Gauging Major Turns With Psychology

By Jamie Saettele AAA

"All economic movements, by their very nature, are motivated by crowd psychology." -- Financier Bernard Baruch

At times, a market will appear to move based on fundamentals, while at other times, the same market will move in the opposite direction on the same news! The key to understanding the highest probability move is to understand the psychology associated with that market. You must also understand that markets move in trends but reverse at extreme levels of bullishness (tops) and bearishness (bottoms). This characteristic is best explained through the words of the English economist Arthur C. Pigou. He explained that "an error of optimism tends to create a certain measure of psychological interdependence until it leads to a crisis. Then the error of optimism dies and leads to an error of pessimism."

There are specific tools that traders can use to gauge the psychological state of a specific currency market. Once the psychological state is understood, the trader can act appropriately; sell extreme bullish readings and buy extreme bearish readings, in accordance with appropriate risk parameters of course. Read on to find out how this strategy works.

Mood Swings
Psychological extremes forecast major trend changes. Paul Macrae Montgomery's "Time magazine indicator" illustrates the point perfectly. Montgomery noticed that when mainstream media detects a trend, the trend is about to reverse. For example, in 1986, then Federal Reserve Chairman, Paul Volcker, was on the cover of Time with the headline, "The Second Most Powerful Man in America". Bonds soon plunged into a bear market.

Similarly, in 1999, Amazon.com's Jeff Bezos was hailed by Time as "Person of the Year". The internet bubble burst soon thereafter.

In currencies, the magazine indicator has also proved prophetic. In February 2004, The Economist cover read "Let The Dollar Drop". The U.S. dollar index bottomed that week and rallied for three months, from 84.56 to 92.29.

During the last week of December 2004, "The Disappearing Dollar" was front and center on the cover of The Economist. Again, the dollar index bottomed that week and 2005 ended up being best year for the greenback since 1997.

Google Trends also proves the validity of gauging the psychological state of the market in order to forecast trend changes.

Here is Google's description on how these forecasts work:

"Google Trends analyzes a portion of Google web searches to compute how many searches have been done for the terms you enter relative to the total number of searches done on Google over time. We then show you a graph with the results - our search-volume graph - plotted on a linear scale. Located just beneath our search-volume graph is our news-reference-volume graph. This graph shows you the number of times your topic appeared in Google News stories. When Google Trends detects a spike in the volume of news stories for a particular term, it labels the graph and displays the headline of an automatically selected Google News story written near the time of that spike." (For related reading, see Understanding Cycles - The Key To Market Timing.)

A search for "weak dollar" produces the chart in Figure 1. The search volume and news reference volume both spike in December 2004 and November 2006. Not coincidentally, EUR/USD topped out at 1.3670 in late December 2004 and topped out at 1.3370 in early December 2006. For the contrarian, there is no better indicator than the financial press.

Source: Google Trends
Figure 1

Trader Commitment
There are many sentiment indicators that make trades based purely on the possible psychological extremes. The Commitment of Traders Report (COT) is one source of information that provides insight regarding the psychological state of a specific market. The Commodities and Futures Trading Commission (CFTC) defines the COT report as:

"… providing a breakdown of each Tuesday\'s open interest for markets in which 20 or more traders hold positions equal to or above the reporting levels established by the CFTC. The weekly reports for Futures-Only Commitments of Traders and for Futures-and-Options-Combined Commitments of Traders are released every Friday at 3:30pm Eastern time."

The report details the open interest for commercial traders and speculators. In currency futures, commercial traders refer to groups that hedge currency risk, such as multinational corporations. Speculators consist primarily of trend followers, such as hedge funds. The financial press examples above highlight how the "error of optimism" that Pigou discussed tends to lead to a reversal of fortunes. The same logic applies when analyzing the COT report and, more specifically, the speculators' open interest. Extremes in speculators' positioning tend to lead to a reversal. In other words, if speculators are extremely long British pound futures, then look for a top and reversal in the GPB/USD spot price. (To learn more, check out Using COT Report To Forecast FX Movements.)

Figure 2 highlights instances (with arrows) when long positions accounted for more than 90% of speculators' open interest. The GBP/USD topped out in all these instances. The same method can be applied when looking for a bottom and reversal. The chart below also highlights instances when long positions consisted of just 10% (or lower) of total speculators' open interest. These periods are the "error of pessimism" that Pigou referred to. (Find more COT data at the CFTC website.)

Source: TradeStation
Figure 2


Risk Reversal Rate
Another useful tool - and a timlier one - for picking tops and bottoms in the currency market is the risk reversal rate. The rate is updated as options prices update throughout the day, whereas the COT report is released just once a week (and with a lag). The risk reversal rate calculates the difference between call option volatility and put option volatility on currency options. Call option volatility increases as options traders' bullishness increases and put option volatility increases as options traders' bearishness increases. Subtracting put volatility from call volatility produces the risk reversal rate.

An extremely high rate, indicating extreme bullishness on the part of options traders, often leads to a top and reversal. Similarly, an extremely low rate, indicating extreme bearishness on the part of options traders, often leads to a bottom and reversal. Figure 3 a chart of the NZD/USD and its risk reversal rate (1 month 25 delta). Every major turn is accompanied by an extreme in the risk reversal rate. This data can be downloaded from a Bloomberg machine, or via a news plug-in available through various brokers. (For related reading, see The ABCs Of Option Volatility.)

Source: TradeStation
Figure 3

Summary
Tops and bottoms in any market are a creation of extreme market psychology. The COT report is most useful to the long-term trader, while the risk reversal rate is more useful to the short-term trader. Trading a reversal is dangerous, but these tools help immensely in identifying major tops and bottoms. Often overlooked is that these tools indicate when not to make a trading decision. For example, a trader looking to buy the NZD/USD breakout may think otherwise when presented with the above chart. The risk reversal position indicates that bullishness is close to an all-time high and that the psychological state of the market is ripe for a top and reversal. The trader may even consider initiating a short position. Following the psychology of the market will help you as a trader distance yourself from the market noise and make better decisions based on more objective analysis.

For more insight, see Gauging The Market's Psychological State.

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