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COMMITMENTS
OF TRADERS REPORT: THE 1987 CRASH
by James
West
forever a student of the markets
May 6, 2006
I would highly recommend that you first listen to the Financial Sense
interview with Larry
Williams, a real guru when it comes to the COT (Commitments of
Traders) report, before reading my post.
I
also recommend reading the book mentioned in the interview: Trade
Stocks & Commodities with the Insiders by Larry Williams.
You can find the interview
at this
link:
So
what is this report all about?
The
COT report is published every Friday by the Commodity
Futures Trading Commission (CFTC) that seeks to provide
investors with up-to-date information on futures market operations and
increase the transparency of these complex exchanges. (Investopedia.com)
This report provides valuable information about changes in the position commitments
of various types of investors.
These reports are used
to help determine the likelihood of a trend continuing or coming to
an end. (Investopedia.com)
Who
are these ‘various types of
investors’?
Small
traders: These are the small traders, who control a very small
portion of open interest. Their
actions in the market (buying & selling) are to be ignored.
Large
traders: These are the large speculators who are often characterized
as trend followers in the market. The
large traders are typically funds, who like to jump into an existing
trend but often end up having their largest net-long positions at
market tops and largest net-short positions at market bottoms.
Control roughly 30-40% of open interest.
Net
Long/Short positions: This is a simple calculation that gives us a
better idea if – overall – a group of investors are buying or
selling the market. The
calculation is derived by subtracting the total number of contracts
purchased minus the total number of contracts sold in a set time frame.
If the number is positive, investors in this group are bullish on
the market, and if the number is negative investors in this group are
bearish on the market.
Commercials:
An entity involved in the production, processing,
or merchandising of a commodity. (According to the Commodity
Futures Trading
Commission). Also known as commercial hedgers; these players are users
of the commodity. For
example, if Nestle (a commercial) buys sugar, they actually plan on
taking delivery of the product and using it to make some chocolate bars.
These players know the markets better than anybody because it is
their business, they are seldom wrong, and their actions (buying or
selling) are often responsible for starting new trends in the market
place.
Control roughly 50-60% of open interest.
KNOWLEDGE = POWER
If
you are confused, do not worry, I was too when I started studying the
COT report. It takes a
little bit of time before you start making sense of it all.
Still, the best way to learn - in my personal experience - is to
chart COT data from various time frames and to compare them to market
price charts in the same time frame.
If
you are still totally confused about the COT report, just keep this in
mind:
Yellow line rising (commercial buying) = GOOD* for market
Yellow line declining (commercial selling) = BAD* for market
*GOOD
means market is setup to go up; BAD means market is setup to go down.
But just because the market is setup to rise or decline does not
necessarily mean it will do so the next day, it may take a month or two
or more until the move begins!
Here
we go! The much awaited
crash of 1987
January
to February of 1987
Commercial players (yellow
line) are buyers of this market (S&P 500).
In the month of January their net long position stood at
approximately 17 000 contracts. In
late February the yellow line dips to roughly 10 000 contracts.
So while the market is rallying from January to late February,
and commercials are still buyers of this market, they are less-bullish
on the market in February relative to January.
In other words, selling pressure amongst commercials has been
increasing. This should raise a
caution flag to anyone reading the COT report in early 1987. While the
market is still rallying, and the overall trend is up, it would be
advisable to commit a little less money to the market than usual and
tighten up on your stops; oh and of course, look for the next month’s
COT report release for more clues.
March
of 1987
From 10,000 contracts in February, the commercial net long position
rises to 20,000 contracts by mid-March. Okay,
this is interesting. From
January through March, the S&P 500 index has been in a steady
uptrend. However, it is
very unusual for commercials to be buyers in an uptrend.
Commercials like to buy – relatively speaking – at low
prices, and sell – again, relatively speaking – at high prices.
So here we are in an uptrend and commercials are buyers.
This unusual behavior is considered very positive (bullish) for
the market. The large traders or
trend followers (blue line) are, until now, neutral on the market.
(A bullish sign as well)
April
of 1987
From 20,000 contracts, the commercials drop to a new low in April of
5,000 contracts net long, and then drop even further by the April’s
end to 2,000 contracts net long. For
whatever reason, the commercials were buyers in March relative to
February, but are now sellers in April relative to March.
This indecisiveness on the commercial’s part is a good reason
for investors to stay in cash and for traders to make small bets with
very tight stops. If there is one
silver lining to all of this, it is that large traders are still neutral
on the market. Could the market be
topping here? We will have to wait
for more COT data to find out!
May
to June of 1987
Commercial net long position rebounds from a low of 2,000 in April
to a high of 11,000 in mid-May. And
in June it is still much of the same, commercials are net long 11,000
contracts in early part of that month, but then drop to 4,000 contracts
by June’s end. In fact, if you look at the commercial net longs
(yellow line) thus far from January to May, it is slowly but surely
declining, meaning that in the big picture commercials are getting out
of this market. While at the same
time, the price action on the S&P 500 is going no where.
It is stuck in a slightly bearish trading range.
(2 light-blue parallel lines). And
finally we see some commitment on the part of large traders, notice the
spike in the blue line at the very end of June.
This means that the trend followers are finally waking to the
rising prices in the S&P 500 and they want a piece of the action.
This probably means anymore upside in the S&P 500 is limited.
So is the top finally here? We
will need more COT data to find out, but so far it’s looking rather
bearish.
July
of 1987
Hallelujah! Commercials
net long position rises from 4,000 contracts in June to 15,000 contracts
in mid-July. Wow, wail till
you see what happens next, by the end of July commercials are net long
23,500 contracts in the S&P 500; their largest net long position
thus far in all of 1987. And
look at the large traders; they are selling out of this market!
Not only that, but commercials are buying in an uptrend.
Again, this is unusual action, but is considered very bullish.
For whatever reason, commercials are heavy buyers in the market.
The green check mark represents the pivot point, from a potential
top to a renewed buying interest in the S&P 500.
Make note of the green vertical arrow as well. This is a good
example of what I mean when I say the markets get setup by the
commercials ahead of the move itself.
Even though commercials were buyers in July, it took another
month until you saw in a significant rally in August.
(Yellow arrow) As
soon as a savvy investor saw that spike in commercial buying interest in
the month of July, there is only one thing to do, and nobody screams it
out like Cramer; ‘BUY BUY BUY!’
August
of 1987
Is this market for real? A
new high in commercial net long positions followed just as quickly by a
new low in commercial net long positions?!
As commercials are selling like no tomorrow, the S&P 500 is
hitting all time highs. Also
notice the red down trend-line; if you ignore the July spike in
commercial buying for just a second, the yellow line is trending down
once again confirming that commercials are getting out of this market
and that the spike in buying interest was nothing but a one night stand.
This is critical to understand: if commercials are net long in
July, but then they turn net sellers in August, this is a BIG RED FLAG.
It tells investors to move onto the sidelines and for traders to
get ready to short. But what if
commercials became aggressive buyers in September?
What if they went net long 30,000 contracts??
That would be an even BIGGER GREEN FLAG, telling investors to get
back into the market until the COT report tells you otherwise.
(This was not the case,
however, only a hypothetical scenario).
Is
this finally the top? So
far, it sure looks like one.
September
of 1987
In this month commercials are net long -5,000 from a previous net
long position of -4,000 in the month of August.
(Negative net long simply
means that there are more commercial sellers relative to commercial
buyers). Meanwhile, the large
traders or trend followers are, for the first time in 1987, have a
positive net long position in the market of 500 contracts in
late-September. (This is bearish)
Any sane investor or trader analyzing the COT report should NOT
have been initiating any new long positions in the market from August to
September. Looking to short the
market would be advisable.
October
of 1987
The S&P 500 declines over 29% in 4 short days.
The extent of the decline was unexpected, but the decline itself
was foretold by the COT report. Is
there anyway to foretell a market crash like this one?
There is actually; click below to find out more about the
Hindenburg Omen. http://www.financialsense.com/fsu/editorials/mchugh/2006/0410.html
November
to December of 1987
The market crashed, RUN!!! Or,
look at the COT data instead: hmm, will you look at those commercials!
They are quietly buying into the market when the media is
shouting ‘Armageddon!’
What
happened after 1987?
After the 1987 crash,
which marked a long term bottom in the stock markets, large traders were
sellers (in anticipation of lower price), small traders were sellers
(also anticipating lower prices), and - you guessed it - commercials
were buyers (anticipating higher prices).
In the next year or so (from the start of 1988) the S&P 500
index went up to retrace all of its losses from the 1987 crash and went
on even higher, much higher.
This
happens time and time again, and will continue to occur simply because
of the characteristics and fundamental nature of these players and their
views of the markets.
Next
Week.
. .
We
will look at the COT reports for the broad indexes TODAY, and see if we
can find any clues as to where the market is headed next.
What is even more interesting is that we got a confirmed
Hindenburg Omen in April. (http://www.financialsense.com/fsu/editorials/mchugh/2006/0410.html)
In short, the Hindenburg Omen has pretty much, signaled –ahead
of time - all the big market crashes and significant declines in
history.
Until
then,
Happy trading,
James
1)
Investopedia.com. "Commitments of Traders Report - COT."
http://www.investopedia.com/terms/c/cot.asp.
Investopedia Inc (May 04, 2006).
© 2006
James West
Editorial
Archive
CONTACT
INFORMATION
James West
Toronto, Ontario, Canada
Email: westjam @ gmail.com (Remove the space before and after @ when
sending your email)
The
opinions of FSU contributors do not necessarily reflect those of
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