COT Reports – How to Interpret Them

Breakdown of COT Reports

Commercial Traders

Commercial traders are entities directly involved in the production, processing, or merchandising of a commodity. In the FX market, these traders are typically corporations and institutions engaged in hedging activities to mitigate adverse currency volatility. For example, a UK-based company exporting goods to the US may hedge against the risk of a depreciating GBP by taking positions in GBP/USD futures.

Non-Commercial Traders

Non-commercial traders, or speculators, include individual traders, hedge funds, and other financial institutions trading primarily for profit rather than hedging. These traders dominate the FX market, contributing to the bulk of trading volume.

The Role of Corporate Transactions in the Global FX Market

Despite the significant role of corporations in the FX market, their transactions account for a small percentage of overall market volume. The majority of trading activities are speculative, driven by non-commercial traders. Thus, non-commercial net positions in the COT report provide significant insights into market sentiment and trader positioning.

Using the COT Report for Hedging Opportunities

Analysing the Net Figure

The net figure can be used for understanding market sentiment. Peaks and troughs in net positions can signal potential market trend shifts. For example, a peak in non-commercial net positions might indicate limited room for further buying, suggesting a potential downturn in the currency pair. Each net figure in the COT report corresponds to the number of futures contracts. In the case of the GBP/USD currency pair, each futures contract is worth GBP £62,500. When you overlay the non-commercial net figure against a currency pair like GBP/USD, you can observe that whenever the net figure reaches around 50k contracts or more, it generally, but not always, indicates that the exchange rate has reached a near-term peak, followed by a reversion to the mean. You can see an example in the chart below with GBP/USD on the left-hand side and the non-commercial net on the right-hand side.

Practical Application for Hedging and Conversion

COT reports are a great tool in the toolkit of market analysis. They should never be used alone and should always be combined with other indicators and a general quantitative and qualitative assessment of the exchange rate you are exposed to. Here are some ways you can practically use the COT report for hedging your corporate foreign exchange exposure.

Identify Extremes in Non-Commercial Positions

Peaks in non-commercial net positions suggest speculative traders are overly bullish, indicating a possible downwards reversion to the mean. Troughs suggest excessive bearish sentiment, indicating a potential upwards reversion to the mean. For example, if the COT report shows a peak in the net figure for GBP/USD, it could be a signal for UK-based importers to consider buying forward US Dollars as the exchange rate may become unfavourable in the short term.

Monitor Commercial Positions

Although the commercial aspect is smaller and holds less weight because corporates generally aren’t trying to speculate—they just want to hedge their currency exposure for doing business—the net figure can be more random. It’s still good to be aware of how corporates feel about the future of the economy. A lot of hedging activity can point to uncertainty about the future, whereas less hedging might indicate less uncertainty.