What We Can Learn From Retail Traders

An estimated 20 million novices started trading over the last two years — their decisions, behaviors and market sentiment can mean investment opportunity.

Many retail traders bring cognitive biases from everyday life into hyper rational markets. In the past year, we have seen these habits manifest in the boom and bust of suddenly popular categories of risky assets. Consider the rise and collapse of meme stocks touted on Reddit boards or the dimming chant of HODL (hold on for dear life) once shouted by crypto traders. While these are extreme examples of market sentiment, the ambition-led distortions are far more prevalent than many may appreciate.

In general, retail traders are typically looking for a well-timed entry on a fast market movement in the direction of the trade they intend to place. Aren’t we all?

In reality, the limited time to analyze and await the ideal criteria before jumping into a trade typically doesn’t fit into the timeline many novice market participants expect. A round turn trade ‘before dinner is ready’ doesn’t typically happen.

Moreover, many new retail traders also put considerable emphasis on technical analysis. That is not a bad approach; but when novices see any break as if it is destined to generate follow through, struggles often ensue.

Is it a reversal or a stalled trend?

A trader who lands at the extreme of a market position and is ready to jump at the first sign of a reversal can be in particularly lucrative situation. Unfortunately, such systemic turns are the rarity. What is often mistaken for a major reversal is instead just a stalled trend or a more restrained move within a range.

Trading on market sentiment data can help confirm trends in the market. A sentiment-based trading strategy would look to trade against reversal calls in the consensus when other indicators or analysis techniques support a strong directional bias.

Picking tops and bottoms or taking advantage of prevailing trends is not typically a strong suit of retail FX traders. Novice currency traders provide an interesting case study. If we can use retail trader market sentiment as a tool when their habits align to market conditions, a contrarian indicator may turn into a more effective indicator.

Looking at sentiment in motion, we first consider the activities of the large speculative traders (such as hedge fund traders) in the futures markets. Large participants must report their exposure once a week, and that exposure is published by the CFTC in the Commitments of Traders (COT) report. Generally speaking, this group tends to reflect the interests of medium-term investors (with a time frame of weeks, if not months).

Below we see EURUSD relative to net speculative futures positioning behind the same exchange rate. Though the correlation is generally strong over time, there is frequently a notable drift in price and speculative assumptions. Furthermore, the data surrounding EURUSD shows the urgency attached to testing a ‘double bottom’ at a multi-decade low didn’t draw speculative appetite for a bounce from 1.3500.

In contrast to the COT’s weekly updates from ‘large’ market participants in futures, those who consider themselves active FX traders tend to be on track for materially shorter exposures. It is a practical characteristic of retail traders to pursue opportunities that they think will play out over a reasonable time. Unfortunately, the assumption that most technical boundaries are relevant and any reversal could lead to a productive reversal is far-fetched.

In the case of EURUSD these past few weeks, a shift in interest rate expectations helped shape an exchange rate reversal. The pair would also reverse from the ‘double bottom’ of a multi-decade low, and some retail traders happily slapped assumptions on the movement. In this case, the wisdom of the retail crowd just so happened to capitalize on a prevailing state of the market whereby those conditions were the actual backdrop.

In an example of the significant difference between retail and professional traders, we have GBPUSD and the net speculative positioning measures from the CFTC. In this case, positioning has generally tracked price rather than foster contrarian signals. For the so-called ‘Cable,’ the assumption of a dive lower in positioning seems to align with actual price action. Where correlation can be a boon, it can also prove a burden if we extrapolate these relationships to the conclusion that ‘correlation’ is equivalent to causation.

Shifting to the retail trader, it seems the net speculative view perfectly flips the approach shown by the COT report. In fact, the two-year low for GBPUSD seemed to align neatly with the peak in speculative ‘dip buying’ until that point. Of course, there was a healthy push to pick a bottom through the two months leading to that actual turning point.

If we can determine a system by which we are confident that markets are in a range rather than a breakout or trend environment, then we can utilize this retail sentiment measure in a conventional manner rather than a contrarian capacity. Yet, if circumstances reflect a ‘trader class’ that is groping for tops or bottoms where markets are expected to run; we can utilize this data as a contrarian indicator.