Tag Archives: open interest

Long Only is Not Diversification

The cycle of bubbles will continue. Assets will always chase higher returns. The markets in the United States that are available for the general public to allocate funds to are mostly, “long only.” The general investing public is provided with a number of choices as to what they can buy to invest in. We’ve seen the cycle rotate from sector to sector within the stock market or, between stocks and bonds. Arts, antiques, cars and real estate have all had their periods when ownership was lucrative. Fortunately, being able to short sell commodities with a phone call or a mouse click is much easier than selling a car or a house when the market turns.

Lately, commodities have taken center stage as the thing to own. We’ve seen it in gold and oil and more recently in grains, agricultural commodities and stock index futures. Thirteen commodity futures markets set new records for commodity index funds’ open interest in 2010. Over the last few weeks, we’ve seen commodity positions being transferred from the index funds to the small speculators. This transfer of positions from index and commercial traders to small speculators typically occurs near the end of a protracted move.

Bubbles are created through the over popularity of an asset class. The speed of the bubble cycle increases when leverage is involved. We’ve seen this in the stock market crashes of 1929 and 1987 and as recently as May of 2010 in the, “Flash Crash.” The world is still unwinding the over leveraged global mortgage debacle. The new vogue in leveraged assets has been the creation of commodity funds. Commodity funds have provided a long only investment entry into the futures markets for the novice investor. These funds have gone from non-existent to more than $370 billion in equity at the top of the first commodity bubble in 2008. We have since surpassed that total.

The commodity index fund market is no different than the mortgage backed security market was when it was marketed to the public as a way to, “ratchet up returns while providing diversification.” Investment office salespeople need products to sell. These products are usually a good idea at the beginning but, become overpopulated and over valued as a result of a good idea turning into the next big thing and eventually falling of their own weight.

I’ve suggested that the global economy is due to slowdown. Furthermore, the governmental response to the economic crisis has done little to right the long-term path of our economy. Over the last three years, the stock market is higher, reported unemployment is below 10% and gas prices have stabilized. However, it has taken a Herculean effort by the government, which has dropped the Federal Funds rate from 4.5% to 0, expanded the Treasury’s balance sheet by $1.5 trillion and printed $1 trillion on top of that just to bring GDP and our population’s complacency back to where it was at the end of 2007. This is the Government’s form of a leveraged asset, which is also becoming overvalued and overpopulated and is in peril of falling of its own weight.

Diversification among long only assets will not provide the type protection people expect when these markets begin to falter. Over the last five years, there have been 13 weeks when the S&P 500 closed more than 5% lower from week to week. Conversely, there has only been one week in the last 5 years when bonds have closed that much higher. That was the flight to quality run of November 21, 2008. That was the height of the panic of the meltdown. The truth is, when liquidation hits the market, it tends to cross all classes. These are the days when the commentators lead in with, “There’s a lot of red on the board today.” Gold, copper, oil, grains, cattle, etc. have all averaged at least as many large losses as the stock market. Forty percent of these losses coincided with large stock market declines. In this day of instant everything, instant liquidation to cash is only a few mouse clicks away in the futures markets rather than end of day fund settlements.

The futures markets were meant to be traded from the long AND the short side. Commercial traders use this feature to manage their own production and consumption concerns. Individual traders can also have this direct link to the commodity markets. The liquid flexibility of the futures markets allows individual traders to hedge their holdings through the direct use of short selling just as it allows leveraging of outright exposure on the way up.  The right brokerage relationship can make them the perfect tool in the hands of the individual managing their own portfolio as opposed to the long only fund salesman seeking out the next tool in the general public.

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.

Stock Market Players are Increasing their Bets

There’s a difference between a tradeable rally and a fundamentally sound trend. The stock market has been exceptionally strong since Labor Day, turning positive for the year around the middle of September. During this period the two dominant news themes have been the Republican party’s campaign gaining momentum and the Federal Reserve Board’s verbalization of their willingness to do whatever it takes to keep the economy churning. Additionally, we are heading into the strongest seasonal period for the stock market on an annual basis. When these factors are combined with equity managers who have to put money to work on the long side to keep pace with the index, we see a stock market that defies logic by gaining momentum as it rallies.


The S&P has had three outside bars in the last five trading sessions. Typical market movement is just over one outside bar per month. Analysis of these three days shows that they all started lower based on overnight concerns and finished higher on the day’s trading here in the U.S. Whether the buying that came in was from fund managers trying to get capital into the market at a discount, traders covering their short positions or foreign money coming in to buy our equities at a dollar denominated discount is irrelevant. Buying is buying.


We’ve clearly identified the trend is higher. There are sectors with fundamental support like Potash, ADM, ConAgra, Freeport McMoran and so forth. These commodity based companies should rally in an economic environment dominated by a declining dollar. It’s good to own, “stuff.” In fact, the basic materials sector is up over 20% on the year, led by precious metals. An argument can also be made that the historically low interest rates have created a new type of carry trade, where borrowed money is being put to work owning, “stuff.”


The flip side of the stock market’s rally combines technical resistance, bearish commercial positions and a deteriorating labor market. Technically, resistance comes in another 2.5% higher around the April highs at 1200. Also, the market has lost about 15% of its open interest since making the August lows. Healthy trends are supposed to gain open interest as they progress.


Moving to the commercial positions, the open interest peak at the August lows coincided with the last commercial net long position. Over the last couple of weeks, the commercial traders have moved to a dead net short position. This includes a record short position in the Nasdaq. This type of behavior is a perfect illustration of why we follow the commercial traders. Small speculators and funds were accumulating short positions at the August lows while the commercial traders were buying the market against them. We are seeing the exact opposite play at the market’s top, right now. Small speculators and funds are putting money to work in the market as the commercial traders have gone from long position liquidation to outright short position initiation over the last two months.


Finally, the public unemployment rate held steady at 9.6% for the month of September. However, looking deeper into the data, we see that the economy has added only one month’s worth of new jobs over the last year and 90% of those jobs have gone to hiring workers over the age of 65. Employers are paying minimum wage for experience and reliability, not rebuilding long- term work forces. The data also shows that part time workers for, “economic reasons,” which means they can’t find full time employment is the highest ever recorded. The last piece of doom and gloom comes from Richmond Federal Economic Conditions Survey, which shows that companies are issuing a hiring freeze with the one of the largest single month declines that the Number of Employees Index recorded in the last decade. This is reinforced by the plunge in the Workweek index and the New Orders Index.


We may be approaching a climactic event in the stock market. The data spreads that went into crating this article have never been wider. The Federal Reserve Board is talking about a second round of quantitative easing. Their dialogue has created a rush into tangible assets like the commodity markets. It is supplying an artificial floor for the stock market and it has created a rush to buy short and medium treasuries. These moves are based on conjecture and hyperbole. What if the Fed sits tight? The markets have provided the Fed with the action they’ve been unable to create through their own actions. Inflation, low interest rates and a healthy stock market are exactly what they’ve been trying to construct. What happens when these bubbles burst?

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.


Volume & Open Interest 101

The following is reprinted from the Chicago Board of Trade

Volume and Open Interest

Next to price, volume is the most frequentlycited statistic in reference to a futurescontract’s trading activity. Each unit of volumerepresents a contract traded. When a traderbuys a contract and another trader sells thatsame contract, that transaction is recordedas one contract being traded. Therefore,the volume is the total number of long orshort positions.Open interest, on the other hand, refers to thenumber of futures positions that have not beenclosed out either through offset or delivery. Inother words, the futures contracts that remainopen, or unliquidated, at the close of eachtrading session.To illustrate, assume that a trader buys 15contracts and then sells 10 of them back tothe market before the end of the trading day.His trades add 25 contracts to the day’s totalvolume. Since 5 of the contracts were notoffset, open interest would increase by 5contracts as a result of his activity.Volume and open interest are reported dailyand are used by traders to determine theparticipation in a market and the validity ofprice movement. For instance, if a marketmoves higher on low volume some tradersmay not consider this an important pricemovement. However, the same pricemovement on high volume would indicatethat an important trend may be emerging.Combining volume and open interest alsoyields an interesting perspective on themarket. If a contract experiences relativelylow volume levels but high open interest,it is generally assumed that commercialparticipation, via the commitment of traders report is high. This is becausecommercial hedgers tend to use the marketsfor longer-term hedging purposes, puttingtheir trades in and keeping them until they’reno longer needed to manage a given pricerisk. Conversely, high volume with low openinterest may indicate more speculative marketactivity. This is because the majority ofspeculators prefer to get in and out of themarket on a daily basis.