The COT report can be analyzed in the same way that traditional technical indicators analyze price and time. In other words, we can apply filters to the report in order to understand not just whether traders are net long or short, but whether they are becoming more or less bullish and bearish. That shift in investor sentiment can help predict the "flip" and can even be used to trigger a trade entry or exit.
The chart below shows the COT report graph for the AUD/USD. You can see the flip from net long to net short on 9/19/2008. That is not much of a surprise considering price action at the time. You can see what was happening on the price chart below. The black line in the COT chart shows whether traders were net long or short, but the red line further analyzes this data to show the rate of change in that net short bias.
The AUD/USD COT Report Graph
Weekly Chart of AUD/USD Covering the Same Period as the COT Chart Above
As you can see above, traders are net short but have been trending more towards bullishness than bearishness based on the red line which measures the rate of change of that sentiment. With this information, we can assume that the underlying trend is down (based on the black line) but a flip could occur in the near term (based on the up-trending red line.) Building trading systems around this information or using it to define your own bias is relatively simple. Here are two example uses for this information:
1. Building a simple system from this information is relatively easy. For example, assume that you bought the currency pair every time the red sentiment line crossed above the midpoint of the graph and reversed and shorted the currency pair when the sentiment line crossed below the midpoint or neutral level of the graph. That is a simple example, but could be quite effective when combined with a diversification strategy and appropriate risk management. In today's video, we will illustrate a system like that and what kind of returns it has delivered in the past.
2. Both the sentiment line (red) and the net long/short line (black) are important trend indicators. Short-term traders may use the sentiment line to define what kind of trades they are looking for (long or short) based on the direction or trend of the red line. Longer-term traders may only select trades that conform to the net long or short position of the black line. These can be an easy way to define investor sentiment and to understand the strength (or weakness) of the underlying trend.
The video in today's article was a live presentation given by Wade Hansen in 2008. Wade developed the COT report graph including the calculations behind its sentiment line. He has tested the system in the live market and on past data and will share some of his findings in the presentation. The COT report is released each week after the markets close on Friday.
Click here to watch the video now.
Additional articles from this series:
Part one can be found here.
Part two can be found here.
By S. Wade Hansen of PFXGlobal.com and LearningMarkets.com
