Every Friday, the CFTC (Commodity Futures Trading Commission) publishes its COT (Commitment of Traders) report, reflecting open interest data in the futures and options market as of Tuesday of the same week. Although the data is released with a delay, this report is viewed with great attention by the investment community. This is primarily due to the reliability and scope of the information.

The reporting companies are clearing houses, futures commission merchants (FCMs), foreign brokers and exchanges. The section on foreign exchange futures trading is based on contract data at the CME (Chicago Mercantile Exchange), one of the largest derivatives exchanges in the world. For this reason, the information in the COT report can be considered representative and comprehensive.

What are futures?

They are a financial instrument in which a buyer and seller agree to transact in the future at parameters fixed today. An airline will need a supply of fuel in 3 months’ time and wishes to hedge against a possible rise in the price of this key raw material for its business. A fuel producer, on the other hand, has the opposite interest – it fears a fall in prices and lower revenues from its future production. Both parties enter into a futures transaction and after 3 months the producer delivers and the airline pays for the commodity at the price already set.

It is apparent that if the spot price has risen in the meantime, the airline has made a profitable transaction – in theory, it could sell this fuel at market price and make a profit. The opposite happens with the producer – if it had not tied itself to the futures contract, it could have disposed of its commodity at a higher price. Therefore, the futures buyer profits when prices rise above the pre-fixed price of the futures contract. But the seller wins if they fall below it.

The specific example assumes physical delivery, but for example futures contracts on EUR will be settled by cash payment. Futures are a regulated, exchange-traded instruments with clearly defined parameters (volume of a contract, method of settlement of obligations). In this sense, the two parties in the above example will not be contracting directly with each other but will buy/sell the volume of futures they need on the exchange – where liquidity is provided by a myriad of other market participants. It is this data that the COT report summarizes.

COT Report (short version)

Here is what its abridged version looks like as of October 11, 2019, based on EUR futures data as of October 8, 2019.

Chart 1: COT Report EUR Futures. Chart: CFTC

Chart 1: COT Report EUR Futures. Chart: CFTC

Open interest reflects all existing long and short positions that are not settled (offset) by delivery, payment or other method at the time of reporting.

Each futures contract has a buyer and a seller counterparty. Thus, the aggregate number of long and short positions is identical. When a new transaction is concluded between a particular buyer and seller, the open interest will increase by one contract. Conversely, if an existing contract is settled, the open interest will be reduced by one contract.

The COT report offers a section for futures only and one for futures and options. Since options are a different financial instrument in nature, they are equated to futures contracts based on their delta coefficients. Henceforth, we will refer to futures only, but the logic of interpretation applies to both reports.

Reporting Groups

The data on open interest is categorized into three groups according to the profile of the reporters – commercial, non-commercial and nonreportable.

The commercial group is involved in the real output of a commodity, agriculture products, etc. Therefore, the primary purpose of commercial futures contracts is to hedge price risk.

For example, a grain producer might prefer to fix the selling price of his crop months before it is harvested. Particularly if he believes that this price is high. The more the price rises, the more his motivation to lock in his production at those prices by selling futures will increase.

When the trend is downward other types of commercial traders, such as resellers, will become more active. The lower the price, the greater their interest in buying futures (getting the commodity at that price in the future). Especially when they believe that the price has fallen below its fair value and a rise is imminent.

For this reason, commercial traders sell futures when the trend is upward and buy futures when prices fall. Their trades are in the opposite direction of the trend.

This pattern is weaker but also valid in foreign exchange futures trading. There, commercial traders buy and sell futures driven by different motives. If a company in Europe (EUR) expects payment in dollars in a month’s time, it will be worried about a possible depreciation of the dollar. To this end, it will hedge this risk with a one-month futures contract, fixing the future EUR/USD exchange rate today.

Another company, however, will trade foreign exchange futures with totally different motives. On an aggregate level, the signals from commercial traders in currencies will not be as clear as those in agri-crops or commodities but will follow the same logic of trading against the trend.

The second group of trades, carried out by non-commercial traders, reveals the speculative sentiment in futures markets. It involves large investors such as hedge funds, investment banks and other financial institutions. They trade for profit.

Compared to commercial traders, they react faster to market changes and their main objective is to identify the trend and get the most out of it. It is the behaviour of the non-commercial group that arouses the greatest interest among currency traders.

Speculators adapt quickly to market changes and execute trades in the direction of the trend – market behaviour that corresponds to traditional trend-following trading strategies for the forex market.

In practice, commercial and non-commercial traders execute trades in the opposite direction of each other much of the time. The former sell in an uptrend while the latter buy during this period. And vice versa.

The third group covers contracts that do not fall into the first two categories. The unreported positions represent mostly transactions of small investors and traders. As a rule, they are vulnerable to short-term market fluctuations. For this reason, they are often losers. The behaviour of this category carries limited content of an analytical nature.

The above table dated October 11, 2019, represents the concise version of the COT report. Open interest amounts to 514,638 contracts. It can be seen that within the group of large speculators (non-commercials) dominated the sellers (238,190 contracts short versus 162,777 contracts long). This represents a net short exposure of 75,413 contracts (=162,777-238,190). Such a ratio reflects bear dominance.

However, looking at this data makes more sense as trends. Thus, the report provides a clearer answer to the question of how attitudes have changed for a given trading group. It can be seen that long positions were reduced by 9,481 contracts compared to the previous week, while short positions barely changed. This is a net change in favour of short positions.

Chart 2: EURUSD Price Change Compared to Futures Open Interest. Chart: Myfxbook

Chart 2: EURUSD Price Change Compared to Futures Open Interest. Chart: Myfxbook.com

The above chart overlays the EUR/USD spot price charts and the COT report data for the same currency pair. The information covers a 5-year period. The blue histogram shows the change in open interest over the period.

At the sub-window of the chart, we can see the net exposure for the three groups of market participants (Commercials: 54,591, Large Speculators: – 75,413, Small Speculators: 20,822). The zero horizontal represents a kind of neutral level regarding COT data. The total number of net long contracts above it is equal to the total number of net short contracts below it (each contract has buyer and seller).

At first glance, it is striking that the groups of commercials and large speculators move almost opposite – completely as expected. For much of the time, changes in EUR/USD have been accompanied by similar movements in the non-commercials – also according to preliminary expectations.

FX Analysis Based on COT Report

Charts such as the one above can be interpreted in several basic ways.

It is worth considering the extreme values for the period. They are formed when there is a significant difference in favour of long or short contracts in a given trading group.

Looking at the non-commercials (large speculators), in the first extreme case, we can see how short positions have increased relative to long positions, reaching a value of -226,560 contracts at their lowest point. In this time period, logically, the EUR/USD quotes have also declined. Banks, hedge funds, and other speculative players have made profits on their short positions. At the same time, the group of commercials has reached mirror extremes. It has bought during the downturn and suffered losses.

No one can determine how far the existing trend may continue. When the chart is viewed from today’s perspective, the extreme values are visible, but in real time it is difficult to predict where the dominance of buyers or sellers will end. After all, large speculators are gradually exhausting their power to push prices even more to the downside.

In the first extreme case, EUR/USD formed a bottom and realized a correction of 10 figures in the next two months. In the second case, long positions (within large speculators) dominated short positions and at their peak were 151,476 contracts longer. This was followed by a complete trend reversal and a powerful downward trend in EUR/USD.

During these turning points, the patience of commercial investors who had been increasing their exposure (in the first example buying futures, in the second – selling) while prices moved against them paid off.

Trading against the trend is extremely risky. This is mostly due to the fact that most trades cover a short time interval – sometimes intraday. It is difficult to determine the exact day or week that marks the beginning of a correction or reversal in a monthly or yearly trend. Still, when extreme values are present in particular categories of futures traders, caution should be heightened. Because the subsequent counter-movement holds serious potential. Future COT reports should confirm that the change is gaining traction.

The second method of applying the information from the COT report to forex trading is related to overcoming the zero neutral line (the red horizontal COT line) by the large speculators.

The red dots on the chart mark these moments. At this point, long futures positions take precedence over short ones or vice versa for the particular trading group. In both cases on the chart, sentiment has been shifting for weeks in the direction of the zero level, after which the trend has persisted. Quotes have followed the direction of speculators. This is a particularly favorable environment for trend-following strategies. Market participants looking for earlier signals may have identified the incipient change even before the neutral line was broken.

In fact, it can be said that this is the third approach to analyze the COT report. It is evident from the chart that the correlation between non-commercials and EUR/USD trades is high.

If a trader has opened or plans to open a long or short position, he will feel more confident when the data on futures trades is in line with his investment intentions. Of course, periods of asynchrony between speculators’ behaviour and the prices of the relevant asset exist for a variety of reasons. But they will sync again in a matter of time.

This positive correlation is particularly beneficial to longer-term investors who develop their positions over weeks and months.

Conclusion:

The COT report offers comprehensive official statistics on currency futures. There is a pattern between the behaviour of individual trading groups and changes in forex prices. The information in the report reflects relatively old data, which somewhat limits its application for short-term traders.

It makes more sense to analyze the behaviour of individual trader groups as a longer-term trend rather than as a weekly data. For this reason, the COT report has more value for longer-term investment strategies. However, shorter-term traders will also perform better when they execute trades in unison with the futures market. The focus of their attention should fall mostly on the behaviour of large speculators, who as a rule react quickly to market changes and stick to trend-following strategies.

Futures data should be interpreted mostly for currencies for which there is an active trading in the derivatives market. 

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