Trading Psychology: Consensus Indicators - Part 2

By Jason Van Bergen AAA

Consensus indicators may cause an astute trader to do exactly the opposite of what, at first glance, the market is telling him or her to do. The best sources for getting a sense of consensus on the markets are investment newsletters, the press and newspaper and television advertisements. (For more about consensus indicators, see Trading Psychology: Consensus Indicators - Part 1.)

Despite their usefulness, however, consensus indicators aren't the only gauge of market psychology. There are many other groups of players with large stakes in the markets; these are professional investors and traders with much larger financial stakes than the ubiquitous (and noisy) market commentators and advisors. By virtue of the size of their financial commitments, these professionals are often considered better able to gauge the prospects for certain investment vehicles. (To read more on behavioral finance, see Taking A Chance On Behavioral Finance, Understanding Investor Behavior and Mad Money ... Mad Market?)

The activities of professional market players are collectively referred to as commitment indicators, whereby a group is measured on the basis of its actual financial commitments to particular investment vehicles. Commitment indicators are applicable to most trading instruments, including those found in equity markets and commodity exchanges.

There are several agencies that attempt to categorize the wide range of investment and trading professionals and measure their success (or lack thereof) against similar players. Let's take a look at some examples of commitment indicators applicable to commodity traders as well as those used to measure corporate insiders trading their companies' stocks.

Commodity Traders
The Commodity Futures Trading Commission (CFTC) requires that big speculators (those who are long or short at least 100 contracts of corn or 300 contracts of the S&P 500 futures) report their positions on a daily basis. The CFTC compiles these reports into the weekly Commitment Of Traders Report.

The Commitment Of Traders Report divides all commodities traders into three groups: commercial traders, small speculators, and large speculators. Commercial traders are also knows as hedgers, as they are actually engaged in business activities where hedging on the futures or options markets is a normal course of their business operations. The business activities of hedgers can be enormously broad: hedgers may be stock traders who trade S&P 500 futures to hedge their stock portfolios or they may be large farming companies that hedge their summer's harvest with wheat futures.

Regardless of their trading activities, commercial traders are one of the few groups on any exchange that can legally trade on inside information. If our wheat farmer friend was the only one who knew that the summer's weather would wreak havoc on the nation's wheat crop (as if weather forecasts can be considered inside information!), he could legally insure the price of his anticipated crop by purchasing futures against the summer price of wheat. (For more about futures, see Futures Fundamentals and Becoming Fluent In Options On Futures.)

The individual trader who is not part of an exclusive group that might have inside information on his or her commodity of choice can still benefit from the knowledge of the insiders by examining the open interest records of commercial traders. If the open interest (commitments) indicates a majority of long positions, then the individual trader may construe the open interest commitments to be the best indicator for writing a long contract for that particular commodity. (For further reading see, Discovering Open Interest - Part 1 and Part 2.)

This is a very significant point because commercial traders (hedgers) are one of the few groups on any stock, option, or commodity market to demonstrate significant trading success on an ongoing basis. The Commitment Of Traders Report is one publicly available document that is worth its weight in gold for the individual commodities trader.

But the story does not end at the long and short positions. The trader still does not know whether the long or short position is a hedge against ownership of a physical commodity. So the trader must then look at a newsletter called the Bullish Review, which measures current commitments against their historical norms. Only an extreme bullish reading on the Bullish Review would indicate uncommon bullishness of the commodity commitments; likewise, only an extreme bearish reading would indicate uncommon bearishness. (To learn more, check out Digging Deeper Into Bull And Bear Markets.)

The second and third groups that are mentioned in the Commitment Of Traders Report deserve a brief mention here, as well. Large speculators are considered noncommercial traders by the report because they meet the minimum number of contracts to be included on the report, but their futures contracts are not explicitly used for hedging in their business activities. Most of the large traders at present are commodity funds, which generally do not provide useful trading information because of their poor long-term performance on the commodity markets. The small speculators are not considered reportable positions because they do not meet the minimum number of contracts for the report. Small speculators compose the balance of the masses, and their activities should probably not be considered a source of useful information.

Equity Traders
The equity markets' equivalent to the Commitment Of Traders Report is the Securities and Exchange Commission's (SEC) Insider Trading Report. You will immediately notice the similarity between the commercial trader of the futures market and the corporate insider of the stock market - the corporate insider is most likely to trade based on inside information of his or her company's business activities or his sense of his company's future prospects. Note that for the purposes of this discussion, inside information is not being referred to in the legal sense, but is simply referring to a corporate insider's general feeling over the future prospects of his or her company and the influence of these feelings on his or her trading decisions for the company's stock. (For more on this, see Uncovering Insider Trading, Can Insiders Help You Make Better Trades? and When Insiders Buy, Should Investors Join Them?)

Insider buying and selling is tabulated by the SEC and released to the public once each month. While individual corporate insiders, when considered in aggregate, are notoriously poor market timers, more than three insiders buying or selling may just indicate the imminence of positive or negative news (a gray area in legal terms). Insiders have been known to buy their own company's stock after severe market drops and to sell during a market rally when their stock is overpriced. Due to its imprecise nature, trading solely on the basis of an Insider Trading Report is probably not the best course of action, but this information may be useful when used in conjunction with other analysis.

Short Sale Ratio
A commitment indicator relating to stock exchange members is the short sale ratio, which measures not only shorting by members and specialists, but also total shorting on a particular exchange. The short sale ratio is typically broken into the member short sale ratio (members to total shorting) and the specialist short sale ratio (specialists to members). These ratios have traditionally been used to show stock market tops and bottoms, but they have lost some utility lately because of the predilection to arbitrage skews the results.

Odd Lot Activity
The odd lot sales ratio measures the ratio of odd lot sales (which trade less than 100 shares of stock at a time) to odd lot purchases. Greater odd lot selling indicates that the market is near the top; odd lot purchases mean the market is near the bottom. The odd lot activity ratio has also lost usefulness lately for a number of reasons, not the least of which is that the New York Stock Exchange (NYSE) has established preferential treatment for odd lot orders, meaning that many professionals now trade in 99-share lots to ensure preferential fills for their orders. (For more about fill, see What order can I use to eliminate the chance of getting a bad fill?)

In conclusion, commitment indicators run the gamut from commodity trading to equity trading, but they are certainly most valuable when used to glean information about the actions of professional commodity traders. Commercial traders, or hedgers, are distinguished by their rare ability to execute successful trades over time, and, as such, their actions are some of the best models for the individual small trader to mimic.

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