Because the COT report is published weekly, it would be more suitable for longer term traders to use as a market sentiment indicator. So, how do we do that? Well, besides using the changes in open interest and changes in the number of long and short contracts as a volume indicator, my favorite way to use the COT report is to find extreme net long and net short positions. This can be great indicator that a market reversal is around the corner because if everyone is long a currency, who is left to buy? No one. And if everyone is short a currency, who is left to sell? Again, no one. The only thing a market can do is go the other direction. Here’s a chart example:
This is an example chart of the US Dollar Index from freecotcharts.com. In the top half of the chart we have the price action of the USD index futures with each bar representing weekly data. On the bottom half of the chart we have data on the net long/short positions broken down into three categories: Commercial (Blue), Large Non-commercial (Green), and Small Non-commercial (Red). We will pay attention to the Large Non-commercial positions since commercial positions are for hedging and small retail traders aren’t really a factor.
Let’s examine this chart and see what it can tell us. We can see that the US Dollar began a nice little bull run at the start of 2005. As the value of the net long positions of large speculative traders (green line) rose, so did the price of the USD futures index. In the first week of July 2005, net long positions grew to over 20K contracts. This was an extreme area of longs and soon after the market began to sell off USD index futures. The USD index price dropped from 91 to 86, but it only proved to be a retracement as the index rallied to a new high of about 93.16 and higher level of 29K net long contracts.
As you have probably already asked yourself, “with this many longs who is left to buy?” Not too many traders really. With the market appearing overbought in November 2005, we began to see the number of long USD index futures contracts decline and a drop in the index price from 93 all the way down to about 84. Wow, can you imagine if you positioned yourself before this move?
By now I bet you’re asking, “I trade the spot forex market not futures. How does this apply to my trading?” Great question! Since we’re already taking a look at the US Dollar, let’s look at one of the best vehicles to trade the Greenback in the spot forex market: EUR/USD.
Here’s a weekly chart of EUR/USD:
If we had applied what we learned in the previous section by positioning ourselves for market reversals, we could have caught two significant moves from July 2005 to May 2006 in EUR/USD.
First, in July 2005, if a trader saw the extreme levels of net longs in the USD index futures, this trader would catch the possible upcoming selloff of the Greenback by buying EUR/USD. This trader would’ve been proven right, and paid off handsomely as this position could have caught a maximum of 700 pips. Again, if this trader were so astute to catch the extreme level of long USD index futures contracts in November 2005, buying EUR/USD would have been the best bet as the pair rallied from about 1.1650 to almost 1.3000….wowzers!!! That’s over 1300 pips gained! So, from July 2005 to May 2006, a trader could have caught almost 2000 pips just using the COT report as a market reversal indicator. Pretty good, eh??