Trading on sentiment: using IG client sentiment data

Trading on sentiment data can help traders identify trends in the market that may not be obvious to novice traders. DailyFX provides client sentiment data based on all live IG CFD trades in the forex, commodity and indices markets and acts as a contrarian signal.

A contrarian sentiment trading strategy would look to make a trade in the opposite direction whenever sentiment shows a strong directional bias. This may seem counterintuitive, but is well-founded and will be explained in this article.

This article will cover:

• 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

IG Client Sentiment, or IG CS, uses data derived from IG retail traders with live positions. Essentially, the tool makes it easy to see where the majority of IG traders are positioned, i.e. long vs short.

Using IG’s Client Sentiment tool as a contrarian indicator can be viewed as ‘fading the crowd’ – in other words taking the opposite direction of retail traders. All of this is made possible with IG’s 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 thorough research and technical analysis, and ensure to always use an appropriate trade size in relation to their account size.

• Why is client sentiment a contrarian indicator?

Before implementing a sentiment trading strategy, it’s useful 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 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 both retail and institutional 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:

1. Use IG Client Sentiment to establish the market and direction of the trade
2. Is the market range-bound or trending?
3. Overlay net-long/short positions over the price chart to see the bigger picture.

1. Use IG Client Sentiment to establish the market and direction of the trade
   
   Traders can look to sentiment at the start of the analysis process or they can begin with thorough technical and/or fundamental analysis and seek out client sentiment for confirmation.

   Using client sentiment as the starting point can be 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, compared with the number of traders holding short positions in the same market.
   
   Traders should be drawn to extreme levels (very short or very long) when analysing 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 77% for GBP/JPY. The figure is written in red (representing shorts) and the horizontal bar also depicts the sentiment imbalance in favour of short positioning.

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 77% of traders being net short GBP/JPY, this indicates that for every one trader holding a long position there are roughly 3.35 that are holding short positions, which represents a sizeable imbalance in the positioning of the pair.

General trading signals produced by IG Client Sentiment

At this stage, we know which market to trade and know the direction to trade if we want to ‘fade the crowd’ 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 actually makes sense.

Returning to the GBP/JPY example, after realizing that most traders are short GBP/JPY, 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 GBP/JPY chart below, it’s clear to see an overall uptrend, confirmed with price trading well above the red 200 DMA, despite retail traders remaining strongly net short. Being heavily short in a strong uptrend 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. 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, “View Full 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/red sentiment line shows when traders are net long/net short. If there is a large distance between the sentiment line and 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 uptrend and sentiment is showing over three times more short traders for every long trader, therefore, this can be regarded as a bullish signal.

The lower section of the diagram simply shows the actual number of short and long traders overtime. Since traders had become increasingly net-short, it’s no surprise to see the red line well above the blue line for long periods.

While IG Client Sentiment is a useful tool, it doesn’t mean it’s perfectly predictive. Traders should still look to utilise strong risk management in their trades, even with the assistance of IG CS.