Using Market Sentiment Indicators

Many individual traders who are not operating out of large dealing rooms in the Interbank forex market can find themselves somewhat challenged when it comes to gauging the sentiment of the market.

Although they might have access to a wide variety of financial news and economic data over the Internet, they may still lack the personal communication network that the Interbank forex market thrives on.

Nevertheless, several indicators that have arisen from the currency futures market trading on the Chicago International Monetary Market or IMM can provide considerable assistance to traders in assessing market sentiment.

Specifically, two of the most important of these are the open interest in currency futures contracts and the Commitment of Traders or COT report issued on a weekly basis by the U.S. Commodities Futures Trading Commission or CFTC.

Using Futures Open Interest to Gauge Market Sentiment

Spot forex trades do not generally permit the tracking of volume or open interest since they trade in the over the counter market. This contrasts with currency futures that trade on exchanges like the Chicago IMM which provide useful volume and open interest data for the currency market.

The technical information provided by open interest can be useful in supporting a fundamental analysis determination of market sentiment, perhaps obtained from consumer confidence data or other surveys.

For example, if the open interest in a currency futures contract is decreasing after an extended period of overall rising spot prices, then it would imply theoretically that market sentiment is turning from positive to neutral with respect to the currency as futures traders start to square their long positions. This signals that the end of the trend is approaching.

Alternatively, if the open interest is expanding in a declining market, this would indicate growing negative market sentiment as futures traders increase their short currency futures holdings. Such an observation would support the continuation of the downwards trend.

The Commitment of Traders Reports

The weekly Commitment of Traders or COT report is issued by the CFTC each Friday covering positions in futures contracts as of the preceding Tuesday.

The information contained in the report includes a listing of all major participants in the market and their activities as far as open long or short positions in currency futures and options.

Also, the report summarizes reportable positions that consist of options and futures positions that must be reported to the CFTC by regulation.

In addition, the report includes non reportable positions that are made up of open long and short positions held by traders that are not obligated to report. The report also contains the numbers of both reporting and non-reporting traders.

Using the COT Report to Assess Market Sentiment

Traders can use the changes in positions listed in the COT report to gauge how the market's sentiment is changing over time, with a focus on the positions held by non commercial currency futures traders that tend to be speculators rather than hedgers.

When using the COT report, traders will often look for extreme positioning situations as a sign of a possible market reversal after a significant trend has established an especially strong market sentiment in one direction.

Hence, if the COT report showed a historically excessive number of shorts among non commercial traders in a downward trending market, then this might be a good time to consider closing short positions in anticipation of an imminent upward market correction. Similarly, an excessive amount of longs would indicate the time to close long positions for a downward correction.

The absolute level of non commercial positioning listed in the COT report can also be used as a simple gauge of market sentiment for analysis purposes. Forex traders might also use flips in non commercial positioning in currency futures from positive to negative as a sell signal or from negative to positive as a buy signal.