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How We Use COT Data

December 19, 2021

From the desk of Steven Strazza @Sstrazza and Ian Culley @Ianculley

We study a wide variety of sentiment data as we incorporate many different indicators into our day-to-day analysis.

In its simplest form, sentiment tells us how certain market participants or investors feel about the market.

Are investors feeling bullish and increasing their exposure to risk?

Or, are investors feeling fearful and positioning defensively?

More often than not, these are contrarian indicators that work best when at extremes.

One of our favorite sets of sentiment data comes from a weekly report published by the Commodity Futures Trading Commission. It is called the Commitment Of Traders, or COT report, and it simply outlines how various participants are positioned in futures markets.

We get lots of questions regarding how we analyze the COT report, so let’s talk about two of the main ways we find value in this information.

1. Look for momentum divergences to confirm an unwind in positioning

The analysis of COT positioning should consider both sentiment and momentum.

Stacking COT positioning with a momentum indicator, like RSI, gives us two studies that provide similar information but with very different inputs. 

This allows us to look for confirmation or the lack thereof between our momentum and positioning indicators. 

When positioning gets stretched, look for a two- or three-peak divergence in momentum for signs of a potential top or exhaustion.

This is where the weekly chart of Gold comes into play as a great example:

Below price, we have a 14-period RSI as our momentum indicator and traditional COT data reporting net positioning (large speculators in black, commercial hedgers in red, and small speculators in grey).

In February '20, large specs. recorded their largest long position in history. We can think of positioning or sentiment as being "stretched" at those levels after sixteen months of increases in long exposure.

Six months later, in early August, gold hit new all-time highs accompanied by a two-peak divergence in momentum and a large spec positioning that had already begun to roll over.

These were clear signs that momentum and sentiment were entering a corrective phase after a period of expansion. As it turns out, this was also an excellent indication that price was entering a corrective phase. Gold has been trending lower ever since as momentum and speculative positioning have cooled off.

Using these two different forms of sentiment and momentum indicators -- one derived from price (RSI) and the other gathered from positioning (COT), can be very helpful in identifying levels of exhaustion in ongoing trends.

And that brings us to our next point...

2. This data is most valuable at extremes

Since COT data is a measure of positioning and therefore sentiment, we’re only interested in extreme readings. The vast majority of the time positioning falls somewhere in no man’s land and is of little-to-no use in our analysis. That’s why we focus on 3-year and historical extremes. We compare the current positioning to these extremes in the COT table we publish each week.

A great example of the value in these stretched readings can be seen in the commercial positioning for Gold in the summer of 2016 and the fall of 2018.

In 2016 commercial hedgers piled on the shorts and reached their largest net short position in history (up to that point). At the same time, price peaked as it ran into a logical level of overhead supply.

Like we mentioned earlier, these extreme conditions can mark exhaustion in the trend. When we see extreme readings occur at a logical level for prices to stop and reverse, we want to pay extra close attention. This was the case in 2016.

It’s when the commercials hedgers begin to unwind their position that price begins to follow. That’s exactly what we saw in 2016 when gold futures began to trend lower as commercials reduced their shorts.

Also, notice how the commercial hedgers are considered the “smart money” here. When positioning is at extremes we want to trade in the same direction as the commercials, and the opposite of the speculators.

Understanding stretched positioning as a potential inflection point gives us an edge in anticipating the future direction of prices.

Conversely, we can take the same approach when commercials hold an unusually large long position. The fall of 2018 was a great time to look for a near-term bottom in gold as commercial hedgers held their largest net long position since 2001.

As commercials began to lighten their long positions soon after, gold kicked off a major rally that took us back to new all-time highs last summer. 

The bottom line is that when we see extreme readings in positioning, we want to start looking at price and momentum to confirm a reversal in the direction of the trend.

Our COT Heatmap is published each week in our commodities column, which our members can access here.

Please reach out to us with any questions!

Allstarcharts Team