We can gain valuable insights into currency markets by looking at who is long and short in the futures market. The smart money in these markets has a couple of clear favorites, and (exchange-traded funds) ETFs can be used to follow their trades. And for those willing to use options for leverage, triple-digits profits are a possibility.

Large traders always have to report their positions in any market. In the stock market, the Securities and Exchange Commission requires quarterly reports from traders and firms managing more than $100 million. Anyone making a large investment in a single company, more than 5% of its outstanding shares, is also required to file a form that discloses the details on their position.#-ad_banner-#

While this information is useful, it is not always very timely. Quarterly reports come out 45 days after the end of the quarter, so we see what the biggest investors owned on Dec. 31 in mid-February, for example. Individual positions are reported in a timelier manner. Large positions, buys greater than 5%, are reported within 10 days of the time that threshold is reached.

Traders are also required to report on their holdings in the futures markets, and those reports are required weekly. The definition of a large trader in the futures market varies depending on what is being traded, but it could include traders with as few as 25 contracts. This information is compiled by the Commodity Futures Trading Commission (CFTC) and published as the Commitment of Traders (COT) report.

The COT report also includes information about what market participants known as commercials are doing. A commercial trader is defined as one “engaged in business activities hedged by the use of the futures or option markets.” In the cocoa market, for example, The Hershey Company (NYSE: HSY) would be a commercial trader since they hedge cocoa futures as part of their chocolate business. In currencies, large banks would be an example of commercial traders.

After accounting for large traders and commercials, the CFTC assumes the rest of the market action is attributable to small speculators, a group including smaller funds and individual traders.

Many individual traders avoid futures markets because they are uncomfortable with the high degree of leverage and risk in these markets. Even if they choose not to trade futures, an analysis of the COT report could be applied to ETFs, which are available for a number of commodities and currencies.

In general terms, most traders use the following assumptions to analyze COT data:

— The commercials know the market better than anyone. They will generally be right. Commercials will also generally be early because they will need time to enter and exit large positions.

— Small traders will generally be wrong. There will be some who are successful, but as a group, small traders will usually be wrong at major turning points.

— Large traders have a mixed record, but trends in their positions could have a major impact on prices.

Applying these assumptions to currencies, the COT data shows that there has been a significant shift in sentiment in several currencies recently.

Commercials have become bullish on the British pound and Australian dollar, while small investors have turned bearish. To make the raw data from the COT report easier to interpret, in the chart below, I convert the position of each group to an index with 100 being bullish and 0 being bearish. The green line shows commercials, the red line is small traders, and large traders are shown as the black line.

ETFs are available for both of these currencies. CurrencyShares Australian Dollar Trust (NYSE: FXA) and CurrencyShares British Pound Sterling Trust (NYSE: FXB) are both oversold on the weekly chart, and based on the COT data, are both buys.

Of the two, I think FXB offers greater potential gains. The price target offered by resistance at $161 is about 8% above the current price. FXA faces resistance near $106, about 4% above the current price.

Because the percentage gains in currency markets are relatively small, traders usually use leverage to boost their returns. ETF traders can accomplish that with options. A call option on FXB could deliver significant gains with only a small dollar amount at risk.

Action to Take –> Buy FXB June 151 Calls at $2.50 or less. Set stop-loss at $1.25. Set initial price target at $3 for a potential 20% gain. If the price reaches $3, use a trailing stop 20% below the highest price that the option trades at after that time. Ultimately, this option could reach $8-$10 for a potential 220%-300% gain in three-and-a-half months.

This article originally appeared on ProfitableTrading.com:
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