Using the COT Reports to Predict Forex Price Movements

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Before examining the COT reports and a few ways of using them, let us note two important details:

One of the major problems with the forex market is the lack of a volume indicator. Since there is no forex exchange such as the Nikkei or the NYSE, volume statistics on the entire market are not available. The COT report, tracking the currency and commodity futures allocations of the major speculators and commercial hedgers, is an excellent substitute for the volume indicator, and it should therefore be an inseparable item of any technical trading scheme.
The other point which we would like to emphasize is the lagged nature of the report. As it updates us on positions of the past week, it is a lot more valuable as a long-term indicator, with periods of weeks, rather than days being the field of its measurements.

The COT (commitment of traders) is a report issued by CFTC to update the public on the futures positioning of traders in commodities markets. In the US most futures trading takes place in Chicago and New York, and the institutions covered by the report are heavily concentrated in these locations.

Let’s examine the body of a COT report.

Open interest describes the amount of open futures contracts that are being held. In other words, it is the total volume of open contracts in the market, but not the transactions.

Reportable positions are the positions held by institutions that meet the reporting requirement of the CFTC. These are the major players in the CBOT, and their choices are usually backed by hordes of analysts and their studies.

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.

1. Creating a currency portfolio based on the COT report positioning.

We can use the COT report data to create a diversified currency portfolio. By examining the COT report, we can have a good idea of the attitude of major traders toward the USD, but to make real use of the the data we must create a portfolio of currency pairs, such as AUD/USD, EUR/USD, USD/JPY. Since the market can be, overall, long the USD, but can be short the USD against one or more currencies, we do not want to be caught holding a pair in which the USD will lose value, while the COT is still long. 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? In general, it’s a good idea to make our portfolio interest-neutral, so as to express in our currency allocations our USD-positive idea, while declining to say much about the currencies we will short.

For instance, we will short AUD/USD and EUR/USD (and the carry is negative) and long USD/JPY and then we will manage our currency pair ratios in such a way that the total interest received will not exceed the Fed rate. 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. Thus, for instance, if the commercial sector is long the EUR, and the speculative sector is long the AUD, the trader would simply arrange his portfolio to reflect the market’s choice by assigning a large part to EUR/AUD. 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.

2. Exploiting reversals in positioning to create a portfolio

It’s also possible to arrange the above mentioned portfolios to profit from trend reversals as signaled by COT reports, but we caution against this method, unless the trader carefully hedges his position by trading uncorrelated(or negatively correlated) pairs. 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. Our only suggestion is that the trader be aware of the potential of false signals, and, as per the usual principle, avoid trying too hard to catch bottoms and tops.

3. Using the COT report as a long term volume indicator

An exceptionally useful and prudent use of the COT report is regarding it as a volume complement to the price studies generated by conventional technical analysis. The trader can simply refuse to act when a technical signal fails to be confirmed by a similar movement (signaled in increasing open interest) in the COT report. For an uptrend, he would expect a corresponding rise in open interest, and for a down trend, a corresponding fall. It is also possible to devise indicators for this purpose, and MACD, Williams Oscillator, or Stochastics can all be drawn on the COT report data.

This approach is akin to using volume and price data simultaneously while exploring stock market charts, and those with experience in that field will easily grasp the importance of the COT report. Nonetheless, those with little knowledge of other markets can still greatly benefit from its utilization, especially when trading on a purely technical basis.

4. Using flips in positioning to predict market reversals

In the sample COT chart above, non-commercial net positioning for Euro is short, since 38 percent of traders are holding short positions, while thirty percent hold longs. One way of exploiting this segment of the COT report is by taking note when net positioning switches from long to short and vice versa, and predicting forex market reversals on that basis. In the above example, when net positioning of the non-commercial sector switches to long, we would use the development as a signal for buying euros, coupled with some input from other sources of technical analysis.

While this method can produce results that are much more reliable than those generated by pure technical analysis, the trader should still be aware of whipsaws and unpredictable spikes and collapses that can sometimes arise. Percentage values are easier to recognize, and are easier for recognizing position flips.

5. Using extreme positioning to gauge market exhaustion

Comparing long or short positioning with historical extremes can also be beneficial in identifying market extremums. Experience shows that there are absolute values which indicate a bought-out, or sold-out currency, and as the COT positioning hits these values, there’s a significant chance of a rapid reversal.

Extremums can also be termed bubbles, as they characterize a market that is already in an unsustainable phase of rise or fall. The problem with this method lies in the fact that it’s always hard to pick up tops and bottoms: there’s no reason to expect that positioning cannot exceed a previously registered high, before collapsing. Still, if one has the determination and the resilience, extremums reported by the COT report have much greater value than that reported by price based technical analysis.

It is possible to confirm the absolute extremes on the COT report with extremes on moving averages or oscillators on the price chart.

Summary

The COT report is a very useful tool which can be substituted for the volume indicators of stocks analysis. Absolute long and short positioning and historical comparisons can be useful for identifying market extremes. Percentage changes in open interest can be valuable in noting position flips and predicting market reversals in the medium term. If there ever were an ultimate technical indicator, its seekers have their greatest luck in COT data. But the old advice on not putting all eggs in the same basket is still valid: it’s better to confirm signals from the COT report with data from other aspects of technical analysis, and of course fundamental analysis, before reaching decisions.

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