Forex Markets: How To Read The Commitment Of Traders Report?

medium.com/@globalprimeforex/forex-markets-how-to-read-the-commitment-of-traders-report-1f315d3cc4db

September 13, 2018

Global Prime Forex

Sep 12, 2018
Authored by Ivan Delgado Egea, Head of Market Research at Global Prime. You can
follow me via twitter https://twitter.com/delgado_egea

Find out why Global Prime is the highest rated broker at Forex Peace Army.

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Summary
The belief that the CoT analysis is lagging is a myth.
The right interpretation of the CoT data offers an edge.
Find out the most useful resources to collect the CoT data.
Learn to join trends in the direction of the smart money.

The general mantra in the forex industry has usually taken with a pinch of salt the usefulness of
the CoT (Commitment of Traders) report on the basis that by the time the information is
published, it’s not really that practical, and at best, it only offers minimal forward-looking and
insightful information.

In this guide, I will provide enough supporting evidence to make a compelling case as to why the
CoT report, against conventional belief, does not represent a lagging indicator and why the right
interpretation of the data provided every week offers comprehensive insights on how the smart
money is positioned.

What Is The Commitment of Traders Report?

The commitment of traders report, which from now on, we will refer to as the CoT for
convenience, is a series of reports gathered by the CFTC (U.S. Commodity Futures Trading
Commission) on a weekly basis, published every Friday at 3:30 E.T., and reflecting the
breakdown of positions held by the different types of traders trading futures and options, up to
the prior Tuesday.

What this means is that by the time the data is received, it doesn’t capture the prior three days’
changes in positioning, and because of that, a widely common assumption is to think that the
data is barely useful or actionable and very much lagging in nature. Again, I’ll prove that to be a
wrong myth.

The Unique Characteristics of Futures and Options Markets

Unlike the opaque and fragmented state of spot forex, with no exchange or central entity that
facilitates transparent price discovery, future and options markets in the US must report the
actual volume that is transacted. What this means is that there is a component of transparency
in the data reported that will never be as accurate via spot forex.

Open interest represents the total number of contracts outstanding among all market
participants. We should think of open interest as new business (additional liquidity). While
volume measures the actual number of options or futures being exchanged between buyers
and sellers. The right interpretation of this information is key to determine a bias.

Another piece of the puzzle that must be emphasized is the nearly 100% correlation that exists
between the spot forex and the currency futures contracts; while at times there might exist
some minor variations, by and large, it’s a very accurate proxy, therefore we can utilize the
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futures data as a means to decipher and anticipate forward dynamics in the spot forex market.

Who Are the Traders Required to Report Their Positions?

There are up to 20 different type of traders across all futures and options markets, who after
reaching a minimum threshold in their activity, must comply by law to report their positions via
firms such as FCMs, clearing members or foreign brokers and exchanges, and it then gets
divided by category or classification based on the nature of the business purpose.

As part of the classification of traders, there are certain types, most notoriously, the large specs
(smart money) and the commercial accounts, that due to their business purpose, will provide
the most insights. Other types of traders that will also reveal snippets of valuable information,
and as I like to make the analogy, also leave a trail of breadcrumbs along the way, include
leverage funds, asset managers, and dealers.

In layman’s term, the smart money is simply a fancy term to describe the traders/entities with
the most knowledge to be consistently profitable and with an ability to move the market, given
the large size of their transactions. These account types are referred to as large specs and we
may also include leverage funds (also known as speculators). Large specs include mainly hedge
funds and banks trading for speculation purposes, and for the most part, have no need to use
the futures market as hedging, with the sole intention being profit-driven. Large specs are
characterized by being trend-followers, guided by fundamentals and without the need to
change their views frequently, given that their involvement in the market tends to occur, barring
unexpected events, at key macro levels where enough liquidity is available.

Meanwhile, the leverage funds category includes various types of money managers, such as
registered commodity trading advisors (CTAS); registered commodity pool operators (CPOs) or
unregistered funds identified by CFTC, and they also engage in managing and conducting
proprietary futures trading and trading on behalf of speculative clients.

Now, let’s throw into the mix another key category as is the commercial-type accounts, which
are the entities commercially engaged in business activities hedged by the use of the futures or
options markets. Note, this group’s involvement orbits around their need to buy or sell the
futures contract in order to minimize the risk of exchange rate variations down the road, with a
tendency to carry large positions too. Due to the hedging nature of its activity, they act as
contrarian traders, buying when prices are low and vice versa.

The usefulness of following commercial accounts is that at times, they unintentionally apply
such pressure on prices, that tend to be the force initiating and signaling potential reversal
points in the market. What’s more, commercials are particularly knowledgeable about their
industries, therefore, are best placed to possess the highest level of insider information in the
potential future directions of a particular asset. After all, there is no other category as involved

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and knowledgeable in the underlying asset as the companies with a commercial interest in the
industry (i.e./ German brand BMW has a major interest to hedge EUR transactions. Therefore,
the company may have access to sources and information others don’t).

The other two account types that we want to pay attention to include asset managers and
dealers. The former are institutional investors who tend to act slowly in established trends and
include pension funds, endowments, academic institutions, insurance companies, mutual funds
and those portfolio/investment managers who predominantly represent institutional clients.
Meanwhile, dealers are typically described as the “sell side” of the market or net hedgers. They
don’t take positions to speculate for profits but instead design various financial strategies to
allocate assets to institutional clients. They tend to act as liquidity providers and have matched
books or offset their risk across markets and clients.

Why Following the CoT Offers an Edge?

Let’s now reflect on what’s been presented so far, and you will be able to start connecting the
dots as to why unpacking the CoT report is critically important and should be at the top of your
list at the beginning of a new week. First of all, as a recap, what we’ve learned so far:

Spot forex is non-transparent vs. regulated and transparent futures and options, allowing
us to extract critical information.
Spot forex and currency futures show a correlation of nearly 100%.
Certain trader types (smart money) get the bias right most of the time.
The smart money doesn’t tend to alter positions that frequently, hence a 3-day delay in
reporting the data does not make the information irrelevant.
The involvement of commercials and their aggressive changes in positioning represent
another important signal for a potential change in bias.
Asset managers and dealers act as a second layer of information that helps to
complement a hypothesis and reinforce a certain bias in the market.

Useful Resources to Collect the CoT Data

There are 4 types of reports published by the CFTC. However, there are only two we want to pay
attention to, which include 1. The legacy and 2. The traders in financial futures (TIFF), with the
proper version including futures and options activity. Find below these resources:

Click here to view a table of the latest legacy report:

These reports are broken down by the exchange, with a futures-only report and a combined
futures and options report, the latter being the one we want to stick with. It is then unpacked
into reportable open interest positions for non-commercial (speculators) and commercial
traders (hedgers).

Click here to view a table of the latest TIFF report.:

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These reports include financial contracts, such as currencies, U.S. Treasury securities,
Eurodollars, stocks, VIX and Bloomberg commodity index. These reports have a futures-only
report and a combined futures and options report, the latter the one we want to use. The TFF
report breaks down the reportable open interest positions into Dealer/Intermediary, Asset
Manager/Institutional, Leveraged Funds, and Other Reportables.

Click here to access the historical data:

In this section of the CFTC website, any entity or individual is free to download the historical data
accumulated over the years of the different classified CoT reports. This site is very handy in case
you want to crunch the numbers and conduct your own backtesting.

Click here to access a 2018 comparison table:

This document comprises a handy personal notebook, where I annotate the most recent
changes in positioning in order to assist my weekly analysis.

Now, you may be asking yourself, is there any platform out there where you may gain access to
this data in a way that is more intuitive and overlays the changes in market positioning with the
actual movement of price?

The answer is yes, and my favorite website, one that allows analyzing the latest changes with
precision, it offers the longest history of CoT data embedded to the charts and I find most
intuitive is called CoTbase.com. There is no need to subscribe if you don’t wish, as I personally
unpack every week’s data, doing the heavy lifting for you.

Having reached this juncture, this is where I will start drilling down even further and start
blending the theory with the practicality via some chart examples so that you can start to fully
dispel the myth of the CoT being useless and start to realize its power by exploiting the data to
gain an edge.

Open Interest and Volume: The Foundation

The first inputs to pay attention must be volume and open interest. Why is this so important?
Because at the end of the day, volatility and valuations are a function of liquidity in the markets.
So, how can we gain access to changes in liquidity? Open interest is the answer, as it’s a measure
closely linked to liquidity. Remember, open interest is the total number of outstanding
contracts, while volumes are the total transactions that took place.

Therefore, to gain conviction over a developing bearish market (as the Aussie in the example
that follows), we could analyze whether or not open interest increases, which fuels the
continuation lower on renewed commitment, ideally replicated by volume increasing or at least
maintaining a steady measure.

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In the following picture, you can observe a table courtesy of CoTbase.com, with some very
useful calculations to gauge how strongly or poorly committed a market is in a particular
direction.

Source: CoTbase.com

Find below an example of the current readings in the Aussie. It shows a total score of -55%, with
-3 in vol score and -8 in open interest score, which essentially translates in a market that should
remain bearish given the amount of total transactions and change in outstanding positions in
the last 5 days (from Aug. 21st to Aug. 28th, 2018), which is then cross-checked with the most
critical element, the price action.

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Source: CoTbase.com

On the flip side, if on a bearish directional move, the open interest showed a decline, it has a
different meaning altogether, suggesting longs are liquidating their positions, and hence capital
is leaving the market rather than coming in, which more often than not, leads to an exhaustion
in the trend.

In the case of the NZD below, we can observe an open interest score of 0, which means that in
the last 5 trading days, from Aug. 21nd to Aug. 28th, the commitment of buyers was poor, hence
the odds are skewed towards an eventual exhaustion of the move and a resumption of the
trend.

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Source: CoTbase.com

Don’t forget that the CoT analysis is a top-down holistic approach. Therefore, don’t take the
above readings as a hard rule but rather as a series of clues to build up an eventual picture with
enough factors aligning.

Large Specs and Leverage Funds: The Smart Money

Next comes the non-commercial positions, often referred as large specs. Remember that given
the similarity of their business nature and correlation in positions, we will also include leverage
funds in the explanation. Firstly, to prove the point that they tend to be right most of the times,
find below a chart of the Euro/US Dollar where I show how all the sustainable trends have one
main characteristic behind, and that is, they are unambiguously driven by the large specs
category. It doesn’t matter the futures market you analyze, the same pattern will keep popping
up, that’s why knowing their intentions and current positioning is cardinal.

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Source: CoTbase.com

Which brings us to the next key point. Every time we analyze the weekly changes in positioning,
we want to match off and find congruences between the directional move in price being backed
up by an increase in the total number of large specs, especially when in trending markets. If
that’s the case, it sends a message that the move carries enough substance to find new legs for
a potential continuation the following week/s, with large specs likely sitting on the bid/offer
adding to their positions in line with their underlying views.

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The Sterling is a perfect example of a market with clear bearish connotations, as large specs
have been building up short positions as prices moved lower and even adding shorts during the
up move. What this means is that the smart money continues to bet for the continuation of the
downtrend in GBP/USD.

Source: CoTbase.com

Another critical exercise in your trading pairs is to mark up in your chart with vertical lines the
period where this new engagement of large specs occurred (on sequences of 5 days). On the
contrary, if a move in a trending market has an absence of involvement via neutral or
decreasing large spec changes, which in the majority of cases is correlated with a decrease in
open interest, it means that the move is getting to a potential point of exhaustion and is more
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dubious in nature to find sustained follow through. The cases in which a favorable directional
move can lack an increase in large specs may be due to a removal of liquidity in the market due
to a re-assessment of positionings.

In the chart below, it will be immediately obvious how the correctional move in the AUD/USD
lacked any type of commitment by the large specs community, suggesting that the move was
running the risk of exhausting before sellers regained control in line with the underlying
downtrend.

Source: COTbase.com

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Commercials: Hedgers with Powerful Insights
Like the large specs, this group also tends to carry large positions and due to the hedging nature
of its activity, act as contrarian traders, buying when prices are low and vice versa. Therefore, in
any healthy trend, we should expect commercials sellers to increase on directional moves
higher or commercials buyers to dial up their exposure on a directional move to the downside.

That’s the theory, and it makes perfect sense as these accounts have an inherent interest to
cover their exposure through the constant buy/sell of the futures or options to eliminate the
risks of exchange rate variations. However, a few nuances apply, which makes this category a
very interesting one to follow closely. Firstly, when a directional move in price, let’s say a bullish
one, comes amid an increase in total commercials, that should be considered an anomaly that
will prompt us to ask ourselves the following question. Why would commercials increase their
exposure in a week when prices traded higher? More often than not, the reason lies in a
fundamental shift in their perception of cheap or expensive valuations.

As an example, if EUR/USD trades from 1.13 to 1.16 in the last 5 trading days the data is
collected, and commercials show an overall increase, it’s telling us that they are betting with
conviction for the price not to trade much lower. Otherwise, they may have refrained to gain
that much exposure, waiting for lower prices. By the same token, it also reveals that if price rose
300 pips, and yet commercial longs showed more activity vs shorts, it leads us to think that even
as the EUR/USD recovered ground, commercials shorts were not that compelled to add, which,
in the majority of cases, implies expectations for higher prices in the future, thus less compelled
to add short business.

As shown in the chart below, whenever we see bullish weeks accompanied by an increase in
commercials, the area tends to act as a predictor of either a trend reversal or at least a
stronghold from which commercials will be active defending the area in their perception of
cheap/expensive levels based on their own models of valuation or insider information.

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Source: CoTbase.com

Another powerful combination is to analyze how extreme commercial positions are vs their
historical references, as well as the percentage rate of changes from week to week. You will
notice that when commercials reach certain extremes based on historical data if combined with
a significant variation in the number of new business added, it tends to accurately pinpoint
turning points in the market. So, ideally, what we want to pay attention to is the bundle of
commercials at significant extremes — a lookback of 3y is a good rule of thumb — and sudden
changes in positioning. Some discretion applies as one should put both factors into context with
the current dynamics in the price.

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Below, you can see a chart of the Australian Dollar vs US Dollar. Key turning points in the chart,
more often than not, occur when the commercial positions are at extreme levels or at areas of
significant reference, having previously acted as a turning point. Note, the current positioning in
commercials as of late Aug. 2018, while getting extremes, still doesn’t show any signs of finding
enough commercial pressure to turn around, and as a historical reference, the positions could
still get more extremes (see the horizontal line from 2015).

Source: CoTbase.com

Asset Managers: The Slow Moving Macro Whale

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We’ve now come to the asset managers’ category. Since their performance is based on the
average of the industry, this category plays it much safer, engaging in well-established trends
or/and where they expect the price to be heading in a time horizon of at least 3 to 6 months.
While not the group that has the most relevance in the movement of the currency futures short
term, at times, their involvement represents a significant share of the total outstanding
positions and acts as a key component to monitor.

For example, in the EUR/USD pair, while the rate has been trading lower since April 2018, note
how overwhelmingly bullish asset managers remain? This reveals an overall positive outlook
that cannot be ignored, which would make sense if one is to consider the expectations for a
slowdown in the pace of rate hikes by the Fed in 2019, just as the ECB mulls the options to start
tightening policy next year, which may lead to closing the gap in the current divergence in
monetary policies. The US yield curve, with the risks of inverting in the near future, is another
mid to long-term component that asset managers would analyze to understand the outlook,
and as it stands, the market is far from telegraphing that the US economy is on a sustainable
path. These are all factors that have an impact on asset managers to remain bullish in EUR/USD.

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Source: CoTbase.com

Dealers: The Knowledgeable Hedgers

We’ve probably come to one of the most overlooked categories, but not necessarily one to
brush aside, as it can provide some great hints and can also act as a contrarian indicator. Like
the commercials, dealers also fulfill a function of net hedgers, so it’s not at the core of their
business model to speculate in the future direction of prices, as in the case of non-
commercial/large specs. This category is probably one of the most sophisticated (large banks,
dealers in securities, swaps and other derivatives) and knowledgeable about future market
directions. Since their main activity consists to allocate investment products to institutional
clients, they act as liquidity providers via their need to constantly have matched books.

As an example, let’s say dealer A creates a customized investment product for investor B (large
spec). The function of dealer A in this situation would be to make sure that the product offered
to investor B is hedged against the market, therefore, a dealer long that is increasing during a
bearish phase, it implies that the smart money remains short-side committed, with supply-
based products in demand. When an anomaly occurs, and we spot a dropping market that finds
no increase in the total net exposure of dealers, that is a clue that their need to hedge against
products they allocated is more limited. Hence, sending a signal that the market could be on the
cusp of a turnaround.

Find below a chart of the Euro futures. Notice how there was less involvement by dealer shorts?
That was a communication that the market was turning from bullish to more bearish, as dealers
exhibited less need to hedge via shorts due to the decrease in long EUR investments they
allocated, while a greater need to go long and hedge the increase in demand for short EUR
strategies.

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Source: CoTbase.com

Percentage Levels in Open Interest and Context

One more clue that helps is to monitor the percentage of open interest vs outstanding positions
in a particular category of traders. If any of the categories show an extreme level of open
positions vs open interest, to the tune of 40–50% (one must cross-check with historical data to
pinpoint the right threshold for each market), it suggests that a potential turnaround in prices
may be near, especially if this excess of positions is held by the most relevant players as is the
case of large specs or commercials. This concept has many resemblances to the comparison of
total committed positions vs historical levels in the past, but it goes one step further, by also
factoring in what percentage it represents from the total outstanding positions.

Last but not least, another component not to sidestep is context. It’s absolutely essential that all
the explanations provided above are adjusted to the circumstances of events (dynamics)
present in the market. This means that any major fundamental release, namely central bank

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policy meetings, geopolitical events or economic data, may distort the analysis of the CoT report
as players reassess their exposure in the market.

Source: CoTbase.com

What’s more, the price context is also important and we must always reflect on whether the
market is on a trend or trapped in range conditions. When the latter applies, the insights that
may be obtained from the CoT might not be as actionable as when analyzing trends, given that
the change in positioning tends to be less committal and more short term in nature, with algos

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and intraday traders more dominant. That said, the CoT is nonetheless a great weapon, even
during times of non-bias conditions, to gauge what side is most at risk or alternatively, whether
or not, a potential breakout of the range gets validated by an increase in open interest.

Source: CoTbase.com

Is the CoT That Lagging After All?

We’ve come to the end of this handy guide to interpret future market dynamics based on the
most recent market positioning by the smart money. If by reading this guide you no longer find
the CoT data to represent a lagging concept and if you believe that from now on, it can provide

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some very useful information that is applicable to your forex trading, then my mission would
have been accomplished.

If you have any questions regarding this guide, or you’d like to know more about it, you can
reach me out anytime, I will be more than happy to answer your doubts and elaborate on the
explanations above via seeking alpha.

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