Commercial Traders vs. Small Speculators

This week I’d like to use the Commitment of Traders Disaggregated Futures and Options report to illustrate exactly why we follow the commercial traders as well as why most individual small speculators lose money on their own in the markets.

First of all, “the markets” is a generic term intended to describe anything that an individual has direct access to and can use to make their own financial decisions regarding the predicted direction of that instrument. These include individual stocks and bonds as well as exchange traded funds, mutual funds and commodity futures markets.

Most individuals whether planning for their own retirement or actively trading investment capital will scour their information sources trying to find an individual stock, ETF or mutual fund manager who consistently beats the markets. The truth is, very few actually do. Furthermore, the individual banking on continued outperformance is usually buying in at the tail end of what has been a successful run. Finally, the successful run usually has more to do with the manager or stock fitting the right part of the business cycle at the right time to gain alpha rather than the company being run better than its peers or the manager having an inherent knack for their market. Study after study has been done to prove that chasing high returns will lead to lower realized returns in one’s individual account over time.

This same mentality can readily be seen in the commodity markets and is reported on a weekly basis in the Commitment of Traders Reports. The Disaggregated Futures and Options report is simply a subset that breaks down the larger report into individual trader types and totals their actions in several select markets. Last week, the commercial traders were on the dead opposite side of the money managers and small speculators.

Before we look at the numbers it’s important to remember that many of these markets were over extended near their highs or lows.

Crude oil’s decline in price wiped out more than 12,000 managed money and small speculator long positions while the commercial traders purchased more than 8,000 contracts. Crude oil sold off more than $10 per barrel and has now bounced $7 off of its lows.

The corn market, which we had suggested, had become overbought above $7 per bushel sold off to $6.30. Commercial traders had accumulated a net short position of more than 450,000 contracts and repurchased nearly 10% of their position on this break at a significant profit. Managed money, on the other hand was washed out of more than 48,000 contracts on the market’s decline. The same pattern can be seen in the other grain markets as well as cattle and cocoa.

We’ve also picked up the same pattern in the S&P 500 and the Euro currency. Both of these markets were driven by individual investor sentiment and had moved well beyond the collective commercial traders’ value area. The results of one way sentiment could be seen as both of these markets rallied sharply in the face of individual and managed money short covering as their, “end of the world” bets failed to pan out.

These reports are compiled on Thursdays. Therefore, I don’t have the information on gold and silver’s sell off, yet. However, I do expect it to follow the same pattern. This week, buying the Euro and the stock market when every news outlet was putting their own spin on doomsday seemed very counter intuitive. However, setting aside one individual’s opinion and trading on the collective opinion of those who know far more than I do put us on the right side of some very volatile markets. Our firm will continue to focus on their collective knowledge and sizeable bankrolls to help filter out the news and focus on the opportunities.

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 of loss in investing in futures.

Sugar Futures Set to Fall

The Sugar market is one of the most volatile commodity markets. Sugar has made four moves of plus or minus more than 50% since the beginning of 2010. Sugar touched .36 cents per pound this February. This was the highest sugar futures have been since 1980 when they reached nearly .45 cents per pound. Currently, October sugar futures are around .28 cents. I believe the fundamental supply factors in this market are set to drive sugar down to a more normal valuation around .16 cents.

Sugar prices have generally rallied this summer based on four primary factors. First of all, there have been logistical issues in Brazil’s harbors. Brazil is responsible for nearly half of the world’s sugar production. Brazil is also a major exporter of soybeans, cattle and other agricultural goods. In fact, agriculture is responsible for 20% of their labor force compared to less than 1% here in the U.S. Major snafus in the harbor construction projects currently under way caused delivery tightness in the March sugar contract and contributed to the market’s peak in February.

The second primary contributor to sugar’s rally has been the refining spread. This is the difference between the price at which raw sugar can be purchased and the refined sugar can be sold. This spread advanced to more than $160 per ton which, attracted significant sugar purchases for delivery to refiners. This is similar to the temporary conditions we discussed in February of the crude oil crack spread that drove gas prices higher even as the price of crude oil declined.

The competition for sugar delivery also made its way into the ethanol market. The sugar based ethanol production of Brazil and other countries is far more efficient than the corn based ethanol industry in place here in the U.S. However, just like here in the U.S. food based ethanol production pits the forces of hunger and fuel against each other. Therefore, rising crop prices coupled with rising fuel prices combine to tax individual households and define the upper boundaries consumer demand.

The final push in upward sugar prices is more persistent. The growth in the economic viability of developing third world countries has led to increased sugar consumption. Better food and a more varied diet are typically the first splurges for a rising standard of living. The growth of purchasing power overseas will continue to fuel this trend and will place a higher floor on sugar futures prices in the years to come.

World sugar production is always volatile. Over the last 20 years, the annual surplus or deficit between sugar consumption and demand has been split nearly 50/50 on an annual basis. This year it looks like there will be a significant sugar production surplus. Reports from Thailand, India, Brazil, Europe and Russia look very favorably towards large harvests. The shipping issues in Brazil have been figured out and they are also reviewing the possibility of cutting back ethanol subsidies. Furthermore, the market inefficiency of the refining spread has been fully exploited and is now back to normal levels. Thus, the supply side of the sugar market looks bountiful.

Technically, the remaining long positions appear to be held by small traders and Commodity Index Traders while commercial traders are actively selling their forward production at these prices. This leaves the market susceptible to a sell off as CIT’s and small speculators will exit their long positions as the market turns negative. Finally, I expect the market to ultimately test its fundamental uptrend around .16 cents. This represents a value target in line with the global population growth and consumption patterns.

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 of loss in investing in futures.

Falling Coffee Futures – Morning Smiles

This week, I’d like to get away from the pending doom and gloom in Europe and share a little good news on something a little closer to all of our hearts; the morning cup of coffee. We discussed the prospects for higher coffee prices throughout 2011 nearly a year ago due to increasing end line demand and a change in the way the exchange accepted coffee for delivery. Most major roasters raised prices by 10-15% throughout 2011. The fact that they were able to keep prices reasonable in the face of a coffee supply price that nearly doubled was a testament to the effectiveness of forward hedging in the futures markets. Fortunately, coffee prices may have just seen their peak.

Coffee prices traded at over $3 per pound last month. These historically high levels have only been seen twice before this year and those were 20 years apart in 1977 and 1997. In May, coffee futures reached $3.08 per pound. I believe this will mark the high water point for this rally. Last December, we projected a high of perhaps $2.70 per pound based on the supply and demand factors in the market. The rally to the highs has been the work of commercial coffee growers who over sold their forward production.

The futures markets allow farmers to lock in market prices for crops that they intend to deliver at the end of the growing season. Depending on the farmer, they may borrow money to sell forward production using margin. Their loans are procured using their crops as collateral. Typically, both producers and processors have a good idea of the value area for their given futures markets. Therefore, this strategy allows both the producers and the processors to more efficiently run their businesses. However, there are times when the market moves beyond its expected boundaries and commercial margin traders find themselves over leveraged. This is what pushed the market above $3 per pound.

The commercial coffee traders’ actions are reported weekly in the Commitment of Traders Report and we can clearly see that the only group actively buying coffee futures at these prices are commercial producers who over sold their forward production and are trying to manage their losses as best they can.

What can we expect going forward? Using history as an analog, we know that the previous two ventures above $3 per pound saw the coffee market return to its baseline levels from the beginning of the rally. In other words, it gives back all of its gains. In this case, a reasonable target would be the $1.60 area that it was trading at last July. Coffee is currently trading around $2.70 per pound. Given the size of the coffee futures contract of 37,500 pounds this equals a dollars and cents risk of approximately $14,250 with a potential reward of $41,250. As you can see, coffee is one of the more volatile contracts to trade and we will be looking for selling opportunities going forward.

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 of loss in investing in futures.

The Yield Curve Twist

In 1961, John F. Kennedy had an economic dilemma. Facing a recession, how could the U.S. spur long term demand without lowering interest rates, which at the time, would’ve placed the U.S. in the position of lender to the carry trade. The lender in the carry trade is the patsy due to a weak domestic currency and a bleak economic forecast. President Kennedy was no patsy. The plan they put into place was called, “Operation Twist.” This involved the Federal Reserve selling short-term credit and buying long-term. Remember that prices and yields run opposite to each other. Therefore, the more short-term paper the Fed sold, the lower they forced prices and the higher short-term yields became. Conversely, the more long term paper they bought, the more it pushed up prices and lowered the long term yield thus, flattening the yield curve.


Fast forward to 2011. The Dollar is sagging, short term rates are near zero, QE1 and QE2 have passed and we still face a general lack of demand as our country works through the deleveraging process in an effort to right the ways of fifteen years of over spending. Our Democratic President is up for re-election and needs something to spark his domestic relevancy. I understand that the Federal Reserve and the Executive branch conduct their policies independently with the same target of the greater good and I’m not suggesting collusion or conspiracy theories – just noting the timing of conjuring a fallen hero’s memory.


So, what’s it mean? There are several positive factors to this policy. First of all, unlike the Quantitative Easing Programs, Operation Twist won’t expand the Fed’s balance sheet. This plan doesn’t create more debt; it simply lengthens the maturity date of the debt portfolio as long as the short term sales match the dollar amount of the long term purchases. We can probably agree that not increasing the current debt level is a good thing. Extending the maturity date of our debt portfolio also makes sense at historically low interest rates. It’s kind of like the U.S. is going to refinance their house.


This process is also designed to strengthen the Dollar. Currency trading is basically short term arbitrage between interest rates and economic outlooks of the currency pairs being traded. Selling short term paper in the markets keeps short term rates higher which strengthens the U.S. Dollar. Higher short term rates will be very helpful to money market programs and retirees looking for yield. The strengthening U.S. Dollar can then be advantageously used to repay debt previously incurred at lower costs. The strengthening Dollar will also help to mute inflation sensitive commodity prices once the economy gets rolling again. Finally, a stronger Dollar will make us less likely to be the global patsy lender in the carry trade.


The commercial traders have already forecasted the moves in the markets. The changing shape of the yield curve can be seen in the sell off of the Eurodollar complex. This short term vehicle’s current yield of nearly 0 projects out to March of 2012 with a rate of nearly .4%. This coincides with a rise in yield on the 2 year Treasury Note of nearly 7% from where it was only one week ago. Meanwhile, the long bond has exploded to new highs in price equating to an all time low yield of 3.152%.


The general purpose of this move is to change the shape of the yield curve. Banks make money by borrowing cheaply in the short term and lending at higher rates in a longer time frame. The effects of Quantitative Easing and the TARP programs  provided a very favorable banking yield curve coming out of the ’08 collapse. In fact, it was the financial stocks that led us out of recession (and maybe caused it?). This move will decrease banks’ overall profitability in the near term but should fuel longer term business and consumer lending without increasing the overall debt levels.



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 of loss in investing in futures.

Will Germany Kill the Recovery?

Monday morning a client and I were discussing what had changed that would explain the shift in investors’ sentiment from safety to risk. According to the several sources I read on a daily basis, my answer was that absolutely nothing had changed. All of the structural problems both domestically and globally were still on the table. The stock markets’ rally as well as the support in copper, oil and interest rates can only be tied to investors’ shortsighted expectations of economic policy going forward. Unfortunately, we all know that expectations can be quite different from reality.

Ben Bernanke’s comments from the Jackson Hole meeting on August 26 suggest lower interest rates throughout 2012. However, he was quick to point out that any long-term recovery would have to be headed by Washington because it is not the Federal Reserve’s job to do the heavy lifting of job creation and budget management. This was Bernanke’s way of putting the focus of the economy back on the Congressional cause rather than expecting him to deal with the effects of their actions.

The economic data here in the U.S. continues to weaken and expectations of another recession are rising. Last week, jobless claims came in over 400,000. Remember, we need to create more than 115,000 jobs per month just to hold the unemployment rate steady. This week, the mortgage application index dropped to its lowest level since February of 1997 and the Michigan Consumer Sentiment Index has fallen more than 20 points in the last three months. The correlation between this index and domestic GDP is high enough that the decline in the index points to a year over year drop in GDP by more than 2%. This type of decline in GDP has always led to recession.

The supporting arguments for the stock market’s continued success are usually tied to low interest rates, global trade and positive earnings. Unfortunately, when these factors are put into the context of our current economic cycle, the long-term negatives will outweigh the short-term positives. The historically low interest rates are due more to fear than they are a stable economy or falling inflation. When investors are willing to pay the U.S. Treasury to hold their money, fear is clearly the driving cause. The global trade argument has two flaws. First, our companies doing business over seas are being paid with a U.S. Dollar that is declining in value. The Dollar is only 4% off of the ’08 lows and is down more than 17% from last year’s high. Secondly, Europe, which makes up 57% of the U.S. Dollar Index is facing a meltdown similar to ours from 2008 and the trigger could very well be pulled next week.

The political dissent in Germany is running at a feverish pace. Next Wednesday, the Bundestag, Germany’s constitutional ruling court will vote on the legality of the European Union’s bail out. Specifically, Germany will determine whether the $600 billion bailout fund conflicts with Germany’s own fiscal solvency. Recent polls show that Chancellor Merkel will be unable to even count on her own party’s support.

Investors have reached a perverse sentiment where the worse the news becomes; the more likely they think a government coalition is to be there to bail them out. Remember the banking and auto sectors of ’08? Here we are years later and the economy is worse off than it was before yet the Dow Jones was within 10.5% of its all time high and more than 80% higher than its ’09 lows just one month ago.

The U.S. debt ceiling debacle triggered the most recent wave of selling. The markets have been relatively quiet since with strong buying coming in near the lows from commercial traders. My concern is that the commercial traders will be net sellers of stock index futures this week as they bank some profits and take risk off of the table in advance of next week’s Bundestag ruling on the constitutionality of Germany’s direct participation in the European Financial Stability Facility. Any withdrawal of support from Germany would literally be, catastrophic. Given Germany’s history of political dissent as well as their recent history of economic self-sufficiency this decision could very well be an historic landmark.

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 of loss in investing in futures.