I’ve studied and used Commitment of Traders (COT) data for years. Before I get into how to use the information to make money, let me briefly explain what a COT report is.

The COT reports are compiled by the government (U.S. Commodity Futures Trading Commission) and provide a breakdown of each Tuesday’s  positions held by traders of  futures markets. The weekly reports are released every Friday at 3:30 p.m. Eastern time.

Here’s part of a sample report…

This is a COT report for gold futures. It was released today, Friday 10/30/09,  for data as of Tuesday, 10/27/09. Gold futures are traded on the Commodity Exchange (COMEX). There are three types of futures traders represented in the report — Non-commercial, Commercial, and Non-reportable.

The Non-commercials are large speculators. They’re usually commodity funds, hedge funds and other large futures traders trying to profit from trading the futures market — in this case, gold.

Commercials use the commodity in their business activities. A good example of a commercial trader would be a gold mining company using the futures markets to hedge the price of its production. Think of the commercial traders as the “smart money.” They’re the ones “in the know.” They actually use or produce the commodity. The commodity is their business so they have to know a lot about it and they get the best information.

The Non-reportables are small speculators. Their positions aren’t large enough to have to report weekly positions to the Commodity Futures Trading Commission (CFTC). So the small speculators are just lumped together in a category called non-reportables.

The group I focus on are the commercial traders — the smart money. They will tend to sell futures contracts when prices are rising and buy futures contracts (or sell less futures contracts) when prices are falling.

Let’s use a gold mining company as an example. Let’s say the price of gold is $800 an ounce. As the price of gold moves up toward $1,000 an ounce the company is making more money on its production (all things being equal). So the company may want to lock in profits and hedge its risk against falling gold prices by selling futures at higher prices.

On the other hand, let’s say the price of gold is $800 an ounce and starts falling toward $600. The company may not have profits to lock in. Or it may think there is not much risk of prices falling much further. So it may decide against selling futures contracts. Or it may buy back the futures contracts it sold at higher prices.

Now notice the commercial position on the above gold COT report. Commercials are long (have bought) 89,306 contracts and they are short (have sold) 372,785 futures contracts. So they are “net short” 283,479 contracts (372,785 minus 89,306). That’s a big net short number. And that’s because gold prices have been going up. Remember the commercials sell as prices are rising and they buy as prices are falling.

Okay, here’s one way you can use the report to make money. It has been my experience that when the commercial traders have the smallest net short position (or the largest net long position) they have had in the previous 18 months it means the underlying commodity is undervalued and, therefore, presents a very good buying opportunity.

On the other hand, when commercial traders have the largest net short position (or the smallest net long position) they have had in the previous 18 months it presents a good selling opportunity. So the idea is to buy when the commercials are have the most bullish position and sell when they have the most bearish position.

I’ll give you a recent example.

On March 3,  2009 the COT report for cotton showed a maximum bullish commercial position of net long 16,051 contracts. It was the largest net long position for commercial traders of cotton futures in 18 months. Cotton futures at the time were trading at 42.50 cents per pound.

On October 20, 2009 the COT report for cotton showed a maximum bearish commercial position of net short 50,523 contracts. It was the largest net short position in 18 months. In other words, the commercials were selling more and more  futures contracts as the price went up. Cotton futures were now trading at 67.23 cents per pound. That’s about a 37% increase in price in about seven and a half months.

I played it by buying the cotton ETF (BAL). I bought BAL at 23.78 a share on March 5,  2009. I sold it on October 26, 2009 at 35.46 — over a 50% gain.

I monitor the COT reports every week. I’ll post the buying and selling opportunities in the members area when I see them and how to play them.