We mentioned that the COT report sometimes gives trades too much information. Our example was of the number of traders that have to report, and we asked why anyone would care how many traders had to report? The market moves based on buying and selling, not based on how many people are in the market.
And so, now we want to focus on how we can determine when a market is overbought and when it is oversold. Of the most importance, we want to focus on the percentage of long and short interest compared to total interest.
Numbers that matter
Forex traders often fall into the trap of looking at the raw numbers of the COT. “If long interest changes from 50,000 contracts to 70,000 contracts, then clearly the market is becoming overbought,” an inexperienced trader might say.
This sounds right—the numbers are increasing and the market may be moving up, but what if long interest and short interest both increase? We can’t really say that the market is overly bullish then, can we?
You need to be able to determine the proportion of long and short interest. You need to be able to find the percentage of long and short positions. Knowing what percentage of open interest is short or long is the only way to see how sentiment is playing into the market.
We’ll use an example from the February 7, 2012 COT report for the EURUSD.
Please click this image and open it in a new tab to view:
This report is broken up into several different pieces.
We see that there are several different types of traders, including Dealer Intermediaries, Asset Managers/Institutional traders, Leveraged Funds, Other Reportables, and Nonreportable positions.
How to Find Trades with the COT Report
We cut out a small section of this report so that it can be viewed all on one page. We also highlighted important parts of the report in different colors to make it easier to read.
- The circles point to the types of traders in the market.
- The red line highlights the long, short, and spreading interest. (Spread traders are when a trader is both long and short as a hedge.)
- The blue line highlights the contract for which this data represents. In this case, we are reading the COT report for the EURUSD pair.
- The green line highlights the amount of positions opened by each category of trader as of the time of the last report.
Watch the Changes!
The most important part of the COT report is how the data changes over time. Look to the Dealer Intermediary portion of the COT report and follow through to the Changes from January 31, 2012 line. Notice how greatly the Dealer Intermediaries (brokers and selling agents) have reduced their long positions in the Eurodollar contract.
In just one week, Dealers cut back their long EURUSD trades by 9,178 contracts. Meanwhile, Dealers did not cut back on their short positions by nearly that much. In fact, dealers only reduced their short positions by -106 positions, not nearly as much as the -9,178 contract change in long EURUSD positions.
If dealers are cutting back nearly 90 times as many long positions as they are short positions, clearly they don’t expect the EURUSD to fall much more.
You can also look to Asset Managers and Institutional investors to see how they’re playing the market. Asset Managers increased their long positions and cut back on their short positions. Meanwhile, the next category on the list, leveraged funds, cut back their long positions by more than 15,000 contracts. Leverage funds also cut back on their short positions by more than 10,000 contracts.
The real goal is to see how much net change in positions occurred from week to week. The report says that the total change was -16,671 contracts, meaning there are -16,671 less contracts on the market this week than last. Now, what we need to know is by what degree did traders cut back on short positions vs. long positions.
If traders reduced their stakes by -16,000+ contracts, what if 15,000 of those were short positions? Well, then we would know that the market is cutting back on its short exposure hoping for a rally in the EURUSD. And what if 15,000 of those were long positions? Then we know the market is cutting back on long exposure, thinking the market will drop in the future.
