UNDERSTANDING COMMITMENT OF TRADERS (COT)

Why the COT Report?

It is difficult to quantify volume traded at each price level since the currency market is decentralized and there is no single exchange that tracks all trading activities. In place of volume-based trading, many traders look to the Commodity Futures Trading Commission's (CFTC) Commitments of Traders (COT) report for more information on positioning and volume. If used wisely, the COT data can be a pretty strong gauge of price action. The caveat here is that examining the data can be tricky, and the data release is delayed as the numbers are published every Friday for the previous Tuesday's contracts, so the information comes out three business days after the actual transactions take place.

Reading the COT Report

Here is a quick list of some of the items appearing in the report and what they mean:

Commercial - Describes an entity involved in the production, processing, or merchandising of a commodity, using futures contracts primarily for hedging
Long Report - Includes all of the information on the "short report", along with the concentration of positions held by the largest traders
Open Interest - The total number of futures or options contracts not yet offset by a transaction, by delivery or exercise
Noncommercial (Speculators) - Traders, such as individual traders, hedge funds and large institutions, who use futures market for speculative purposes and meet the reportable requirements set forth by the CFTC
Nonreportable Positions - Long and short open-interest positions that don't meet reportable requirements set forth by the CFTC
Number of Traders - The total number of traders who are required to report positions to the CFTC
Reportable Positions - The futures and option positions that are held above specific reporting levels set by CFTC regulations
Short Report - Shows open interest separately by reportable and non-reportable positions
Spreading - Measures the extent to which a non-commercial trader holds equal long and short futures positions

Taking a look at the sample report, we see that open interest on Tuesday June 7, 2005, was 193,707 contracts, an increase of 3,213 contracts from the previous week. Noncommercial traders or speculators were long 22,939 contracts and short 40,710 contracts - making them net short. Commercial traders, on the other hand, were net long, with 19,936 more long contracts than short contracts (125,244 - 105,308). The change in open interest was primarily caused by an increase in commercial positions as non-commercials or speculators reduced their net-short positions.

Three Primary Premises

Flips in market positioning may be accurate trending indicators.
Extreme positioning in the currency futures market has historically been accurate in identifying important market reversals.
Changes in open interest can be used to determine strength of trend.

COT – Commitment of Traders

Commercials – Most informed group and provide countertrade position for the majority of open interest in the market. These are the “Smart Money”.

Standard Commercial Accumulation Phase:

Commercials are the largest short sellers in the marketplace because they are hedging their business needs.
Commercials control the long term trend based on 12 month or 4 year extremes.

Coming from 12- mon or 4-yr extreme net short, we're in sell program.
Coming from 12-mon or 4-yr extreme net long, we're in buy program.

Large Speculators – Large firm traders, funds, and high level private speculators who for the most part trend trade. Generally on the right side of the market
Small Speculators – Majority of traders. They are the “Dumb Money”. Consistently wrong on the side of the market.

Open Interest in COT Data

Open interest tends to increase when new money is poured into the market, meaning that speculators are betting more aggressively on the current market direction. Thus, an increase in total open interest is generally supportive of the current trend, and tends to point to a continuation of the trend, unless sentiment changes based on an influx of new information.
Conversely, overall open interest tends to decrease when speculators are pulling money out of the market, showing a change in sentiment, especially if open interest has been rising before.
In a steady uptrend or downtrend, open interest should (ideally) increase. This implies that longs are in control during an uptrend, or shorts are dominating in a downtrend. Decreasing open interest serves as a potential warning sign that the current price trend may be lacking real power, as no significant amount of money has entered the market.
Therefore, as a general rule of thumb, rising open interest should point to a continuation of the current price move, whether in an uptrend or downtrend. Declining or flat open interest signals that the trend is waning and is probably near its end.
When open interest rises or drops quickly, likely price moves in the opposite direction.
Conventional Price Relationship:

Open Interest Up, price up is bullish
Open Interest Up, price down is bearish
Open Interest Down, price up is bearish
Open Interest Down, price down is bearish