Contrarian Sentiment Trading

Alex Boyd
alex@poseidonfx.com
http://poseidonfx.com

Abstract. Investing in the Foreign Exchange (FX) currency market is a dangerous proposition. With
many participants failing to generate yield, including both retail players
1
and the largest fund
managers
2
, it is crucial to approach currency trading with caution and preparation. We choose to
analyze the potential to monetize the specific trading behavior of US retail FX brokers clients.
Enormous amounts of compelling data exist
1
which will lead us to conclude that retail FX traders
are not only poor at currency trading, but systematically and reliably poor
3
at it. We propose that
by inverting the positioning of retail FX traders and applying this as a filter, alpha can consistently
be added to a portfolio.
1 WHO ARE RETAIL FOREX TRADERS?
A retail Forex trader is, for the purposes of this document, a US-based client of a US-based Retail Foreign
Exchange Dealer, or Forex broker for short. They are not classified as a Professional, or as an Eligible
Contract Participant
4
. As of Q1 2014
1
there are approximately 94,882 retail Forex traders in the US.
Essentially, a retail Forex trader is a person or entity who is trading for speculation personally not an
institutional investor.

1
Finberg, Ron. Final Q1 2014 US Broker Profitability Report (CitiFX Results Included). 5/18/2014. Web.
7/17/2014. URL: http://forexmagnates.com/final-q1-2014-us-retail-forex-profitability-report-citifx-results-
included
2
McGeever, Jamie and Fletcher, Laurence. FX Concepts demise signals tough times for forex hedge funds.
12/19/2013. Web. 7/17/2014. URL: http://www.reuters.com/article/2013/12/19/us-forex-hedgefunds-
idUSBRE9BI0P720131219
3
Shea, Timothy. Traits of Successful Traders. 6/26/2011. Web. 7/17/14. URL:
http://docs.fxcorporate.com/fxcm-traits-of-successful-traders-guide.pdf
4
Definition of an Eligible Contract Participant, available from the CFTC website:
http://www.cftc.gov/consumerprotection/educationcenter/cftcglossary/glossary_e


2
2 RETAIL TRADER INVESTMENT PATTERNS
In the Traits of Successful Traders report by FXCMs research division DailyFX
1
, we can see that there are
a number of patterns exhibited by retail traders. First, more than 50% of trades are closed in profit, but
their average loss on a losing trade is greater than the average gain of a profitable trade. Second, their
profitability tends to increase in proportionally with their account size, and lower leverage utilization has
a correlation to profitability as well. Despite these factors, in aggregate, retail traders are not profitable
1

and typically do not produce returns on their account. Finally, they typically employ range trading
type strategies, where weaker currencies are bought, and stronger ones are sold.
In sum, retail traders fight the trend of the market and consistently lose money while doing so. The
following graph illustrates that, over a period of years, retail traders as a group consistently lost money
far more than half of the time:

Figure 1: Percentage of retail FX traders who were profitable, q/q, from Q4 2010 to Q1 2014
The data above are compiled from Forex Magnates Broker Profitability reports, which aggregate data
from the brokers themselves every quarter as required by the CFTC.
5
The numbers used in the graph
above is the average of all brokers reported client profitability percentage, regardless of how many
accounts the broker actually had. There is some variation q/q of how many retail traders were
profitable, but the average percentage of profitable retail clients in graph above was actually 31.43%.
In other words, almost 70% of retail traders tend to lose money in any given quarter. We can conclude
that, as a general rule, retail traders are unsuccessful at trading the FX market. This should not be much
of a surprise, but we feel it is important to substantiate what is certainly a popular adage.
3 POSSIBLE REASONS FOR RETAIL FX TRADING BEHAVIORS
Next, we turn to educated speculation regarding the reasons why retail traders are so consistently
unsuccessful at FX trading. There are numerous potential contributors. Retail traders:

5
Reports can be found on ForexMagnates.com, under the tag forex profitability:
http://forexmagnates.com/tag/forex-profitability


3
Are generally not as well-informed as their institutional counterparts
Do not take trading as seriously as do larger players
6

Are poorly-capitalized, and over-leveraged
3

May keep trading even in the absence of profitable trading activity, if a desire to trade is present
(by contrast, an institutional portfolio managers job is to make money, and will likely lose
clients if performance suffers
2
)
Are not necessarily involved in the FX market to make a profit they could be trading for the
purpose of experiencing entertainment or excitement
Some of these potential reasons have documented evidence, while others without it are nonetheless
highly plausible. It follows fairly straightforwardly that a poorly-informed, poorly-capitalized,
unpressured investor does not have as high a chance of success in FX trading as does a well-capitalized
professional with an informational advantage and constant pressure to succeed from an employer or
client base.

4 THE FOREX DEALING DESK OR MARKET MAKER MODEL
Given the chronic disadvantages had by retail FX traders, it is easy to see why many retail brokerage
firms would want to offer liquidity directly to these traders, who are their clients. After all, if you can
expect that your clients will entirely of their own accord time the market poorly, then it is in your
interest to accept that liquidity. The same is true of a casino, who has a direct interest in offering games
to their gambling clients, when the odds are stacked in favor of the house!
In this classic Dealing Desk model of FX trade execution, the trade is placed with a dealer firm, who
has the option to either 1) offset their risk elsewhere in the market, or 2) keep the risk on their books,
for all or part of the trade duration
7
.
In practice, very little information is available to the public about how exactly risk may be kept on the
books or offset. The PoseidonFX founders do have brokerage experience, but we cannot of course
reveal trade secrets. Suffice it to say that both options are available to the dealer. (Of the current
brokerage firms operating in the US at the time of writing, there are only two that offset all client risk
with other liquidity providers, in their primary business model
8
.)
Can we be sure that running a business in this way by accepting the opposite side of retail FX trades
is profitable? If so, it would lend evidence to our thesis. There are two ways to show that this is true.

6
Li, Hao. FXCMs Drew Niv on account profitability: key lessons for forex traders. 3/14/2011. Web. 7/17/2014.
URL: http://www.ibtimes.com/fxcms-drew-niv-account-profitability-key-lessons-forex-traders-275445
7
Source: http://www.fxcm.com/advantages/forex-execution/dealing-desk
8
These companies are Forex Capital Markets (source: http://www.fxcm.com/advantages/forex-execution/dealing-
desk ), and Manhattan Beach Trading (source: http://mbtrading.com/exnspread.aspx). PoseidonFX does not make
recommendations regarding the readers choice of brokerage firm.


4
First, referencing the Q2 2013 earnings report by Gain Capital, a market-maker FX broker, we can see
that they earned revenue of 2.5 pips per trade
9
, while charging less than that for their bid/ask spread
10
.
If the client only pays a spread of e.g. 1.8 pips, while the dealer earns 2.5 pips, then the extra revenue
per trade comes from how the clients risk is offset after the trade is taken; whether later on in the
trades lifetime, or not at all! Therefore, extra revenue can be made from taking the opposite position
of retail traders.
The other way to illustrate the profit potential of trading contrary to retail positioning is by looking at
the spread costs for Forex Capital Markets, a US broker that allows their clients to choose between
Dealing Desk and No Dealing Desk models. At the time of writing, the typical bid/ask spread for Dealing
Desk accounts is one full pip lower than for No Dealing Desk accounts
11
. The explanation given by the
broker, with which we agree, is that it is more profitable to take the other side of a retail trader than to
simply pass on the liquidity to another party.
While this information does help our argument, one key difference must be noted here. Accepting retail
trader liquidity, and consuming liquidity to trade contrary to retail positioning for ones own account,
are two very different businesses. However, the point that we feel does lend credence to our argument
is the mere advantage had by trading against instead of trading neutral to retail FX traders.
Therefore, this is an advantage which we should look to exploit. We will turn to that next.
5 THE USEFULNESS OF RETAIL TRADERS UNPROFITABILITY
Thus far, the data has shown retail FX traders to be consistently unprofitable, and we have outlined
some plausible reasons why this might be the case. We have discussed business examples in which this
data is already being used by institutional FX firms, for their own benefit. So, if consistent investment
performance is the goal, may traders simply invert consistent underperformance to reach that goal? In
this case yes.
Merely inverting a poor trading strategy is not necessarily a good idea, unless the strategy is
consistently-poor. Note that what we are looking for is not the quality of the performance itself, but
how well we can rely on that performance to continue into the future
12
. There are good reasons to
think that retail FX traders will, for the foreseeable future, continue to act in the ways that they do, and
exhibit the patterns that we have observed. These reasons are implicitly shared by the market-maker
brokers that continue to accept retail trades onto their books, on the assumption that this will continue
to be a profitable course of action.
For these reasons, we reiterate the conclusion that FX investors should look to position themselves
contrary to what retail traders are doing. We now need a way of accessing their sentiment: to know
how they are trading, so that we might do the opposite.

9
Source: http://leaprate.com/2013/08/07/gain-capital-forex-com-revenues-and-profits-soar-in-q2/
10
Source: http://www.forex.com/pricing-live-spreads.html
11
Source: http://www.fxcm.com/advantages/forex-execution/compare-execution-types/
12
Past performance does not necessarily guarantee future results.


5
6 QUANTIFYING RETAIL TRADER SENTIMENT
Because forex is not traded on an exchange, forex traders do not have access to the same sort of official
documentation detailing the positioning of traders like speculators of other assets do
13
. Fortunately, a
number of reliable, public, commercial sources exist that display the actual real-time positions of a large
aggregate number of retail FX traders. This information is available from retail brokers worldwide. Lets
examine and evaluate these sources:
6.1 DUKASCOPY
Source: http://www.dukascopy.com/swiss/english/marketwatch/sentiment
Features:
Positioning data only
Updated every 30 minutes
Public, easily accessible
Some historical sentiment information is also available

6.2 OANDA
Source: http://fxtrade.oanda.com/analysis/open-position-ratios
Features:

13
For example, the CFTC Commitment of Traders report on futures positions:
http://www.cftc.gov/MarketReports/CommitmentsOfTraders/Index.htm


6
Historical and current open orders are available, along with floating positions
Updated every 20 minutes
Public, easily accessible
Wider variety of pairs than Dukascopy

6.3 DAILYFX
Source: http://www.dailyfx.com/technical_analysis/sentiment
Features:
Graphical representation of positioning with price action overlaid
Updated once per week
Public, easily accessible. Some data is available more frequently, but requires a login
Low variety of pairs
Current and historical information is available



7
A quick look at the data from the sources above, as sampled at the time of writing on July 17, 2014,
leads us to conclude the following: the sentiment ratios displayed are quite similar among the different
sources. For instance, most traders are long EURUSD, USDJPY, and AUDUSD, while most are short
GBPUSD.
7 EXAMPLE USAGE
Given the sources of retail sentiment data outlined above, and the conclusion we drew in 4, it is fairly
straightforward to come up with a trading bias. (Note that PoseidonFX cannot and does not provide
investment advice.)
Taking stock of the fact that most retail traders are short the GBPUSD to a high degree, we would
therefore seek buying opportunities on this pair. The historical situation shows that these conditions
have persisted for quite some time:

Figure 2. Source: http://www.dailyfx.com/technical_analysis/sentiment?technicalSentiment=GBP/USD
In Figure 2, the red histogram indicates retail trader short positioning. The green histogram indicates
retail trader long positioning. The black line indicates the price of the instrument. It is very clear that
the price has risen dramatically, while retail short positioning has remained or intensified over the
period. For purposes of comparison, lets look at a similar graph using another source:


8

Figure 3. Source: http://fxtrade.oanda.com/analysis/historical-positions
The point is even clearer when observing Figure 3, above. Retail short positioning, or bearish/selling
sentiment, occurs despite an enormous trend upward in the price of the GBP/USD exchange rate.
8 BACK-TESTING THE THEORY
Though the example shown above regarding the GBP/USD is quite clear on its own, in order for our
argument to be sound we must demonstrate that this strategy is an effective one in a variety of cases.
Lets first outline an example base strategy that involves merely taking a look at the positions held by
retail traders, and doing the opposite for our own account:
SAMPLE BUY LOGIC: If, at the beginning of the trading day, Oanda retail Forex positioning shows
that more than half of their clients are SHORT a particular instrument, go LONG at market.
SAMPLE SELL LOGIC: If, at the beginning of the trading day, Oanda retail Forex positioning shows
that more than half of their clients are LONG a particular instrument, go SHORT at market.
This equity curve shows the 1-year performance of the above strategy (transaction costs are not
included):


9

Figure 4. Equity curve showing the performance of a basic "contrarian sentiment" strategy. Past performance does not indicate
future results. Hypothetical results are prepared with the benefit of hindsight. Please view the complete risk disclaimer on the
PoseidonFX.com website
14
for a complete warning regarding hypothetical results, which cannot be fully described here.
Even during a period of time in which FX volatility was relatively low
15
, the sample system above
performed fairly well. Again, in plain English: all we did here was to buy when retail was selling, and
sell when retail was buying. The legend in the graph above denotes which currency pairs were used to
compile the composite results curve (which is in blue). Percentage returns for each FX pair in the back-
test were calculated based on the actual movement of the currency e.g. shorting from 0.8012 to
0.8000 produces a percentage return of +0.15% and then summed to compile the composite curve.
Though this information alone should not be relied upon to make investment decisions, we believe that
it does add strength to our argument, even when the thesis is tested during market conditions that
many consider harsh for speculation.
9 OBJECTIONS & REBUTTALS
We have thus far outlined reasons why retail FX traders can be described as systematically
unprofitable, and some example ways to use the various data sources available to act on this
conclusion. There are some potential objections to the use of so-called Sentiment Trading.

14
Source: http://poseidonfx.com/risk-disclaimer
15
Rodriguez, David. Why is FX Volatility So Low, and How do we Trade Inevitable Return?. 5/7/14. Web.
7/18/14. URL: http://www.dailyfx.com/forex/fundamental/article/special_report/2014/05/07/forex-why-is-
volatility-so-low-and-how-do-we-trade-high-volatility.html


10
9.1 WHAT IF RETAIL TRADERS GROW MORE PROFITABLE OVER TIME?
This is possible, but unlikely. Recall the discussion in 3 regarding the plethora of reasons why retail FX
traders in aggregate experience losses in the FX market: in sum, the disadvantages of low capitalization,
lack of information, and lack of seriousness. These reasons are unlikely to change, barring any serious,
significant change in the structure of the retail FX market. It is not necessarily true, but very likely, that
most retail traders in aggregate will continue to lose money.
9.2 WHAT IF RETAIL TRADERS STOP TRADING FX, AND THUS STOP PROVIDING SENTIMENT DATA?
Given the increase in FX volume in recent years
16
, and the large numbers of active retail FX traders
17
that
currently exist, it is unlikely that this group will suddenly decide to no longer trade currencies. The more
likely reason why retail traders would not be able to trade FX is due to regulation or law of some sort,
which would force FX traders to cease doing business. Lets examine that possibility.
While recent regulations (such as the CFTC leverage limitations resulting from the Dodd-Frank Act
18
)
have made it more difficult for traders to lose money, the trend has been in favor of free markets being
allowed to determine currency prices.

This is visible on both the large scale (e.g. the PBOC increasing the band around which the price of the
Chinese currency, the CNY, may float
19
), and the regional scale (e.g. IIROC and the provincial Canadian
financial regulators allowing their residents to trade FX and CFDs, such as British Columbia and, to some
degree, Alberta, who now allows Accredited Investors to trade FX
20
).

Nobody can predict future regulation with complete accuracy, but sweeping regulation preventing all FX
trading seems unlikely. Moreover, even if such regulations were enacted in the US, many brokers have
more than one regulatory jurisdiction, and therefore such regulation would have to be implemented
across an extraordinarily-wide group of countries. Such a thing does not seem like a high priority for
global regulators; it is therefore unlikely that, at some point in the near future, no retail traders could
continue to trade FX.
9.3 WHAT IF RETAIL TRADER SENTIMENT & POSITIONING DATA STOPS BEING PUBLISHED, FOR
EXAMPLE IF IT BECOMES ILLEGAL TO PUBLISH IT?
This is an interesting objection, but we feel it is implausible. Who would make it illegal? As with the
previous objection, each and every country in which a brokerage firm may be registered would have to
pass such regulation. Its theoretically possible, however, there is little evidence that the publication of
retail positioning data is anything but positive. We feel that, especially after the Credit Crisis of 2008,
financial transparency seems to be valued very highly over opaqueness.

On other fronts, for example, FXCMs sentiment data has recently become available to a far-larger base

16
Source: Bank for International Settlements: http://www.bis.org/publ/rpfx13fx.pdf
17
Source: FXCM 2013 Annual Report, posting 183,679 retail active accounts
18
Greenberg, Michael. CFTC finalizes forex rules: leverage reduced to 1:50. 8/31/2010. Web. 7/17/2014. URL:
http://forexmagnates.com/cftc-finalizes-forex-rules-leverage-reduced-to-150
19
Zero Hedge. China Widens Dollar Trading Band From 1% to 2%, Yuan Volatility Set To Spike. 3/15/2014. Web.
URL: http://www.zerohedge.com/news/2014-03-15/china-widens-dollar-trading-band-1-2-yuan-volatility-set-spike
20
Source: http://www.albertasecurities.com/Publications/CSA_Forex_Trading_Alert_Backgrounder.pdf


11
of clients
21
. More and more brokerage firms (such as Oanda, FXCM, Dukascopy, CMC Markets) and
technology firms (such as FXBlue
22
, Forex Factory
23
, and Myfxbook
24
) have begun to publish the data. By
and large, the trend has been to increase the availability of such data, not to decrease it.
10 CONCLUSION
Thus far, we have hoped to show that retail FX traders are systematically poor investors, and that by
using and inverting the data taken from publicly-available measures of retail positioning, it is possible to
attain a reliable directional bias (remember, though, that past performance does not necessarily
guarantee future results).
Why would this be? After all, retail traders do not have much of an effect on the FX market as a whole.
And it should be obvious that there is no real reason for FX exchange rates to move in concert with the
purpose of causing losses specifically for smaller account-holders that would be absurd.
Our best guess as to why Contrarian Retail Sentiment Trading might provide a trading edge is that it
does a great job of aggregating a wide variety of viewpoints, all of which are nonetheless similar in that
they are deficient in one way or another, as described in 3. In other words: every retail trader is a
person with a set of beliefs, emotional dispositions, etc; this trader is one of thousands of data points,
which act as inputs for a sentiment trading system. Each person/data point is unique, lending a large
degree of complexity to the actual sentiment data source. However, each unique retail trader
him/herself has a low probability of success.
Moreover, the aggregation of the data into one single ratio, e.g. 20% of retail traders are currently long
GBP/USD, simplifies what would otherwise be an extraordinarily-complex system of inputs, and allows
meaningful conclusions to be drawn from it. We nevertheless think it wise not to solely rely on this
indicator, though, and to overlay an additional framework on top of the sentiment filter before
deploying it in an actual investment environment. We hope to explore these additional frameworks in
future papers.

21
Source: http://dailyfxondemand.com
22
Source: http://www.fxblue.com/connect/connect.aspx
23
Source: http://www.forexfactory.com/trades.php
24
Source: http://www.myfxbook.com/community/outlook