Tuesday, September 26, 2006

Traders Helping Traders Big Weekend Edition

The rest of the Big Weekend Edition is online at


Here's the Lesson Du Jour

I was just toying with the thoughts...what are the funds up to in soybeans? I noticed that they have slowly increased their short position in beans. Just for fun, I thought I would look at all the COT's, and with the exception of coffee, they are consistently net long. Why is that? Why are they suddenly taking a net short position in beans?


[I'll defer this question to Tom as he has some great advice regarding the COT data.]

Thanks for the question ... been awhile since I had a opportunity to do my COT tirade ... just kidding ... sort of ... :)

First we need to get a handle on what and who we're looking at. The COT is the by product of a CFTC requirement that all traders taking positions above a certain size (it varies according to market) report their TOTAL positions to the CFTC on a regular basis. The penalty for not doing so is steep.

The report itself is divided into 3 parts: Commercial, Non Commercial and Non Reporting. The non reporting number is us little guys, Commercials and others with positions below reporting thresholds. This number is derived by deducting the reported positions of Commercials and Non Commercials with reportable positions from the total open interest number.

The commercial number is just that, commercial firms reporting positions. The Non Commercial number is everyone but commercials who hold positions above the threshold. This would include funds, institutions and individuals with large positions.

Commercials take positions for very different reasons than funds or you and I. There are 2 classifications of commercials: producers and users.

Producers are already LONG the cash market. They own, raise, grow, store or otherwise control the physical commodity. Since they are LONG the cash they use short positions in the futures market to hedge there physical holdings. The only way they get hurt is by falling prices - they get less for the product when it is time to sell the physical. You will almost never see these people LONG the futures. Why would they? They are LONG the cash, getting long the futures only expands there risk of lower or falling prices.

Users have just the opposite situation. They have a need to buy the commodity; they are SHORT the cash market. They are only hurt by rising or higher prices. They use the futures market to hedge their purchase requirements by being LONG futures to offset the risk of their SHORT cash positions.

You will rarely see these folks short futures ... again, because that only expands their risk which is already substantial because they MUST buy the commodity to make their product. Think Kellogg's buying corn to make Cornflakes or Rolex and Zales Jewellers who need Gold and Silver to make watch cases and bands. You can think of all kinds of examples.

The commercials do what they do for actuarial reasons; it is, effectively, an insurance policy for them. The net positions, long or short, of the commercials will fluctuate depending on prices, production, etc. IT IS NOT A CASE of the commercials sitting around deciding whether to be long or short as we do.

At times the Elevators, Co-op's, and the farmer will be in the futures with big short positions and users will be absent the market. At other times the users will be in there long to the teeth and the producers will be on the sidelines. Commercials tend to be very early in taking positions and hold them for long periods through thick and thin ... until their insurance policy has served its purpose.

Why do you think the short side has been expanding as to commercials ... are we not in the midst of or beginning harvest? When do we historically have lowest prices? Right before, during and just after harvest when we have tons of stocks. Lots of reasons for the producers, the short guys, to be in there right now, low urgency for the users to be playing as their risk is higher prices.

Funds are a different story. They do what they do for the same reasons we take positions ... acceptance of the price fluctuation risk from the producers and users in exchange for hoped for profits. However they do their thing much differently than we do it. They have huge amounts of money to play with. They trade with very little overhead. They are in and out in the blink of an eye since they can make out quite nicely on very small price changes. A penny move for us barely covers our overhead. With 3,000 contracts in play a penny is big money for them. You get the picture.

I firmly believe we cannot gain any edge from following the COT. The actions of commercials and funds are in the prices we see on the charts. It's in there already. Trying to gauge what and when they will do things is futile. The best defence against these behemoths is to track Resistance and Support closely, to roll stops at significant R&S points and to work with small stops affording us an opportunity to demand performance from the market - and when it doesn't materialize to be gone early in the recognition process.

These are absolutely the best tactics to contend with these guys and play the game in their shadow.