In todays piece, we will dissect the topic of how to trade forex using the Commitment of Traders (COT) Report, allowing traders a sneak peek into what the COT reports are all about and why every trader in the forex market should pay attention to these reports on a weekly basis.

What is the Commitments of Traders (COT) report? The Commitments of Traders (COT) report is released by the Commodities and Futures Trading Commission (CFTC) every Friday, and this report is a breakdown of open interest on each Tuesday for financial markets or instruments in which at least 20 traders hold trade positions that are deemed to be equal to, or above the CFTCs established reporting levels. The Commitment of Traders report is thus a sentiment indicator, because it basically tells a trader what other traders (especially the major market players) are doing in the market. By knowing whether the major players in the market have selling or buying commitments, traders can factor their trades accordingly.

There is an official release schedule which like the economic calendar, contains a schedule of the release dates of the COT reports. This schedule is available on the CFTC website .

The reports are arranged according to short and long formats. The short format reveals open interest by separating the reportable from the non-reportable positions. The long format groups data year on year and also shows the positions held by the biggest four or eight traders in addition to the same information presented in the short format.

INTERPRETING THE COT REPORTS

We are currency traders, and so the COT reports for the currencies traded in the forex market are what we will be interested in. We therefore access the COT reports by clicking on the Market Reports tab on the home page of the CFTC website, and then clicking on the Commitment of Traders tab. Then scroll down on the new page to Current Legacy Reports, and click the Long Format or Short Format link (Futures Only) under the Chicago Mercantile Exchange. This opens up a table that looks like this:

The table displays the COT for several commodities and currencies. You therefore have to scroll down the page to bypass the COT for commodities such as Live Cattle, Lean Hog, Cheese, etc and get down to the listing for currencies.

We would be more interested in the Non-Commercial part of the reportable positions, which are those held by the institutional traders in the market (hedge funds, major banks, etc). We will not be using the commercial figures or the non-reportables.

As a trader, you would have to scroll down to the currency of choice, and take a look at the number of short positions against the number of long positions. The trick is to look for where there is an overwhelming number of positions, and also to look for two currencies where the balance of the tilt in the positions runs in opposite directions. In other words, if you have two currencies paired as A/B, then you would want to see if there is a greater weight in short positions in A and a greater weight in long positions in B, prompting the trader to use this inverse weighting to short the A/B currency pair on the forex platform. Conversely, if there is a greater weight in long positions in A and a greater weight in short positions in B, then the trade would be to go long on A/B.

So in summary,

a) Look at the non-commercial numbers in terms of long and short positions. There must be a clear-cut, overwhelming tilt in positions to one end.

b) Look for two currencies which are paired together in the forex market, and watch to see if the weighting of the positions is in opposite directions, then set the trade accordingly.

How to Determine the Weighting of Positions on the COT Report

Take a look at these figures for the the Japanese Yen.

We can see there are almost 4 short positions from major market traders than there are long positions, which shows that the major market players are more short on the JPY than long. We can see that the net short positioning/weighting on the Japanese Yen is quite large. The negative net positioning on the JPY shows that traders are actively shorting the JPY. When we consider that at the time the COT figures shown above were obtained, traders were actively long on the Nikkei 225 and short on the JPY as a result of the award of the 2020 Summer Olympic Games to Tokyo, it would then be foolhardy for any retail trader to be long on the JPY.

All the trader then needs to do is to look for a currency where trade positions are heavily weighted on the buy side, and then go long on the pairing of this currency with the JPY. We see this here with the Euro where even though there is not much differential in long and short positions, the tilt is clearly towards long positions.

What the trader would then do is to go long on the EURJPY currency pair, and as we can see from this chart, this move has gained 149 pips since the market opened for the week on September 9, 2013 as at the time of compiling this article:

It is important to use only currencies where the differential is significant enough to create a bankable trade. If the differentials are not significant enough, the trades should not be taken.

Now look at these figures:

We can see that not only is the differential between the short and long positions on the Swiss Franc not very significant, but the trade volume is very low as well. So the retail trader should avoid getting into any trade on this currency as the situation is.

ANOTHER WAY TO USE THE COT REPORT

There is another way that the COT reports can be deployed in the forex market, and that is in predicting reversals and the extent of such reversal moves.

In order to do this, the trader has to be able to plot a bar chart showing the positive or negative differential for a currency on a scale of 1 to 100, with each bar representing a three-year period. Usually, if an asset has a negative differential more than -80%, then a bullish reversal is likely. If the asset has a positive differential greater than +80%, then a bearish reversal on that currency is very likely.

This is a complicated way of assessing overbought and oversold market conditions, and for this reason we will simply advise traders to stick to using the COT reports as has been described earlier. Keep it simple.

CONCLUSION

A COT reports is to be used strictly as a sentiment report and should not just be used to open and close positions in a blanket manner. The trader must strive to look for a fundamental basis for the positions shown by the COT report as belonging to the institutional traders. When such is found, with the appropriate differential, it will then be proper to look for technical basis to initiate the corresponding trades in the direction of the differential.

Attention!

The author’s views are entirely his or her own.