Looking inside markets: The COT report

From the Issue of Managed Futures Today
Analyzing the balance between different market players in the Commitments of Traders report reveals supply and demand dynamics not evident in price action.

Published each week by the Commodity Futures Trading Commission (CFTC), the Commitments of Traders (COT) report details the positions (“open interest”) of different types of traders in the U.S. futures (and options on futures) markets. The release reflects 70 to 90 percent of all positions in each market; the CFTC only includes positions that meet or exceed specific thresholds for each market (e.g., 400 or more Japanese yen futures contracts). Futures brokerages and clearing houses are required to report the futures and options positions of their customers that are at or above the CFTC’s reporting limits. The COT report, updated each Friday, reflects positions from Tuesday of that week.

In the broadest sense, the COT report breaks down the long and short positions of two major types of futures market participants: hedgers (“commercials”) and speculators (“non-commercials”). However, there are different types of hedgers and speculators, and participants in one group may occasionally participate in a different group. In 2009 the CFTC began publishing a more detailed (“disaggregated”) version of the COT report with even more specific trader sub-categories (see “Understanding the COT players.”).

The commercials, or hedgers, often have existing positions in the cash market and are seeking to hedge directional risk by trading futures. They tend to know most about a market’s supply and demand. For example, beef producers who want to lock in their selling price for their product in the year might sell August live cattle futures (LCQ11). The beef producers simply want to offset price risk; they don’t intend to profit from price moves.

Understanding the COT players

Figure 1: Commercials and Non-CommercialsThe CFTC publishes Commitments of Traders data in various formats, with some reports longer and more detailed than others.

In the simpler “legacy” COT report, traders are simply divided into commercial (hedger), non-commercial (speculators), and nonreportable (small) positions. Figure 1 shows this report for the S&P 500 futures (SP) from Jan. 25. In the newer “disaggregated” COT report, this position data is divided into four more-detailed trader categories: 1) Producer/Merchant/Processor/User; 2) Swap Dealers; 3) Managed Money; 4) Other Reportables. Figure 2 shows the disaggregated COT report for crude oil (CL) futures for Jan. 18.

Figure 2: The "Disaggregated" COT Report: Crude Oil

The Producer/Merchant/Processor/User group contains those traders traditionally referred to as “commercials,” or hedgers — large businesses that actually deal directly in the underlying cash market, such as grain merchants and oil companies, who either produce or consume the commodity in question. For example, an agribusiness that produces and sells grains to various food producers might sell wheat, soybean, or corn futures to lock in prices for these commodities to hedge against an unexpected price decline. On the other side of the equation, the food producer might buy contracts on these commodities to hedge against a future price increase. (In financial futures, a commercial trader might be a mutual fund manager who is hedging his stock holdings with stock-index futures.) This category of traders typically has access to supply and demand information other market players do not.

The Money Manager group contains those traders traditionally known as large speculators (“large specs”), which are the most important sub-group in the “non-commercial” category. These are commodity trading advisors (CTAs), commodity pool operators (CPOs), and hedge funds — institutional and quasi-institutional money managers who do not deal directly in the underlying cash markets, but speculate in futures contracts on a large-scale (and often long-term) basis for their clients.

A Swap Dealer (a subset of the broader “commercial” category) is defined by the CFTC as “an entity that deals primarily in swaps for a commodity and uses the futures markets to manage or hedge the risk associated with those swaps transactions.” Swap dealers are typically on the other side of transactions with money managers (speculative traders) or traditional commercials hedging their exposure in the physical commodity. Swap dealers were broken out of the commercial category because these traders’ positions do not reflect the pure hedging actions taken by true “commercials.” The CFTC also created a separate group for commodity index traders (not shown) in 12 agricultural and “soft commodity” (coffee, sugar, cotton, cocoa) markets, to account for the trading activity of commodity index fund managers (including exchange-traded funds, or ETFs) that had been distorting the commercial category.

The final category, Other Reportables, represents all other reportable trader positions not placed into one of the other three categories. (The positions of small traders, including the general public, are reflected in the “non-reportables” category in other COT reports.)

In Figure 1, for each category of trader the report shows the raw position totals (number of open contracts), the change in these numbers from the previous week, the percentage of total open interest represented by each category, and the number of traders in each category.

Positions are shown as long, short, and (for all categories except Producer/Merchant) “spreading,” which represents the number of offsetting long and short positions held in a particular trader category. The long and short columns display any remaining positions beyond these offsetting positions.

The CFTC points out that traders in one category may sometimes be active players in another; the Commission categorizes traders based on their predominant trading activity.

By contrast, non-commercials, or speculators, are seeking to profit from market trends, often taking the other side of the trade. Commodity trading advisors, commodity pool operators, and other futures money managers fall into this group. A third general group, “nonreportable,” represents small retail traders (as well as some small hedgers and professional traders with positions below reporting levels) left after commercials and non-commercials have been counted.

Over the years, traders have analyzed the COT report to gain insight into market dynamics: Are commercial hedgers net long or short in a particular market? How long or short are they? What are the large speculators (money managers) doing? What about the general public? This data — especially when the long or short positions in certain trader categories reach historically high or low levels — can help traders determine whether a market might be reaching a bullish or bearish extreme, or whether a trend is likely to persist.

Making sense of the numbers: Gauging supply and demand
Although anyone can access COT data each week, it doesn’t mean the report is easy to interpret. Despite studying COT data for decades, professional traders and academics haven’t found a simple, foolproof way to profit from the report; different traders employ different strategies depending on time frame and input from other market factors. However, the commercial and non-commercial groups often behave in predictable ways that offer clues about a market’s future direction.

For example, in January 2009, several experts discussed the COT report and how to interpret it at a meeting of the Professional Risk Managers’ International Association in Chicago. As originally reported in the February 2009 issue of Futures & Options Trader magazine, Hilary Till, co-founder of proprietary trading firm Premia Capital Management and research associate at the EDHEC Risk and Asset Management Research Centre, described how the COT report reveals relationships between supply and demand. Till considered COT data helpful because, “when you’re back-testing you have some evidence that…can be tied back to fundamental factors,” she said. For more than a century, she added, traders, have noticed “seasonal trends in inventories mirror seasonal trends in futures markets.” As inventories rise, commercials producing or holding the physical commodity tend to hedge by going short futures; when inventories fall, commercials tend to unwind those hedges, pushing price higher. Non-commercials are often taking the opposite side of the market.

Figure 3: Inventories and Non-Commercial PositionsIn Figure 3, the top chart shows the average change in gasoline inventories from 1985 to 1998, while the bottom half shows a similar trend in average net non-commercial gasoline positions. Comparing these charts shows inventories peak in March, while speculator positions don’t peak until May.

How can this type of information translate into trading? For example, Till and her colleague Joe Eagleeye found buying gasoline futures in March and selling in May, a strategy first proposed by Paul Cootner in 1967, was profitable from 1985 to 2002 and also made money from 2004 to 2007 (the strategy was quite volatile, however).

In the grain markets, this idea, called the “net-hedging-pressure strategy,” translates into prices climbing after inventories peak and dropping before harvest begins. In 1992, Henry Bessembinder, now a finance professor at the University of Utah, found this approach had value from 1967 to 1989. Table 1 shows soybeans, wheat, and corn futures rallied when commercial positions were net short and fell when commercials were net long. For example, corn rallied 16.25 percent annually when commercials were short and dropped 19.96 percent per year when they were long.

Table 1: Fading the CommercialsFigure 4 shows corn futures with commercial, non-commercial, and small trader positions (longs minus shorts) from August 2004 to January 2009. The commercial and non-commercial positions clearly move in opposite directions. For example, the commercials peaked in January 2005 as non-commercials dropped to an eight-month low. And when commercials reached a three-year low in February 2007, non-commercials hit a relative high.

Figure 4: Corn Prices vs. Positions

In addition, price tended to drop when commercials were long and climb when commercials were short. For example, price slumped when commercials were long in the second half of 2004. And price surged from August 2006 to February 2007 when the commercial positions were overwhelmingly short.

One part of the puzzle
Generally analysts and traders distill the COT data to be able to measure current levels in one group relative to the levels in another group, or the current level to long-term historical levels. For example, the current COT report might show commercial traders are exceptionally long in a particular market, and have increased their long positions significantly over the past few weeks. At first glance this might seem to have a bullish implication, but if the current reading is, say, not even in the upper 50 percent of long commercial readings over the past five years, the bullish outlook is discounted.   

Furthermore, COT readings are not timing signals by any means. Professional futures traders or money managers will tell you that creating a strategy based on COT data without considering price patterns and other market information is, essentially, foolhardy. COT analysis more typically function as a filter for taking trades in one direction or another, or as a supporting factor in a longer-term trend system. Nonetheless, the data is widely watched and provides information not found in other sources.