Trading with the commercials

Successful futures trading is about stacking the odds in your favor. In addition to deciphering fundamental data and implementing seasonal patterns to identify supply and demand imbalances and recurring periods of strength and weakness, traders also employ a host of technical indicators and programs to fine-tune trade entries. 

Retail traders, especially, find themselves at a tremendous disadvantage in their attempts to obtain and assimilate this multitude of information into a cohesive trading strategy. Conversely, commercial traders — as tracked by the weekly Commitments of Traders (COT) report — possess the resources necessary to compile all this information into actionable responses to current market behavior, as well as expectations of future market behavior. 

The Commodity Futures Trading Commission (CFTC) publishes the COT on a weekly basis. The report has been around in various forms for more than 30 years and is one of the primary analytical tools publicized by traders such as Larry Williams and Steve Briese, the editor of Bullish Review. The report tracks the buying and selling of different types of traders, including small speculators, large speculators, and the aforementioned commercial trader category. 

The primary screening process for the following trading approach is based on the behavior of commercial traders.

Trading practicalities
Small traders run into three major obstacles when attempting to trade using the COT report. First, many small traders simply don’t have the account size necessary to trade a properly diversified portfolio of commodities using weekly data. Weekly swing points, channels, and trends — combined with the highly leveraged and volatile nature of the futures markets — will simply place too much of an account at risk. For example, a survey of markets, using one market from all the different futures market sectors (and including a S&P 500 E-Mini contract), showed the value of the average weekly range was approximately $1,350 per market at December 2011 volatility levels. Using this data as a starting point and a typical trend-following exit of two-thirds of the three-week average range to signify a statistically valid reversal, the average value at risk would be approximately $2,680 per market. A trader diversified into four futures markets with low correlation would have more than $10,000 at risk.

Second, very few small traders can stomach market swings on the weekly time frame. Using the previous example as a starting point and the same volatility threshold for statistical significance, it is a reasonable assumption the dollar value of the account could regularly sustain swings of more than $10,000 without justifying any portfolio modifications. Even assuming a large retail trader maintains an account balance of $50,000, this puts 20 percent of the account at risk in any given week. 

The third issue concerns recapitalization and the holding time of trades, which obviously increases dramatically on a trend-following basis. Markets can meander for months, providing no significant net gain or loss, tying up capital that could be employed in trades with a shorter time horizon. It’s imperative for small traders to employ their capital as efficiently as possible, and this means not wasting time in markets that aren’t providing immediate positive returns. Frequent recapitalization is one of the keys of proper money management and leverage modification.

The purpose of this study is to apply COT report data on a daily time frame to generate more trading signals with smaller initial risk, while maintaining a high degree of accuracy. (The studies and charts were created using Pinnacle Data, Moore Research seasonal data, NeuroShell, and TradeStation software.)