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Friday, December 28, 2007

The Commitment of Traders Report: Who is Commited to What? - Part I

Let's switch gears and talk about Commodity Futures for a bit. There is another powerful 'early warning system' that I use when I'm trading Futures options in the Commodity Futures markets. It is to be found in the Commitment of Traders Report, or the COT Report.

What is the COT? Well, to understand that, let's examine once again, what we are dealing with, when we are talking of the Commodity Futures market. When you engage in these markets, you are doing more as to speculating about Future prices. Actually, the private individual speculator (you and I) provides a valuable service to the economy in that we provide liquidity to the price of the Commodity being traded. Who are we providing this liquidity, or this ease of movement for?

When we deal with Commodities, we're dealing with ... well ... commodities. Things that our civilization needs in order to function. Let's say we trade in Sugar #11. You are engaged in the market, where the prices for Sugar are determined. Companies deal in huge contracts in the contract months in order to sell the sugar they have produced, or, to buy sugar they need to produce, say, their candy. Pioneer Sugar is looking sell sugar. They are what we would call a "Commerical Interest". But Hershey needs to buy sugar in order to make it's candy bars. They too, are deemed a "Commerical Interest". Many times, traders will simply refer to them as "The Commercials". Without the Commercials, and without the Sugar market, you and I can't pick up a Babe Ruth candy bar. The Commercials are exceedingly well informed as to the price and outlook of the Commodity in which they trade. It is, after all, their livlihood. They also comprise about 80% of the volume in the Commodity Futures Markets. The Commitment of Traders Report will tell you the net positions of all of the Commercial Interests in the Futures Markets, long or short. Many places will even plot these positions over time on a graph for you.

So is it as easy as following what they do to make a profit? You see they are net short, just short the market as well? Well, not so fast. There are different reasons why the Commercials are in the market.

Now here's the important thing to understand about the Commericals. They also use the Commodity Futures Markets as mechanism to hedge whatever it is that they produce or sell, because their business involves a high degree of risk when it comes to their profits and where the future price of the commodity will arrive at.

Let's illustrate it this way. You have a farmer. He's selling Corn. Actual, real Corn. It looks like he'll have a great crop. He might sell his Corn for $6.00 a bushel (I'm just picking that number out for the sake of an example). But, farming involves a lot of risk. Will he actually be able to harvest his corn? Will storms come through and damage his crop? Will it flood? How does he offset such risks? He "hedges his bets" and takes an opposite position to his production expectations in the Futures markets.

That is a very rough example of how a Commerical Interest hedges. Further information can be found in this excellent article. Different Commercial Interests have different reasons for getting involved in the Futures market. Needless to say, it can be hard at times to understand why the Commercials may be in a particular position.

So where are we at with all this?
  1. Just try to remember who the Commercials are, and why they do what they do.
  2. A report comes out each week, called the Commitment of Traders Report, or COT
  3. This report tells you the net positions of the Commericals
  4. Many services will plot this out, over time, on a chart
Are the Commercials positions the only thing that the Commitment of Traders Report tells you? No. I will continue tomorrow with Part II, and we will discuss the Large Traders, and Small Speculators. The other two groups mentioned in the COT Report . . .

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