Kub's Den

Sometimes an investment idea just lasts and lasts -- until it doesn't. The market convinces a bunch of people to buy dot-com stocks, for instance, and the success of their positions convinces other people to follow along with the trend. That goes on and on until the world eventually runs out of people to buy into the idea, or until prices just get too lofty to attract additional purchases. Then the market snaps back and everyone scrambles to liquidate their investments before prices collapse.

In commodities, this phenomenon -- an information cascade among investors -- can just as easily happen in either direction as prices move up or down. Traders looking to profit on the direction of the lean hog futures market, for instance, might see prices above 60 cents per pound at the start of the year, then decide that the price level has been driven too high by fears of the African swine fever epidemic in China, especially when the U.S. swine herd and pork supply continues to expand. That population of speculative traders might start short-selling lean hog futures at the "too-high" prices, with the aim of profiting as prices fall. And as prices do indeed tend lower over a couple of months, and the success of the short-selling strategy attracts more speculative participation, the speculators amass ever-larger net-short positions (more contracts sold than purchased). Sure enough, open interest in lean hog futures rose 20% in the first two months of this year while speculators chased this bearish idea.

But when the market ran out of sellers (when no one was willing to sell the April contract below $52.250), the snap back to reality arrived and lean hog futures prices in the past two weeks have risen even faster than they were falling during the downtrend. Speculators who haven't scrambled to liquidate their short futures positions (by buying an offsetting quantity of futures contracts) have found their unleveraged profits eroding by as much as 5% per day on a volatile day like last Friday, when lean hog futures traded limit-up.

During the month leading up to March 5, speculative investors have continuously amassed ever-larger bullish positions in the live cattle futures market and ever-larger bearish positions in the corn futures market. On average, this population of traders (titled "Managed Money" by the CFTC's classification system) has been accumulating almost 1,300 additional long live cattle futures contracts each trading session in 19 trading sessions from Feb. 5 to March 5. During the same timeframe, the "Managed Money" side of the market has been accumulating a whopping 9,500 additional short corn futures contracts per day, based on their expectation that they will profit as corn prices will fall.

The traders whom we call "Managed Money" or "speculators" are typically individuals and limited partnership funds who are participating in the commodity futures markets specifically to seek profit on price movements. That makes them distinct from the bona fide hedgers (the "Producer/Merchant/Processor/User" segment) who participate in the commodity futures markets to lock in prices of the commodities that they will produce or use to add value during their day-to-day business activities (e.g. a soybean processor crushing oil and meal end products worth more than the raw material). A bona fide hedger will tend to place a hedge trade for a futures contract, let's say, six months down the line, and then leave that hedge position untouched no matter what direction prices go. Somebody looking to make a quick buck on the weather rally in cattle futures will behave differently. Speculators are more likely to enter or exit futures positions as their price outlook changes. Their money ebbs and flows through the market.

During several recent volatile ag market movements, we may have witnessed the start of a sudden retreat of speculative investment money after a month-long bout of trend-following success. Speculators have spent the past several months building up bullish live cattle futures positions (these traders hold more than eight times as many long futures contracts as short futures contracts), enjoying the ride as the April contract has climbed from $118.55 last fall to $130.45 on March 1. That's looking like it may have been the top -- and now the snap back occurs. Open interest started falling this week and traders really started rushing for the exits Tuesday. The price of that April live cattle contract dropped $2.35 in a day.

Grain markets also have immense vulnerability to sudden spooky liquidation from the "Managed Money" population of traders. Corn is by far the largest agriculture futures market in terms of the total number of contracts traded. Speculators hold 3.7 times as many corn contracts as live cattle contracts, but in the corn market, those speculative traders are dwarfed by the more stable participation of producers, merchants, processors and users. Corn speculators' overall net-short futures position has been growing during this February to March timeframe. Notice that's a net-short futures position -- the kind that profits as prices fall (which they have so far been doing). On March 5, speculators held 1.8 times as many short corn futures positions as long positions. Therefore, the potential here, if speculators felt the downward trend was ending and suddenly wanted to exit their positions, would be for a snap-back that takes prices suddenly upward while speculators scramble to buy corn futures to offset their previous sales.

That certainly seems to have happened in the wheat market this week. Look at Tuesday's sudden 24 1/2-cent upward jump in the May Chicago wheat contract, which previously fell by almost $1 per bushel during a more-or-less uninterrupted downward trend the past three weeks. Low trading volumes and jumpy gaps in the bid/ask spread for wheat futures during recent trading sessions have suggested that the market has run out of people willing to sell at such low prices (front-month Chicago wheat futures seem to have bottomed out at $4.24; HRW futures seem to have bottomed out at $4.14 1/4 and HRS futures seem to have bottomed out at $5.50 3/4) -- for now.

The "Managed Money" speculative traders likely still have a larger net-short futures position in benchmark Chicago wheat futures (72,449 more short futures and options positions than long futures and options positions as of the March 5 Commitments of Traders report) than in HRW wheat futures (44,870 net short) or HRS wheat futures (8,329 net short). So, if the rush for the exit continues, and if it's driven by the need to abandon a trend-following strategy that may have been successful in the past but isn't likely to continue, then the size of these bearish speculative positions may allow us to contemplate the scale of the potential snap back -- if and when things turn around.

Elaine Kub is the author of "Mastering the Grain Markets: How Profits Are Really Made" and can be reached at elaine@masteringthegrainmarkets.com or on Twitter @elainekub.

(BE/BAS)

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