However, there is a problem, we can not simply rely on the printed CFTC position report to judge, “Hey, it seems that the market is already in an extreme situation.”
Determining the extremes of the market is difficult, because net longs and net shorts are not always related. The extreme level 5 years ago may not be the extreme level this year. So, how should you deal with this problem?
What you want to do is to create an indicator that can help you measure whether the market is at an extreme level. Below we will teach you how to create the index in a few steps.
- Determine the time period you want to cover. The more parameters entered in the index, the less extreme market sentiment signals we get, but the signals are more reliable. The fewer the input parameters, the more extreme signals of market sentiment, but the feasibility of the signal is greatly reduced.
- Calculate the weekly position difference between large speculators and commercial traders.
The formula is as follows:
Position difference = net position of large speculators-net position of commercial traders
Note: If large speculators hold extreme long positions, this may mean that commercial traders hold extreme short positions. Then, the calculated index will be positive.
On the other hand, if large speculators hold extreme short positions, it means that commercial traders hold extreme short positions, and the calculated index is negative.
- Sort the calculated data in ascending order, from the smallest negative value to the largest positive value.
- Assign the largest value to 100 and the smallest value to 0.
Now, we have the CFTC position indicator! This index is very similar to the RSI indicator and the random indicator we talked about in the previous course.
Once we assign each calculated difference, we will be able to discover whether the new data input to the index is in an extreme state, that is, whether it is close to 0 or 100. If the CFTC report shows that the market is in an extreme state, then it can send us an accurate signal that the market is at the top or bottom.
Long and short percentages determine the top and bottom of the market
We already know how to determine extreme sentiment in the market, what should we do next? Once again, not every extreme sentiment in the market means that the market will form a top or bottom, so we need a more accurate indicator. Calculating the percentage of speculative bulls or bears will help us measure whether the market is at the top or bottom.
Through the CFTC position report for the week ending August 22, 2008, we found that there were 28,085 speculative net short contracts as of the week. As of March 20, 2009, there were 23,950 net short contracts. With this information alone, you are likely to say that the market is very likely to form a bottom in August, because we see that there were more speculative short positions at that time.
But wait a moment. It may not be right to draw this conclusion easily, right?
Through further research, we found that the number of short contracts in the week of August 22, 2008 was 66,726, while the number of long contracts was 38,641. Through calculation, we found that the short percentage of the week was 66,726/(38,641+66,726), which is 63.3%.
On the other hand, there were only 8,715 long contracts in the week of March 20, 2009, and short contracts reached 32,665. This means that the short percentage of the week reached 32,655/(8,715+32,665), or 78.9%.
What does this mean? This means that the bottom of the market is more likely to form when the shorts ratio reaches 78.9%, rather than 63.3%.
As shown in the figure, the bottom of the market did not form around August 2008, when the Canadian dollar was generally trading at around 0.9400 against the US dollar. The exchange rate continued to decline in the next few months. Until the week of March 20, 2009, the Canadian dollar short ratio reached 78.9%, and the Canadian dollar bottomed at 0.7700 against the US dollar. Then, what happened? The Canadian dollar is starting to stabilize and pick up. This is the bottom of the market, right?
Market sentiment summary
Are those thousands of trend quotes exciting for you?
Before we trade based on the CFTC report analysis, please keep in mind that this situation is only when the report shows a perfect reversal signal in the market.
It is best to find out why the reversal may occur.
Is the economy booming?
Or is the economy in the middle of a recession?
Remember, the CFTC position report measures the market sentiment of traders over a specific period of time. Like any other tool in your trading toolbox, using CFTC reports as a trading indicator does not always show a market reversal. Therefore, please take a moment to study the report in order to form your own judgment on the report information, which data is helpful for your transaction, and which is useless.
At the same time, before we finish this lesson, please always remember that market prices are not only driven by CFTC reports, stochastic indicators, Fibonacci, etc.
The market is driven by countless people responding to a series of factors such as economic analysis, fundamental reports, and political events.
to sum up:
· As a trader, judgment of market sentiment is one of our jobs;
· One of the ways to measure extreme sentiment in the market is the CFTC position report;
· Through the understanding of the activities of the three major types of traders (commercial traders, non-commercial traders, retail traders), we can choose the appropriate entry point at the top or bottom of the market;
· Remember that every occurrence of the top or bottom of the market is accompanied by extreme sentiment in the market, but not all extreme sentiment in the market means the formation of the top or bottom of the market.