Do Sentiment Indicators Really Help Your Trading?

08/20/2015 6:00 am EST

Focus: STRATEGIES

Rob Colville

Founder and CEO, The Lazy Trader

Rob Colville, of TheLazyTrader.com, profiles some common sentiment indicators in order to show what they do (and don’t do) and provides a basis for the trader considering whether or not to incorporate any as part of his analysis and trading process.

Can you even think of anything you like more than identifying a strong trend set-up, acting confidently on it, and ultimately capturing the meat of that move? If you can’t, well, I don’t blame you. There’s practically nothing more fun—or more profitable—in all of trading than that and traders will often go to great lengths to find it.

For some, it’s mainstream sentiment indicators or pouring over charts or fundamental data, while some traders even use new-age technical tools while trying to spot trends before they start. Pure price action traders, however, tend to avoid sentiment indicators—all indicators, in fact—and as a result, a debate over whether sentiment indicators are really beneficial in trading lives on.

Today, we’ll examine the subject of sentiment indicators, profiling some common ones in order to show what they do (and don’t do) and we'll provide a basis for traders considering whether or not to incorporate sentiment indicators as part of their analysis and trading process.

The Most Popular Sentiment Indicators…

Sentiment indicators typically show the raw number or percentage of traders who hold a certain position in a given asset or currency pair. In practice, sentiment indicators are intended to isolate cases where extreme sentiment (bullish or bearish) may act as a precursor for a reversal in the prevailing trend, and thus, create opportunities to trade in the direction of the new trend.

What follows are among the most common sentiment indicators used today:

The Commitment of Traders (COT) Report—Released by the Commodity Futures Trading Commission (CFTC) each Friday and showing data from the previous Tuesday, the COT report shows how many large and small speculators—as well as commercial traders—are long and short particular assets and currency pairs. Because large speculators are also trend followers, theory holds that when too many large speculators are on one side of the market, there is a higher likelihood of a reversal.

Futures Open Interest—Open interest is simply the number of futures contracts currently unsettled in a particular asset. Generally speaking, increasing open interest suggests a trend has further to run, while decreasing open interest may signal a reversal ahead. Open interest data for the forex market must also be interpreted slightly, as all data is for single currency futures (i.e. euro futures), not applied currency pairs like EUR/USD, EUR/CHF, etc.

Broker Data—For transparency, brokers may also publish the number or percentage of client trades that are long and short a particular asset or currency pair, although this data is broker-specific and does not necessarily represent an accurate picture of total market sentiment. Nonetheless, various other tools and sentiment indicators may also be available free of charge on your broker’s Web site or in the platform itself.

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…And How Traders Can Use Them

Quite possibly the most important point about sentiment indicators is this: Although sentiment indicators can be useful tools for 1) identifying trend reversals and 2) confirming existing trends, they are not accurate buy and sell signals on their own. Only when used in conjunction with technical and/or fundamental analysis can sentiment indicators be used to guide actual trade decisions, and even then, extreme sentiment can last longer and reversals may or may not materialize as expected.

So while sentiment indicators do not represent a trading strategy all their own, they may assist traders with these key functions:

Finding an Asset/Currency Pair to Trade—When prospecting for new trade ideas or searching for opportunities during those dreaded Summer Doldrums, perhaps a look at select sentiment indicators will help you locate trends and/or trend reversals in markets or assets you weren’t following as closely. You may then apply your own, careful analysis, and perhaps even find a qualifying trade set-up that wouldn’t have crossed your desk otherwise.

For Confirmation/Confluence—Price can often tell you everything you need to know about market sentiment, but if you see a chart signal that suggests a trend reversal is at hand, a check of the sentiment indicators, like COT positioning, or futures open interest, for that market or asset could help validate that signal rather quickly and with relative ease, enabling you to execute with more confidence and peace of mind.

Conclusion

Great, long-running trend trades don’t come along all the time, yet they are what most every trader will devote tireless effort to finding. And while sentiment indicators are among the common tools used to do so, the essential takeaway here is this: Sentiment indicators are viable tools used by many to spot trends and trend reversals, but they are not valid entry signals in and of themselves.

Ask yourself whether pure price action trading is enough for you to spot opportunities and effectively act on them, and if yes, then adding sentiment indicators to the mix likely isn’t necessary. However, if you want to cast a larger net—maybe consider some new markets and/or currency pairs or help to confirm trend and/or reversal signals on your charts—then perhaps sentiment indicators are worthy of some consideration.

By Rob Colville of TheLazyTrader.com

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