Combining Sentiment and Technical Analysis for a Swing Trade

There is a wide of array of sentiment indicators which you can use to generate trade ideas and confirm trades. One of the most popular ones is the long-short ratio. It shows the percentage of traders who are long and short a particular currency pair. Over time we can see how a currency pair’s price has acted in relation to the percentage of traders who are long or short.

Figure one shows the GBPUSD price (black line) over the last year. The blue graph marks the percentage of long positions.

Figure 1. GBPUSD %Long (left scale) vs. Price (right scale)

Back in December and early January of 2013 the percentage of longs was quite small–in the 30% area. The price makes a double top and then proceeds to head to lower and the number of longs begins to climb again.

Currently, the same circumstances are materializing in the GBPUSD. The long percentage is near 30, but in this case it has been for some time. There is a potential double top in the price, which is very close the price area of the last double top.

This is all evidence that a significant drop is forthcoming in the GBPUSD.

Yet, as traders we don’t have the luxury of just making predictions, we also need a way to enter and exit this trade in a risk controlled way.

I took a short position on November 11 (small red bar third from the right in figure two) as the price made a lower high and began to move to the downside indicating a downtrend had possibly begun.

Figure 2. GBPUSD Daily with Trade, Stop and Target Marked – November 13

The price then proceeded to make a lower low, which helped confirm the outlook.

A sharp rebound on November 13 is putting the trade somewhat at risk though. If this was the start of a downtrend, the price should have fallen a bit further and the rebound should not have been quite as strong.  In other words, the pair isn’t acting quite right. Therefore, I’ll need to see how this trade continues to play out. If the rebound continues I may look for an early exit, as it is highly likely I can find another short entry at a different price once (and if) the price is shows signs of weakness again.

As it stands now though I am short at 1.6014, with a stop loss above the recent swing high, and a target at 1.5775.

The target is based on a Fibonacci Extension, but also provides a reward to risk ratio of about 1.7:1.

This target area is chosen because it allows for a good profit, but there is also a possibility that the downtrend (if it materializes) will experience a pullback around that level. If the price is indeed in for a significant move lower as the sentiment indicates, I can then look for another short entry on pullbacks.

Considerations

When I took the trade I was expecting a little more immediate strength to the downside to develop. But in trading, you need to roll with the punches and trade what the market gives you. While the trade is currently just in the money, there hasn’t been much follow through to the downside as of yet. In order for this trade to work out, and for me to stick with, I will need to see that selling pressure come in relatively soon.

Also, the long percentage as been near 30% for the last couple months as this potential double top has been forming in the price. Therefore, it is quite possible that the price could continue to channel here for another couple weeks.  This is why caution is still warranted even though sentiment and the dropping price indicated the short-side was where to be.

If the price keeps moving higher, I will actively manage the trade, therefore neither the stop nor target are set in stone at this point. If the price does start dropping, it may not be possible to get the same entry point I have, which potentially increases risk the lower the price drops since it will be further from the stop level.

This is not a recommendation to buy or sell. It is simply how I have constructed a current trade and the thought process and tools I used to come up with a game plan. The stop on this position is quite large; therefore, pay special attention to position size.  No trade should expose your account to more than 1% risk if your stop is hit (see Determining Binary Options Position Size).