THE SMART MONEY
When they fail
10
PRicE PROjEcTiONS
With daily pivots and more 20
SWiNG TRADiNG
When is a breakout
really a breakout?
26
FOREX TRADiNG
The basics
32
iNTERViEW
Larry Levin,
futures trading educator 36
THE EQUiTY cURVE
Arbiter of success
42
PRODUcT REViEW
n
thinkorswim Sharing
THE TRADERS’ MAGAZiNE SiNcE 1982
www.
traders.com
NOVEMBER 2014
* Rating based on Barron’s magazine 2014, a hands-on review of each company’s online brokerage products and services by a Barron’s journalist, in several categories, after which numerical scores are assigned per category and aggregated to determine overall numerical score and star rating. Barron’s is a registered trademark of Dow Jones.
IMPORTANT INFORMATION: The Futures Toolkit is designed to demonstrate what we believe are the valuable benefits of using TradeStation. No investment or trading advice, recommendation or strategy regarding any security, group of securities, market segment or market is intended or shall be given. The purpose of any particular trading strategy, technique, method or approach discussed or demonstrated is solely to illustrate how TradeStation may be used, and we are in no way suggesting that it will guarantee profits, an increase in profits or the minimization of losses.
All support, education and training services and materials are for informational purposes and to help customers learn more about how to use the power of TradeStation software and services and to help provide other customer support. No type of trading or investment recommendation, advice or strategy is being made, given or in any manner provided by TradeStation Securities, Inc., TradeStation Forex or their affiliates.
No offer or solicitation to buy or sell securities, securities derivatives, futures products or off-exchange foreign currency (forex) transactions of any kind, or any type of trading or investment advice, recommendation or strategy, is made, given or in any manner endorsed by any TradeStation affiliate. Past performance, whether actual or indicated by historical tests of strategies, is no guarantee of future performance or success. Active trading is generally not appropriate for someone with limited resources, limited investment or trading experience, or low risk tolerance. Please visit our website www.tradestation.com or www.tradestation-international.com for relevant risk disclosures. System access and trade placement and execution may be delayed or fail due to market volatility or volume, quote delays, system and software errors, Internet traffic, outages and other factors. Equities, equities options, and commodity futures products and services are offered by TradeStation Securities, Inc. (Member NYSE, FINRA, NFA and SIPC). Forex products and services are offered by the TradeStation Forex divisions of IBFX, Inc. (Member NFA) and IBFX Australia Pty Ltd, ABN 84 142 210 179, holder of AFSL #363972. ©2014 TradeStation. All rights reserved.
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32 Trading Forex: Understanding The Basics, Part 1
by Imran Mukati
In this first part of a new series on foreign exchange trading, you’ll get an overview of the basics of trading currencies.
35 Q&A
by Don Bright
This professional trader answers a few of your questions.
36 Battling The Futures With Larry Levin
by Jayanthi Gopalakrishnan
Larry Levin is president and founder of Trading Advantage, a firm specializing in trading education. Trading Advantage has made it its mission to teach students to trade online. We spoke with him about what it takes to start trading futures.
41 Futures For You
by Carley Garner
Here’s how the futures market
really works.
42 Slow Down: Equity Curve Ahead
by Robert Cocchiola
The equity curve judges the success or failure of your system. What makes an equity curve good or bad? What does it take to achieve a good equity curve? We’ll take a look.
10 When The Smart Money Fails
by Giorgos E. Siligardos, PhD
The Commitments Of Traders aggregated report is a handy tool for watching the moves of the most significant players in the markets. But what happens when the “smart money” fails? You may be able to gain some insights from the reports. Find out how.
20 Price Projections, Part 5
by Sylvain Vervoort
Here in part 5 of Sylvain Ver-voort’s “Exploring Charting Techniques” series, he looks at techniques such as measured moves, Fibonacci projections & retracements, and daily pivots to estimate future price levels.
25 Explore Your Options
by Tom Gentile
Got a question about options?
26 Swing Trading With Momentum On Your Side
by Ken Calhoun
Seeing a simple breakout may convince you to place a trade, but how do you know if a breakout is really a breakout? Here’s one way you can jump into a trade and not get caught off-guard.
n Cover: David Goldin
n Cover concept: Christine Morrison
Copyright © 2014 Technical Analysis, Inc. All rights reserved. Information in this publication must not be stored or reproduced in any form without written permission from the publisher. Technical Analysis of StockS & commoditieS™ (ISSN 0738-3355) is published monthly with a Bonus Issue in March for $89.99 per year by Technical Analysis, Inc., 4757 California Ave. S.W., Seattle, WA 98116-4499. Periodicals
postage paid at Seattle, WA and at additional mailing offices. Postmaster: Send address changes to Technical Analysis of StockS & commoditieS™ 4757 California Ave. S.W., Seattle, WA 98116-4499 U.S.A. Printed in the U.S.A.
INTERVIEW FEATURE ARTICLE
This article is the basis for Traders’ Tips this month.
TIPS
CONTENTS
NOVEMBER 2014, VOLUME 32 NUMBER 12REVIEW
48 • thinkorswim Sharing
Product review: Social media sharing tools and online community for thinkorswim users
TIPS
DEPARTMENTS
6 Opening Position 8 Letters To S&C 54 Traders’ Tips 57 Advertisers’ Index 57 Editorial Resource Index 59 Classified Advertising 59 Traders’ Resource 61 Trade News & Products 62 Books For Traders 63 Futures Liquidity$$$$$$
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EDITORIAL [email protected]
Editor in Chief Jack K. Hutson Editor Jayanthi Gopalakrishnan Production Manager Karen E. Wasserman Art Director Christine Morrison Graphic Designer Wayne Shaw Staff Writer Dennis D. Peterson Webmaster Han J. Kim
Contributing Editors John Ehlers,
Anthony W. Warren, Ph.D.
Contributing Writers Don Bright, Thomas Bulkowski,
Martin Pring, Barbara Star, Markos Katsanos
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Author i za tion to pho to copy items for inter nal or per sonal use, or the inter nal or per sonal use of spe cific cli ents, is grant-ed by Tech ni cal Anal y sis, Inc. for users reg is tergrant-ed with the Cop y right Clear ance Cen ter (CCC) Transactional Reporting Serv ice, pro vided that the base fee of $1.00 per copy, plus 50¢ per page is paid directly to CCC, 222 Rosewood Drive, Danvers, MA 01923. Online: http://www.copyright.com. For those organ i za tions that have been granted a photocopy license by CCC, a sep a rate sys tem of pay ment has been arranged. The fee code for users of the Transactional Reporting Serv ice is: 0738-3355/2014 $1.00 + 0.50. Sub scrip tions: USA: one year (13 issues) $89.99; Foreign surface mail add $15 per year. Air mail: Europe add $25.50 per year; else where add $39 per year. Sin gle copies of most past issues of the cur rent year are avail a ble pre paid at $8 per copy. Prior years are avail a ble in book format (without ads) or from www.traders.com. USA funds only. Washington state res i dents add sales tax for their locale. VISA, MasterCard, AmEx, and Discover accepted. Subscription orders: 1 800 832-4642 or 1 206 938-0570. Technical Analysis of StockS & commoditieS™,
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ven though traders may convince themselves otherwise, most enter and exit positions based on intuition or emotions. Rarely do they make their trading decisions based purely on objective reasoning. Many people don’t realize that participating in the markets based on intuition is the reason traders or investors get so shattered when the market falls sharply. Not knowing what to do, they freeze and just watch their profits turn into losses, surprised that things can
turn around so quickly. The sad reality is that it’s natural to get drawn to the idea of making profits, so if a stock keeps moving up, you sometimes buy it without giving it much thought.
We forget that the markets are not logical. They thrive because of the irrational nature of our emotions. In fact, if the market was a living being, it would probably get a good dose of daily entertainment observing our actions. The thought of making money gets us excited, but when it comes to thinking of how to protect our capital, we write it off thinking it won’t be necessary. Yet protecting our capital is what will separate us from the average, unsuccessful trader. Only a handful of people give importance to or take pride in protecting capital, which is probably why there are more unsuccessful traders than successful ones.
November 2014 • Volume 32, Number 12
opular media plays a big role in luring people into participating in the markets, since they always hype up bullish markets. As tempted as it may be to get swayed by what you hear, step away from the market chatter and see what is really going on. Invest time in figuring out what variables will help you identify the market internals. Is it volatility, market breadth, money flow, or some other variable? What will make you scratch your head and say to yourself that something is not right? If you look back at the past market crashes, you’ll find that they took place because of some anomaly in the market. Something didn’t sync, and as a result, the markets crashed and took away profits from those who were unprepared. There’s no reason for you to be in that camp.
Before I sign off, I would like to mention that voting in our annual Readers’ Choice Awards poll has begun. Please take a moment to visit our website at Traders.com and vote for your favorite products, services, and articles. The results of this poll, which will be published later in our annual Bonus Issue, can be helpful — who knows, you may discover something new that may just help you figure out how to identify those market anomalies. Happy trading!
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• A smoother indicator for more reli-ability (see some of John Ehlers’ past articles in this magazine as my favorite example); • Calculation periods that are coordi-nated with the primary strategy; and • Robustness, which means an indicator that works over a wide range of time periods and for many markets. Most indicators transition from trend-ing to mean reversion as the calculation periods get shorter. And because we can’t know what calculation period will work in the future, you’ll want to use multiple time periods to give more stable results. Above all, remember: “Loose pants fit everyone.” Perry kaufman [email protected] Thank you for sharing your comments, which are based on several decades of market research and which will no doubt benefit many readers. And thank you, of course, for being one of the original subscribers to this magazine.
Perry Kaufman is the author of several books on market analysis, including the seminal Trading Systems And Methods, now in its fifth edition (Wiley).
Kaufman’s most recent articles in this magazine were “A Better Trend” (April 2014) and “Slope Divergence: Capital-izing On Uncertainty” (June 2014). Our most recent interview with him appeared in our July 2014 issue (“Keeping Abreast With Perry Kaufman”), in which he discusses the evolving markets and the importance of evolving your strategies with them.
Subscribers to S&C can read past S&C articles at our website, www.traders.
com, in the Complete Article Archive area. Readers can also visit the Complete Author Archive at www.traders.com and search for “Kaufman” to help locate his past S&C articles or to look up John Ehlers’ past articles.—Editor
LOOKING AT CYCLES
Editor,
I just wanted to compliment Koos van der Merwe for his September 2014 S&C article, “Looking At Cycles.” No one else gets it right like he does.
mike, New Jersey
Thank you for your feedback.
Readers who enjoy van der Merwe’s work — and appreciate his insights from his 45 years of history in the markets — may also be interested in his posts at our Traders.com Advantage online publication at Traders.com, available to all S&C subscribers (http://technical. traders.com/tradersonline/home.asp).
Past S&C articles by van der Merwe can be found in the Complete Article Archive area of Traders.com.—Editor
BINARY OPTIONS
Editor,
I read Gail Mercer’s Sep-tember 2014 article in S&C, “Binary Options: Scam Or Trading Meth-odology?” with great interest, since I have always been very skeptical about this kind of offering due to the low payout rate. Thus, I was surprised to find a payout table (Figure 6 in the article) suggesting that with a payout rate of 70%, after 500 wins and 500 losses the trader would have netted $3,500. In my mind, the net payout would be $-1,500. If my stake is $10 (as in the example) and the payout rate is 70% ($7.00), I would win $7 on my stake (not $10 plus the $7 payout) which, after 500 wins, would equal $3,500. Taking the 500 losses with a stake of $10 into con-The editors of S&C invite readers to submit their opinions and information on subjects
relating to technical analysis and this magazine. This column is our means of communica-tion with our readers. Is there something you would like to know more (or less) about? Tell us about it. Without a source of new ideas and subjects coming from our readers, this magazine would not exist.
Email your correspondence to [email protected] or address your correspondence to: Editor, StockS & commoditieS, 4757 California Ave. SW, Seattle, WA 98116-4499. All letters become the property of Technical Analysis, Inc. Letter-writers must include their full name and address for verification. Letters may be edited for length or clarity. The opinions expressed in this column do not necessarily represent those of the magazine.—Editor
OPEN NOTE TO READERS
Editor, I’ve been reading TAS&C since its be-ginning [in 1982], but lately I’ve seen a tendency for comments to request and stress specific parameters, especially for indicators. I’d like to share my experi-ence in hopes that it will be meaningful to some of the newer technicians. Please note that these are generalizations. There are always exceptions, but exceptions are not the rule. • An indicator is not a system. Don’t try to make it one. It is a tool to help entry & exit timing. • There are too many requests for “opti-mal parameters” and too many authors showing the “best parameters.” There is no such thing as “the best.” There is only “the best” for one example. •
One or two examples of good per-formance does not make a robust system.
• The more parameters and the more rules, the less chance of future suc-cess.
• Unless you’re looking to capture noise, longer calculation periods improve results while price noise will make shorter patterns unreliable. • Finding the optimal parameters is an exercise in overfitting and ultimately, in losing money. What you do want is: • To use an indicator for timing; • Show that an indicator is “scalable,”
that is, it generates a predictable increase or decrease in signals as the calculation period is made shorter or longer;
L
ETTERS
sideration, which would equal $-5,000, my balance would be $-1,500. To win with this kind of system, you would need a win ratio of 59% (590 trades out of 1,000 x $7 win = $4,130 against 410 trades with a $10 loss = $-4,100; net win = $30). This would be a return of only 3% after 1,000 trades with a negative win probability (41/59).thomaS BleeS
Editor’s note: We also received several
other letters from readers with a similar question.
Author Gail Mercer replies:
On payout, the broker pays the original stake of $10 plus the 70% return. Thus, it’s not $7 * 500 but rather $17 * 500, or $8,500. You need to calculate in the original “bet,” which was $10. When the binaries pay out, they return the original bet ($10) plus the 70% increase ($7) for a total payout of $17 per trade.
The table in Figure 6 is not a profit & loss table. It shows the total net payout. For example, if the trader started with a $1,000 account in binaries, had 500 winners, followed by 500 losers, at the end of 1,000 trades he would have an in-crease of $3,500 in profit (over his initial deposit of $1,000). But if he started with a $5,000 account and had 500 negative trades immediately, he would have blown his account. And if it was just random winnings and losers, then he could potentially still end up with a profit of $3,500 at the end of 1,000 trades. The percentage-based payouts on binaries do not pay commissions.
VOTING UNDERWAY FOR ANNUAL READERS’ CHOICE AWARDS
Editor’s note: Voting is now
open in our annual Readers’ Choice poll on your favorite products and services related to trading and investing. Fill out the ballot at our website to cast your vote in each category, then look for the compiled results in our 2015 Bonus Issue due out in February. Only subscribers to S&C are eligible to vote, so if you’re not subscribing, visit our website at www. traders.com to sign up!
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T
by Giorgos E. Siligardos, PhD
The Commitments Of Traders aggregated report
is a handy tool for watching the moves of the most
significant players in the markets. But what happens
when the “smart money” fails? You may be able to
gain some insights from the reports. Find out how.
he year 2008 was an important year for stock
market analysts, not just because it was one more
crash to study but also because it debunked the
myth of infallibility of some highly regarded market
participants. In this article I will first provide a brief,
yet comprehensive, overview of the Commitments
Of Traders (COT) aggregated report along with its
characteristics and the way most analysts use it. Next
I will discuss the commercials’ failure to anticipate
the crash of 2008 and the lesson to be learned from
their fiasco. Finally, I will provide a short overview of
the disaggregated and Traders In Financial Futures
(TFF) reports introduced a few years ago by the
Com-modity Futures Trading Commission (CFTC).
COT
basiCsEach week, the CFTC, an independent agency created
by the US Congress to regulate the US commodity
futures and option markets, releases the aggregated
COT report to the public from its website, www.cftc.
gov. The report is free of charge for transparency
reasons and contains the collective positions of all
market participants and the major players in various
derivatives markets based on their volume of trades
and predominant role in the marketplace. Since its
inception, the COT report has gone through various
changes, such as the increase in frequency of release,
use of combined futures & options positions, and
introduction of the disaggregated report. However, its
core purpose is always the provision of information
about the sum of long and short positions of the most
influential market participants. This is accomplished
in aggregated reports through the release of the
posi-tions of two major categories: commercial hedgers
and large speculators.
The commercial hedgers (or simply “commercials”)
are the large and influential market participants who are
theoretically not interested in price speculation but use
the derivatives market to hedge their business risk
as-sociated with the underlying instruments. A large wheat
producer and a wholesale commercial consumer are
typical examples of “commercials” in the wheat market.
Both hedge their risk regarding wheat prices.
An oil-producing firm and a transportation company
are examples of “commercials” in the oil market. The
first hedges its risk of descending oil prices whereas
the second exerts hedging to be protected from rising
prices by locking in the delivery of oil at a specific
price. In the stock and bond markets, examples of
commercials are capital market mutual funds,
insur-ance companies, and pension funds offering hybrid
products to their clients. In the currency markets,
examples of commercials are large firms who sell
or buy products internationally.
The large speculators (or “large specs”) are large
market participants who try to profit from the price
fluctuations of the derivatives market. Their
busi-ness is almost always completely unrelated to the
underlying products of the derivatives they trade. A
speculative fund that applies algorithmic trading in
futures & options on the S&P 500 is an example of a large spec. The official name of large specs in the COT report is reportable non-commercials.
The commercials and the large specs are what the CFTC calls reportable categories (since they are required to report their positions to the CFTC). But the COT report also contains information about the total positions of all market participants. Subtracting the positions of commercials and large specs from these totals, the CFTC derives the positions of all those who don’t have the obligation to individually report their posi-tions. These form the COT’s non-reportables category, or the small speculators (“small specs”). As you have probably guessed by now, the small specs include all the small fish or all those who engage in either hedging or pure speculation but are significantly undercapitalized compared to the other two categories. The discrimination between the small specs and the other categories is thus based on their average trading volume. The small specs do not meet the CFTC’s reportable level of trading volume.
It is important to emphasize the following:
n The small specs category contains small hedgers (who use the underlying for their business) and pure specula-tors. Most traders in this category however, are pure small speculators.
n The classification of a market participant for a com-modity depends on his trading volume and his major role in the marketplace for that particular commodity. The CFTC states that it classifies traders by market and not by trading activities. Thus, a market participant may be classified by the CFTC as a commercial in some commodities and as a non-commercial in other commodities. Once a trader is classified as a com-mercial for a commodity, all his activities are reported in the “commercials” category of the COT report for that commodity. For example, if a cotton producer is classified as a commercial for cotton but he engages in some speculative trading in the cotton futures market, his positions will still be presented as commercial activity in the COT report for cotton.
n Most derivative contracts never go to actual delivery of the underlying. Hence, it is profound that the commercials are those who primarily participate in the exercising and delivery procedure, since they are the ones interested in
using the underlying in their off-the-market business. The large specs almost always close their positions before expiration since they are only interested in price speculation. Even though a small part of the small specs category uses the derivatives for hedging their business risk, the participation of small specs in the exercising and delivery processes is negligible compared to that of the commercials.
n The term hedge fund can be a misnomer. Almost all modern hedge funds are unregulated pooled investment vehicles of private equity that engage in high-risk trad-ing strategies on behalf of affluent venturous clients. I therefore deliberately avoid using the term hedge fund in this article to prevent misunderstandings. Instead, I use the term speculative fund.
s
marTanddumbmOneyThe commercials are widely consid-ered to be the most knowledgeable when it comes to the fundamentals of supply or demand in the underly-ing instruments of the derivatives markets. Since the primary motive for their engagement in derivatives is to hedge their business risk, they are considered more unbiased when it comes to evaluation of price exag-gerations. The ideal situation for a large wheat producer, for example, is to know that he can sell his product at a specified price in the near future. The more he believes the prices will fall in the future, the more he is in need of hedging his increased risk. He can do this by either taking a short position in the wheat futures market or by buying puts in the wheat options market. The summative net position of all commercials’ positions in the wheat futures and options uncovers their general perception about the future price for this commodity. Since they are consid-ered the most informed and prudent of all market participants when it comes to the future prospects of their products, that is, they know the information from its source, they have earned the term smart money in the market jargon.
The large specs, on the other hand, are considered less knowledgeable about the fundamentals of the markets than the commercials. Due to the nature of their job, they are only interested in speculation and are more vulnerable in assuming risks and following price trends. They generally do not have the same quality and timing of information as commercials do.
The small specs are considered the uninformed public. Their small financial assets make them much more susceptible to low-quality, lagging information. The speculative part of the small specs category usually assumes reckless risk blinded by eagerness for quick and large profits. Even the hedgers of this category are often the last to know when a trend change is im-minent. Because of this they are granted the nickname dumb money by analysts who study COT reports.
Greed, panic, and the inability
to know future prices should
be assumed even for the
ultra-informed market players.
C
lassiCCOT
analysisIf you plot the individual net positions (longs minus shorts) of commercials, large specs, and small specs as three separate indicators below the chart of the underlying commodity, you can see how the various market participants value the prospects of that particular commodity. The sum of the three values of these indicators is always zero. The three classes of participants in the derivatives markets sell and buy contracts to (and from) each other. These indicators, therefore, slice the zero-sum of all open interest into three numbers, which are the net positions of commercials, large specs, and small specs.
A typical COT analyst watches for extreme values in rela-tion to their past. This is because each indicator has specific idiosyncrasies that may vary from time to time. For example, it is typical for the indicator of commercials in physical com-modities to be negative (see sidebar “Commercials Are Usu-ally Net Sellers”). Hence, it doesn’t help to wait for a positive reading of that indicator to arrive at the conclusion that the smart money bets in a bull market, generally speaking. Some analysts even apply volatility bands around these indicators or construct stochastic-like oscillators to quantify occasions when the COT indicators are relatively high or low with re-spect to their past.
The ideal situation for a trend-reversal signal from a pro-longed bullish market seems to be a relatively low value for the commercials indicator (indicating that the smarts are afraid that the market is prone to decline) and a relatively high value for the small specs indicator (indicating that more and more of the dumb money blindly and emotionally enter the uptrend when the party is about to end). Similarly, if during a prolonged downtrend the commercials indicator is relatively high and the small specs indicator is relatively low, a trend reversal from bearish to bullish is considered to be likely.
Many analysts who study COT reports would also like to see the large specs and small specs indicators following a trend while the commercials indicator goes against it during extreme trending conditions. That would indicate that even
the professional speculators are emotionally positioned at the wrong side, drunk by the ferocity and duration of the trend. That is widely considered a perfect scenario to apply contrary opinion. Note that the indications from the commercials are generally of value for long-term analysis and not short-term. Commercials usually build their hedging positions slowly and don’t focus on being protected by sluggish short-term price swings. As a result, the commercials indicator readings are not timing signals but alerts as to whether the prices have moved too far above or below reality-justified levels.
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THE COMMERCIALS ARE USUALLY NET SELLERS
In most cases (during the history of COT report), the commer-cials have usually been net sellers and consequently, the com-mercials indicators have been negative for significant periods of time. For the physical commodities, this is because a lot of the commercials are producers, which means they are long the underlying. They therefore hedge their risk by taking the short side of the price either via futures or options. Wholesale buyers of the underlying products, who are also considered commercials, may hedge their risk of high prices by going long the price via derivatives. However, since they can usually transfer a portion of the high prices to the end consumers, they are generally not as worried as the producers and are not so aggressive in hedging. But if extreme and sudden shortages are projected, it can send the prices of commodities flying. At those times, the wholesale buyers step in and hedge their risk by going aggressively long the
prices in the derivatives market. This drives up the commercials’ indicator, and when an indicator that is usually negative starts taking high positive values, it tells you something.
Since many of the commercials are conservative investment firms, when it comes to the bond and stock markets, they need to protect their portfolios from depreciation, and this again makes them more willing to take the short side of the prices via derivatives. In the currency markets, there is no general bias for the commercials to be net sellers or buyers.
T
heCrashOf2008
Are the commercials right all the time? The crash of 2008 gives us a case to study. In Figure 1 you can see a chart of the S&P 500 with three subcharts below it. The first subchart shows the commercials indicator, the second shows the large specs indica-tor, and the third shows the small specs indicator. There are also five vertical (enumerated) dotted lines that pinpoint five time instances. You will notice that there is no scaling in the vertical y-axis except the zero lines in the COT indicators. This is done in order to concentrate on the juice of the charts.
The time represented by line 1 near the end of 2007 finds the commercials indicator positive and making a historic multiyear high (not clearly shown in this chart due to the limited time span it covers). At the same time, the large specs indicator was sharply negative, whereas the small specs indicator was in a downtrend albeit in highly volatile fashion. Could it be that the smart money was seeing something that the large specs and the dumb money were unable to see?
A couple of months before the summer of 2008 (line 2), the S&P 500 fell, giving blatant sell signals according to almost all classic technical analysis disciplines. The commercials, on the other hand — albeit more wary than previously — were still
firmly bullish. To their surprise, the S&P 500 fell quickly during the following months and they turned into bears and took their most negative net position near the worst time, that is, close to the reversal point at line 3. The large specs were also completely out of reality near the bottom, as they had a nega-tive net position. Since the commercials and the large specs were largely net short at the bottom, the small specs were largely net long and consequently they had the right position at the right time.
Then, all of a sudden, the behavior of commercials and small specs followed the textbook model I discussed earlier. During the times represented by lines 4 and 5 in particular, their behavior correctly indicated that the setbacks of the S&P 500 were only minor corrections in the context of a long-term uptrend.
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henindOubT,
geTOuTBefore discussing why the smart money fails at times and to put it in a rational frame, I find it worthwhile to elaborate on two concepts. The first has to do with the definition of fail-ure of the commercials, and the second has to do with the importance of filtering your perceptions and analysis tools through the touchstone of technical analysis.
Regarding the first concept, I loosely define “failure” for the commercials as wrong sig-nals generated by the commercials indicator according to the classic guidelines I set forth earlier. For example, when the commercials indicator is unusu-ally high with respect to its past, but in the sequence it declines swiftly and the market falls significantly (see, for example, the behavior of the commercials indicator between lines 1 and 3 in Figure 1), then this constitutes a failure. It is important to clarify this because the commercials are predominantly hedgers. They participate in the derivatives markets to lessen or eliminate the risk they have on their open positions or their opportunity cost in the spot markets. Consequently, failure for them must logically mean an inability to make a good hedge. Later in this article, however, you will see that the commercials engage in soft speculation or they alter their rigid hedging rules at times, and this adds more common-sense meaning to the term failure in relation to their COT indicator.
Regarding the second concept, let me show you how I dealt with the commercials’ failure in 2008. During the last days of 2007, while the stock market seemed to be in the early stages of a correcting phase, I wrote an article titled “What The End Of 2007 Showed” (see “Further reading”), which first went public in January 27, 2008. The purpose of that article was to report the conflicting signals of four non-strictly technical tools I use to gauge the long-term prospects of the stock market: the COT
2005 2006 2007 2008 2009 2010 2011 2012 2013
S&P 500
1 2
3
4
5
Commercials
Large specs
Small specs
FIGURE 1: COT INdICATORS bEFORE ANd AFTER THE CRASH OF 2008. During the times indicated by lines
1, 2, and 3, the commercials indicator was strikingly incorrect, whereas at times 4 and 5, it correctly showed that these setbacks of the S&P 500 were merely temporary pauses in the context of a long-term bullish trend.
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indicators, the insiders’ activity, the sector rotation model, and the cash levels of mutual funds. The first two were severely bullish whereas the others were clearly bearish. Although I couldn’t arrive at a firm answer regarding what to expect for 2008 due to this and other conflicts, and given that there was no firm technical signal for trend reversal at that time — the long-term uptrend had technically ended and the stock market was nondirectional — I stated in the article that I was leaning toward the continuation of the bullish environment after the correction was over. I gave some nontechnical arguments for this, including my strong belief as to the importance of the bullish signal from the commercials. Here’s how my article concluded:
…all the indications require confirmation from the market and this is where technical analysis comes in. During the last months of 2007, the stock market is fluctuating, trying to find a direction and the strong multiyear uptrend that started in 2003 is in serious danger. The technical signals in the broad stock market indices will give the final answers. One thing is for sure, however: This unusual coexistence between extreme readings in the four indicators and its implications should be noted for future reference when similar situations emerge.
A couple of months later, you could see how important these words were with respect to the technical factor in such conflict-ing situations. I wrote one more article that went public in April 20, 2008. The title of the article was “Interest Rates And The Stock Market: The Current State” (see “Further reading”). In that article I first reported the bullish behavior of interest rates at that time along with the steep upward-sloping yield curve that facilitates bull markets in stocks. I then contrasted the bearish technical situation of the S&P 500 index. The market had already fallen from its January levels, triggering sell signals according to any rational technical analysis discipline despite
several non-strictly technical indicators (including the COT report) being still positive. In that article I wrote:
What does technical analysis say about the current situation? My proprietary technical indicators stopped considering the long-term trend of the S&P 500 as bullish in November 2007 and the current trend of the S&P 500 is considered bearish by almost any classic technical analysis tool. In Figure 4 you can see that the S&P 500 is under its 200-day simple moving average and both the horizontal support HL-2 and the upward trendline TL-1 are broken. Also, near the horizontal line HL-1 (a previous resistance), the S&P 500 index created a confirmed reversal formation (double top or head & shoulders, whichever you prefer).
(Note: The Figure 4 that I refer to can be seen as Figure 2 in this article).
Then, in the final paragraphs I concluded:
Undoubtedly, the current state of interest rates sends bullish signs for the stock market via the bond uptrend and the normal steep yield curve, but the final trigger must be given by technical analysis. One should not only look at what the market must do but he must also look at what the markets are doing. The cur-rent stock market status is technically bearish, and “playing” a bearish game from the long side is not appropriate.
I am not comfortable when my technical analysis contradicts my other analysis tools, and my answer when being asked my opinion about the current situation is: “Well, my perception is bullish… but you know, the trend became bearish and I don’t argue with the trend.” In those tough times when you get contradictory signals from your various analysis tools, the minimum you can do is stop trading aggressively and consider significantly reducing your risk exposure using the derivatives market. If the contradictory signals are really strong and you feel uncomfortable then you can always stop trading completely until all things become clear.
S&P 500 (daily)
1700 1650 1600 1550 1500 1450 1400 1350 1300 1250 1200 1150 1100 1050 1000 950 900 850 800 750 98 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 1700 1650 1600 1550 1500 1450 1400 1350 1300 1250 1200 1150 1100 1050 1000 950 900 850 800 750FIGURE 2: TECHNICAL “SELL” SIGNALS IN S&P 500 jUST bEFORE THE STRONGEST PART OF THE CRASH. The technically weak situation of the S&P
The market viciously plummeted a few weeks later. What initially seemed to be a sharp correction in the context of a bull market back then is seen as the highs of a steep waterfall in today’s historical charts.
f
inanCialsvs.
physiCalCOmmOdiTiesLet’s now move into some subtle issues of the COT report by stressing an important difference between the commercials in the financial markets (stocks, bonds, and currencies are what CFTC puts in the financials category) and the commercials in the classic commodities markets. As I mentioned earlier, the commercials are theoretically not interested in price speculation (unlike large specs) but they use the derivatives market to hedge their business risk associated with the underlying instruments. The discrimination between the commercials and large specs is pretty clear when the classic commodities are concerned (like agricultural or mined products), but for the case of financial markets, this discrimination is a bit hazy. This is because doing business in the financial sector (especially in the stock market) is often translated in seeking additional profits from the price movements of the financial instruments.
For example, a large corn producer isn’t really focused on making a profit from the price fluctuations in the corn market. But an actively managed conservative mutual fund that uses fundamental analysis to invest long term in large-cap stocks mostly for their dividends usually expects some additional profits through capital appreciation. The corn producer and the mutual fund can be categorized as commercials — those who need to hedge their risk. The corn producer would prefer the price of corn to be relatively stable, but the mutual fund would prefer some volatility for its stocks so that it could exploit possible cheap opportunities to add to its portfolio. This places the mutual fund closer to — although not exactly — a large spec than the corn producer. This subtle idiosyncrasy of the commercials in the financial markets makes them less unbiased and more prone to assume some kind of extra risk by being less hedged for the sake of additional profits. Undertaking risk is the nature of the financial services business.
Since it is common for some commercials in financials to expect some profit from the price movements of the underlying instruments, they are doomed to employ valuation techniques in order to find times when it is best to be loosely hedged. This adds a guessing factor and of course room for errors. Yes, they are more knowledgeable, more informed, and more prudent than the pure speculators, but they don’t know the future. In fact, they can be wrong at times. Most important, they will possibly be wrong at the worst times, that is, at those times where sudden unforeseen news strikes the markets. This is because the smart money, by definition, foresees the news that can be foreseen; otherwise, it wouldn’t be called “smart.” Now, consider this: What happens when striking news hits the financial markets and the most informed players are positioned on the wrong side? They will have to cut short their losses by altering their hedging positions of course, and since they are big fish (otherwise they wouldn’t be in the COT’s reportable category) they will also be tumultuous on their way out. But perhaps the most important
effect of their sudden change of view is the psychological shock to all those who watch and respect their actions. The feedback loop takes care of the rest.
Note also that the money entering and leaving the stock mar-ket investing funds — even the most conservative ones — is strongly affected by market prices. A mutual fund investing in large S&P 500 stocks, for example, may be forced to liquidate positions in order to satisfy redemptions from frightened inves-tors during a severe bear market. This may alter its hedging needs in S&P futures.
e
venTheCOmmerCialsCanbeemOTiOnalAlthough there is a lot of automatic trading behind the scenes to facilitate and objectify the hedging process, the trading is planned and overseen by humans. Who is to say that even a commercial participant in nonfinancial commodities, who knows the fundamentals of his market well, will not buckle in front of a potential opportunity for big profits and resist in altering his strict hedging rules? For example, in the paper “Why Do Hedgers Trade So Much?” (see “Further reading”), the authors argue that hedgers in wheat, corn, soybeans, and cotton markets frequently change their futures positions over time for reasons unrelated to output fluctuations. This implies a form of speculation. Recall that earlier I stressed that com-mercials in a commodity can at times engage in speculation for that commodity but their trading activity is still reported in the commercials category (since their categorization is based on their predominant trading activity), and you will understand that the scenarios I presented are not pure fiction.
Consider what will happen when these deep-pocket smart types realize that they are positioned on the wrong side of the market and they have also deviated from their strict hedg-ing plan. What will happen to a stock mutual fund or wheat producer (who is typically long in the stock and wheat spot markets, respectively) when they realize that they are softly hedged against price declines at a time when a sudden crash occurs for whatever reason? They’ll panic.
Was greed the reason for the commercials’ unusually high net long position in the S&P 500 near the beginning of the crash of 2008? Or was fear the reason for the commercials’ large net short position near the end of the crash? I don’t know, but what I know is that greed, panic, and inability to know the future prices should be taken for granted even for the most prudent and ultra-informed market players. It must come as no surprise to see the commercials following a trend, especially in markets where the concept of risk-taking is interwoven with the concept of doing business. If all big players were prudent, there would be no bankruptcies for large firms. Later, you will see how the advent and significant presence of swap dealers in the markets made it possible for pure speculative or diversification actions (unrelated to fundamental supply/demand) to sneak into the commercials’ positions.
s
marTdOesnOTmeanneuTralEven if there are commercials who will at times engage in some kind of speculation, most of them are mainly concerned
about hedging their business activities. The amount of hedging they would need to undertake would depend on their views and expectations with respect to the funda-mentals of their business. In other words, even if their motive is benign and they are focused only on hedging their business risk, they may conservatively change their hedging from time to time based on their estimations about their products’ prices. Though the commercials do not base the prosperity of their business on projecting the market price swings, and even if they may not be interested in extra profits from them, they have a projected price — acting more like a fair value — for their com-modity in their mind. When they anticipate deviations from that price, or the market moves away from that price, they tighten or relax their hedging.
Is it a bad thing that the commercials may conservatively accommodate their hedg-ing accordhedg-ing to their perception about the price of their business products? Not necessarily. The commercial hedgers in the derivatives market have, by definition, an opposite position in the spot market. If their business is in physical commodities and they always perform 100% hedging, then the commercials’ indicators will move in sync with the current production or demand levels of these commodities. That is good, but it is the slight deviation from full hedging that conveys some extra piece of information regarding the projected supply & demand from the commercials’ deep knowledge to the COT analyst. Yes, this makes room for errors, but hey, we can’t have it all, can we?
The moral, therefore, is that there is no waterproofing in the markets. The com-mercials are usually right in their view of when the prices of physical commodities or financials are unusually high or low because they know the fundamental infor-mation from its source. However, they can also fail at times because nobody knows the future. When the smart money fails, it means that some serious reason — which is extremely difficult, if not impossible, to be known beforehand — was the cul-prit. Further, since the commercials are the most influential in reputation, don’t be surprised if their failures are of epic proportions due to the cascading effect of feedback loops.
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a
speCialTypeOfhedgerThere is a group of market participants falling into the commercials category of the aggregated COT report whose activity — although clearly hedging in nature — arises from, and conveys actions from, ambiguous incentives. This is the group of swap dealers (SDs). An SD is defined by the CFTC as an entity that deals primarily in swaps for a commodity and uses the futures markets to manage or hedge the risk associated with those swaps. The SDs are over-the-counter (OTC) dealers offering swap agreements tailored to the needs of large firms and institutions. The SDs need to hedge the risk exposure from their positions in those swaps, and when they cannot do it in the OTC markets, they do it in the organized exchanges. In this sense, the SDs act to transport positions from OTC markets to the exchange markets.
Say that a large firm enters a swap agreement with an SD, which implies a long position in oil. The SD is therefore short oil and needs to hedge its risk via either the OTC market or the oil futures market, taking an appropriate long position. As a result, the long position in oil for the firm raised from the OTC swap agreement may finally be transformed into a long position in the oil futures market, and it is reported to the CFTC as the SD’s hedging position. The character of the firm that entered the swap and motives for its actions are unknown and, although in most cases it just tries to satisfy its business needs, it could be an outright speculator. Regardless, this OTC action was transformed in an action categorized as hedging due to the involvement of the SD. As another example, consider a firm that enters a swap just to diversify its risk with no particular interest in the underlying instruments. Any implied position from the swap may finally result in a commercial’s reportable position in the COT report because of the involvement of the SD.
It is apparent that since SDs hedge their positions using the exchange derivatives markets, they must be registered as hedgers in the exchanges. Hence, they must be categorized as a type of commercial. However, their massive trading volume and ambiguous character as potential conveyors of speculative or otherwise non-hedging positions from the OTC markets to the exchanges is what motivated the CFTC to start reporting the so-called disaggregated and TFF reports a few years ago. To avoid misunderstandings, these reports do not contain the commercials designation.
a
neWClassOfrepOrTsIn 2009, the CFTC began publishing a more detailed, or disag-gregated, version of the COT report for physical commodities with four categories of market participants as a way to cope with the SDs’ ambiguous role in the marketplace. In the sidebar “The Disaggregated COT Report,” there is a detailed explanation of this relatively new version of trader categorization. For the sake of transparency in financial instruments, the CFTC started publishing the Traders In Financial Futures (TFF) report in 2010. The TFF redistributes the positions of commercials and large specs in financials into four categories. In the sidebar “The Traders In Financial Futures Report,” you can see a comprehensive overview of the TFF report.
It must be stressed that although the disaggregated COT data for physical commodity markets can be re-aggregated to get back to the three categories of the old type of report (called the Legacy Report), the TFF is not a disaggregation of the legacy report for the financial futures markets, and it is for this reason the CFTC does not use the term disaggregation for the TFF (see sidebar “Re-Aggregating The New COT Data”). The CFTC, as of now, continues to publish the legacy reports along with the disaggregated and TFF ones.
The new reports are a significant improvement in terms of transparency and information. Their history, however, is short and, at present, it is difficult to derive fact-based conclusions about how they could be used to gain additional insight on the market dynamics. The TFF in particular is different from the legacy report of the financials and it should not be uncritically compared to it. The aim of these new reports is to weed out the commercials category from hybrid or ambiguous cases. It will be interesting to see how the new pure commercials will weather future market crashes and booms. For the time being, it is important to keep in mind that the commercials in the legacy report may contain pos-sible speculative positions brought from the OTC world.
h
OWmuChCanTheyfail?
Since the COT indicators are not derived from price or volume, they offer a different view of the market than classic technical analysis does. It is helpful to keep an eye on them for additional information. The COT’s smart money can experience bad times, which is when the statement “when smarts fail, their failure is
THE dISAGGREGATEd COT REPORT
The original aggregated report (now called the Legacy Report) breaks down each Tuesday’s open-interest positions of all major derivatives contracts that have more than 20 traders into com-mercials and large specs, whereas the disaggregated report for the classic commodities markets breaks down the same open interest into the following categories:
• Producer/merchant/processor/user • Swap dealers
• Managed money • Other reportables
The producers/merchants/processors/users (includes the large producers and consumers of the underlying) and the swap deal-ers substitute for the commercials category of the legacy report
whereas the managed money, along with the other reportables, substitutes for the large specs category. The managed money includes participants such as Commodity Trading Advisors, Commodity Pool Operators, and speculative funds (market participants who are engaged in managing and conducting large-scale organized futures trading on behalf of clients), whereas the other reportables include deep-pocket participants who don’t fall into the other categories (for example, affluent individuals who trade their own accounts). Again, the positions of small specs can be indirectly derived by subtracting the posi-tions of the reportable categories from the sum of posiposi-tions of all market participants.The categories of disaggregated report are currently applied to classic commodities futures markets like metals, agricultural products, and livestock as well as for goods like lumber and energy (gas, oil, etc.).
highly likely to be of epic proportions” comes to light. When such an event takes place, small traders have a distinctive ad-vantage over the big players because they can get in and out of the market quickly and efficiently. The small traders can weather the failures of the big players when they happen by filtering the commercials indicator.
It is important to cut both your losses and your risks short. When something doesn’t act the way it should, such as the market ignoring the commercials’ indicator calls, and you start to worry, there’s no point waiting for a loss to appear. It’s time to cut your risk short and get out. In Jack Schwager’s Market Wizards, Michael Marcus said that he was heavily long in soy-beans during the late 1970s. He was expecting the market to be limit-up for the next three days because of extreme soybean shortages and bullish government reports. But on the first day, the market opened limit-up and it then started trading down. Here is how Marcus reacted (in his own words): “I said to myself, ‘Soybeans were supposed to be limit-up for three days and they can’t even hold limit-up the first morning?’ I immediately called my broker and frantically told him to ‘sell, sell, sell!’” Giorgos Siligardos holds a doctorate in mathematics and a Market Maker certificate from the Athens Exchange. He is a financial software developer, coauthor of academic books in finance, frequent contributor to this magazine, and scientific contributor in the Department of Finance and Insurance at the Technological Institute of Crete. Material from his course writings on derivatives has been used in educational enchiridia for bank managers. His academic website is http://www.tem. uoc.gr/~siligard and his current views on the markets can be found at http://market-calchas.blogspot.gr/. He may be reached at [email protected].
f
urTherreadingBraswell, Jason [2005]. “Commitment Of Traders Report: Demystified,” Technical Analysis of StockS & commodi
-dealers) who design and sell various financial assets to clients. The traders in this category could be thought of as commercial producers for the financials since their business is mostly to create financial products and earn commissions from selling them. The other three TFF categories represent the buy side of market participants who predominantly buy what the sell side creates and offers. More precisely, the asset manager/ institutional, who could be thought as commercial consumers for financials, includes large institutional investors and organiza-tions such as mutual and pension funds, insurance companies, and institutional fund managers who are what we think of as large (mostly conservative) investors. The leveraged funds are primarily speculative investment pools that engage in systematic or proprietary aggressive trading on behalf of clients who prefer high-risk investments. The other reportables category includes affluent individuals who trade their own accounts as well as some other market participants who — according to CFTC’s judgment — don’t fall into one of the other categories such as corporate treasuries and credit unions.
THE TRADERS IN FINANCIAL FUTURES REPORT
The Traders In Financial Futures (TFF) report breaks down the open-interest positions of all major derivatives contracts in financial instruments into the following categories:
• Dealer/intermediary • Asset manager/institutional • Leveraged funds
• Other reportables
The main idea behind the TFF report is to divide the financial derivatives market participants into sell and buy sides. The term buy & sell here has nothing to do with the long/short positions these participants might take but rather with their role in the marketplace. It remains to be seen how this division will be of practical use for the COT analysts since, contrary to the legacy report, it separates the (previously considered similar) roles of institutional investment funds from the creators and dealers of financial products.
The dealer/intermediary category represents the sell side and includes market participants (mostly large banks and swap
RE-AGGREGATING THE NEW COT dATA
It is possible to derive the legacy report from the disaggregated one for the physical commodities. The producers/merchants/ processors/users and swap dealers form the commercials category. The managed money and other reportables form the large specs category. For the financials, it is not possible to re-aggregate the TFF report to get back to the legacy report. This is because — as the CFTC points out — participants classified into one of the four categories in the TFF are drawn from either the commercial or noncommercial categories of traders in the legacy report.
tieS, Volume 23: August.
Briese, Stephen [2008]. The Commitments Of Traders Bible: How To Profit From Insider Market Intelligence, Wiley Trading.
_____ [1990]. “Commitments Of Traders As A Sentiment In-dicator,” Technical Analysis of StockS & commoditieS,
Volume 8: May.
Cheng, Ing-Haw, and Wei Xiong [2004]. “Why Do Hedgers Trade So Much?” available online at SSRN, http://ssrn. com/abstract=2353218
CTFC, “Disaggregated Commitments Of Traders Report: Ex-planatory Notes,” http://www.cftc.gov/ucm/groups/ public/@commitmentsoftraders/documents/file/disaggre-gatedcotexplanatorynot.pdf
_____ “Traders In Financial Futures: Explanatory Notes,” http://www.cftc.gov/ucm/groups/public/
@commitmentsoftraders/documents/file/tfmexplanato-rynotes.pdf
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