Basic Forex Strategies Part 2: Understanding Market Sentiment

Market sentiment is a strange phrase for whoever is not familiar with forex and financial investments in general. Following a common prejudice, these two terms sound like an oxymoron: how can a market have a sentiment? As it turns out, as long as market agents are human beings, there will always be emotional factors involved. Whereas this can be seen as a good thing from a human standpoint, emotions represent a further problem, a further factor that needs to be interpreted and needs forex trading strategies in order to be interpreted.

A particular market sentiment determines a trend and is largely based on expectations. The main question is: is the market going up (bullish sentiment) or down (bearish sentiment)?
Although sentiments are the opposite of objectivity there is nonetheless a way to try to give an interpretation: the open interests. Open interest analysis is one of the most interesting ways to analyze traders’ attitude towards the currency market.
Analyzing open interest is one of the most common forex strategies for those who trade on future, less common among those who operate on the spot market, the reason is that spot market does not offer enough information about its open interest. All transactions are carried out over-the-counter and not over formal exchanges, and there is therefore no data than can be analyzed. On the other hand though, it is possible to take the futures market as a reference to do this kind of analysis.

Open interest is usually confused with volume, but they actually are two different things. Open interest refers to the total number of open futures contracts at a given moment on the market. Any time a futures contract is opened, the open interest is increased by one, whenever it is closed, the open interest index is decreased.
The difference between open interest and volume is that any exchange of existing open contracts will increase the volume, but will leave open interest unaltered.

Open interest tends to increase whenever there is more money on the market. This is a signal that there are new speculations being carried out more aggressively against the current trend. In other words, an increase in the open interest is generally a signal of sentiment of support to the current market trend, unless it changes again, based on a new set of information. By contrast, an open interest decreases when speculators are taking money away from the market.
In a consolidated trend, whether bullish or bearish, open interest should ideally increase. If the opposite happens, it could be a warning that the current trend is losing stability, as there is no fresh money being invested in the market.

An increasing open interest means that the market sentiment is supporting the current trend, a decreasing open interest means that the sentiment is going in the opposite direction.
How does this become a forex trading strategy? Even if all this applies to the futures market, in most cases, the trend of futures currency market exchanges is strictly related to the spot market if the same currency. This means that futures market trend can be a very meaningful indicator for the strength of the same currency on the spot market.

Check out part 3 of Forex Trading Strategies