Using the Commitment of Traders (COT) Report in Forex Trading
There are potentially many ways to use the COT Report for analyzing a forex pair. Here is one COT Report forex strategy, along with basics of what the COT report is, and why it is worth paying attention to.
COT Report Basics for Forex TradingCopy link to section
Simply put, large traders and institutions must disclose their futures positions each Tuesday, which is called the “As of “date (currencies, or forex pairs, trade via futures market as well via the forex and cash markets). These positions are then revealed to the public each Friday, at 3:30 PM EST, in the COT report published by the Commodity Futures Trading Commission (CFTC).
How these large traders and institutions are positioned gives insight into whether a trend is likely to continue or reverse. While the data only shows information on futures contracts, and not the transactions that occur in the forex market, the COT report is still a very good estimate of how other traders are positioned, and thus should be monitored by both currency futures traders and forex traders.
Before going into COT Report forex strategies I want to briefly outline a few of the key elements. The COT Report has quite a bit of data, yet there is really only a few pieces of information I care about: the net position of Commercials, the net positions of Large Speculators, and how these positions have changed over time.
Commercials are hedgers, businesses, producers, etc, who have large positions that are often offsetting another position or transaction. Commercials include importers or exporters who are hedging foreign currency exposure to control costs or normalize income. As a group, these are counter trend traders. They can afford to hold positions against large trends because their transactions are often a hedge, and thus do not expose them to a direct loss. Think of a gold producer. They know they will be producing gold, and will need to sell it. They therefore sell gold futures to lock in a price that they can sell their gold at. If the price of gold goes up, they missed out on making more on their gold, but they still get to sell their gold at the price they locked in. If the price of gold goes down, they still get to sell at the price they locked in. The commercials are largely engaged in this type of trading. They do want to get a good price for whatever it is they are doing, but they are not typically speculating (although some may) on what the price will do, they are simply locking in prices (for commodities or currencies) to run their business.
Large Speculators on the other hand are mostly hedge funds. Despite the name “hedge fund” these large speculators are rarely hedged, and therefore cannot sustain large losses or afford to trade against the trend. As a group Large Speculators are trend followers. Speculators are the people on the other side of the Commercial’s transactions.
Since Large Speculators are trend followers and much more sensitive to price movements (they are speculating and are therefore more likely to experience a direct loss of funds if a trade goes opposite to what they expect) than the Commercials, Large Speculators are the group of prime interest and the group on which our COT Report forex strategies are based.
Calculating the net position over time “by hand” is possible as the reports are released weekly by the CFTC, but that is ultimately unnecessary. Using a COT Report chart is one of the easiest ways to track the data for trading purposes.
COT Report data is chartable on barcharts.com. Select the futures contract you wish to view a chart of. The COT data is shown along the bottom of chart (we only care about the one that includes Large Spec., Small Spec, Comm Spec)
The following is an example of a Euro (FX) futures chart showing the COT Report data along the bottom. The frequency of the chart is “weekly continuation” and the period is 5 years.
In the chart above we can see the net positions of the Commercials (red) and Large Speculators (green). The chart shows that the speculators usually move with the price, and commercials against the price. When a line is below the “0” mark it means the net position is short, while above the “0” line means the net position is long.
One other thing to note is that a currency future is relative to the US dollar. Therefore, the Euro future will move with the EUR/USD. The Canadian dollar future will move with the CAD/USD, which is inverse to the USD/CAD forex pair most forex traders are used to. When the USD is the second currency in the pair, the future and the currency pair will move in unison. In currency pairs where the USD is first, the futures will move opposite the pair, such as the case with the CAD futures. Remember this when analyzing COT data and acting on it in the forex market.
By visually seeing the COT data in this way we can extract useful information, which then provides the basis for our COT Report forex strategy.
COT Report Forex Trading – Extreme Levels Can Indicate a ReversalCopy link to section
When speculators are accumulating a position it can be a confirmation that there is interest in the trend. If shorts are being accumulated as the price drops, or if long positions are being accumulated as the price rises, this can be a good sign the trend will continue. But speculators have a limit–they can’t purchase or sell indefinitely. They may run out of money, simply wish to take profit (or losses) or may no longer feel as much conviction to keep buying at higher prices or selling at lower prices. When speculators are tapped out, want out or don’t want to invest anymore, there is nowhere left for the price to go, but to reverse.
Therefore, the COT data can be used as a type of “overbought/oversold” indicator in terms of the health of the traders within the market. Each futures market will be a bit different, but critical COT levels will often repeat and indicate when speculators are overextended.
The Euro futures chart above shows that when speculators were 200,000 contracts short, or close to it, this generally resulted in a price reversal to the upside [over time these extreme levels may continue to push outwards. It is not a single level that is important (200,000 contracts, for example) but rather watching for new extremes, and then reversals in price and COT direction after those extremes start to show up].
This method is not recommended for a top or bottom picking strategy; it can be used to provide a context for other analysis and be used to confirm reversals in price though. Extreme levels can look easy to isolate in hindsight, but are not ideal timing indicators. That said, it is very useful for alerting traders when a reversal could be nearby. The COT data should not be acted on alone though; wait for price to confirm a potential reversal signal in the COT data (more on this later).
Let’s look at another example, and see how the COT data could have aided in making a trading decision.
The chart below shows Canadian dollar futures (D6), along with COT data. We can see that the Canadian dollar was in a long term decline versus the US dollar (futures contracts are traded against the USD, unless otherwise stated). In 2015, Large Specs had accumulated a short position close to -65,000 contracts. This only resulted in a minor bump up in price. In early 2016, the same short position resulted in a much larger up move. Of note is that this is when oil started to bounce, and the Canadian economy is heavily dependent on the price of oil. The rise in oil combined with an extreme reading on the Large Specs pointed to a move higher in the Canadian dollar.
Ultimately though, we want price action to help confirm our trades. While those COT levels in 2015 and 2016 were more extreme than what we had seen in the past, it would have been relatively hard to make a trade based on them…unless you were also looking at oil and making a determination that it was likely to turn higher, which would bolster the Canadian dollar in early 2016.
With a few data points behind us for reference, the next major opportunity to use the COT came in 2017. But first a bit of context. In 2016 the price shot up, and the up move has larger than the last swing to the downside (Sept ’15 to Jan ’16). That is a very positive price action signal. It indicates that the downtrend may be over. But we want more evidence, which is why I usually wait for a pullback before taking trade (with most of my strategies). Throughout out 2016 and into 2017 we have a very lengthy and slow-moving decline. It is a much weaker down move than the prior up move. That’s another positive sign (read Price Action Trading with Velocity and Magnitude).
Based on the price action, the stage is set. We have two compelling price action reasons to consider a long trade. In May, COT Large Spec short positions increase to well below the -65,000 point of interest. The position ultimately reaches -99,000 in late May. By mid-June that short position has decreased to below 90,000 and the position moves up toward zero every week after, showing that the Large Specs are quickly shifting their bias. Price is also rising during this time.
If we zero in on a daily chart we can see some possible trade locations. The first would been at the bottom of this weak descending channel. 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). For those who have read my Forex Strategies Guide, this would be a Front-Running trade. 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. If you are trading the USD/CAD, the same analysis would apply, but it would be flipped upside down. Remember, we were expecting the CAD to increase in 2017, based on price action and COT data. If we expect the CAD to go up, what will the USD/CAD do? It will fall, because if the CAD goes up, the USD goes down. The same trades and setups are present on the USDCAD chart, except we would have been going short the USDCAD (which is equivalent to going long the CADUSD or CAD futures).
Trading With COT Extremes – WarningsCopy link to section
Have other pieces of evidence that help confirm a trade. It isn’t wise to just assume the price will reverse because the Large Specs are near a historically extreme level. Over time, these extreme levels tend to expand. In the CAD futures chart above, -99,000 was extreme. That may hold in the future as well, but several years down the road new extremes may be hit at 125,000 or 150,000. 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. The extreme COT alerts us to a possible trade (or to avoid a trade) but it doesn’t SIGNAL a trade.
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.
IF THE COT IS NOT NEAR AN EXTREME, I DO NOT CONSIDER IT IN MY TRADING DECISIONS. I wouldn’t over-use this indicator. If you get a valid trade signal based on your strategies, and the COT data isn’t near an extreme, that doesn’t mean you shouldn’t take your trade signal. COT data is just an extra piece of data. If I get a valid trade signal, I take it. It’s just that occasionally COT may help in analyzing or confirming (or rejecting) trades. But as we can see from the CAD example, the COT data was only relevant (to how I trade) a few times over the last several years. 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 2007, we would see that 65,000 to 100,000 contract positions had been significant in the past as well.
COT Report Forex Trading – ConclusionCopy link to section
One way I like to use COT data on my chart is to look for extremes in Large Spec. positions. While it isn’t an exact timing indicator, if other conditions align and I get a valid trade setup, an extreme level on the COT can often mean a sharp and large price reversal. 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.
Just because a COT reading is at or near an extreme doesn’t mean the price will have a massive 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. This is why we don’t use the COT in isolation. 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).
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