Knowing the Market Sentiment (Part V)
When you look at the COT report, you should focus on the non-commercial participants rather than on the commercial participants. You would want to know the reason. Commercial participants are mostly trading forex futures for hedging purposes. They keep on rolling on their positions from month to month for hedging even though they maybe taking losses.
However, large speculators like the hedge funds and the banks trade the forex futures contract for speculation and capital gains only. Most will immediately close their losing position instead of rolling it over to the next month. Large speculators do not have any intention of taking delivery of the currency in cash like the commercial participants.
There is a close correlation between the forex futures market and the spot forex market. By gauging market sentiment in the forex futures market, you can also gauge the market sentiment in the spot forex market.
Forex futures are basically spot prices adjusted for the forwards to arrive at the future delivery price. Near and on the maturity of the forex futures contract, both the prices converge and become equal.
The main difference between the spot forex market and the forex futures market is that the spot forex market is not a centralized market. It is an Over the Counter (OTC) market. However, Forex futures are traded on a Centralized Exchange Chicago Mercantile Exchange (CME). CME functions as a clearing house between the counter parties.
You should become familiar with the differences in price quotation system used in both the markets. When either the spot or the future price of the currency rises, the other also tends to rise and when either falls, the other also tend to falls. For example, if GBP futures price goes up spot price of GBP/USD goes up too. The spot and futures prices of a currency tend to move in tandem.
Calculate the net position of the non-commercial contract by subtracting the long position total from the short position total. Usually when a particular currency is trending up against the US Dollar, the non-commercials tend to register a net long position as the large speculators would like to continue riding the trend.
The opposite is also true when a particular currency is trending down against the US Dollar. The non-commercials will have a net short position when the market is trending down against USD. You can tell if the latest net positioning is skewing towards an extreme reading by comparing the latest net positioning with that of the past few weeks or months.
When the majority of the market is positioned incorrectly, dramatic price moves like the major turning points tend to occur. You can detect turning points in the spot forex market with the COT reports by keeping an eye on the net directional positioning and net contract volume in the non-commercial category.
You can use your COT report analysis to optimize your trading strategies. Entry and exit cannot be timed solely based on COT report but it can generate warning signals of a possible turn ahead in the spot forex market. What deters many traders from using the COT report is its raw organization of data. COT report is a treasure trove.
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