Makeup Of Euro Currency Market

Includes: FXE
by: Chris Ridder, CFA

Today the euro made a 21-month low and traders/investors are curious as to how to position themselves, and what their competitors are doing. However, large institutions dominate foreign exchange (FX) trading, and the traders there get to see the flow of orders coming in and can take notice of which way clients are leaning. Are the weak hands buying? Is the smart money selling out? Since this market is primarily traded over the counter most of this information is available to only a privileged few.

But, there is still a small sliver of the financial markets where a snapshot of how various players are positioned is revealed. The information is released each Friday by the CFTC in its "Commitment of Traders" (COT) report. The data represents positions as of the previous Tuesday. The publicly traded FX futures market is much smaller than the over the counter FX market but information about what actors are doing, with a delay in timing, is available. The following is a table of the actors reported:

CFTC Description Dealer Asset Mgr Lev Money Non Report
Trader Vernacular Banks Asset Managers Hedge Funds Small Speculators

The CFTC reports how much in each category is long, short or spreading in the futures market. For my analysis I took the net percentage reported. I find this more meaningful than saying, "X is net long 10,000 contracts," since the open interest of futures contracts changes over time. As an example, if dealers were 25% long and 10% short, then I would report the net being at + 15%. Here is a chart showing how the various players positioned themselves over the last six years, through May 15, 2012.

One can see that dealers are very much net long. However, dealers (banks) also trade the cash OTC FX market and will arbitrage the cash and futures markets. So even though they are net long, there is the possibility of them being net short the cash market and having a neutral position. Here is how dealers have acted over time vs the FXE (euro etf).

Over the last several months the net long position for dealers in the futures markets has not worked, and the same for net short position in 2006 and 2007. Most likely the dealers/banks are hedged and not losing money, except for JP Morgan Chase (NYSE:JPM).

The report also includes asset managers and their collective view on the market.

Over the last two months their outlook has turned negative on the euro.

Next up, is the category of levered money, i.e. hedge funds.

One can see that over the years this "group" has very much been on the correct side of the market. It has been net short since July of 2011. It appears wise to trade along side of these funds.

Finally, we come to those traders so small that their positions don't need to be reported (but the aggregate of open interest is).

One can see that the "small speculators" have been net bearish since 2011 too. I have noticed in the past that when this category gets a market call "right" in other markets, it typically leads to a very large move. This is because the normally correct "smart" money is on the wrong side and now has to reverse positions.

Such a thing happens when the fundamentals of a market change quickly, as in the case of coffee futures in 1994. A freeze occurred and the long small "specs" were very much on the right side of the market, much to the surprise of the normally, "correct" commercials.

Now this is possibly occurring in a much larger market. A potential dramatic change in the political stability and financial integrity of Europe exists. One can look at another article, "Euro Bulls Hope Fed Research Is Only For Shampoo", I wrote to see potential downside targets in the euro, if such a fundamental shift tremors through the euro currency market.

Disclosure: I am long FXE options