Have you ever been told not to be afraid of being different? Being the odd one out can be beneficial in many areas of life, but it can be deadly while Forex trading. As a Forex trader, you do not want to be going against the tide - this is one field where crowd psychology is very useful.
The main thing that causes the financial markets to move in a specific direction is how people think about a particular financial instrument. When many people believe in, say, a currency, they tend to buy more of it and create a bullish market; if they don’t have faith in it, a bearish market is created when they sell that currency. Both the bullish and bearish scenarios are characteristics of market sentiment, which is basically how people feel about any financial instrument.
Understanding market sentiment
Now that you know what market sentiment is, in a nutshell, how do you identify it? You have to know your environment in order to succeed in it, therefore, to understand the global Forex market, you need to be aware of financial movements around the world from news announcements.
Upon comparing fundamental and technical analysis, it’s easy to see which of the two systems informs you about market sentiment, fundamental. Even for the technical trader, the importance of market sentiment cannot be ignored, and they still need to know about these sentiment indicators. There are probably just as many technical as there are fundamental traders, so the actions of each group affects the entire Forex market. Understanding the Forex market sentiment becomes important for every trader because you want to be among other traders when the markets shift.
When a particular currency is very popular, it tends to rise in value, and if the market sentiment is strong enough, huge shifts can be experienced and traders with long positions benefit a whole lot. The opposite is also true, where short positions become profitable due to a lack of faith in a currency. However, markets don’t stay in a consistent trend for long, and at some point the trend will be reversed. Market sentiment can help you identify these reversals, too.
For trading to occur, there have to be buyers and sellers, so if the Swiss Franc was being bought for a long time, it becomes overbought and pretty soon the buyers will run out and the sellers will take control. In this sense, market sentiment is not only for identifying trends, but also identifying signals of an overbought or oversold market.
Alright, that’s all you will need to know about using market sentiment to your advantage, but first you will need to ‘observe’ sentiment, and this is done through indicators.
Examples of sentiment indicators you should know
There are various measures which traders use to determine the market sentiment, but we’re only going to focus on the most popular. Remember, crowd mentality is key here, and you want to be on the side with most participants. The 3 most popular indicators in the world are:
CBOE Volatility Index (VIX)
This is a measure calculated by the Chicago Board Options Exchange (CBOE), the oldest exchange for options in the world and one of the most popular in the market. I bet you’re wondering why a Forex trader should be interested in the options market if they don’t participate in it, but it’s all about accepting what you can get.
The Forex market is decentralized, and there is no single location from which to determine how market participants feel about any particular currency. However, if you remember the post on the history of binary options, then you know that currency pairs are also part of the options market. You would also remember that they work by traders speculating whether a currency will be more or less valued in the future, and since the options market is centralized, it is possible to know if people believe a particular currency will be more or less valuable later on.
VIX has also come to be known as the ‘fear index’ because it indicates the traders’ view of currencies in the future. The calculations involved in creating the VIX are complicated, but you won’t need to learn exactly how it’s done, all you need to know is how to interpret the final results. Presented as a line chart, the VIX rises when traders buy call options and it drops when they buy put options whereby calling is similar to going long and putting is shorting. The index shows market sentiment for the next 30 days, and indicates overall market sentiment on certain instruments.
Just take a look at the chart below on how the VIX was reacting to various news events, and you will see just how useful this tool can be when trading the markets.
Since VIX is calculated based on S&P 500 index options, it represents the traders’ thoughts on the US Dollar, hence, good news for the dollar (bullish sentiment) is represented as a rise in VIX, presenting an opportunity to go long on the dollar and vice versa.
Commitment of Traders (COT) report
The COT report is similar to the VIX in that it does not use Forex market data since it’s still decentralized that even the CFTC (Commodity Futures Trading Commission) cannot get any data. However, it’s different from the VIX because instead of extracting data only from options exchanges, the CFTC finds their data from both the options and futures markets. The futures market is different from the options market, but it still involves currencies, and the information is very useful to Forex traders.
The report is published every Friday at around 2:30pm EST (10:30pm GMT+3) on the CFTC website. The US session of the week’s Forex trading session ends at 4:30pm EST when major exchanges on Wall Street close for the weekend, and the release of the COT report causes a flurry of activity in the markets in the final minutes of the week. You, too, can use this information to make trades.
On the website, you will find lots of information about various currencies, stocks and commodities showing how much traders have bought or sold each of these instruments in the past week. As you can imagine, this is a lot of information and amateurs get confused by the volume of data, which is why I’ll cover trading with the COT reports in a separate post.
For now, you only need the basic principle – learn how much of a financial instrument has been bought or sold. Then, if a certain currency has been bought far more than it has been sold, it may indicate that it’s been overbought and that you might look out for selling opportunities. You don’t want to be caught against the tide though, so it’s only an indicator of potential selling opportunities, not that you should sell that currency right away.
High/low sentiment ratio
This is a sentiment indicator which compares the number of stocks reaching 52-week highs versus those reaching 52-week lows and calculating the difference as a percentage based on the total number of trades on that day. For example, the latest data received at the end of yesterday’s NYSE closing session showed 352 companies reaching 52-week highs against 320 reaching 52-week lows. The result, 32, is compared from the previous day’s high/low sentiment and the percentage change calculated.
The results can then be converted into a visual graph which shows the fluctuations for each company’s stocks or for the entire exchange, say, the NYSE. This market sentiment is not limited to stocks, though, but can also be used to indicate the highs and lows of futures, commodities, bonds and interest rates, all of which can guide a Forex trader’s strategy. In the example above of the NYSE high/low index being 32, this might not be a huge indicator for a trading opportunity. On the other hand, the NASDAQ had 282 highs and 26 lows, and that is a strong bullish sentiment. If you had this information before trading, you would be looking for buying opportunities there.
To use this indicator, you can download it from various online sources, install it against your Forex trading platforms and use it concurrently with your Forex charts, or you could simply find the information online and do your own calculations. The former may seem attractive, but in most cases you would be charged for it, so why not just do the work yourself? After all, no one ever told you Forex trading was easy, right? Besides, there are various pluses and minuses to trading advisors, and you might want to know them before downloading an indicator.
Listen to this to find out more about market sentiment: