According to the April, 2012 Foreign Exchange Committee's Semi-Annual Foreign Exchange Volume Survey, there are on average almost $4.3 billion of forex spot transactions on a daily basis. With so many participants - most of whom are trading for speculative reasons - gaining an edge in the forex market is crucial. Fundamental analysis provides a broad view of a currency pair's movements and technical analysis defines trends and helps to isolate turning points. Sentiment indicators are another tool that can alert traders to extreme conditions and likely price reversals, and can be used in conjunction with technical and fundamental analysis.

Sentiment Indicators
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.

"Extreme levels" will vary from pair to pair. If the price of a currency pair has historically reversed when buying reaches 75%, when the number of longs reaches that level again, it is likely the pair is at an extreme, and you should watch for signs of a price reversal. If another pair has historically reversed when about 85% of traders are short, then you will watch for a reversal at or before this percentage level.

Sentiment indicators come in different forms and from different sources. One is not necessarily better than another, and they can be used in conjunction with one another or specific strategies can be tailored to the information you find easiest to interpret.

Commitment of Traders Reports
A popular tool used by futures traders 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.

Barchart.com provides an easy way to chart COT data along with a particular futures price chart. The chart below shows the Daily Continuous Euro FX (December, 2012) futures contract with a Commitment of Traders Line Chart indicator added. The COT data is not displayed as a percentage of the number of traders short or long, but rather as the number of contracts that are short/long.

Daily Continuous December Euro FX Futures
Figure 1. Daily Continuous December Euro FX Futures
Source: Barchart.com

Large speculators (green line) trade for profit and are trend followers. Commercials (red line) use futures markets to hedge, and, therefore, are counter-trend traders. Focus on large speculators; while these traders have deep pockets they can't withstand staying in losing trades for long. When too many speculators are on the same side of the market, there is a high probability of a reversal.

Over the time period shown, when large speculators were short about 200,000 contracts, at least a short-term rally soon followed. This is not a definitive or "time-less" extreme level and may change over time.

Another way to use the COT data is to look for cross-overs. When large speculators move from a net short position to a net long position (or vice versa), it confirms the current trend and indicates there is still more room to move.

Weekly Continuous December Euro FX Futures
Figure 2. Weekly Continuous December Euro FX Futures
Source: Barchart.com

While the cross-over method is prone to provide some false signals, between 2010 and 2012 several large moves were captured using the method. When speculators move from net short to net long, look for the price of the euro futures, and by extension the EUR/USD, to appreciate. When speculators move from net long to net short, look for the price of the futures and related currency pairs to depreciate.

Futures Open Interest
The forex market is "over-the-counter" with independent brokers and traders all over the world creating a non-centralized market place. 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 as open positions.

If 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.

The following table shows how open interest is typically interpreted for a futures contract.

Open Interest Interpretation
Figure 3. Open Interest Interpretation

The data then must be applied to the forex market. For example, strength in euro futures (US dollar weakness) will likely keep pushing the EUR/USD higher. Weakness in Japanese yen futures (US dollar strength) will likely push the USD/JPY higher.

Futures volume and open interest information is available from CME Group and is also available through trading platforms such as TD Ameritrade's Thinkorswim.

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.

Many brokers provide a sentiment tool on their website free of charge. Check multiple brokers to see if sentiment readings are similar. When multiple brokers show extreme readings, it is highly likely a reversal is near. If the sentiment figures vary significantly between brokers, then this type of indicator shouldn't be used until the figures align.

The Swiss bank Dukascopy provides multiple sentiment tools, one of which is pictured below, based on their client orders.

Dukascopy Liquidity Consumer Sentiment Index (November 2, 2012)
Figure 4. Dukascopy Liquidity Consumer Sentiment Index (November 2, 2012)
Source: http://www.dukascopy.com/swiss/lv/marketwatch/sentiment/

Certain online sources have also developed their own sentiment indicators. DailyFx for example, publishes a free weekly Speculative Sentiment Index (SSI), combined with analysis and ideas on how to trade the data.

The Bottom Line
Forex sentiment indicators come in several forms and from many sources. Using multiple sentiment indicators in conjunction with fundamental and technical analysis provides a broad view of how traders are manoeuvring in the market. Sentiment indicators can alert you when a reversal is likely near - due to an extreme sentiment reading - and can also confirm a current trend. Sentiment indicators are not buy and sell signals on their own; look for the price to confirm what sentiment is indicating before acting on sentiment indicator readings. Losing trades still occur when using sentiment - extreme levels can last a long time, or a price reversal may be much smaller or larger than the sentiment readings indicate.

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