With so many participants - most of whom are trading for speculative reasons - gaining an edge in the forex market is crucial. Fundamental analysis provides a broad view of a currency pair's movements and technical analysis defines trends and helps to isolate turning points. Sentiment indicators are another tool that can alert traders to extreme conditions and likely price reversals, and can be used in conjunction with technical and fundamental analysis.
Sentiment is the net amount of market player's optimism or pessimism reflected in any asset or asset price at a particular time. It is the collection of emotion and bias in determining a price over or under the supposed "value," and it is a subject of study by behavioral finance departments, which are interested in the ways that human bias affects prices. When emotion becomes excessive and prices thereby deviate substantially from the norm, a price reversal is usually due, a reversion to the mean.
For example, if investors expect upward price movement in the stock market, the sentiment is said to be bullish. On the contrary, if the market sentiment is bearish, most investors expect downward price movement. Market sentiment is usually considered as a contrarian indicator: what most people expect is a good thing to bet against. Market sentiment is used because it is believed to be a good predictor of market moves, especially when it is more extreme. Very bearish sentiment is usually followed by the market going up more than normal, and vice versa.
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 our aforementioned currency pair continues to rise, and eventually 90 of the 100 traders are long (10 are short); there are very few traders left to keep pushing the trend up. Sentiment indicates it is time to begin watching for a price reversal.
Forex market sentiment indicators
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 and sell signals on their own; look for the price to confirm what sentiment is indicating before acting on sentiment indicator readings.