Trading sentiment is difficult because sentiment is such a woolly concept and trying to second guess what the market is “thinking” and position yourself accordingly is no easy feat. Rather than trying to understand the whys and wherefores of the market, a number of traders prefer to cut to the chase and ask “Is there a measurable way of tracking sentiment?”. This is where the COT report helps. The COT report is far from perfect, but for currency traders , where the market uses a distributed set of exchanges and true volume information is not available, the COT report is as good as it gets. In the start of this article we will look at trading sentiment using the COT report, and later on we will link it back to woollier version of sentiment, which is what we see in the mainstream and financial media.
What is the COT Report?
The Commitments of Traders (COT) reports provide a breakdown of each Tuesday’s open interest for futures market reports in which 20 or more traders hold positions equal to or above the reporting levels established by the CFTC. Reports are published every Friday and provide both long and short positioning for three different categories of traders:
Commercials: entities involved in the production, processing, or merchandising of a commodity, using futures contracts primarily for hedging;
Large Speculators: traders, such as individual traders, hedge funds and large institutions, who use futures market for speculative purposes and meet the reportable requirements set forth by the CFTC; and
Small Speculators: small traders who do not fit within the reporting requirements for the CFTC and make up the rest of market activity. These traders make up the small difference in the total market open interest between the commercials and the large specs.
The COT report can be viewed at the CFTC website. There are several places on the web that have graphical charts that let you view the history of COT data for free. I use Commodity Futures and Forex Trading Charts.
Timing charts provides a nice feature called the “COT Index”. The COT index shows the net position of the different groups of participants as a proportion of their 26 week high net position. It is a good way of showing extreme positioning in the market.
How Can I Use it?
In the old days, big traders and commodity funds represented the smart money. Today the pond is much deeper and the smarter and bigger fish are the hedgers who need to carry out transactions for and protect their global businesses (such as agribusiness, mining, oil, manufacturing, etc). Increasingly, the hedgers also include sovereign funds whose role is to protect capital put aside for future development in countries.
The commercials are not actually trading to make money. They are purchasing currencies to support future transactions and to hedge against currently active transactions. They are managing their reserves of cash in the same way that your local super market will manage their reserves of stock. When commercials are net long they are buying money to support future transactions and when they are net short they are selling money they already have. Due to the size of the commercials, they can afford to sell into rallies and be net short when an average trader would have been stopped out long ago.
For example, if a US Company is operating in Japan and it needs 10 billion Japanese yen to conduct business with local Japanese companies, it needs to convert some of its dollars to Japanese Yen. The analysts within the US company review the underlying fundamentals and it looks like the Japanese Yen is going to appreciate. So what they do? They buy the yen now so they’re paying a cheaper price. If they buy a month later, it would cost more than the current price. So in this sense they’re profiting from a lower cost of providing the Yen, which translates to better ROI.
Due to the size of commercial interests, when the volume of commercial activity starts stacking up they actually have enough cash to turn the tide of the market on secondary swings. A trader can exploit this by simply looking for examples of extremes on the COT index and swing highs and lows. When the market is at a low for example, and the commercials are extremely long on the COT index, it is a good sign that the commercials are buying the dip to provide funds for future commercial activities