How Sentiment Indicators Work
Sentiment indicators show the percentage, or raw data, of how many trades or traders have taken a particular position in a currency pair. For example, assume there are 100 traders trading a currency pair; if 60 of them are long and 40 are short, then 60% of traders are long on the currency pair.
When the percentage of trades or traders in one position reaches an extreme level, sentiment indicators become very useful. Assume our aforementioned currency pair continues to rise, and eventually, 90 of the 100 traders are long (10 are short); there are very few traders left to keep pushing the trend up. Sentiment indicates it is time to begin watching for a price reversal. When the price moves lower and shows a signal it has topped, the sentiment trader enters short, assuming that those who are long will need to sell in order to avoid further losses as the price falls.
Sentiment indicators are not exact buy or sell signals. Wait for the price to confirm the reversal before acting on sentiment signals. Currencies can stay at extreme levels for long periods of time, and a reversal may not materialize immediately.
Commitment of Traders Reports
A popular tool used by futures traders to get a sense of sentiment is also applicable to spot forex traders. The Commitment of Traders (COT) is released every Friday by the Commodity Futures Trading Commission. The data is based on positions held as of the preceding Tuesday, which means the data is not real-time, but it’s still useful. Interpreting the actual publications released by the Commodity Futures Trading Commission can be confusing, and somewhat of an art. Therefore, charting the data and interpreting the levels shown is an easier way to gauge sentiment via the COT reports.
Futures Open Interest
The forex market is “over-the-counter” with independent brokers and traders all over the world creating a non-centralized marketplace. While some brokers publish the volume produced by their client orders, it does not compare to the volume or open interest data available from a centralized exchange, such as a futures exchange.
Statistics are available for all futures contracts traded, and open interest can help gauge sentiment. Open interest, simply defined, is the number of contracts that have not been settled and remain open positions.
If, say, the AUD/USD currency pair is trending higher, looking to open interest in Australian dollars futures provides additional insight into the pair. Increasing open interest as the price moves up indicates the trend is likely to continue. Leveling off or declining open interest signals the uptrend could be nearing an end.
Position Summaries by Broker
To provide transparency to the over-the-counter forex market, many forex brokers publish the aggregate percentage of traders or trades that are currently long or short in a particular currency pair.
The data is only gathered from clients of that broker, and therefore provides a microcosmic view of market sentiment. The sentiment reading published by one broker may or may not be similar to the numbers published by other brokers. Small brokers with few clients are less likely to accurately represent the sentiment of the whole market (composed of all brokers and traders), while larger brokers with more clients compose a larger piece of the whole market, and therefore are likely to give a better indication of overall sentiment.