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I recently received an email that referred back to an article I wrote in 2009.  It referred to a tool that I use in order to identify probable turning points in the markets.  The student asked if this was still a valid tool and if I still used it today.  The tool is the Commitment of Traders report.

The Commitment of Traders (commonly referred to as the COT) report has been published by the Commodity Futures Trading Commission since 1962 and provides information on the open interest of futures contracts.  The report, which can be found at www.cftc.gov, is published every Friday and contains the data from the previous Tuesday.  A futures contract is a derivative which gets its value from an underlying asset. It is traded to either profit from future values of the asset or to hedge a position in the asset against a drop in price.  The COT shows open interest in a multitude of commodity, currency, and stock index futures.  Open interest differs from volume in that volume is the number of contracts actually traded per day while open interest is the number of contracts entered into, either long or short, that have not been offset by transactions or exercise.  They are new or open contracts which may offer clues as to what the traders are anticipating price to do in the asset.  This information can be used to assist us in our own trading decisions whether we are trading currency, commodities, futures, options, or even stocks.

The COT breaks down open longs and shorts into three categories.  We have the Commercials, the Non-Commercials, and the Non-Reportables (also known as speculators).  The Commercials are people or businesses that deal directly with the underlying asset such as farmers, miners, and international businesses.  With commodity futures, they understand the true supply and demand of the asset and are trying to hedge against future price movement that could hurt operating profits.  They are not usually trying to profit from the futures contract itself.  Stock index futures are used to hedge institutional portfolios and for arbitrage opportunities.   The non-commercials are large speculators and can represent “smart money.”  They are speculating on the future movement of the trend in the underlying asset.  The non-reportable positions are the so called “dumb money.”  There are the small individual traders trying to play the direction of the markets for profit and are often wrong.

The COT provides the open interest for both longs and shorts for all three categories of traders.  Subtract the net shorts from the net longs in each category to see if the commercials, non-commercials, and small traders are net long or net short.    To use the COT data, many trading platforms like Tradestation will allow you to chart the data as an indicator.  Look to see if the traders are going net long or net short?  Are they increasing their longs or their shorts?  To trade with the trend, follow the non-commercials.  Remember, this is the “smart money” that seeks to profit from price movement in the futures contract.  If they are net short and increasing their shorts, look to go short yourself.  If they are net long and increasing their net longs, look to open longs as well.

The most powerful trading signal comes when the commercials and speculators are trending in one direction while the non-commercials, are trending in the opposite.  The divergence of these groups shows the professionals taking money from the public and you should definitely follow the professionals for greater probability of success.

The following chart shows the S&P 500 Futures on a weekly chart with the COT Net Position as an indicator below.  Look at how the divergences and the non-commercials indicated the trend.   They seemed to trade in the correct direction.  A similar picture was painted in early 2009 when the professionals bought ahead of the market bottom while many traders sold off into the decline.

Watch the markets carefully and especially the large traders… they will lead the way.  There is a lot of market noise in the news today.  Worries about sovereign debt, elections, possible inflation, etc., are weighing on everyone’s mind.  Trade in the direction that the markets and your charts tell you, and look for clues from the smart money.

DISCLAIMER This newsletter is written for educational purposes only. By no means do any of its contents recommend, advocate or urge the buying, selling or holding of any financial instrument whatsoever. Trading and Investing involves high levels of risk. The author expresses personal opinions and will not assume any responsibility whatsoever for the actions of the reader. The author may or may not have positions in Financial Instruments discussed in this newsletter. Future results can be dramatically different from the opinions expressed herein. Past performance does not guarantee future results. Reprints allowed for private reading only, for all else, please obtain permission.