How to trade a commodity using Commitment of Traders (COT) indicator?

Updated: Dec 7, 2019

Weekly Technical Summary for WTI Crude Oil 24th Sept 2019:

- Commercial hedgers increasing short position on Nymex traded Crude Oil Futures as indicated by COT

- If this progresses further, we will see a rise in Commodity price.

Crude Oil Extraction From Sea

Last weekend (14th Sept) saw a historic event in the Oil industry with deadliest drone attacks on two major Oil Facilities of Saudi Arabia, destroying nearly 50 % of nation's global supply of crude oil. This is estimated to cause a reduction of 5.7 millions of barrels every day of #Oil supply by Saudi Arabia, which is almost 5% of the global oil supply. Saudi Arabia ranks 2nd in the world's top oil producing nations. Now the dynamics are obviously going change. Although Saudi Aramco, the owner of these Oil plants believes that it can get back the facilities in order by end of Sept (this doesn't sound realistic given the magnitude of disruption). With the Supply - Demand dynamics changing we will see a different behavior in the Oil price.

Based on the technical analysis (WTI Oil analysis) we earlier observed price chart for Nymex traded WTI Oil futures, consolidating in a converging cone, suggesting a lag of some time when the price would oscillate to the converging cone mean, before deciding on the further direction, mostly towards north.

Crude Oil jumped / gapped up by $9 up to $61 pb on market open on Monday the 16th Sept, because of the uncertainty and the after-shock of the weekend event. Past entire week the prices have settled around the just prior highs seen around mid-July 2019 around $58 pb. No surprise there on sudden increase of trading volumes last week.

How to trade a commodity using the Commitment of Trader (COT) indicator?

In COT indicator, the Red line represents net open interest of future contracts held by those traders who either receive or deliver physical commodity, for e.g. Oil producers. The Green line represents net open interest held by large commercial brokerages, market-makers and fund managers, so large speculators who do not take or give delivery of the physical commodity. Even players like large Airlines buy Oil contracts to protect themselves from future price shocks. They do not take delivery of crude oil but its refined product i.e. petroleum. These trades also contribute towards the Green line moves.

Red line below zero indicates that hedgers have a net short position on future contracts. Logically thinking - oil producers future contracts to lock future price and protect themselves from price shocks.

Speculators pay attention to hedgers and buy the contracts shorted by hedgers.

The net-net position has to be zero (world's total short positions should equal world's total long positions).

The way to use COT indicator is as follows:

- Commodity Hedgers lead the global commodity transaction. These are people who are buying short positions of commodity futures. Basically they are fixing a specific price for a time period in near / mid-term future so that they can carry on with their production process for delivery. This provides a huge certainty for how much they are going to sell their produce for, at the end of futures maturity. This further helps in planning expenses, which matter hugely for traders who produce and sell Oil (given gigantic production costs)

- Institutional / Industrial traders are following on to this: what quantities of the commodity would be available in future at what price. To secure their demand / requirement of the commodity, these traders will buy long positions for future time frame.

- Thus the net-net short and long positions always zeroes out.

- So, as the hedgers increase their short positions we see gradual increase in Oil price, as indicated by the Green arrows, while as the hedgers reduce their short positions we see gradual decrease in Oil price, as indicated by the Purple arrows (in above weekly price chart). Its generally more indicative to study weekly commodity futures charts to make sense of the trading behaviors.

- Applying the above logic: last week, we saw that the COT lines have started diverging, indicating hedgers are securing short positions, thereby suggesting a leading increase in Oil price to follow.

We believe now that the price is stabilized after the sudden single day spike seen earlier, Crude Oil price will start increasing from the current level. A stable price point around $60 per barrel could further push this price point higher up-to $65 per barrel during the later part of 2019.

For prior weekly analysis on Crude Oil:

US WTI Crude Oil Technical Analysis – 14-Sept-2019