The COT Report

The COT Report is a weekly publication (published Friday) where the CFTC (Commodity Futures Trading Commission, www.cftc.gov) reports positions in futures held by the following categories of investors:

1. Commercial Traders (CT)

These traders use futures as a tool to hedge the risk of the underlying commodity and which exceed a certain amount of positions established by the CFTC itself. These are normally involved in the production or processing of the underlying commodity.

2. Non Commercial Traders (NCT)

They are those traders who do not use futures as a means of hedging but rather as a speculative instrument and, at the same time, exceed the amount of positions envisaged by the CFTC. They are normally big traders such as funds and investment houses.

3. Small Traders (ST)

They are those whose positions are not exceeding the expected levels and, consequently, are classified as small investors.

Example of COT report concerning the future on the Japanese yen as proposed by the CFTC:

The sum of the net positions of the three players in the market gives, by definition, a null value, thus confirming that the game in the market is totally a "zero-sum" game!.

If we accept the hypothesis that the Commercial Traders, are directly involved, possess better information than anyone else participating in the market, it is essential to monitor their behavior in order to understand how they evaluate the situation of the underlying commodity being monitored.

Commercial Traders generally have a "contrarian" market approach, ie they tend to increase (decrease) their bullish positions (bearish) as the market falls and, conversely, to decrease (increase) their bullish positions (bearish) with a gradually positive trend in the market.

Below is a typical "contrarian" approach by Commercial Traders on the soybean market:

The natural counterparts of the Commercial Traders are, due to their considerable financial endowments, the Non Commercial Traders which follow a classic "trend following" approach. In fact, the latter tend to increase their positions in the same direction as the trend they aim to ride.

Trend following approach of Non Commercial Traders on the same soy market:

The difference between the total positions held by the market and the sum of the positions held by the Commercial Traders and the Non Commercial Traders returns, by definition, the amount of positions held by the Small Traders.

Generally the attitude of these tends to resemble that of the Non Commercial Traders. Since the Small Traders normally represent a minority share of the market, the monitoring of their behavior will be secondary and may be neglected (with the exception of some extremely "pulled" market phases).

Below is a chart showing the haphazard attitude of Small Traders on soy:

How to interpret and use the COT Report

As with the classic oscillators commonly used in technical analysis, even in the analysis of the Cot the trader will have to look for those situations in which the position of Commercial Traders, Non Commercial Traders or both parties (which is very frequent) is found in critical phase, indicating a situation of overbought or oversold on the commodity in question. This situation could in fact signal the potential inversion, or in any case pause, of the trend in progress.

Below is an example of an oversold market in relation to an American Treasury Bond:

In the above figure we have highlighted a market situation in the phase of strong oversold market. As you can see, in fact, in mid-2004 the Commercial Traders (blue line) were in a strongly bullish position compared to previous periods. At the same time the Non Commercial Traders (red line) were definitely exposed on the short side of the market compared to the previous one.

In this situation it would undoubtedly have been necessary to seriously consider the possibility of closing any short positions held on the US debt stock and then perhaps starting to face the same market on its long side.
Continuing with the previous comparison between the commitments of Traders and technical oscillators, any divergences from the usual Cot trend will also be the object of our attention, signaling, often well in advance, potential future inversions of the current trend.

An example of this type can be found by analyzing the oil futures:

Here we find a divergent attitude towards the uptrend market. The Commercial Traders, which instead of increasing their short positions decreases them, and the Non Commercial Traders which instead of increasing their bullish exposure reduces it.

Conclusions

The Cot is a formidable tool for outlining the behavior and expectations of each of the market players from a mid-term perspective.

Although important, this indicator should never be used as the sole method of approach to trading and investing. In fact, it will be accompanied by the usual technical or fundamental methods that are usually used for portfolio choices.