18 January 2006 • CURRENCY TRADER

V olume data and analysis is commonplace inthe equity market — several popular techni-cal indicators depend on the easy availabili-ty of volume — but in the spot forex market,

volume numbers are a proprietary secret of the banks andbrokers executing the trades.

The business is, literally, private. When a fund or multi-national corporation has a big trade to do, such as $2 billionin a day (or over two or three days), they tell their banks notto move the market as they execute the orders. So, even

when you see a big price move, you never know whether ithad “real money” behind it, meaning it was an authenticcommercial transaction such as a foreign acquisition or anew stock or bond position, or if it was a speculative moveby a hedge fund.

Volume confirms or denies price action. When a stock is

rallying, you want to see volume rising, too. When pricesare going up but volume is falling, you may questionwhether the move has legs.

Stock traders have access to volume data in real-timethroughout the trading day. In the futures market, true vol-ume data typically isn’t available until a day later — e.g.,you get Friday’s currency futures trading volume onMonday. Before then, what you see is something called“tick volume,” which is not the actual number of contractstraded, and can be misleading.

A “tick” is the smallest price fluctuation that can be trad-ed — e.g., 0.0001 for the euro futures. When the eurochanges from 1.1850 to 1.1851, it has moved one tick. Tickvolume reflects the number of ticks the market has movedover a given time interval — say, every five-minute bar.

The price can move one tick regardless of whether there

THE BIG PICTURE

Volume:The ultimate guide to sentiment

Not knowing “real” volume in the spot forex market is a challenge for currency traders.

Tick volume and futures “commitment of traders” data can help you gauge market sentiment.

BY BARBARA ROCKEFELLER

Even when you see a big price move, you never know whether it had

“real money” behind it, meaning it was an authentic commercial transaction

such as a foreign acquisition or a new stock or bond position, or if it was

a speculative move by a hedge fund.

CURRENCY TRADER • January 2006 19

was one or 100 contracts behind the move. (You can check“time and sales” to verify trade size, but that is a laboriousprocess.) As a result, when you chart tick volume, you getthe appearance of correspondence or correlation — i.e., aprice peak is usually accompanied by a peak in tick volume.

Although it’s not true volume data, it can still be useful.For example, on Nov. 23, 2005 (the day beforeThanksgiving), the Euro spiked over 50 points — nearlyhalf its average daily range — with no accompanying boostin tick volume during those hours (Figure 1). You couldhave used this information to imagine the price move was ablow-out top lacking the support of many buyers, andtherefore was something to be avoided on the long side oreven exploited on the short side.

Notice the tick volumein the bottom window hasnot been updated for thenext bar (the Friday afterThanksgiving) — thatinformation would comethe following Monday,although a live data serv-ice (like eSignal) displaystick volume all day. Thecircled price bar is theday before Thanksgiving.Four of the five previousbars had higher highs,and they all had higherlows, connected by the uptrendline.

Now look in the bottomwindow. The first and sec-ond days of the new upmove had rising volume,but after that, volume fellor at least failed to matchthat of the highest volumeday. On the fatefulWednesday, volume wasactually significantlylower — despite the eurohaving made a new pricehigh. Even though it wasa (short) day ahead of a virtual four-day holiday in the U.S.,a divergence between price and volume can be a dandyindicator in its own right. Sure enough, on the Friday afterThanksgiving, the euro failed to make a new high andclosed at its low. The close also violated the minor supportline, although at the time it was not clear if this was signifi-cant.

The COT report: The open interest storyForex traders spend a lot of time deducing market senti-

ment from the price reaction to various news releases andeconomic developments: When dollar-favorable newscomes out but the dollar fails to rise, is the tone turningagainst the dollar or it is just a “sell on the news” phenom-enon? Analyzing the news can be complicated and it’salways time-consuming. What we are really seeking is agrip on the supply-demand dynamics — and volume, inconjunction with price data, is the single best indicator ofsupply and demand.

As noted, tick data is not true volume data, although itcan be useful. The real volume data is reflected in theCommitment of Traders Report from theCommodity Futures Trading Commission (located atwww.cftc.gov/cftc/cftccotreports.htm), which totals all the

open trade positions among different classes of traders(commonly referred to as “open interest”). Like all govern-ment data, you need patience to grind though the defini-tions and get a handle on what the data means. (You alsohave to wade through soybeans and rough rice to get toSwiss francs and Japanese yen.) Frankly, the COT data is sopoorly organized and so hard to understand that mosttraders give up after a first effort.

However, Larry Williams recently wrote a new bookcontinued on p. 20

An up move complemented by declining tick volume is followed the next day by a downmove and low close.

FIGURE 1 — TICK VOLUME

Source: Reuters’ DataLink

20 January 2006 • CURRENCY TRADER

THE BIG PICTURE continued

titled Trade Stocks & Commodities with the Insiders: Secrets ofthe COT Report (Wiley, 2005), which may re-ignite interest inthe report. Also newly available is COT data in a usableform from Trading Systems Analysis Group(www.tsagroup.com). You can download the data to Excelor MetaStock and generate eye-catching charts.

Before venturing into the COT report, you absolutelymust understand one seemingly obvious, but frequentlyoverlooked, aspect of futures trading: For every buyer, thereis a seller. In other words, brokers might “make a market,”which means to step in with their own trading capital if themarket gets so one-sided that liquidity dries up, but on thewhole, each trade is created out of fresh cloth when a seller

agrees to an offer to buy from a new party. And it shouldn’tbe a surprise to know that often the sellers line up togetherin one category and the buyers line up in a different catego-ry. Thus you have one class of traders all on the long sideand another class all on the short side.

What are these categories? The CFTC in its infinite wis-dom has the futures brokerages report their customers asbeing either “commercials,” meaning they supposedly havean underlying commercial purpose in taking the futurestrade, or “non-commercials,” which means “speculators” tothe rest of the world. The non-commercials are sub-dividedinto large speculators and small speculators, the lattergroup being you and me.

In the COT data windows, the blue line represents commercial traders, the green line is non-commercial traders, and the redline represents small traders. Circle A shows the non-commercials (green) switch from slightly long yen to very long yen, twoweeks ahead of a big move up. In circle B, non-commercials switch from a moderate 60 percent long position to a big shortposition (over 80 percent).

FIGURE 2 — COT ANALYSIS

Data source: CFTC, Reuters’ DataLink; Chart: Metastock (COT program by tsagroup.com)

CURRENCY TRADER • January 2006 21

Because the customers themselves are responsible forchoosing their category and they have a self-interest inbeing considered “commercials” because of the lower mar-gin requirements for that category, it goes without sayingthat some commercials are really speculators, which makesthese categories less than tidy and accurate.

In addition to the categorization issue, the main draw-back to the COT report is its delayed delivery. The report isissued every Friday afternoon for the week that ended theTuesday before. Since market sentiment can easily changedirections in three days, is the report really helpful in mak-ing trading decisions? The qualified answer is, “Yes, some-times,” but remember that often we are at such a total lossthat any clue to market behavior is welcome.

This is not to say the COT report is a last-ditch factor toturn to when all else is failing, but rather a tool with limita-tions. Once you acknowledge those, you still have a tool.During the euro’s corrective up move in September, forexample, the proportion of long open interest by the non-commercial category reached a record high level. Wheneveryone in a category who was going to buy has alreadybought, you can take three guesses as to where the priceheads next. The simple act of exiting the positions, whichmeans selling to cover previous purchases, drives the pricedown.

So does the standard quarterly rollover when the currentcontract matures and the next contract in the cycle takes itsplace, such as when December rolls to March. These effectscan be clearly seen on COT charts and dismissed for whatthey are — not a change in sentiment, but a mechanical re-jiggering of positions.

The COT report doesn’t always deliver a tradable insight,but when it does, it pays to take heed. For example, inFigure 2, the COT data for the Japanese yen is displayed ingraphic form using the TSA Group’s software. The top threewindows show the COT data and the bottom window isprice data. In the COT data windows, the blue line repre-sents commercial traders, the green line is non-commercialtraders, and the red line represents small traders.

The top window shows the three groups’ net positions bynumber of contracts. On the right hand side of the chart, thehigh blue line means commercials are net long, while thelow green line shows the non-commercials are net short,and the red line shows small traders slightly short. Notethat if you add all the longs and all the shorts, you get zero,reflecting that for every buyer, there is a seller.

This takes some getting used to, but it’s worth it tobecome accustomed to the display characteristics. TSAGroup points out, for example, that when you have a bigdivergence such as this one, price is generally trendingstrongly. When the number of contracts is smaller and the

divergence is smaller, the market is moving sideways. Youcan verify this observation yourself by eye.

The second window in Figure 2 contains a proprietarystrength index that shows the percentage of each categorythat holds the net position of the entire category, and thusthe strength of the conviction of the group. Obviously itmeans one thing if 90 percent of a category is long or shortand another thing if only 35 percent are long or short. Onthe right side of the chart, showing the latest data, the bluecommercials are about 60 percent long while the green non-commercials are about 80 percent short. In a nutshell, thismeans the non-commercials feel more strongly about beingshort than the commercials feel about being long.

As for predictive value, the first area circled (A) is thefirst week of February 2005, when the Group of Seven (G7)was holding a meeting. The non-commercials switchedpositions to a large long yen position — two weeks ahead ofa major upside breakout (see the area in the price portion ofthe chart marked by a triangle). In circle B — also aroundthe time of the February 2005 G7 meeting — they did theopposite and shorted the yen. A glance at the price chartshows the non-commercials were correct in positioningthemselves on both occasions.

In fact, in currencies, it generally pays to follow thespeculative crowd rather than to follow the commercials,despite age-old commodity trading lore of always follow-ing the commercials.

The third window shows total open interest. This iswhere you can detect the closing of positions marking thequarterly maturity of the futures contracts, although thischart uses continuous contract data, which minimizes thateffect.

Using volume and open interest in either tick volumeform or through the COT report can enhance your trading,and it is about to become a far more important factor in themonths to come.�

For information on the author see p. 6.

Related reading

“Larry Williams looks inside futures” Active Trader, January 2006.Larry Williams discusses his book on the COT report andhis techniques for using COT data in futures and stocks.

“Floyd Upperman: Digging into COT data” Active Trader, February 2006.A CTA shares his insights on interpreting the COT reportand the methods he outlines in his upcoming book.