COT - A Trend and Reversal Indicator

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Introduction

As we touched on in the introduction of Trading COT as a Volume Indicator, The COT can be used as a reversal indicator too. This is possible by finding net long and short positions and anticipating a market reversal on this exhaustion position.

COT as a Reversal and Trend Indicator

Using timingcharts.com we can chart currency pairs, highlighting net long and short positions below the price action.  Using these charts we can choose which currency futures to chart within different time frames.  We can also add indicators, overlays and moving averages as well as COT reports.  Below I've charted daily EUR/USD futures over a 2 year time frame, with no indicators or overlays.  I have however charted COT net positions below the chart.

You'll see the net positions are made up of our three groups we studied in Trading Market Sentiment - COT Report.  At the moment we are only interested in The Commercials, or hedgers (blue line) and The Large Traders, or speculators (green line) - We'll focus on Large Traders most.

EUR/USD Futures - COT Confirming Trend and Trend Exhaustion

There are a couple of ways to look at the reversal confirmation using The COT net positions data.  
  • The first is by observing the extreme values of the net long and short positions of Large Traders.  These extremes may signal an exhaustion and hopefully a reversal of trend.
  • The second takes confirmation from net position crossover by large traders and commercials
The Trend Exhaustion Confirmation

In the above chart of EUR/USD we can see that Large Traders positions (green) turn from an extreme short position in May 2010 to an extreme long position in May 2011.  During this time the price of EUR/USD trended up from 1.20 to 1.49.  Speculative positioning indicates trend direction.  From this net long position in May 2011 to Jan 2012, trader sentiment has been to sell long positions and take up a short position.  Will this be an exhaustion point?

It's hard to say what an extreme net position is, as we can't compare net positions historically.  Net positions really depend on how liquid the market is and liquidity changes throughout time for various reasons. It's best to do nothing until signs of an actual reversal are seen.  Once the trend is in place that's your confirmation.  The COT Index (see below) is one way of comparing historical positions.

Note: You may have noticed from our chart that the speculators (green line) and commercials, or hedgers (blue line) gave opposite signals. While hedgers buy when the market is bottoming, speculators sell as the price moves down.  They have two very different goals.  Hedgers are balancing currency risk and speculators are out to make money from currency trends.

Net Position Crossover Confirmation

The second confirmation comes from the crossover of net positions between commercials and large traders.  When these net positions cross this can signal a trend reversal has happened.  I've circled these positions on the above EUR/USD chart.  Green circles highlight large traders net positions crossing above commercial net positions - Long reversal and long on trend.  Blue circles highlight large traders net positions crossing below commercials - Short positions increasing.

As you can see this reversal confirmation strategy catches the move later than the Trend Exhaustion Strategy, but the advantage of this strategy is that it does create a signal, taking the emotion out of your trading decisions.  In our example most of these net position crossovers would have caught the trend depending on timing, but beware of whipsaw as highlighted on our chart.

COT Index and Extreme Positions

We talked above about not being able to compare net positions historically. This leaves us in the dark on the whereabouts of these extreme net positions and awaiting the reversal before gaining confirmation. However, there is a COT index indicator which acts like the RSI or Stochastic indicator.

The chart below from timingcharts.com shows our index from the EUR/USD chart we have already looked at. See how the scale is now an index from 0 to 100?  Use it in the same way as above for net position crossover, or use it like an RSI to measure trend exhaustion and the start of a new trend.  30 and 70 could be your signal/confirmation lines, indicating momentum has switched from long to short or vice versa.  Play about with it to come up with your own signal lines, as my suggestions are only that - suggestions.

EUR/USD Futures - COT Index

NB.  To get the index you must change net positions to COT Index as highlghted by the green circle.  Also, the more data you include, the more robust the index will be.  In this case my 2 year view has 100 weeks of data - as highlighted with a green circle.  

To Sum Up

The COT Report is a complement to your overall technical analysis and shouldn't be used on it's own as a trading indicator.  The lagging nature of the report (published weekly) also means that it should really only be used for determining long term sentiment on reversals and trend.  

Technical analysis is not an exact science and although these ideas can increase the probability of making the correct trade, many will go against you and large losses can be incurred. Your own trading strategy needs to be formed and hopefully you'll be on your way to achieving this on completion of this course.

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Introduction

As we touched on in the introduction of Trading COT as a Volume Indicator, The COT can be used as a reversal indicator too. This is possible by finding net long and short positions and anticipating a market reversal on this exhaustion position.

COT as a Reversal and Trend Indicator

Using timingcharts.com we can chart currency pairs, highlighting net long and short positions below the price action.  Using these charts we can choose which currency futures to chart within different time frames.  We can also add indicators, overlays and moving averages as well as COT reports.  Below I've charted daily EUR/USD futures over a 2 year time frame, with no indicators or overlays.  I have however charted COT net positions below the chart.

You'll see the net positions are made up of our three groups we studied in Trading Market Sentiment - COT Report.  At the moment we are only interested in The Commercials, or hedgers (blue line) and The Large Traders, or speculators (green line) - We'll focus on Large Traders most.

EUR/USD Futures - COT Confirming Trend and Trend Exhaustion

There are a couple of ways to look at the reversal confirmation using The COT net positions data.  
  • The first is by observing the extreme values of the net long and short positions of Large Traders.  These extremes may signal an exhaustion and hopefully a reversal of trend.
  • The second takes confirmation from net position crossover by large traders and commercials
The Trend Exhaustion Confirmation

In the above chart of EUR/USD we can see that Large Traders positions (green) turn from an extreme short position in May 2010 to an extreme long position in May 2011.  During this time the price of EUR/USD trended up from 1.20 to 1.49.  Speculative positioning indicates trend direction.  From this net long position in May 2011 to Jan 2012, trader sentiment has been to sell long positions and take up a short position.  Will this be an exhaustion point?

It's hard to say what an extreme net position is, as we can't compare net positions historically.  Net positions really depend on how liquid the market is and liquidity changes throughout time for various reasons. It's best to do nothing until signs of an actual reversal are seen.  Once the trend is in place that's your confirmation.  The COT Index (see below) is one way of comparing historical positions.

Note: You may have noticed from our chart that the speculators (green line) and commercials, or hedgers (blue line) gave opposite signals. While hedgers buy when the market is bottoming, speculators sell as the price moves down.  They have two very different goals.  Hedgers are balancing currency risk and speculators are out to make money from currency trends.

Net Position Crossover Confirmation

The second confirmation comes from the crossover of net positions between commercials and large traders.  When these net positions cross this can signal a trend reversal has happened.  I've circled these positions on the above EUR/USD chart.  Green circles highlight large traders net positions crossing above commercial net positions - Long reversal and long on trend.  Blue circles highlight large traders net positions crossing below commercials - Short positions increasing.

As you can see this reversal confirmation strategy catches the move later than the Trend Exhaustion Strategy, but the advantage of this strategy is that it does create a signal, taking the emotion out of your trading decisions.  In our example most of these net position crossovers would have caught the trend depending on timing, but beware of whipsaw as highlighted on our chart.

COT Index and Extreme Positions

We talked above about not being able to compare net positions historically. This leaves us in the dark on the whereabouts of these extreme net positions and awaiting the reversal before gaining confirmation. However, there is a COT index indicator which acts like the RSI or Stochastic indicator.

The chart below from timingcharts.com shows our index from the EUR/USD chart we have already looked at. See how the scale is now an index from 0 to 100?  Use it in the same way as above for net position crossover, or use it like an RSI to measure trend exhaustion and the start of a new trend.  30 and 70 could be your signal/confirmation lines, indicating momentum has switched from long to short or vice versa.  Play about with it to come up with your own signal lines, as my suggestions are only that - suggestions.

EUR/USD Futures - COT Index

NB.  To get the index you must change net positions to COT Index as highlghted by the green circle.  Also, the more data you include, the more robust the index will be.  In this case my 2 year view has 100 weeks of data - as highlighted with a green circle.  

To Sum Up

The COT Report is a complement to your overall technical analysis and shouldn't be used on it's own as a trading indicator.  The lagging nature of the report (published weekly) also means that it should really only be used for determining long term sentiment on reversals and trend.  

Technical analysis is not an exact science and although these ideas can increase the probability of making the correct trade, many will go against you and large losses can be incurred. Your own trading strategy needs to be formed and hopefully you'll be on your way to achieving this on completion of this course.

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