How to Measure FOREX Market Sentiment

By gauging market sentiment, currency traders can project future trends in the forex markets.

By gauging market sentiment, currency traders can project future trends in the forex markets.

Forex traders play the up-and-down swings in major currencies, such as the Japanese yen, the British pound, the euro, and the U.S. buck. If you're speculating in the forex market, one variable you should keep track of is market sentiment. You don't have to go far for this info -- the brokerage that handles your trades probably keeps its own sentiment indicator. By trading against the herd instinct in currency speculators, you might be able to stand out among traders.

Basic Considerations

On the spot market, traders deal in currency pairs. Each pair matches one currency with another; the pair rises and falls with the supply and demand for one and/or the other currency. The USD/JPY pair, for example, prices the amount of Japanese yen a single U.S. dollar will buy; the pair rises as the dollar gets stronger. The EUR/USD gives the amount of U.S. dollars you can buy with one euro, and rises with the euro. You can go long or short, meaning you can bet on a rise or a fall, respectively, in the price of each currency pair.

Spot Market Indicators

Major forex brokers keep track of long and short interest in each currency pair, with "interest" meaning the number of open trades for either position. Brokers use this data to create a sentiment index, according to the broker's own algorithm. DailyFX.com, for example, keeps the Speculative Sentiment Index, or SSI. This handy number set shows the change from week to week in the sentiment on particular currencies. To make it easy, the broker breaks down the numbers in a table and then gives the signal: bullish (positive) or bearish (negative).

Futures and Options

In the futures market, speculators buy and sell currency contracts that carry an expiration date. Buying or selling these contracts is basically a bet on the direction of a single currency. You can gauge market sentiment by the open interest in the currency, which is reported each week in the Commitment of Traders report issued weekly by the U.S. Commodities Futures Trading Commission. This shows the number of open positions as well as the long and short interest in each contract. The greater the proportion of long positions, the more positive the market sentiment on that particular currency.

Contrary Traders

Experienced traders often treat market sentiment as a contrary indicator. Some traders will fight the crowd, and buy and sell against the prevailing trend in sentiment. When everybody's going long, then any information that runs counter to the bullish view will inspire the herd to slam it into reverse, which will then drive the market price in the opposite direction: down.

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