One of the ways that many traders use the COT report is as an extreme indicator, so let’s look at an example, but please remember that if you are using the report for currency then each pair has different characteristics, so whilst these indicators may work well with one pair, they may be less successful with another – so please make sure you have plenty of data and back test your results before betting your entire account!
Here is our original chart of the net positions of non commercial contracts, where we view the data from a different direction. Here we are looking for the extremes in terms of volume, and it is based on the premise that at these points all the traders who want to trade long are already in the market, which has reached saturation. With so many speculators weighing in one direction, there is no one left to buy or sell, and the market reverses. Now in the case of the CAD/USD chart, we can see that this point was reached at around 80,000 net long, which was in fact around the 16th October 2007. Approximately two weeks later, the USD/CAD in the spot market reversed it’s long decline and started to turn – a reversal which is still in place. Now this brings me on to some very important points when using these indicators which are as follows :
It takes large non-commercial speculators many weeks, if not months to close these large futures positions. If they were to close all the contracts simultaneously, then the markets would collapse under the weight of selling, or soar on the buying. Trading in such large volumes has to be done slowly over weeks, if not months, so as not to put the price up against yourself if you are buying, or push prices down if you are selling. So when we see a signal using these indicators, it is not a timing signal, merely an indication that a change may be starting to occur – in other words these are long term indicators for long term trading – not short term. Some of these indicators work well on some pairs and less well on others – so please check them for yourself and back test each one.
Finally, there is one other way to use the COT report and that is as a contrarian indicator, in much the same way as the VIX. If you believe, like many people do, that the small trader or investor is generally on the wrong side of the market most of the time, then if you take the non reportable positions, and do the exact opposite, this could work as well – it’s not something I do myself, but many traders use the information in this way – take the net position of the small traders, and trade in the opposite direction – try it and see, it might just work for you!