Trading Forex on Sentiment: A Case Study

03/12/2010 12:01 am EST

Focus: FOREX

For years, savvy traders have incorporated sentiment into their trading approach. 

While fundamental analysis looks at the economic factors of a market and technical analysis looks at a graphic representation of the decisions that traders have already made, sentiment is an attempt to get a feel for what traders are thinking after seeing the fundamentals and before they make that trade. While futures traders have had access to the Commitments of Traders (COT) information to see who has done what, and stock traders have used a variety of reports to include the put/call option ratio and short interest ratio in their approach, traders at FXCM have the Speculative Sentiment Index, or SSI, to complete their trading approach. 

These numbers are based on the fact that individual traders like to try to pick tops and bottoms in the financial markets.  I say “try” because most of the time, they find themselves in a losing trade as the trend continues. Like most traders, I like to wait for those extreme conditions before making a trading decision. Like a rubber band being stretched until it breaks, I look for when these top and bottom pickers load up against a trending move. As the market moves up to a new high or new low, these traders must exit their position, which adds more fuel to the trending move. So I wait for a -3 reading to look for a buy or a +3 reading to look for a sell. 

This is not a timing indicator, but rather a part of a total approach to trading. So I first make sure that the market is in a strong trending move on a daily chart move to incorporate the fundamentals into my approach as I feel that the trend offers the best representation of the opinion of the traders on the fundamentals. I then use technical analysis to better time my entry. I also look for an extreme reading against the trend. 

The current USD/CAD situation is a good example. The daily chart shows a downtrend. The SSI reading is at +3.28, which means that there are more than three times as many long (buy) positions as there are short (sell) positions open at FXCM. Now all I need is confirmation from the technicals to time my sell. One can simply use a move down to a new low. What better confirmation do we need to note a bearish situation than a new low? 

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This could also serve as a clue to those buyers that they are wrong, which may lead to more selling as they exit those buys.  A look at this hourly chart of the USD/CAD shows that a move down through the 1.0235 low might offer that solid selling opportunity with a protective stop placed above the buy side high at 1.0294 to limit our risk. 

By Thomas Long of

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