Commodity
Futures Market Types:
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Annual
and Perpetual Production Markets
To understand commodity futures prices, you
need to understand the production and consumption of
the commodity in question. Some futures contracts are based on
annually produced commodities: Corn, Wheat, Soybeans, Cotton, Cattle,
Hogs, etc. An annually produced commodity tends to have supply
available at one time (harvest) while demand is variable, and segmented
throughout the year. Other
futures contracts are based on a market with variable production cycles,
and more constant demand components: Petroleum Products (Crude Oil,
Unleaded, Heating Oil), Metals (Gold, Silver, Platinum), etc.
This
transitioning between "certainty" and "uncertainty" is
key to understanding futures prices. Because anticipation of changes in
supply and demand can create fear or greed, markets tend to move much
farther than would be thought- and can stay at these emotional levels
longer than most people would anticipate. It is this factor which
constantly buoys prices, creating "irrational exuberance", to
quote the Chairman of the Federal Reserve.
It is these
reoccurring periods of potential changes to future supply or demand which are our
primary focus. By placing these reoccurring events into the context of
supply, demand, and the current market one is able to narrow down
potential speculative situations into areas where the most opportunity
exists.
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Annually
Produced Commodities
These commodities tend to exhibit the most
strength historically at the beginning of their production cycle.
For example, Grain Futures are typically the most likely to rally during
field preparation until planting is completed. This is because if
planting goes poorly- too much rain, too little rain, too hot, too cold -
then yield will be lower, and supply will be less.
Because nobody can tell the future, the market tends to build a
"risk premium" into prices, to compensate producers for the risk
involved.
Historically the weakest time of the year
for the above commodity futures contracts is when the risk associated with
the crop lessens: For example, most field crops are much less vulnerable
to weather- rain and temperature- after they pollinate. So after
"normal" pollination, prices tend to be weak as market attention
turns to the eventual flood of supply, which will be hitting the market.
The above are general guiding principles
for commodity futures traders. Some years they correctly foreshadow
tops and bottoms and other years they don't! Traders should always
use other forms of analysis in conjunction with seasonality, because
seasonal events can be early or late depending upon the uniqueness of each
year.
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Perpetual
Production Commodities
Because these commodities tend to have
constant year around production, the demand or usage cycle is more
important. These commodities rely upon a distribution network, and
the behavior of wholesalers dictate prices in most years.
Historically the strongest times of the
year are when wholesalers begin to build inventory:
For example, Heating Oil distributors start
to build inventory in March through May. They need to purchase the
Heating Oil for distribution before the public starts to buy it.
Therefore, prices have historically been strongest well before the cold
snaps hit. Gold wholesalers buy in July ahead of Christmas jewelry
demand.
Historically the weakest times of the year
is when wholesale demand has peaked, and retail demand is starting to
grow: For example, by October Heating Oil distributors own all the product
they need, and they are worrying about selling their inventory! This
causes them to run specials, and have very little appetite for buying
more. If you have owned a retail store and bought a large amount of
a product, you know the feeling of hoping you can get rid of it now,
versus the feeling of counting your money when you bought it. The
same goes for Gold; jewelers buy before the Christmas shopping season,
knowing that if they don't sell it all before the end of the shopping
season, they will sit on it for months.
The above are general guiding principles
for commodity futures traders. Some years they correctly foreshadow
tops and bottoms and other years they don't! Traders should always
use other forms of analysis in conjunction with seasonality, because
seasonal events can be early or late depending upon the uniqueness of each
year.
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General
Conclusions on Using Seasonals
This transitioning between
"certainty" and "uncertainty" is key to understanding
futures prices. Because anticipation of changes in supply and demand can
create fear or greed, markets tend to move much farther than would be
thought- and can stay at these emotional levels longer than most people
would anticipate. It is this factor which constantly buoys prices,
creating "irrational exuberance", to quote the Chairman of the
Federal Reserve.
It
is these reoccurring periods of potential changes to future supply or
demand which are our primary focus. By placing these reoccurring events
into the context of supply, demand, and the current market one is able to
narrow down potential speculative situations into areas where the most
opportunity exists. Warren
Buffet, in his 1998 Berkshire Hathaway annual report, summed it up best as
saying ...
"Under these
circumstances, we try to exert a Ted Williams kind of discipline. In his
book The Science of Hitting, Ted explains that he carved the strike zone
into 77 cells, each the size of a baseball. Swinging only at balls in
his 'best' cell, he knew, would allow him to bat .400; reaching for
balls in his 'worst' spot, the low outside corner of the strike zone,
would reduce him to .230. In other words, waiting for the fat pitch
would mean a trip to the Hall of Fame; swinging indiscriminately would
mean a ticket to the minors."
For
the futures trader, the best cells are represented by the times of the
year when a particular market has had a strong historical tendency for a
directional move. Waiting patiently for only these situations may make the
difference between profits and losses in the game known as speculation.
Of
course, just because a market has reacted a particular way in the past
does not mean it has to repeat this year- read those disclaimers; they
are there for a reason! However,
having an understanding of the past, and strong tendencies of the market
to move in a particular direction can be used in conjunction with other
methods to make an informed decision regarding your positions.
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