In this review, we will get acquainted with such a concept as the “mood” of the Forex market. With its help, you can get confirmation about the direction of the current trend and warnings about its possible completion.
What is market sentiment?
Market sentiment, or market sentiment (English market sentiment) is the prevailing mood of the majority of market participants at the current time. The word “sentiment” has French roots and in translation means “feeling, mood”. Sentiment shows what market participants are now more tuned in to – to buy a financial instrument (or a group of assets), or to sell.
In other words, market sentiment can be defined as the current balance of optimism and pessimism of traders, investors and other market participants regarding a particular financial market or asset. It is a kind of collective emotion based on certain expectations. Expectations are formed, as a rule, by the news background and various fundamental factors.
For example, if market participants are confident that the stock market will rise, they begin to actively buy stocks, which increases demand and supports a bullish trend. If the majority of speculators are confident that the stock price will decline and a bearish trend will emerge, people will start selling assets that, in their opinion, will soon fall in price. As a result, there will be an oversupply in the market, leading to lower prices.
Forex market sentiment shows what most of its participants now prefer to do: buy or sell currency. There are expressions among traders: “buy bucks” is the mood to buy the US dollar against other currencies, and “sell bucks” is the mood to sell the US dollar against other assets.
Various factors influence the mood and expectations of market participants. Factors contributing to the growth of the exchange rate form a positive sentiment (mood to buy). The factors leading to a depreciation of the currency create negative sentiment (a mood to sell). Consider below the factors influencing the mood of the Forex market.
What factors influence the mood of the Forex market?
The mood of the foreign exchange market is most influenced by the so-called “fundamental” factors. These include various financial, economic and political events that directly affect exchange rates. Fundamental analysis studies the influence of these factors. I will list the most significant of them:
- Monetary policy of Central Banks – cycles of increasing or decreasing the main interest rate can form long-term trends of strengthening or weakening of the national currency. If rates are expected to rise, the market sentiment will be “bullish”: market participants will be inclined to buy the currency. If a rate cut is expected, then vice versa.
- Economic factors – the release of positive data on the growth of the country’s economy (GDP, employment, production, etc.) improves market sentiment in relation to the country’s currency.
- Political factors – elections, government resignations, scandals, sanctions, etc., can create negative sentiment for a particular currency.
- Rumors and expectations – this includes political and economic factors, only in the form of rumors and expectations.
- Force majeure is a variety of natural disasters, man-made disasters, terrorist attacks, epidemics. They are able to form a strong negative sentiment in relation to a particular currency.
The time of influence of fundamental factors on the sentiment of the Forex market can be short-term (from several minutes to several days) or long-term (several weeks, months, years). For example, the published data on the growth of unemployment in the last month may have a short-term negative impact on sentiment, and the statement of the head of the Central Bank about the need to raise rates can form a long-term positive sentiment on the currency.
Indicators for assessing the sentiment of the Forex market
Various indicators can be used to determine the current market sentiment. They try to assess the sentiment of market participants and express them in the form of numbers or graphically. They can be used to draw conclusions about how the current beliefs and attitudes of traders can affect future price behavior.
Let’s consider three popular indicators for assessing the current sentiment in the Forex market.
US dollar index
The US Dollar Index (DXY) is the primary indicator that can show the current sentiment against the world’s leading currency. The direction of movement of the index (current trend) reflects the current market balance. The growth of the index indicates a positive sentiment and strengthening of the US dollar against major currencies, a decrease in the index indicates a negative sentiment and weakening of the American currency.
The US dollar index is traded on exchanges in the form of various settlement contracts – futures and options. With the help of technical analysis, you can analyze the index chart and determine what sentiment is now for the US currency: positive, negative or neutral. You can find the DXY index chart on various information resources, for example, on tradingview.com.
COT reports on currency futures
COT report (Commitments of Traders) is a weekly publication that shows the cumulative positions of different participants in the futures market. The COT report is published every Friday by the US Commodity Futures Trading Commission (CFTC). Although the data is provided for futures, it has a very high correlation with the Forex market.
COT reports show net long or short positions in futures contracts for currencies (and other assets) of three groups of traders:
- Commercial Hedgers are large companies and institutions that use the futures market to hedge against risks in the cash or spot market. Have a moderate effect on overall sentiment.
- Large non-profit traders (Large Traders) – large institutional investors, hedge funds and other organizations that trade in the futures market for investment and profit. The sentiment of this group is the most significant for the market.
- Small Traders – The majority of this category is made up of individuals or small companies. Have little impact on the foreign exchange market.
You can follow the sentiment of currency futures based on COT reports on various analytical resources, for example, at finviz.com. Below the charts of currency futures, a diagram is displayed on which the positions of the above groups of traders are displayed with three lines. Finding the lines in the positive zone indicates the prevalence of buy positions, in the negative – the sentiment for sell.
Moving averages are another popular and visual tool for assessing sentiment. Moving averages show the average value of the price of the selected currency pair over a certain period of time. If the price rises above its average prices, this indicates the current positive sentiment, if it falls below, then it is negative.
Moving averages with a short period (from 5 to 50) are used to assess short-term sentiment, while long-term periods are used to assess long-term sentiment (100, 200). For example, when the price of a currency pair crosses the 200-day SMA upward, it indicates that sentiment is turning positive and an uptrend may begin. Conversely, if the pair quotes fall below the 200-day SMA, this indicates negative sentiment and foreshadows a downtrend.
Using Forex Sentiment in Trading
When using market sentiment in trading, I would distinguish two strategies. The first is confirmation of the current trend direction. That is, we determine the main direction in which we will mainly trade. The second strategy implies the appearance of signals about the end of the current trend and the beginning of a correction or even a reversal.
Confirming the direction of the trend
To do this, you can use the forex market sentiment indicators described above. When sentiment indicators are not close to extreme values, they can help confirm the current trend:
- The US dollar index shows an upward trend (sentiment positive for the dollar) or a downward trend (sentiment negative for the dollar).
- The chart based on COT reports shows that Large non-commercial traders are starting to change their position – a move to a negative area confirms a downtrend, to a positive area – an uptrend.
- An upward crossing of the 200-day SMA by the daily chart confirms an uptrend, while a downward crossing of the 200-day SMA confirms a downtrend.
- News background – positive news supports the upward trend in the currency, negative news strengthens the downtrend.
Let’s take the D1 chart of the USD / JPY currency pair.
- The USD / JPY pair has risen above the 200-day SMA.
- The US dollar index is showing an upward movement.
- The lines of the COT chart for the yen futures are not at the extreme values, the line of positions of Large non-commercial traders (Large Traders) begins to move down (sell the yen against the dollar).
- The news background is positive, stock markets are growing – this contributes to the growth of the USD / JPY pair.
As a result, sentiment indicators confirm the upward trend in the pair, we are looking for opportunities to open buy positions using technical analysis.
Signals of a possible correction or trend reversal
Reaching extreme values, as well as changing signals of sentiment indicators to the opposite, warns of a possible correction or trend reversal:
- The US dollar index is changing its direction, the formation of reversal patterns is possible.
- The COT chart shows the extremes, the position lines of Large Traders and Commercial Hedgers show a strong divergence.
- The price chart breaks off quite far from the 200-day SMA, after which it begins to move back, crossing the faster moving averages (for example: 7, 14)
- News background – positive news contributes to the development of an upward correction, negative news provokes a downward one.
After a strong upward impulse on the D1 chart of the USD / JPY currency pair, signals of a possible correction or downward reversal appeared:
- The USD / JPY chart moved far up from the 200-day SMA, after which it crossed the faster moving averages (7, 14) from top to bottom.
- The dollar index also turned down.
- The COT chart for Yen futures shows extreme values for the year, the lines of positions of Large Traders and Commercial Hedgers diverged as much as possible.
- The news background is neutral.
Forex sentiment indicators signal that a downward correction has begun for the USD / JPY pair. Now you should refrain from buying, you can even search for short-term sell positions using technical analysis.
Forex sentiment is the prevailing sentiment of the foreign exchange market participants. With the help of various indicators of sentiment, it is possible to assess who is currently dominating the market – “bulls” (believe in the growth of the currency) or “bears” (bet on a decline in the currency). Forex market sentiment is used in trading as a useful addition to the basic rules of fundamental and technical analysis.