Warning on the Dollar COT Report

The following commentary comes from an independent investor or market observer as part of TheStreet's guest contributor program, which is separate from the company's news coverage.

By Scott Pluschau

NEW YORK ( ETF Digest) -- The Legacy Commitments of Traders Report released by the Commodity Futures Trading Commission on Jan.13, 2012 is flashing a warning sign the trend may be running on fumes. This COT report was as of the cutoff date on Tuesday, Jan. 10, 2012.

The Legacy COT report is broken down into two categories: The Reportables and the Non-Reportables for the current "Open Interest." Each digit of open interest is a single contract between a buyer (long) and a seller (short).

In the reportable category, there are two types of traders, the Commercial trader and the Non-Commercial trader.

Commercial traders must prove to the CFTC that they have a legitimate reason to "Hedge" their business with the use of futures. They have deep pockets and "transfer risk." That is why they are known as the "Informed Money."

The commercial traders in the Dollar Index added to their short positions by a total of 3,792 contracts and went long an additional 156, for a NET increase in their current short position of 3,636 contracts. They are currently short 59,023 contracts and long a total of 6,061. A nearly 10 to 1 ratio of strong handed sellers.

Open interest is currently 69,024 contracts, which is an increase of 2,971 contracts from the prior report which to me is a sign of rampant speculation since price continues to make new highs in the face of continued commercial selling.

The Non-Reportable category shows an increase of 958 contracts in their long positions and an increase of 72 contracts in their short positions for a NET increase in their current long positions of 886 contracts. The Non-Reportable category is long 9,765 contracts and short 1,390. The Non-Reportable category has only one class of trader, and they are the "Small Speculators." They "accept risk," and it is usually with leverage trying to make a profit. They have a reputation for "weak hands."

In the Reportable Category the Non-Commercials increased their long position 1,882 contracts and decreased their short position 868 for a NET increase in their long position 2,750 contracts. They are now long 52,644 contracts and short 8,057. The Non-Commercials are "Large Speculators." They could be hedge funds, asset managers, a financial institution, a large trader etc. But the bottom line is they are heavy long. The boat is loaded up on one side with speculators. How much more speculation or demand can we get to the "long side"? To use a Texas Hold'em No Limit poker term, it's as if everyone is "All-In."

I believe a pricing pattern breakdown in the Dollar Index will lead to high probabilities of a sharp selloff. The commercials are not buying. That leaves it up to the speculators to continue to buy, and if they are already on the other side of the open interest, who is left to buy? This goes back to the probabilities of supply and demand and it is the reason why the commercial traders are "trend enders."

Think about what happens when the speculators want to sell and nobody else is buying? How do you unload that many contracts of your net long position without demolishing the price? When there are few bids to buy, and there are highly leveraged positions that have to exit "at the market"... that leads to a violent selloff if the bids are thin and the offers are large. Margin calls will exacerbate the supply side of the equation.

What could these commercials possibly know in the face of Euro disaster? Is this front running QE3 for a bailout of the Euro? Holding a leveraged long Dollar Index position while the market is closed with the current structure of this COT report would have me feeling like I was playing a game of Russian roulette.

I have no position in the dollar Index, and I am well prepared to speculate to the short side when there is an appropriate reversal pattern that develops. Although I believe this has great potential, trying to time the top is a good way to lose money.

Let's look at the chart below. Dollar is making new highs again but it is unable to close above the prior one. This is the second consecutive time it has happened, signaling a lack of demand at higher prices.

Keep in mind I do not rely heavily on technical indicators but it is worth pointing out the slight bearish negative divergence I marked with red trendlines on the MACD Oscillator and the RSI indicator.

Lastly the pattern on the dollar right now is a small "Inverted" or "Expanding Triangle" where the trendlines are diverging rather than converging as compared to the more common "Symmetrical Triangle." I have drawn this with blue trendlines. While the symmetrical triangle shows consolidation, the expanding or inverted triangle is showing confusion or congestion. This market over the past few days does not seem to be sure which way it wants to go.

Another name for the expanding or inverted triangle is a "Broadening Top," but since this is not a pattern that has gone on for weeks, I would not classify it that way since it isn't so "Broad."

There is an ETF that has a well defined broadening top that I will be touching on next week.

For those looking for a bullish play on the Dollar, symbol UUP is the exchange traded fund for U.S. Dollar Bullish and for those who are looking to short the dollar, symbol UDN, is U.S. Dollar Bearish.

Dave Fry did an excellent article on the Top Ten Established Currency ETFs back in December of 2011.

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Comments are welcome at Scott.Pluschau@etfdigest.com.
This commentary comes from an independent investor or market observer as part of TheStreet guest contributor program. The views expressed are those of the author and do not necessarily represent the views of TheStreet or its management.