is Sentiment Analysis In Forex Trading?

Introduction

Forex sentiment analysis is the study of the overall perception of the forex market. Sentiment analysis helps traders to understand the price behaviour of currency pairs and make appropriate decisions. In short, forex sentiment enables participants to view the market from a broader angle. In this article, we will discuss the significance of sentiment analysis and share some popular forex sentiment indicators.

Key Takeaways

  • Sentiment analysis helps traders to understand the price behaviour of currency pairs and make appropriate decisions.
  • The market sentiment reflects how a majority of traders feel about the performance of a currency pair.
  • Sentiment analysis is a vital tool to gauge possible market moves.
  • Traders can use two common sentiment indicators – the Contrarian Methodology and the Commitment of Traders report.

Forex sentiment analysis is the study of the overall perception of the forex market. Sentiment analysis helps traders to understand the price behaviour of currency pairs and make appropriate decisions. In short, forex sentiment enables participants to view the market from a broader angle. In this article, we will discuss the significance of sentiment analysis and share some popular forex sentiment indicators.

Understanding the Market Sentiment

The market sentiment reflects how a majority of traders feel about the performance of a currency pair. Dominating market sentiment drives the price direction of a currency pair. If a dominant group of market participants holds a bullish view, then the price of a currency pair is likely to rise and vice versa.

Significance of Sentiment Analysis in Forex Trading

Sentiment analysis is a vital tool to gauge possible market moves. Market sentiment flows hand-in-hand with the mood of traders. If investors hold an optimistic approach, it remains bullish. On the other hand, if traders are pessimistic about the market, the sentiment is likely to remain negative.

For example, if 80 out of 100 traders place buy orders on EUR/USD, and 20 traders go for a sell order, then it means that the market sentiment is in 80% favour of the bullish trend. It is worth mentioning here that sentiment analysis does not let you know specific entry or exit points. However, it can help you decide whether or not to ride with the flow of the market.

Forex Sentiment Tools

Forex sentiment tools help traders to identify the direction of trend through sentiment analysis. Sentiment tools also assist in determining what most traders think about the market trend. Remember, market sentiment in the forex and other financial markets does not work the same way.

In the stock and equity market, traders measure the volume traded to assess the market sentiment. If stock prices show an upward trend, but the traded volume keeps decreasing, then the overbought market conditions prevail. Similarly, if a downward trend of stock prices observes a sudden increase in the traded volume, then it indicates a bullish market sentiment.

On the other hand, the forex market is a decentralized market having no central authority regulating it. Therefore, it becomes difficult to know the volume for all traded currencies. However, traders can use two common sentiment indicators as explained below;

  1. Contrarian Methodology
  2. The Commitment of Traders report

1) Contrarian Methodology

The contrarian trading strategy involves going against the market sentiment. Contrarian traders prefer placing long orders for a weakening currency and vice versa. The idea behind such an approach is to take benefit of the market saturation. If everyone is buying an asset, then the sentiment traders might take benefit by selling an overpriced asset. On the other hand, a selling spree enables sentiment traders to buy currency pairs at low prices.

In other words, contrarian traders believe that a price reversal is imminent when the market sentiment reaches an extreme level. That means a price trend is likely to become exhausted when long or short positions exceed the opposite side overwhelmingly.

However, if you follow a contrarian trading strategy, do not forget the other side of the picture. The market could continue following the prevailing trend without undergoing any reversal. Therefore, traders are advised to perform a detailed market analysis before using the contrarian trading style.

There are several technical indicators available that traders can use to gauge the market sentiment. For example, the Relative Strength Index – (RSI) indicator can help traders identify the oversold and/or overbought market conditions. The RSI indicator is a single line indicator having fluctuating scale range starting from 0 to 100.

  • · 0-30 – Represents oversold market conditions
  • · 30-70 – Represents neutral market conditions
  • · 70-100 – Represents overbought territory

 

Since the RSI indicator fluctuates between 0-100, it helps investors to find the highest and lowest points in the market.

Example 01 – In the 4-hour EUR/USD chart given below, you can see EUR/USD was following an upward trend, and the RSI reading remained above 70 for most of the time. Hence, it signaled a diminishing pressure to buy the pair. As a result, the price took a reversal and started falling downwards.

Example 02 – Given below is a 1-hour chart for GBP/USD. You can see that GBP/USD was trading downward, and the reading for the RSI dropped below 30, generating a selling pressure. Consequently, the GBP/USD price exhibited a reversal.

The Commitment of Traders (COT)

The Commodity Futures Trading Commission (CFTC) publishes the Commitments of Traders (COT) report every Friday. The report shows traders’ net short and long positions of the previous week ( till Tuesday) in the Chicago IMM exchange.

The report helps traders to understand the dynamics of the market. The report presents a breakdown of the open interest rate for options and futures market. According to CFTC, around 20 traders hold positions equal to the reporting level. Some traders may even hold positions above the reporting figures.

Let’s take a look at a sample report given below. Although the COT report doesn’t reflect the real-time data, it can still help traders gauge the prevailing market’s sentiment. Using the COT report, traders can decide to open intermediate or long-term positions. You can access the COT report from the CFTC’s website. Do not forget to select the short format after scrolling down to the section labeled as currency legacy reports, as shown in the image below.

A COT report contains a lot of information. You can search the COT report to find the relevant information. With that being said, let me explain the main categories of the British Pound report attached below;

 

  • Non-commercial: This category reflects the combination of positions of different classes of traders, including hedge funds, corporate investors, and individual investors. Not to mention, all of them hold major interest in speculative gains.
  • Commercial: This head represents large entities that hedge against investment uncertainties by relying upon the futures market.
  • Non-reportable positions: This category shows numbers amid positions that fall below the CFTC reporting standards.
  • Long: It reflects the number of positions for buying future contracts.
  • Short: It reflects the number of positions for selling future contracts.
  • Open interest: This category reflects the number of undelivered or unexercised contracts.
  • The number of traders in each category: It reflects the number of traders in each category that need to report the CTFC.

 

Understanding the COT report

The COT report reflects positions for different types of trades, including commercial, non-commercial, and small-scale investors.

1) Commercial Traders – Hedge Funds

Hedge funds fall under the category of commercial traders mainly interested in protecting their funds against market insecurities. For example, financial institutions use hedging techniques to safeguard their investment from sudden fall or rise in currency prices.

It is worth mentioning here that commercial traders usually follow a bullish stance at the market bottoms while embracing a bearish stance at the market tops.

2) Non-Commercial Traders – Speculators

The non-commercial type of investors include speculators who make profits from price fluctuations. Non-commercial traders hold big accounts, making futures markets move smoothly. Trend following is one of the key characteristics of speculators. Hence, non-commercial traders open buy positions when the market shows upward trends and places sell orders after identifying downward trends. The non-commercial traders continue placing trades until the market undergoes price reversal.

3) Small Investors

This class of traders comprises small individual traders holding retail trading accounts with limited investment. In general small traders don’t bother to follow prevailing market trends. Hence, they remain less profitable as compared to other classes of traders, i-e commercial and non-commercial. Nonetheless, small traders also look for market bottoms and tops to enter positions if they wish to follow trends.

How to use the COT report for trading?

The COT report is released every Friday. It is paramount for you to know how to use it for analyzing the market sentiment. The COT report can help you take precise mid-term and long-term trading decisions.

Traders can use it by employing multiple techniques. One of the main methods is to identify extreme net short or long positions. By identifying these positions, traders can ascertain when the prevailing trend might weaken. A weakening trend could also indicate a market reversal.

You can also use indicators to spot extreme market sentiments and interpret the COT report easily.

For example, given below is a 3-year chart taken from TimingCharts.com. You can see the Euro FX futures with an incorporation of the COT indicator.

 

There are three lines on the COT indicator, including blue, green, and red. The blue line represents commercial traders, while the green line is for non-commercial traders. Similarly, the red line represents retail traders.

First of all, let us focus on the green line. As mentioned above, the non-commercial traders open positions following the dominating market trend. Even non-commercial traders that include speculators having big accounts cannot afford losses for a longer period of time. Hence, if a majority of non-commercial traders hold the same view, then the market is highly likely to take a reversal.

If we take a close look at the chart around 6th December, then we can understand the market shifts. You can see the market was experiencing a downward trend. Speculators were holding net short positions at extreme levels, so did the currency value. Then the market took a reversal and started printing an upward trend.

In such a scenario, if you could have spotted the market reversal using the COT indicator, booking several hundred pips could not have been a problem in subsequent months.

Similarly, you can use the COT indicator to identify market bottoms and tops. Not to mention, opening positions in times of extreme market sentiments usually yields more profits.

By looking at the chart shared above, you can spot that the green line and blue line representing non-commercial and commercial traders move in opposite directions.

Whenever the market shows an upward trend, commercial traders tend to remain bearish while non-commercial traders stay bullish.

On one side, the non-commercial trader’s speculative positioning can help to identify the prevailing market trend. On the other side, you can spot market reversal by considering the hedging positions of commercial traders.

The market bottom occurs when non-commercial traders keep going short while commercial traders keep placing long orders.

Similarly, when commercial traders place sell orders while non-commercial traders keep on buying positions, then the market top occurs.

 

It is always a good idea to wait until you receive confirmed indications of market reversals to start placing trades. Identifying the location of extreme market sentiments is not an easy task to do.

Conclusion

Sentiment analysis can be an effective method to identify trading opportunities. It becomes even more productive when used with technical and fundamental analysis. Knowing market sentiment, you can estimate potential reversal or identify prevailing market trends to position yourself accordingly. Honestly, sentiment analysis can make a difference between your success and failure in forex trading if used properly.

Summary

Sentiment analysis can be an effective method to identify trading opportunities. It becomes even more productive when used with technical and fundamental analysis. Knowing market sentiment, you can estimate potential reversal or identify prevailing market trends to position yourself accordingly. Honestly, sentiment analysis can make a difference between your success and failure in forex trading if used properly.

Sources

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