Short Selling the Futures Market

Since the stock market’s dramatic sell off on May 6th, it has traded sideways to lower. The market has made new lows twice since then while each rally attempt has been capped by resistance roughly half way back to the top. Technically speaking, this is called consolidation and consolidation usually means continuation. The idea of an object in motion remaining in motion goes back as far as Isaac Newton and it still holds true to this day. This motion is what trends are made of and that is why consolidation is viewed as a pause in the existing trend’s general direction and in this case, the trend is down.

Over the last two months of consolidation we’ve also seen volatility increase to the downside. There have been twice as many big down days as there have been big up days. The largest down day came as the result of June’s monthly unemployment report, which resulted in a sell off of 4.5% to nearly 6%, depending on the stock index. Additionally, this month’s unemployment report comes out Friday, July 2nd. The national rate currently stands at 9.7% while Ohio is full a percent higher at 10.7%. Furthermore, several leading economists feel that our unemployment situation has yet to peak. Finally, July through October is typically, the seasonally weakest period of the year for the stock markets.

Clearly, there are no guarantees as to the future direction of any market. However, it is unwise not to take into account the current weighting of pros and cons when making financial decisions. That being said, what actions are available to someone who has owned a stock like General Electric for so long that the dividends and splits of the stock have left them with a cost basis of virtually nothing? Therefore, any sales of the stock would be subjected to substantial capital gains taxation. The typical response in this situation is one of helplessness. Just ride it out. The stock market comes and the stock market goes.

There is an active alternative to this feeling of habitual helplessness. That alternative is the calculated use of the futures markets. The construction of a futures contract is based on the agreement to either make or, take delivery of a given contract by the contract’s future delivery date. This is the basis of the old cliché, “Where do you want your load of pigs?” The reality is that less than one percent of the futures contracts traded are ever delivered and those delivered, are by design. Every trade in the futures market requires a buyer and a seller. The usefulness of futures is that it doesn’t matter how you initiate the trade. You can create a new position as either the buyer or, the seller and exit the trade prior to the delivery date thus, eliminating delivery issues.

Lets walk through a real world scenario using the General Electric example above. The owner of the General Electric stock wishes to protect their investment without having to pay the capital gains taxes on a lifetime or, generations of accumulation. Assuming the expectation of the stock market is lower, an appropriate amount of stock index futures can be sold to create a new position. This is called a short position and it makes money if the market declines in value. The portfolio has been protected by, “selling high.” If the market does decline or, the perspective on the market changes, the futures trade is offset by buying back what has been sold. This is, “buying low.” The cash difference between what has first been sold high and then covered by, buying low, is the profit accrued on the trade. This profit can be used to offset the loss in Cedar Fair on the broad market’s decline.

This same strategy can be used to generate protection or, profit in any market that is expected to fall. These include agricultural contracts like corn, soybeans or, cattle and also include things like the U.S. Dollar or gold and silver. The commodity markets were designed from the beginning to be used as a tool to hedge risk. This tool is available and applicable to a wide range of individuals and their respective needs. Furthermore, we can track the professional’s trading positions through the Commitment of Traders Report and use it as guide to time the entr4y of a short position. The next time a market is expected to decline don’t just sit there helplessly and watch the market value of your holdings – stocks, cash, precious metals, grains, etc. decline with it. Once educated, ignorance is no longer an excuse.

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.

Don’t Pay Up for Precious Metals Diversification

Gold and silver have exploded in recent years. The contributing factors of low interest rates, economic uncertainty, global fear and pending inflation have done their share to boost precious metals’ outsized gains relative to the stock market. Gold has rallied more than 150% over the last five years while the broad stock indexes are all flat to lower, depending on the day. Silver, for its part, has nearly doubled in the last five years. Given our still historic low interest rates and the growing economic trouble overseas as well as our ballooning governmental budget deficit, it’s reasonable to believe that the forces behind this trend continue to remain intact. The question has changed from, “Should I be invested in precious metals,” to “What’s the most cost effective way to maintain a presence in precious metals.”

The boom in the precious metals market has brought with it the familiar hype of the gold bugs. It has also fostered the invention of precious metal Exchange Traded Funds (ETF’s) and cash for gold TV commercials. Commodity futures markets have also benefited from the added attention being paid to gold. Each of these has a place in the marketplace and each has a vested interest in hyping their product as the one that’s best suited to your needs. However, if you are ascribing to efficient portfolio theory and seek to include precious metals ownership as a part of your portfolio diversification plan, the best bang for your buck is through commodity exchange traded contracts which are regulated by the Commodity Futures Trading Commission (CFTC) and guaranteed by their appropriate exchange.

The market sectors mentioned above can be lumped into two categories: small speculators and investors. Gold bugs and cash for gold are for people with left over jewelry, some family heirlooms and gold coins like American Eagles or South African Krugerrands. Typically, this type of gold ownership sell side biased. This means owners of small pieces or collections are keeping an eye on price and hoping to sell when they think the market has peaked. When they bring their physical collections to market, they will end up at the coin shops, pawn shops, cash for gold, or their local jewelry shop. The willing buyers are always waiting and ready to pay below market value for collections that may have taken a lifetime to accumulate. Upon recent survey of the available outlets, prices to be paid were typically $40 per oz under market value for gold and $.30 per oz under market value for silver. Those on the buy side of this equation, looking to add to their private physical collections will find themselves paying up $30 – $50 per oz over market value in gold and up to $1.20 over per oz in silver. Therefore, small speculators in the physical precious metals market may lose more than 10% of the value of their collection in the buying and selling process.

Passive investment in the precious metals can be done in two ways, ETF’s and commodity exchange traded products. The benefits of ETF’s are that the amount to be invested can be determined beforehand and the investor can pick their own allocation, even if that amount is less than the price of one ounce of gold. The downside is these ETF’s typically underperform the actual market they are designed to track. Typically, one would expect a dollar for dollar rise and fall between the price of the metal and the value of the account. However, due to administrative fees, expenses, incentive fees, cost of acquisition, advertising, etc, the longer the ETF trades, the further behind the actual price they fall. Therefore, it is possible to lose money in a flat market, or realize a smaller return than one would expect in a rising market.

Finally, exchange traded commodity contracts like those listed with the Chicago Mercantile Exchange Group are the actual proxy to which ETF’s and local dealers tie their prices. Perhaps the single biggest drawback to these products is their preset size. There are about half a dozen precious metals products listed ranging in full cash value from $18,000 to $125,000. These contracts have several benefits for passive portfolio diversification. First, these are standardized products fully assayed and certified by the appropriate exchange. This assures the investor that their 100 ounces of gold is 24 carat and their silver is .9999 fine and that the value of your holdings can be found 24 hours a day, rather than being quoted by the guy in the shop down the street.  Secondly, there are no administration fees, advertising costs, or incentive fees. The only charge is a one- time commission to your commodity broker, typically, around $50 per contract. Also, you will control the actual metal and not find yourself invested in mining sales or land right options because you didn’t read the prospectus thoroughly. Finally, the biggest reason exchange traded products are so much more cost effective is the use of margin and the amount of cash it frees up for the individual investor. The $18,000 contract mentioned above requires a cash deposit with the exchange of $1,150. This allows the individual investor to use the remaining $16,850 in excess cash for a money market account and earn interest on top of any return produced in the actual market itself. Therefore, those wishing to pursue efficient portfolio theory and diversify their holdings can most efficiently implement this process through the use of commodity futures markets.

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.