The Market sentiment is the dominant market opinion. It can be bullish or bearish, being reflected in the participants’ orders. In other words, the market sentiment reflects if the most important participants consider whether that the price will rise and open Buy orders (the market is Bullish) or that the price will decrease and initiate Sells (the market is Bearish).

In the Capital Market and Futures Contracts Market an important indicator of market sentiment is the trade volume.
For example, when a stock’s price is rising, but its trading volume is falling, this could signal an overbought market and the end of the ascending trend. On the other hand, when a stock’s price is falling, but its trading volume is rising, this could signal an oversold market and thus the end of the descending trend.

Forex Market is not a centralized market therefore we don’t have direct data on traded volumes. However, there is an auxiliary tool we can use in this respect – the Commitment of Traders Report, issued by CFTC every Friday.
When determining the market sentiment, the number of trades has no significance. You should pay attention to net trading volume – opening trade volume without considering the spread or commission.

Therefore, COT reflects the trading volumes by three participant categories:

1. Hedging funds and hedgers
2. Large speculators
3. Small speculators / retail traders

1. Hedgers trade to protect themselves from sudden price changes. This group also includes farmers who want to be sheltered by purchased or sold goods’ sudden price changes, as well as banks and large corporations.

Let's assume that they want to buy products/services and they must pay back with a currency whose price is rising. Basically, they will pay more in the future for what they want. In this case, they conclude (link) futures contracts. If the currency appreciates, they will offset the increased goods’ price by the futures contract selling price (their profit). If the currency depreciates the surplus saved on goods’ purchase, will offset the loss recorded under the futures contract.

2. Large Speculators

They trade at high volumes therefore they may influence the price evolution. This category also includes hedging funds, but this time not for preventive purposes but to obtain speculation profits.
As a rule, this category trades within the trend and closely watches the evolution of Moving Averages.

3. Small Speculators

This category compresses the individual investors who carry small accounts (compared to the other participants) and the hedging funds. They usually concentrate on the reversal points, aiming to take advantage of a new trend from its very beginning.


Deciphering the COT report

The COT report is available at: http://www.cftc.gov/MarketReports/CommitmentsofTraders/index.htm

  - Market Data & Analysis - Undertaking Commitments of Traders - Current Legacy Reports - Short Format - Chicago Mercantile Exchange - Only Futures.
 

In order to understand this report, we must explain each of its components:

•  Commercial: Hedging funds.
•  Non-commercials: Large and small speculators
•  Long: the number of Buy orders, declared at CFTC
•  Short: the number of Sell orders, declared at CFTC
•  Open interest: the number of unfulfilled contracts.
•  Reportable positions: the number of options and futures to be declared at CFTC.
•  Non-reportable positions: the number of options and futures which don’t need not be declared at CFTC.

The information above allows us to identify the market sentiment for a week, so the report is considered to be useful for longer-term trades.
As a rule, the major position of speculators signals the general price trend, as the major position of the hedgers signals potential reversals.
If non-speculators step up their purchases while speculators sell intensely, this could mark a new low extreme point.
If non-speculators sell intensely while speculators buy, this could mark a new extreme high point.

So, while speculators are ultimately taking advantage of the general trend, the participants in the first category are having advantage of reversals.

Note that every High or Low is associated with an extreme market sentiment, but not any extreme market sentiment will be followed by an extreme point.

In any case, trading based on the COT report data is only recommended in conjunction with other confirmation signs.

The maximum efficiency of sentiment analysis is given by its correlation with technical and fundamental analyses.


Using the COT report as a reversal signal

Although this report signals potential reversals, we cannot know for sure when they will actually occur. We can use the report data to create our own indicator for this purpose:

•  keep a record of the ratio between the large speculators’ net trading volumes, on the one hand, and of the non-speculators’, on the other hand, for each week within the chosen period.

If you want to identify only the relevant signals you should consider a longer period. (There will be less but more conclusive signals).

Let’s assume that you want to analyse the trading volumes within 3 months.

• calculate the difference between the net volume of large speculation trades and the net volume of non-speculative trades for each of the 12 weeks.

If the first category buys at large volumes and the second one sells at high volumes, the difference will be positive, and vice versa.

• arrange these values on a 0-100 scale (0 for the lowest value and 100 for the highest one). Now you have a scale like an indicator’s scale. When the price touches one of these two levels this could be a potential reversal point.

We have stated that not every extreme market sentiment is marked by a new extreme price level. Thus, a more eloquent signal of their occurrence could be the percentage of speculative positions.

% Speculative Buy orders = No. of Buy contracts / (No. of Buy contracts + No. of Sell contracts)

% Speculative Sell orders = No. of Sell contracts / (No. of Buy contracts + No. of Sell contracts)