The Japanese Yen continues to trade towards record-highs against the US Dollar, but an important divergence between USDJPY price action and trader sentiment warns that a reversal is imminent. Typically we see that large professional traders buy into strength and sell into weekend—following clear currency trends.

Yet a look at recent CFTC Commitment of Traders data shows that speculative futures traders are effectively flat—few are positioned for further Japanese Yen strength (USDJPY declines).

US Dollar/Japanese Yen Trades towards Lows but Sentiment Warns of Divergence

us_dollar_japanese_yen_forecast_bottom_body_Picture_5.png, US Dollar/Japanese Yen Near Big Reversal - When Might We Get Long?

Low participation rates can likewise be seen through FX Options markets which are near their most bullish US Dollars against the Japanese Yen in history. In the past 10 years, forex options traders have consistently paid a significant premium for out of the money USDJPY puts—aggressive bets on or hedges against USDJPY weakness.

Yet current readings actually show that options traders are near their most bullish USDJPY on record—a clear discrepancy given that the USDJPY is trading towards record-lows.

US Dollar/Japanese Yen Price Action Shows Divergence against FX Options Sentiment

us_dollar_japanese_yen_forecast_bottom_body_Picture_6.png, US Dollar/Japanese Yen Near Big Reversal - When Might We Get Long?

Given the substantial divergence between sentiment and USDJPY price action, the risk of reversal is high. Yet timing a Japanese Yen turnaround has been exceedingly difficult—especially as these divergences between price action and sentiment have existed for some time. Where can we watch for more short-term signal of the long-awaited USDJPY reversal?

We often use our retail trader-based Speculative Sentiment Index to time shorter-term price action across major currency pairs, and we’ll watch the next signals in the USDJPY with a close eye.

Retail FX Trader Sentiment is at its Most Extreme USDJPY since Record Lows

us_dollar_japanese_yen_forecast_bottom_body_Picture_7.png, US Dollar/Japanese Yen Near Big Reversal - When Might We Get Long?

If retail crowds are buying, we prefer to sell. Yet we likewise see that the retail crowd is extremely net-long at bottoms and extremely net-short at tops.

Our SSI shows that there are nearly 10 retail traders long the USDJPY for every short. That’s below the almost-incredible 17.6:1 seen at February’s record-lows and the 17.5:1 seen through the massive declines in October, 2011. Yet we would argue that retail sentiment puts current price action closer to a bottom than to further losses. What would be the signal to get long?

One of our sentiment-based trading strategies is designed to catch major trend reversals as traders change their bias, and said system could provide accurate signal to get long the USDJPY. The “Tidal Shift” (also known as “Momentum2”) trading strategy goes long if retail trading crowds are at their most net-short in the past 145 hours—roughly a trading week. There are certainly no guarantees that it will accurately call the bottom, but given clear sentiment divergences we feel risk/reward favors USDJPY long positions.

Forex seasonality studies suggest that major tops and bottoms occur at the beginning and end of the trading month, and as such we may need to wait until August to see a Japanese Yen turnaround. Of course, there are never guarantees in trading and sentiment can remain extreme for far longer than you can maintain proper maintenance margin in your account. Yet we like the risk/reward on USDJPY long positions through the foreseeable future.

--- Written by David Rodríguez, Quantitative Strategist for DailyFX.com

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