Most of our trading is based on the consensus opinion of the commercial trader group as reported in the weekly Commitment of Traders report. We track their behavior in a couple of different ways but the simple conclusion is that we want to buy when they're buying and sell when they're selling. You'll see the net commercial trader position plotted in the second pane of the stock index charts, below. We measure their actions on a sum and momentum basis. This allows us to determine how anxious the commercial traders are to get their trades executed at a given price level which, in turn, tells us a lot about the importance of a given area. Obviously, the previous year's lows are an important area. Based on the collective actions of the commercial traders across the major indices, we've issued a COT Buy signal.
Looking at the chart below, you'll notice a few key features. First of all, we only take trades inline with commercial trader momentum, plotted in the third pane. This ensures that we're on the same side of the market as its biggest players and arguably, the ones who know a given market the best. Typically, this means the people growing the commodity or, the end users of a given commodity. However, we've found this approach works equally well in cash settled non-commodity contracts like the stock indices and currencies.
The next thing we look for in an entry is what we call, "market tension." This occurs when the commercial traders' position is at odds with recent market direction. We've seen this on the recent stock market decline and tension is created as commercial momentum pushed into positive territory in the Dow, S&P and Nasdaq as the indices, themselves fell. Notice also that the Russell has been in this state since late summer. We also saw the opposite of this over the summer when three of the four major indices shifted to negative momentum and remained there through the end of the year. This prompted us to write, "Small Speculators Got Greedy in the S&P 500," right here at Equities in late December. The COT buy and sell signals have been plotted on their respective charts. You can clearly see that the collective nature of these signals provides a wonderful leading indicator.
We've plotted the 2015 lows on each of the charts. You can see that the S&P and Russell have penetrated the 2015 lows while the Nasdaq and Dow have managed to hold. This is a key technical level that has brought the commercial traders back to equities on the buy side. We feel that their actions combined with the technical save by the Nasdaq and Dow could save this market from impending free fall and create a rally worth trading. We believe that the easy money that's been made through buy and hold over the last several years has come to an end. Those looking to beat the indices will have to be more nimble going forward. The use of timing signals combined with futures or ETF's can do wonders to generate alpha in a stagnant to declining market. Therefore, we'll continue to rely on the collective wisdom of the largest traders and take our shots accordingly.
