There are several sayings intended to keep us on the right path in our financial lives, and in this day of data crunching, quantitative analysis, backtesting, and the neverending search for the best new method, perhaps none is more true than “Success breeds success.” When I first began my trading career in Chicago, I didn’t spend much time with new traders. Partly because many didn’t last long enough to get to know their last name, and partly because I was married with a young child and a lot of bills to pay. I did spend time with as many of the grizzled veterans and established traders as I could.
Early on, after what had been one of my worst days, I was full of self-doubt and felt the pressure of the world on my shoulders. I sat in the member’s break room, just off the S&P 500 trading pit with my head in my hands and an untouched cup of coffee in front of me. I hear a chair slide out at my table and a graveled voice of experience ask, “You bust out kid?” I look up to see Bill Katz, who had been a member since the blackboard trading days on Franklin Street. I replied that I hadn’t and his point was that as long as you get to come back tomorrow, you’re still doing something right.
The point of this story is that many people ask me questions about why I follow the weekly Commitment of Traders (COT) report, what group I follow within the report, and why. The month of November has been a great illustration across multiple market sectors. This week, I’d like to explain how it all plays out.
The Commodity Trading Futures Commission (CFTC) tabulates the weekly Commitment of Traders report based on the trading of several individual groups of traders. Over the last couple of years, in the interest of “transparency,” the groups have been broken into several subsets as well. For our purposes, we can break it down into the following main categories.
1. Large Speculators: Any trader with an interest greater than the CFTC’s reporting level in any individual market.2. Small Speculators: All individual traders with an interest less than the CFTC’s reporting level in any individual market.
3. Non-Commercials: Any organization trading in commodity futures with substantial reporting interest not tied directly to the production or consumption of the markets that they hold reportable positions in. These include commodity index traders, exchange traded fund managers, and swap dealers.
4. Commercial Traders: Producers or consumers of commodities. These are the true hedgers in the commodity markets. These hedges can be directly tied to gold, corn, and oil just as easily as bonds, currencies, and stock indexes.
Following the commercial traders is “Success breeding success.” This group of traders has a fundamental understanding of value either through the production of, or the end consumption of the commodity market in question. These people make the calls on when to stock up on raw materials for future consumption, or when to sell forward production and base their livelihoods on their ability to ascertain value. Furthermore, in the case of publicly traded companies like BP plc (BP), Con Agra Foods (CAG), or General Mills (GIS), their research entreats themselves to the good graces of their shareholders and board members.
November’s trading was an excellent depiction of this mechanism at work. This month saw very strong rallies in metals, grains, and the stock markets. In these three market sectors, non-commercial traders fueled the rallies. In fact, we saw soybeans, platinum, and palladium either reach or nearly reach record historical buying levels. The one thing these markets all had in common was momentum. These market sectors had all been in established upward trends. Many of the non-commercial traders represent commodity funds and exchange traded funds, which are obligated to maintain certain percentages of each market in their portfolios to match their disclosure documents. This forces them to buy more on the way up and sell more on the way down to maintain the proper allocation percentages. Their actions in the marketplace are mechanical and take little account of a market’s value when making their trading decisions.
Here is a link to a .pdf worksheet showing when the COT report hit extremes:
Commercial traders played their hands like the World Series of Poker for the month of November. These same markets that rallied on the strength of non-commercial buying managed to reach their highs just as the threats of European solvency issues and a Chinese slowdown came in to turn the tide. The proactive analysis of the commercial traders throughout these recent market tops allowed them to position themselves favorably for the markets’ coming declines. Their selling was quite obvious on the screens and reported by the CFTC in the COT report.
By Andy Waldock of CommodityandDerivativeAdv.com
