Talking Points:
- Sentiment describes how the majority of traders view a currency pair.
- The Speculative Sentiment Index from DailyFX tracks retail sentiment specifically.
- Downloadable Historical SSI is available to backtest its effectiveness.
When someone asks me what my favorite trading tool is, I quickly lead them to the Speculative Sentiment Index
or SSI. The turning around of my Forex trading career from my first two
years in the red to the profitable trader I am today I attribute to the
SSI and its direction filtering ability. The best part is that it's
free to use and DailyFX offers historical SSI for historical testing for
free as well. Inside this article, I will explain what sentiment is and
how we can download this data for testing our own strategies with this
powerful filter.
What is Sentiment?
Sentiment is a description of how a person or a
group of people feel about something specific. In the case of trading,
it's going to describe the ratio of bulls vs. bears. It tells us how
many people have long positions and how many people have short positions
for a given instrument.
In the case of DailyFX's Speculative Sentiment
Index, it gives us a comparison between how many retail Forex traders
are currently long and short on each major pair. Why does this matter
you ask? Because when the SSI moves to an extreme level, price usually
moves in a predictable direction against the retail crowd. The USDCHF is a recent example of this phenomenon.
Back in February, USDCHF
retail sentiment reached a 3-year high of +7, meaning there were 7
traders who were in a buy position in the USDCHF for every 1 trader that
was in a sell position. This 7-to-1 ratio meant over 87% of the retail
trading crowd were long this pair. Knowing this, we should have looked
to Sell the USDCHF for three reasons:
- Statistics show that most retail traders lose money. So if most retail traders were buying USDCHF, it might have been best to take the opposite trade.
- If most people had already bought the USDCHF, there were not many people left that could join them. The sudden lack of new buyers could have meant the price would begin to fall.
- If price did start to move against this group of buyers, one by one they would have begun to get stopped out. These stop orders would have then pushed price lower hitting a greater number of stops and could have created a cascade of sell orders.
Learn Forex: USDCHF SSI is Still in Positive Territory
Downloading Historical SSI Data For Testing
We should all understand how SSI works now. We find
out what the retail crowd is trading and look for an opposing trade. But
what if we want to analyze SSI's impact on price over a larger sample
size? How can we know if using SSI as a filter will work for our own
personal trading strategy? Luckily, DailyFX offers historical SSI data
that we can use to semi-manually backtest strategy performance with and
without SSI as filter. This allows us to directly assess its strength as
a filter over a greater amount of time.
To access the data, we need to login to www.dailyfxplus.com using our FXCM account number and password or by subscribing for $19.99/month.
Once we log in, we need to select "Speculative Sentiment Index", click
the top (most recent) SSI submission, then click "SSI data via this ZIP
file."
Learn Forex: Downloading Historical SSI Data
On Your Mark, Get Set, Backtest!
Now that we have this historical SSI data, we can
look at our trading history to see what trades would have been filtered
out by SSI and see if this filter would have been an improvement. Better
still we can backtest new strategies by only allowing them to buy when
SSI was negative and only allowing them to sell when the SSI was
positive and see what affect it has.
My next article will feature just that, backtesting
an ordinary strategy and comparing its trading results to the exact same
strategy that uses the SSI as a filter. We will then be closer to
definitively calculating SSI's strength.