While many traders are intimately familiar with trading strategies that are based for the most part on price data, such as RSI, Bollinger etc, it can also be highly beneficial to use data derived from outside-market forces. Data that is external to the market can tell traders about the forces that drive prices in the first place.

One highly valuable source of such data comes for free, courtesy of the US Government. The US government requires traders to disclose their positions. The Commitment of Traders (COT) report provides a breakdown of open interest in specific markets for which enough traders hold positions equal to or higher than the reporting levels required. Simply put, it helps you see what the other traders are doing. It lets you see their long and short positions. Even better, the report is divided into the group that knows what its doing (the “commercials”) versus the group that doesn’t really know what its doing (The “non commercials”).

Let's take a moment to contemplate. Consider a trade. For every buyer there is a seller and vice versa. One person is right, the other wrong. One person profits, the other loses. Now, if you know what the commercial guys (known as the “Smart Money”) are doing, why not follow their lead? Don’t be the “losing” party on that trade. Instead, join the smart money and trade out to the dumb money.

The COTS report allows you to do exactly this. It consists of Futures contracts in the various markets. Being a futures contract, it really looks ahead and sees what one particular group is doing.

The data on the government website is extensive, but not all that easy to read. Fortunately, site such as ifxg.com automatically read and chart the data for you, all at no cost to you. So instead of dealing with complex data, you can simply view a graph, such as one shown for Corn below:

We graphed Corn COTS data from August 2007 to November 2008. The Smart Money (Commercials) is plotted in gold. Notice in the February/March 08 timeframe, the smart money was significantly Short on their Corn positions. Because they needed another party to be the buyer or seller in their trade, they entered a trade with the “dumb money” – and notice how it's almost a mirror image. The dumb money was Long on Corn.

Sometimes the smart money and dumb money trade their viewpoints. Here below is the Euro for the same timeframe. The Smart money and dumb money started with completely opposing views, however, in the latter months it was a very range bound market with no decisive view as to who was long or short:

 What To Look Out For

Typically, when you see extreme differing opinions between the smart and the dumb money, you can expect a price reversal. In the chart above, the October 07 timeframe would have been a good time to expect the price to reverse. The dumb money was buying in droves, taking the Long positions and expecting it to go up up up. At the same time the smart money knew it had to come down and were selling like mad. An extreme such as this normally indicates a major price reversal is on its way.

Pay special attention to the pricing of a commodity to understand what is meant by Long and Short. If we look at this 2005 extract of the EURUSD pair:

We see that in July 2005, the Commercial traders were seriously Net Long and the dumb money was Net Short. This is exactly the kind of extreme we like and need to look for. So, what happened to the price of EURUSD? Remember, at these extremes, we expect a price reversal. Being Long on EURUSD means you expect Euro to rise, USD to drop. The dumb money was expecting Euro to continue to drop. What actually happened? The EUR shot up and you would have made a lot of money!

Seriously, How Good is this Data?

Many traders use only COTS data, while others combine it with some other indicators. In an excellent book “Building Winning Trading Systems with TradeStation” by George Pruitt and John R. Hill (Wiley Trading), they used the power of TradeStation to back test how using COTS data would have performed over a set timeframe. They ran the simulation on the S&P 500 and based on their results, it certainly looked like the Commercial traders had the upper hand:

In a 6 month period, a total of 68 trades were placed, 44 of them winners, with a Total Net Profit of $297,567.50. Please be sure to reference their book for details. They had some more insightful number crunching, but the point here is that following the smart money is generally the way to go.

Open Interest

The COTS data also provides the Open Interest. Open Interest can be used to confirm a trend. If the Open Interest is rising, and the price is rising, this generally signifies confirmation of an up trend. So what is Open Interest? It’s a little tricky but essentially if a new Long trader enters a trade with a new Short trader, then Open Interest goes up by 1. But, if that trader with his long position sells it to another trader wanting the long position, the Open Interest doesn’t change.

Open interest can be charted here.

Use Open Interest charts to look for trend conformations. These charts must be used with caution – if you see high Open Interest near market tops, it can also signify a reversal.