In Forex trading, there are three types of analysis that most traders use–fundamental, technical and market sentiment. The third option has become widely used as it’s primarily based on the sort of collective emotion shared among traders.
Think of it as buying something that many recommend. This adds a certain level of confidence to that particular product or service.
So how do you take advantage of that combined feeling among market participants to make a winning trade?
How to trade on market sentiment
Before anything else, it’s important to remember that a market sentiment approach doesn’t provide you with precise entry and exit data. However, you will have a good idea on which way a majority of the market leans and then make a decision on whether to go with or against the flow.
Sentiment indicators
For example, 60 of the 100 traders trading the USD/EU pair are long while 40 are short. This means 60% of them are long on the said currency pair. It’s up to you to follow the majority.
When any specific position reaches an extreme level, the market sentiment becomes a useful indicator. Going back to the previous example, if 60% of traders push to 90%, expect a price reversal since only a few traders are left to push the trend further.
Commitment of Traders Reports (COT)
Because Forex doesn’t have a centralised market, it’s difficult to properly measure the volume of the currencies traded. This is where COT comes into play, especially for spot Forex traders. The report is published every Friday by the Commodity Futures Trading Commission and contains data on which positions speculative and commercial traders previously held.
While the data isn’t real-time, you can still use it to identify market sentiment. Say the COT shows that a majority of traders have a more bearish attitude in a bullish market. It’s likely that the market could go in a reverse direction.
When trading options and stocks, other indicators are used to determine market sentiment. These include volatility index or fear index, bullish percentage index, high/low sentiment ratio. put/call ratio, and stocks above/below moving averages.
Use market sentiment the right way
Since trading on market sentiment alone doesn’t provide precise data, you should use it as part of your wider analysis and combine it with other indicators. Unlike technical analysis, market sentiment analysis isn’t black and white. This is why you should not rely on it solely when you decide which trade to take.
