Market sentiment: risk-on, risk-off and the COT report

Macro numbers alone can't explain prices. Markets are made of people and funds who get scared, grow overconfident and all rush to the same side. Sentiment describes that collective mood. Measuring it helps you understand why a currency falls while its economy is doing fine, or why a trend runs out of steam.

Risk-on and risk-off

Traders often sum up the market's mood in two words. In risk-on, investors are optimistic: they buy stocks, high-yielding currencies and commodities. In risk-off, fear dominates: they sell those assets and retreat to safety.

Why these safe havens? The yen benefits when Japanese capital invested abroad is brought home as conditions worsen, and when yen-funded carry trades are unwound. The Swiss franc benefits from Switzerland's reputation for stability. The dollar remains the world's reserve currency: in a crisis, everyone needs dollars to repay their dollar-denominated debt.

To know which regime you're in, look at a few thermometers at once: the major stock indices, equity volatility indices, AUD/JPY, often used as a risk barometer, and the behaviour of gold. When they all tell the same story, the regime is clear.

The CFTC COT report

In the US, the CFTC, the futures market regulator, publishes the Commitments of Traders report, or COT, every week. It breaks down open positions in futures contracts, including those on the major currencies listed in Chicago: euro, pound, yen, Swiss franc, Canadian dollar, Australian dollar, as well as gold and oil.

The report comes out on Friday afternoon, New York time, with positions as of the previous Tuesday. So it's a snapshot that's a few days old. It's no use for intraday trading, but it's valuable for understanding the underlying positioning over several weeks.

The COT can be used in two ways. As long as the net position grows with the trend, it confirms the move: speculative money keeps coming in. When it hits a historical extreme, it becomes a warning: if everyone is already long, the slightest shock can trigger a wave of selling.

There's also a more detailed version of the report, called Traders in Financial Futures, which separates asset managers from leveraged funds, among others. Leveraged funds are often the most reactive: their position changes go hand in hand with major trend turns. To get started, the non-commercial net position in the legacy report is more than enough.

Finally, remember that the Chicago futures market is only part of the currency market, which trades mostly over the counter between banks. The COT gives a reliable read of speculative positioning, not a full picture of every flow.

Retail sentiment, used as a contrarian signal

Many brokers publish the share of their retail clients who are long or short on each pair. This data is often used against the crowd. Retail traders tend to buy a falling currency hoping for a bounce, and to sell a rising one too early.

In practice, if a very large majority of retail traders are long a pair in a downtrend, many traders read it as a sign the decline can continue: those buyers' stops are fuel for the move lower. Conversely, a flip in retail positioning can come with the end of a trend.

The two sources complement each other well. The COT shows what large speculators are doing, often with the trend. Retail sentiment often shows the opposite. When speculators are heavily long a currency and retail traders heavily short, the uptrend is usually well established; when both camps end up on the same side, caution is in order.

Building sentiment into your routine

1. Every morning, identify the regime: risk-on, risk-off or neutral, using the indices and AUD/JPY.
2. Every weekend, note the non-commercial net position on your currencies and how it changed over four weeks.
3. Spot the extremes: they make you more cautious about the trend continuing.
4. Combine with technicals: a sentiment extreme plus a reversal pattern at a key level makes a stronger scenario.