In this article We are going to explore how to gauge Market Sentiment through different ways, primarily the CoT.

Market Sentiment is purely how you feel about the the past, present and future state of the markets in regards to its current price. There are many popular sayings coined by traders such as "Trend is your friend" or "never catch a falling Knife". 

Many traders use Moving Averages to show Market sentiment. As its averages the previous number of periods, anywhere from 5 to 200. They might be willing to only trade with the direction of the MA, this in essence is Market Sentiment.

If you are bullish then you believe the security that you are describing is going to appreciate in value and if you are bearish you believe the opposite.

Methods of Identifying Market sentiment:

Moving Averages:

  • Firstly, you can use the aforementioned way using a Moving Average, for example, take a look at the EURJPY H4 chart
  • So you use the MA to decide which direction you trade in, as Bullish set-ups in the green box gain a lot of momentum and bearish reversals are sluggish and ineffective. vice versa for the blue box.
News:

  • This one is the most simple to understand but potentially the hardest to use. This requires some basic fundamental understandings on how the markets and the economy work.
  •  I won't go into too much detail, but broadly, if you are reading consistent negative news articles you can expect that the market and markets participants (you and me) will be more apprehensive about the overall outlook and will have a more bearish perspective.
Commitment of Traders report - CoT:

  • The CFTC releases the CoT for the Currencies that are traded on the Chicago Mercantile Exchange under futures. For example EURUSD futures are 6E_F and allocated EUR in the CoT with AUDUSD being 6A_F, AUD. And so on.
  • The CoT report released 30 minutes after the markets close on the friday of every week measure the Long and short positions in contract size for each of the Currencies. Normally the Non-Commercial figures are used which show the Speculators in the market (once again you and me).
  • The only strange thing about this report is, while it is released on the friday it shows the Long and Short positions for the close of trading on Tuesday earlier that week.
  • Here is a chart showing the CoT report vs. EURUSD weekly chart (dukascopy)
  • You can quite clearly see the Correlation between the price of EURUSD (Thick red)  and the Net Speculator Positions (Thick Black).



Here you can download the raw data as shown below for the GBPUSD over the last week. (27/03/2012) - (Courtesy of CFTC)

  • Here are many terms that may need explaining such as 
  • Long : The amount of contracts of £62,500 that are outstanding
  • Short : The amount of contracts of £62,500 that are outstanding
  • Net position : This is the total number of Longs - shorts.
  • Open interest : The amount of contracts that have yet to be exercised / covered.
Out of all of these the Net position is the most important to gauge market sentiment as it shows whether more people are long or short the market. As through the basic laws of any market mechanism price will represent the demand of said security.

One other Use of the CoT report is to see what side of the trade is driving the market. Long or short covering. 

For this example we will look at that EUR CoT chart placed above:

  • From AUG 2011 you can see a large drop in the Net position line (thick black) but if you look carefully you can see the Long Positions (thin Black) were little changed and it was the Short position that were driving the market as they exploded upwards (thin red).
  • Using this you can deduce that there is underlying strength and you get the phenomenon that is short squeezes.  
  • This is where Some traders take profits in a falling market temporarily slowing the fall down and providing a small bounce. Next more traders jump on with Buying back to cover as they believe that price may move up and they want to protect their positions.
  • Here is where it gets interesting. Traders panic and you see a quick violent jump up as many cover their shorts, which is seen by a near 1000 pip move in 3 weeks.

I hope you can appreciate and see the importance of the CoT report and that you should pay close attention every week to it as it can be a very good leading indicator for Sentiment and can provide invaluable help in directional trading for the following week.

Thank you very much for reading this Article and I hope this has helped you.

Adrian.
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