With so many participants most of who 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.
Market sentiment in its most basic definition defines how investors feel about a particular market or financial instrument. As traders, sentiment becomes more positive as general market consensus becomes more positive. Likewise, if market participants begin to have a negative attitude sentiment can become negative. While sentiment is not unique to the forex market it can be directly translated to currency pairs.
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.
The Commitment of Traders (COT) is released every Friday by the Commodity Futures Trading Commission. The data is based on positions held as of the preceding Tuesday which means the data is not real-time, but it's still useful. Interpreting the actual publications released by the Commodity Futures Trading Commission can be confusing and somewhat of an art. Therefore charting the data and interpreting the levels shown is an easier way to gauge sentiment via the COT reports.
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 buying and selling signals on their own; look for the price to confirm what sentiment is indicating before acting on sentiment indicator reading.