Inside The Futures World
Want to find out how the futures markets really work? DeCarley Trading senior analyst and broker Carley Garner responds to your questions about today’s futures markets. To submit a question, post your question at http://Message-Boards.Traders.com. Answers will be posted there, and selected questions will appear in a future issue of S&C. Visit Garner at www.DeCarleyTrading.com. Her books Currency Trading In The Forex And Futures Markets; Commodity Options; and A Trader’s First Book On Commodities, are available from FT Press.
COT, REPORTABLE OR NON
How do I read the CFTC’s COT report and should I be following the commercial or nonreportable groups?
In the “Futures For You” column in the December 2011 issue, we learned that the CFTC’s Commitment of Traders (COT) report displays the net long and short positions of large speculators, hedgers, and small speculators. This time, let’s look at how this information might be useful to traders regardless of the overall strategy.
Traditionally, traders look to computer-generated oscillators such as relative strength index (RSI) and stochastics to identify overbought or oversold market conditions. I also like monitoring market sentiment in trading blogs, chat rooms, and news services for signs of overcrowded opinions; but the best place to determine whether prices have been stretched too far may be the COT report.
In my opinion, the best use of COT data is to identify overcrowded trades. Once a market is overheated, it can be vulnerable to mass liquidation, which can wreak havoc on the profits of those following the herd and, worse, could even lure latecomers just before the trend sharply reverses. Remember, once the last man buys, the market sells, and the COT offers a behind-the-scenes glimpse into when and where that might be.
The herd phenomenon occurs in the financial markets to various degrees of severity: those with their eyes open might be able to combat their greedy hearts. Years of observation have led me to believe avoiding the wrath of overcrowded trades is one of the most critical factors determining success and failure. As Warren Buffett once said in a CNBC interview: “We don’t want to make money on the bubble. We just want to survive it without losing our shirts!”
Let’s look at the three basic COT categories and how they might be useful:
In the world of COT, the commercials are synonymous with hedgers. This category is made up of large corporations, small businesses, and even individuals who are close to the action and are likely to be knowledgeable on the subject. Nonetheless, traders should not attempt to follow their lead! Although there are highly intelligent individuals making futures market decisions for those in this category, their motives are different than ours or those in other COT categories.
Commercials establish positions in the futures markets as a means of hedging their price risk. Their goal isn’t to predict where the market is going, or even profit from trades held in the futures markets; they are simply offsetting risk of positions held in the cash market.
Follow the smart money?
Those reportables that aren’t legitimate hedgers are commonly called large speculators. This COT group is considered to be the smart money simply because they are well capitalized and, in theory, must have known what they were doing to get into the position they are in.
If the COT reveals large speculators moving from long positions into short ones, it signals that the category has grown bearish and this might be a good time for traders to consider following suit. Of course, it is never a good idea to blindly follow large speculators; they are likely have much deeper pockets that most small ones. Specifically, those trading enough positions to fall into the reportable category typically have the luxury of less than perfect timing due to mass amounts of capital backing their speculation. If you can’t ride out adversity like the large specs, following their lead could mean running the risk of being forced out of the trade before it ever becomes successful.
Conversely, if large speculators have amassed a large net position in one direction, you’ve missed the opportunity to follow their lead. Instead, you should be looking for a possible trend reversal. After all, if they’ve already bought, the only way to exit is to sell.
Fade the small specs?
Unfortunately, most traders who fall into the small speculator category lose money. In fact, most believe that roughly 80% of market participants walk away from leveraged speculation with less than they started with. This is why many analysts look at the COT’s small speculator category as contrarian. If COT data suggests the small speculator category is net short in a particular market, it might be time to consider being bullish. This might seem irrational. After all, why would you want to buy when everyone is selling?
Simple. Small speculators have a history of inaccuracy and also tend to be fickle. This means they are likely to be late getting into the market and quick to liquidate once the tide turns. In addition, small speculators tend to move together and are known to chase markets with hopes that previous price action will be indicative of future results. If you see small speculators accumulating a net position in one direction or the other, you might want to play the opposite side.
Knowing what each trading category is doing is useful but is no guarantee. The COT report should be used like any other trading tool, with corroborative technical and fundamental reasoning.