Tuesday, June 12, 2007

Commitment of Traders Analysis

Who’s on for the rally ride?

In today’s information driven society there never seems to be a dearth of data to rummage through and analyze. Because of regulations and the internet, much of the data is public and can be found by using some simple search methods. In the financial world, analysis is key in making decisions on certain stocks, sectors or industries. One report that has been readily available since 1962 is the Commitment of Traders (COT) report.

First published by the Commodity Futures Trading Commission (CFTC) in 1962, the report provides investors with up-to-date information on futures market positions and operations. Simply put, they were looking to provide better transparency in a market that was misunderstood at the time (some may argue that the futures market is still somewhat vague). The original report consisted of 13 agricultural products that traded in the futures market, but has since expanded to include most futures contracts.

The COT report tracks the trading activity each week of three distinct groups of traders; small traders, large speculators and commercial hedgers. Small traders are defined by trading fewer contracts than the CFTC requires you to report. The S&P 500 futures contract reporting level was changed from 300 contracts to 600 contracts in 1997 and remains at that level today. A large speculator is defined as trading a number of contracts in the required reporting level (greater than 600 contracts). The last group is the commercial hedger who is defined as a corporation which takes a position in a particular commodity for business reasons (i.e. hedging the price of corn for a corn farmer). The individual reports can sometimes be hard to understand, but there are services out there to simplify them for the individual or business. Schaeffer’s Investment Research has done a nice job in disseminating the information into a free and easy to understand charting tool that is free (http://www.schaeffersresearch.com/). After playing around with the COT charting tool, I noticed a few things that you might want to consider in your own analysis of the current market environment.

Let’s take a look at the five year chart below of the S&P 500 index and the related COT report of the small trader’s “net positions”. The red line is the price movement of the S&P 500 index while the blue line tracks the net positions of the COT report on a weekly basis. A negative net positions number indicates that the commodity is short during the selected time-frame while a positive net positions number indicates that the commodity is long.

Notice that while the S&P (red) has continued to move higher since bottoming out in 2003, the small traders have continued to lighten up on their long positions noted by the decrease in net positions. So if the small traders are continuing to lighten up on their long positions (especially right after Feb. 27th), how is the market continuing to pressure new highs each week?
That brings us to the next five year chart, seen below, which depicts the “net positions” of large speculators. Notice that, for the most part, large speculators had a negative net position for much of 2003 and 2004, but have since ramped up the buying efforts and helped propel this market where it is today; all-time highs. This five year chart also shows something that piques my interest. Notice anything?

This next chart overlays the COT report for large speculators and the S&P 500 over the past 12 months. Remember in the first chart what happened after the 4% drop on February 27th? That’s right; the small traders decreased their net positions. In complete contrast, the “smart money” or large speculators bought in on this dip most likely due to a perception that the move was overdone and it was a good buying opportunity. They were absolutely correct as the index has moved approximately 10% from the lows in February. Also make note that these same large speculators were decreasing their net positions leading up to the February 27th sell off. Another smart move.

Now take another look. It is fairly obvious that the increase in net positions didn’t last long and continues to decrease as many analysts, researchers and traders have noted the markets increasing potential for a major correction at what is being considered an above average length bull market and overbought conditionsAre the large speculators and the small traders finally on the same page? According to these COT charts, the answer is yes. But that does not necessarily translate into being correct as the market continues to move higher. They seem to not be participating in what would seem to be an obvious bullish market. I am not the only one out there looking for a pullback in the next few weeks, so take the COT reports (http://www.cftc.gov/) into consideration the next time you are looking for where other traders are putting their money.

Sources: CFTC, Schaeffers Investment Research

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