The group of markets known as the, “softs” or, “exotics” include markets like coffee, sugar, orange juice and cocoa. These are all traded on the Intercontinental Exchange and each market marches to its own beat. These markets are known for their volatile moves but rarely get the trading attention they deserve. For some, like orange juice, it’s due to low trading volumes that make it tough to execute any more than a couple of contracts. However, others like coffee, sugar and cocoa have more than enough volume to handle 10 contracts or more in a single execution. Finally, because these markets have little correlation to the majors, their analysis is frequently overlooked. Today, I’ll review one of my favorite trading techniques in these markets and detail the current situation setting up in the cocoa futures market.
Today’s Scottish secession vote takes a 300-year-old issue and covers it with 21st century journalism. There’s hardly any angle that hasn’t been talked to death. Surprisingly, I’ve found something of major importance leading up to the vote that isn’t being discussed anywhere. The commercial traders in the Commodity Futures Trading Commission’s weekly Commitment of Traders report are making a clear point that they collectively feel that the currency markets are about to tighten, rather than continuing to widen as they have for the last month or so.
Is it possible that Ben Bernanke and now, Janet Yellen along with the rest of the Federal Reserve Board got it right? Have they captained us out of the depths of global financial collapse and into a new golden era of stock market gains and low interest rates? Quantitative Easing one, two and three along with Operation Twist were all specifically designed to keep interest rates artificially low by flooding the financial markets with cash. That cash found its way into the stock market, the commodity markets and the housing markets because the artificially low interest rates it created pushed money away from interest rate investments. Currently, the process has come full circle and now that the stock market is at all-time highs, it appears that the hot potato balancing act between stimulus and inflation is being handed off to Germany. This is probably not a good sign.
Commercial traders in the stock index futures behave quite differently than the Index traders or, small speculators who act as their counterparts. Collectively, this is perfectly logical. Index traders are positive feedback traders. Positive feedback traders add on to their bullish positions as the market climbs and scale out of their bullish positions as the market declines. This keeps their portfolio balanced to their available cash resources. This also places them on the side most likely to buy the highs and sell the lows. Typical trend following. Small speculators are a sentiment wild card. Their position is more price and sentiment based than anything else. The randomness of their sentiment makes their positions too yielding to lean on.
Commercial traders, on the other hand are negative feedback traders. Their strategy is a mean reversion, value based methodology. Collectively, their models tell them what price is, “fair.” The higher the market gets above their fair value, the more they sell. Conversely, the more the market falls below their fair value, the more they buy. Their direct actions typically trace out the meanderings of a wandering market placing their sell signals atop the market’s intermediate rallies and their buy signals below the intermediate lows.
There are two other aspects of commercial traders’ habits that must be examined before we approach the current outlook. Commercial traders use the stock index futures to hedge their equity portfolios. Their ability to sell short the stock index futures provides them with easily implemented downward protection against a decline in their equity portfolio. Furthermore, direct short sales in the stock index futures avoids the uptick short sale rules in equities along with the avoidance of accounting for capital, gains or losses as well as any changes in basis. This aspect of their behavior is observed by the varied but consistent, slightly negative correlation between the commercial net position and the underlying market.
The second aspect of commercial usage of the stock index futures is their implementation of options and the corresponding trades this forces them to execute in the stock index futures. Just as commercial traders maintain a slight short bias in the futures to protect against equity declines, commercial traders also sell upside calls in the options market in order to collect the premium and lock in some short-term gains. Selling call options creates an instant credit in the trader’s account but similar to unearned income this cash is actually a liability whose profit is realized over the course of time. The short call option creates a net short position in the futures market. Commercial traders use the markets’ declines to jump in and buy enough futures to offset the upside liability created by the short call options thus, locking in the added alpha they collected upon the initiation of the short call option position.
Now that the basics are out of the way, let’s look at how this plays into the current market situation. Three out of the last four quarterly futures and option expirations have seen some very specific trading behavior by the commercial traders. Better yet, it’s been easily traceable as you can see on this S&P 500 futures chart The market starts acting up around a month prior to expiration. That places us about a week out from the beginning of what I’m expecting from the June expiration and the June pattern has been the most consistent occurring in each of the last five years.
The pattern plays out with commercial traders pressing the market lower about 20-30 days prior to expiration. This decline accomplishes several tasks. First of all, it washes out the weak small speculative long position. Second, it’s far enough to force index sellers to lay off part of their portfolio. Finally, its far enough for the commercial traders to cover their direct short hedges as well as allowing them to get futures bought against their short call option positions at a discount. This buying has been enough to run the market straight back up to the highs and create a new churning pattern of consolidation at the highs leading into expiration.
This leaves the market sitting near the highs again and creates the same scenario of index buying and small spec buying that helps grind the market higher, yet again. It’s clear the way this has played out over the last few years that the commercial traders are in fact the only beneficiaries of these late quarterly cycle gyrations. However, it’s also clear that their footprints are easy to track including one of our recent pieces, “Commercial Traders Own the Stock Market Gyrations.” While we feel this is true most of the time, we feel far more certain given our current place in the stock index futures’ quarterly expiration cycle.
The stock market doesn’t seem to know whether good news is good or bad news is good. The equity markets have sold off between 4 and 6 percent since we published this key reversal in early March with the small cap Russell 2000 and Nasdaq 100 tech stocks peaking a month before the big Dow and S&P stocks rolled over. April’s unemployment report supplied the catalyst for the Dow and S&P sell off but again the question becomes, “is bad news still good for business friendly easy monetary policies or, does good news mean we’re finally back on track?” Based on a number of factors, it appears the answer is somewhere in the middle. The Goldilocks equity market likes its data neither too hot nor, too cold.
Trading the grain markets has always been tricky, especially during the planting and harvesting periods. Historically, this has placed us at the agricultural epicenter for global grain trade. Obviously, tension in Ukraine and the corresponding 15% spike in wheat prices have reminded everyone that even the agricultural markets are now a global game. In this respect, it’s no longer enough to keep an eye on domestic weather patterns to determine the success of our winter crops or anticipate spring wheat seeding. Now, it is imperative to focus on global production issues and World Trade Organization (WTO) agreements, as well.
I was fortunate enough to be interviewed for a Wall Street Journal heating oil story last week. The primary question was, “How high can prices soar?” Supplies have tightened up considerably during Mother Nature’s onslaught and another bout of cold weather is hitting us, pushing prices higher yet again. Short-term demand related issues like the ones we’re experiencing now due to the weather are never a reason to jump into a market. My less than sensational outlook on current prices pushed me to the closing section of the article. This week, I’ll expand on the topic by looking at the diesel and heating oil markets and formulating a trading plan for the current setup.
This is the third cautionary report I’ve written on the stock market in six weeks. The last time I focused this heavily on the stock market was in early 2009. Back then, I was making a point to everyone who’d lost their shirt on the way down that employing the leverage provided by stock index futures contracts would be a great way to recoup some of their lost funds when the market bounced. This week, we’ll discuss the same strategy only in reverse. I’ll explain how to use leveraged futures to protect your equity portfolio ahead of time in case you haven’t taken the appropriate actions.