Long-term Trading Strategy with the COT Report

What is the COT Report?

The COT Report or the Commitments of Traders provides insights into who is buying and selling different futures contracts and to what degree. The COT Report is issued every Friday by the CFTC and there are several different components to it. You can look at the futures only, or futures and options combined. The COT Report shows the positioning of three different participants or type of traders in each futures market, measured on the close of business on Tuesday:

  1. Commercial Traders: These are the largest powers in the marketplace and in Forex they are typically hedgers, not speculating.
  2. Non-commercial Traders: These are the second largest group of traders and in Forex they are typically known as the large speculators like Hedge Funds, CTA, and big volume traders.
  3. Non-reportable: These are the small traders that are trading in smaller amounts and in Forex they are typically known as the small speculators.
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Figure 1: Japanese Yen COT Report – Sample

While the COT Report shows data with a three-day lag, the fact that the positioning information of the two largest participants in each market is reported at all is pretty impressive and can provide traders with some interesting insights into the potential future direction of prices.

How to use the COT Report?

Going forward you’ll learn how to use the COT Report to gauge where the market is and how to make decisions in that market. Professional traders look at the COT report as a contrarian or as a consensus indicator. The first thing you want to know is whose hands the market is in: are the commercial traders buyers or sellers? Or maybe the large speculators are buyers or sellers? Once we have established who is in control of the market and compare that with historical data. We wait for the net positioning to turn at extreme levels of overbought or oversold markets, the higher the better, before we act on any information.

Use the COT Report as Contrarian Indicator

The sad reality is that retail traders lose most of the time and that’s one of the main reasons why professional traders use the positioning of small and large speculators as a contrarian indicator. What we would like to look for is for an excessive position in the speculator group because we know that if something is going to go wrong, and the market moves against their position, retail traders and even Hedge Funds who comply with strict risk management rules, are quick to cover their position.

Figure 2: Japanese Yen Futures

Figure 2: Japanese Yen Futures

In Figure 2 we have the Japanese Yen futures contract and the COT Report is highlighted on the bottom of the chart. This is a long-term strategy that involves trading against the “dumb money” or large speculators because they are most wrong at market turning points. In this particular example, we have seen the large speculators trimming down their long positions since the beginning of May bringing the bullish bets to the lowest level since the beginning of the year.

The COT Report is not a timing tool. That’s one of the reasons why it can be a great additional tool to be incorporated into your own trading strategy or you can simply use support and resistance levels to time the market.  This is a long-term strategy you can only trade off of the daily and weekly S/R levels.

Use the COT Report as a Consensus Indicator

The COT Report can also be used as a consensus indicator if we’re focusing on what the Commercial Traders are doing. This is a great trading approach to spot major turning points in the market. If we’re in a bullish trend and the Commercials are selling at extreme pace than we’re close to a major reversal. The same is true if we’re in a bearish trend and Commercials are buying at extreme pace than we’re close to a major low in the market.

Figure 3: Gold – COT Report

Figure 3: Gold – COT Report

In Figure 3 we have highlighted a perfect short trade example by using the Commercials positioning to gauge the market sentiment. As previously mentioned, the COT Report is not a timing tool and as we highlighted on the chart, we can see the Commercials shorts hanging near all-time record for almost three consecutive months before any real selling is seen. In this case, the trigger for our short trade could have been the breakdown of the $1300 major support.

Conclusion

The most important thing to remember when trading with the COT Report is not just whether the Commercials are net buyers or sellers, or if the large speculators are net buyers of sellers, but how extensive long or short they are compared to historical data. In this regard, the most fruitful trades by far are made when these positions hit historical new records.