CoT Report Trading Strategy
It means that the position remains open for one more week. Based on the price action, the stage is set. As I said before , the conditions discussed here are only one out of three points to be checked when opening a trade. The COT commitment of traders is a report issued by CFTC to update the public on the futures positioning of traders in commodities markets.
1. Creating a currency portfolio based on the COT report positioning.
Non-reportable positions cover everyone who do not suit the above criteria, and they are also termed small speculators. Of reportable positions, non-commercial includes all actors who do not possess any interest in making use of the underlying currency or commodity, such as hedge funds, brokerage firms, investment banks and other related firms.
Commercial open interest is created by firms that have the desire to receive or deliver the underlying. Thus the roles played by the two categories of traders is quite different. Spreading covers those trades who hold an equal number of long-short positions on the future contracts. The report provides data on the percentage of long or short contracts to the total, on the number of traders in all three categories with positions on a currency, and finally the changes in open interest in comparison with the previous reporting period.
Over the years the COT report has become quite a popular tool for all kinds of traders. Here are a number of ways of exploiting the data provided by the COT report. We can use the COT report data to create a diversified currency portfolio. Let us now suppose that the non-commercial sector is overall long the USD in our example. What should be the criteria in deciding the currency pairs that will be included in our portfolio in such a situation?
Why do we do this? Because all we want to do is to gain from the appreciation of the USD while limiting the volatility caused by the carry trade.
By making our position interest-neutral, we will, we expect, be able to ride through such disruptions. This will reduce the volatility of our portfolio, and will also reduce the potential return from our investment, but it does create a longer-lasting, more resilient position.
Another, but much riskier way to create our COT-report based portfolio would be to simply long what the commercial sector is long, and to short the commodity or currency in which the non-commercial traders are long. And one can go on with this method, to create an interest-neutral portfolio in the previously described way, thereby limiting the volatility of the position, and ensuring a more successful long-term strategy. Correlations statistics of currency pairs are available from most major forex brokers.
It is nonetheless true that major changes in the strength of a trend, or its reversal on a permanent basis, are indeed noted by changes in open interest, and institutional positioning. Remember, based on the price action we were expecting another move higher, and at this point the COT is at an extreme reading, confirming a move to the upside is likely coming. The price consolidates at the bottom of the channel, and then breaks above that consolidation, providing the first possible entry into a long trade note that at this point, the Large Specs were still increasing their short position.
The price then rallies to the top of the channel, and consolidates. At this point the Large Specs are starting to buy short position is moving back toward zero.
So price and COT are confirming a move up. The price breaks higher out of the consolidation and the descending channel, signaling another possible trade. Since that time, the Large Specs have become bullish, flipping from short to long. This has helped fuel the rally, which is why we want to anticipate what these guys will do, and we do that by knowing that a big reversal is often coming when these these Large Spec positions are near extremes. The above chart is a futures chart though, not a forex chart.
Have other pieces of evidence that help confirm a trade. Over time, these extreme levels tend to expand. In the CAD futures chart above, , was extreme. That may hold in the future as well, but several years down the road new extremes may be hit at , or , Positions can also stay near extreme levels for extended periods of time, without causing a price reversal.
That is why we need other pieces of evidence. This article is focused on COT, and how it can be used as an additional piece of evidence for taking trades.
The article did not discuss stop loss levels or profit targets taking profits. These are elements of a trading strategy, and should be considered on each trade before placing it. COT data is not a strategy in and out of itself, rather it is just a tool that can be combined with a trading strategy and trading plan.
COT data is just an extra piece of data. If I get a valid trade signal, I take it. It is still worth paying attention to, because when price action and extreme COT levels collide, it lets you know the likely direction of a major move.
When looking at COT data, start with at least a 10 year chart for picking out extreme levels. Prior extreme long and short Long Spec positions are areas of interest, but remember these tend to expand outward over time. Make a note of these extreme levels, and then watch for trade signals as the price nears or exceeds these levels.
If you only look at extreme levels on a 1 or 2 year chart, you may be missing historically significant information. If we look at a CAD futures chart with COT data going back to , we would see that 65, to , contract positions had been significant in the past as well.
Since we know that extreme COT levels often cause the price to move in the opposite direction of the recent trend, we gain insight into what direction we want to be trading before the reversal actually occurs.
As COT levels reach extremes, it can also warn us to avoid trading in that trend direction, as it may be ripe for a reversal. Sometimes we have positions stay at extreme levels for long periods of time, and the price continues to move in the trend direction without any major price reversals.
We want to combine this approach with other technical or fundamental approaches, and ideally with specific price action strategies that confirm when the price reversal may be starting. Each currency pair has different characteristics, especially the high-yielding ones, which rarely see flips since most positioning tends to be net long for extended periods as speculators take interest-earning positions.
In this example, the left axis of the chart is reversed compared to Figure 2 because the GBP is the base currency. The reason why these extreme positions are applicable is that they are points at which there are so many speculators weighted in one direction that there is no one left to buy or sell. As a result, exhaustion ensues and prices begin reversing. Open interest is a secondary trading tool that can be used to understand the price behavior of a particular market.
The data is most useful for position traders and investors as they try to capitalize on a longer-term trend. Open interest can basically be used to gauge the overall health of a specific futures market; that is, rising and falling open interest levels help to measure the strength or weakness of a particular price trend.
For example, if a market has been in a long-lasting uptrend or downtrend with increasing levels of open interest, a leveling off or decrease in open interest can be a red flag, signaling that the trend may be nearing its end. Rising open interest generally indicates that the strength of the trend is increasing because new money or aggressive buyers are entering into the market. Declining open interest indicates that money is leaving the market and that the recent trend is running out of momentum.
Trends accompanied by declining open interest and volume become suspect. Rising prices and falling open interest signals the recent trend may be nearing its end as fewer traders are participating in the rally. Notice that market trends tend to be confirmed when total open interest is on the rise. In early May , we see that price action starts moving higher, and overall open interest is also on the rise.