Using Sentiment Analysis in Forex
To do sentiment analysis in Forex, the Speculative Sentiment Index (SSI) is a tool that can be used to understand how different traders are positioning themselves in the market. Continuing with the articles already published on the role that the Commitment of Traders (COT) Report plays in the market, on the analysis of Market Profile and the assessment made of the Money Flow Index, this text will address the interesting topic of sentiment analysis, with a focus in Forex. It will do so mainly by understanding what it is and how traders can read it.
What is the Sentiment?
Sentiment is about spotting traders’ positions, to ultimately understand how they are thinking, and how to take advantage of it. The most used indicator that can be used to understand where retail traders are positioned in the market is SSI. It comes in different forms and formats, but the main idea that traders need to understand when they are using it is that its main purpose is to capture potential opportunities for contrarian trading. And this is so because it allows us to identify where the herd is.
The herd is a pejorative term normally used to describe retail traders. As was explained in our previous analysis of the COT Report, there are mainly three types of players in the market: hedgers, big institutions and small institutions and retail traders. As was also explained, by understanding where retail traders have their positions, new opportunities for contrarian trading open themselves.
Supporting the SSI is, therefore, the way that the markets function from a psychological standpoint. Small and inexperienced retail traders tend to be driven much more intensely by greed and fear. They let their emotions get in the way much more often when compared to professional traders.
The reasoning behind the way these traders operate is very simple, therefore. When the market is clearly on the way up they buy. When the market is clearly on the way down they sell. Greed gets in the way of their reasoning.
The SSI allows us to understand where these traders are – and as more experienced traders to benefit from this knowledge.
How to Use the SSI for Sentiment Analysis?
SSI is the prime indicator to do sentiment analysis (although there are others such as the COT report, for long-term trading), but acquiring the SSI in the form of an indicator, for Forex, does not come cheap. Unfortunately we cannot have access to it via MT4 and so traders can’t always see whether they apply to their trading style unless they actually sign up for one of these platforms that provide this service.
One such broker is FXCM and in this last section we will use their indicator as the starting point to explain how to read the SSI. The indicator can easily be accessed on this website:
It shows the positions of retail traders in different financial instruments. From the difference between the number of traders holding long positions and those holding short positions, it establishes a percentage. When this number is above 0 it means that retail buyers with long positions prevail over the same type of traders with short positions. The same happens in reverse – when below 0 short retail traders are prominent.
So what can be extracted from this particular conclusion: when disparities between these two positions are higher, traders should be on alert for a potential reversal in the market.
How useful is this information? Well, we need to be aware that as with any other indicator the SSI is not the holy grail for trading. Here at ANALYTICAL TRADER, we consider it a relevant indicator but certainly not the most relevant one.
Nonetheless, the SSI is one of the most relevant indicators to understand where retail traders are in the market. And just because of this it certainly deserves our attention.
Continuing with the analysis that sentiment and volume play in the financial markets, in this article we saw how to do sentiment analysis using SSI. This indicator provides a very efficient way to understand where the herd is. When values are above 0 it means that there are more retail buyers in that particular position, and vice versa. In another article we will suggest different ways to trade using the SSI.
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