In trading, sentiments offered by other investors are traders are very important in determining the market moves. This is simply because any person trading the market has his own opinion on the future price of the shares, currencies, or commodities. At times, the majority of the traders might be wrong while at other times, they might be correct. These market participants include: the commercial traders (hedgers), non-commercial traders, and retail traders. The Commitment of Traders (COT) report is released on a weekly basis and is used by traders to evaluate the general outlook of the market.
Personal sentiments matter
As stated above, these sentiments are important but not always satisfactory to traders. For instance, assuming that 80% of the market participants believe in going long EURUSD, and then something significant such as an interest rate decision is announced, then the minority will have their say. The key thing here is for investors and traders to believe in their analysis and their opinions. Before entering, exiting or holding a particular asset, it is important to conduct a good analysis, based on the fundamental or technical indicators. If you believe that the EURUSD will go up, then you should go long regardless of what the COT report says. In fact, many investors have lost a lot of money by following these sentiments.
In COT, hedgers, who are also known as the commercial traders’ intention is to shield themselves against a sudden unexpected price movement on an asset. For instance, if a sudden interest rate decision is made, the fact is that the market will react suddenly and many people will lose money. To avoid this situation, the commercial traders will always put in place measures to protect their money. In many cases, the hedgers are usually very bullish when the market is at the lows and very bearish when an asset is trading in the highs. When it’s at the lows, they believe that chances are high that the market will undergo a reversal. Investment banks and large hedge funds are also put in this category because they want to protect themselves from these sudden changes.
On the other hand, large speculators or non-commercial institutions are never interested in holding an asset. Their goal is to enter a market, make a good profit and exit immediately. They are different from hedgers who want to hold an asset for a few months or years. The goal of the large speculators is to identify a trend and then bet that the trend will go on and then enter the position. These individuals and companies mostly participate in the futures markets because they have huge sums of money. For this reason, in checking the Commitment of Traders, the decisions that they make are critical and have a huge chance of moving the market. In addition, they commonly use the moving averages to study the trend.
Finally, the retail traders are the smaller market participants who are mostly on the wrong side of the market. Their sentiments are never all that essential to the market meaning that they can’t move the market.
How to interpret the COT report
To explain this section, I will use the chart below.
To start, I recommend that you ignore the commercial and the retail traders since their actions are not very significant. From the chart, it is clear that the EURUSD pair was on a steady decline in the beginning part of 2008. At the same time, when the increased short positions from the non-commercial traders reduced, the currency pair also decline. Mid-September, the net short positions of the pair went to a 1-low. Afterwards, investors went bullish as the non-commercial traders started buying the pair. The same happened in November when the non-commercial trader’s sentiments changed.
In conclusion, it is important to note that the sentiments from the non-commercial traders will not always be correct. Many times, the market has gone against their opinions. A good example happened early this year when the Swiss National Bank (SNB) removed the currency peg. This was a sudden move, one which nobody had anticipated. The market reaction was severe to most investors who had traded the Swiss dominated currencies. Therefore, the key to success when using the COT model is to understand when the extremes have been reached and then make the entry or exit decision. You should use stop losses to limit the losses you make.