Learn to Trade

Do Sentiment Indicators Really Help Your Trading?

By Rob on July 17, 2015

Reading Time: 4 minutes

Have you ever thought how sentiment indicators could help you identify a strong trend set-up? The confidence that indicators can give you is not to be ignored. There’s practically nothing more fun—or more profitable—in all of technical trading than that. Traders will often go to great lengths to find it.

For some, it’s mainstream sentiment indicators such as pouring over charts or fundamental data. For others, it is using new-age technical tools while trying to spot trends before they start. Pure price action traders, however, tend to avoid sentiment indicators. This is because they are not convinced they are beneficial.

Today we will examine the subject of sentiment indicators. Profiling some common ones in order to show what they do and do not do. They provide a basis for traders considering whether or not to incorporate them 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. Thus, they create opportunities to trade in the direction of the new trend.

The most common sentiment indicators used today:

The Commitment of Traders (COT) Report

Released by the Commodity Futures Trading Commission (CFTC) each Friday. It shows data from the previous Tuesday, and shows how many large and small speculators 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 reversal trading taking place.

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. Whilst 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). It is 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. This data is broker-specific and does not necessarily represent an accurate picture of total market sentiment. Various other tools and sentiment indicators may also be available free of charge on your broker’s Web site or in the platform itself.

See also: The Real Reason Your Broker Offers Forex Education

…And How Traders Can Use Them

How to Use Sentiment Indicators in Your Trading Sentiment indicators can be useful tools for the following: 1) identifying trend reversals; and 2) confirming existing trends. Yet they are not accurate buy and sell signals on their own. Only when used in conjunction with fundamental and/or technical analysis can sentiment indicators be used to guide actual trade decisions. But beware, even extreme sentiment can last longer. Reversals may or may not materialize as expected.

Sentiment indicators do not represent a trading strategy all their own. Yet 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. In particular the trends you are seeking will be reversals in markets or assets you were not following as closely. You may then apply your own, careful analysis. Perhaps you may find a qualifying trade set-up that would not have crossed your desk otherwise.

For Confirmation/Confluence

Price can often tell you everything you need to know about market sentiment. Yet if you see a chart signal that suggests a trend reversal is at hand, a check of various sentiment indicators can help. These are COT positioning, or futures open interest. Typically the chart signal signal will be a movement in the candlestick pattern such as an engulfing candle. The data you will for that market or asset could help validate that signal rather quickly and with relative ease. This enables 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.