Futures Daily for Feb 14, 2013

Look at natural gas today! I don't think I've ever seen any commodity move nearly 4.5% in a single day before! Wheat, sugar, hogs, and silver are also big movers today! There is plenty of volatility!

CME Expands Hours for Ag Futures

from Farm Futures:

CME Group announced Tuesday it would expand electronic trading hours in its CBOT grain and oilseed futures and options beginning Monday, May 14. The expansion will give the market access to CBOT corn, soybeans, wheat, soybean meal, soybean oil, oats and rough rice futures and options on CME Globex for 22 hours per day.
In a press statement, Tim Andriessen, managing director, agricultural commodities and alternative investments, CME Group says: "As we've grown our customer base in agricultural commodities around the globe, we've received increased interest in expanding market access by providing longer trading hours. In particular, customers are looking to manage their price risk in our deep, liquid markets during market moving events like USDA crop reports. In response to customer feedback, we're expanding trading hours for our grain and oilseed products to ensure customers have even greater access to these effective price discovery tools."

Market Rumors True, Longer Hours Ahead

Part of this move could be in reaction to a new electronic trading platform that fires up May 14 too. Intercontinental Exchange Inc., will begin trading grain futures contracts on the same day, pending regulatory review. That platform will also have a 22-hour trading day, but will use CBOT numbers for settlement. CME says that beginning May 13 for trade date May 14, customers will have expanded access to CBOT corn, soybeans, wheat, soybean meal and soybean oil futures as follows:
Sunday to Monday - 5 p.m. to 4 p.m.
Monday to Friday - 6 p.m. to 4 p.m.
Open outcry trading hours will continue to operate from 9:30 a.m. to 1:15 p.m. Central time Monday to Friday.

The Pandemic of Corruption in the Financial Markets

Jim Puplava: Joining me as my special guest on the program today is Ann Barnhardt, formerly of Barnhardt Capital Management. And Ann, you were a commodity broker for eight years and then you formed your own independent brokerage for six years. A couple of weeks ago you made the painful decision to shut your doors because you felt your clients’ money and positions were no longer safe. What led you to draw those conclusions?
Ann Barnhardt: Well, obviously, it was the MF global collapse and more specifically the fall out after the MF Global collapse and the reaction by the CFTC, the SEC and most especially by the Chicago Mercantile Exchange [the “Merc”]. The actions, specifically by the Merc after the MF Global collapse were unprecedented, unfathomable and completely and totally intolerable. The Merc itself basically did the equivalent of sticking a nine millimeter in their mouth and pulling the trigger by not stepping forward, backstopping the MF Global client accounts and at the very least, the Merc should have allowed the MF Global customers to liquidate their accounts and then transfer to other firms. What the Merc did was the worst possible thing—they froze those people out of their accounts and didn’t allow them to liquidate while the markets continued to trade. And I cannot over-emphasize the importance of that, the risk that those people were exposed to in the cattle business (and my forte is cattle. I am actually a cash cattle person. My brokerage business was geared almost exclusively towards livestock and grade. I have a lot of contacts in the cattle industry who didn’t necessarily do their futures business with me but were contacts of mine who did do business through brokers that cleared through MF) who lost tens of thousands of dollars on hedge positions that they wanted to get out of but could not get out of in the week and a half after the MF Global collapse.
This has never happened before. This was a complete breach of fiduciary duty by the Chicago Mercantile Exchange itself to the point that it literally has destroyed the entire paradigm. I got to the point where I could no longer tell my clients that their free cash customer funds, not even exposed to the market place—just their cash sitting in their account, non-margined—was not safe. I couldn’t tell them that their money was safe. At that point it was morally incumbent upon me to get my client out of this completely dysfunctional, basically destroyed marketplace. Get them off of those railroad tracks and get them away from the risk. Now, I didn’t clear through MF, but with the European collapse and knowing what we know about how these financial entities are leveraged in European paper and the cascading nature of all of this I had to act before the proverbial poop hit the fan because if you sit around and you wait until after the poop hits the fan it is too late. You wouldn’t get anybody out. To me, it wasn’t really a painful decision. It was a complete no brainer.
Jim Puplava: In the past, when firms went under customer funds were intact and the exchanges would step in, as you mentioned earlier, to backstop everything to keep customers 100% liquid. And normally, a quick transfer from the bankrupt firm, the bankrupt firm would be immediately replaced. Why do you think they did not allow that to happen this time?
Ann Barnhardt: You tell me. I will use the word again, it is suicidal. What they did was suicidal. So you are absolutely right. Up until last month on Friday, October 31^st, the customer segregation of funds rule was utterly sacrosanct. Even when Refco imploded and imploded quite dramatically in 2005, no customer funds were gone. It was on the prop trading side of the company but the customer funds were there, were accounted for, and it is the onus of the Mercantile Exchange to audit these FCMs [Futures Commission Merchant]. MF Global was under the auspices and under the supervision, of the auditing supervision, of the CME. And I believe that MF was audited not just annually, but quarterly. Also, there is the question of how in the world can the Merc miss the margin being posted. The Merc is supposed to be moving equity and doing margin wire transfers twice a day every day. How could those customer funds be “missing”. They aren’t missing. They were stolen. They were stolen by Jon Corzine and his cadre of associates at MF Global. So yes, again, to your listeners who may not fully appreciate the gravity of this, this has never, ever happened before. Nothing even close to this has ever even happened before and it is the function of the Mercantile Exchange itself—the reason why the exchanges exist is that they stand in the middle of every transaction and they act as the de facto counterparty to every single transaction so that, for example, my clients never had to worry about the credit worthiness of the other individual, whoever it might be, who is on the other side of any trade that they did.
Now, for every buyer there is a seller and it is a one-for-one, zero-sum game; but to ensure the credit worthiness and the integrity of the market, the function of the Mercantile Exchange itself is to stand in the middle of every transaction and be the guarantor. So a year ago when Terry Duffy held a press conference [watch it here] and said never in the history of the Mercantile Exchange has a customer ever, ever lost funds resulting from the collapse of a firm, he was telling the truth a year ago. Everything changed on Halloween of this year though. And that's why I had to shut the doors of my brokerage because I could not in good conscience continue forward knowing that the Mercantile Exchange was no longer going to fulfill their fiduciary duty.
Jim Puplava: In the futures market, which is highly leveraged, if you open up a futures contract you are usually leveraged 10-to-1, so they require an exceptional firm base on which to function. And the major integrity of the whole system is the segregation of customer funds. That was breached by MF Global. And let’s not sugar coat this, Ann, basically management stole all of the non-margin cash, invested it in highly speculative securities and what has astonished me has been the reaction of the exchange and regulators—where is the investigation into Jon Corzine?
Ann Barnhardt: Well that is the point of this. We are now living in a lawless, Marxist, Communist, usurped, what used to be a representative republic but is no more. This is no longer a nation of laws. This has now transformed into a nation of men. It doesn’t matter what crime you commit. In the case of Jon Corzine, this man has stolen in excess of a billion dollars. I think by the time it is all panned out it is going to be closer to $3 billion of customer funds that he stole. Why did he do it? Is he stupid? Well, of course he’s not stupid. This is a former head of Goldman Sachs. This man doesn’t have a low IQ per se. Why in the world would a man wake up in the morning one day and say you know what, I think I am going to steal all the customer seg funds in this FCM that I’m running, which is the biggest FCM in the country. Yeah, that sounds like a good plan. No. Why would a man like that even engage in a nefarious plot like this? Because he knew going into it he could get away with it. And the reason he could get away with it is he is in tight with the Obama regime. He is one of Obama’s highest fundraisers. Earlier this year Jon Corzine had a fundraiser dinner at his New York City apartment for Barack Obama where it was charged at $35,000 a plate. Okay? He bundled high six figures for Obama in one evening! He is a crony of the regime. This is Marxist Communism. There is no rule of law. And these people, these poor MF customers are just sitting out here helpless to do anything because there is no law enforcement because this is no longer a nation of laws. The rule of law no longer exists. There is no longer justice in this nation. And no nation, no culture, no society can survive if there isn’t a foundation of justice. That is why we are teetering on the precipice of collapse and I foresee civil war coming within the next several years.
Jim Puplava: You know, we had Gerald Celente on this program and he had an account with Lynn-Waldok, which was eventually taken over by MF Global, and he's been trading futures in gold. He had a plan when he built up enough he would eventually take delivery. Well, they stopped him out of his trade, sequestered his margin (or his cash) and forced him out of a trade and closed his account.

[Click here to listen to Gerald Celente's MF Global experience]

So what you are talking about—because the exchange did not backstop and then froze customer accounts—is they forced, would you say, millions if not hundreds of millions of dollars of losses on these customers?
Ann Barnhardt: Absolutely. If we are talking several billion in customer seg funds then the losses that were incurred could easily by the customers in that week, week and a half that they were frozen out could easily, easily get into the hundreds of millions it might even breach into the low billions. No question about that. And yeah, and even with options. You know, I talked to cattleman who have put options on as hedges to put a floor underneath the price of the cattle in case—so imagine this, you buy a put option four months ago, you pay the premium. You post that money. Then this happens, you are frozen out of your account. Your account gets transferred to another firm, without your consent. By the way, none of the customers were allowed any input into this. Their accounts were just sent to RJ O’Brien and other firms like that without their consent. And then once the positions were transferred, even if it was a risk limited position like a long put option, then the new clearing firm called them the next morning after the trade settled and said there was no equity in your account because all that money got stolen. So you are going to have to pay the premium for this put option again. So it's doubling the cost essentially for a lot of these people out here who are dealing in what is supposed to be the very risk limited paradigm of long options. The entire situation could not have been handled any worse. In fact, I would take it a step further. It was handled so poorly I can’t imagine that these people are that stupid at the Merc and at the CFTC and so forth. I can’t believe that the bankruptcy trustee is that stupid. This almost seems like it was so bad that it had to have been nefarious.
Jim Puplava: You know, Ann. You believe that MF Global is just the tip of the iceberg. That there is massive industry exposure to European sovereign debt. In fact, the day you and I are doing this interview the Fed just engineered a major swap with central banks. It was a central bank love fest on Wednesday of group money printing. That tells me that central banks acting in unison the way they did shows they are afraid that there's something big out there that is about to happen and that they are trying to maybe plug a hole in the dyke.
Ann Barnhardt: Well, if anybody out there understands fourth grade arithmetic you know from metaphysical certitude that Europe is done. Europe is mathematically impossible. It cannot be saved. You want to make a start. You even want to make a start at trying to bail out Europe we are talking $25 trillion just to start. And it would then—if you were going to bail out the entirety of Europe—you would now be talking about hundreds of trillions of dollars. Okay, people, there isn’t that much wealth or money on the surface of the earth. The total gross domestic product of the entire planet earth is I think just under $70 trillion. And we are talking about in excess of $100 trillion to bail out Europe? This is now mathematically impossible. These people have so leveraged themselves and so leveraged these governments in these countries giving their brain dead citizenry free hand outs and entitlements that it is now mathematically impossible to save the paradigm. It's not a matter of if the global financial system is going to collapse. Oh, it's going to collapse. You better trust and understand that. It's just a matter of when. And these piddling little maneuvers that these people are making that the Fed is doing. Oh, we are going to give Europe some money. Okay. What I saw this morning, what the Fed is getting ready to do in terms of Europe, is keep Europe going for another seven days. Well, fantastic. Thanks for that. That is literally the brain dead mindset of these politicians. All they are doing is looking to kick the can down the road. At first it was kick the can down another 10, 12 years. Then it is kick the can down the road for another year. And then it was well, let’s kick the can down the road for another few months. Now we're literally to the point where all we can do is kick the can down the road for a matter of a few days. It's not going to make it. I will be very surprised if we make it until Christmas.
Jim Puplava: You know, one would have thought Ann, after the 30 to 40:1 leverage leading up to the financial crisis of 2008, pre-Lehman, that financial firms would have learned. And especially a guy like Jon Corzine that saw Goldman have exposure to AIG with $13 billion in credit default swaps which we bailed him out 100 cents on the dollar. Apparently, this lesson was not learned at MF Global because the leverage, what was the figure? I think it was 100:1—it was just astounding.
Ann Barnhardt: The only lesson that these criminal degenerates learned from the 2008 situation was that they could do anything they want and that pimp daddy government would bail them out. You have to understand, people like Jon Corzine, these are evil, evil people. He went into MF Global looking to rape that company personally for his own good. And that's what the motivation of a lot of these people are. You have to get your heads around this. You have to get your heads around the fact that there are truly evil people in the world who do not give a crap about anyone or anything except themselves, their own personal wealth and their own personal power. And they would sell their grandmother to the Nazis for a nickel without hesitation if they thought they could get away with it. It's the same with people like Jon Corzine, and then we have talked about the fact that Jon Corzine is tied into the Obama regime. And we now know that the government is absolutely stuffed to the gills almost exclusively with this same type of moral degenerate culture. These people that are in the government—not just the Congress and Executive Branch but also in the bureaucracy—they are in it for themselves. They are in it for the money. And two weeks ago when we had the 60 minutes exposé on the insider trading, those of us who have been in the business have known intuitively that that was going on for a very, very long time. We knew that there was front running going on by politicians. A great example of this is someone like Harry Reid. When he entered Congress, Harry Reid had a low six-figure net worth. He now has an eight-figure net worth. And he's never done anything except be a United States Senator. The salary I think of which is something like $170,000 a year. How does that happen? How does a man with $170,000 a year salaried position go from having a six-figure net worth to an eight-figure net worth? That doesn’t make any sense unless he is doing nefarious, illegal, insider trading type deals.
It is obvious what's been going on. You have to start acknowledging these people for what they are, and that is moral degenerates who are basically sociopaths and psychopaths. Meaning they don’t feel any sympathy or empathy for other human beings. The only thing they care about is themselves. They will do anything. They will steal. They will lie. They will cheat. They will lie to your face. They will look in the camera with this tremendous earnestness and lie with fork tongues through their teeth in order to advance their wealth and power. And if we, as a people, don’t get real about this, if we keep having these Pollyanna visions that these people are all on our side and they are really looking out for us. And they are doing the best they can. We will be cork screwed into the ground and this nation will be reduced to a smoldering rubble. You've got to wake up.
Jim Puplava: I would like to go back to MF Global for a second. There is something even worse as you look into the details—it's been hinted and that there could be possible clawbacks. I’m wondering if you might explain that possibility and what a clawback means for, let’s say you had an account at MF Global and, I don’t know, you didn’t feel comfortable with the commodities market—the volatility. So you pulled the money out. There is a possibility they can go after you.
Ann Barnhardt: Oh, absolutely. Clawback is a fairly common tactic in bankruptcies. And what it is is looking at the bankrupt entity and looking at the money that went out of that entity in the time period immediately preceding the collapse. And I don’t know what time frame they would look at MF. I don’t know if it would be 30 days or 60 days or 90 days—I have no idea. But the trustee has in the last two weeks said that yes, clawback is on the table. So what that means is, let’s say for example, you are a savvy individual and you are a good steward of your money. And you are doing business with a firm that clears through MF Global. You are looking at MF Global’s publicly available bond yields. And you see in the six weeks before the collapse that their bond yields spiked parabolically [see chart here]. They went from 6% to 18%. That is a sure, sure sign of massive trouble. And so being an intelligent, informed, aware person who is a good steward of their wealth, what do you do? You say I’m getting out of this company. I am getting my money out of MF Global because something bad is about to happen looking at these bond yields. You can also do the same thing looking at the stock price. You could do the same thing looking at downgrades by the ratings agencies. There's all kinds of ways that you can come to these conclusions.
The other thing is if you're a hedger. If you are a bonafide hedger—if you had positions on and the market moves in favor of your hedge position on the futures side, you don’t leave that equity sitting in your account. What your broker like me does is they wire that money home because you are using that money probably to either offset a cash transaction or to pay down a revolving line of credit. You're not getting any interest on your money sitting at MF Global so you might as well get that equity out of there, send it home and pay down your line of credit so you are not paying interest on that money. So there would organically have been lots and lots of money flowing out of that company in the period immediately before the collapse. Either due to natural hedges, organic in and out functions or due to intelligent people looking at the bond yields and saying uh oh we better get out of here. The bankruptcy trustee can legally claw that money back. Say okay, I am going to go and I am going to dive into your pocket now. And I am going to claw back your money which you, in your responsibility and in your good stewardship pulled out of a company that you knew to be in trouble. Oh yeah, so these MF customers will essentially be raped three times—they will have their cash stolen out of their accounts, they were then locked out of their position so they couldn’t trade and were fully exposed to market risk, paralyzed, unable to do anything for excess of a week. And then, number three rape, is having the bankruptcy trustee come back and literally seize money out of your own personal checking accounts and business accounts and so forth. And clawing it back to feed this bankrupt entity. And you know what the cherry on top of the sundae of all this is? And this is what blows my mind—the bankruptcy trustee, right now, as this is being recorded on the 30^th of November. The bankruptcy trustee is still allowing MF Global to trade proprietarily for itself, for the company proper.
It is unbelievable. The rule of law is dead in this country.
Jim Puplava: You know, adding to this just prior to that was the restructuring of Greek debt, where the derivatives association announced that it was a voluntary restructuring so therefore the bankers didn’t have to pay out on credit default swaps. So what you have here, Ann, I believe is a system where the government is protecting the too-big-to-fail at the expense of the customers. And with it, the rule of law is thrown out to protect Wall Street, what does that say about the integrity of the system? It is no wonder people are losing faith.
Ann Barnhardt: There is no integrity in the system. And let’s make it simple—it is not just about the government protecting the “too big to fail banks". It is about criminal oligarchs as individuals protecting each other. They don’t give a crap about the customers of JP Morgan or you know, Citi or Goldman or anything. What they care about is each other. The Obama regime is protecting Jon Corzine proper, the individual. Because he is one of them. He is one of these criminal oligarchs. And for your listeners who may not remember, Jon Corzine is a former congressman. But immediately preceding MF Global he was the Governor of New Jersey and he just cork screwed Jersey into the ground. It is Chris Christy who beat Jon Corzine to become the governor of New Jersey. So yes, this Republican, Chris Christy, was elected in New Jersey—uber liberal, blue state New Jersey—because Corzine financially destroyed this state. And again, this guy Corzine is former head of Goldman. He is not stupid. You have to stop thinking that these people are just misguided or that there is some sort of a difference of opinion on economic theory. These people are nefariously trying to destroy everything in this country. It's called the Cloward-Piven strategy. Go in and destroy and collapse the entire economy, everything and then rebuild a new Marxist, Socialist, fascist state out of the burning rubble of this destruction. This is intentional. This is nefarious. This is not a function of incompetence. It's a function of malice of forethought and conscientious theft and destruction.
Jim Puplava: What would you advice? I am a long term believer in the bull market in commodities, but how do you play commodities when the futures market is no longer secure? And what does this do to the proper functioning of the markets? In other words, now that you've closed your firm because you don’t believe in the integrity of the system and we just listed a series of reasons why—not honoring contracts, appropriating funds, not allowing trades to go off. Not one investigation, in fact, this goes even further than that. We had Bill Black on the program recently, who helped make prosecutions in the S&L scandal. And at that time, 2,000 individuals went to jail. There has not been one criminal charge brought by the justice department since the 2008 crisis. So given that this is where we are, what do you advise and what will you do personally?

[Listen to Bill Black's tell-all interview on why no one has gone to jail]

Ann Barnhardt: Well get the hell out. Get out of all paper and it's not just the commodities markets. This is going to cascade through everything. It is going to get into the equities. It is going to get into 401ks and IRAs, it is going to get into pension plans and so on and so forth. Total systemic collapse. Get out! I don’t know how I can be anymore plain about this. I say this over and over and over again and then I get scads of emails saying, well I can’t get out of my 401k. Yes, you can. Yes, you can. Take the penalty and get the hell out of there. What would you rather do? Would you rather pay the 10% penalty or would you rather have it all go up in smoke? Because that's what we're staring down the barrel of. Number two, we seem to have this backwards. In terms of what I do, cattle and grain specifically, the futures markets are the derivatives. The futures markets are derived from the actual cash commodity market. Now, I am blessed because my area of expertise is actually in the physical cash market, actual cattle on the hoof. So I have a consulting firm and I'll continue to teach cattlemen how to trade actual physical cattle. But, yeah, to all the people out there listening—you are going to have to get away from paper and get back into physical commodities, the real deal. Anything that is on paper anything that involves a promise or a commitment is no longer valid because as we said there isn’t a rule of law anymore. People can steal from you. Your money can be confiscated. And think how easy now it is to confiscate people’s wealth. Most of our wealth in this society exists as zeroes and ones on a computer server. It takes no effort whatsoever to steal zeros and ones on a computer server. So what I have been telling people is you need to get into physical commodities. And the rule of thumb is if you can stand in front of it with an assault rifle and physically protect it, then it's real—it's a real commodity. That includes food, that includes water, that includes long guns and ammunition. That includes fuel. That includes precious metals—gold and silver coinage. Most especially silver coinage because silver is the metal of barter and transaction and currency. Gold is the storage metal because it's so valuable per ounce. And also, silver is extremely undervalued relative to gold because that market has been synthetically suppressed for the last several years by again, these nefarious actors. So yeah, reallocate into physical commodities.
Jim Puplava: How do you know that somebody like just as we saw in 2008 or recently with MF Global—that is somebody like a Goldman, a JP Morgan that is writing credit default swaps on European debt—how do you know if you have an account with this group that they pledge your assets for collateral or they comingle them with the firm’s assets and then what do you do?
Ann Barnhardt: Oh, exactly. Corzine isn’t alone in this. The reason the MF Global situation happened the way it did is as we eluded to earlier because Corzine had that company just suicidally leveraged. He took those customer funds and then leveraged it into European, sovereign, junk paper at about 100:1 ratio. Massive. Massive leverage. That is why his collateral call was the first one to come and why it took him out because he was so heavily leveraged. Don’t kid yourself. These other entities are doing the same thing. It is just that they are not as heavily leveraged as Corzine was. So yes, the entire paradigm is no longer trust worthy. There is no meaningful government or industry wide regulation and I have been saying this for years. That regulation in the financial industry in the United States both government based and private regulation—private industry regulation—is a monstrous, monstrous joke. The top tier of those organizations are evil, nefarious people. The mid level are halfway stupid, halfway evil who again, are just there to collect their salary paycheck and will say and do anything that they are told and who really don’t understand the business that they are trying to regulate. And then the lower level, the grunts, the actual auditors who go out on site, a lot of those people are super incompetent, affirmative action hires. And yes, I said it and I am not ashamed of it. They are affirmative action hires. They have no business being there doing what they are doing. They are also hiring a lot of kids 15 minutes out of college who are literally reading off the script and couldn’t audit a company if their life depended on it.
So what they do is they send these incompetent people out into the field and into lower management. And then when the poop hits the fan, they blame them. It is absolutely evil and it is a complete joke. And Madoff was the first proof of that. There have been other ponzi schemes since Madoff happened that haven’t gotten as much notoriety, but there was a big one in the futures industry that all of the FCMs were invested in. And the regulatory body of the futures industry the NFA, they audited that Ponzi scheme, they totally missed it. They even admitted that they signed off on it because they really didn’t understand what they were doing. I mean, that is the level of incompetence and evil that we are talking about in terms of these regulatory bodies. The only way to fix this is to shut the whole damn thing down and start from scratch. I am personally looking in the next decade for the emergence of a new exchange within the United States [that is, a replacement of the Chicago Mercantile Exhange]. Word on the street is it might happen in Dallas and I would be fully in favor of that. Start over from scratch.
Jim Puplava: Alright. Well the message: get physical and protect yourself. We have been speaking with Ann Barnhardt, formerly of Barnhardt Capital Management. Ann, I want to thank you for coming on the program and sharing your thoughts.
Ann Barnhardt: Thank you for having me, it's been a pleasure.

ETFs Vs. Futures

by Jeff Carter:

In the comments, and in my email I received corrections on my math.  That 500 SPY equal 1 ES.  That changes the calculation on my profit/loss.   Also in calculating the emini profit, I made the mistake of calling a 5 lot emini trade a “one lot” trade.  My confusion came from 5 ES=1 SP.
The advantages of futures are these:
1.  lower commissions
2.  little or no slippage, no trading against your order, no internalization of your order.
3.  more bang for the buck, you are able to control a lot of stock for smaller money.
4.  ability to trade 24/7
5.  Faster electronic systems. Futures platforms are speedier for the retail trader.
6.  Better taxation
ETF advantages
1.  Less volatility; the market isn’t as highly leveraged
2.  More accessible through more retail platforms.  Your broker might not offer futures.
3.  If you decide to step up your size, your commission rate can go down.  In futures to get rates down you must lease or purchase a seat at a futures exchange.
Original Post with corrections below (corrections in italics)
There are a lot of fund manager’s that recommend ETF’s. There are a lot of traders that like trading them, and the retail public seems to like them. ETF’s can be pretty innovative. They allow you to take a flyer on a market segment, while still incorporating Eugene Fama’s efficient market hypothesis(EMH) because you aren’t picking a single stock, but a basket of them.
If you adhere to the EMH, you will be invested in a mutual fund or ETF that replicates that broader market. Buying sector ETF’s allow you to raise the “beta” in your portfolio, assume a little more risk, without assuming the risk of holding one single stock.
However, if you are looking to increase your beta on the entire market, you’d be better off trading futures. If you want to cash in on the commodities craze don’t trade a commodities ETF.  You’ll be better off in the futures market.
Let’s compare and contrast a popular futures contracts with it’s ETF. Everyone knows about the S+P 500. It is the fund manager’s index. The ETF that replicates that index is called the $SPY or “spider”. The futures contract that replicates it is the S+P 500, but there is a bite sized contract called the emini S+P that is exclusively traded electronically.
For this example, assume that you thought the market was going up. We will also assume you are clairvoyant, and bought the low of the day and sold the high of the day.
If you buy a $SPY, the commission rate for a normal trader is $9.99. Some discount houses don’t charge you a commission at all! Of course, that means they are trading in house against your order and giving you a worse price than you would have gotten in the market. Or, they are selling your order to a hedge fund or bank and you still are getting a worse price. Let’s assume your slippage is only one penny, it’s probably a bit more.  There is no free lunch anywhere in the market.  If you are buying 1000 contracts though, it’s still costing you an extra $10 on each side of your trade, or $20 all day.
Yesterday’s $SPY range (2/4/2011) was 130.23-131.20, or .97. If you bought the low and sold the high you made $970. Nice trade! Of course, your commission costs were $19.98, slippage costs $20, leaving you with a profit of $930.02. Uncle Sam wants his piece. That will cost you 35% in the top tax bracket. $325.51 bucks. Your net/net is $604.51. You can still buy the first round of beers at the close.
But, what if you did the same thing in the futures market using an eMini S+P? The cost to trade 1 eMini future is $2.01.  To compare apples to apples, you would have executed a two lot.   2 ES=500 SPY Commission=$4.02. In futures, there is no internalization or payment for order flow.  You play in the same pool with everyone else.  Advantage here is the futures market by $35.97 all in on commissions and slippage.
The range yesterday was 1298-1308.50 If you bought the low, and sold the high you made 10.50. On a  2 lot trade, you made $525.  Less commissions, you made $520.98.  Uncle Sam still wants his piece, but he wants it in a different manner.  Futures are taxed at 60/40.  This means 60% of your gain is taxed at the capital gains rate, 15%, and 40% at whatever the highest tax bracket rate is.  In this case, the highest rate is 35%.  The blended rate works out to be roughly 23% or $119.83.  Your net profit is $401.15.
ETF profit, 604.51.  ES profit $401.15.   $203.36 in favor of the ETF. For every future you add, you get $262.50 added to your profit.   It costs you $2.01 to add.  If you trade 3 futures, the profit is equivalent.
Already I can hear the critics and retail brokers screaming.
Here are some other differences in the markets.  Futures trade 24 hours, and are more volatile than ETF’s.  I’d readily concede that point. Because futures are traded on margin, they have more volatility.  ETF’s margin can only be 50%.  A futures contract will always have more intraday volatility than a cash equity contract.
They will say the ranges of the two products are different, so of course the money will be different.  However, dollar for dollar the all in costs of trading+taxes are significantly higher in the ETF world than the futures world.  Let’s assume I made $1000 bucks in each.  After commissions, slippage and taxes, my take in the ETF would be $624.01.  In futures, $754.52.  You are giving up 21% of your profits for the same analysis that goes into the trade!
You might say, I don’t trade 1000 lots in the stock market.  That’s cool.  You can assume as much or as little risk as you want in the futures trading.  Just remember 1 eMini~ 250 500 shares.  As you trade less, the advantage swings to futures even more, because commission rates get even cheaper by comparison.
The bang for the buck you get with futures, lower all in commissions, and lower taxes gives you incentive to take on that volatility.  Plus, virtually all futures are traded electronically.  You are not waiting to find out if you are filled.  You are filled in the blink of an eye.
The nice thing about ETF’s is that there are so many of them.  They are pretty versatile so you can use different ones to try and take on more risk.  The federal government via the SEC prohibits trading of narrow based indexes.  Exchanges like CME Group and ICE can’t offer a futures contract based on a narrow basket of stocks.  There are ETF’s that you may want to trade that cannot be replicated by futures.
But, if you are going to trade Gold ETF’s you can see from the above example you’d be far better off trading Gold eMini’s.  If you want to trade an Oil ETF, you are far better off trading an Oil eMini.  Take a flyer on a currency?  You are better off trading eMicro’s or eMini currencies at $CME.
You get the picture.  Expand your horizons and you will expand your profitability.

Stock Futures Collapse After Stock Exchanges Close Early for Holiday

Lind/Waldock Themes for 2010 Futures

The financial and commodity markets will be influenced by a number of major events in 2010. Central banks are ripe to exit a period of unprecedented monetary ease, governments in Japan, Europe, and the U.S. will issue historically high levels of debt, parts of the emerging world face real estate and equity market bubbles, and the U.S. will hold important midterm elections, which could impact consumer and business confidence. Furthermore, the euro will face a test of its reserve currency status with numerous countries failing to meet the Maastricht Treaty. These dynamics are occurring during a historically slow economic rebound. Below are ten themes which should influence market pricing throughout 2010.
1. Trend toward normalized monetary policy
As the international macro landscape continues to show signs of improvement, the unwinding of the ultra-stimulative policies that fueled the global recovery will be a major theme of 2010. Monetary tightening will remain very uneven as the continued variation in the pace of regional recoveries dictates a divergent exit. The draining of excess liquidity will expose vulnerabilities in the financial system.
2. Excessive appreciation in emerging market real estate and equity markets
Policy stimulus in the emerging world was excessive and likely exceeded the amount necessary. The policy backdrop remains supportive for EM equities. The cocktail of globally loose policy, the search for yield, and fundamentally appealing EM picture may prove to be a mixture quite alluring to capital, thus encouraging speculative flows.
3. Growing uncertainty over the ability of governments to fund large decifits
The IMF predicts that in 2010, the average government gross debt as a percentage of GDP for the seven major advanced economies will be 109 percent, and 113 percent in 2011. It was only 84 percent in 2007 and 77 percent in 2000. History suggests that post-recession, the reduction in government spending is rarely equivalent to the increase catalyzed by the retrenchment in the private sector. Diluted interest in government debt and an increased budget deficit-to-GDP ratio will put upward pressure on yields, and perpetuate steepness in the yield curve.
4. Jobless Recovery
A jobless recovery will characterize 2010. MFGR sees the unemployment rate peaking in 2010 at 10.5 percent and closing the year between 9.5 percent and 10 percent. The unemployment rates in EM and ASEAN countries should fall more steadily, while it will likely increase in Europe. On the U.S. front, the outlook for taxes is murky, and the healthcare initiative, which will likely force all employers to provide care or pay a penalty, will discourage the expansion of the labor force.
5. The composition of global growth in 2010 is not significantly different than 2009.
MFGR believes that the recovery pattern witnessed in 2009 will continue into 2010. Asia will see steady expansion. The U.S.’s economic outlook will pick up gradually and Europe will face a stagnant and anemic recovery. The U.S. will lead the recovery out of the Eurozone and Japan. Global imbalances will continue to unwind. Countries such as China will ultimately move toward tighter monetary polic and looser fiscal policy in terms of tax regimes in order to control inflation and perpetuate growth.
6. Passage of the Democratic healthcare plan will mark an apex in U.S. liberlism. Government policy will shift toward the center into mid-term elections.
The public is angry over the impact of a stimulus plan which may have saved the financial system from meltdown, but did little to improve the standards of living. Politicians, at the core, are survivalists, and thus, policy is likely to move toward the center to attract discontented voters.
7. The tax burden in the U.S. and Europe is likely to increase.
The ongoing deterioration in public finances, at both the state and government levels, will put upward pressure on taxes in the U.S. In Europe, taxes are increasing for higher-income workers in the U.K., and the Greek budget will work to cut down on tax evasion, while raising tax on property transactions.
8. The VIX is likely to remain capped.
Historically, the VIX moves inversely to the path of profit growth and positively correlates with the trend in the Fed funds rate, with a two-year lag. The trend in profit growth and the level of the Fed funds rate argue for low volatility through 2010. A major or lasting rally in capital market volatility looks more likely in 2011.
9. Investor appetite for commodity investment is uncertain, but most likely to ease.
Investment flows into commodities had been strong in recent years. The low interest rate environment and distrust of equity markets have supported commodity buying. Going into 2010, some of the headwinds supporting commodities as an asset class will diminish. It is hard to believe investors will year after year raise their allocations to commodities.
10. Intermarket correlations will erode as individual market fundamentals become the predominate driver of capital and commodity market price direction.
The heavy liquidation of all asset classes in late 2008 and early 2009 has ended, and money has moved back into the financial and commodity markets. The normalization of investment flow should allow markets to focus more on individual fundamental factors. Hot money is not likely to just flow in and out of the market based on risk-taking, as most books should be near desired weighting.

Series of Grain-Related Tweets

Arlan Suderman, in an online chat through Twitter, is explaining agricultural futures:

Good morning, Nick, and all who are following for this onthefarm chat

I write market analysis for Farm Futures the magazine, FarmFutures.com and daily e-newsletter Farm Futures Daily. 

It used to mean just studying supply and demand fundamentals and seasonal charts, but it's much more now.

This week's markets are a good example. Fundamentals didn't change, but money flow dynamics gave far different results day to day

The grain futures market is designed to be the purest form of supply & demand driving price that there is.

Traders bid for grain or livestock each day in the pit based on what they believe the future value of the commodity will be.

They're traded in standardized futures contracts of 5,000 bushels with a set delivery month for the contract.

Traders are pricing in an expectation/fear of a big increase in yields in USDA's October 9 crop report, like in 2004

Supplies are always largest at harvest, pressuring prices, but fear/emotions play a major role in driving prices day to day.

The focus tends to shift to demand trends once traders have a handle on the size of the crop; usually by mid-October.

Traders are like you & I; trying to make a living. They manage massive amts of $$. Their job rides on being right.

They fear being wrong; particularly newer traders who haven't been through volatile markets before. Greed also plays a role.

Last fall's collapse of the financial system provided another example.

Ordinary Americans w/ $$ invested in funds demanded cash back from the funds, requiring them to liquidate positions in futures.

Greed was a factor, but fear was also a major factor. End users were afraid that Midwest floods has slashed production.

End users are usually slow to panic, but they'll provide the final push in a bull market fearful they won't have enough grain.

Speculative funds are usually sellers before prices hit their peak. They typically recognize when prices are getting too high.


Fund investment of corn, beans Chic & KC wht topped $55 bln in spring '08, several months before market peaked. 


It's difficult to draw conclusions from 1 or 2 data years, but new genetics certainly have helped crops deal with adversity. 


New genetics has given great stability to production agriculture, making traders wary to buy into a weather threat after 2008. 


We haven't had a widespread drought since 1988. Hopefully drought tolerance will be well est. before we do again in genetics.


I think it says a great deal that demand will grow by nearly 1 bln bu. this year and we still have plenty of corn to meet it. 


I follow overall production trends. There's a difference between what happens on the individual farm and across the Corn Belt. 


I closely follow how genetics is impacting overall production trends and ability to withstand adversity.


We then adjust our forecast models accordingly for anticipating yield results. 


Great consistency of production. I use a 20-year trend yield. We've varied from that trend by more than a few bu. 2x in recnt yr


This year will be a great test of genetics. Sunlight is a major limiting factor of yield. The Midwest was quite cloudy this summer


If in fact this is a big crop, it will mean that genetics is re-writing the text book on photosynthesis. 


I should say that corn yield consistency has been excellent. Soybeans have still struggled w/ dryness/adversity late in growth. 


One of the factors that drives me is the money-flow dynamics of the markets. 


Analysts point to yields, demand, etc., but prices often follow DOW & crude tick for tick, inverse of the dollar on currency mkts 


We've seen that happen a lot this fall. Seasonal harvest pressure adds to losses as $$ rallies, but falling $$ supports prices. 


Dollar, equity & energy markets are very intertwined on a daily basis. Dollar is probably most dominant factor this year. 


However, these markets have taken their turns in which leads on a day to day basis. Dollar currently more dominant. 


Big focus today is on Federal Reserve meeting, with policy statement coming out as grain markets close at 1:15 CDT. 


Any change in Fed policy to withdraw stimulus could lead to seasonal correction in equity/energy mkts, pressuring grains. 


That would likely be accompanied by rise in dollar, but I expect Fed to hold the line yet at this time.


Non-ag traders looking 3-5 years out. Fiscal policy argues for cheap dollar leading to inflationary pressure.


Commodities provide hedge against inflation; particularly food- and energy-based commodities. Global stocks of each are snug.


Today is interesting. Grains are divorcing a bit from outside markets.


Underlying chart support held when crude pressured prices early. Traders covering short (sold) positions. Chart-driven. 


Demand is also picking up on price breaks as end users take advantage of cheaper prices. 


Soybeans are the driver short-term, but corn takes a stronger leadership role in 2010 and 2011 as the global economy heals.


Traditionally, wheat is the leader. Domestic stocks need to shrink first. Much of recent rise in global wheat stocks is in China. 


China will be a major driver of grain demand over the next several years. 


That's why we follow China's economic recovery closely. China is buying soybeans at nearly twice the pace of last year's record buying spree.


They had a shorter crop due to drought and they also would rather own hard assets vs our shrinking currency.


China places high priority on having adequate food supplies. It must avoid social unrest. 


It will threaten actions against food imports, but it will be very selective in actually doing so. Food stocks are essential. As such, no actions on soybeans until they have enough.



Demand is so strong that we must have a big bean crop this year. We'll find out Oct. 9 if we do or not. Rationing needed if not.


In other words, the final crop size will determine if we have significant upside potential or not. We're a few weeks from knowing


I'm bullish agriculture. We're in a slump now, but that will turn. The world needs our production capacity.


However, we must be smart about it and maintain equity stability on the farm. Keep debt to a minimum. Manage margins. 


We should mention that the markets are highly regulated already, unlike the picture one gets from the news these days. 


I think we've covered enough to make people think. In summary, I'm bullish US agriculture!

Taking Down Michael Masters

Scott Irwin takes down Michael Masters

Econbrowser is pleased to host another contribution from Scott Irwin, who holds the Laurence J. Norton Chair of Agricultural Marketing at the University of Illinois. Today Scott offers a critique of a recent report by Michael Masters on the role of commodity speculation.

The Misadventures of Mr. Masters: Act II
by Scott Irwin

The impact of speculation, principally by long-only index funds, on commodity prices has been much debated in recent months. The main provocateur in this very public debate is Mr. Michael Masters, a hedge fund operator from the Virgin Islands. He has led the charge that speculative buying by index funds in commodity futures and over-the- counter (OTC) derivatives markets has created a "bubble," with the result that commodity prices, and crude oil prices, in particular, far exceed fundamental values. Act I of the Masters farce was his testimony to the Homeland Security Committee of the U.S. Senate in May of this year. Act II is now upon us in the form of a lengthy research report co-authored by his research assistant, Mr. Adam White, and his testimony this week to a subcommittee of the Energy and Resources Committee of the U.S. Senate.

My purpose in writing this post is to show that Mr. Masters' bubble argument does not withstand close scrutiny. He first makes the non-controversial observation that a very large pool of speculative money has been invested in different types of commodity derivatives over the last several years. The controversial part is that Mr. Masters concludes that money flows of this size must have resulted in significant upward pressure on commodity prices, which in turn drove up energy and food prices to consumers throughout the world. This argument is conceptually flawed and reflects a fundamental and basic misunderstanding of how commodity futures and related derivatives markets actually work. It is important to refute Mr. Masters' argument since a number of bills have been introduced in the U.S. Congress with the purpose of prohibiting or limiting index fund speculation in commodity futures and OTC derivative markets.

The first and most fundamental error Mr. Masters makes is to equate money inflows into futures and derivatives markets with demand, at least as economists define the term. Investment dollars flowing into either the long or short side of futures or derivative markets is not the same thing as demand for physical commodities. My esteemed predecessor at the University of Illinois, Tom Hieronymus , put it this way, "for every long there is a short, for everyone who thinks the price is going up there is someone who thinks it is going down, and for everyone who trades with the flow of the market, there is someone trading against it." These are zero-sum markets where all money flows must by definition net to zero. It makes as much logical sense to call the long positions of index funds new "demand" as it does to call the positions of the short side of the same contracts new "supply."

An important and related point is that a very large number of futures and derivative contracts can be created at a given price level. In theory, there is no limit. This is another way of saying that flows of money, no matter how large, do not necessarily affect the futures price of a commodity at a given point in time. Prices will change if new information emerges that causes market participants to revise their estimates of supply and/or demand. Note that a contemporaneous correlation can exist between money flows (position changes) and price changes if information on fundamentals is changing at the same time. Contrary to what Mr. Masters asserts, simply observing that large investment has flowed into the long side of commodity futures markets at the same time that prices have risen substantially does not necessarily prove anything. Mr. Masters is likely making the classical statistical mistake of confusing correlation with causation. One needs a test that accounts for changes in money flow and fundamentals before a conclusion can be reached (more on this later).

Mr. Masters' second error is to argue that index fund investors artificially raise both futures and cash commodity prices when they only participate in futures and related derivatives markets. In the very short-run, from minutes to a few days at most, commodity prices typically are discovered in futures markets and price changes are passed from futures to cash markets. This is sensible because trading can be conducted more quickly and cheaply in futures compared to cash markets. However, equilibrium prices are ultimately determined in cash markets where buying and selling of physical commodities must reflect fundamental supply and demand forces. This is precisely why all commodity futures contracts have some type of delivery or cash settlement system to tie futures and cash market prices together. (This is not to say that delivery systems always work as well as one would hope. See my earlier post here.)

It is crucial to understand that there is no change of ownership (title) of physical quantities until delivery occurs at or just before expiration of a commodity futures contract. These contracts are financial transactions that only rarely involve the actual delivery of physical commodities. In order to impact the equilibrium price of commodities in the cash market, index investors would have to take delivery and/or buy quantities in the cash market and hold these inventories off the market. There is absolutely no evidence that index fund investors are taking delivery and owning stocks of commodities. Furthermore, the scale of this effort would have to be immense to manipulate a world-wide cash market as large as the crude oil market, and there simply is no evidence that index funds are engaged in the necessary cash market activities.

This discussion should make it crystal clear that Mr. Masters is wrong to draw a parallel between current index fund positions and past efforts to "corner" commodity markets, such as the Hunt brother's effort to manipulate the silver market in 1979-80 . The Hunt brothers spent tens of millions of dollars buying silver in the cash market, as well as accumulating and financing huge positions in the silver futures market. All attempts at such corners eventually have to buy large, and usually increasing, quantities in the cash market. As Tom Hieronymus noted so colorfully, there is always a corpse (inventory) that has to be disposed of eventually. Since there is no evidence that index funds have any participation in the delivery process of commodity futures markets or the cash market in general, there is no logical reason to expect their trading to impact equilibrium cash prices.

A third error made by Mr. Masters, and unfortunately, many other observers of futures and derivatives markets, is an unrealistic understanding of the trading activities of hedgers and speculators. In the standard story, hedgers are benign risk-avoiders and speculators are potentially harmful risk-seekers. This ignores nearly a century of research by Holbrook Working, Roger Gray, Tom Hieronymus, Anne Peck, and others, showing that the behavior of hedgers and speculators is actually better described as a continuum between pure risk avoidance and pure speculation. Nearly all commercial firms labeled as "hedgers" speculate on price direction and/or relative price movements, some frequently, others not as frequently. In the parlance of modern financial economics, this is described as hedgers "taking a view on the market." Just last week, when commenting on new survey results of swap dealers and index traders , the CFTC stated that, "The current data received by the CFTC classifies positions by entity (commercial versus noncommercial) and not by trading activity (speculation versus hedging). These trader classifications have grown less precise over time, as both groups may be engaging in hedging and speculative activity." (p. 2)

What all this means is that the entry of index funds into commodity futures markets did not disturb a textbook equilibrium of pure risk-avoiding hedgers and pure risk-seeking speculators, but instead the funds entered a dynamic and ever changing "game" between commercial firms and speculators with various motivations and strategies. Since commercial firms have the considerable advantage of information gleaned from their far-flung cash market operations, they have traditionally dominated commodity futures markets and speculators have tended to be at a disadvantage. (If you are skeptical, I recommend reading the classic study by Michael Hartzmark about who wins and loses in futures markets.) In this light, entry of large index fund speculators has the potential to improve competition in commodity futures and derivatives markets, particularly as index funds become smarter about moving in and out of their positions.

I believe the points made here already build a persuasive case against Mr. Masters and his bubble theory. But there is more. It is possible to conduct a formal test of the hypothesis that money flows from index funds aided and abetted the recent boom in commodity prices. This can be done by running what are known as "Granger causality" tests between futures price changes and index fund position changes in commodity futures markets. To begin, the evidence available before the current commodity price boom ( summarized here ) would lead one to be highly skeptical of the hypothesis that positions for any group in commodity futures markets consistently lead futures price changes (this will not be true for individual traders with real skill). The CFTC has conducted thorough Granger causality tests in the crude oil futures markets, and guess what? They found absolutely nothing using non-public data on the daily positions of commercial and non-commercial traders. I am working with a Ph.D. student here at the University of Illinois to extend this testing to other commodities using the same daily database of trader positions, including those for index fund traders. As you might guess, I do not expect to find much evidence of a connection between index fund trading and futures price movements in other commodity markets. If we find anything, I expect the relationship to be small and fleeting.

While it is always possible to dither over the power of Granger causality tests or whether the specifications adequately control for changing fundamentals, I think most unbiased observers will reach the same conclusion: there is virtually no hard evidence to date of a link between index fund investment and commodity price changes. Isn't it about time for Mr. Masters to exit stage left?

Understanding Commodity Arbitrage

from Econbrowser:

Commodity arbitrage

Scott Irwin is the Laurence J. Norton Chair of Agricultural Marketing at the University of Illinois. He has been doing some fascinating research on the relation between spot and futures prices in agricultural markets that may shed some light on the role of speculation in recent commodity price movements. We are delighted that Scott agreed to share some of the results of his research with Econbrowser readers.

Commodity Arbitrage
by Scott Irwin

The performance of commodity futures markets during delivery periods is normally little-noticed and followed only by a few economists with an inordinate interest in these markets. However, that has changed in recent months due to skyrocketing interest in commodity markets in general and the odd behavior of cash and futures prices during delivery periods for grain futures contracts at the CME Group (formerly the CBOT).

First, some background. Most storable commodity futures markets, such as those for corn, soybeans, and wheat, are still based on physical delivery. If I buy one December 2008 corn futures contract and hold the contract to the delivery period (normally the first half of the expiration month), then I, the "long," will receive 5,000 bushels of corn at one of the specified delivery locations from the "short" on the other side of the contract. The short (seller) must supply the corn either out of their inventory or purchase the grain in the cash market. It is important to note that the vast majority of futures contracts are offset before the delivery period and only a small percentage of futures contracts typically are settled by actual physical delivery. However, the delivery process is nonetheless essential as it ties the futures price to the cash price at delivery locations. In a perfect market with costless delivery at one location and one date, arbitrage should force the futures price at expiration to equal the cash price. Otherwise there would be a violation of the law of one price.

In reality, delivery on grain futures contracts is not costless (who really wants corn on a barge at an Illinois River shipping station) and complicated by the existence of grade, location, and timing delivery "options" that have a demonstrated value to sellers of contracts. So it is better to think of a zone of convergence between cash and futures prices during delivery periods, with the bounds of convergence determined by the cost of participating in the delivery process.

This is where things get interesting. The charts shown below are drawn from an ongoing research project to examine the delivery performance of CBOT grain futures contracts over the last several years. (My collaborators on the project at the University of Illinois are Darrel Good, Phil Garcia, and Eugene Kunda.)

The charts show the difference between cash and futures prices (the basis) on the first and last day of the delivery period for corn and wheat futures contracts expiring between December (Z) 2001 and March (H) 2008 and soybean futures contracts expiring between November (X) 2001 and March (H) 2008. (For those readers unfamiliar with the letter designations for contract months, the monthly codes can be found here.) As an example, the soybean delivery location basis for the November 2001 contract (in the Illinois River North of Peoria shipping zone) was -25.75 cents per bushel on the first day of delivery and -16.75 cents/bushel on the last day of delivery. Note that a negative basis means the futures price is greater than the cash price and a positive basis means that the futures price is less than the cash price. Also keep in mind that there are two delivery zones for corn, four for soybeans, and three for wheat. Convergence patterns at the presented location for a given commodity are representative of the convergence patterns at other locations.

In each of the three markets, convergence generally is within reasonable bounds through 2005 (ignoring problems created by hurricane Katrina in September 2005). Starting in early 2006, convergence performance deteriorates in all three markets, reaching a nadir in September (U) 2006 when the cash price of wheat ended up 90 cents below futures on the last day of the delivery period. Corn and soybean contracts recovered somewhat by late 2006 and early 2007, but wheat continued to perform very poorly. It is interesting to observe that these patterns reversed during the remainder of 2007 and early 2008. Now it is the soybean market that is performing the worst, with the cash price 85 cents below futures on the last day of the delivery period for the March (H) 2008 contract.

While the recent convergence failures are dramatic, in isolation each episode is not necessarily damaging to the overall economic functioning of the markets. The real economic damage is associated with increased uncertainty in basis behavior as markets bounce unpredictably between converging and not converging. This is damaging because, as first pointed out by Holbrook Working many years ago, basis in storable commodity futures markets should provide a rational storage signal to commodity inventory holders. If the difference between the current cash price and futures for later delivery is wide (cash well below futures) this should be a signal to store and vice versa. However, this depends on the signal being accurate. That is, the basis should narrow over time thereby earning "the carry" for someone holding stocks of the commodity and simultaneously selling the futures.

The following chart dramatically illustrates the deterioration in basis predictability for soybean futures contracts since 2006.

The x-axis measures the level of the delivery location basis on the day after the preceding contract expires (except new crop November contracts, which start on the first trading day of October). The y-axis measures the change in the delivery location basis from the day after the preceding contract expires to the first day of delivery. If delivery location basis is perfectly predictable, then all points will lie on a line with a slope of -1 that runs through the origin. In other words, if basis is -50 cents/bushel two months before expiration, the change in the basis over the subsequent two months should be +50 cents/bushel. The blue regression line indicates the soybean futures market performed reasonably well before 2006 compared to this theoretical benchmark. The red regression line shows the precipitous drop in basis predictability over the last two years. Not only does basis change by far less than the initial basis (slope = -0.36), the wide scatter of points indicates very little precision in predicting the change. More formally, R² is an indicator of hedging effectiveness and it drops from a respectable 78% pre-2006 to only 19% post-2006. I believe this is an underlying reason for much of the current uproar over convergence problems.

An obvious question is what caused this mess. One line of thinking is that this reflects a temporary imbalance in the markets due to the extraordinary structural changes going on in commodity markets. While it is certainly true that the markets have gone through once-in-a-generation changes in price levels, extraordinary tight supplies, and unprecedented speculative investment, this still does not answer why arbitrage was unable to bring cash and futures prices together during delivery. It is difficult to envision an increase in delivery costs that would explain the magnitude of convergence failure we have seen. Another line of argument is that the influx of investment in commodity futures by so-called long-only index funds has created bubbles in futures prices. Aside from the fact that there is a seller for every buyer of a futures contract, the fund/bubble argument has a difficult time explaining the fact that convergence problems do not have the same pattern over time in corn, soybeans, and wheat. The third line of argument is that contract specifications need to be changed to increase storage premiums paid by takers of delivery or that takers should be compelled to ship grain instead of holding it in storage. These may be useful changes, but it is not yet clear how these factors could explain the observed convergence failures.

Congress is now interested and the CFTC is holding a hearing on April 22^nd. Let's hope that cooler heads prevail and we seek a better understanding of the source of convergence problems before reaching conclusions about what changes are needed or mandated.

Not All Derivatives Are to Blame For the Financial Crisis

from WSJ:
Any doubt about how broadly U.S. corporations rely on fancy financial instruments vanishes with a look at who's lobbying Congress to forestall tougher regulation.

Companies from Caterpillar Inc. and Boeing Co. to 3M Co. are pushing back on proposals to regulate the over-the-counter derivatives market, where companies can make private deals to hedge against sudden moves in commodity prices or interest rates.

Many in Congress blame such instruments for exacerbating the financial crisis last fall. To fix the problem, a White House plan unveiled last month calls for more of the trades to take place on exchanges where regulators can monitor them, and requires dealers -- and ultimately companies -- to put more money aside to secure against big losses if trades turn bad.

This naturally has Wall Street in a stir, but it has also sent dozens of big manufacturers and other major corporations scurrying to Washington.

Caterpillar, which uses derivatives to offset increases in the price of copper, says new regulations may drive U.S. companies to seek financing overseas.

MillerCoors LLC, Bayer AG's U.S. unit., and Delta Air Lines are among those lobbying on derivatives, which they use to manage fluctuations in materials prices, commodities, fuel, interest rates and foreign-currency swings.

At least 42 nonfinancial companies and trade associations are lobbying Congress on derivatives, according to a Wall Street Journal analysis of lobbying disclosure forms filed through April.

That's more than triple the 14 nonfinancial companies that lobbied on derivatives in all of 2008 and zero in 2005. The figures include only companies that specifically name derivatives as a lobbying issue.

"Not all derivatives have put the financial system at risk and they should not all be treated the same," Janet Yeomans, treasurer of 3M, wrote in a letter to Sen. Mike Crapo (R., Idaho).

The companies argue the White House plan will make it more expensive to manage risks and force them to put aside cash as collateral that could otherwise be used more productively.

Treasury officials say their aim is to prevent another financial meltdown caused by hidden exposure to derivatives risk.

The issue will be fleshed out Friday as lawmakers question Treasury Secretary Timothy Geithner in a joint hearing hosted by the House Financial Services and House Agriculture committees as they grapple with crafting legislation. Some lawmakers say they hear the concerns and fear the new rules will hurt American companies, but there are others who want to push for more regulation.

Companies use derivatives to hedge risk. A company that borrows money at a variable interest rate might buy instruments to turn the borrowing into fixed-rate debt. Others use derivatives as protection against swings in currencies or the price of commodities such as food and oil.

Lobbyists say at least 90% of Fortune 500 companies use over-the-counter derivatives.

The administration's proposal calls for all "standard" derivative contracts to be cleared through a central body and traded on an exchange or equivalent electronic platform.

The clearinghouse would require daily pricing of the assets, which could require companies to post additional collateral, in the form of cash or short-term securities. Customized contracts would be permitted, but the proposal would require higher levels of capital to secure against risks.

Nonfinancial companies say it's unfair for them to be put in the same boat as Wall Street speculators, some of whom use derivatives to make bets on market movements. They also say they typically have collateral backing the risk and standardized contracts aren't necessary.

Chesapeake Energy said it had $6.3 billion in over-the-counter derivatives as of June 2008, against which it posted $11 billion in collateral, backed by letters of credit and mortgages on its gas and oil properties.

"This is how most end-users utilize this market and, as a result, help alleviate systemic risk," Chesapeake said in a letter to the Treasury Department.

Energy companies are particularly worried because the swings in oil and gas prices are so wide. Barry Russell, president of the Independent Petroleum Association of America, warns that restricting hedging would have "a devastating impact."

The National Association of Manufacturers has intensified its meetings with lawmakers, officials said, as has the Business Roundtable and U.S. Chamber of Commerce.

At a recent hearing, Sen. Crapo said he agrees regulation is needed to protect the economy against systemic risk, but "if Congress overreaches ... I believe there could be very significant negative implications on how companies manage risk."

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Think Speculative Traders Are Bad for Commodities? Think Again!

The following comment was placed by a farmer in a forum on Agweb.com:

Illinois/Wisconsin border: If the CBOT ever vanished, we would all be in serious trouble. How else would you be able to offset your risk? That’s the job of the futures market...to allow me to put off my risk onto someone else (think speculators). If you want to call the CBOT a "legalized gambling center" with "manipulated markets" and "insider trading" then that’s your business. But just remember, those "gambling market manipulators" gave you the option to sell $7 corn through 2010 and $6.50 corn for 2011. In my opinion, you lose the right to complain if you are given an opportunity but don't take advantage of it. I certainly didn't sell all my crops at those prices but I can't blame anyone but myself because the opportunity was there.

What would happen to farmers and agriculture commodity prices without the current futures markets? This farmer gives a stark view of what would happen! Here's a hint: Think higher!

Congress Drafts Legislation to Restrict CDS Futures

Congress has drafted legislation today to begin to restrict credit default swap futures only to those who plan to take delivery. If this goes very far, it could panic the market. This is only the first shot from the Democrat-controlled Congress. Will they do the same in the grain, crude oil, and other futures markets as well? They've threatened to! This will dry up liquidity and drive capital to overseas markets. It will literally amplify the very conditions that Congress hopes to prevent.

By restricting the capital markets in this way, Congress risks the following:

1. Capital will flow out of the United States to futures exchanges in other countries. This, in turn will drive the Dollar lower, and commodities prices will move higher. Money and commodities flow to places where they are welcome. If Congress creates an unwelcome environment in the United States, both the capital and the commodities will go elsewhere. Can the U.S. afford to create long lines at gas pumps by creating a fuel shortage here? Can the U.S. afford to see capital flight to other countries, collapsing the Dollar and run the risk of the Dollar being dumped as the world's primary reserve currency?
   
2. Liquidity will dry up, giving greater power to large market participants to control prices and manipulate the markets. George Soros is a master at manipulating small, illiquid financial markets. Remember the Hunt Brothers and their manipulation of the silver market? As prices rose, more and more participants entered the market, until the Hunt Brothers lost control and they could no longer manipulate the small silver market. Liquidity brought an end to their manipulations. Strong liquidity in any futures market is critical to prevent any market participant from exercising too much control.
   
   One reason for the current crisis is that derivatives products were created for which there was no market. A market without liquidity exacerbates the wild price swings when a single market participant need to change positions or exit the market and can't find a willing buyer or seller. Liquidity prevents this. This is precisely what has caused the current crisis. The absence of a liquid market eventually caused the government to step in and buy toxic assets for which no liquid market existed.
   
3. It will make price discovery more difficult and constrained. One of the reasons that this financial crisis occurred is because so many derivatives products were created without price transparency. This action will reduce transparency, and amplify the very problem that created the crisis in the first place.

If they were wise, Congress would, instead, take action that would encourage greater transparency and liquidity. This will have a negative and destructive effect on the futures markets. It won't improve conditions. It will amplify the very conditions that created this imbroglio in the first place.

We are now beginning to see signs of over-regulation that harms financial markets. We are seeing signs of a brewing trade war and trade sanctions. These are precisely the conditions that multiplied and deepened the Great Depression. Congress must have the wisdom to resist the temptation to engage in populist actions that will make matters worse. If they don't, everyone will pay the price for their stupidity!

Today -- Tumult and Turmoil!

With the amount of worry and turmoil in the market today, I expect that we will soon see another rescue or bail-out very soon. Here is a quick summary:

Dollar is Down, and if it remains this low, it will be in bear market again at day's end

Gold is Up $50/oz. in a few days

Oil is Up partly due to geopolitical supply fears, partly due to Dollar weakness

Treasuries are Down due to fear that the Feds will have to bail out Fannie, Freddie

Commodities Up almost across the board due to Dollar weakness

Futures Spread Trading: Controlling Risk - Creating Opportunities

Futures Spread Trading

by Rick Dawson

Introduction

Futures spread trading has always been a popular method of trading futures. However, many beginning traders focus exclusively on buying and selling futures outright. Spread trading is the preferred approach for many professional traders. By adding spread trading, traders can increase their opportunities and better manage their risk.

This article will focus on futures spreads instead of options spreads. A futures spread is the purchase and sell of futures contracts in related markets. (A spread is also created when a trader or hedger takes a futures position opposite an existing or potential cash or physical position. However, this type of trading – basis trading - is outside the scope of this article.) The two positions must have an economic relationship to qualify as a spread.

Futures may be spread between different:

1. Points of time. This is also known as a calendar spread. The same commodity is bought and sold in different months. An example of this would be an old crop / new crop grain spread where you're short July corn and long December corn. If you're short the nearby month it's called a bear spread. If you're long the nearby month it's called a bull spread.

2. Commodities. An example of this would be a long December corn / short December wheat spread. I would also include spreads between a commodity and its products in this category, such a soybeans versus soymeal and bean oil (crush spread) and crude oil versus gasoline and heating oil (crack spread).

3. Markets. An example of this would be a long September Minneapolis / short July Kansas City wheat spread. In this example, you're long spring wheat which trades on the Minneapolis grain exchange and short hard red winter wheat which trades on the Kansas City board of trade. (Note that September is the first new crop month in spring wheat whereas July is the first new crop month in winter wheat.)

Note that a spread may fit in different categories. For example, a spread between December Minneapolis wheat and May Chicago wheat would different markets and points of time. A spread may not easily fit in a specific category. For example, is a spread between 10-year and two-year notes a commodity spread because two commodities are involved or is it a calendar spread because it's really a trade involving interest rates at two different points of time? It really doesn't matter as long as there is an economic relationship between the two contracts. In other words, a spread created via a correlation study between orange juice and pork bellies doesn't qualify as a spread. Correlation is not causation.

Why Trade Spreads?

The components of “legs” of a spread tend to move together. This makes sense when one considers the fact that if there's an economic relationship between the two legs then the same market forces will push both up and down. The implication of this that when you spread trade you give up a certain amount of opportunity. But the compensating factors still make spreads an attractive trading approach.

Cons:

1. A certain amount of opportunity is lost

2. A stop order isn't available on except with a broker willing to take the order – probably on a “not held” basis.

3. Commission costs may be greater because multiple contracts are involved.

Pros:

1. Usually less volatile than an outright long or short position

2. Tend to have lower margin requirements

3. More amenable to fundamental analysis

4. Good trading vehicle for positional trading

5. Offer additional “trending opportunities”

I would like to focus on the last benefit of spread trading. Speculation wisdom usually emphasizes the importance of trading with a trend. The problem is that futures markets tend to spend a lot of time in consolidation or trading ranges. It's interesting in note that two markets may not show a pronounced trend but if you spread one against the other then a trend will emerge. For example, if you had sold July '08 cotton on the close of 20 March 2008 at 73.83 and covered on 29 April 2008 on the close at 69.25 would have gained 323 ticks for a $1615 profit on futures contract with an initial margin requirement of $2520. (See the chart below.) However, during this time July cotton had a high of 82.23 for a potential loss of $4200. If you're honest with yourself, would you have stayed in this trade? Probably not. And even if you did, would the stress and frustration been worth it? Most traders would not think so. A chart of December '08 cotton shows a similar story.

(please click on chart to open up larger version in separate window.)

However, once you spread December Cotton long against July Cotton short a much more tradeable trend emerges. On March 20^th and April 29^th this spread closed at 5.45 and 8.45 respectively for a 300 tick gain or $1500 on a spread with an initial margin requirement of only $420. Consider the chart below. Any trader would admit that this trade would be been a lot less stressful for a gain not much different than an outright short would have been.

(please click on chart to open up larger version in separate window.)

Conclusion

The components or “legs” of a spread tend to move together. This makes sense when one considers the fact that if there's an economic relationship between the two legs then the same market forces will push both up and down. Spreads tend to underperform strongly trending markets. However, markets tend to spend a lot time in consolidation ranges during with times spreads can offer more trends and opportunities.

Rick Dawson is a registered Commodities Broker with Common Sense Capital. See the website for contact information. Trade ideas and setups are available at the Pattern Report. There is a risk of loss in futures, options, and spread trading.

Here is a link to Common Sense Capital's website.