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An estimated 20 million novice traders have started trading in the last two years – their decisions, behavior and market sentiment can mean investment opportunities.
Many retailers bring everyday cognitive biases into hyper-rational markets. Over the past year, we’ve seen these habits manifest in the ups and downs of suddenly popular categories of risky assets. Consider the rise and fall of meme stocks touted on Reddit boards, or the somber chant of HODL (hold on for dear life) once shouted by crypto traders. While these are extreme examples of market sentiment, ambition-driven distortions are far more common than many might believe.
In general, traders are typically looking for a timely entry into a rapid market move in the direction of the trade they wish to place. Aren’t we all?
In reality, the limited time to analyze and await the ideal criteria before entering a trade does not usually fit into the schedule that many inexperienced market participants expect. A round-turn trade “before dinner is ready” doesn’t usually happen.
In addition, many new retailers place a high value on technical analysis. That’s not a bad approach; but when novices view each pause as destined to endure, struggles often ensue.
Is it a trend reversal or a stuck trend?
A trader who lands at the extreme of a market position and is ready to jump at the first sign of a reversal can be in a particularly lucrative situation. Unfortunately, such systemic turns are a rarity. What is often mistaken for a major reversal is instead just a stalled trend or more cautious range-bound movement.
Trading market sentiment data can help confirm market trends. A sentiment-based trading strategy would aim to trade against consensus reversals when other indicators or analytical techniques support strong directional bias.
Picking highs and lows or taking advantage of prevailing trends is not typically a forte of retail forex traders. Newbie forex traders offer an interesting case study. If we can use retail traders’ market sentiment as a tool as their habits adjust to market conditions, a contrarian indicator can evolve into a more effective indicator.
Looking at sentiment in motion, let’s first look at the activity of the large speculative traders (like hedge fund traders) in the futures markets. Large participants are required to report their commitments once a week, and this commitment is published by the CFTC in the Commitments of Traders (COT) report. In general, this group tends to reflect the interests of medium-term investors (with a timeframe of weeks, if not months).
Below we see EURUSD versus speculative futures net positioning behind the same exchange rate. Although the correlation over time is generally strong, there is often notable price drift and speculative assumptions. Furthermore, data surrounding EURUSD shows that the urgency attached to testing a ‘double bottom’ at a decade low has not whetted a speculative appetite for a recovery from 1.3500.
Chart of EURUSD overlaid on CFTC’s reported net speculative futures positions … [+]
John Kicklighter
In contrast to the weekly COT updates from “big” market participants in futures, those who consider themselves active forex traders tend to take much shorter exposures. It is a handy trait for retailers to follow opportunities that they believe will unfold over a reasonable period of time. Unfortunately, the assumption that most technical limits are relevant and that any reversal could result in a productive reversal is far-fetched.
In the case of EURUSD, a shift in interest rate expectations over the past few weeks has helped shape an exchange rate reversal. The pair would also reverse from the “double bottom” of a multi-year low, and some retailers happily slammed assumptions on the move. In this case, the wisdom of the retail crowd happened to take advantage of a prevailing market condition, with those conditions being the very backdrop.
Chart of EURUSD overlaid with IG speculative net positioning from FX retail traders, including net … [+]
DailyFX.com
As an example of the significant difference between retail traders and professional traders, we have GBPUSD and the CFTC’s speculative net positioning actions. In this case, positioning has generally tracked price rather than encouraging contrarian signals. With the so-called “cable”, the assumption of a price decline in the positioning seems to coincide with the actual price movement. Where correlation can be a blessing, it can also prove a liability if we extrapolate these relationships to conclude that “correlation” is synonymous with causation.
Chart of GBPUSD overlaid on the net speculative futures position reported by the CFCT … [+]
John Kicklighter
Turning now to the retailer, it appears that the speculative net view perfectly reverses the approach shown by the COT report. In fact, the two-year low for GBPUSD up to that point appeared to coincide exactly with the peak of speculative ‘dip buying’. Of course, in the two months leading up to this actual turning point, there was a healthy push to find a bottom.
If we can determine a system where we are confident that the markets are in a range and not in a breakout or trending environment, then we can use this measurement of retail sentiment in a traditional rather than a contrarian manner. However, when circumstances reflect a “class of traders” groping for highs or lows where markets are expected; We can use this data as a contrarian indicator.
Chart of GBPUSD overlaid with speculative net positioning by forex traders at IG, including net … [+]
DailyFX.com
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