When is a Level a Trap?
When is a Level a Trap?
Commodity Futures markets are dominated by Commercial traders on a daily basis. These Commercial traders are market participants that use the Commodity in their daily business. After all, the reason we even have Commodity markets is because of the Commercial traders. They must be in the market each day hedging (limiting price fluctuation risk so they can lock in a profit margin for their business). This group of traders conducts, on average, 65% of the daily volume in the Futures markets each day. Sometimes people refer to the large traders (large speculators who trade over a certain number of Futures contracts and have to report these to the Exchanges) as smart money. If the truth were to be known, the smart money is actually the Commercials in the markets. They know every fundamental reason for when and why a price should change. Commercials are very well capitalized with lines of credits from banks to back their trading decisions.
Commodity markets are built on supply and demand. When there is excessive demand for a Commodity, prices will rise. When there is excessive supply of a Commodity, prices will fall. At any given time, there is only so much supply of any given Commodity, and once demand strips this supply, it has to be replenished; this will take time. There is always fear in the Commercial trading arena that when a Commodity is needed for delivery or processing, that there may be less supply than anticipated, causing Commercials to pay up as demand outstrips supply.
I tell you this information because if you understand who needs these Commodities, you will understand why there are times during the trading year that prices can be structured to tell us who is controlling the market. There can be excessive demand and the supply is tight causing Commercials to pay up, or supply is plentiful and the Commercials are storing the Commodity.
When studying Futures market prices you can see one of two scenarios: Figure 1
- Normal Market or Contango ñ Prices are less expensive in the near months than the distant months
- Inverted Market or Backwardation ñ Prices are more expensive in the near months than the distant months
Figure 1
Figure 1 shows us the Cocoa and Sugar markets with their corresponding closing prices. Notice how with the Cocoa prices, each month's prices are getting a little higher. This is referred to as a normal market. The reason for each month's prices being higher is that Commercial traders are buying the actual Commodity in the cash market and physically storing it in warehouses until the delivery month arrives. This is typically done when there is ample supply and less demand for a particular Commodity. While storing these Commodities for future delivery, the Commercials will encounter carrying charges. The carrying charges are storage (building rent/mortgage), interest (interest paid on credit line while storing) and insurance (building and inventory). There are other smaller fees, but these three are the primary ones. Adding up all these costs and dividing by 12 will show how much it cost to store the Commodity each month. This is reflected in the ascending price order. During this time, the particular Commodity could be in a downtrend or uptrend.
Figure 1 also shows us the Sugar #11 market. Notice how March is trading for 32.75 and each succeeding month is priced less than March. This is referred to as an inverted market. In London, they call it backwardation. An inverted market sends market participants a very important signal and should be heeded. When you see a market in this inverted formation, it is screaming at you "a full blown bull market is underway and do not step in front of it!"
Markets will become inverted when Commercials perceive there will be, or is, a major supply shortage in the future of a particular Commodity. Remember in a normal market how the Commercials had the luxury of time on their hands and they could buy the Commodity and sit on it until delivery? Well, an inverted market is telling you that nobody is willing to store the Commodity, and everybody wants it right now. All the demand is right now and it outstrips the current supply. As soon as the Commercials get the Commodities in their hands, it is out the door and to a processor or end user.
Figure 2 is a weekly chart of the Sugar market and the bull market we have been in twice now. Both of these bull moves had inverted markets.
Figure 2 shows supply level marked in blue, and to the left, January 2010 (unmarked) is another supply level. When identifying levels on charts, it pays to take some time and look at the price structure of the market you are trading. If you see a normal market, then selling at these levels would probably be a good trade. However, if you see an inverted market, you may want to think twice about selling such a fundamentally dominant bull market. Eventually, the Sugar market will return to a normal market and exhibit its usual carrying charge structure. As of writing this article, the Sugar prices are starting to revert back to a normal market, but it feels too early to say the bull is dead in Sugar.
Even though we all know how to identify support and resistance levels on a chart, it would be advisable to find your edge when it comes to qualifying these levels. Commercial traders are usually very patient and will wait for their price because they understand the fundamentals of the markets better than anybody else. But when you see the prices inverting like they have been in Sugar, you know they are being forced to pay up in price. This is very out-of-character for Commercial traders and should not be ignored.
"There are two kinds of failures: Those who thought and never did, and those who did and never thought." Laurence Peter
Good Trading,
- Don Dawson
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