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How Important are Commodity Futures Speculators?

I have been involved in Commodity Futures trading now for 24 years and have had the opportunity to see first-hand the significance of my participation as a speculator. Many of you are probably wondering what significance one trader could have on something as big as the Commodity Futures markets. And I would expect that kind of question from traders who have only traded on an electronic trading platform. While my trading activity alone does not create the market liquidity needed to keep the world Commodity markets trading daily, collectively our trades make up the required liquidity to make the markets function the way they were intended to some 200 years ago.

Commodity Futures markets are truly a market of Supply and Demand (not to be confused with the supply/demand levels we instruct at Online Trading Academy). Every day of our lives we must use products that are traded on exchanges such as CME Group and the Singapore Mercantile Exchange. Imagine a day without using some form of energy (oil, gasoline, natural gas or heating oil). Then try to survive a day without food or clothing. What about our homes we live in? Lumber, Copper, Cotton and Crude Oil again for roof shingles make up just some of the Commodities used to construct our homes. These products are produced and processed daily by and for commercial interest using these products. Then they are packaged and shipped to end users or consumers for future use.

Because of commercial interest, the Commodity Futures markets were created. With the volatility in prices around the world, you can see how difficult it would be for a commercial interest to know what they were going to pay/get paid when they needed a Commodity sometime in the future. Commodity Futures contracts were created to help commercial interest lock in fixed prices on products that are to be delivered or delivery taken at a future date. Commodity Futures exchanges, where the products trade, act as intermediaries and guarantors of the Futures contracts. They also create the contract specifications for each Commodity Futures contract so every participant knows exactly what they are buying or selling.

This is where I want to explain to you why you and I are so significant to our global economies as Commodity Futures speculators. Many novice traders come into Futures and treat this venture like nothing more than a video game. They see a monitor, mouse and some flashing lights on the screen and get the image of an online game. This is absolutely the furthest from the truth a trader can get when it comes to trading Commodity Futures. From my experience, this is partially the reason so many novice traders fail, because they think of this as a game and not a business for commercial interest to hedge their price risk. The Commodity Futures markets were not created for us speculators; they were created purely for commercial interest to hedge their price risk of the physical Commodity they owned or planned to buy – end of story. Speculation came about because of capitalism and perceived opportunity. For some, this has been the case; for others, it has been their financial ruin. The role of the speculator in the Commodity Futures market is nothing more than to provide liquidity for large commercial interest. The sooner you realize your function as a speculator, the sooner you will see who moves market prices.

Many years ago when I started trading, I was considered the black sheep of my family. Nobody in my family had ever been involved in the financial markets, much less the Commodity Futures markets. I remember my dad warning me that if somebody delivered 40,000 pounds of Live Hogs to our house, that I was going to have to take care of them all. I started thinking I would need a lot of new names for my pets if this ever happened. I assured him that would not happen, but he was just not sure of what I was trying to do with this trading thing. To be honest, I was not sure either.

Being from a blue collar family, I was raised to work hard and put my money in the bank and someday live off social security and the money I had saved over the years at the bank. As a trader, I soon became skeptical of that happening and that I had better take my finances into my own hands. Today, my dad still feels it is safer to have your money in the bank than the markets. When we have family get togethers, I always ask him how that 0.000000001 % interest rate is treating him. He just grunts a little and says rates will come back. I just remind him it probably won’t happen in his lifetime. I know, can you feel the love?

When I got my Series 3 Commodity Brokers license, he did not know what that was either. So, when we were out and he would introduce me to somebody, it went like this, ‘I want to introduce you to my son; he is a bookie.’ Always nice to make your parents proud of how you turned out. So, I thought I would try and explain how important what I do as a trader is to our economy. I tried conveying how expensive certain things would be if traders (speculators) like me were not around. The following is what I explained to him.

Since the commercial interest are so big in the markets, they must pick price zones to place large orders to enter and exit the market. There are two types of commercial interest: Producers and Processors. Producers typically already own the physical Commodity, and Processors are planning on purchasing the Commodity at a future date to process, package and ship at even a later date. A Producer owns the Commodity that makes them net long the market already. To hedge against prices dropping, they sell Futures contracts to lock in higher prices. A Processor will need to purchase the Commodity at some point in the future to process a product (candy, gasoline, bread, etc.). This makes them net short the physical Commodity so they must buy Futures contracts to lock in lower prices for future delivery. Figure 1 will display this price action on a chart.

Commodities Trading Strategies

As we look at Figure 1, we can see that the Wheat Farmer is looking to lock in higher prices to protect the crop he will own. To do this, he is looking to sell the Wheat contract around the $9.20 to $9.80 price zone. He is placing an offer to sell at these prices.

Below that we see that General Mills will need Wheat to make products for some future delivery time. They are posting bids in the $5.75 to $6.40 zone. These become the market bid prices.

If there were no other participants but these two entities, then the current bid would be $6.40 and the current offer would be $9.20. For the market to make a trade, a buyer and seller would have to agree on a price. As this example stands, there is no way they could make a trade with a bid/ask spread that far apart. Neither entity could afford to trade with the other participant and stay profitable.

This is where speculators come into the picture. Speculators act as the engine to get prices from one price point to another so that commercial interest can hedge their price risk. This hedge is rarely done with other commercial interest, but instead they take the other side of the speculators trade in most instances. Notice that as price leaves the $6.40 level that an uptrend starts to form. This is what most speculators are looking for is a trend to participate in. Once they see this trend, the buying will keep coming into the market until a larger force (Producer) absorbs all the current demand in the market. Once this demand is absorbed by the Producer, the price will eventually start to fall because there are no more buyers left. This causes the trend to turn down and the speculators are now looking to sell in this trend until eventually, the speculators push the prices down to where General Mills (Processor) is waiting for lower prices to start buying Futures contracts to hedge with. Eventually, they absorb all the supply in the market and prices will begin another uptrend. At that point, the speculators will jump on board that trend too.

This cycle is repeated over and over in the Commodity markets and yet many are not aware of why prices turn at certain levels and times of the year. It all comes down to the commercial interest that are hedging their positions. Figure 1 shows a perfect cycle of prices rising and falling into these levels. We all know the markets are not perfect as this is just an example of what happens on a regular basis.

By observing this price action, I hope you can see that speculators provide the liquidity to move prices around for these larger commercial interest. Just imagine what a loaf of bread or a gallon of gas would cost us if these Processors had to go out and pay retail prices whenever they had to process a product. I can assure you that we would be paying two maybe three times as much for any commodity product that we would need to buy today. The next time somebody says you are just playing a video game, just explain the significance you play in our global/domestic economy. If they don’t want to see higher prices paid, then they should thank you.

‘The intuitive mind is a sacred gift and the rational mind is a faithful servant. We have created a society that honors the servant and has forgotten the gift.’ Albert Einstein

When trading, always leave space in your mind to learn.

– Don Dawson

DISCLAIMER This newsletter is written for educational purposes only. By no means do any of its contents recommend, advocate or urge the buying, selling or holding of any financial instrument whatsoever. Trading and Investing involves high levels of risk. The author expresses personal opinions and will not assume any responsibility whatsoever for the actions of the reader. The author may or may not have positions in Financial Instruments discussed in this newsletter. Future results can be dramatically different from the opinions expressed herein. Past performance does not guarantee future results. Reprints allowed for private reading only, for all else, please obtain permission.

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