COT Report: Let's Keep This Simple

 | Jun 09, 2017 | 2:00 PM EDT
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(This commentary originally appeared on Real Money Pro at 1 p.m. ET today. Click here to learn about this dynamic market information service for active traders.)

If you have followed any of my writing, whether it be books, articles, columns or newsletters, you are aware of my reliance on the Commitments of Traders report, known simply as the COT report. This report is issued weekly by the Commodity Futures Trading Commission (CFTC) depicting where three particular groups of traders are positioned in each of the commodity futures markets. This information can come in handy when trying to predict future price moves because it gives us a glimpse into the minds -- and a snapshot of recent behaviors -- of large speculators, small speculators and commercial hedgers.

Not surprisingly, the CFTC tends to make matters far more complicated than they need to be; after all, they are a government agency and that is what they do best. For instance, on the CFTC.gov website, you will find various forms of the COT report. Some of them break down the aforementioned three categories even further (long format) and others include option traders in the stats. We focus on the simple three-category COT report known as the short format. Depending on the market and the situation, we might or might not include option trading data in our COT analysis, but for this exercise, we will.

In summary, the long and short option positions held by speculators will be accounted for relative to their delta. Delta is the rate of change of an option relative to a one-point move in the futures market. Thus, if the delta of a corn call option is 50%, a trader long the call would be considered long half of a futures contract, but a trader short that same call would be considered short half of a futures contract.

Now that we know the basics, let's look at a few markets. I tend to look at the world in a skeptical manner, and that personality trait carries into my market analysis. Accordingly, I tend to be bullish in markets where most people are bearish and vice versa. I'm not saying this is necessarily a good thing, but it is always important to speculate in line with your personality. Otherwise, emotions will play a bigger role than they should; nothing good comes from that.

With a counter-popularity approach to the COT report, I look for markets that have extreme net long or net short positions held by speculators. The premise of this approach assumes if all the bulls are already in the market, there might not be anybody left to buy. Further, they will need to liquidate (sell) at some point. Similarly, if all the bears are short, sellers might become scarce. We see a few markets on the board that might be ripe for sharp reversals based on the COT report.

There are more speculators long live cattle futures now (at least according to the latest COT report, which lags about a week) than we've seen in several years, maybe ever. Thus, it is hard to imagine a scenario in which another round of buyers floods the market; on balance, cattle isn't necessarily a deep market, so most of the available buying power has probably already been expended. Accordingly, although it will be a bumpy ride, the best trades will likely be from the bearish side of the cattle market in the coming months. Those playing the upside might fare OK, but doing so is playing against probabilities. In our view, cattle would be more fairly valued in the $1.10 per pound.

Canadian Dollar Futures

Another market we have our eye on is the Canadian dollar. The loonie is seeing one of the largest speculative net short positions in history at just over 111,000 futures contracts (this combines small and large speculators and includes option traders). When currency speculators get "too short," the reversal can be surprisingly swift. For instance, Canadian dollar speculators were similarly short, but not to this magnitude, in January 2016. The result was a quick move from $0.70 vs. the U.S. dollar to $0.80. On this occasion, the Canadian is on a bit of an upswing rather than a trough. Yet we see the potential for a return to the $0.80 handle should prices break above trendline resistance near $0.75. In effect, we think the low $0.80s could be seen. In the meantime, look for support near $0.72.

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