While the COT Report is not an exact timing indicator, it can aid in forex trading and provide a context for the current, and future, market environment. There are potentially many ways to use the COT Report for analyzing a forex pair; here are three COT Report forex strategies.
Speculators are Trend Followers
Speculators drive trends. Contrary to popular the convention "Don't follow the crowd," we actually want to follow the crowd...at least for a time. If others are buying, we want to be buying too. This is how trends occur, and how traders make money. The trick is to get out before everyone starts heading for the exit.
Therefore, use the interest of speculators as a confirmation tool for trends. If the Euro is moving higher and speculators are increasing their long position this means big traders are pushing the market in your favor if you are long the EURUSD. Trade with the big boys, and follow the trend. Don't get too greedy though, because if all the speculators are long, then there is no one left to keep pushing the trend. This brings us to the next way to use the COT data.
Extreme Levels Can Indicate a Reversal
When speculators are accumulating a position it can be a confirmation that there is interest in the trend - if shorts are being accumulated as the price drops or if long positions are being accumulated as the price rises this can be a good sign the trend will continue. But speculators have a limit--they can't purchase or sell indefinitely. They may run out of money, or simply wish to take profit (or losses). When speculators are tapped out, want out or don't want to invest anymore there is nowhere left for the price to go, but to reverse.
Therefore, the COT data can be used as a type of "overbought/oversold" indicator. Not in terms of price and arbitrary levels like most overbought and oversold indicators, but in terms of the health of traders within the market. Each futures market will be a bit different but critical levels will often repeat and indicate when speculators are overextended.
This method is not recommended for a top or bottom picking strategy; it can be used to provide a context for other analysis and be used to confirm reversals in price though. Extreme levels can look easy to isolate in hindsight, but are not ideal timing indicators. That said, it is very useful for alerting traders when a reversal could be nearby. The COT data should not be acted on alone though; wait for price to confirm a potential reversal signal in the COT data.
Watch For Speculators to Flip Their Position
With the third approach we are looking to capture "the meat" of the trend. If speculators are net short and that short position continually decreases until eventually it crosses above zero, a new trend is quite possibly underway.
The movement from net short to net long or vice versa signals a change in sentiment and that a new trend is emerging or has already begun. Using the logic of our first method of following the speculator trend (when it aligns with price) this shift represents a potential trading opportunity. Exiting positions can be done when the price breaks the trends, when speculation reaches extreme levels or when speculative demand begins to wane. Again, the COT data should always be combined with price analysis, and not acted on in isolation.
COT Report Forex Strategies- Conclusion
The COT report is useful in at least three ways for forex trading. None are precise entry and exit signals but rather provide a context for other analysis and can be used as a confirmation tool for reversals or trends. The first uses COT data as a confirmation tool for forex trends. The second method alerts us when speculators are over-extended, which could in turn lead to a reversal. The third method can be used to see shifts in sentiment and potentially catch a chunk of the trend (but remember to watch for over-extension). When using any indicator, wait for price to confirm the indicator signal.
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