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The general mantra in the forex industry has usually taken with a pinch of salt the usefulness of the CoT (Commitment of Traders) report on the basis that by the time the information is published, it’s not really that practical, and at best, it only offers minimal forward-looking and insightful information.
In this guide, I will provide enough supporting evidence to make a compelling case as to why the CoT report, against conventional belief, does not represent a lagging indicator and why the right interpretation of the data provided every week offers comprehensive insights on how the smart money is positioned.
The commitment of traders report, which from now on, we will refer to as the CoT for convenience, is a series of reports gathered by the CFTC (U.S. Commodity Futures Trading Commission) on a weekly basis, published every Friday at 3:30 E.T., and reflecting the breakdown of positions held by the different types of traders trading futures and options, up to the prior Tuesday.
What this means is that by the time the data is received, it doesn’t capture the prior three days’ changes in positioning, and because of that, a widely common assumption is to think that the data is barely useful or actionable and very much lagging in nature. Again, I’ll prove that to be a wrong myth.
Unlike the opaque and fragmented state of spot forex, with no exchange or central entity that facilitates transparent price discovery, future and options markets in the US must report the actual volume that is transacted. What this means is that there is a component of transparency in the data reported that will never be as accurate via spot forex.
Open interest represents the total number of contracts outstanding among all market participants. We should think of open interest as new business (additional liquidity). While volume measures the actual number of options or futures being exchanged between buyers and sellers. The right interpretation of this information is key to determine a bias.
Another piece of the puzzle that must be emphasized is the nearly 100% correlation that exists between the spot forex and the currency futures contracts; while at times there might exist some minor variations, by and large, it’s a very accurate proxy, therefore we can utilize the futures data as a means to decipher and anticipate forward dynamics in the spot forex market.
There are up to 20 different type of traders across all futures and options markets, who after reaching a minimum threshold in their activity, must comply by law to report their positions via firms such as FCMs, clearing members or foreign brokers and exchanges, and it then gets divided by category or classification based on the nature of the business purpose.
As part of the classification of traders, there are certain types, most notoriously, the large specs (smart money) and the commercial accounts, that due to their business purpose, will provide the most insights. Other types of traders that will also reveal snippets of valuable information, and as I like to make the analogy, also leave a trail of breadcrumbs along the way, include leverage funds, asset managers, and dealers.
In layman’s term, the smart money is simply a fancy term to describe the traders/entities with the most knowledge to be consistently profitable and with an ability to move the market, given the large size of their transactions. These account types are referred to as large specs and we may also include leverage funds (also known as speculators). Large specs include mainly hedge funds and banks trading for speculation purposes, and for the most part, have no need to use the futures market as hedging, with the sole intention being profit-driven. Large specs are characterized by being trend-followers, guided by fundamentals and without the need to change their views frequently, given that their involvement in the market tends to occur, barring unexpected events, at key macro levels where enough liquidity is available.
Meanwhile, the leverage funds category includes various types of money managers, such as registered commodity trading advisors (CTAS); registered commodity pool operators (CPOs) or unregistered funds identified by CFTC, and they also engage in managing and conducting proprietary futures trading and trading on behalf of speculative clients.
Now, let’s throw into the mix another key category as is the commercial-type accounts, which are the entities commercially engaged in business activities hedged by the use of the futures or options markets. Note, this group’s involvement orbits around their need to buy or sell the futures contract in order to minimize the risk of exchange rate variations down the road, with a tendency to carry large positions too. Due to the hedging nature of its activity, they act as contrarian traders, buying when prices are low and vice versa.
The usefulness of following commercial accounts is that at times, they unintentionally apply such pressure on prices, that tend to be the force initiating and signaling potential reversal points in the market. What’s more, commercials are particularly knowledgeable about their industries, therefore, are best placed to possess the highest level of insider information in the potential future directions of a particular asset. After all, there is no other category as involved and knowledgeable in the underlying asset as the companies with a commercial interest in the industry (i.e./ German brand BMW has a major interest to hedge EUR transactions. Therefore, the company may have access to sources and information others don’t).
The other two account types that we want to pay attention to include asset managers and dealers. The former are institutional investors who tend to act slowly in established trends and include pension funds, endowments, academic institutions, insurance companies, mutual funds and those portfolio/investment managers who predominantly represent institutional clients. Meanwhile, dealers are typically described as the “sell side” of the market or net hedgers. They don’t take positions to speculate for profits but instead design various financial strategies to allocate assets to institutional clients. They tend to act as liquidity providers and have matched books or offset their risk across markets and clients.
Let’s now reflect on what’s been presented so far, and you will be able to start connecting the dots as to why unpacking the CoT report is critically important and should be at the top of your list at the beginning of a new week. First of all, as a recap, what we’ve leaed so far:
There are 4 types of reports published by the CFTC. However, there are only two we want to pay attention to, which include 1. The legacy and 2. The traders in financial futures (TIFF), with the proper version including futures and options activity. Find below these resources:
Click here to view a table of the latest legacy report:
These reports are broken down by the exchange, with a futures-only report and a combined futures and options report, the latter being the one we want to stick with. It is then unpacked into reportable open interest positions for non-commercial (speculators) and commercial traders (hedgers).
Click here to view a table of the latest TIFF report.:
These reports include financial contracts, such as currencies, U.S. Treasury securities, Eurodollars, stocks, VIX and Bloomberg commodity index. These reports have a futures-only report and a combined futures and options report, the latter the one we want to use. The TFF report breaks down the reportable open interest positions into Dealer/Intermediary, Asset Manager/Institutional, Leveraged Funds, and Other Reportables.
Click here to access the historical data:
In this section of the CFTC website, any entity or individual is free to download the historical data accumulated over the years of the different classified CoT reports. This site is very handy in case you want to crunch the numbers and conduct your own backtesting.
Click here to access a 2018 comparison table:
This document comprises a handy personal notebook, where I annotate the most recent changes in positioning in order to assist my weekly analysis.
Now, you may be asking yourself, is there any platform out there where you may gain access to this data in a way that is more intuitive and overlays the changes in market positioning with the actual movement of price?
The answer is yes, and my favorite website, one that allows analyzing the latest changes with precision, it offers the longest history of CoT data embedded to the charts and I find most intuitive is called CoTbase.com. There is no need to subscribe if you don’t wish, as I personally unpack every week’s data, doing the heavy lifting for you.
Having reached this juncture, this is where I will start drilling down even further and start blending the theory with the practicality via some chart examples so that you can start to fully dispel the myth of the CoT being useless and start to realize its power by exploiting the data to gain an edge.
The first inputs to pay attention must be volume and open interest. Why is this so important? Because at the end of the day, volatility and valuations are a function of liquidity in the markets. So, how can we gain access to changes in liquidity? Open interest is the answer, as it’s a measure closely linked to liquidity. Remember, open interest is the total number of outstanding contracts, while volumes are the total transactions that took place.
Therefore, to gain conviction over a developing bearish market (as the Aussie in the example that follows), we could analyze whether or not open interest increases, which fuels the continuation lower on renewed commitment, ideally replicated by volume increasing or at least maintaining a steady measure.
In the following picture, you can observe a table courtesy of CoTbase.com, with some very useful calculations to gauge how strongly or poorly committed a market is in a particular direction.
Find below an example of the current readings in the Aussie. It shows a total score of -55%, with -3 in vol score and -8 in open interest score, which essentially translates in a market that should remain bearish given the amount of total transactions and change in outstanding positions in the last 5 days (from Aug. 21st to Aug. 28th, 2018), which is then cross-checked with the most critical element, the price action.
On the flip side, if on a bearish directional move, the open interest showed a decline, it has a different meaning altogether, suggesting longs are liquidating their positions, and hence capital is leaving the market rather than coming in, which more often than not, leads to an exhaustion in the trend.
In the case of the NZD below, we can observe an open interest score of 0, which means that in the last 5 trading days, from Aug. 21nd to Aug. 28th, the commitment of buyers was poor, hence the odds are skewed towards an eventual exhaustion of the move and a resumption of the trend.
Don’t forget that the CoT analysis is a top-down holistic approach. Therefore, don’t take the above readings as a hard rule but rather as a series of clues to build up an eventual picture with enough factors aligning.
Next comes the non-commercial positions, often referred as large specs. Remember that given the similarity of their business nature and correlation in positions, we will also include leverage funds in the explanation. Firstly, to prove the point that they tend to be right most of the times, find below a chart of the Euro/US Dollar where I show how all the sustainable trends have one main characteristic behind, and that is, they are unambiguously driven by the large specs category. It doesn’t matter the futures market you analyze, the same patte will keep popping up, that’s why knowing their intentions and current positioning is cardinal.
Which brings us to the next key point. Every time we analyze the weekly changes in positioning, we want to match off and find congruences between the directional move in price being backed up by an increase in the total number of large specs, especially when in trending markets. If that’s the case, it sends a message that the move carries enough substance to find new legs for a potential continuation the following week/s, with large specs likely sitting on the bid/offer adding to their positions in line with their underlying views.
The Sterling is a perfect example of a market with clear bearish connotations, as large specs have been building up short positions as prices moved lower and even adding shorts during the up move. What this means is that the smart money continues to bet for the continuation of the downtrend in GBP/USD.
Another critical exercise in your trading pairs is to mark up in your chart with vertical lines the period where this new engagement of large specs occurred (on sequences of 5 days). On the contrary, if a move in a trending market has an absence of involvement via neutral or decreasing large spec changes, which in the majority of cases is correlated with a decrease in open interest, it means that the move is getting to a potential point of exhaustion and is more dubious in nature to find sustained follow through. The cases in which a favorable directional move can lack an increase in large specs may be due to a removal of liquidity in the market due to a re-assessment of positionings.
In the chart below, it will be immediately obvious how the correctional move in the AUD/USD lacked any type of commitment by the large specs community, suggesting that the move was running the risk of exhausting before sellers regained control in line with the underlying downtrend.
Like the large specs, this group also tends to carry large positions and due to the hedging nature of its activity, act as contrarian traders, buying when prices are low and vice versa. Therefore, in any healthy trend, we should expect commercials sellers to increase on directional moves higher or commercials buyers to dial up their exposure on a directional move to the downside.
That’s the theory, and it makes perfect sense as these accounts have an inherent interest to cover their exposure through the constant buy/sell of the futures or options to eliminate the risks of exchange rate variations. However, a few nuances apply, which makes this category a very interesting one to follow closely. Firstly, when a directional move in price, let’s say a bullish one, comes amid an increase in total commercials, that should be considered an anomaly that will prompt us to ask ourselves the following question. Why would commercials increase their exposure in a week when prices traded higher? More often than not, the reason lies in a fundamental shift in their perception of cheap or expensive valuations.
As an example, if EUR/USD trades from 1.13 to 1.16 in the last 5 trading days the data is collected, and commercials show an overall increase, it’s telling us that they are betting with conviction for the price not to trade much lower. Otherwise, they may have refrained to gain that much exposure, waiting for lower prices. By the same token, it also reveals that if price rose 300 pips, and yet commercial longs showed more activity vs shorts, it leads us to think that even as the EUR/USD recovered ground, commercials shorts were not that compelled to add, which, in the majority of cases, implies expectations for higher prices in the future, thus less compelled to add short business.
As shown in the chart below, whenever we see bullish weeks accompanied by an increase in commercials, the area tends to act as a predictor of either a trend reversal or at least a stronghold from which commercials will be active defending the area in their perception of cheap/expensive levels based on their own models of valuation or insider information.
Another powerful combination is to analyze how extreme commercial positions are vs their historical references, as well as the percentage rate of changes from week to week. You will notice that when commercials reach certain extremes based on historical data if combined with a significant variation in the number of new business added, it tends to accurately pinpoint tuing points in the market. So, ideally, what we want to pay attention to is the bundle of commercials at significant extremes — a lookback of 3y is a good rule of thumb — and sudden changes in positioning. Some discretion applies as one should put both factors into context with the current dynamics in the price.
Below, you can see a chart of the Australian Dollar vs US Dollar. Key tuing points in the chart, more often than not, occur when the commercial positions are at extreme levels or at areas of significant reference, having previously acted as a tuing point. Note, the current positioning in commercials as of late Aug. 2018, while getting extremes, still doesn’t show any signs of finding enough commercial pressure to tu around, and as a historical reference, the positions could still get more extremes (see the horizontal line from 2015).
We’ve now come to the asset managers’ category. Since their performance is based on the average of the industry, this category plays it much safer, engaging in well-established trends or/and where they expect the price to be heading in a time horizon of at least 3 to 6 months. While not the group that has the most relevance in the movement of the currency futures short term, at times, their involvement represents a significant share of the total outstanding positions and acts as a key component to monitor.
For example, in the EUR/USD pair, while the rate has been trading lower since April 2018, note how overwhelmingly bullish asset managers remain? This reveals an overall positive outlook that cannot be ignored, which would make sense if one is to consider the expectations for a slowdown in the pace of rate hikes by the Fed in 2019, just as the ECB mulls the options to start tightening policy next year, which may lead to closing the gap in the current divergence in monetary policies. The US yield curve, with the risks of inverting in the near future, is another mid to long-term component that asset managers would analyze to understand the outlook, and as it stands, the market is far from telegraphing that the US economy is on a sustainable path. These are all factors that have an impact on asset managers to remain bullish in EUR/USD.
We’ve probably come to one of the most overlooked categories, but not necessarily one to brush aside, as it can provide some great hints and can also act as a contrarian indicator. Like the commercials, dealers also fulfill a function of net hedgers, so it’s not at the core of their business model to speculate in the future direction of prices, as in the case of non-commercial/large specs. This category is probably one of the most sophisticated (large banks, dealers in securities, swaps and other derivatives) and knowledgeable about future market directions. Since their main activity consists to allocate investment products to institutional clients, they act as liquidity providers via their need to constantly have matched books.
As an example, let’s say dealer A creates a customized investment product for investor B (large spec). The function of dealer A in this situation would be to make sure that the product offered to investor B is hedged against the market, therefore, a dealer long that is increasing during a bearish phase, it implies that the smart money remains short-side committed, with supply-based products in demand. When an anomaly occurs, and we spot a dropping market that finds no increase in the total net exposure of dealers, that is a clue that their need to hedge against products they allocated is more limited. Hence, sending a signal that the market could be on the cusp of a tuaround.
Find below a chart of the Euro futures. Notice how there was less involvement by dealer shorts? That was a communication that the market was tuing from bullish to more bearish, as dealers exhibited less need to hedge via shorts due to the decrease in long EUR investments they allocated, while a greater need to go long and hedge the increase in demand for short EUR strategies.
One more clue that helps is to monitor the percentage of open interest vs outstanding positions in a particular category of traders. If any of the categories show an extreme level of open positions vs open interest, to the tune of 40–50% (one must cross-check with historical data to pinpoint the right threshold for each market), it suggests that a potential tuaround in prices may be near, especially if this excess of positions is held by the most relevant players as is the case of large specs or commercials. This concept has many resemblances to the comparison of total committed positions vs historical levels in the past, but it goes one step further, by also factoring in what percentage it represents from the total outstanding positions.
Last but not least, another component not to sidestep is context. It’s absolutely essential that all the explanations provided above are adjusted to the circumstances of events (dynamics) present in the market. This means that any major fundamental release, namely central bank policy meetings, geopolitical events or economic data, may distort the analysis of the CoT report as players reassess their exposure in the market.
What’s more, the price context is also important and we must always reflect on whether the market is on a trend or trapped in range conditions. When the latter applies, the insights that may be obtained from the CoT might not be as actionable as when analyzing trends, given that the change in positioning tends to be less committal and more short term in nature, with algos and intraday traders more dominant. That said, the CoT is nonetheless a great weapon, even during times of non-bias conditions, to gauge what side is most at risk or alteatively, whether or not, a potential breakout of the range gets validated by an increase in open interest.
We’ve come to the end of this handy guide to interpret future market dynamics based on the most recent market positioning by the smart money. If by reading this guide you no longer find the CoT data to represent a lagging concept and if you believe that from now on, it can provide some very useful information that is applicable to your forex trading, then my mission would have been accomplished.
If you have any questions regarding this guide, or you’d like to know more about it, you can reach me out anytime, I will be more than happy to answer your doubts and elaborate on the explanations above via seeking alpha.