How to tell when a trading idea has become too popular - DailyFX Tips & Picks

WITH Syriza’s victory in Greece, markets should be very nervous given what has been said on TV and in the press. The anti-austerity party is expected to try to renegotiate existing austerity measures with the Troika, which should be a no-brainer sell signal for most euro-dollar traders. So why is euro-dollar higher when I write this?

One of the reasons might be the fact that the markets discount the future and, in the case of euro-dollar, many traders went short ahead of the election results and last week’s ECB meeting. This means that certain traders are now booking profits on their ideas. It’s a classic example of “buy the rumour and sell the fact”.

Given this, if we wait until all conditions are perfect, we might end up being late on a trade and lose money. So how can we tell when an idea has become too popular?

One way of getting this information is to see how brokers’ clients are positioned. One example is the FXCM SSI index. It shows how many traders are long versus how many are short. In the case of FXCM, a sample is taken from its 185,000 clients. They turned aggressively bullish on euro-dollar when prices traded near $1.2300. But by the ECB meeting last week, euro-dollar had declined by nearly 1,000 pips and traders decided that the best strategy was to sell. The SSI indicator is therefore telling us that the idea of shorting euro-dollar is now too popular and might be unprofitable.

All market behaviour is, of course, not explained by a single variable like the FXCM SSI index, but it does help.

For more on the SSI, see http://bit.ly/SSI2015
Alejandro Zambrano is a currency strategy analyst at DailyFX.com.