From its September 30 all-time high of $1.4282, so far this week the euro/dollar exchange rate is down over 200 pips, or two full cents.
Two hundred pips is no small move. A long-term forex speculator who holds positions for months or years may not feel the pinch, but an average over-leveraged trader with a 5, 10 or 20-to-1 margin account could not sit it out. A move like that can cut your trading account in half; it has "margin call" written all over it.
Of course, only those forex traders who have been short the buck, long the euro, have been running this risk. But it's probably not too big of a stretch to say that the majority has indeed been short the USD. Market sentiment indicators have been showing that the majority of the forex public has been very, very anti-dollar. Take a look at this chart Elliott Wave International’s Short Term Update published last Friday (Sept. 28), for example:
The Daily Sentiment Index, represented in this chart by the red line, is constructed by polling forex traders to see whether the majority is bullish or bearish. It’s a good measure of collective sentiment; high DSI readings suggest an overbought market, while low DSI suggest oversold conditions. As the chart shows, last Friday, almost 91% of the polled forex traders believed that the euro had further to gain. Two days later, the euro topped.
That leads to a paradoxical conclusion: the best time to buy a market is when everyone has sold it, and the best time to sell is when everyone has loaded up. However, paradoxical as it may seem, this contrarian reasoning does make sense: in each case, you are betting against crowd psychology stretched to the point where it's about to snap back. In this case, the snapback came for the EUR/USD.
An extreme DSI reading does not always mean that a reversal is at hand. But experienced forex traders know that when a market gets so one-sided, more often than not it's a sign of an impending reversal. How do you actually pinpoint one? Try combining sentiment data with an Elliott wave count. A contrarian method in itself, it looks at the market's internal structure to help you time the turnaround points.
(Editor's Note: To learn more about trading forex using wave analysis, watch this free 8-minute video from Elliott Wave International's Senior Currency Strategist, Jim Martens. Watch "Learn to Trade With Elliott Wave Analysis" now.)