October 16, 2017
The forex market is made up of many traders, investors and companies that sell their goods and services overseas in different currencies. It’s said that the price contains all available information, which means that with a disciplined trading approach and fundamental and technical analysis all traders can be consistently profitable.
However, obviously this is not the case. Two different traders can have very opposite views on where the market is heading – one might be bearish and the other bullish. Now imagine that all market participants have an impact on the market, just with their different views on the market. As with any other financial market, this is also the case with forex, and at this point market sentiment analysis comes into play.
Market sentiment is simply a measure of the overall emotional and psychological state of forex market participants. It gives us clues about what percentage of market participants are currently bullish or bearish on the markets. A number of reports and indicators provide us with valuable information about the current market sentiment, the most famous of which is the Commitment of Traders report.
What is the Commitment of Traders Report?
The Commitment of Traders report (COT) is published every Friday at around 2:30 pm EST by the Commodity Futures Trading Commission (CFTC). The report measures the net long and short positions taken by traders, and in this way, provides important information on whether the market sentiment is leaning more to the bullish or bearish side.
You can find the COT report on CFTC’s website here:
Scroll down to the “Current Legacy Reports” and find “Chicago Mercantile Exchange” on the list. After that, click on the “Futures Only” short format in the same row on the right.
You might ask yourself why do we use reports from the futures market. As forex is traded OTC (over the counter), there is no way to get the current open positions on the spot FX market, and the futures market is therefore our best shot to try to measure the market sentiment.
How to Read the COT Report?
After you open the short format of the report, you will get a table of future contracts that are published in the report. Just scroll down to find the instrument you’re interested in (currencies), which will look something like this for the euro:
The report shows the total non-commercial (i.e. speculators and traders), commercial (i.e. big companies that try to hedge their currency risk) and nonreportable (i.e. positions that do not meet the CFTC’s reporting requirement) positions on the market.
Traders focus on long and short positions of non-commercial traders, and try to spot extreme levels on long and short positions. For example, the report above shows that almost twice as much non-commercial traders are currently long on euro futures (187,053 contracts), compared to traders who are short (96,220 contracts). This signals that the majority of traders reported by the COT report are bullish on the euro.
How to Interpret and find Tops and Bottoms with the COT Report?
Simply said, hedgers (commercial traders) buy when the market is at its bottom, while speculators (non-commercial traders), sell as the price falls. This means, positions of commercial traders can be used to determine possible market tops and bottoms (reversals), while positions of non-commercial traders can be used for trend following. Of course, it might be hard to determine when a sentiment extreme will occur, that’s why the best way to trade COT reports is to combine them with fundamental and technical analysis.
Another way to determine the current market sentiment is to calculate the percentage of long and short positions. A simple way to do this is using the following two formulas:
% long = number of long positions / (long + short positions)
% short = number of short positions / (long + short positions)
From our example above, we can calculate that around 66% of non-commercial traders are net long (187,053 / (187,053 + 96,220)). The higher the percentage, the higher the chance that the market will move in that direction. Generally, a percentage of 80% or above is a strong signal that the market will be bearish or bullish.