As a retail trader, your orders will hardly have any influence on the overall market prices. However, when large investors such as commercial traders or professional traders place their orders, they will likely define where prices are heading. Therefore, it’s of extreme importance to find what these large traders are doing and to be on their side. In this article, we intend to explain how you can spot what the big players are doing, i.e., tracking the “smart money”, and take advantage of their actions.
What is the “Smart Money”?
So, what exactly is the “Smart money”? It’s the name we use to describe professional and large traders with a big amount of capital. In this category, we may find both institutional investors, investment banks and hedge/mutual funds. Not all funds can be considered professional since some of them lack the expertise or the size to truly impact markets. Besides, small funds usually do not have enough capital to place orders capable of influencing prices.
Besides being the traders with the largest amount of capital, these are also the traders with access to more information and knowledge about the markets. Note that both hedge funds and investment banks have huge teams of researchers continuously analyzing the market. They also spend large sums to have access to the latest news before the rest of the market. As such, the odds are that professional traders will spot some opportunities faster than the “average trader”. This is why it’s extremely important to know what they are doing. Due to the size of the organized actions of these traders, they are usually behind biggest price movements. Therefore, knowing what they are doing should be one of the first objectives of any trader.
Tracking the Smart Money
The most direct and efficient method to understand when these players act in simply by looking at a price-volume chart. Due to the large size of their orders, these traders are not able to hide their actions. There is a myth that says that because of dark pools, they are able to hide their actions. Some institutional traders do use dark pools, but they can only hide their orders during execution, which can be a matter of milliseconds. After the order is executed, there’s no way to hide it, as exchanges (and consequently Forex liquidity providers) will report it in the volume.
1- Interpret the direction of their trading
You’ll need to look at prices and volumes to know this. Our article about volume trading explains some ways to observe this. The important thing here is to see where there is a general and organized action, and various funds are buying or selling a currency consistently. You can see this in lower timeframes, like 1 minute, as well as in daily/weekly timeframes.
There are many supply/demand patterns, which our VSA indicator shows, and one of the most prominent SUPPLY ones is a wide range bar, closing on the lows, with volume above the average. The demand ones close on the highs instead. Even though these are wide range bars, many times the prices will continue trending, as you can see in the chart below.
General buying/selling pressure leading fast price movements
Buying pressure marked by high volumes that move prices upwards.
2- Take a look at fundamentals
In long-term trading (daily timeframe and above), good fundamentals make it more likely for big traders to have an interest in a given currency. Traders should be aware when talking about “fundamentals” given that some economic measures like the GDP growth or the interest rate hikes, although important, are not a leading indicator. We frequently see these variables changing only after price corrections in the value of the currency. Traders are better off by looking to the increase of the spread of the interest rates or the movement of a related commodity. These variables are usually a good proxy for the fundamentals that drive currencies and often are leading indicators. In the image below, for instance, we can see how correlated are the AUD with the price of Gold. If the price of gold increases, large traders know that this will benefit the AUD and start buying the currency.
AUD/USD – Gold (Source: Bloomberg)
3- Sentiment
“Listen to what the market is saying about others, not what others are saying about the market.”
-Richard Wyckoff
- Sentiment indicators such as COT report and SSI index will give you secondary information. Although it has its usefulness, COT report shows the actions of ALL large traders, even the ones that aren’t so good. Traders should, therefore, pay special attention to their analysis, because the report may have some lag in what comes to be a market turn. Traders should use the COT report mainly as a confirmation, or as a search mechanism for extreme values between large investors and hedgers. The image below presents some examples when the large spread was linked with a market turn
COT report
- On the other hand, the SSI shows the actions of small retail traders, which are usually wrong and in the opposite direction of smart money. In this indicator, look for historically high % of long positions to look for a short, and vice-versa for long positions. You can combine both information to be more confident about the right direction you should trade.
SSI Index
Conclusion
If you aren’t using volumes in your analysis, you are missing a big part of the picture. By showing the market’s activity, volume together with prices shows what the big traders are doing. Only these traders are capable of placing orders large enough, and in an organized manner, to sustain market trends, so you should look closely at what they are doing. By tracking the smart money, you can follow their actions and be on the right side of the price movement.
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COT Report (Commitment of Traders Report) is one of the most relevant pieces of information when it comes to understanding the role that volume plays in Forex. It is published by the Commodity Futures Trading Commission and released every Friday, around 2.30 pm EST. But why do so many people speak about the COT report? In order to understand this general question we need to address four issues in this guide: why is it relevant, where to find it, how to understand the COT report and, finally, whether or not a trading strategy is possible with information extracted from the report. Let’s start with the first question.
Why is the COT Report so Relevant?
When we are trading any financial instrument some of us tend to be concerned with the role that volume plays in driving price. But how can I have a better understanding of this issue?
If in markets such as stocks the volume can easily be identified by everybody, in other markets such as Forex there is no day-to-day indication of the volume that is affecting the market. One way to understand this is, therefore, by looking at the COT report.
Forex transactions are normally made over-the-counter. And this essentially means that they are done on a daily basis and without the formal registration in one big aggregator of data such as the Chicago Mercantile Exchange of the real players and real investments involved. Without the collection of this information, it becomes almost impossible to accurately understand where the volume in the market is.
What the COT report allows is, therefore, for an understanding of this question. And this is so because its main purpose is to register what happens in futures markets. These types of markets are ones where traders need to keep their positions open for more than one day – so it becomes inevitable that entities that regulate this market understand what is affecting price volatility and who is affecting price volatility.
By having to keep their positions open for more than one day, traders in these futures markets allow us to understand where volume is.
Where to Find and Terminology: the Commitment of Traders Report Explained
There are two ways to find the COT: the traditional way and the modern one. Let’s start with the first one.
The official report can easily be found in CFTC website through this link.
Once the document is downloaded – look for Currency Legacy Report / Chicago Mercantile Exchange – Futures Only / Short Format – don’t be scared with the information. Just search for the particular instrument you want to look at and that’s it.
Commitment of Traders Report in CFTC
More relevant is to decipher some important terminology in this report. Let’s do it here then:
Commercial – These are big businesses that use the futures market to hedge against some other investment.
Non-commercial – Mixture of retail, hedge funds and financial institutions that play the game not to hedge but to win.
Short – Number of positions open that are selling futures contracts
Long – Number of positions opens that are buying futures contracts
Open interest – These are orders that were not yet executed
But even though we would recommend you to go through this traditional route so you understand all the terminology used and get a better grasp of what really constitutes the COT report, there is another way that you can use.
A simple indicator can be used to understand how the COT report is affecting different currencies. This indicator can be accessed on Finviz.
COT Report Finviz
What is showed here are different currencies and the weight each type of trader has in these different currencies.
How to Read the COT Report?
Once we understand key terminology it’s time to address probably the most important section of this article: how can I read the information contained in the COT report? The report gives us important information about three main players that represent three main market positions.
Hedgers or Commercial Players – These are all those that aim to protect their positions in futures markets because they want to hedge against some investment made in another financial instrument. Their interest is not to make money but to hedge a particular position.
These are contrarian traders and the reason for that has to do with their own self-interest – for example, since they want to hedge a particular long position in a particular financial instrument, they understand really well when things can turn. Commercial players or hedgers are therefore bullish at market tops and bearish at market bottoms.
Large Investors. These are the traders you want to be following. They are the sharks of trading, and trade to make money on speculation. They also tend to add to their positions along the way – and this reinforces the powerful effect of the trend.
Small Investors – These are all those hedge funds or retail traders that own small trading accounts. The most relevant information about small investors is that they tend to be on the wrong side of the market.
They normally buy when the market is at the top of the trend, and sell when the market has no more room to go to the downside.
Is a Trading Strategy based on the COT Report Possible?
Can we use the Commitment of Traders Report for a trading strategy? Previously we have discussed three important questions regarding the Commitment of Trader’s report: why is it relevant, where to find it and how to understand the COT report and finally what is its main message for us as traders. The last important topic to address is the link between the COT report and trading strategies: can it be used as a tool to trade?
Like so many other indicators, the Commitment of Traders Report can, in fact, be used as a tool to trade if we fully understand – and read correctly – where volumes of the market are and where the different positions of the different types of investors that characterize this report are.
Having understood that this report allows us to identify three main types of traders –hedgers, large and small investors – we can use it in our trading in two particular occasions:
Reversals (Type One) – When the spread between commercial hedgers and large investors is big, then we should expect a market reversal.
This can easily be explained by understanding that large investors are normally accumulating their positions around key reversal points. When this happens this in and off itself is a sign of a potential reversal. If the spread between the Large Investors and Hedgers is high, and it reaches a peak, then it means that we are in a tipping point towards a potential reversal that we can catch in its infancy.
Large Traders and Hedgers Spread in COT Report
Reversal (Type Two) – A subtle trading strategy looks at the importance of large traders in determining where the market will go next. When large traders start to reverse their positions (i.e. the large investors line’s trend starts reversing), we can expect a market reversal most of the times.
COT Report Large Traders Trend
Finally, what can we expect from this indicator? While it’s very useful to spot trends reversals, the COT report does not provide a holy grail to trading. First, this information is more relevant for long-term trades; second, it needs to be complemented by other information and knowledge of other forces that move the market.
If you want to further understand how to correctly identify these forces and to correctly understand market sentiment keep following our comments in the blog, or look at our indicators and take advantage of successful trading strategies.
