Quite often, individual traders have their own opinion about the markets and will act based on that opinion. However, taken on a grander scale, that defines the market sentiment. In Forex, the market sentiment is measured by the number of traders who go bearish or bullish on a country’s currency. This is the whole pair expressing a certain sentiment.

A positive outlook on the AUD coupled with a negative outlook on the USD in the AUD/USD pair would usually be reason enough for traders to go long.

The risk involved when trading the Forex market sentiment is, as usual, the possibility of loss. An over the counter (OTC) trading system, like the one Forex has, increases the risk compared to other markets due to the fact that getting reliable currency pair data at any given time is much more difficult.

Sentiment analysis

Analyzing FX traders’ psychological and emotional states first requires indicating and measuring it. Even using a number of indicators, it can be challenging to get an accurate measurement. That’s because it involves taking into account multiple individual opinions in order to get a percentage that shows how bullish (optimistic) or bearish (pessimistic) the market is. That being the case, when emotion comes into play, in extreme cases for some and not so much for other traders, it is far harder to get accurate data.

However, in most cases, that would go hand in hand with fundamental or technical analysis in order to get a better understanding of the Forex market as a whole. Although a hard task, all methods of analysis can be used simultaneously to aim for utmost accuracy.

Sentiment indicators

There are several indicators that come in handy to measure the sentiment of a market. Those are Commitment of Traders (COT), Contrarian Methods with Sentiment Indicators, Moving Averages, and Volatility Index (VIX).

Volume (as an indicator outside FX)

Before going into the specifics for each one, another common indicator should be mentioned and that is trading volume. While it may not be useful for identifying the direction a market is headed towards, it helps grasp just how much interest there is out there.

In the case of Forex, it is not as popular due to the market’s OTC nature. However, volume can provide data on how commodities and shares are traded. For instance, if a company’s stocks continuously rise but volume is falling, that can be seen as part of the data reported on a regular basis. Consequently, this can be taken as an indication of a pessimistic market sentiment.

Commitment of Traders (COT)

The COT report gives data overall transactions, regardless of the position taken, in the forex market as well as other markets such as commodities, futures, and options. At around 8:30 PM GMT on Friday (5 AM AEST on Saturday) of every week, the Commodities Futures Trading Commission (CFTC) reports what the overall interest is in the markets. It is sorted in three groups by categories of traders – commercial, non-commercial, and non-reportable (speculators).

Within the many sections of the report, FX traders will be looking at the currency pairs and positions taken by large-scale traders. They are required to report regularly, as they are considered major drivers in the market movement. Some of them include banks, institutional traders, hedge funds, and more.

Contrarian Methods with Sentiment Indicators

Contrarian traders are driven by market sentiment and run in the opposite direction of the crowd. They go short when the outlook is positive and go long when it is negative. Combining this approach with fundamental and/or technical analysis as well as other sentiment indicators makes it possible to graph out crowd behavior with decent accuracy.

Moving Averages (MAs)

Going above the average means sentiment is headed in a positive direction. Conversely, going below the average means the sentiment is negative.

Assessing short and long sentiments requires using moving averages for the same period. For instance, the 50-day simple moving average (SMA) and the 200-day SMA are two such MAs. When the 50-day SMA crosses above the 200-day SMA, prices are going uphill and the bullish sentiment known as the golden cross comes into being. When it is below the 200-day SMA, prices tend to go down and the bearish sentiment referred to as the death cross is born.

Volatility Index (VIX)

The VIX, aka the fear gauge, is primarily followed by traders of options, futures, and equities, as it tracks volatility on the S&P 500. It gives a better idea of the market sentiment by indicating the amount of confidence or fear that traders are feeling. A value of 0 reflects a bullish market sentiment or trader confidence. A value of close to 100 reflects a bearish market sentiment or trader fear. 

In other words, the higher the VIX index is, the more the market fears a trend reversal. Traders looking to protect themselves against risk is a sign of market volatility increasing. Low volatility means that there is a low level of fear. Adding moving averages to the VIX allows for a rather clear distinction between highs and lows.