Trading against the 90% that lose - copied fr Pivotfarm

We often hear figures about the 90% (or even more) that lose money on a consist basis. It’s a ‘fact’ often quoted by gurus and a common belief held by traders. The question for professional traders then becomes how do we benefit from this landslide of people on the wrong side of a trade?

Although an often discussed subject, how we actually use the ‘90% lose’ fact is not often approached. In this article we will discuss 2 freely available pieces of data that with the right analysis and interpretation can provide savvy traders with a great edge to trade against the 90% that lose.

COT Index

The Commitment of Traders Data is created by the CFTC – The Commodity Futures Trading Commission and is published weekly every Friday. This body gathers and publishes the open futures positions on all publicly traded US futures contracts as well as the corresponding options.

The data consists of 3 main categories.

Commercial Traders – These are the bigger players in the markets, the smart money and consist of large firms that actually use the commodity being traded, includes companies like…BP in the Oil and Gas Market, Nestle in the Cocoa and Sugar market. The main function of these traders is to hedge the price of the commodity that they trade in.

Large Speculators – These consist primarily of commodity fund traders and are mainly trend following. The position sizes of these traders tends to be in tandem with the movement of price.

Small Speculators – The little guys, individual traders and small firms, these are the traders that tend to be wrong in the market at the tops and bottoms of markets.

COT data is often misused and misunderstood, in its raw form the COT information describes the number of contracts long/short held by these groups. For example the Large traders component may have 56,000 contracts long S&p 500 emini and 23,000 contracts short. The net position would thus be +33,000 long. Many traders use the net number itself, we feel that this does not provide enough information. +33,000 sounds bullish, but the key is where is this number relative to the historical average of each commodity group.

This is where the COT Index comes into play, the construction of the COT Index is nothing more than putting this weeks net position into a format that will tell you where the current number is in relation to past numbers over the last 6 months. The point is, if the net position is the highest it has been over the 6 month period then the COT Index is 100 and if it is the lowest, then it is 0. Any variation between the two will constitute its respective relation to the historical average.

How do we use this data? We believe that the COT Index offers a good indication of market sentiment and future direction. The key is to follow the smart money (Commercial) and trade against the other 2 groups when they are at an extreme.

Extremes in the data are figures below 30.00 and above 70.00. The ideal situation for a short position is a low reading in the Commercial COT and high readings in the Large and Small trader numbers. For example the Commercial COT Index reads 5.97, this means that the net commercial position is strongly biased to the short side. The Large and Retail (our main contrarian focus) are reading 97.70 and 100.00 respectively, meaning they are the most long side biased they have been in the last 6 months. For traders this means that their focus should be on short side trades, the goal is to follow the commercial traders. This is the ideal alignment of the the groups for optimum success.

This scenario has been present in the EURUSD for the last 2 weeks. So we are expecting some continued short side bias in that pair

Remember this is longer term view so more swing oriented, however the swing view is also important for day traders when trying to line up the higher probability “trend” following trades.

Retail Traders Position Summary

Also known as the Long-Short ratio this is a tool primarily offered by Forex firms, we haven’t been able to come across the same data in the futures as yet. The data is based upon the collective trades and trading direction of many thousands of retail traders (the average Joe). This group of traders is notoriously wrong at predicting market direction, market tops and bottoms with some simple analysis we can look at this data and take a contrarian view, for example if over 70% of retail traders are long USDJPY this offers us a short bias. Savvy traders should then be focusing there energies on short side trades.

It is the 24th of August 2010 today over the 2 months over 70% of retail traders have been positioned on the long side of USDJPY the currency has had a sustained decline in that time, with a major breach of support today.