Using a Trader’s Engagement Report to Trade Stock Indices

This has been a tumultuous week in equity markets, as news events and political leverage have sent the markets of China and Greece down more than 5% and 11%, respectively. Here in the US, Wednesday’s stock tried to mimic global markets, but was met with solid supply in the S&P 500 and Dow Jones industrials around Thanksgiving lows. Meanwhile, the Russell 2000 found support near the critical 1150 level that has underpinned it since late October. We posted a short review on Equities.com earlier in the week in which we project expected weakness in equity markets due to the change in position of traders over the past two weeks. This has led many to wonder exactly how we use these reports to forecast trading opportunities in the commodity markets. We will use this week’s article to explain our approach in detail within the context of today’s equity markets.

The discretionary part of the COT Signals counseling service is typically described as a three-step process. First of all, we only trade according to the impulse of commercial traders. We have long believed, three generations worth, that no one knows commodity markets like those whose livelihood is based on proper forecasting of their respective markets. This includes real commodity producers such as farmers, miners, and drillers, along with professional equity portfolio managers who use stock index futures to hedge and leverage their cash portfolios. Tracking the net position of traders provides quantitative evidence of the actions of hedgers both long and short within an individual market. The importance of your net position lies in the collective wisdom of this business group. Your combined access to the best information and models is summed up in your class actions. The final part of the trading equation is tracking your position momentum. Your eagerness to buy or sell at a certain price level is just as important as your net position. We only operate in the direction of business momentum.

The second step in this process is how we translate the weekly commitment of traders data into a day-to-day trading method. Commercial merchants have two main advantages over the retail merchant. First, they have much deeper pockets and have the ability to make or receive the underlying commodity as needed. Second, they have a much longer time horizon. Think about the entire growing season or your fiscal year quarter to quarter. Therefore, we have to find a way to minimize risk and preserve our capital. We do this by using a proprietary short-term momentum indicator on daily data. The setup involves finding markets that are momentarily at odds with the momentum of commercial operators. If the trading momentum is bearish, we are expecting our indicator to return an overbought situation in the short term. On the contrary, if traders are bullish, we wait for a market to oversold in the short term. The short-term momentum indicator is labeled on the second chart.

Once we have a short-term overbought or oversold condition opposite the trade momentum, an active setup is created. The trigger is pulled when the short-term market momentum indicator recedes through the overbought / oversold threshold. Waiting for the reversal provides two key elements for a successful trade. First of all, it keeps us out of the runaway markets. Markets are prone to bouts of irrationality that catch even the most seasoned commercial traders off guard. News events, weather issues, and government reports can wreak unexpected havoc. Waiting for the reversal also provides us with the swing high or low that is necessary to determine the protective stop point that will be used to protect the position. Everywhere there is a circle, red or blue, there was a trading opportunity in the S&P 500 this year. Within each circle, the highest or lowest value was the protection stop point. It is imperative to know the protective stop before carrying out any operation. This allows the trader to determine the appropriate number of contracts to trade in relation to the capital of his portfolio. Risk is always the number of concern for the success of the negotiation. Currently, the protective stop levels are 17,980 on the Dow, 1189 on the Russell 2000, and 2079 on the S&P 500.

Today the Dow, S&P 500, and Russell 2000 all contain this same set of circumstances. Given the high valuations, the speed of the recent rally and recent global economic events, it seems prudent to expect a retreat from these highs. Clearly, that’s what commercial traders, who were the TOP buyers at October lows, believe is about to happen. We will heed their collective wisdom as they have successfully called every major move in the stock market for 2014.

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