The COT indicator is a powerful forex trading tool that is surprisingly used by a minority of traders. The indicator is based on the reports published by Commodity Futures Trading Commission (CFTC) each Friday.
The reports from the CFTC can be used by traders to spot potential big trend changes in the forex market, by trading with the “smart money”.
In this article, I will give you a layman’s guide to the COT indicator and show you how to use it to your advantage.
What are the CFTC Reports?
Each Friday, the Commodity Futures Trading Commission (CFTC) publishes the future and options trading activity by market segment in several markets, including currencies.
The main purpose is to monitor the markets and identify potential situations of market manipulation. Therefore, we are able to see how different groups are positioned in the market.
What are the segments?
The participants are divided into three segments:
Non-Commercials: This is all large professional traders such as hedge funds, commodity trading advisers, commodity pool operators, well-capitalized individuals, and locals on and off the exchange floors.
All of these are trading for financial gain and tend to do well in trending markets. However, at big turning points, they tend to be heavy long at tops and heavy short at bottoms.
Commercials: These are banks, institutions, and corporations who are hedging cash positions in order to protect themselves against currency changes.
Commercials also have a good sense of the “fair-value” of a currency and are able to keep an objective view because they are not affected by their emotions.
Historically, they tend to be on the right side of big market reversals, meaning heavy short at markets tops and heavy long at market bottoms.
Speculators: This is retail traders trading for financial gain. We don’t pay attention to these due to their small size. The big majority also loses in the long term.
How to read it?
As a forex trader, you mainly need to pay attention to the currency futures. The reports cover the following currencies:
- USD (dollar-index)
- Canadian Dollar
- Swiss Franc
- British Pound
- Japanese Yen
- Australian Dollar
- New Zealand Dollar
- Mexican Pesos
- Russian Ruble
The reports can be found here, and will look like this:
Non-Commercial: This is a mixture of individual traders, hedge funds, and financial institutions, these are traders who looking to trade for purely speculative gains.
Commercial: These are the big businesses that use currency futures to hedge their cash position and they’re not speculating.
Long: The number of long contracts reported to the Commodity Futures Trading Commission (CFTC).
Short: The number of short contracts reported to the CFTC.
Open interest: this column represents the number of contracts out there that have not been exercised or delivered.
Non-reportable positions: These are the open interest positions of traders that do not meet the reportable requirements by the CFTC.
As you can see, the report shows how many futures contract each segment is holding. To get a better overview, you can use the COTbase.
How do I use it?
The way to use to COT indicator is to look for big divergences between the non-commercials and commercials, and trade with the commercials.
The reason is that the commercials are not influenced by greed and fear, and usually know the “fair-value” of a currency. They are not in the market to make money, but hedge cash positions.
The Non-commercials are trading for financial profit and are influenced by greed and fear. The majority will lose on their trading.
Generally, a divergence over 10, is considered to be a good potential setup.
Since commercials aren’t using the foreign exchange market for financial profit, they can allow the market to move against them for a while.
Retail traders must, therefore, have patience when using the COT indicator. It may take some time for the trend to change.
Therefore, many recommend using the COT indicator with position trading.
Using the COT indicator together with technical analysis is highly recommended. It will give you better risk-reward trades and increase your odds of succeeding.
For instance, if you see a good potential trade with the COT, you can then check the technicals. If the markets are approaching an important resistance level, it will many times test it.
The COT indicator is a powerful indicator that can help you spot big market reversals in the forex market. By looking for big divergences between commercials and non-commercials, you can trade with the “smart money”.
It is important to take into consideration that trend changes can take some time, so be patient.
Please note that you should use this together with technical analysis. It can further increase your odds of succeeding.