Getting Sentimental with Forex Trading
Sentimental analysis is what it sounds like – gauging the market sentiment. What does that mean? Well, as traders, a part of our job is to determine if a market is bullish, bearish, overbought, oversold, and to plan a trade for those market conditions – basically putting all of the things we’ve learned up until this point all together.
So how do we do that? What tools can we use? And how do we react to certain conditions? Well, that’s what we’re going to find out today – we’re going to take a look into sentiment analysis in forex trading.
Now there are a couple of ways to gauge different market conditions. Does anyone know what those two things are? You guessed it: technical and fundamental analysis. Now, in the School of Pipsology, we’ve covered most of the commonly used technical indicators out there for forex trading, so you should be an expert at that already right?
But how about the fundamental tools? What fundamental tools are available to gauge sentiment?
Well, in stocks and options, sentiment is measured using volume data. For instance, if a declining stock suddenly reversed on high volume that means the market sentiment may have changed from bearish to bullish. Or if a stock price was rising on gradually declining volume, then that may be a sign of an overbought market.
But have you ever seen volume data on any forex charts?
Probably not.
Being that the foreign exchange does not have a centralized market, volume data cannot be accurately calculated. So, where’s a trader to go to get such valuable data? That’s where the COT report comes in.
Commitment of Traders Report
The Commodity Futures Trading Commission publishes the Commitment of Traders report (COT) every Friday, and it measures the net long and short positions taken by traders in the futures market. It is a great resource to gauge market sentiment from the “big players” because of their large positions they are required to report to the government. Of course, it is very important to see what the “smart money” is up to because they move the markets and it may have an impact on your positions.
Below, we have an example of the Swiss Franc COT report taken from August 22, 2006 Check it out:
The report is pretty straight forward, but here’s a quick run down of what each category is.
- Non-Commercial - This is a mixture of individual traders, hedge funds, and financial institutions. For the most part, these are traders who looking to trade for speculative gains.
- Commercial - These are the big businesses that use currency futures to hedge.
- Long - number of long contracts reported to the Commodity Futures Trading Commission (CFTC).
- Short - number of short contracts reported to the CFTC.
- Open interest- this column represents the number of contracts out there that have not been exercised or delivered.
- Non-reportable positions;- These are the open interest positions of traders that do not meet the reportable requirements of the CFTC.
- Number of traders- total number of traders who are required to report positions to the CFTC.
- Reportable positions;- the number of options and futures positions that required to report according to CFTC regulations.
In the center of the report we see “CHANGES FROM 08/15/06.” This section shows the change in Open Interest and the changes in the Long and Short positions from the previous week.
How to Use the COT Report
Because the COT report is published weekly, it would be more suitable for longer term traders to use as a market sentiment indicator. So, how do we do that? Well, besides using the changes in open interest and changes in the number of long and short contracts as a volume indicator, my favorite way to use the COT report is to find extreme net long and net short positions. This can be great indicator that a market reversal is around the corner because if everyone is long a currency, who is left to buy? No one. And if everyone is short a currency, who is left to sell? Again, no one. The only thing a market can do is go the other direction. Here’s a chart example:
This is an example chart of the US Dollar Index from freecotcharts.com. In the top half of the chart we have the price action of the USD index futures with each bar representing weekly data. On the bottom half of the chart we have data on the net long/short positions broken down into three categories: Commercial (Blue), Large Non-commercial (Green), and Small Non-commercial (Red). We will pay attention to the Large Non-commercial positions since commercial positions are for hedging and small retail traders aren’t really a factor.
Let’s examine this chart and see what it can tell us. We can see that the US Dollar began a nice little bull run at the start of 2005. As the value of the net long positions of large speculative traders (green line) rose, so did the price of the USD futures index. In the first week of July 2005, net long positions grew to over 20K contracts. This was an extreme area of longs and soon after the market began to sell off USD index futures. The USD index price dropped from 91 to 86, but it only proved to be a retracement as the index rallied to a new high of about 93.16 and higher level of 29K net long contracts.
As you have probably already asked yourself, “with this many longs who is left to buy?” Not too many traders really. With the market appearing overbought in November 2005, we began to see the number of long USD index futures contracts decline and a drop in the index price from 93 all the way down to about 84. Wow, can you imagine if you positioned yourself before this move?
By now I bet you’re asking, “I trade the spot forex market not futures. How does this apply to my trading?” Great question! Since we’re already taking a look at the US Dollar, let’s look at one of the best vehicles to trade the Greenback in the spot forex market: EUR/USD.
Here’s a weekly chart of EUR/USD:
If we had applied what we learned in the previous section by positioning ourselves for market reversals, we could have caught two significant moves from July 2005 to May 2006 in EUR/USD.
First, in July 2005, if a trader saw the extreme levels of net longs in the USD index futures, this trader would catch the possible upcoming selloff of the Greenback by buying EUR/USD. This trader would’ve been proven right, and paid off handsomely as this position could have caught a maximum of 700 pips. Again, if this trader were so astute to catch the extreme level of long USD index futures contracts in November 2005, buying EUR/USD would have been the best bet as the pair rallied from about 1.1650 to almost 1.3000….wowzers!!! That’s over 1300 pips gained! So, from July 2005 to May 2006, a trader could have caught almost 2000 pips just using the COT report as a market reversal indicator. Pretty good, eh??
Summary
Now, before we get all excited and start betting the farm on what the COT reports says, let’s remember a couple of things.
First, this is just one example of how the COT report can signal market reversals. I could sit here and post examples all day, but the best thing for your trading education is to review past COT data and charts, which is freely available all over the internet. I’m a firm believer in backtesting, not just to see if a strategy works, but how a strategy may fail me at certain times. This technique does not always correlate to market reversals, so take the time to study this report, and get your own feel of what works and what doesn’t.
Second, market prices aren’t driven by COT reports, MACD, Stochastics, Fibonacci numbers, or anything like that - the markets are driven by millions of people reacting to fundamental reports, economic analysis, and politics. Use these tools in conjunction with what’s going on in the world, and you can gain a serious edge and insight to what the market is feeling and be prepared to act on it.
No comments:
Post a Comment