Crude Oil and the World Market

Crude Oil and the World Market

 

May has been an interesting month in the crude oil futures market. The crude oil market has sold off more than 25% of its value in the last month. It has gone from trading at over $90 per barrel down to $67 per barrel. The selloff has been based on two primary concerns; First, the continuing slowdown in Europe and secondly, the growing strength of the U.S. Dollar. However, commercial traders are betting that these concerns will be more than offset by continued growth in developing countries and declining domestic production through the politicizing of off shore drilling.

The European Union is going to face continued economic pressure as they deal with the after effects of their own credit bubble. We have written extensively about the troubles in Greece, “Pandora’s Grecian Riddle.” We also suggested that Greece would merely be the first European Union to succumb to the hubris of its own administration and that this would quickly be followed by Spain and Italy. An appropriate parallel is to the individual financial giants here in the U.S. as the government decided who lived and who died. For the purpose of understanding the selloff on crude oil, the important takeaway is one of simple human basic need. The countries in the European Union will experience a manufacturing slowdown. However, they will continue to cook, heat their homes, drive their cars and maintain the base needs of fully developed countries.

The growing strength of the U.S. Dollar has made crude oil cheaper because crude oil is traded on U.S. exchanges and priced in U.S. Dollars. Therefore, as the Dollar rallies, so does our purchasing power. However, since the beginning of May, the Dollar has only rallied about 7%. Obviously, this does not account for crude oil’s 25% decline. Of course, astute readers will recall that in February, when the Dollar rally began, crude oil experienced a 14% drop on a 4% rally in the Dollar. This created a selloff down to $70 per barrel before rallying back to $90. Therefore, the correlation remains within normal boundaries.

The growing case for crude oil bargain hunting at these levels can be made through the case of the developing middle class of very large Asian populations. The demographic argument states, broadly, that money follows population growth and education. Psychologically speaking, people first seek to meet their basic needs of food, shelter and clothing. As these needs are met and existence transitions to living, the population wants better food, nicer clothes, DVD players and cars. These populations will develop their economies from the inside. However, their production facilities will require more raw materials to produce an equal amount of goods than the efficient production facilities in developed countries. Their higher rate of consumption will help to support global demand for fossil fuels.

British Petroleum’s recent disaster in the Gulf will further constrict domestic supplies going forward. No one can argue the magnitude of this disaster. Many more Americans will truly see and feel the impact of this environmental calamity because it happened in the Gulf, rather than in Alaska, like the Exxon Valdez. The emotional impact will rally voters to back Obama’s moratorium on offshore drilling and put further National Park drilling in jeopardy.

Finally, let’s look at the market internals themselves. Commercial traders, via the Commitment of Traders Report have continued to buy the market the entire way down through this decline. This means that the people who live and die by this market feel that these are value prices. Their trading programs are not based on swing trading. Their trading methodologies are based on fundamental factors like supply and demand and currency exchange rates. They also incorporate seasonal usage data into their trading algorithms, which suggests the crude oil market should continue to see increased demand through the end of August.

The sum conclusion of this selloff in crude oil is that it should be viewed as a buying opportunity for the long term. This is one of the situations where efficient portfolio analysis would suggest that allocating a portion of an overall portfolio to inflation sensitive, fundamental goods would not only put your trading in line with the commercial hedgers, but also provide some overall portfolio diversification.

This blog is published by Andy Waldock. Andy Waldock is a trader, analyst, broker and asset manager. Therefore, Andy Waldock may have positions for himself, his family, or, his clients in any market discussed. The blog is meant for educational purposes and to develop a dialogue among those with an interest in the commodity markets. The commodity markets employ a high degree of leverage and may not be suitable for all investors. There is substantial risk in investing in futures.

Commercial Trader’s Role in the Stock Index Futures

This blog is published by Andy Waldock. Andy Waldock is a trader, analyst, broker and asset manager. Therefore, Andy Waldock may have positions for himself, his family, or, his clients in any market discussed. The blog is meant for educational purposes and to develop a dialogue among those with an interest in the commodity markets. The commodity markets employ a high degree of leverage and may not be suitable for all investors. There is substantial risk in investing in futures.

The stock market’s recent sell off between 7.5% and 14% depending on the index, was immediately followed by five straight day’s worth of rally. Apparently, the TV pundits are saying that the electronic meltdown was just what the market needed to attract fresh buying to the markets and push them back to 2007’s happy market levels. Unfortunately, based on commercial traders’ positions, they don’t seem to share the talking heads rosy outlook. In fact, their trading actions appear to favor, “The Coming Double Dip,” opinion.

Throughout the month of April, commercial traders have been steadily building short positions in the stock index futures. The behavior of the institutional trader is to vary their short position in the stock indexes to offset their perceived sense of risk in the stock positions they currently own in their portfolios. The execution of short hedges in the stock index futures allows them to hold on to their individual issues. The ability to protect their portfolio without having to sell individual issues also protects them from incurring capital gains penalties on their core positions. Thus by tracking commercial traders’ momentum we can get a feel for not only their positive or, negative outlook on the stock market but also their sense of urgency.

Individual investors need to know what options are out there to help them protect their hard earned equity portfolios. The stock index futures offer direct hedges to the Nasdaq, Dow, S&P 500 and Russell 2000 indexes. These markets cover everything from blue chips to heavy tech and small cap. They also trade in various size contracts to help tailor hedge positions to your underlying investments.At these levels, the small contracts have approximately the following cash values:

Market                 Cash Value        Margin RequirementS&P 500                      $56,500                  $5,625Dow Jones                  $52,500                  $6,500Nasdaq                        $18,750                   $3,500Russell 2000                $68,000                  $5,250

Using the above values, one can see the effectiveness of using futures to hedge an equity position, rather than a Contra, Profund or, other inverse equity mutual fund through the following example.

John Doe has $250,000 in equity positions through individual stocks, mutual funds and retirement plans. John is afraid that the market’s rally has run its course and given the overall economic outlook, would like to be able to protect his portfolio in the event of a downturn. Unfortunately, John has had some of the individual stocks for so long that his cost basis makes selling them and paying capital gains taxes an unappealing option. Several of his mutual funds are held in various retirement accounts run by managers who don’t solicit investment advice from their clients on a regular basis. Finally, John has another $75,000 in cash, short term rates and money markets. He considers this his operating cash for any opportunities or emergencies that might come up. So, what can John do protect his self in the event of a market downturn without tying up all of his free cash?

Assuming he would like to hedge half of his portfolio, he would determine the makeup of his holdings to see how he’d like to balance his hedge – small cap, blue chip, tech, etc. Now, he wants to give himself room for another 10% higher in the equities due to the “January Effect” or, market exuberance. Therefore, the free cash needed for this strategy would be approximately, $16,000 in margin to carry the equivalent of a $125,000 short equity mutual fund. Plus, he’s going to need an extra $12,500 to provide a cushion of another 10% rally in the equities. His total free cash outlay is $28,500. Thus, he effectively hedges half of his equity position while tying up only 25% of his operating cash.

The commitment of traders report for the stock indexes can be a good barometer for anticipated movement in the stock market. Furthermore, through the use of stock index futures and a competent broker, individuals can implement the same type of equity protection as the big boys.

Please call with any questions.Andy Waldock866-990-0777

Uncovering Value in the Commodity Markets

Uncovering Value in the Commodity Markets

The electronic meltdown in the stock market also cued a selloff in many commodity markets. Typically, markets move in their own individual rhythms. However, when fear dispossesses logic and panic takes over, it becomes a case of sell first and ask questions later. As the stock market selloff accelerated and we watched the media reports of the riots in Greece, survival became the primary concern. Now that the dust has settled, it’s time to appraise the current state of the markets. I believe the shock to the system uncovered some fruitful trading opportunities.

First, let’s examine the context of the markets prior to the selloff. In the currency markets, the Australian and Canadian Dollar as well as the Japanese Yen had been consolidating near the upper end of their ranges. All three had been holding their own since the U.S. Dollar’s rally has come, primarily, at the expense of the Euro, Swiss Franc and British Pound. The same pattern appears in the metals and energies as gold, silver and platinum as well as heating oil, unleaded and crude had also had been consolidating near their highs.

Secondly, let’s consider the composition of the markets’ participants through the Commitment of Traders Report at these price levels. Commercial trader positions in the markets above were gaining momentum in the direction of their established trends with the only exception being the silver market. This means that even as the markets were moving higher, the traders we follow, commercial hedgers, anticipated higher prices yet to come. For our purpose, we track the commercial hedgers. Prior to the market shock, we presumed that we were in a value driven futures market and no one knows fair value like the people who produce it or, have to use it. In fact, it is precisely their sense of value that provides the commodity market’s rhythmic meanderings that swing traders love so much. Let’s face it, producers know when their product is overvalued and it should be sold just as well as end line users know when they should be stocking up at low prices.

Finally, in the wake of “Volatility’s Perfect Storm,” we have seen the commodity markets snap back from losses of 3% – 4% in the world currency markets to 7% – 10% in the physical commodity markets. This sharp selloff and snap back to the previous range of consolidation prices is called a “Spike and Ledge” formation in technical analysis and pattern recognition. Typically, this occurs when an outside force creates a counter trend shock to the market and scares everyone out. The fear of being in the market is replaced immediately by the fear of NOT being in the market and missing the move. The shock forces out the market’s weaker players while allowing the strong to accumulate more positions at better prices. This is why COT Signals has been kicking out buy signals since the meltdown. Following the commercial trader positions has allowed us to buy into oversold markets. Our targets for these positions can be calculated by adding the depth of the market’s decline to the top of the consolidation levels. If the market you’re following sold off 5% from its highs, a spike and ledge projected target is 5% above the market’s previous highs and a protective stop would be placed just beyond the spike.

This blog is published by Andy Waldock. Andy Waldock is a trader, analyst, broker and asset manager. Therefore, Andy Waldock may have positions for himself, his family, or, his clients in any market discussed. The blog is meant for educational purposes and to develop a dialogue among those with an interest in the commodity markets. The commodity markets employ a high degree of leverage and may not be suitable for all investors. There is substantial risk in investing in futures.

 

Volatility’s Perfect Storm

Volatility’s Perfect Storm

I’ve been actively trading the stock indices – S&P 500, Nasdaq, Russell 2000 and Dow futures for 20 years and I’ve never seen a day like today. It was truly a, “Perfect Storm.” I believe this will happen more and more frequently in the future as the three main reasons for May 6th’s volatility are gaining momentum all of the time.

First, public complacency was the highest it has been since the summer of 2007. Every bailout and new government program bolsters the warm and fuzzy investor psyche that allows us to believe everything will work out. The Volatility index measures the cost of protecting your stock portfolio through the purchase of put options. Put options are like buying portfolio insurance. If you hedged your $300,000 stock portfolio it would have cost you approximately $8,500 in put premium to protect the full value of that portfolio through June, from any downside risk. That same insurance policy in the afternoon would have been worth $23,625. Considering the value of your portfolio equaled the decline of the stock market, you would’ve lost 3.25% on your $300,000 or, $9,750. The difference between the $8,500 paid up front versus the current portfolio’s value of $290,250 plus the current value of the insurance policy $23,625 means that your net worth on the stock market’s biggest point loss day in history would have actually INCREASED by $5,375. The increase in the VIX is the reason for the inflated option premium and the magnitude of the rally of the VIX bears testament to the market’s general complacency.

Secondly, All of the markets are tied to each other. That’s why we are Commodity AND Derivative Advisors. In the age of electronic commodity trading, one issue always affects another one and that one in turn, affects another on and so on. Every trade in an outright market like the S&P 500, Euro Currency or, Japanese Yen will have an effect on the other markets related to it. This has, in effect, created one giant butterfly effect. In the age of algorithmic trading, where the minutest of market inefficiencies are exploited by aggressive capital placement, abnormal market moves will become self fueling. Many of these models use markers based on the model’s expectation of, “normal,” relationships to its data points. When things get pushed beyond the model’s, “normal,” expectations you have a case of, “If you liked stock ABC at $12 a share, you’re going to love it at $4 a share.” There were at least two stocks in the S&P 500 that traded to 0, today. This means they were broke, bankrupt, didn’t exist. Two Fortune 500 companies disappeared on someone’s lunch break and by the time the employee got home from work, no one knew the difference. Twenty minutes of electronic market butterfly effect.

Finally, as the market began to fall, the media was showing the Greek police force in full riot gear after passing their severe austerity vote in an attempt to procure financing from the European Union. Furthermore, the context of the day’s discussion among the talking head TV pundits was the doom and gloom surrounding the demise of the European Union, civil protest and bankruptcy in Greece with the specter of Spain’s impending default as a backdrop. Doom and Gloom sells. Traders, both retail and institutional are listening to the end of the world as we know it while watching the stock market meltdown and trading programs are ticking off one sell order after another in an attempt to be the first ones to market with their orders. The pursuit of greater bandwidth on their data feeds, faster processors in their computers and deeper levels of quantifiable algorithms put them in the lead in the race to the bottom and right back up. Welcome to the new age of 24 hour doom and gloom media coverage, total connectivity and computer programs replacing common sense trading. We specialize in common sense trading.

 

This methodology is published by Andy Waldock. Andy Waldock is a trader, analyst, broker and asset manager. Therefore, Andy Waldock may have positions for himself, his family, or, his clients in any market discussed. This method is meant for educational purposes and to illustrate the correlation between the commercial’s trading and its effect on creating turning points within the commodity markets. The commodity markets employ a high degree of leverage and may not be suitable for all investors. There is substantial risk in investing in futures. The information contained herein comes from sources believed to be reliable, but are not guaranteed as to accuracy or, completeness.