Between 2001 and 2004, volume in the foreign-exchange market increased more than 50%, illustrating the overall rise in popularity of currency trading. The advent of online trading following the technology boom has allowed many equity and futures traders to look beyond their more traditional trading instruments. Most short-term traders or speculators trade FX based on technical analysis, so equity and futures traders who use technical analysis have made the switch to FX fairly easily. However, one type of analysis that traders have not been able to transfer over to currencies is volume-based trading.

Since the currency market is decentralized and there is no one exchange that tracks all trading activities, it is difficult to quantify volume traded at each price level. But in place of volume-based trading, many traders have turned to the Commodity Futures Trading Commission's Commitments of Traders (COT) report, which details positioning on the futures market, for more information on positioning and volume. Here we look at how historical trends of the COT report can help FX traders. (Find out how to gauge the psychological state of a currency market in Gauging Major Turns With Psychology.)

What is the COT Report?

The Commitments of Traders report was first published by the CFTC in 1962 for 13 agricultural commodities to inform the public about the current conditions in futures market operations (you can find the report on the CFTC website here). The data was originally released just once a month, but moved to once every week by 2000. Along with reporting more often, the COT report has become more extensive and - luckily for FX traders - it has also expanded to include information on foreign currency futures. If used wisely, the COT data can be a pretty strong gauge of price action. The caveat here is that examining the data can be tricky, and the data release is delayed as the numbers are published every Friday for the previous Tuesday's contracts, so the information comes out three business days after the actual transactions take place.

Reading the COT Report
Figure 1 is a sample euro FX weekly COT report for June 7, 2005, published by the CFTC. Here is a quick list of some of the items appearing in the report and what they mean:

  • Commercial - Describes an entity involved in the production, processing, or merchandising of a commodity, using futures contracts primarily for hedging
  • Long Report - Includes all of the information on the "short report", along with the concentration of positions held by the largest traders
  • Open Interest - The total number of futures or options contracts not yet offset by a transaction, by delivery or exercise
  • Noncommercial (Speculators) - Traders, such as individual traders, hedge funds and large institutions, who use futures market for speculative purposes and meet the reportable requirements set forth by the CFTC
  • Nonreportable Positions - Long and short open-interest positions that don't meet reportable requirements set forth by the CFTC
  • Number of Traders - The total number of traders who are required to report positions to the CFTC
  • Reportable Positions - The futures and option positions that are held above specific reporting levels set by CFTC regulations
  • Short Report - Shows open interest separately by reportable an non-reportable positions
  • Spreading - Measures the extent to which a non-commercial trader holds equal long and short futures positions


Figure 1

Taking a look at the sample report, we see that open interest on Tuesday June 7, 2005, was 193,707 contracts, an increase of 3,213 contracts from the previous week. Noncommercial traders or speculators were long 22,939 contracts and short 40,710 contracts - making them net short. Commercial traders, on the other hand, were net long, with 19,936 more long contracts than short contracts (125,244 - 105,308). The change in open interest was primarily caused by an increase in commercial positions as noncommercials or speculators reduced their net-short positions.

Using the COT Report
In using the COT report, commercial positioning is less relevant than noncommercial positioning because the majority of commercial currency trading is done in the spot currency market, so any commercial futures positions are highly unlikely to give an accurate representation of real market positioning. Noncommercial data, on the other hand, is more reliable as it captures traders' positions in a specific market. There are three primary premises on which to base trading with the COT data:

  • Flips in market positioning may be accurate trending indicators.
  • Extreme positioning in the currency futures market has historically been accurate in identifying important market reversals.
  • Changes in open interest can be used to determine strength of trend.

Flips in Market Positioning
Before looking at the chart shown in Figure 2, we should mention that in the futures market all foreign currency exchange futures use the U.S. dollar as the base currency. For Figure 2, this means that net-short open interest in the futures market for Swiss francs (CHF) shows bullish sentiment for USD/CHF. In other words, the futures market for CHF represents futures for CHF/USD, on which long and short positions will be the exact opposite of long and short positions on USD/CHF. For this reason, the axis on the left shows negative numbers above the center line and positive numbers below it.

The chart below shows that trends of noncommercial futures traders tend to follow the trends very well for CHF. In fact, a study by the Federal Reserve shows that using open interest in CHF futures will allow the trader to correctly guess the direction of USD/CHF 73% of the time.



Figure 2: Net positions of noncommercial traders in the futures for Swiss francs (corresponding axis is on the left-hand side) on the International Monetary Market (IMM) and price action of USD/CHF from April 2003 to May 2005 (corresponding axis is on the right-hand side). Each bar represents one week. Source: Daily FX.

Flips - where net noncommercial open-interest positions cross the zero line - offer a particularly good way to use COT data for Swiss futures. Keeping important notation conventions in mind (that is, knowing which currency in a pair is the base currency), we see that when net futures positions flip above the line, price action tends to climb and vice versa.

In Figure 2, we see that noncommercial traders flip from net long to net short Swiss francs (and long dollars) in June 2003, coinciding with a break higher in USD/CHF. The next flip occurs in September 2003, when noncommercial traders become net long once again. Using only this data, we could have potentially traded a 700-pip gain in four months (the buy at 1.31 and the sell at 1.38). On the chart we continue to see various buy and sell signals, represented by points at which green (buy) and red (sell) arrows cross the price line.

Even though this strategy of relying on flips clearly works well for USD/CHF, the flip may not be a perfect indicator for all currency pairs. Each currency pair has different characteristics, especially the high-yielding ones, which rarely see flips since most positioning tends to be net long for extended periods as speculators take interest-earning positions.

Extreme Positioning
Extreme positioning in the currency futures market has historically also been accurate in identifying important market reversals. As indicated in Figure 3 below, abnormally large positions in futures for GBP/USD by noncommercial traders has coincided with tops in price action. (In this example, the left axis of the chart is reversed compared to Figure 2 because the GBP is the base currency.) The reason why these extreme positions are applicable is that they are points at which there are so many speculators weighted in one direction that there is no one left to buy or sell. In the cases of extreme positions illustrated by Figure 3, every one who wants to be long is already long. As a result, exhaustion ensues and prices begin reversing.


Figure 3: Net noncommercial positions in GBP futures on IMM (corresponding axis is on the left-hand side) and price action of GBP/USD (corresponding axis is on the right-hand side) from May 2004 to April 2005. Each bar represents one week.
Source:
Daily FX.

Changes in Open Interest
Open interest is a secondary trading tool that can be used to understand the price behavior of a particular market. The data is most useful for position traders and investors as they try to capitalize on a longer-term trend. Open interest can basically be used to gauge the overall health of a specific futures market; that is, rising and falling open interest levels help to measure the strength or weakness of a particular price trend. (To learn more, read Gauging Forex Market Sentiment With Open Interest.)

For example, if a market has been in a long-lasting uptrend or downtrend with increasing levels of open interest, a leveling off or decrease in open interest can be a red flag, signaling that the trend may be nearing its end. Rising open interest generally indicates that the strength of the trend is increasing because new money or aggressive buyers are entering into the market. Declining open interest indicates that money is leaving the market and that the recent trend is running out of momentum. Trends accompanied by declining open interest and volume become suspect. Rising prices and falling open interest signals the recent trend may be nearing its end as fewer traders are participating in the rally.

The chart in Figure 4 displays open interest in the EUR/USD and price action. Notice that market trends tend to be confirmed when total open interest is on the rise. In early May 2004, we see that price action starts moving higher, and overall open interest is also on the rise. However, once open interest dipped in a later week, we saw the rally topped out. The same sort of scenario was seen in late November and early December 2004, when the EUR/USD rallied significantly on rising open interest, but once open interest leveled off and then fell, the EUR/USD began to sell off.


Figure 4: Open interest in the EUR/USD (corresponding axis is on the left-hand side) and price action (corresponding axis on right-hand side) from January 2004 to May 2005. Each bar represents one week.
Source: Daily FX.


Summary
One of the drawbacks of the FX spot market is the lack of volume data. To compensate for this, many traders have turned to the futures market to gauge positioning. Every week, the CFTC publishes a Commitment of Traders report, detailing commercial and non-commercial positioning. Based on empirical analysis, there are three different ways that futures positioning can be used to forecast price trends in the foreign-exchange spot market: flips in positioning, extreme levels and changes in open interest. It is important to keep in mind, however, that techniques using these premises work better for some currencies than for others.

Related Articles
  1. Forex

    The Secret to Forex Trading: Limit the Downside

    The odds against becoming a profitable Forex trader are high, but many small investors still try to tame this beast.
  2. Chart Advisor

    3 Ways to Trade the Rising Volatility

    With volatility increasing in the markets, many are turning to these three volatility-capturing exchange-traded products.
  3. Term

    What is a Prime Brokerage?

    A prime brokerage offers special services to certain clients.
  4. Chart Advisor

    Big Double Top Patterns On the Verge of Breaking

    These stocks have created big double top chart patterns, and are on the verge of breaking the patterns to the downside--a bearish signal.
  5. Mutual Funds & ETFs

    ETF Analysis: PowerShares DB Commodity Tracking

    Find out about the PowerShares DB Commodity Tracking ETF, and explore a detailed analysis of the fund that tracks 14 distinct commodities using futures contracts.
  6. Investing Basics

    5 Tips For Investing In IPOs

    It’s not easy to profit from IPO​s, but the money is there.
  7. Options & Futures

    Use Options to Hedge Against Iron Ore Downslide

    Using iron ore options is a way to take advantage of a current downslide in iron ore prices, whether for producers or traders.
  8. Investing Basics

    The 3 Best Investments Bill Ackman Ever Made

    Learn about the three best investments Ackman ever made. Ackman has demonstrated a consistent track record of success in all types of market environments.
  9. Stock Analysis

    4 Companies Affected by the Appreciating Dollar

    Learn why the appreciating dollar negatively impacts certain companies such as Google, Facebook, Procter & Gamble and Johnson & Johnson.
  10. Chart Advisor

    Gold Struggles to Climb Higher and May Fall Soon

    Traders will be watching the price of gold over the coming weeks. We'll take a look at how a couple major moving averages are suggesting that the next move could be lower.
RELATED TERMS
  1. Implied Volatility - IV

    The estimated volatility of a security's price.
  2. Plain Vanilla

    The most basic or standard version of a financial instrument, ...
  3. Normal Profit

    An economic condition occurring when the difference between a ...
  4. Theta

    A measure of the rate of decline in the value of an option due ...
  5. Derivative

    A security with a price that is dependent upon or derived from ...
  6. Security

    A financial instrument that represents an ownership position ...
RELATED FAQS
  1. Tame Panic Selling with the Exhausted Selling Model

    The exhausted selling model is a pricing strategy used to identify and trade based off of the price floor of a security. ... Read Full Answer >>
  2. Point and Figure Charting Using Count Analysis

    Count analysis is a means of interpreting point and figure charts to measure vertical price movements. Technical analysts ... Read Full Answer >>
  3. What assumptions are made when conducting a t-test?

    The common assumptions made when doing a t-test include those regarding the scale of measurement, random sampling, normality ... Read Full Answer >>
  4. How do futures contracts roll over?

    Traders roll over futures contracts to switch from the front month contract that is close to expiration to another contract ... Read Full Answer >>
  5. How is the value of a pip determined?

    A pip in foreign exchange trading is a measure of a price movement in a currency pair. "Pip" is an acronym for price interest ... Read Full Answer >>
  6. How does a forward contract differ from a call option?

    Forward contracts and call options are different financial instruments that allow two parties to purchase or sell assets ... Read Full Answer >>

You May Also Like

Trading Center
×

You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!