Trading Sentiment

The large speculators (or non-commercials as they are sometimes known) make money in the markets because they play a counter party to hedgers and speculate on directional movements in the markets. The large specs tend to trade with the trend (but unlike the commercials they dont have the cash to turn the short term trends). For example, when the market is trending bullishly and the large specs are long this is a good time to trade long. However, when the large speculators are extremely long or short (i.e. when the green line on the COT index is at an extreme, there are no large speculators left in the market to act as counter party for the hedgers and the trend peters out (see examples of green lines above) and the trend will collapse. So you need to be careful trading with the large specs.

COT Caveats
When using the COT report, there are a few things to look out for:

Strong trading signals from COT are uncommon. If you are swing or a day trader, you will probably find that about 5% of all your trades are strongly influenced by COT. Most of the time you will find you are trading off of technicals.
Never use the COT report in isolation. You need to combine it with some form of technical analysis to get some sense of the character of the trend and where to enter and exit the trend. In particular, dip buying by the commercials can’t be confirmed unless the sentiment of the commercials on the COT matches the direction of the trend;
COT is not a market timing tool and it may take 1 day to 6 few weeks for a COT report to play out, so you need to manage your entries, stops and risk exposure accordingly;
Be careful not to be tripped up by different quoting conventions for the Spot market and the Futures market;
Make sure you look at COT reports in combination. For example, if you are trading the USD/JPY, you should be looking at the COT report for both the Yen and the Dollar index;
The COT report does not work that well on all pairs. Before you use it you should do some back testing to get a sense of which pair it works well for;
The COT report lags by at least 3 days as it is based on Tuesdays open interest data and released on a friday. If you are using it, you need to look at the character of the trend since the Tuesday when it was calculated. If the price action confirms the direction of the COT report, then the trade is safer to undertake. If the price action does not confirm the same direction, then you need to start hunting for evidence that the trend is changing its nature (perhaps in the news, economic data, etc);
Be careful during periods where commercials are not dominating the open interest, as the COT report may not reflect true market positioning. At this time commercials are usually just squaring their positions or mainly focusing on hedging rather than accumulating currencies for future business transactions. This is particularly common at year end when they are squaring their positions. For example, in the diagram above the COT Window II shows open interest. At year end 2007, open interest dropped off significantly and the market has gotten a bit wild ever since;
In the currency markets, most of the trading is done in the spot market and not the futures market. While arbitrageurs ensure the markets are highly correlated, you do need to be constantly looking wider than just the COT for disconfirming information. It is a good idea to build up your variant perception.

Sentiment in the Media
Another way of tracking sentiment is to use the media as a gauge. The media provides a constant stream of information about the markets, ranging from simple reporting about how much the dollar was up or down today, through to endless prognostications about where the various media commentators and interviews with “experts” about where the market will go next.

Normally the media are not that helpful as they report information after the fact and they usually try to place an interpretation on the market price action for the day that bears no resemblance to reality. However, the media does have its uses when trading sentiment.

There are three kinds of media publications:

Reports by financial reporters who are serving the finance industry. Examples of this includes what we might see written in the Wall Street Journal, Reuters, Bloomberg, UK Financial Times, etc;
Reports by financial reporters serving the mainstream who have a “general” interest in finance. This might include magazines like Forbes, Business Week, or the Economist, etc; and
Reports by non-financial main stream reporters on financial matters. This might include Time magazine or your morning breakfast personality who on one article may be talking about dodgy builders, an interview with Punxsutawney Phil and an “in depth” piece on the global financial crisis.
Generally the first 2 kinds of financial media are reporting in a similar vein to how the large specs are moving. They are simply reporting on the trend. So if you see an article, on Reuters or Bloomberg about the “Market continues to be up today”, what you are seeing is confirmation of the trend. The first kind of information is more like reading a daily chart or a four hourly chart and in some circumstances the second kind of information is like reading a weekly chart. You need to be careful about the second kind of information. If an small article buried away on page 44 of a magazine talks about the rise in the dollar, then that is a bullish sign. The moment they have a 3 page spread about the rise of the dollar and a cover devoted to it, then they are behaving more like the third kind of media source.

The third kind of information and major coverage in the second kind of media source represents the dumb money. These are the late comers to the trend. Long after the smart money has left a major trend, you will see Forbes magazine covers provide images of the crashing dollar and and your breakfast reporter talking about how it is not good to travel overseas because of the low value of the dollar, you can pretty much be assured that the trend is over and the Commercials are buying up. There has been a study of magazine covers done over 20 years of Time, Business Week, The Economist, etc magazine covers. The finding was simply that:

“Statistical testing implied that positive stories generally indicate the end of superior performance and negative news generally indicates the end of poor performance“

More Information on Trading Sentiment
By far the best resource on the COT report is Larry Williams book on “Trading Stocks and Commodities with the Insiders: Secrets of the COT report“. There is another book called “Sentiment in Forex Market: Indicators and Strategies to Profit from Crowd Behavour and Market Extremes” by Jamie Saettele (2008), but it is over priced and just summarizes what is in Larry’s book. Kathy Lien has an article on COT trading over at investopedia, but I think she misses the point. DailyFX also provides weekly updates on their interpretation of the COT report, but I have never been a big fan of it.

FXCM Daily FX also have their speculative sentiment index (SSI), which effectively just tracks the sentiment of retail forex traders. Some traders rely on it, but personally I feel it does not provide any more information than the COT Small Specs (i.e. nothing – it is just noise). If you do want to use it, you could have a look at using it as a contrarian indicator and trade in the opposite direction to the SSI index.