By Eric M. Wall, Man Financial

Tracking of trader position data and estimating the prevailing market opinion, or trader confidence, in the markets is not new to the capital markets industry. Over the years, a litany of approaches have been introduced, all aimed at solving the problem of identifying the consensus bias in the marketplace. Each theme emphasizes its own logic in prioritizing the aspects of trader behavior. The benefit is clear. With a current understanding of to what degree all traders, or similarly motivated trading groups, are positioned, investors are better equipped to gauge the capacity for further developments in the trend of the market. For example, knowing that the majority of traders in a market are extremely bearish might provoke concerns about the capacity to attract new selling. A favorable turn in trader confidence during an up trend might be seen as shift in "the pack" as traders begin to follow the trend and adopt a more bullish view. This clearly influences contrarian and trend-following approaches and can have a profound impact on timely market entry, exit and money management.

In short, trading success can be directly linked to the position changes of other investors, and informed trading decisions cannot be made without some sense of the prevailing market opinion or awareness of critical shifts in trader confidence. The specific benefits associated with following position imbalances stretch from directional insights on price action through implications for market volatility. However, this analytical venue is complicated by the quality of pertinent information. It is therefore in the interest of individual investors to have a clear understanding of the specific features to look for when choosing trader confidence sources. Investors can then learn how to merge these tools with their decision-making methods and make this information part of each trading decision.

Simply stated, gauging market confidence is not an exact science. It is not feasible to identify the position of every trader participating in a given market. Even if this information were somehow attainable, it would be impossible to determine to what degree these positions related to the entire risk capital of the trading set or if this list of traders represented a complete set of potential investors in the given market. Therefore, this type of research focuses on empirical assessments. The two generally accepted approaches in this venue are Consensus Estimates and Position Tracking.

Consensus Estimates are an attempt to determine the prevailing market view by polling market participants and/or monitoring the forecasts and expectations of market professionals. Opinions and content are ranked to determine an aggregate market view. Similar to a game of checkers, each piece is equal in ability and influence. Tactical movement and overall positioning determine strategic advantage.

Position Tracking takes aim at the question through an arduous process of matching trading activity with specific trading units and/or closely monitoring the positions of similarly motivated groups. This data is used to compile an aggregate market position and identify trading groups that may have a larger, or lesser, influence on market activity. As in chess, each piece has different strengths, weaknesses and abilities. This has an influence on short term "battles" and positioning, as a whole, also remains key. 

Though these approaches differ in perspective, breadth and complexity, they are the same in the larger objective, which is to win the game! However, the methods and motivations associated with Consensus Estimates can bring the objectivity of this approach into question. Given the composition of position data, unique to futures contracts, therefore, our discussion will focus on the Position Tracking as a tool for gauging trader confidence.

Short Interest and Commitment Of Traders

Most stock exchanges track the short selling in each stock. Short selling is borrowing and selling a security the seller does not own. The exchange compiles all of the short selling in the stock, called "short interest" and publishes this tally. Firms are then required to report short positions to the respective exchange. The exchange compiles the short positions data each month, publishing it shortly thereafter. A compilation of these figures results in an aggregate position estimate.

The Commodity Futures Trading Commission (CFTC) provides a similar report called the Commitment Of Traders (COT). Clearing members, futures commission merchants, and foreign brokers file daily reports with the CFTC. These reports reveal the futures and option positions, long and short, of traders holding positions above reporting levels set by the CFTC. Traders are grouped into three categories. Large Trader and Commercial (end-users) positions are considered "reportable" and their positions typically control 70-90 percent of the total open interest in any given market. Small Trader positions represent the portion of open interest that remains. The Commission compiles the COT data for each Tuesday and the report is released on the Friday that follows.

The frequent publishing of the COT data provides a timely read on market positioning, vis-à-vis short interest releases. In both settings, a historical reference and/or valuation of the current standings is required to derive meaning from the position changes. A review of this nature allows investors to consider current positioning and gauge the potential impact going forward.  The breakdown of COT data into "similarly" motivated fund, hedger and individual groups provides insights as to positioning imbalances that may lead to short and longer term market ramifications.

Positioning Imbalances

For an example of how trader positioning information and market component imbalances play out in a trade setting, we will use the analysis generated by Access Market Research, Inc. on Mini-Dow Futures.  AccessMarketResearch.com is a resource center, covering a variety of domestic futures markets. Their analytical products provide daily evaluations of position, price and volatility conditions for a variety of time horizons. Proprietary trader positions and market bias estimates are generated daily. Their proprietary readings represent a comparison of recent shifts in trading positions, prevailing market bias, price and volatility to thousands of similar market settings in the past. Simply stated, Access Market Research, Inc. generates daily valuations on position and price data and delivers market warnings and forward indications for a variety of time frames.

Directional Indications 

On January 26, as the Mini-Dow futures were etching new year highs, AccessMarketResearch.com generated a market warning for the Mini-Dow futures. Their commentary suggested there has been an excessive shift toward buying by Small Traders.*

Rich/Expensive Relationships

During the same 3-week period, net selling emerged from Large and Commercial traders. From the standpoint of comparing selling and buying, it was clear that the buying effort by small traders was excessive relative to the net selling effort. This also suggested Small Traders bullish positioning was aggressive, vis-à-vis reportable positions.* 

Market Activity Expectations

It was also reported that the low market activity readings increased the risk of aggressive movement. This did not provide explicit suggestions on market action going forward. However, the cyclical nature of volatility, the confidence imbalance between the various trading groups, and the relatively low reading in actual volatility, gave rise to the view that more expansive activity could be expected in coming sessions.*

Unwinding Risks Going Forward

The hefty positioning of Small Traders, coupled with emerging bearish reportable positions, suggested an increased risk of a temporary setback, via long position unwinding (selling to liquidate long positions).*

*Past performance is not necessarily indicative of future results.

Implications For Volatility

Though the extent of the price movement had triggered a directional warning, this had yet to contribute to a relative increase in option prices. Access Market Research, Inc. suggested that June options (Dow Industrials Futures) were inexpensively priced for the period going forward. While this gave no guarantee of an immediate increase in option prices, it did suggest that long option strategies might offer trading advantage, when employing the shorter term directional indications. This point was punctuated by the confidence imbalances, discussed above.*

In the days that followed the market warning on Jan 26, there was a surge in market active, as a precipitous drop in Mini-Dow futures unfolded. During the decline, the Access Market Research, Inc. Small Trader Confidence, Price and Volatility Gauges drifted back to more "normal" levels. In addition, there was a notable increase in option premiums as the aggressive slide in price provoked an increase in option activity and a jump in implied volatility.*

*Past performance is not necessarily indicative of future results.

Select Features

Investors are cautioned against basing the success of the application of trader confidence on one example. It is telling, however, that so much pertinent information could be gathered and analyzed from position, price and option data. Equally encouraging is the timely manner in which clients were warned of the increased risk of shifts in these variables, just as Mini-Dow futures were establishing new contract highs only a few days ago.  Notably, the multiple market assessments did not suggest a specific trading strategy. The nature of the approach focuses on timing of market action, not on entry, exit or profit objectives.  When searching for a valid reference for this type of information, investors are urged to favor a resource with the following features:

Daily Market Indications - Lagging assessments rarely provide valuable insights.   Market indications should be pertinent and refreshed daily.

Trading Group Estimates - Position tracking of similar trading groups limit position draw-down provide critical short-term indications.

Overall Market Confidence - A daily indication of the prevailing market confidence aids in the determination of strategy, longer term.

Rating Of Shifts In Price And Volatility - As positions shift, these components are impacted and should also be quantifiably gauged.

"Picture Of The Market" - Trader confidence and prevailing market opinion view should provide immediate and more distant directional indications.

Quantified Position Risk - Specific ratings should be employed to aid the process of learning when shifts threaten, or support, existing trends.

Multiple Time Horizons - Providing indications for a variety of time frames allows for a "fit" of indications and personal market approaches.

Indicative vs. Directive - Market analysis should be indicative, providing a format that allows for a variety of individual trading strategies.

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About Eric Wall
Eric Marshall Wall joined the Man Financial Inc. team in 2003, bringing with him a long and successful career in research and analysis of cash, futures and options markets. As a Strategy Director at Standard and Poors, Eric advised institutional traders and brokers. Twice published, Eric has also been quoted in the WSJ and Bond Week, and is a regular guest on CNBC and Reuters TV. Following his career at S&P, Eric Marshall spent 3 years developing his own proprietary market analysis to select investors. Eric Marshall's research roots bring a fresh approach to assisted brokerage.

If you trade CBOT Dow futures and are interested in submitting a strategy for publication on the CBOT Web Site please contact us.

The information in this commentary is provided from sources believed to be reliable, but the Chicago Board of Trade does not guarantee its completeness or accuracy. The opinions expressed within the commentary may change without notice. The commentary was prepared for general circulation and does not have regard for the particular circumstances or needs of any specific person who may read it. Neither the information nor any opinion expressed in the Commentary constitutes a solicitation for the purchase or sale of any futures or options contracts.