There are many types of traders using various forms of techniques to milk the market each and every single moment. My bias is towards price action technical analysis minus indicators but lately, I have been complementing it with sentimental analysis using risk on-risk off mood after some great observations.
There has been a long standing argument between traders as to which is better; between fundamental analysis and technical analysis. None of the factions have been able to completely prove the power of one over the other so it always ends at “what works for you”.
Today, I come your way with another type of analysis which is a goldmine that hasn’t been well utilized. This other type of analysis which has not been well exploited by traders is sentimental analysis.
As the name suggests, sentimental analysis gauges where the bias of the big players towards a particular market is. Sentiment can be measured in various ways but below; I will show you how to gauge it in one particular way which in my opinion is the best.
Three ways to gauge risk by sentimental analysis.
You might have heard about the Commitment of Traders report (COT). This is a report released by the Commodity Futures Trading Commission on every Friday and it is available on the cftc website. The COT report shows the number of big market players that are short or long a particular instrument. It is one of the good ways to measure sentiment; but I will not go into details since it is not the focus for today.
Some brokers if not all, also make known on their websites, the percentage of traders that are short or long a particular instrument. The idea is to be on the side where the percentage is higher. So for instance, if 82% of traders were short GBPUSD and 18% were long, a good trade will be to sell the pair. This however is a bad way to gauge sentiment since the forex market is highly decentralized; and the broker is only showing positions only from his end.
The ultimate way to use sentimental analysis (Risk on-Risk off).
If you already know about the risk on-risk off (RoRo) sentiment and how to measure it, then congrats, you can skip to the next lesson. If not, then take a ride with me. Gauging sentiment by RoRo is superb in my view; and all that is below is about that.
The first thing we need to know about Risk on-Risk off are the trading instruments that are termed risky and those that are not. In conventional trading knowledge, stocks are classified as risky assets whilst bonds are known to be “safe” investments.
It is meaningful since stocks can generate massive returns within a relatively shorter time as compared to bonds. Investors always assess the health of the global economy to decide which assets to invest in.
When risk is perceived as low, stocks tend to win the bet; when risk is perceived as high, bonds and some currencies become the go-to of the investors. (not to be confused; low risk perception makes appetite for risky assets high whilst high risk perception causes investors to flee to safety).
Simply put, stocks rise in risk-on moods and bonds rise in risk-off moods (or stocks fall in risk off-moods and bonds fall in risk-on moods).
How risk on risk off sentimental analysis relates to currency trading.
On currencies, EUR, GBP, AUD, NZD and CAD are similar to stocks as the risk-on instruments. These currencies attract risk because of their backing by commodities (gold and oil) and the positive correlations between them against the U.S Dollar.
USD, JPY and sometimes CHF are the risk off instruments because of their safe haven status. These three currencies are safe havens because; the dollar is the most attractive currency in the world due to its high liquidity. Japan gains attention in instances of global turmoil because of its high foreign investment. Whereas, Switzerland is widely viewed as a politically neutral county.
Gold however is one commodity that refuses to belong; although investors perceive it as a risky asset, it can unexpectedly be a safe haven as well.
This is how measuring the global risk sentiment can make you a better trader.
This might seem a bit complicated at first; but a little effort by way of gauging correlations, and it might be able to pay the bills. Most of the time, a country’s main stock correlates negatively to the country’s currency.
That is, if the S&P 500 is rising, the Dollar is falling or if the Nikkei is falling, the JPY is rising. At a first glance; it wouldn’t make sense as to why a stock does not correlate positively to its currency most of the time; but it plays out so due to the intricacies of exports and imports.
As a retail trader you can gauge risk by monitoring the movement of stocks (S&P 500 for USD and Nikkei for JPY). Or by simply monitoring the risk on currencies (EUR, GBP, AUD, NZD and CAD) and applying your price action techniques to see the mood.
Note: In the shots below are live market representation of sentimental analysis RoRo for May 2019, the red vertical lines represent May 2019 in the Metatrader charts.
When the stocks or risky currencies are moving up, risk is on because the big players buy the risky instruments. Conversely, risky assets are sold when risk is off; they’d be moving down, so expect at least one of the safe havens to be extra strong in such a situation.
The trick is to pair the strongest risk appetite currency with the weakest safe haven in a risk on mood and pair the weakest risk appetite currency to the strongest safe haven in a risk off mood. Pairing safe havens or pairing risky assets during such times would not be so much of a nice idea. This is because you might not catch the greatest daily pip move.
Also, you must note that markets move up steadily most of the time when risk is on; but they move down faster (what I like to call free falls) immediately risk is off. All that said, the JPY pairs tends to get most of the attention in risk off moods; since they tend to have the mind-boggling moves most of the time.
However, note that this doesn’t always work since correlation is not constant and many are the factors that affect market movement aside risk sentiment. Just as captured in the words of the great economist, John Maynard Keynes; “the market can stay irrational longer than you can remain solvent.”
If the risk on-risk off type of sentimental analysis is new to you, take your time and observe the markets whilst staying open minded. With patience and great observation coupled with healthy anticipation; it could help improve your trading. Did I miss anything with respect to gauging risk? I’d love to hear from what you have to add.