Commitment of Traders (COT) Explained: Insights into Market Positioning
Overview of the COT Report
Every Friday, the Commodity Futures Trading Commission (CFTC) releases its Commitment of Traders (COT) report, which provides open interest data for the futures and options markets. Although the data is slightly outdated (as of Tuesday), investors closely analyze this report because of its comprehensive and reliable information.
The data is compiled from submissions by clearinghouses, futures commission merchants (FCMs), foreign brokers, and exchanges. The section covering foreign exchange futures is based on contracts from the Chicago Mercantile Exchange (CME), one of the world’s largest derivatives exchanges, making the COT report data representative.
What are Futures?
Futures are financial contracts where buyers and sellers agree today to transact at predetermined terms in the future. For instance, an airline planning its fuel needs in three months may want to hedge against potential price increases for this vital resource. On the other hand, a fuel producer may fear a price drop, which could reduce future revenues. Both parties can enter into a futures contract, locking in the price now, with the producer delivering the fuel in three months and the airline paying the agreed-upon price.
If, at the time of contract expiration, the spot price for fuel is higher than the agreed-upon price, the airline could, theoretically, sell the fuel and make a profit. Conversely, the producer receives less since he sells at a price below the market. Thus, buyers profit when prices rise above the fixed futures contract price, while sellers benefit if prices drop below it.
When trading commodities like fuel, the physical product is delivered. However, settlement is made via cash payments in many financial futures, like those for the euro.
Futures are regulated, exchange-traded securities with defined parameters like contract size and settlement methods. In practice, the parties involved don’t contract directly with each other. Instead, they trade on exchanges where numerous other participants provide liquidity. The COT report summarizes this trading activity.
COT Report (Short Version)
This summary is based on EUR futures data as of October 8, 2019, as reported in the release on October 11, 2019.
Table 1: COT Report EUR Futures. Source: CFTC
Open interest (OI) reflects all existing long and short positions not settled (offset) by delivery, payment, or other method at the reporting time.
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 OI will increase by one contract. Conversely, if an existing contract is settled, the OI 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 derivative instrument, they are equated to futures contracts based on their delta coefficients. Henceforth, we will refer to futures only, but the interpretation approach applies to both reports.
Reporting Groups in the COT Report
The Commitment of Traders report categorizes data into three main groups based on the trader’s profile: commercial, non-commercial, and nonreportable.
Commercial Traders
Commercial traders primarily produce physical commodities like agricultural products. Their primary motivation for trading futures is to hedge against price fluctuations and reduce market risk.
For example, a grain producer may prefer to lock in the selling price of their crop months in advance, especially if that price seems favorable. As prices rise, the producer becomes more inclined to hedge by selling futures contracts.
Commercial traders typically act contrary to market trends: They sell futures contracts when prices rise and buy when prices fall. This behavior stems from their need to hedge rather than speculate.
This pattern is less pronounced but still observable in currency futures. For instance, a European company expecting a monthly payment in dollars might hedge against potential dollar depreciation by locking the EUR/USD exchange rate via futures.
Non-Commercial Traders
Non-commercial traders include hedge funds, investment banks, and large financial institutions. These traders are mostly investing for a profit. As such, they are quicker to react to market changes and typically trade in line with trends.
Fundamental analysts often examine the behavior of non-commercial traders as significant trading volumes support their activity. Unlike commercial traders, non-commercial traders tend to buy during uptrends and sell during downtrends, effectively moving with the market.
Nonreportable Positions
Nonreportable positions generally represent the activities of smaller players, who are often more susceptible to short-term market fluctuations and tend to be less consistent in their performance. Their trades are typically not heavily scrutinized by the investment community.
Commercial and non-commercial traders often take opposite market sides. Commercial traders tend to sell when the market is rising and buy when it is falling. In contrast, non-commercial traders usually do the reverse, buying into uptrends and selling into downtrends.
How to Read the COT Report
The table above, dated October 11, 2019, shows a short version of the COT report. Total OI amounted to 514,638 contracts. Among the group of large speculators (non-commercial traders), sellers had the upper hand, with 238,190 short contracts versus 162,777 long contracts. This translates to a net short exposure of 75,413 contracts (162,777 – 238,190), highlighting the bearish sentiment of this reporting group.
However, the data becomes more insightful when viewed as a trend. Long positions of non-commercial traders decreased by 9,481 contracts compared to the previous week, while short positions remained nearly unchanged. This shift further tilts the balance towards a net increase in short positions, indicating the growing bearish stance among large speculators for a week.
Chart 1: EURUSD Prices compared to Futures open interest. Source: Myfxbook.com
The chart above overlays the EUR/USD spot price with COT report data for the same currency pair over five years. The blue histogram illustrates changes in open interest throughout this timeframe.
In the sub-window of the chart, net exposure for the three groups of market participants is displayed: Commercials (54,591 contracts), Large Speculators (-75,413 contracts), and Small Speculators (20,822 contracts).
The zero horizontal line represents a neutral level. The total number of net long contracts above it equals the total number of net short contracts below it (since each contract involves a buyer and a seller).
At first glance, it is evident that the movements of Commercials and Large Speculators are nearly opposite, which aligns with expectations. Generally, changes in EUR/USD have been accompanied by corresponding shifts in non-commercial positions for much of the time.
FX Analysis Based on the COT Report
Charts like the one shown above can be analyzed in various ways to gain insights from the COT report.
Extreme values
One method is to examine extreme values within the report. Extreme values occur when a significant imbalance exists between long and short contracts within a trading group. For example, an extreme situation might arise among non-commercial traders (large speculators) when short positions greatly exceed long positions (-226,560 contracts on the chart). The dominance of sellers cannot continue indefinitely. Although the exact timing of a shift in their sentiment is difficult to predict, entering such extreme historical levels signals a potential change.
Neutral line cross
Another approach is to monitor when large speculators cross the zero-neutral line (marked by the red horizontal line). The red dots on the chart indicate the moments when long positions surpass short positions, or vice versa. When sentiment has been shifting towards these zero levels for weeks, the trend often continues in the same direction. This environment is particularly favorable for trend-following strategies. Traders looking for early signals might spot the impending change even before the cross of the zero line.
Trading Framework
A third approach involves the COT report as a framework for shorter-term trades. Traders are more confident when the view of large speculators coincides with their investment intentions. Although discrepancies between the behavior of the non-commercial group and asset prices may occur, the correlation between the two is positive over time.
Conclusion
The COT report provides statistics on futures, showing how different trading groups behave and how their actions correlate with changes in asset prices. However, since the report is based on relatively old data, its utility for short-term traders is somewhat limited.
Analyzing the behavior of individual trading groups is more meaningful when viewed as part of longer-term trends rather than weekly fluctuations. Consequently, the COT report is particularly valuable for investment strategies with an extended time horizon.
Shorter-term traders can also benefit by aligning their trades with the broader futures market trends. They should focus on the activity of large speculators, who typically respond quickly to market changes and implement trend-following strategies.
Forex analysts typically focus on highly liquid currencies because less-liquid pairs, such as exotic currencies, don’t trade actively in futures markets, resulting in low data quality.
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