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Did you wonder why the pound fell last Monday despite a positive PMI report? Or maybe you scratched your head when the euro pairs broke your “solid” technical levels. If you were guilty of the scenarios I just mentioned, then you might be neglecting your sentiment analysis, the third leg of the magical market analysis stool.

Unlike the fundamental and technical aspects of trading, sentiment analysis takes into consideration the collective risk appetite of market participants. But before you call or tweet all your forex friends to ask how they feel about the market, you should first take a look at these helpful tools in gauging market sentiment:

EUR/JPY – Our Barometer of Risk

All graduates of the School of Pipsology should be familiar with this nifty correlation. As we’ve mentioned in our lesson on using EUR/JPY as a barometer of risk, we usually expect the euro to rise whenever the DAX (that’s the German stock market!) rises.

The reason for this is that in order for investors to invest in the DAX, they would need to get their hands on some euros. This triggers demand for the euro, driving up the price of EUR/JPY.

However, whenever risk aversion kicks in, we see a strong down move in EUR/JPY as traders take their money out of foreign equity markets.

Here’s a look of the performance of the DAX and EUR/JPY over the past 9 months.

DAX vs. EUR/JPY 2011

As you can see, the DAX and EUR/JPY have had a nice correlation so far in 2011. EUR/JPY is now hitting lows it hasn’t seen in over a decade, while the DAX has dropped nearly 50% since its highs this year. If risk aversion continues to dominate, I wouldn’t be surprised to see EUR/JPY and the DAX drop below the 100.00 and 5,000 psychological marks!

Credit default swaps

With all the recent talks about defaults, I think it’s about time we take a look at credit default swaps (CDS).

Basically, CDSs are instruments that traders use to protect themselves against a default. In the event of a default, the buyer has the option to “swap” the defaulted bond with the seller of the CDS for cash, which normally amounts to the face value of the bond.

In order to avail of this right, a buyer has to pay upfront a principal and a series of payments to “insure” the bond.

So how can you use CDS’s to gauge market sentiment?

One way to look at it is to see which direction the CDS premiums are headed. If premiums are on the rise, it means that market participants are pricing in a potential default, which doesn’t bode well for market sentiment.

As recently as two weeks ago, insuring $10 million worth of 5-year Greek debt would have required an initial payment of $5.8 million, and then an additional $100,000 each year during the duration of the bond in order to protect a bondholder from default.

To save you the trouble of having to go through all the financial calculations, this means that the markets were pricing in a 98% chance of default on Greek debt! NINETY-EIGHT PERCENT!!!

Volatility Index

The Volatility Index (VIX), dubbed as the “fear index,” estimates expectations of asset price fluctuations for the next 30 days. More specifically, it tracks the expected volatility of maturing S&P 500 options.

Since the VIX estimates fluctuation expectations, a rising number signals increased uncertainty in markets. Meanwhile, a falling VIX usually indicates improving market confidence.

VIX vs. EUR/JPY 2011

If we take a look at the VIX’s daily chart and compare it to EUR/JPY, another reliable risk barometer, we can see that the two indicators are almost inversely correlated, at least for the past couple of days. EUR/JPY nearly fell to 100.00 just as the VIX jumped above 40! Coincidence? We wish.

There you have it, forex geeks! Three simple tools to improve your overall market analysis! Why not take it for a spin and tell me all about how your trades went? I’ll be right here on my cool Twitter and Facebook pages!