When NOT to Fade Retail Traders

By Brad Zigler

Every Friday, a dedicated brotherhood of traders and analysts eagerly await the afternoon release of the Commodity Futures Trading Commission's Commitment of Traders report. The reports reveal clues about the buying and selling behavior of three groups of futures traders: the commercials (otherwise known as "hedgers") and the noncommercials ("speculators" in everyday lingo).

Oh, I hear you. You're saying, "Wait a minute. That's only two categories. Where's the third?"

Well, it's actually a subset of the noncommercial class. You see, there are "large" speculators, and then there are "small" ones. You're deemed "large" if you're required (or rather, your broker is required) to report your positions daily to the CFTC. Reporting levels vary from commodity to commodity, and positions can be amassed above the reportable level, just as long as they don't grow beyond the commodity's speculative position limit (if one exists). Sit tight with that notion for a minute, while we deal with the "small" traders.

If you're trading onesies or twosies, you're in the "nonreportable" category. It's not that the CFTC doesn't know you're there; it's just that you're an afterthought, really. The regulator first notes all the reportable positions - hedgers and speculators alike - and compares that total to a commodity's open interest. The difference represents the nonreportable positions held by small speculators.

Analysts looking for market sentiment clues and potential turning points keep track of the size and directionality of traders' positions, even though the data in the report isn't real time. The COT report, published on Friday, reflects traders' commitments as of the previous Tuesday, so you're at least three business days behind when you get the report. Still, the COT report can be very useful in identifying shifts and trends.

When you think about the players in the futures market, you're likely to think that commercial traders - hedgers - have market insights that would enable them to predict price movements better than the small traders. To check this, let's look at the crude oil market over the past three years:

Commercial Net Short Positions - NYMEX Crude Oil

Although they're constantly net short, hedgers lightened their positions almost in lockstep with the 2007-2008 run-up in oil prices. In other words, they found higher prices a less compelling hedge environment.

Compare that with large speculators (made of mostly commodity funds). These accounts were most heavily long-weighted a full year before oil's peak. In fact, the funds began selling while oil was still climbing:

Large Speculator Positions - NYMEX Crude Oil

But small speculators-where were they?

As a rule, retail traders don't stray too far from a net flat position. So for much of the oil market's crescendo and denouement last year, small specs were net short, exhibiting a prescience (albeit a bit premature) not usually credited to these much-maligned investors.

Small Speculator Positions - NYMEX Crude Oil

To their further credit, small speculators have increased their oil bullishness since the market bottom last winter. In fact, a new net long high of 21,637 was registered in mid-June, when oil topped $70.

But since then, all that retail bullishness has evaporated. As of the last COT report, small speculators held a net long position of only 112 contracts. That's the tiniest position since October 2007, when a net short position of 54 contracts was tallied. Since 2006, in fact, small speculators have stalled half a dozen times. And in all cases, oil prices were higher the week after. The average subsequent gain was 3.6%.

Now, a lot of professional traders talk of "fading" the small investor trend, or of taking the opposite tack as the "uninformed public." It seems, however, that whenever small investors stop dead in their tracks, that's been a good time to buy oil.

Will the retail track record hold up? Check back on Friday.

Comments

[john s. gordon:]

nice report.
> jack

Aug 28 10:53 AM

[untrusting ...:]

Interesting article, however would bet that oil falls below $70 before and if it does go above $75 .. regardless of what your stats show.

Aug 29 04:36 PM