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Using Forex Market Sentiment Indicators

Reading time: 10 minutes

The Forex market has millions of traders, and they all have their own personal strategies and thought processes. Market sentiment is the dominating emotional condition of market participants towards market directions. Forex market sentiment is frequently used as a way of measuring crowd behaviour.

Forex Market Sentiment Indicators

The human instinct to follow the crowd causes traders to develop collective ideas and goals. For instance, when the crowd is buying, the majority will also buy and the same is true if the crowd is selling. What the crowd anticipates is actually an unsurpassed example of Forex market sentiment indicators.

The question is, what indicator represents this? This is either a graphical or numerical identifier which is developed to present the overall feelings of FX market participants about the Forex market. Those who utilise sentiment Forex indicators aim to work out how future behaviour is influenced by diverse aspects (i.e macroeconomic conditions, inflation, politics and unemployment).

Hence, those Forex sentiment indicators help to define whether traders are bullish or bearish to the current conditions of the FX market. We've developed this article in order to provide you with the knowledge concerning what these indicators are and how you can apply them.

The Main Sentiment Indicators

Every price movement of any security has reference to market sentiment. In case there is little or even no news about a security, Forex market sentiment may be the greatest and decisive short term factor in all price movements. Even when we observe the publication of significant news about a security or company, the ultimate price movements are frequently amplified or reduced. This is all down to the question of whether the FX market is bearish or bullish at that time.

There are a lot of efforts to gauge market sentiment with great accuracy, so there are a lot of various types of sentiment indicators. Some sentiment indicators, like volume ones, can be utilised for personal securities. The majority of sentiment FX indicators are based on using broad market data.

There are a certain number of market indicators which are based on the principle, whether right or not, that uninformed Forex traders sometimes make the wrong decision, purchasing at market tops, and accordingly selling at market bottoms. For instance, one of the old Forex market sentiment indicators is formed on odd-lot trading statistics that gauge a number of stock shares being purchased or sold in odd lots, which are in fact less than the 100 shares constituting a round lot.

Being based on the odd-lot theory, most of those buyers are assumed to have a small amount of money to trade with, and thus are expected to be the least advanced players on the FX market. For this reason, it's expected that they purchase during the period of an optimism peak, and sell during the pessimism period, and when the market bottomed out.

If we take a look at informed traders, they view odd-lot purchasing as a sell signal, and conversely odd-lot selling as a purchase sign. Eventually, they do precisely the opposite of the uninformed Forex traders' actions. Most of these Forex sentiment indicators are additionally known as contrarian indicators. The odd-lot isn't the strongest indicator, perhaps due to the fact that the vast majority of odd-lot buyers aren't actually traders.

They are purchasing for the long term and exclusively when they possess a certain amount of money, which suggests that they are not good sentiment FX indicators. What can be more reliable, if we consider that short sellers are Forex traders, is the odd-lot short sale ratio. That is the number of odd-lot short sales divided by the number of odd-lot sales. It works on the premise that a higher odd-lot short sale ratio identifies a Forex market bottom.

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Another representative of sentiment indicators which is considered even more reliable than the previous one is the put/call volume ratio. This is the ratio of the entire number of pits to the whole number of calls traded in one day. A put is an option that increases in value when the underlying security diminishes in value. This implies that you would purchase a put if you anticipated that the price of the underlying security was going to dwindle in the near future.

A call is a concrete option that increases in value as the underlying security increases in value. This means, that you would purchase a call when you anticipate the price of the underlying to go up soon. The put /call volume ratio is one of the most contrarian market sentiment indicators, because it is mainly at a maximum at Forex market bottoms. For this reason, it would seem that uninformed traders purchase puts when the the market has already declined.

Market volatility is another common measure of market sentiment. To clarify this term, it is the total amount that the price of a concrete index or security at a certain time diverges from the mean price, as gauged over a particular period of time. Higher levels of volatility mean more uncertainty for Forex traders.

Traders are likely to feel more anxious at times when the Forex market is declining or at the bottom. Low rates of volatility suggest that uninformed FX traders feel comfortable and this represents a sell signal. High rates of volatility are more regular at FX market bottoms, when uninformed traders are the most pessimistic about the market. It is important to exemplify the most popular volatility market sentiment indicators:

  • CBOE Volatility Index (VIX)
  • NASDAQ Composite Index (VXN)
  • S&P 100 Index (VXO)

Breadth Indicators

The breadth of the Forex market is based on a certain number of securities taking part in a market trend. Bigger breadth helps to validate either a bearish or bullish trend. Among the popular breadth indicators are the new highs/new lows ratio and also the advance/decline ratio. The advance/decline ratio incorporates a number of advancing issues. There are stocks that closed higher today compared to the previous trading session, divided accordingly by the number of declining issues.

That is the number of stocks closing relatively lower than in the preceding trading session. There is also the new highs/new lows ratio, which is the number of issues achieving 52-week highs divided by the number attaining 52-week lows. When the breadth Forex sentiment indicators are on the move in the same direction as the Forex market, then is regarded as a confirmation of the trend.

Divergence of the breadth indicator and the market itself is a signal that the trend may be changing. Bullish divergence occurs at a Forex market bottom, when the number of declining issues or, for example, new-low issues is decreasing even when the index is still declining. In turn, a bearish divergence occurs at a market top. That happens when the number of advancing issues or new-high issues reduces from previous trading sessions.

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Volume Indicators

Let us proceed onto another type of sentiment indicators. If you consider market sentiment as being like the feeling of the crowd, it makes sense that tracking volume could be useful in summarising market sentiment, or maybe the sentiment about a certain security. We can outline the rational way of tracking sentiment, and that is by noting the volume on downtrends or uptrends.

High volume acts as confirmation of the trend, however, price movements based on low volume have much less importance. It is suggested by professional traders to concentrate on volume spikes, where volume suddenly expands by two or more times than the previous average. Those spikes may identify significant news about a security or a company, so it would be sensible to check the news.

The time price movements are based on essential news, and a new trend may start to form, or the current trend may be augmented and prolonged. Another important element of Forex market sentiment indicators to discuss is the on-balance volume (OBV). It is the cumulative total of where volume is added on the days that the price closes higher, and deducting volume on the certain days when the price actually closed lower.

Most of the time the OVB achieves a maximum a few days prior to the price peak, and acquires a minimum of a few days just before the price bottoms out. Therefore, the OBV indicators identify cumulation by buyers or distribution by sellers. The accumulation is a buy sign, whilst distribution is a sell sign.

Some traders refine the volume data by working out what percentage the high close or low close is away from the midpoint. It is calculated by supplementing the high price and low price accordingly for the day, and then dividing it by two. As a consequence, the volume added or deducted is adjusted by how much the day's close diverges from the midpoint.

Conclusion

There are a lot of sentiment indicators and nearly endless ways to interpret them. Such indicators should be utilised with other indicators, and with fundamental analysis. How well any of those indicators work is difficult to evaluate. However, sentiment FX indicators seem to be well established, and they are frequently reported in the financial press. Overall, applying indicators is a crucial approach in measuring market sentiment.

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