Open interest contracts from 1st Jan. 2008 to 11th Feb 2010 - Gold Contracts

The chart above indicates the weekly change in open interest for spot gold over a two year period with the first week of 2008 on the far right of the chart and with last week’s open interest on the far left.  Last week’s open interest  for gold was 466,905 contracts, having fallen from the previous week’s 480,860, the fourth fall in a row from the high of mid January where the short term top was 528,924.  The broader picture for the data clearly indicates the peak which approached 600k contracts in early 2008, down to a low of 261k towards the end of 2008.  Whilst the last four weeks is a relatively short time scale, it does indicate falling open interest coupled with falling prices which could suggest that the gold bulls are either offsetting or squaring off.  This combination is usually taken as a sign of strengthening as once these positions have been squared off then the recent decline in gold prices should come to an end as the longer term bullish trend resumes.   How far this will run in the future is difficult to forecast but the 600k upper limit at least provides us with a guide for future analysis.   Our technical analysis of the spot chart has supported the view that gold is currently in a longer term bullish trend.   One further point to note from the 2 year open interest chart is the first quarter of 2008 where we saw falling open interest against a backdrop of rising gold prices which is normally considered a bearish signal and indicative of a potential reversal in the market which indeed was the case in late March when prices collapsed dramatically.  At the time many market commentators were forecasting a long bull run for gold!!

Spot gold price - Weekly from 1st Jan 2008 to 17th Feb 2010

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So what’s changed? Well I am delighted to say virtually everything, and I hope the following will provide a brief explanation of the changes, what they mean for us as traders, and how we can use the new data sets to provide more detailed and meaningful analysis of all the various markets we trade.

For those of you who have never come across the COT report, or perhaps heard of it but never really investigated it further, it provides and overview of all the futures and options traded by various designated groups, and is issued weekly every Friday afternoon at 15.30 Eastern Time, by the Commodity Futures Trading Commission in the US, which is the regulatory body for all futures and options trading. The data is based on open interest trading volumes up to and including the previous Tuesday of each week, and until recently the report used three crude categories to report, namely large speculators, commercials and small traders. Over  the years these groupings had become increasingly meaningless with many traders discrediting some of these completely, and partly as a result of industry pressure, coupled with Government demands for reporting transparency on speculators activity in the markets ( particularly from hedge funds), the CFTC was finally forced to provide a new and more meaningful report, which came into effect on 4th September 2009 late last year. To use the CFTC’s own words ; “ the new disaggregated data has been produced to increase transparency and promote market integrity,”. For those of you familiar with the old reporting style, these are still available and running in parallel with the new reports which have now been kick started with over three years of historic data.

So, what are the new groupings and how do they differ from the old one’s, and what are the opportunities for us as traders to use this deeper insight into the futures and options world to provide more meaningful analysis and more accurate analysis and trading signals? First let’s start with the new groups which are as follows :

• Producer, Merchant, Processor, User : Examples in this group, for gold for example, would include gold bullion producers, bullion banks, refiners, large bullion users. The CFTC itself explains this group as ” an entity that predominantly engages in the production, processing, packing or handling of a physical commodity and uses the futures markets to manage risks associated with those activities”
• Swap dealers : This is perhaps the most contentious and interesting of the new groups, as it is this one alone that has seen spectacular growth in the last few years, with this group accounting for for over 37% of the futures and delta options on NYMEX, an increase of almost 10% from three years ago. For those of you unfamiliar with the term, a swap dealer is the individual who acts as the counterparty’ between two parties involved in a swap contract, generally in commodities, and uses the futures market to manage or hedge these risks. Swap contracts are generally privately negotiated between two parties and therefore an OTC trade with the swap dealer acting for a fee referred to as the spread. The swap dealers counter parties could be anyone from a speculative trader such as a hedge fund, to a more traditional type of trader such as a commercial client managing risk on a physical commodity. (If you would like to read about a real case, then simply follow the link here to a recent article in the Finanical Times which is interesting reading!) It is the rise of this single group that has made previous analysis of the COT data almost meaningless with the commodities and futures market now dominated by the financial players rather than the traditional producers and consumers, making much of the previous analysis meaningless and unreliable. Most of the growth in swap dealers has come from from an increase in volumes of time spreads, rather than more conventional long or short positions, with spread positions being more closely associated with the growth of commodity indices ETF’s and other forms of investment strategies, far removed from the original concept of hedging risk for producers and suppliers. Finally, it is this group that has been responsible for the breakdown in price structure within the commodity markets, with resultant contangoes in crude oil and related products.
• Money Manager : The money manager grouping primarily contains those traders who are registered commodity trading advisers, registered commodity pool operators, or unregistered funds identified by the CFTC, and as a group are identified as managing futures trading on behalf of other clients. In general this group would include portfolio managers, hedge funds and institutional funds.
• Other Reportables : This is basically the ‘catch all’ category for all other large traders that fail to fit into one of the above.

Outside of the above four major groups there are of course the non-reportable traders – these are the small private investors or traders who are not required to report their positions. So, what are we to make of the new report and more importantly how are we going to use the new groupings to obtain better insights for you in your trading, whether in commodities or in forex?

Like many other commodity and forex traders we are still analysing the new data to some extent, and looking at all the possible opportunities that this may present for us as traders. However, those of you who follow my trading regularly will know that I like to keep things as simple as possible, as the more complex an analysis becomes then generally the less insight it provides. As a result I have decided to start my weekly analysis of the new COT data with a comparison of Open Interest volumes against price, which provides a valuable insight into possible turning points and changes in market sentiment. Over the next few months I will be expanding this analysis to look at the new disaggregated groups in more detail, and if you would like to be updated with the analysis direct to your inbox, then simply fill in your details below, and you will receive my weekly analysis regularly, which I hope will prove to be a useful addition to your trading toolkit.

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With Japan’s fiscal year end now passed, we can begin to focus with more confidence on the COT index for the Japanese yen.   However, as always we need to bear in mind that the COT index must be viewed as a sentiment indicator and not a timing indicator and cannot always be correlated with the spot market.   All the index is telling us at present is that the commercials are continuing to build long futures positions in the Japanese Yen and that this will translate into Yen strength at some point in the spot forex market.

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Everything I say may appear slightly contrarian when viewed using the COT index as an indicator but the British Pound is a good example at present which I hope will make the point with a little explanation.  At present the Commercial futures holders are net long and have been for some time even whilst the pound has been falling heavily in the spot market which may seem odd at first glance.  However, if we stop and think for a moment about the nature of the commercial holders, these are institutions with very deep pockets who are taking long term view of the market and are therefore building their positions by buying at what they consider to be a low price with a view to selling the contracts in the 12 to 18 months once the pound has recovered.

All of the above merely highlights the timeframes one is dealing with when viewing the COT index; it is not a timing indicator as such but much more a sentiment and direction indicator for the longer term.  The extremes of the chart, whether zero or 100 are the points at which the sentiment shifts in the commercial holders and at which point we may expect to see a change in price direction in the spot market in the following period.

The Australian Dollar Cot data is very interesting this week as there appears to have been a major transfer of future contracts by the commercial holders who are now net short.  This is not unprecedented and happened at the end of last year.  This does not necessarily signal a long term change in sentiment, merely a response to current market conditions and does not alter my bullish long term of the Aussie Dollar, confirmed to some extent by the weekly chart which is now showing a double bottom. However, in the short term we may see prices continue to fall this week following the shooting star of last week.

You can keep up to date with fundamental news on the economic calendar by simply following the relevant links.

For completeness I have included the COT Index for the New Zealand although one has to exercise caution when viewing this data.  The prime reason is that  liquidity in the New Zealand Dollar is relatively low given that its primary attraction for currency traders was in the carry trade and in particular against the Japanese Yen.  A quick look at the New Zealand Yen pair shows a clear correlation between a major turn in the index and the start of the “great unwind” of the carry trade.   This is not shown on the current chart as it occurred outside the 52 week period under consideration and since then an extreme of 95 to 100 has not been achieved hence the peak of the chart is currently only displaying as 60 at the moment. Recent price moves in the New Zealand Yen pair would suggest that we may be seeing a resurgence in the New Zealand in the next few months especially as it did not take out the low of 42.47 last posted in late 2000.

All the fundamental news is now available in the economic calendar.

For those of you new to the COT report, it can be a confusing report, both to read, but also to interpret, and in order to try to help you with some of the terms, you will find an explanation of the basic terms and ways to use the data in the navigation bar at the top of the page. As with any set of data, the figures can be ‘sliced and diced’ in many different ways, and there is always a lively debate in the trading forums and among  professional traders, of the benefits or otherwise of the COT data.  Some traders will point to it as a meaningful long term indicator, others will suggest that since the data is delayed, it has very little value. Whoever you believe, or whatever system you develop of your own, there is one fact that cannot be denied. The numbers supplied are accurate, and do provide an insight into the real futures market.

As a commodities and currency trader, I use the COT report in several different ways, and the first point I have to stress is simply this – that in my opinion the COT data does provide a meaningful view of the commodities market, so long as you follow the commercial trading group, but  that for other markets such as currency, then the commercial data has less weight. This is simply my own personal view and you may agree or disagree, but my reasons for having this view are quite straightforward:    Ask yourself this simple question  – ‘in trading in a commodity, who is likely to know more about the market, the balance of supply and demand, the future demand, and any issues which may affect prices in the future ? – the commercial producers, or the non-commercial speculators. In my view I believe that if you are trading in commodities, then the commercial group, will provide a better guide than the speculators, for the simple reason that logically they will have a much better idea of the market and all the pressures affecting prices, from a suppliers perspective, than could a speculator.  The  speculator is there simply to follow the trend, the commercial producer or grower has a physical product to sell, and as an expert in their market, will (in my view ) always be better informed, and therefore have a better view of how prices are likely to move in the future.  So in summary, in my commodities trading, I follow the commercial group, and on a weekly basis I will be providing an update on the various commodities,  starting with gold, silver and oil.

The weekly numbers I use are converted into a COT Index chart which then provides a ratio between 0 and 100, based on the net positions against the net difference of the maximum and minimum for the period. I use a 52 week period, and when the ratio reaches 90 or above, then the commercial group are heavily short compared to the last twelve months, and therefore this indicates that as a group that is essentially selling a product, then they are selling at what they believe are the best prices, and therefore we can intepret this as a likley signal that prices will fall.   Conversley, when the ratio falls to below 10, then the commercial group are not heavily short, and therefore are waiting for higher prices to follow, and will start selling into the rise – in this case we can therefore expect a rise in prices.  So in summary when the indicator is at a high of 90+, then we can expect a price fall in the cash market, and when the indicator is at a low of 5 and below, then we can expect a turn and prices to move higher. The most important point to note is that as a group, the commercials are the only ones physically selling a product, and therefore when they sell, they are looking for the best prices possible. So when they are selling heavily, it is not unreasonable to assume that this is the point at which they feel that prices will not rise further.