The Secret of Commodity Trading – The Armchair Trader

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Could commodity markets make a quiet comeback? It seems so, with commodity indices rising in 2016 and broader inflation expectations rising following the election of Donald Trump last year. Commodity markets generally do well during times of inflation, which is also why they weren’t as good before 2016.

But let’s say you’ve been interested in trading so-called ‘soft’ commodities throughout the current inflationary cycle – what should you keep in mind? Traders who have followed these markets have seen them go through both feast and famine in recent years: Coffee shot up to $ 3 / lb due to rust disease, but then fell back to $ 1. . And sugar hit 35 cents a pound before being subjected to a four-year bear market from which it did not fully recover, even with its recent bull run.

Each of the major commodities – coffee, cocoa, cotton and sugar – tend to carve their own furrows when it comes to price action. For example, cocoa had an excellent year in 2002, during a declining bear market, and was the best performing commodity market in 2015, when falling oil prices weighed on commodity indices. raw.

One of the reasons is the slow supply in these markets.

“While the oil taps can be turned on and off daily, cocoa, coffee and sugar have multi-year production cycles, up to 20 years for cocoa trees for example,” explains Olivier Kinsey, a portfolio manager with a hedge fund Ballymena. “The cotton cycle is one harvest per year and per hemisphere. Therefore, there are big delays in getting supply responses to price signals. “

While cotton can be replaced by other materials if it becomes too expensive, other soft materials cannot. In addition to this, they are also subject to the concentration of production. This means that a very localized production distribution can quickly turn a market upside down. Take the example of French West Africa, which represents 70% of world cocoa production. It doesn’t take much – a drought, for example – to drive prices up quickly. Brazil accounts for half of the world’s production of Arabian coffee beans – again, weather conditions or pests that damage the Brazilian crop will also have a direct and appreciable impact on the coffee market.

How to take advantage of price changes

Successful commodity trading, whether you use futures, CFDs or ETFs, comes down to being aware of the trading conditions on the ground. This is why many successful commodity traders start their careers in organizations responsible for the production and sale of commodities. It gives them an overview of the dynamics that drive the markets.

I’ll give you a great example: I previously advised a client who was responsible for much of the logistics required to transport and store cocoa in West Africa, dealing with smallholder farmers, governments and cocoa buyers, all at the same time. It became increasingly clear to me that this company’s assessment of the future size of the cocoa crop – in Ghana, for example – was different from that predicted by analysts in Chicago and London. This is because they were in the field in Africa, visiting the farms, and could make a much more accurate assessment of the cocoa harvest. If I had traded cocoa futures at this point I would have sought to establish a short position as I could see the market was overly bullish in its valuations.

Good traders value good sources of information

Hedge fund manager Kinsey cites Vietnam as an example of checkered sources of information when it comes to assessing the impact of weather on crops:

“A lot of information and data is publicly available in coastal areas, but there is a lack of weather stations in the highlands of Vietnam and it is these microclimates that are relevant,” he says. “Yet time is only one factor and optimal weather does not always lead to a good harvest, as technology, disease, abuse and animal husbandry are also relevant.”

Some commodity traders are very technical in their analysis, while others rely on fundamentals. Yet some of the best performing commodities players are fundamental traders; they only turn to a more technical analysis of commodity markets when those markets are very loose, and that’s not always the case. Part of the skill is knowing when to rely on techniques and when to put them to the benefit of fundamental analysis, because unlike gold and oil, softs require a bit more work in the markets and that that makes them work.

Example: Ethanol parity

Seasoned software traders are often aware of the impact other markets can have on the product they are focusing on. It can be as mundane as currency changes, but it can also be more esoteric. For example, there is a relationship between the prices of sugar and ethanol. In October 2016, sugar prices went out of their price range relative to ethanol. Before falling back. This was largely motivated by speculative stocks.

The relationship between sugar and ethanol occurs because sugar factories in Brazil, one of the largest producers of sugar, can switch between ethanol and sugar, depending on what seems more lucrative. Since ethanol is also used in cars in Brazil, if oil prices rise, again, plant owners might be tempted to switch to ethanol in search of profit, resulting in a decrease in refined sugar on the market.

We will come back to the subject of cross-market analysis again in future articles, in particular with regard to commodity markets. Make sure to check back regularly.


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