The Other Big Guy in the Commodity Markets
The Other Big Guy in the Commodity Markets
Trading Commodity Futures used to be on pure Supply and Demand in the true sense before Index Funds came along. For instance, there were consistent seasonal patterns that occurred year after year in the grain markets. In spring, the grains were planted and prices were generally higher during this time of year. During the winter months, much of the grains in the elevators were consumed by livestock (as much as 80% of Corn grown in the United States is used to feed livestock) in feedlots due to the lack of grass available to them. After the grains were planted, the summer droughts and crop diseases would cause their usual price volatility as market participants tried to anticipate what the grain yields would become before the harvest season. As the harvest season would come, farmers would bring their crops in from the fields and take them to the grain elevators to sell them. This would always bring a huge supply of grains to the market at the same time, thereby, causing prices to typically fall. The grains were then put in the grain elevators for winter storage to be used by livestock feeders. Cattle ranchers would purchase grains from the grain elevators during the winter to feed their livestock and then the cycle would begin all over again in the spring. I miss those good old days of reliable seasonal patterns.
Today, investors have an appetite for hard assets known as Commodities. Investors are learning that a diversified portfolio with these Commodities helps to produce wealth building. In Figure 1, notice how the Commodity markets were at very depressed levels and in a sideways channel from about 1983 to 2003. Shortly after the tech bubble in the Equity markets, Commodities started gaining popularity. Many investors were afraid to invest in Commodities by themselves because of all the horror stories they had heard about this perceived volatile market. For many investors, the tech bubble crash was enough wild bull riding for them; they wanted somebody else to manage their portfolios and to diversify at the same time. This demand for Commodity investing led to the growth of Commodity Index Funds. For many traders, these are very similar to ETFs (Exchange Traded Funds) for other markets like Gold, Oil, Grains etc., except that these index funds hold baskets of Commodities instead of just a single Commodity.
Figure 1 (Chart courtesy of Moore Research Company www.mrci.com)
One of the most popular Commodity Index funds is the Goldman Sachs Commodity Index (GSCI). We all know how big Goldman Sachs is and the effect that they have on the Equity markets. Well, they are no different in the Commodity arena. An investor can participate in this index through a Futures contract or an ETF. The ETF is listed on the New York Stock Exchange under the symbol GSP. The Futures contract trades on the Chicago Mercantile Exchange (CMEGroup) under the symbol GI and trades on the Globex 24 hour platform. Refer to the respective Exchanges for the contract specifications of each of these before trading them. As always, I strongly recommend you know and understand the market you are trading.
The GSCI was designed to allow investors to participate in the Commodity markets with a diverse basket of Commodities much like they would by investing in the S&P 500 Index that allows them to trade a basket of stocks in one Index.
GSCI is a weighted index of 24 Commodities and is considered to be an economic indicator. The appropriate weight that is assigned to each Commodity in the index is in proportion to the amount of the Commodity flowing through the economy. Currently, Crude Oil has the largest weighting in the index because of the large world demand for this product.
The GSCI represents a very broad sector of the Commodity markets with the 24 selected products that make up the index. Of these, there are six energy products, five industrial metals, eight agricultural products, three livestock products and two precious metals. Figure 2 shows the products and their respective weights in the index as of October 2010.
This reflects a passive portfolio of long only positions in the Futures markets. Unlike a passive index fund in the equity markets where the Stocks do not expire, the GSCI has to deal with expiring Futures contracts. This requires monthly rollovers in the index.
When the GSCI rolls over the Futures contracts, they always use the nearest Futures contract. Some ETFs use distant Futures contracts which can cause problems with good correlation between the ETF and the Commodity because of inverted (backwardation) type markets.
Since Crude Oil Futures expire every month, the GSCI must roll these contracts each month. Some of the Commodities in the GSCI only expire every 3 months or so and do not need as many rollovers. Figure 3 will list the contract months that each of the Commodities will need to be rolled over.
One of the reasons I wanted to write about this topic is that there is a trade for us Commodity traders that you might want to examine. Each month, when there is a rollover in these contracts, there is an Intra-Commodity Spreading opportunity for five days of the month. On the fifth through the ninth business day of the month there is a rollover from the next expiring contract to the next front month Commodity. GSCI is always long Futures contracts. When the contract needs to be rolled over, they have to sell the long position in the upcoming expiring contract and buy the next front month Commodity. For example, in Crude Oil, currently November is the front month and December is the next front month after November expires. These rollovers are done the month before they expire. This means the November rollover is done during October 7th ñ 13th (9th & 10th fell on the weekend). The Commodity pits have actually named this time of each month as the Goldman Roll.
During this Goldman Roll period, a trader might have an opportunity to place a Spread trade by selling the November Crude Oil contract, while simultaneously buying the December Crude Oil contract. This will put you in sync with some big money coming into the markets. Obviously, you would like to support this trading decision with some technical analysis such as Supply/Demand levels, or perhaps some form of trend analysis.
GSCI usually rolls approximately 20% of their positions per day during this 5-day period. This is a good example for many traders who only watch the stock indexes and think that all rollovers are done on the same day by all market participants. If everybody rolled over on the same day, there would be very wild price swings and this would cause very poor price fills on trades.
The impact that these index funds have on our markets is incredible. The Commercial trader still holds a large percentage of Open Interest in the agricultural markets, but in other sectors, the index funds can have as much as 35% - 40% of the Open Interest. You can view what these large index funds are doing each week by visiting the Commodity Futures Trading Commission website for the weekly release of the Commitment of Traders report. Here is the link to their website: http://www.cftc.gov/MarketReports/CommitmentsofTraders/index.htm
Many of these index funds are called initiating buyers in the market. This means that they typically are buying new highs in the market and being responsive like many traders and trying to buy pullbacks in the market. For this reason, you find large traders during the day trying to push prices higher in anticipation of finding these large buy orders above the market. If you have ever watched a market trend steadily go up for a few hours or days, then all of a sudden see a parabolic move up, it was probably because an index fund was buying the market.
When these index funds get through with their buying frenzy that can last for months or even years, they will then look to take profits like everybody else does. One of the tip offs that the index funds are exiting their positions is the large decreases in Open Interest, as prices fall after a long uptrend.
I hope that introducing you to this group of traders will help you better understand who you are trading with in the Commodity markets. Seems like each day you read reports from the trading floors all around the different Exchanges where you hear the index funds were buyers or taking profits. It seems they are here to stay and we just have to be aware of them and try to avoid getting run over by their passive aggressive trading behavior. I do like the opportunity they offer us when they get ready to roll over their positions.
"To be yourself in a world that is constantly trying to make you something else is the greatest accomplishment." Ralph Waldo Emerson
- Don Dawson
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