Meet the World's Biggest Oil Speculator

Yes, the world's biggest short bet that crude oil prices will fall is Fed Chairman Ben Bernanke. Based upon the Fed's statement yesterday at the close of the FOMC meeting, crude oil and other commodity prices should soon start to moderate, and perhaps fall. The financial markets perceived the statement as being weak on the Fed's commitment to fighting inflation. The statement was perceived similarly by both commodities and stock markets, causing stock market index futures to fall, and inciting a reaction of higher prices across the board in the commodity markets.

If this morning's follow-through of prices in both arenas is any indicator, the Bernanke Fed has made a bad bet. They shorted oil, and prices moved higher, with stocks moving sharply lower in reaction.

Stocks Uncertain of Fed Statement

The stock indexes, after trading erratically for an hour following today's Fed statement, have begun to sell of. There was much debate over the meaning and weight of the Fed's statement. Stock index futures were higher throughout the trading session until the Fed statement. It remains to be seen if the stock index futures will hold onto some of the day's gains from earlier in the session. It appears that the bears are in the driver's seat for the moment, and that the stock market didn't care for the Fed's statement. Many traders received the impression that the Fed will be somewhat weak on fighting inflation for the short- to medium-term future.

My long treasury futures trade has been amplified, as investors are fleeing into treasury futures. Go treasuries!

Grains Surge Higher on Early Fed Statement Release

The Fed released its statement early, before the grain markets closed today. This caused all the grain prices to explode higher in the closing minutes before the market closed. This soybean chart shows the market reaction following the early Fed statement.

Other commodity prices moved higher also. Both gold and crude oil recovered somewhat off of an otherwise down day.

Waiting On the Fed

Many futures today are in a stagnant waiting mode for the Fed statement to be released at 2:15 pm EST this afternoon. Volatility should be vigorous following that.

The grains have been fairly active today, but without huge moves in either direction. Since the Fed decision is released at the same time that grains trading closes for the day session, the impact will likely be felt first this evening.

I have been trading primarily treasuries and soybeans today. Good day for both. Treasuries, for some reason, trade more sedately than most other futures. I like them because they tend to more more smoothly and gradually, and I can place larger trades because of the smaller margin requirements. Treasuries (I trade the 10-year) are my favorite futures vehicle to trade after soybeans. I also like treasures because, since they tend to move more slowly than other futures, I can monitor and day trade other futures at the same time.

Stocks Swell as Crude Oil Swoons

The stock market index futures have risen upon the weekly release of the EIA crude oil inventory numbers that indicated a larger-than-expected rise in crude oil inventories. Crude oil has sold off forcefully, dropping nearly $5 a barrel on the news. Needless to say from these two charts, they are directly correlated.

S&P 500

Crude Oil

New Writers on this Blog

Today, readers here on this blog may have noticed that a new writer appeared with an article. Rick Dawson is a futures broker and friend of mine, and he has submitted an article on spread trading for the benefit of (me and other) interested readers.

I admit that I know nothing about spread trading. I am planning to educate myself more so that I can take advantage of spreads to increase my own trading profits. Anyone who would like more information can contact Rick by clicking on the links in his article.

I have no affiliation or financial connection of any kind to Rick's firm, Common Sense Capital. I receive no remuneration or referral fees from him, either. I just wanted to have him write so that I could learn, and in so doing, perhaps benefit other people also.

Other writers may also appear on this blog from time to time also. If you or someone you know would like to submit an article, feel free to contact me.

I hope regular readers will enjoy Rick's article. Good stuff!

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.

Grain Prices Collapse on Profit-Taking

USDA data yesterday afternoon showed no strong impetus for higher grain prices, leading to profit-taking today. This chart shows corn on the left, and soybeans on the right. I have exited all my long trades for grains. I expect grain prices to remain relatively well-supported, but am open to shorts going forward. Today is an example. Even wheat has reversed and prices are now flat for the day. In a tight trading range environment like this one, swing trading is my specialty. I will take both long and short positions alternately.

Generally, I trade only on a short-term basis (day trading). However, over the past few weeks, a very strong bullish trend was under way in the grain markets, so I took some longer-term positions, which I have now liquidated.

I have begun opening additional futures accounts with other brokers. This way, I can trade long-term chart with one broker while trading short-term (day trading) with another. Why would I do this? Because I can take short-term profits within a longer-term trend.

Wheat Sharply Higher

Not very often does wheat lead the way in the grain complex, but such is the case today for the first trade of the day.

Crude Creeps Higher, Unconvinced!

While I personally don't trade crude oil futures (or haven't so far this year), I was disappointed that last weekend's summit in Jeddah, Saudi Arabia, didn't result in anything but rhetoric. Apparently, today's crude oil futures market feels the same way, since prices are moving higher, and are within $2 of the all-time high price. This is remarkable, considering that the July contract expired just last Friday.

Grain Bull Signals an End

My indicators on the daily chart have indicated an end to the grain bull of the past few weeks. Unless prices surge higher at the beginning of trading next week, this bull is done! Here are the daily charts of the three major grains I trade.

Corn
Soybeans
Wheat

Saudis Boost Oil Production Even More

On the eve of a historic meeting in Jeddah, Saudi Arabia for both oil producing and consuming nations, the Saudis have graciously announced that they will increase oil production by 500,000 barrels a day. Just a few days ago, they said they would increase by 200,000 barrels a day.

It's a Stock Market Bloodbath!

The stock market indexes, having broken through key technical support on both the Dow and S&P 500 indexes, are in freefall today.

Risk Aversion Trumps Potential Profits!

I frequently hear asset management people tell people to hold onto stocks that are falling with the justification that eventually, they just have to turn around, or that they have fallen so far, they must have hit bottom. They reason that prices must move higher, and investors should therefore remain in them so that they don't lose out on the opportunity when stocks eventually move higher. I disagree with this philosophy for various reasons:

1. Opportunity Loss -- Every dollar that is invested in a losing stock/trade is a dollar that can't be used in a winning stock or trade. If that money is locked up in a bad trade, there are a myriad of opportunities missed that might have made money instead! One opportunity that is lost on a falling stock is the opportunity to short it instead. Even if -- like me -- you don't short stocks, you could profit from buying an ETF that does short that market sector! You could be making money from the ill sentiment toward that stock, instead of losing it. Or you could at least stop the loss by hedging with an inverse ETF in the same sector. Perhaps the greatest opportunity missed with this philosophy is the opportunity to have purchased that same stock or ETF at a much lower price. Taking a small, early loss is the only way to avoid this opportunity loss.
   
2. Clear Head -- When you exit a bad trade, your analytical skills improve immediately because you have cleared your head and can see the markets with a more objective perspective. It is amazing how releasing our minds from the emotion of a bad trade can help us to more clearly recognize the good ones.
   
3. Irrational Markets -- There is a saying (don't know who to attribute it to) that the financial markets can remain irrational longer than you have money to wait out that irrationality. This is true! You'll go bankrupt waiting for that "inevitable" turnaround that you just knew would eventually come. Even if that turnaround does come one day, there is a good chance you'll never see it because you'll lose your money waiting for it. It also seems to come just when we have been pushed out of the market after we just couldn't stand any more loss.
   One of my favorite thoughts from Phantom of the Pits is that we must recognize the blessing of a small loss. He also says that the trader who loses least, wins most.
   
4. The "Falling Knife" -- This idea comes from the very potent image that if you try to catch (or in this case, hold onto) a falling knife, you will get very bloody and experience severe physical trauma. The same concept is also true of our finances. Trying to catch a falling stock also bloodies the financial waters of our lives just as surely as catching a physical knife blade does. These financial "gurus" who suggest "holding on" to losing investments always reason that because prices have fallen substantially, they must therefore begin to rise now. No, they don't! Prices that are down can go even lower. Much lower! Momentum is to the downside! Stocks can go to zero! Don't try to catch a falling knife! Take your losses early, and you'll not only sleep better at night, but you'll also be able to keep a clear head (#2 above) to select other investments and get back into the market to make money instead.
5. Fox in the Hen-House -- Many of these supposed investment advisers and experts are in a losing market position themselves. It is true that "misery loves company". Many of these people (or their clients) are losing money on the same stocks they are recommending to others, and therefore they are hoping that by suggesting that other people buy them also, their own (or their clients') loses will stop and the stocks they recommend will start to move higher again, thus rescuing them from their own misery and losses. Corporate executives are notorious for recommending their stocks even while they are selling those same stocks themselves. These people have a gross conflict of interest, so all their comments should be taken with a grain of salt -- better yet, a pound or two of salt. This is also true for many investment advisers.
   

I would rather exit a bad trade quickly (Phantom's Rule #1), and buy that stock back again later at a much better price when the bottom has truly formed and when my thinking is clear. Thus, my purchase price is better and my return on investment is also improved versus someone that buys and holds regardless of market turmoil.

Miss First 20% and Last 20% of Trend
One investment tip that I have heard attributed to the Rothschilds (although I don't know if this is true) is that they don't try to catch the first 20% or the last 20% of a stock's rise. If someone holds onto a bad trade, they stand to risk all or most of the rise, not just miss the first or last 20%. I have found that my trading methodology allows me to accomplish this -- getting in at the early stages of a new trend, and getting out just as the momentum is starting to wane. Sometimes I'm wrong, but more often than not, I'm successful, and my successful trades are far more profitable than my bad ones. Learning strong technical analysis skills helps tremendously to reduce the risk and raise profits.

Best Book on Risk Vs. Profits
My philosophy on focusing on reducing risk instead of on profits was influenced heavily by Phantom of the Pits in his book, "Phantom's Gift". It's the best book on trading that I've read, and what makes it even better is that it is available free. That's not just a bargain. From the perspective of return on investment (ROI), it's value is therefore literally infinite! My only real investment is the time to read it and the effort to change my behavior. I can't make a better investment than that!

Crude Oil Moves Higher on Expiration Day

This chart is today's tick chart for the oil contract that expires today. Since the contract will expire today, the volume is relatively weak compared to more active contracts. Just one week ago, this contract had volume of many times more than today.

If prices dropped precipitously on the expiration day of a futures contract, one could make the argument that the off-setting activity of speculators was the key cause of that rapid drop; commensurately, one could make the case that the rising prices prior to today were also caused by speculators. However, since prices are rising strongly on the day of contract expiration, as speculators are being forced to sell en masse to exit the market, this is evidence that commercial hedgers are driving oil prices higher, not speculators. While these commercial hedgers are the key reason that prices move higher, both commercial hedgers and speculators add needed liquidity to the market.

S&P 500 Breaks Through Support Also

The S&P 500 Index has also broken through key support at 1330. It is doesn't rebound by the end of the day, or if it goes substantially lower, prices will likely go much lower still in the near future. We may test the lows of last Spring.

The NASDAQ too is plunging, but without support levels, it goes down even faster!

Dow Breaking Below Key 12,000 Level

This could spell much lower stock prices to come. It remains to be seen if stocks can rally to take the stock indexes back above key technical support levels, but by just looking at these charts, the probability doesn't look that good.

Rumors of War Sends Oil Higher Again

Talk of Israel carrying out war preparations for possible strikes against Iran are sending oil prices into high, record territory again. Will it never end?

Commodity Commercial Hedgers Increasing Their Presence

With food and energy commodities having increased their prices so much over the past year, more businesses are being forced to participate in the futures markets that never have before. Why? Because they must hedge the higher prices. These market participants are not speculators. They are commercial hedgers who are buying to take delivery of these commodities to use them in their products. Ironically, with so many more commercial participants taking long-only positions in the futures markets, this may be pushing prices still higher. These commercials, by the way, represent 80% of the trading volume in the futures markets! They outnumber the speculators by several times!

Here is the definition of commercials from the Bloomberg website:

Commercial Hedgers
Commercials that take futures positions in commodities so that they can guarantee prices at which they will buy raw materials or sell their products.

Stock Traders -- Selling the Rallies

The daily chart for the S&P 500 (left) shows that stocks have been on a distinct downtrend now for the past few weeks. It appears to have been triggered by the bad jobs report two weeks ago. It seems like every day, new revelations come to light that wear down stocks. Stock traders, with so much bad news arriving almost daily, are selling the rallies, including selling after yesterday's higher close (right chart), which was the first one this week.

I am watching the Dow 1,990-2,000 level, and the S&P 1330-1340 level. These are key technical support levels. The futures this morning, having sold off somewhat overnight, appear poised to make another attempt to breach these levels and continue the downward slide. These are the dog days of summer for stocks, and it's only June!