The COT Report, Futures Contracts, and Trading Strategies
If you trade at very high frequency, with anything lower than the daily chart, you can stop reading and do something else with your time. If you trade long trends or invest in stocks or CFDs or ETFs and you ride very long positions, then understanding the COT report is a useful skill to add to your tools.
The COT Report
It is made available on Fridays and pertains to the Tuesday before that. You can find the raw version from the source, with is the Commodity Futures Trading Commission OR you can see a synthetic version in many places, such as Barchart’s graphs, which are great for a visual overview.
It provides the positions of large players in futures markets: commercials (banks and large brokers), hedge funds, etc. It gives the longs and shorts on your chosen commodity, forex pair, index, etc. I will discuss how to interpret this in a minute, but for now, lets start with an example…
Since I like forex trading, lets have a look at the USD COT report positions overview as of Tuesday 21 2017 (which means it pertains to data on Tuesday Nov 14) and shows the last 3 years of data (you can pick more or less, but 3 years is generally good):
As you can see, you have 3 graphs here: 1) the average usd value relative to a basket of currencies (up is appreciation of usd in broad terms and down is depreciation of usd in broad terms); 2) the old COT report format reporting; 3) the new COT report format reporting, which is the one you should look at:
Using the COT
In general, you look at the TTF COT report and you see there are 3 important categories: Dealer intermediary, Asset manager, and Leveraged funds (hedge funds). “Other reportables” is generally NOT important, other than for jpy in some cases (in the case of forex), but generally you can disregard this line.
As with technical analysis and all other forms of financial analysis and trading strategies, there is a great deal of “over interpretation / over analysis” and overkill when it comes to the COT.
First, before I explain things, notice what happened in October 2017: the red line (“Dealers / Intermediaries”) started to go “down” and the USD appreciated strongly by more than 6% (equivalent to more than 2000+ pips easy on most pairs) for 2 months. Then, from mid January 2017 to September 2017, the red line gradually trended up (less negative, going towards zero) and the usd depreciated 10 %… a LOT of pips!
I will thus right away give you the general interpretation and simple use of the COT and I will THEN explain:
- Go in opposite direction to the “dealers / intermediaries” (i.e. banks). If the red line is going up, banks are going “more long / less short”, so you should have a short macro bias (bearish) on this instrument. If the red line is going down, banks are going “more short / less long”, so you should have a long macro bias (bullish) on that instrument.
- Notice extreme positions in either shorts or longs (generally the red line again). If you have an extreme, it may signal a turnaround soon… although my general philosophy about this is to always wait for the market to TELL you and avoid supposing anything in advance about where the market may go…
- The green line generally goes opposite to the red line. These are speculative positions directly in the futures market, and NOT hedging strategies.
The data is always “late”: it is available Friday and gives a snapshot of the last Tuesday… so if you are trading for fast ups and downs, all this is not useful at all. The data DOES signal the aggregate expectations of major players who look at the market all day, your round, and have experts and good information, so this IS useful overall, if you trade long term positions.
For the small trader, the only actionable pieces of info are 1) extreme positions and 2) the last 2 moves by banks (dealers). That’s the best you can extract from the COT for useable info, the rest should come from your own assessment of fundamentals (macro trends for inflation, central bank stance, growth, etc. in the case of forex trading, as I explained in previous posts) and technical (chart) analysis.
Futures, Hedging, and the COT
Why should you go “opposite to bank COT positions”? This seems mysterious, right? Allow me to explain…
Banks use futures contracts to hedge their balance sheets. This means that if banks HAVE lots of USD (or EUR or CAD or whatever) in their assets, they are HOLDING that asset, which means their “spot” position (cash) is “long usd”… what happens to the bank if the usd depreciates in general versus many other currencies? Their assets are LOSING value, and that’s something to avoid!
If banks do NOT have lots of usd in their assets, it means they are providing the demand for usd by their clients by buying “as they go” in the spot market because they have thin reserves. In such a context, if the usd appreciates, they will be forced to purchase usd at increasing prices, which is also bad!
Banks make money by providing intermediation services and by earning commissions on spreads (selling a bit higher than what they pay to buy) and other operations. They don’t want fluctuations of the market value of their assets to affect them negatively. So if they HOLD lots of usd (they hope for usd appreciation and they fear usd depreciation), they would like to offset the potential loss of their cash (spot) position by “neutralizing” it with a different position in the futures market (I will explain below, keep reading)… and if banks are short on some asset in their cash (spot) position, they also want to neutralize the impact of fluctuations with a different position in the futures market.
Futures Explained
I will explain Futures contracts only, and will only mention that options are futures that you have the “option” to use or not (in a somewhat oversimplified nutshell!)…
A futures contract works like this (I will simplify a bit to avoid details that might confuse you and I will prioritize making the basic idea stand out):
The current price of “something” is 100$. We enter into a futures contract together today and you take a “long” position (buy from me in the future at a specified price in the contract) and I take a “short” position (sell to you in the future at a specified price in the contract). Suppose the date specified in the contract is in 3 months and the price specified in the contract is the same, 100$ (it can be different). That’s the general setup.
If price goes up to 110$ and we reach the maturity date, then I must sell to you this asset at 100$, but it is worth 110$ in the market at that point: I am selling at a loss of 10$, while you can buy it at 100$ from me and can sell it immediately in the spot market at 110$, so you are making a 10$ profit. Price went UP, which makes the long position profit and the short position lose.
If price goes down to 90$ and we reach the maturity date, then I can sell to you for 100$ something that is only worth 90$ in the market at that time, so I am making 10$ profit, and you must buy from me at 100$ while you could pay only 90$ in the spot market at that time, so you are losing 10$. Price went DOWN, which makes the long position lose and the short position profit.
Here is a futures contract:
So what’s the link with the COT report?
The COT report shows you what banks are doing in the Futures market! Since banks only want to hedge their balance sheet positions, it means that if they are LONG in futures in the COT, they are short in their cash position (and they will win on their Futures contracts if price goes up)… and you want to be on the side of the spot position of banks (hence opposite to the COT report), because if banks are generally bullish on the usd (or whatever else), they will buy the dips and price will find support from lots of big players. Get it? Now re-read the post and explore the COT and try to find ways to use the info you see in your long term strategies. Clap to show appreciation, share to spread the knowledge, and comment to give extra to the post.
Pascal Bedard
pbedard@yourpersonaleconomist.com
