Contrarian Approaches with Sentiment Indicators

It is the study of crowd behavior that forms the basis of contrarian investing: selling when optimism has peaked or buying when pessimism has peaked and the market has bottomed out. Such an approach could not really exist if theefficient market hypothesis were true, since price action would constantly be determined by the logical offundamentals. A contrarian approach can only exist because prices are mostly determined by market sentiment.

Crowd behavior is a composite of many types of biased thinking and therefore it is virtually impossible to quantify. But yet, there are some tools that fall under the category of market sentiment indicators which we will use to determine bullish sentiment and bearish market sentiment.
There are many sentiment indicators, and an almost infinite variety of ways of interpreting them. In any case they should be used with other indicators and even with the fundamental analysis as we have described it so far.

There is a general perception that a sentiment indicator is like a technical indicator based on past price data over aperiod of time. It is somehow displayed like a technical indicator, but with some differences. First of all it is not based on price action in the way a technical indicator is. Moreover they don't lag as technical indicators do. Sentimentindicators are most often used together with technical indicators in order to generate buy and sell signals. But perhaps the most important is their usefulness as risk control indicators assessing if markets are reaching asentiment extreme and therefore a change of bias is possible, or if there is still room for a trend extreme to develop.

There are many attempts to accurately measure market sentiment and so there are several different kinds ofsentiment indicators—only a few are presented here. One good thing about sentiment indicators is the fact that they are transparent and in many cases freely accessible. Let's look at some of these indicators which can be extremely helpful to spot market turns.

Commitment of Traders Report (COT)

The COT provides up-to-date information about the trend and the strength of the commitment traders have towards that trend by detailing the positioning of speculative and commercial traders in the various futures markets. Remember that the spot Forex is an over-the-counter market, therefore the futures market is used here as a proxy for the spot market. The Commodity Futures Trading Commission (CFTC) releases a new COT report each Friday.

The COT report contains a lot of information, but the meat of the report is the data which shows the net long or shortpositions for each available futures contract for commercials and non-commercial traders. There are COT reports forequity traders (stock futures), commodity traders (including oil and gold) and currency traders (currency futures).

Commercial traders represent companies and institutions that use the futures market to hedge risk in the cash orspot market. These participants have a preference to buying on weakness and selling into strength (negative-feedback or counter-trend trading). They are trading without emotion, as they are hedging risk, long-term, and only change positions when the price deviates a lot from what theiy consider fair value. The typical commercial tradingpattern is to average down in a bearish market (or up, in the case of an up-trending market). There seems to be uniform agreement that the commercials (hedgers) are the group that determines the direction of prices.

These market participants have very deep pockets, in the sense that they can endure positions against markettrends for a long time. The COT report gives us an idea about the trend for a particular asset class and tells us what the big money is doing.
In order to spot for market turns we shall pay attention to this category because commercials are typically mostbullish at market bottoms and most bearish at market tops. They don't do this because of a contrarian approach but rather because they are hedging.

Non-commercial traders, on the other hand, are considered speculators. This category includes large institutional investors, hedge funds and other entities that are trading in the futures market for capital gains. These participants are usually trend followers, buying when prices increase and selling when prices decrease. They behave like positive feedback traders: they enter late when the trend is underway, suffer through any pullbacks, and exit late when their algorythms are convinced the trend is over causing them to lose heavily at major trend changes especially when considering they usually have highly leveraged positions. But don't misunderstand: they are not losers, they simply do poorly as a group compared with more optimized possibilities. Large speculators may be associated with superior forecasting ability, therefore you want to know if they are net long or net short and avoid trading against them.

Trends of non-commercial futures traders tend to follow the trends very well. But it's worth noticing that in the futures market all foreign currency exchange futures use the U.S. dollar as the base currency. This means that net-shortopen interest in the futures market for the Swiss franc (CHF) shows bullish sentiment for USD/CHF. In other words, the futures market for CHF represents futures for CHF/USD, on which long and short positions will be the exact opposite of long and short positions on USD/CHF.

Knowing what the commercial and non-commercial traders are doing through the COT report gives us some idea about the market extremes for a particular currency. Jamie Saettele, in his book “Sentiment in the Forex Market” resumes the idea by explaining:

"You have probably noticed that speculative positioning and commercial positioning move inversely to one another. If a statement is made about the relationship between speculative positioning and price, then the opposite is true about commercial positioning and price. For example:

Speculators are extremely long when commercials are extremely short (and vice versa).
A top in price occurs when speculators are extremely long and commercials are extremely short (and vice versa).
Speculative positioning is on the correct side of the market for the meat of the move but is wrong at the turn.
Commercial positioning is on the wrong side of the market for the meat of the move but is correct at the turn."

Source: “Sentiment in the Forex Market” by Jaemie Saettele, John Weiley & Sons, Inc., 2008

VIX

The VIX (Volatility Index) has a fair amount of popularity and usefulness for Forex traders as a market sentimentindicator to measure implied volatility. Remember, volatility is the magnitude of movement that a price deviates from the mean price over a specified time period. Specifically, the VIX measures the implied volatility, rather than the historical volatility, of the options bough and sold on the S&P 500 index. If we consider options as a protective measure against a corrective price move against a major trend, then we understand that the greater the impliedvolatility is, the greater is the fear among the trend following traders that the market is reaching an extreme (a bottom or a top).

There are some currencies which are sensitive to equity markets and that is the reason why this indicator also serves to build a Forex trading methodology.
As with other sentiment indicators, traders look at extremes in the VIX. If the VIX shows a downtrend this means that traders are buying fewer options, which in turn means they are complacent with the underlying prices. When the VIXhits an extreme bottom, then traders prepare for a reversal in the VIX which implies a higher risk trading environment coming soon.
Pairs such as the USD/JPY or EUR/JPY are sensitive to equity prices and can thus find a reliable tool in this indicator. A bottom in the VIX can be seen as a reversal from a top extreme in those pairs as traders have reached a top of confidence and optimism towards the trend.