Watching the Smart Money
Futures’ trading has been around for hundreds of years. Even before Futures Exchanges existed trading was done by either a handshake or a forward contract. Producers and Processors of Commodities both have always needed a way to protect against price risk. The Producer, who owned the Commodity was concerned prices might drop before they delivered their product. Processors always worry that price might rise before they purchase the Commodity to process and later sell. Price risk is always a concern to these entities in the Futures markets.
These entities are comprised of Commercial traders who use a physical Commodity in their day to day business. Commercial traders do approximately 60% of the daily volume in the Futures markets. This makes Commercial traders the largest participant in the Futures markets, next is the Large Speculator and then the Small Speculator.
Commercials know everything there is to know about the Commodity they produce or process. They specialize in that particular market making them the expert on the Fundamentals. If anybody knows the Seasonal patterns of a Commodity it would be the Commercials who deal with this Commodity every day. They’re very well capitalized companies, both in cash and credit lines at major banks. The Exchanges put no restrictions on the number of contracts they can trade. Just these 3 components make the Commercial trader the smart money in the Futures markets and speculators usually lose when they bet against them.
The other significant player in the Futures markets is the large speculator. These are usually companies or individuals that manage funds for other investors. Some examples might be: Commodity Trading Advisor (CTA), Commodity Pool Operator (CPO), Hedge Funds, and Pension Funds and in some cases large individual traders. Like all speculators they are in the business to speculate and make money by correctly determining the markets next direction. With so much money to invest they are generally going to be using trend following methods to make their buy and sell decisions. Like all speculators they are only given so much money to invest for others and it is possible they run out of buying power before a trend actually ends. Also, the Futures Exchanges have restrictions on the number of contracts they can actually trade at any one time. Most large speculators know little about the fundamentals of the markets they trade because they are so diversified in other markets. These 3 components are actually a handicap when they enter the market and begin betting against Commercial traders.
But how do we as small speculators track the positions of these large participants?
A report that is released weekly at 15:30 Eastern Time by the Commodity Futures Trading Commission (CFTC) called the Commitment of Traders (COT) report is the answer. If you are using Trade Station you can see the results on your daily charts. Contact Trade Station and ask them how to insert the indicator called “COT Net Position”.
The COT report tracks the Open Interest, number of contracts yet to be offset and breaks the Open Interest down into Commercial and Speculator positions. Each week we can see how many long and short positions are held by each group of traders. We then subtract the long positions from the short positions and we get a net position for each group. The net long or short is what we will follow in the COT report each week.
By using our charting packages and other websites we can see when the speculators are betting against the commercial traders at extremes. Chart 1 will show us many important pieces of information about the COT report.
First let’s understand that the COT report is a tool to help identify when a trend may be ending and in some cases when another is about to start. The COT is not a timing tool and should not be used as such. Look to use the COT when prices have been trending for an extended period of time and price is coming into a supply/demand zone on a daily, weekly or monthly chart. Think of the COT report as an odds enhancer.