Ladies and gentlemen, get ready to add another powerful tool to your trading and investing toolkit: the Commitment of Traders Report (COT). Published every Friday from our friends over at the U.S. Commodity Futures Trading Commission, the COT report offers us insight on the previous Tuesday’s flow of money into the market.
For any given market, we have particular groups of people trading in it. The two most important are:
1. The large traders (non-commercials). This group is made up hedge funds and other big players who mainly partake in the markets to gain a profit from speculation.
2. The Hedgers (Commercials). This group is made up of people who are in the market by necessity. Farmers who need to sell their crops will enter the financial market to hedge their risk. Multinational companies often need to enter financial markets to limit their foreign exchange risk. The hedger group takes positions in the market as insurance, not as a means of making speculative profit.
The COT report lets us see what positions these two groups are taking. We can then use this as information to tell us what these groups think about future price movements. There are two main things to look at when studying the COT report: momentum and extremes.
When large speculator open interest is continually moving up and above zero, it means that new buy positions are being added. If more buy positions keep getting added to the total open interest, it is a positive sign that large speculators think prices will go up. Not only that, but the fact that buy positions are added makes price go up as they bid up the last price.
If you are considering taking a long position in a particular futures, first check the COT report to see what large speculators are up too. If you see that the market is net-long (meaning there are more long positions than short positions) and the net-long keeps increasing, it means that large speculators probably think that prices will increase and so you can feel validated in taking a long position.
Essentially the COT report on large trader activity can be used as a confirming indicator that price will likely continue to go in a particular position, especially if the large traders are piling on a one-sided trade.
The COT report is also an exceptional indicator for market reversals. Since any given market is usually made up of a finite amount of participants, if the majority of those participants are on one side of the market (either all long or all short) then there is a significant imbalance in place. The scenario is quite simple. Imagine that based on previous data from the COT report you deduced that there are about 50,000 large traders. If the large trader position is reaching the 50,000 or -50,000 point, it should signal that the majority of the market is on one side of the spectrum. Further, if large trader positions are around 50,000 it means that most of them are long and expect price to go up.
The problem with analyzing a market extreme is that if everyone who wanted to buy has already bought, there is no one left to make prices go higher from further buying. So the market reaches an extreme and the only thing left for investors to do is to close out the long trade. This creates some sell orders. Other traders see the price start to go down and start to sell as well. The result is a flood of sell orders, as most of the long positions are abandoned and unwound.
Take a look at the USD Index and you can see that periods of position extremes (circled in pink) run in parallel with market extremes. As a savvy trader, when a market reaches an extreme, you should take caution in following the crowd, and might even consider betting against it.
People tend to forget that markets are run by people. People are prone to error because they reason in part with their emotions. People see prices going up and think they might go even higher. They don’t want to miss out on the next best thing. This ideology works sometimes, and you may infact make a speculative profit by jumping on the bandwagon and riding the wave. The only issue is that when too many people jump on the bandwagon, it stops moving and eventually breaks down. Since the market is made up of people, it is worth your while to pay attention to what the participants are doing and thinking. In the financial game, it really does pay to keep your enemies close.