Trading on sentiment data can help traders identify hidden trends in the market that may not be obvious to novice traders.DailyFX provides client sentiment data based onall live IG trades in the forex, commodity, cryptocurrency and indices markets and acts as a contrarian signal. A successful sentiment trading strategy would look to make a trade in the opposite direction whenever sentiment shows a strong directional bias. This may seem counter-intuitive but is well-founded and will be explained in this article.
Trading with IG Client Sentiment talking points:
- What is IG Client Sentiment?
- Why is client sentiment a contrarian indicator?
- How to create a sentiment trading strategy using IG CS
- Learn more about trading with sentiment
What is IG Client Sentiment?
IG Client Sentiment, or IG CS, uses data derived from IG retail traders with live positions. Essentially, traders are able to see where the majority of traders are positioned, whether long or short, when analyzing trades. Traders can access IG Client Sentiment data using our interactive tool wheremarkets and asset classes can be filtered accordingly.
IG Client Sentiment is viewedas ‘fading the crowd’ or going the opposite direction of retail traders. All of this is made possible with IG’s accurate, real-time data on the most frequently traded markets – which can be used in any sentiment trading strategy.
It’s crucial to note that traders should not trade based on IG Client Sentiment alone but should combine sentiment with technical analysis and ensure that the appropriate trade size (in relation to the account size) is used at all times.
WHY IS CLIENT SENTIMENT A CONTRARIAN INDICATOR?
Before implementing a sentiment trading strategy, it’s essential to understand why client sentiment is regarded as a contrarian signal.
IG Client Sentiment is regarded as a contrarian indicator for two main reasons.
1. Trading against the trend: The majority of retail traders (the population of the IG CS data) are trend fighters. Unfortunately, this appears to be human nature more than logic as this pattern continues to play out. These traders attempt to call tops and bottoms in the market by trading reversals in strong trending markets. This goes completely against the fundamental concept of, ‘The trend is your friend’.
2. Exiting the trade: If the market is in an uptrend and sentiment is overwhelmingly short, all those short traders will eventually need to do the opposite to close the position, which would involve buying to close. Whether a stop or limit is hit, or the trade is closed manually, this will involve ‘buying’ which drives the prices upwards. If short traders significantly outweigh long traders, those short traders will eventually have to buy to close their positions creating buying momentum that will benefit long traders, not short traders.
HOW TO CREATE A SENTIMENT TRADING STRATEGY USING IG CS
This section expands on IG CS by incorporating it in a sentiment trading strategy. The steps involved are listed below:
- Use IG Client Sentiment to establish the market and direction of the trade
- Is the market range-bound or trending?
- Overlay net-long/short positions over the price chart to see the while picture.
1) Use IG Client Sentiment to establish the market and direction of the trade
Traders can look to sentiment at the very start of the analysis process or they can conduct thorough technical and/ or fundamental analysis and seek out client sentiment as confirmation of the trade.
Using client sentiment as the starting point however, can be extremely useful as it can inform which market to trade and in what direction, before any other analysis is even done. Thereafter, traders can use technical analysis to spot ideal entry and exit points for that market.
Establishing the market and direction: Look for markets exhibiting extremes in positioning. Strong upward (downward) trending markets combined with extreme net-short (net-long) client positioning, results in a bullish (bearish) signal.
Using IG Client Sentiment for a clear directional bias
The summary table on IG Client Sentiment, displays the number of traders holding long positions in a selected market, to the number of traders holding short positions in the same market.
Traders should be drawn to extreme levels (very short or very long) when analyzing sentiment, as this is where the tool provides clearer signals. As can be seen in the graphic below, there is a relatively extreme figure of 78% for NZD/USD. The figure is written in blue (representing longs) and the horizontal bar also depicts the sentiment imbalance in favor of the longs.
Readings that are red indicate net short positions in a currency pair, while readings in blue show that traders are net long the pair. Another way of viewing the degree of sentiment is to consider the ratio of long to short traders. It is widely considered that readings greater than 2, indicate a meaningful bias among retail traders as this translates to at least 66.6% of traders net-long/short.
Therefore, with 78% of traders being net long NZD/USD, this indicates that for every one trader holding a short position there are 3.54 that are holding long positions; which represents a sizeable imbalance in the positioning of the pair.
General trading signals produced by IG Client Sentiment
|TREND DIRECTION||RATIO OF NET-LONG TO NET-SHORT||SIGNAL|
At this stage, we know which market to trade and know the direction to trade it but there are further factors to consider and these are explored in the remainder of the article.
2) Is the Market Range-Bound or Trending?
Trending markets: It’s human nature to look for bargains which is why retail traders often look to “call the bounce”, selling in an advancing market and buying a falling market.
Range-bound markets: In well-established ranging markets, preferably with low volatility, selling at the highs and buying at the lows makes sense.
Returning to the NZD/USD example, after realizing that most traders are long NZD/USD, one could reasonably assume that this must be the correct trade to place. This, however, could not be further from the truth.
Taking a look at the NZD/USD chart below, it is clear to see an overall downtrend despite retail traders remaining strongly net long. This seems counter-intuitive but reinforces the notion that retail traders tend to be trend fighters.
To their detriment, retail traders tend to focus more on catching reversals in strong trending markets than trading ranges. Therefore, when trading on sentiment, traders will find more reliable (contrarian) signals in strong trending markets.
3) Overlay net-long/short positions over the price chart
To make the analysis easier, DailyFX provides a comprehensive report on major markets, showing IG sentiment overlaid on price. To get the full report, navigate to the sentiment page and click on the Green button labelled, “IG Client Sentiment Report”.
The report produces a price chart for each market with sentiment superimposed on the same chart. It also includes a paragraph showing all relevant sentiment numbers before providing ether a bullish, mixed or bearish trading bias.
Another useful and often overlooked feature of the report is the changes in long and short positions. This feature is particularly helpful to traders when recent moves in sentiment are sizeable and move conversely to the overall sentiment. Such large changes could indicate a reversal in overall sentiment and the market itself.
Once the report is open, scroll down to find the desired market. Traders will find a chart and a quick summary of recent and overall sentiment numbers.
The top section of the diagram shows how price has evolved (green and red candles) and the blue/redsentiment line shows when traders are net long/ net short. If there is a large distance between the sentiment line and the price, this can be considered as a signal to trade in the direction of the trend.
In the above diagram, price is in a strong downtrend and sentiment is showing over three times more long traders for every short trader, therefore, this can be regarded as a bearish signal.
The lower section of the diagram simply shows the actual number of short and long traders overtime. Since traders had become more and more net-long, it’s no surprise to see the blue line well above the red line for long periods.
While IG Client Sentiment is a useful tool, it doesn’t mean that it’s perfectly predictive. Traders should still look to utilize strong risk management in their trades, even with the assistance of IG CS.