What Everyone Ought to Know about O.I. and Cot
Reliability studies conducted by the Bullish Review across 36 futures markets from 1983 to 1989 show that extremely long or short positions by hedgers CORRECTLY FORECASTED significant market moves 67% of the time. Furthermore, positioning with the hedgers - when they become one-sided in their view - has proved far more profitable than either riding on the coattails of large speculators or fading small traders. Large Specs were reliable only 46% of the time (might as well just flip a coin,eh?), while small traders, understandably, were only 45% on the right side of a profitable trade. (Source Futures magazine - Bullish Review, March 1994).
It is imperative to start with the basics on Open Interest (OI) and the Commitment of Traders (COT) report in order to accurately delineate the significance and importance of both.
To ensure we are all on the same wave-length, please indulge me to set forth my definitions and premise for this overview of OI and COT. There is no doubt you are extremely knowledgeable in this area, however, I think it in the best interest of good communication to define my terms and their significance as I perceive them. Thus, we will all be on the same page.
Open Interest -
The open interest of a commodity is the number of contracts that remain ( i.e. still outstanding ) to be settled in the futures market. Specifically, open interest is the number of contracts held by buyers or owned by short sellers in a given futures market on a particular day. Open interest equals either a total long or a total short position. This bears repeating. If the open interest is 100, it means there are 100 shorts and 100 longs in the market - therefore, Long OI = Short OI = Total OI.
Commercial Hedgers -
As their name implies, Hedgers use the markets for hedging purposes only. If a hedger is a producer and/or fabricator of a given commodity, he can protect his mining production ( cash ) from falling prices by selling futures. This hedge transaction locks in and gives the producer insurance against adverse price moves. Conversely, the hedger protects against anticipated rising prices by buying futures contracts.
The Hedgers have a distinct advantage in evaluating a commodity price, because it is precisely their business. They work with other producers and users, who can fairly and objectively assess the fundamentals (supply/demand dynamics). The sagacious Hedgers rightfully realize that the majority of large short-term price fluctuations IS PURELY EMOTIONAL. Therefore, he accommodates these moves BY SCALE UP SELLING, OR SCALE DOWN BUYING. In other words the Hedger is SELLING as the commodity price is RISING, and BUYING as the commodity price is falling. The Hedgers do this in anticipation of an important trend reversal. A classic example is the late 1992 to early 1993 gold action. (similar to the current situation!) This action by the hedgers is known in the trade as "fading or averaging." The financially well suited Hedgers can afford this luxury, because they own the cash - and they maintain a long approach. The market views the Hedgers as well informed smart money.
Large Speculators -
The Specs consist primarily of the world's commodity funds. It is very important to realize that these market participants rely heavily on the trend following approach. Trend following involves the use of a mechanical trading system that gauges market momentum. The trend following approach is good in capturing profits during long persistent moves. However, their market approach usually errors ( as history attests ) at important top and bottom reversals. Moreover, the Specs do not do well during periods of price consolidation, because the trend following approach gives indecisive readings - and often result in whiplash loses.
Perhaps the most distinguishing difference between the Hedgers and Specs is the fact that the former is much better informed and is exposed to considerably less risk. The Hedgers have less risk for two reasons. Firstly, they have transferred a great deal of the price risks to the Specs and hapless Small Traders. And secondly, as holders of the cash ( i.e. the commodity itself ) , the Hedgers are not subject to the emotional swings - strain - inherent in any volatile market. On the other hand the Specs typically expose themselves to straight positions - offering incredible leverage, which can bring fabulous profits OR crushing loses. A relatively small price move can force the Specs to liquidate their positions - WHICH FURTHER PROPELS THE MARKET!.
Commitment of Traders Report ( COT ) -
The COT has been compiled by the CFTC since 1982. The report reveals how OI is allocated among three key market groups. OI is simply the total amount of outstanding contracts not yet liquidated. The important market groups include Large Hedgers, Large Speculators and Small Traders.
The COT reveals the net traders positions of Hedgers, Specs and Small Traders. By knowing this information, one can anticipate MAJOR MARKET TURNING POINTS. In addition to the 1992-1993 gold example above, here is another.
The Gulf Crisis of August 1990 to January 1991 sent waves of uncertainty rippling through the stock market. The Specs began selling heavily - and by October were holding a net SHORT position ( LIKE THEY ARE NOW IN GOLD ) . The Hedgers during this time were accommodating the move by scale down buying ( LIKE THEY ARE NOW IN GOLD ) . As conditions worsened in the Middle-East - and a war became inevitable - a tremendous imbalance between the strong hand Hedgers and weak hand Specs developed. When the well advertised war ( day-long coverage by CNBC ) finally arrived, the gold market exploded for one of the largest rallies ever.
OI and COT Not Stand-Lone Indicators -
No one suggests analysis of OI may be construed as a reliable stand-alone tool. Indeed a meaningful predictive value is enhanced only by correlating them with other indicators for corroboration. Nonetheless, for those savvy enough to take note and act upon the knowledge that Commercial Hedgers are presently holding their largest net long position in years, may indeed prove to be a profitable venture.
Statistical evidence shows Hedgers enjoy the best long-term track record in calling future market trends (and subsequent reversals). The Specs category primarily consists of fund managers, who rely heavily on the trend following approach. And the hapless Small Traders are considered the worst traders - who typically allow their fear and/or greed to dictate their short-term trading decisions.
The real key to using the COT indicator - proven over time and with numbers, across many commodity markets - is WATCHING THE COMMERCIAL HEDGERS OPEN INTEREST. A word of caution. It behooves one to be careful not to act too quickly - because the Hedgers are long-term players and have very deep pockets. In this regard, other technical indicators should be employed to corroborate the net LONG building posture of the Commercial Gold Hedgers, because the Hedgers are only right on the money 2/3rds of the time.
Having said that, I wish to point out that numerous of my own technical indicators are indeed in accord with the bullish position of the Hedgers. Moreover, the market legend, Larry Williams, is on record as observing: "Keep in mind a bullish stance on the Commercials is not enough to take action. It is when they are bullish and the public bearish, you will want to buy." Willims' indicator of the public's opinion is measured by the Market Sentiment figures - which currently are registering extreme bearishness. For those youngsters at Gold Forum, Larry Williams gained world-fame a number of years ago when he pyramided $10,000 into $1,100,000 in the futures markets WITHIN ONE YEAR!
Personally, I am net long gold investments… VERY NET LONG, but not on margin. My only leveraged position consists of holding June 2000 GOLD CALLS - hence, my only risk related to the Gold Calls is the amount of the premium and commission paid to acquire them.
Sage Advice from Ecclesiastes
Although my bullish opinion on gold is based upon intermarket and technical analysis, complemented by historical/statistical evaluation, prudence forged by many years of international investment experience forces me to echo the sage biblical and appropriate advice of Ecclesiastes :
"wisdom excelleth folly
as far as light excelleth darkness."
but Ecclesiastes also cautioned
"I returned, and saw under the sun, that the
race is not to the swift, nor the battle to
the strong, neither yet bread to the
wise, nor yet riches to men of
understanding, nor yet favor
to men of skill; but time
to them all."