Primer - A quick introduction to speculative sentiment analysis with the Euro

We are waiting on the Euro, with Trichet coming out with
a very hawkish outlook yesterday which probably saved it
from the fall which would have triggered our short trade.

Please note that I do not make these trades, but I am using
the Euro to teach how I would trade if I was like the
majority of traders who buy and sell futures trying
to capture swings. I will come back to my trading techniques
featuring my 2nd principle of trading "Do not predict; react!"
that I first introduced in my post on the Perils of Price
Prediction. But a few things must happen before that,
and I am taking the time to do some more conventional
analysis.

Anyway, in this article I will briefly introduce the concept
of speculative sentiment and its contrarian signals.
The futures market participants are divided into two
main classes, the commercials and speculators. The
commercials are actually interested in buying or selling
the underlying commodity or currency, while the speculators
are only interested in making money off the movements
in price. An example of a commercial is a gold mining
company. An example of a speculator is me.

There are two classes of speculators, or specs for short.
The large specs and the small specs. The differentiation
is based on how many contracts a spec holds, long or short.
It is not very important for our topic.

Speculative sentiment measures the current ratio of
longs to shorts among the speculators. Remember that
for every future contract in existence, there is someone
who sold it and someone who bought it. It is a zero
sum game. But the zero sum is across the entire market,
including commercials and specs. Within each class,
however, the sum is not necessarily zero. In fact,
it very rarely is.

As an example, lets look at the Euro June 2008 futures
which we have been following. It so happens that at
the moment, 52% of specs are long ( thus 48% are short ).
The longs are those who are bullish, of course. The
shorts are bearish. Sentiment is 1.10, which is 52
divided by 48. If 52% of the specs would have been short,
the number would be -1.10. This is just a convenience;
what it means is that positive numbers are bullish and
negative numbers are bearish, and the absolute value
of the number is the ratio by which the majority exceeds
the minority.

Now I will show the chart of the Euro nearest futures
plotted against the SSI ( speculative sentiment index,
which is what we call it ) over the last 5 years.



You will notice that since late 2006, sentiment has
been consistently bearish while the Euro has made an
uninterrupted run upwards. Why is this important ?
Because with the latest SSI numbers finally turning
positive ( bullish ) this increases the chances that
there will be a correction in the Euro, which makes
me a little more confident if and when my short entries
are triggered.

Thanks for your viewership!