The Commodity Futures Trading Commission’s (CFTC) Commitments of Traders (COT) report is a useful tool for traders to determine market trends and to predict major turning points. Here we walk through our recent Discretionary COT signals providing examples in interest rates, forex and energy of how we use the COT report to swing trade the commodity markets on a daily basis. 

Let’s start with a brief description of what the COT is. The CFTC publishes the COT reports to help the public understand market dynamics. Specifically, the COT reports provide a breakdown of each Tuesday’s open interest for futures and options on futures markets in which 20 or more traders hold positions equal to or above the reporting levels established by the CFTC. It is released the following Friday.

The COT reports are based on position data supplied by reporting firms (Futures Commission Merchants, clearing members, foreign brokers and exchanges). The actual trader category or classification is based on the predominant business purpose self-reported by traders. There are four main reports: Legacy, supplemental, disaggregated and financial futures traders.

Legacy reports break down the reportable open interest positions into two classifications: non-commercial (often referred to as speculators) and commercial traders. The supplemental reports break down the reportable open interest positions into three trader classifications: Non-commercial, commercial and index traders. The Disaggregated reports break down the reportable open interest positions into four classifications: Producer/merchant/processor/user, swap dealers, managed money and other reportables.

Our primary focus lies in the battle between the commercial and speculator categories. The commercial traders are those with industrial attachment to the market in question. Typically, these are the growers and drillers or the processors and refiners, respectively. However, this application also works in the interest rate and currency markets because the commercial traders’ actions in the commodity markets are driven by their underlying business concerns. Interest rate and foreign exchange risk are also tied directly to the global commodity markets.

The collective outlook of an industry’s sentiment can be measured through their net and total positions. The net position tells us how bullish, or bearish, they are in a given market at a given price. The faster and more extreme the movement of their net position, the more sensitive we know that industry is to the associated commodity’s current price. 

The commercial traders’ total position reflects the historical capacity of the industrial participants within the market. Ultimately, commodity markets can, though rarely, attract enough speculative interest to overrun the commercial traders’ physical needs within a given market.

Without splitting hairs, we’ll draw out the broad rules and show you how we use the weekly COT data in conjunction with daily data to generate swing trading opportunities in the commodity futures markets.

First, we only take trades in line with the commercial traders’ momentum. Their momentum acts as our industry sentiment index. These are the collective decisions and actions of some of the most connected individuals there are. We want to put their forecasting on our side. Below we’ll look at the interest rate, foreign currency and energy contracts. Consider ExxonMobil (XOM) corporate board members’ connections like Secretary of State, Rex Tillerson or Bill Weldon of JP Morgan (JPM). The point is that there is a very small group of people that make some very big decisions pretty regularly. While we may never know the ins and outs of their reasoning, we can at least track their actions through the COT report.

Second, the speculative behavior is based pretty solidly on support and resistance. Speculators will drive a market from one side to the other in search of a trend and extended directional gains. Extended directional gains occur when there is a fundamental shift in the market. More often than not, markets are in sideways, non-trending action. Speculators will try to jump on any move that could indicate a trend. If and when that move stalls or reverses, they exit the market and take their losses. We model this behavior through our short-term market momentum indicator. Once there is enough speculative interest to push the market into overbought or oversold levels, we start looking for a reversal.

Third, once the reversal occurs, it triggers the entry signal and our protective stop loss point. We always trade with protective stop loss orders covering our positions. Futures trading carries a substantial risk of loss. The newly created top or bottom also provides us with a mathematical risk point that we can calculate in dollars to determine whether the trade suits our risk parameters.