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Mastering Forex trading with Sentiment

“What is important is to assess what the market is focusing on at the given moment.” – Bill Lipschutz

Know this: if the first thing you do in the morning is turn on your computer and sift through chart after chart after chart, looking for setups to get into, then you are not playing the game like the professionals.

Charting, Technical Analysis and Price Action are all valid components of a successful trading strategy, but they cannot offer an answer to the most important question of each trading session, day or week: what is the market concentrated on? In other words: where is the action likely to be?

Majors, Minors, Crosses, Exotics, Emerging Market Currencies…there are over 70 potential currency pairs to chose from on any given day. The question remains: being an individual trader, how can you direct your limited time & energy towards the best possible situations? Where will the movers & shakers be?

What is Sentiment?

Sentiment is simply the market’s aggregate perception of the future outlook for any given asset, based on the information available up until now. Let’s break down this definition, in order to understand it better.

  • aggregate perception = the sum of what all parties with skin in the game are thinking
  • of the future outlook = whether the future looks rosy or bleak
  • based on the information available = given the current fundamental background.

Now let’s get practical. How can a retail trader, at the end of the food chain, possibly understand what the professionals’ view is? Simple: paying attention.

How Sentiment Influences Price and Vice Versa
Source: Proprietary Illustration

Sentiment in Action

For example, the market was quite bearish regarding the Aussie going into this week. The price action was also proving this slant as the following chart suggests:

AUDUSD 4H Chart Source: Pepperstone MT4

So what do we need to ascertain, in order to understand this market sentiment and insert ourselves into the information flow?

In order to play the sentiment game, we need to have a clear view of:

  1. where we are coming from
  2. where we are going (which is also where we will most likely go if no new information hits the market)
  3. where we stand

1. Where are we coming from?

A useful resource would be an end of week market wrap or news article. For example:

The initial phases of the process will seem daunting, because you are effectively “merging onto a busy street”. So at the beginning, the key is to remain calm and remember what you’re looking for:

  • what has happened in the past week?
  • how did the markets react?

In the case of the Australian Dollar, the prospect of more RBA rate cuts has been – and remains – a negative influence. Recent commentary from the RBA Governor implies that an AUD closer to the USD 0.70 region is more in line with prices for Australia’s bulk commodity exports, and that he remains open to further easing. The Aussie, from May 23rd to May 27th, traded heavily due to this tone along with USD strength.

2. Where are we going?

Again, end of week market wraps (for a weekly view) and news articles (for a daily view) are a good place to search for the right information. Now remember: it is not the trader’s role to research/investigate information sources. The trader must choose the appropriate information sources, but then pay attention to what is being reported.

Source: Danskebank

Source: ScotiaBank

Therein lies the subtle difference between trading what you see, and trading what you believe. In order to trade what you see, you must only pay attention in a mindful, non-judgemental manner. In other words, you need to trust the work of others (researchers/journalists in this case) and relinquish your opinion(s) about it for the time being.

So, going into the week of May 30th, a leisurely scroll through end of week reports would have most likely led you towards the following considerations:

  1. There is a Holiday in the US and UK on Monday May 30th. So without the two most important players on the field, it will most likely be better not to trade, and give little weight to the price action seen.
  2. Regarding the USD, we have an eventful week. The market’s attention will most likely be on Non-Farm Payrolls, which is expected to print slightly weak (150-160 K) but not weak enough to tamper with the FOMC’s plans for a further “summer hike”. Other data during the week includes ISM manufacturing index (Wed), expected to fall slightly, and ISM non-manufacturing index (Fri) also expected to fall slightly with factory orders expected lower. So on balance, the market’s expectations are actually bearish for the USD going into the week. This means that any bullish outcomes will have more of an impact, because they will come with the “surprise factor”.
  3. Regarding the EUR, we also have an eventful week. We have EU sentiment indicators (Mon), which are expected to rise. German CPI is also due, expected higher at 0.2%. German unemployment (Tue) is expected to show a drop of 2K, which would keep the Unemployment rate steady at 6.2%. EU unemployment rate (Tue) is expected to fall to 10.1%. PMI surveys (Wed) are expected to remain firm. But the major event of the week will be the ECB (Thur), although no change is expected. Final service/composite PMIs (Fri) should also show consistent growth. On balance, the outlook is positive for the EUR so negative events will have the most impact.
  4. Regarding GBP, there is some data to pay attention to, over and above the usual Brexit/Bremain debate. Manufacturing PMI (Wed) is expected below 50, but slightly higher than previous; Construction PMI (Thur) is expected to fall. Services PMI (Fri) is expected to rise slightly but EU referendum uncertainty will still overshadow these releases. On balance, it seems like a volatile and unclear week on GBP.
  5. Commodity Currencies: Australia has a busy week. Company Operating Profit & Inventories (Mon); Current Account (Tue) and building approvals (Tue) are expected better than previous; AIG Performance of Manufacturing Index (Wed) and GDP are also due and might show some weakness. Retail Sales (Thur) might show lower growth than the previous print; AIG Performance of Services Index (Fri) is the last data point for the week. On balance, the outlook seems slightly bearish on the AUD, so any positive outcomes will pack a punch.

A key focus (for CAD above all) will be the OPEC meeting in Vienna (Thu). Discussions will center on a potential response to recent supply disruptions, including Canadian wildfires and militant attacks in Nigeria. In particular, markets will be watching for any signs of an increase in Saudi Arabian production levels but most likely, OPEC's current strategy will be maintained for now.

Chinese data will also affect commodity currencies like AUD and NZD, beyond risk appetite. Markets are expecting a marginal fall in the official Chinese manufacturing PMI (Wed) and similarly in the Caixin manufacturing PMI (Wed), which might influence risk appetite negatively.

So regarding our Aussie, we have a busy week ahead and the currency will most likely still be in focus. The market is short going into the week, which means it will take worse than consensus news or totally surprising news to knock the currency down more (because traders are already prepared for bad news) and it won’t take much good news to kick the trend our of gear.

3. Where do we stand?

Wherever you are in the world, a good habit is to take into consideration what happened in the session immediately before your own, and go from there. So for example, if you are trading the London session (which is the deepest liquidity pool of the 24-hour cycle), then it would be most useful to explore the developments from the Asian session. And then ask yourself these fundamental questions:

  • Is this new information or not?
  • Is this information going to drive flows to/from certain currencies?
  • Can I use this information and these probable flows to trade in line with my longer term plan?
  • Can I use the probable flows to take a short-term counter-trend stance? Or should I stay flat?

Again, the answer should be self-evident. If you need to “look” for a trade, it’s simply not there. If you need to “force” logical connections, then they are most likely wrong.

So going into the week, we had a UK/US holiday and it’s usually a good habit to not trade or disregard price action during these kinds of days. But on Tuesday, waking up during the European Session, we go to read up on overnight developments and see this:

  • Australia Apr private-sector credit +0.5% m/m, housing +0.4%, business +0.8%
  • Australia Apr building approvals +3.0% m/m vs. -3.0% expected
  • Australia Q1 current account deficit A$20.8 bln, A$19.5 bln eyed, net exports GDP impact +1.1%, +0.7% eyed, government consumption +0.9% q/q.

So the market was hit with strong numbers from Australia! So we can flip onto our AUDUSD chart, to see if the market is responding logically and cares about these numbers. We would expect a surge in Aussie.

AUDUSD 1H Chart – Source: Pepperstone MT4

“..if the price action fails to confirm my expectations, will I be hugely long? No, I'm going to be flat and buying a little bit on the dips. You have to trade at a size such that if you're not exactly right in your timing, you won't be blown out of your position.” – Bill Lipschutz

We always need to verify that the market is reacting in line with our analysis. In this case, the market is reacting as we expected and with such strong momentum, the logical thing to do is simply wait for a retracement to get in and possibly aim for last week’s high as an initial target.

The key is to understand people's expectations, not only about particular risk events (like NFP), but also about broader themes like Brexit, QE, Rate Hikes and general prospects for global growth. The genesis of every significant price move is a change in the underlying assumptions about the future value of an asset, due to new information that conflicts with what is already known.

The more you understand these underlying assumptions, and the better you can assimilate this new information as it comes in, the better you will be placed as a retail trader to exploit the market’s movements.

Sentiment Made Simple

At least initially, following day to day sentiment might seem like a never-ending struggle. Have no fear: there are ways to make your life easier. There are various Sentiment indicators that have been developed over the years, precisely to help ascertain market positioning and thus sentiment. The most famous is probably the Commitment of Traders Report or “COT Report”.

Source: http://www.cftc.gov/MarketReports/CommitmentsofTraders/index.htm

The Commitment of Traders report is probably still one of the most useful sources of information for traders. The reports detail the positioning of “Commercial” entities (i.e. Usually big corporations hedging their exposure) and “Non-Commercial” entities (i.e. big speculators) in the various futures markets. It is useful to attain a longer term perspective on major capital flows, as well as a read on how overextended certain markets may be. It shows large players’ positioning.

The reports are released weekly via the Commodity Futures Trading Commission (CFTC) and can be downloaded and analyzed for free at www.cftc.gov. Below, you can see a typical EURUSD weekly line chart (to evidence peaks and troughs) along with the progressive levels of Net Commercials (Dark Blue) and Net Speculators (Orange). It's easy to see some patterns emerging from the chart – hence the saying "a chart is worth a thousand words".

Source: Proprietary Illustration

  • Commercials are hedging. Commercials are typically large corporations and banks. As the price of an asset rises, they will increase their short position, protecting themselves against declines in price. The more price rises, the more they sell and obtain a higher average selling price. The result is that they are shortest at market tops and longest at market bottoms. They are acting on the basis of whatever their treasury department tells them that they need to do in order to protect corporate profits.
  • Speculators are following the trend. They are big funds and big individual traders that are generally trend-followers. They buy as price increases, and sell as price decreases. The fact is that speculators are consistently wrong in their market timing. Their positioning ratios always seem to be longest at market tops and shortest at market bottoms…

So speculators and commercials move opposite to one another. When a top in price occurs, speculators will be extremely long and commercials will be extremely short. In other terms, speculators will be on the right side of the market for the intermediate portion of a trend, and commercials will be right at the extremes (or turn) of the trend.

Stated more simply: there is an edge to following the speculators until the market reaches an extreme. When the market reaches an extreme reading on the COT, the risk of reversal is larger than the risk of continuation. Every market top/bottom creates an extreme in COT positioning. But not every extreme in positioning creates a market top/bottom.

Every respectable investment bank research department creates a weekly analysis of the COT report. The rationale is as follows: we may not know precisely what the market’s sentiment is today, but by observing the market’s positioning we should be able to infer what sentiment is. After all, if market participants are convinced of a certain view, they should be betting in that direction and thus positioning reports should illustrate their sentiment.

Sample of COT Report - Source: ScotiaFX

Sample of COT Report – Source: RBC Capital Markets

By following the COT report, traders can have a clear view of which side of the market large traders are favouring. The question is: where to find this data, in a ready-to-use format?

Commitment Of Traders: Net position and COT Index – Source: www.timingcharts.com

One ready-to-use source is TimingCharts. On the page, you can visualize the COT positioning as a net position (longs – shorts) and also the useful COT Index, which is a percentile reading of (current net position/net positioning range) in the lookback period. To keep things simple:

  • 52 Week, 26 Week and 13 Week Simple Moving Averages (i.e. 1 Year, 6 Months and 3 months) are quite useful to gauge Speculative pressure on these long-term trends;
  • The most useful extreme readings of the COT Index tend to have a 136-week (i.e. 3Yr) lookback period. Shorter term extreme readings are more prone to false tops/bottoms and can lead to a “fading” mentality where it is not as useful.

Retail Sentiment made Simple

The one difficulty with using the COT report is that it is not timely enough. It is issued every Friday, but the data used is from the previous Tuesday. So in effect the data is 3 days old. Sometimes, 3 days don’t mean a thing. But sometimes, in the case of Central Bank meetings, Non-Farm Payrolls, or other developments, 3 days can mean quite a lot. So how have market participants worked around this issue?

Source: ForexMagnates

Enter Retail Sentiment indicators. Just like there are positioning indicators of large traders (COT), it is just as possible to calculate Retail positioning. But why is Retail Sentiment useful?

  • retail traders are usually on the wrong side of established trends. They act like the “Commercials” and keep fading trends trying to catch tops & bottoms;
  • retail traders are usually fading breakouts;
  • retail sentiment is readily available with little or no delay.

Sentiment Trader Smart Tool – Source: Pepperstone MT4

Retail traders like to pick tops and bottoms, and their trading behaviours can be somewhat represented by a 10-period RSI on a 1H chart. Why?

  • retail traders tend to trade the smaller time frames
  • retail traders tend to use indicators (like the RSI)
  • retail traders don’t have the patience to trade a trend.

How can we use Retail Sentiment to our advantage? In a strong trend, it makes sense to watch retail positioning and trade against it. When the market is ranging, retail traders will be profitable so we can use it as a confirming indicator.

To sum up: understanding market sentiment really can impact your bottom line. Get in agreement with large players, follow the evident trends, and take liquidity from retail traders that are attempting to pick tops & bottoms. Use simple resources like the Smart Trader Tools offered by Pepperstone to gauge sentiment and trade accordingly. Your trading will never be the same.

 

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