Forex Market Sentiment Indicators and How To Use Them

Reviewed by Thomas J. CatalanoFact checked by David RubinReviewed by Thomas J. CatalanoFact checked by David Rubin

What Is a Forex Market Sentiment Indicator?

According to a 2022 triennial report by the Bank for International Settlements (BIS), there are, on average, $7.5 trillion of forex transactions on a daily basis. With so much action and so many participants—most of whom are trading for speculative reasons—gaining an edge in the forex market is crucial.

A forex market sentiment indicator is a useful tool that can alert traders to extreme conditions and likely price reversals. It quantifies how market players feel about a currency pair, the market overall, or the economy to try to predict how traders’ behavior may affect future market performance.

Fundamental analysis provides a broad view of a currency pair’s movements. Technical analysis defines trends and helps to isolate turning points. Sentiment indicators can be used in conjunction with both of them.

Sentiment indicators come in different forms and from different sources. One is not necessarily better than another, and they can be used in conjunction with one another. Or specific strategies can be tailored to the information you find easiest to interpret.

Key Takeaways

• Sentiment indicators measure how traders and investors view the outlook for the markets and larger economy.
• They attempt to quantify these views as a way to predict future market performance.
• Forex traders can use technical sentiment indicators to help identify entry and exit points for currency pair trades.
• But they aren’t used to generate buy and sell timing alerts.
• Forex sentiment indicators include COT reports, open interest, and brokers’ position summaries.

How Sentiment Indicators Work

Sentiment indicators show the percentage, or raw data, of how many trades or traders have taken a particular position in a currency pair. For example, assume there are 100 traders trading a currency pair. If 60 of them are long and 40 are short, then 60% of traders are long on the currency pair.

When the percentage of trades or traders in one position reaches an extreme level, sentiment indicators become very useful. Assume that our aforementioned currency pair continues to rise, and eventually, 90 of the 100 traders are long (10 are short). That means that there are very few traders left to keep pushing the trend up.

Indications

Sentiment indicates it is time to begin watching for a price reversal. When the price moves lower and signals that it has topped, the sentiment trader enters short because they believe that those who are long will need to sell in order to avoid further losses as the price falls.

Sentiment indicators are not exact buy or sell signals. So traders should wait for the price to confirm the reversal before acting. Currencies can stay at extreme levels for long periods of time, and a reversal may not materialize immediately.

What Is an Extreme Level?

Extreme levels will vary from pair to pair. Say that the price of a currency pair has historically reversed when buying reaches 75%. When the number of longs reaches that level again, it is likely the pair is at an extreme, and you should watch for signs of a price reversal.

However, if another pair has historically reversed when about 85% of traders are short, then you will watch for a reversal at or before this percentage level.

Note

The forex market is the largest financial market in the world. It is open 24 hours a day from Monday through Friday.

Commitment of Traders Reports

A popular tool used by futures traders to get a sense of sentiment is also applicable to spot forex traders. The Commitment of Traders (COT) report is released every Friday by the Commodity Futures Trading Commission (CFTC). The data shown is based on positions held as of the preceding Tuesday, which means the data is not real-time. Yet, it’s still useful.

Interpreting the actual publications released by the CFTC can be confusing, and is somewhat an art. Therefore, charting the data and interpreting the levels shown is an easier way to gauge sentiment via the COT reports.

How To Read Commitment of Traders Reports

Barchart.com provides an easy way to chart COT data along with a particular futures price chart. The chart below shows the Daily Continuous Euro FX futures contract with a Commitment of Traders Line Chart indicator added.

The COT data is not displayed as a percentage of the number of traders short or long, but rather as the number of contracts that are short or long.

Large speculators (green line) trade for profit and are trend followers. Commercials (red line) use futures markets to hedge, and, therefore, are counter-trend traders.

Focus on large speculators. While these traders have deep pockets, they can’t withstand staying in losing trades for long. When too many speculators are on the same side of the market, there is a high probability of a reversal.

Over the time period shown, when large speculators were short about 200,000 contracts, at least a short-term rally soon followed. This is not a definitive or “time-less” extreme level and may change over time.

Another way to use the COT data is to look for cross-overs. When large speculators move from a net short position to a net long position (or vice versa), it confirms the current trend and indicates there is still more room to move.

While the cross-over method is prone to provide some false signals, over the years several large moves were captured using the method.

How To Interpret the Data

When speculators move from net short to net long, look for the price of the euro futures, and by extension the EUR/USD, to appreciate. When speculators move from net long to net short, look for the price of the futures and related currency pairs to depreciate.

Futures Open Interest

The forex market is an over-the-counter market, with independent brokers and traders all over the world creating a non-centralized marketplace.

While some brokers publish the volume produced by their client orders, it does not compare to the volume or open interest data available from a centralized exchange, such as a futures exchange.

Open interest, simply defined, is the number of contracts that have not been settled and remain open positions. Thus, futures contracts open interest can help gauge sentiment in the forex market.

For instance, if the AUD/USD currency pair is trending higher, looking to open interest in Australian dollars futures provides additional insight into the pair. Increasing open interest as the price moves up indicates the trend is likely to continue. Leveling off or declining open interest signals the uptrend could be nearing an end.

Interpreting Open Interest

The following table shows how open interest is typically interpreted for a futures contract.

The data then must be applied to the forex market. For example, strength in euro futures (U.S. dollar weakness) will likely keep pushing the EUR/USD higher. Weakness in Japanese yen futures (U.S. dollar strength) will likely push the USD/JPY higher.

Futures volume and open interest information is available from CME Group and is also available through trading platforms such as Charles Schwab’s thinkorswim.

Position Summaries by Broker

To give the over-the-counter forex market transparency, many forex brokers publish the aggregate percentage of traders or trades that are currently long or short in a particular currency pair. These are position summaries.

The data is only gathered from clients of that broker, and therefore provides a microcosmic view of market sentiment.

The sentiment reading published by one broker may or may not be similar to the numbers published by other brokers.

Small brokers with few clients are less likely to accurately represent the sentiment of the whole market (composed of all brokers and traders), while larger brokers with more clients compose a larger piece of the whole market, and therefore are likely to give a better indication of overall sentiment.

Other Access to Sentiment Gauges

Many brokers provide a sentiment tool on their websites free of charge. Check multiple brokers to see if sentiment readings are similar. When multiple brokers show extreme readings, it is highly likely a reversal is near. If the sentiment figures vary significantly between brokers, then this type of indicator shouldn’t be used until the figures align.

Certain online sources have also developed their own sentiment indicators. Dukascopy Swiss Banking Group, for example, posts the SWFX Sentiment Index combined with analysis and ideas on how to trade the data.

Can I Measure Sentiment Without a Sentiment Indicator?

Yes. You can regularly review comments and longer posts expressed by active traders on social media platforms and in relevant news coverage having to do with the forex market. But you then might want to compare the conclusions you draw with sentiment indicators data.

What Is Necessary for a Good Sentiment Indicator.

A good sentiment indicator should communicate the opinions, beliefs, and emotions of the overall group of people who take positions in a particular market.

Can a Sentiment Indicator Tell Me When To Buy or Sell?

Not reliably. Sentiment indicators typically are used to gain a sense of how the market is viewed by those who are active in it, and thus, how participants’ behavior may affect the market going forward.

The Bottom Line

Forex sentiment indicators come in several forms and from many sources. Using multiple sentiment indicators in conjunction with fundamental and technical analysis provides a broad view of how traders are maneuvering in the market.

Sentiment indicators can alert you when a reversal is likely near, due to an extreme sentiment reading, and can also confirm a current trend.

Sentiment indicators are not buy or sell signals on their own; look for the price to confirm what sentiment is indicating before acting on sentiment indicator readings.

Losing trades still occur when using sentiment. Extreme levels can last a long time, or a price reversal may be much smaller or larger than the sentiment readings indicate.

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