There is a herd behavior of the speculative portion of the Commitment of Traders (COT) report that can currently be seen in silver, Dow futures and the U.S. Dollar Index.
One of the primary tenets of COT analysis is that conflict between the commercial and speculative traders typically resolves itself in favor of the commercial traders due to better fundamental analysis.
There are several ways to measure the conflict as the COT report provides the net and total positions of the categories measured as well as the number of traders holding the outstanding positions. Each of these metrics must be taken in context. For example, commercial traders in silver and sugar almost always maintain a negative net position, showing that the commercial portion of these markets is dominated by producers selling rather than processors buying. Our favorite interpolation is our COT Ratio, which calculates the ratio of long money vs. short money by trader group in each market. We use it to determine speculative bubbles.
This spring, speculative traders were long silver more than 5 to 1. Five to one has been the ceiling for silver over the last decade, except for late 2009. Furthermore, the commercial traders set a net short record at the same time the speculators were trying to push the market above $18.50. We use this scenario to generate a short trade as resistance builds against the speculative bubble. The trade is triggered as the market collapses, while risk is limited to the recent peak.
The speculative trading position has evened out considerably, now standing near even money. Just as importantly, the commercial traders have repurchased more than 80K contracts on the summer’s weakness. This leaves silver fundamentally balanced at current levels. This is typically indicative of a long-term bottom being formed.
Last month, speculators were long 8 to 1 in the Dow futures. They are now long more than 11 to one. The small pullback in August was insufficient to scare out the speculative bid. This is a classic example of trend following herd behavior. Speculators are buying new highs, rather than waiting for better prices. We expect this to end poorly as there is little support above 19,000. Our discretionary COT model has already produced a short sale signal and is using the August high as the stop.
Speculators in the Dollar Index have been net long since June 2014, and set the second most lopsidedly bullish COT Ratio of 12 to 1 late this spring. Their only higher reading was 21 to 1in November 2008; two weeks before setting a five-year high. The speculators have been forced out of their longs on the market’s decline as predicted by the commercial traders, and now hold a slightly net short position.
The COT Ratio is a visually intuitive way of aggregating multiple data fields from the COT report. While it won’t predict the next trend, it is very capable of predicting the next collapse.