Using the COT to Buy Gold
02/22/2013 7:00 am EST
No matter how much we read, or how much news we digest, individual traders can’t be plugged into a specific market like people who earn their livelihood by knowing that market well, says Andy Waldock of Commodity & Derivative Advisors, so he advocates using the COT report to gain insights into the market.
The 2013 rally in the metals markets appears to have run its course. The metal markets are now flushing the weak traders out of their positions and, at least for the gold futures and copper futures market, setting up a new bottom to create a summer rally. In the past, we’ve discussed the rotation of money flow through the metal markets. There are four primary US metal markets and the rotation between them hinges on expectations of inflation versus industrial production.
The chain from most industrial to most speculative is as follows; copper, silver, platinum, and gold. This is based on the percentage of the metal used, rather than by weight. Otherwise, silver would far surpass platinum. Investor sentiment for all four metal markets can be tracked through the Commitment of Traders (COT) report published each week by the Commodity Futures Trading Commission. This report tracks the amount of investment among the three primary market participants, commercial traders, index traders, and small speculators.
Categorizing the markets’ participants and measuring their degree of participation within any market is a primary forecasting tool. We use this in the trading world to track the imbalance of positions between the smart money and the dumb money. Our research quantifiably defines the smart money as the commercial trader category in the COT reports. Index trader participation is neutral so that leaves the dumb money as the small speculator.
Don’t take this personally. Commercial traders have access to the best information, algorithms, and intellects. This may include direct physical observation of the markets in question and it certainly includes the research and analysis of a team of highly trained specialists who focus solely on the market they make. We, as small traders, are at an immediate disadvantage simply due to our commodity trading taking a back seat to our day jobs, families, and other obligations that prevent us from putting 40+ hours per week into any single market.
Our trading focus is on the size of the imbalance between commercial traders and small speculators. Commercial traders are, “negative feedback traders.” They have a sense of value for the market they’re trading and the farther away the market gets from their predetermined value area, the larger their position grows. They buy more as their market becomes increasingly undervalued and they sell more as their market becomes increasingly overvalued.
NEXT PAGE: A Few Trade Ideas
Market turning points occur when the commercial traders’ fundamental sense of value kicks in and the market begins moving back towards the expected value area. The forecasting value lies in tracking this imbalance and preparing for the market’s turn. This is part of what we were discussing five weeks ago in, Not Quite Time for Gold to Shine. We wrote, “The absence of an expected rally in the gold market through the last few weeks leads me to believe that the internals simply don’t support these price levels, yet. Therefore, the market will continue to seek a price low enough to attract new buyers beyond the commercial traders’ value area. Typically, this would lead to a washout of some sort that may force the gold market to test its 2012 lows around $1,540 per ounce before finding a bottom.”
The metals markets as a whole have declined over the last three weeks. Silver has been hit the hardest, currently down more than 12%. Copper has held up the best, down 5.2% and gold and platinum are somewhere in the middle.
Commercial traders are net bullish in both gold and copper. Commercial traders have been net buyers in the copper market for four out of the last five weeks and net buyers in gold for each of the last three weeks. Both of these markets are providing us with exactly the type of setup we look for. Commercial traders are net bullish on the weekly charts while small speculators have cracked the market just enough to create an oversold situation on the daily data.
Our quantitative research shows that we can buy in once the gold market begins to turn higher as long as we place a protective stop loss order at whatever this low turns out to be. This defines the risk so we know how many contracts we can trade. We know we have a 65% chance of being profitable and an average profit of $3,865 vs. an average loss of $1,958. The exceptional aspect of this trade is that we’ll only hold the position for five days. This is about how long the market will take to bounce and define a new value area.
The numbers in the copper market are even more impressive. The same setup applies. Our risk will be to the low of this move and we won’t enter a long position until the market starts to head higher. Our analysis shows that we should win about 75% of the time and our wins are once again more than twice our average loss. Finally, we won’t hold the trade for more than five days.
Trading in line with the commercial traders and using the small speculators to compress our risk allows us to trade with commercial effectiveness on a small speculator budget and timeframe.
By Andy Waldock, Founder, Commodity & Derivative Advisors