Trading Sentiment Extremes in FX
-How Sentiment Extremes Occur
-Be Aware of the Sure Thing
-Taking Little Bets when Extremes Occur
“What the wise man does in the beginning, fools do in the end.” Howard Marks
“When everyone thinks alike, everyone is likely to be wrong.” Humphrey Neill
How Sentiment Extremes Occur
When a “sure-thing” develops in the market, beware. Sure things happen when a story aligns in a market that catches the attention of everyone and even common newspapers begin to discuss how great or dire the outlook of a certain situation is. The current example is the Euro as Europe has found itself in a place where no forecast seems too bearish. While the EUR could definitely continue to drop and may in fact hit some of the lower forecasted levels like 1.20 or 1.10, we’re traders and not forecasters and therefore, must be cautious and agile.
The main point today is that when the retail crowd has found the sure thing, the end of the surety may be near. This is not to say that you cannot find great trades that can last or extend longer than you expect them to. This is to say that when everyone thinks alike, the smart money may be starting to take profits and exit the trade, which could lead to a correction at best or reversal at worst if you’re following the “crowd”.
Chances are, Wall Street Trading Desks Have Been in Moves before the Public Accepts the Idea
Be Aware of the “Sure” Thing
Markets are prone to manic behavior where a sure-thing is ever-present albeit always a different. This causes traders small and large to load into the next big “sure” thing as they start to prematurely count the money that is coming their way. Sadly, the future rarely plays out as we think it would have, which can lead to a mass exodus of the next sure thing. It’s still a good idea to follow trends but the argument for trailing stops applies well to strong trends that have a high approval rating from the public.
Recommended Reading: How to Use a Trailing Stop
Alternative Views of What Can Happen Can Prevent Taking on Too Much Risk
Presented by FXCM’s Marketscope Charts
Earlier, we mentioned the idea that the Euro has found itself in a position where no forecast is deemed too bearish. This is not the first time the market has found itself with a wide belief that EURUSD would print 1.000 before long. In fact, in the chart above, the first rectangle in the lower left had a major magazine print in the same week the low was printed with a cover that simply stated €1=$1?, which effectively happened before EURUSD rallied 2000 pips to 1.3992 in the summer of 2014.
Howard Marks of Oaktree Capital put it concisely, “Simply put, risk is low when risk aversion and risk consciousness are high and high when they’re low.” This quote aligns with the infamous Warren Buffet quote, “Be fearful when others are greedy and greedy when others are fearful.”
Recommended Reading: What the Momentum Slow-Down Means for US Dollar Bulls
Taking Little Bets when Extremes Occur
When you feel that we’re at a sentiment extreme around a “sure-thing”, you can take small-bets or little trades to test your theory. In order for this to occur, there are two things I like to look for when recognizing and trading a sentiment extreme and potential reversal.
Quick Tip: If you’d like to practice taking little bets after identifying sentiment extremes, you can set-up a FREE FXCM Demo account here.
A Sentiment Extreme on NZDUSD Would Be Weakened on a Channel Break
Presented by FXCM’s Marketscope Charts
First, is there a “sure-thing” type story that is floating around and can be confirmed by looking at magazine covers, headlines, and overall excitement over the argument? The second thing I look for is a stall in the move in favor of the story or a break of a trendline or channel that was in favor of the story.
Recently, the RBNZ had intervened to weaken the NZD and the potential for a hawkish FOMC allowed traders to pile into the USD all the more. This great story that argues for further downside in the cross could see a sharp pull-back if smart money begins to take profits or if either fundamental story loses its velocity or strength.
Recommended Reading: How Regression Channels Can Enhance Your Trend Trading
I’ll end with another Howard Marks quote that is crucial in understanding that sentiment extremes often make for the worst investments or trades:
“Success in investing is not a function of what you buy. It’s a function of what you pay.”
---Written by Tyler Yell, Trading Instructor
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