Sentiment indicators show the percentage, or raw data, of how many trades or traders have taken a particular position in a currency pair. For example, assume there are 100 traders trading a currency pair; if 60 of them are long and 40 are short, then 60% of traders are long on the currency pair.
When the percentage of trades or traders in one position reaches an extreme level, sentiment indicators become very useful. Assume our aforementioned currency pair continues to rise, and eventually, 90 of the 100 traders are long (10 are short); there are very few traders left to keep pushing the trend up. Sentiment indicates it is time to begin watching for a price reversal. When the price moves lower and shows a signal it has topped, the sentiment trader enters short, assuming that those who are long will need to sell in order to avoid further losses as the price falls.
Sentiment indicators are not exact buy or sell signals. Wait for the price to confirm the reversal before acting on sentiment signals. Currencies can stay at extreme levels for long periods of time, and a reversal may not materialize immediately.
“Extreme levels” will vary from pair to pair. Say the price of a currency pair has historically reversed when buying reaches 75%; when the number of longs reaches that level again, it is likely the pair is at an extreme, and you should watch for signs of a price reversal. However, if another pair has historically reversed when about 85% of traders are short, then you will watch for a reversal at or before this percentage level.