Picking tops and bottoms or taking advantage of prevailing trends is not typically a strong suit of retail FX traders. Novice currency traders provide an interesting case study. If we can use retail trader market sentiment as a tool when their habits align to market conditions, a contrarian indicator may turn into a more effective indicator.
Looking at sentiment in motion, we first consider the activities of the large speculative traders in the futures markets. Large participants must report their exposure once a week, and that exposure is published by the CFTC in the Commitments of Traders report. Generally speaking, this group tends to reflect the interests of medium-term investors .
Below we see EURUSD relative to net speculative futures positioning behind the same exchange rate. Though the correlation is generally strong over time, there is frequently a notable drift in price and speculative assumptions. Furthermore, the data surrounding EURUSD shows the urgency attached to testing a ‘double bottom’ at a multi-decade low didn’t draw speculative appetite for a bounce from 1.3500....
In the case of EURUSD these past few weeks, a shift in interest rate expectations helped shape an exchange rate reversal. The pair would also reverse from the ‘double bottom’ of a multi-decade low, and some retail traders happily slapped assumptions on the movement. In this case, the wisdom of the retail crowd just so happened to capitalize on a prevailing state of the market whereby those conditions were the actual backdrop....
If we can determine a system by which we are confident that markets are in a range rather than a breakout or trend environment, then we can utilize this retail sentiment measure in a conventional manner rather than a contrarian capacity. Yet, if circumstances reflect a ‘trader class’ that is groping for tops or bottoms where markets are expected to run; we can utilize this data as a contrarian indicator....