Following the Cues of Market Traders
Dec 16, 2013
Fundamental factors, speculators and market psychology play their parts in the dairy market.
By Dave Kurzawski, INTL FCStone
Fundamental factors related to supply and demand are still king when it comes to dictating long-term price direction for dairy markets. However, futures market prices generally anticipate the shift in direction long before the fundamental data reflect this change. This phenomenon often leads novice traders to believe that others in the marketplace already own the "answers to the test." Of course, even the notorious Duke brothers in the movie Trading Places proved that having the data prior to a major report’s release isn’t an infallible trading method.
Market psychology often differentiates one trader from another. In its simplest form, it is the difference between being an anticipatory trader vs. a reactionary trader. Anticipatory traders sell into price strength and buy price weakness. Reactionary traders do the opposite. In futures trading, sometimes size does matter. Although there are exceptions, traders with large positions are primarily anticipatory and traders with small positions are primarily reactionary.
As its name implies, a futures market is a price discovery mechanism. It is a daily consensus of where the entire dairy industry feels prices will be at some point in the future. Futures markets — including milk markets — epitomize the old adage that the whole is greater than the sum of the parts. However, it also is important to separate traders into different groups and see what side of the market they sit. After all, a hedger’s agenda in the futures market is often quite different than that of a speculator.
The Commitments of Traders (COT) Report is one of the most important, yet under-utilized reports offered to dairy market traders. Released every Friday afternoon, the report subdivides every futures contract into three main trader groups: Commercial, Non-commercial and Non-reportable. Commercials are represented by both buy side and sell side hedger with large positions. Both Commercial and Non-Commercial traders must report their positions to the Commodity Futures Trading Commission (CFTC). Non-Reportables are either smaller hedgers or speculators with less than a pre-determined level of futures contracts in any one month depending on the commodity.
The Non-Commercial category is further sub-divided the Non-Commercials into "Swap Dealers", "Managed Money" and "Other Reportables." For the purposes of this article in particular, and dairy markets in general, the Non-Commercial categories are listed by and large under the moniker of "speculator."
Of all categories, it is the Non-Commercials, or speculative categories, who often are the most intriguing group to monitor. Unlike hedgers, they have no loyalty to either the long or short side and tend to shift positions when they anticipate a future change in market fundamental indicators.
To give an example of this, recent Class III market activity – our most liquid dairy market - suggests that the speculative money in Class III is leaning toward the short side of the equation as seen in the chart below. It’s interesting to note that with bullishness due to burgeoning export demand, the COT Report gives us some insight into anticipatory traders potentially looking for a shift in sentiment heading into the New Year.
Meanwhile, the Commercial category – or large hedger activity – is showing a growing long position. This means that commercial buyers are gaining more futures/options market coverage than dairy producers. In other words, buy-side hedgers are scrambling to get coverage while producers are given a sense of price security due to price strength over the past several months. That price security is keeping those who did not already hedge on the sidelines, which is can be dangerous as a "feeling" of price security does not equal profit margins.
Overall the COT Report is not a looking glass into the future. It is, however, a summation of market sentiment that should not be overlooked. And in this case, as export demand reaches a fevered pitch, the COT Report is showing that, by and large, those who are purely looking to profit on paper trades are not as bullish on early 2014 price strength as the news would have you believe.
Dave Kurzawski is a Risk Management Consultant with the Chicago office of INTL FCStone. INTL FCStone offers comprehensive risk-management and margin hedging programs and services to dairy producers, processors, traders and end-users. You can reach him at Dave.Kurzawski@intlfcstone.com.