The commitment of traders report is excellent for finding long-term directional changes in market sentiment. We know that buying and selling patterns matter since prices on any market are a function of supply and demand—who is buying, and who is selling, and how much!
As a forex trader, you can use the COT report to find tops and bottoms. Generally, traders use the COT to find prices at which the market is overbought and oversold.
Lesson in Sentiment
Let’s think about how traders might influence the market, and how we can use the information to make money in forex. An abstract example may help you see why the COT report is an exceptional market indicator.
You’re on a cruise ship. There are thousands of people on the ship with you, but everyone is on one side of the ship. Being the smart person you are, you realize that if you run to the other side, you’ll be the only one on the other side and you’ll have a much better view.
What do you do? You run to the other side, of course. Other people start to notice that maybe standing on the crowded side doesn’t make very much sense. More importantly, others notice that if they don’t go to the other side right now, they might beat a future rush of people to the other side. If they move right now, they can trade their standing room only spot for a comfortable beach chair! Let’s move!
The Commitment of Traders report follows alongside the same concept. When everyone is on the same side of a trade—long or short—there isn’t anyone else to join them. To keep the momentum of a trade up, the traders in long or short will have to commit more money to the position themselves. That usually doesn’t happen.
Instead, what does happen is a reversal. When everyone—err, at least a strong majority—is long the market, then the next move is probably going to be bearish. There’s so many people buying and so few selling that when the buyers do eventually sell their positions the market will reverse.
A Manic Market
A quote from the economist Keynes says the following:
“The market can stay irrational longer than you can stay solvent.”
This quote will surely come up more than once in this lesson but only because there’s good reason for it: it’s a great quote.
Keynes is warning us that even though the market may be irrational in buying or selling a specific currency pair, it doesn’t mean that you can make money by going in extremely strong with high leverage. Instead, he asserts that the market can be overbought or oversold long enough that you lose too much money in going against the grain.
That is, before the market proved you right, you lost too much money to hang on. You would have won—the market would have eventually gone your direction—but you put too much money on the line, or too much emphasis on the trade that you lost your shirt before you could collect.
In the next lesson, we’ll show you how to strip the COT report of the good trades, and ignore the bad.
