Sentiment Analysis for Forex Trading

What is Market Sentiment？

Market sentiment defines how investors feel about a particular market or financial instrument. As traders, sentiment becomes more positive as general market consensus becomes more positive. Likewise, if market participants begin to have a negative attitude, sentiment can become negative.

As such, traders use sentiment analysis to define a market as bullish or bearish, with a bear market characterized by assets going down, and a bull market by prices going up. Traders can gauge market sentiment by using a range of tools such as sentiment indicators (see below), and by simply watching the movement of the markets, using the resulting information to make their decisions.

What is Sentiment Analysis in forex trading？

Forex sentiment analysis is the process of identifying the positioning of traders, whether net long or net short, to influence your own trading decisions in the currency market. While sentiment analysis can be directly translated to forex, it is also used for stocks and other assets. Contrarian investors will look for crowds to either buy or sell a specific currency pair while waiting to take a position in the opposite direction of sentiment.

How Forex Sentiment Analysis Works

An example of how sentiment analysis can be applied in forex trading is a large single movement in GBP/USD in 2016, with negative sentiment sending GBP slumping to a 31-year low following Britains vote to leave the European Union. After broadly positive sentiment in the year that followed, negative sentiment then took over much of 2018 again before prices started to trend higher in 2019.

Another example of net short sentiment can be seen in the EUR/GBP chart below, with 21.9% of traders net-long with a ratio of traders short to long at 3.58 to 1. The chart shows in blue the percentage of IG traders taking a net long position, and in red the percentage taking a net short position.

Chart to show net negative sentiment alongside price action

Rising sentiment may mean there are few traders left to keep pushing the trend up. In this case, traders may want to watch for a price reversal. On the other hand, a price moving lower, showing signals that it has topped may prompt a sentiment trader to enter short. The chart below shows an example of the EUR/USD pair experiencing net positive sentiment.

Using Sentiment Indicators

Sentiment indicators are numeric or graphic representations of how optimistic or pessimistic traders are about market conditions. This can refer to the percentage of trades that have taken a given position in a currency pair. For example, 70% of traders go long and 30% go short will simply mean 70% of traders are long on the currency pair.

The best sentiment indicators for forex traders include IG Client Sentiment (as seen in the charts above) and the Commitment of Traders (COT) Report.

IG Client Sentiment

IG Client Sentiment can be a useful tool to incorporate into your trading strategy. It can give a helpful picture of the number of long and short trades occurring in a particular market, giving an impression of the turning points in sentiment. For more on this indicator and how it can assist your trading, be sure to click the link above.

Commitments of Traders Report

The Commitment of Traders (COC) Report, published weekly by the Commodity Futures Trading Commission (CFTC), is compiled from submissions from traders in the commodities markets, giving a picture of the commitment of classified trading groups. The CFTCs report is released every Friday at 15:30 Eastern Time and can be a useful market signal.

The COT report is a weekly sentiment report that can provide forex traders with important information on the positioning of currency pairs. Issued by the Commodities Futures Trading Commission (CFTC) the COT report can be cross-referenced with a traders underlying forex strategy.

The forex market is not the only financial market included in the COT report analysis, which makes this valuable commentary for all traders.

What is the Commitment of Traders Report？

The Commodity Futures Trading Commission (CFTC) COT report offers a unique look at the positioning of futures traders across a broad range of markets, and it is quite often used as a proxy for the FX trading market. In the weekly report, the US regulator breaks down long and short positions and overall open interest according to three separate trading groups. Knowing where traders positions are in the forex market can be valuable information when constructing trade ideas.

It is a requirement of the CFTC that the largest futures traders in the world must report their positions. These positions can be easily tracked due to the margin they must pay to hold their large positions which the CFTC has been publishing since 1962.

More recently since the year 2000, reports are released every Friday at 3:30ET pm. This information can be highly valuable to traders due to the nature of people who come into the futures market. This includes institutions like hedge funds who enter to make a return above their respective index. Some of the largest companies in the world with real-time data of the health of an economy come to the futures market to hedge their exposure to price fluctuations of raw materials that they use to make their product. This allows traders to gauge the positioning of the market at that specific time.

Breakdown of the three main groups mentioned in the COT report:

Commercial Traders – These are most often large multi-national corporations with commercial hedging interests in their respective futures markets. For example, a large Japanese manufacturer may want to hedge their exposure to fluctuations in the USD/JPY exchange rate.

Non-Commercial Traders – This data most often relates to large speculators such as Commodity Trading Advisors and similarly large institutions speculating in specific futures markets. For example, a major commodity fund believes that the US Dollar will appreciate against the Euro and, as such, place bets on Euro forex futures.

Non-Reportable Traders – Non-Reportable Traders are traders who dont fall into either group. Most often seen as small speculators, these are arguably less significant and do not frequently figure into COT report analysis. For example, these traders refer to the leveraged players without deep pockets who are shaken out on big moves

With these general definitions in mind, traders can then decide how to use this information. The image below depicts an extract from the COT report with the three main groups as outlined above.

EUR/USD COT Report:

Source: CFTC

COT Report Trading Strategies

Upon the first reading of the COT report, it may seem confusing how future positions in USD, JPY, GBP or EUR could be helpful for trading EUR/USD, USD/JPY, or EUR/GBP. There is a lot to learn about the COT report but whats often helpful is to find where there is a strong divergence between large speculators and large commercials.

USD/JPY COT Report:

USD/JPY chart confirmation of Non-Commercials selling USD/JPY long positions:

The first place to start with is a clear understanding of ‘net positioning’ which is shown clearly on the report itself, as well as the week-over-week differential of major market bias (circled above).

The specific number is not necessarily important, but rather a clear sign in percentage terms of open interest which makes it easy to identify ‘Non-Commercials’ flipping against the primary trend. Furthermore, when a key flip in the sentiment of ‘Non-Commercials’ is realized and there is a confirmation on the charts that a trend is exhausting, traders are likely trading in the same direction as the big kids.

From the report located above, the number of funds off-loading the JPY shorts increased dramatically from the week prior. When this type of shift from major funds is observed, traders can look for other signs that show the prior trend is losing steam which could indicate a possible exit of open positions. The chart above of USD/JPY notes that there have been four bearish key days (highlighted in red) on USD/JPY since the start of 2014 at the same time non-commercials have unloaded their USD/JPY long positions giving credence that this move down may have more to go. Further validated by the technical indicators used in the chart – RSI and 100-day moving average, which both signal a bearish bias.

Using the DailyFX COT Analysis Report

Another excellent tool is the Commitment of Traders Analysis from DailyFX. This weekly report provides an analysis of the CFTC report, showing the positioning of forex futures trades with a synopsis of the key flips in positioning. This report also helps traders by providing 52-week percentiles of major moves, showing annual bullish/bearish extremes which assist in trade execution - tightening stops or looking for price action to confirm the funds are selling out.