Commodities: Advice on the World’s Most Misunderstood Market

Sometimes when I turn the TV on and listen to the commentators talk about commodities I cringe. For years the media treated commodities as a secondary asset class, or worse, a form of legalised gambling - to some extent they still do. Their understanding of how the markets actually function is rudimentary at best. Now I'm not saying these journalists are not intelligent - some of them are brilliant. They just don't understand how the commodities markets work. But yet they have such power that when the camera light goes on millions of people hear and believe what they say. Having done a lot of television and print media myself, I know that they can be very powerful tools but, as they say in the Spiderman movies "with great power comes great responsibility."

Anyway, let me be clear - I make use of the media and information superhighway every day. While I have colleagues who are deep philosophical thinkers who don't even own a TV, I have five computer screens in my office and two televisions. Does this make me non-philosophical and obtuse? No, because most of the time I keep the volume on the TV down, which improves my IQ immensely.

Distractions of any sort when trading can be of little or no value. The TV blaring opinions that change moment-to-moment can be one of a trader's most useless tools. A friend and colleague of mine, we'll call him Jack, used to work in the office across from mine. Jack is one of the best currency traders I know and he and I come from the same mold. Jack never had a TV in his office; he thought it was worthless and that what was said was mostly drivel. For the most part he was right. More importantly, Jack's point was that TV offered him nothing beneficial for his trading--it only interfered with his system and was a distraction; in other words, just noise. I agree with Jack. I also feel that staring at a trading screen all day long is useless.

Markets move up and down and when they move against you, when the screen is totally red, emotion can creep in, and we all know how detrimental that can be. I suggest sometimes that you simply switch off the screen and do something else. Pet the dog, make a sandwich, go to the gym, make another sandwich (there have been some years where I've gained 20 pounds!) - my point is to leave the scene and clear your head, then come back and decide what to do. You may be amazed at what you find when you return!

Jack was a funny guy; he had very little in his office: a little box over in the corner, a few books on the desk, a light and that was about it - maybe one picture of his family. Truly a minimalist. My office, on the other hand, had tons of stuff in it--pictures books, plaques, TV blaring, etc. So one day I went into Jack's office and I asked him "Not for nothing Jack, but what's the box for, and why don't you keep more stuff in your office?" He looked at me and said, "I can fit everything I have in this office in that little box in about two minutes." Jack's point was that he wanted to be ready to go at a moment's notice. After being a professional trader for a number of years you come to learn that no matter where you're working as a trader it all comes down to results, you're only as good as your last trade.

Now is that true? No, but it's the perception. Truthfully, the media can be an invaluable source of new information and also a good contra-indicator. In other words, if everyone on TV or in the press is talking about how strong copper is, or crude oil, it may be time to look for a downside move, not always, but sometimes.

My advice is to use the news and information as a resource; pull out what you need and leave the rest behind. It's quite possible to be bombarded 24/7 by talking heads and then have no idea what to do. The best plan is to pick one or two trusted information sources, then lay out your own disciplined game plan and stick to it. Alter it occasionally but never stray too far or too fast. You can always hit the mute button on the TV--sometimes that's your best move.

You'll preserve more of your sanity if you tune out all of the opinion and stick with the facts on which you should have based your trades in the first place. Moving your positions with every sound byte on TV only makes one person rich - your broker. Don't do it!

In the world of commodities, figuring out which data NOT to look at can be just as important as knowing what you absolutely must follow on a regular basis. Each commodity is different and learning what's important for corn is a lot different than learning what you need to watch for crude oil. Government numbers such as employment data, GDP, and Federal Reserve announcements impact almost all markets, even the global ones. It's important to have an understanding of the key reports and, even more essential, how much emphasis the markets place on them. Certain reports carry more weight with traders than others.

In addition, as a market changes and matures, certain reports may lose their relevance and new ones may come into play. For example, back when I started in the crude oil markets, everyone followed the American Petroleum Institute report (API), the benchmark report for oil inventories. Not anymore. These days, traders monitor the Energy Information Agency (EIA) report.

Key government reports have been around for as long as the markets and they rarely change. Unemployment numbers, trade deficit, GDP, consumer sentiment. These all are major indicators of the state of the economy, and traders should know when these numbers are going to be announced or published.

I've found that the hardest part about any information or number is not only understanding what it means but, more importantly, anticipating how the markets will react to the data. The second part of this equation is a thousand times more difficult than the first.

For example, if the EIA data for crude oil comes out on a Wednesday morning and it shows a build in crude oil supplies, will the market perceive that as bullish or bearish? In other words, if the report shows more crude oil on hand than expected, you would think that would tell traders the market is heading lower. Not always. Sometimes traders may figure that OPEC will see that supply is higher and immediately cut production, which will have an impact on supplies down the road. So while the front couple of months may drop in price, if you own futures further out they actually could go higher. Commodities trading is like one big chess game; I advise being the knight, not a pawn. You always need to be flexible and agile when trading "off of the numbers." Remember not to get tunnel vision and don't fight the trend after a number, chances are very good that the trend will win.

"Buy the rumor, sell the news" is a common traders' saying, and for good reason. But once again this is not always the best advice. Sometimes what happens is that the markets will already "price in" the anticipated data; then when the numbers are released it's a bit of a letdown from the hype before the number, thus "buy the rumor, sell the news." Another favorite old-time saying I used to hear was, "Those who trade headlines end up selling newspapers."

Here are some of the key reports professional traders follow:

Commitments of Traders (COT) - A report published every Friday by the Commodity Futures Trading Commission (CFTC) that provides investors with up-to-date information on futures market operations and increases the transparency of the exchanges. This is one report that traders rely on heavily, and so should you.

Volume and Open Interest - We talked about this. Open Interest shows us how many people are actually trading any particular market at a given time. The higher the open interest the safer, or at least more liquid a market is to trade.

Commercials' Positions - This shows what commercial and end users are doing. Commercials buy more than individuals, or sell more, depending on market conditions. Traders put a lot of stock into what the commercials are doing because they carry a lot of weight in the market and often control the majority of the open interest.

Unemployment Claims - Jobs are the lifeblood of the economy so traders pay very close attention to these numbers.

Interest Rates - Interest rates affect almost every aspect of people's lives, especially borrowing, and that can impact the ability of traders to invest, so it's important to keep an eye on the Federal Reserve at all times.

More specific to certain commodities are reports such as:

Cattle on Feed - Shows the number of cattle that are in the process of getting ready for slaughter

Crop Progress Report - Shows the condition of the current corps and how and in what condition they may harvest.

Crop Reports for OJ - Shows the orange crop estimates and potential damage from weather, pests, or disease.

EIA Report for Oil - A weekly inventory report, appearing every Wednesday, for crude oil and products derived from it

Natural Gas Inventories- Same as the EIA report for Crude Oil, except it comes out on Thursdays and only measures the amount of natural gas in storage in cubic feet.

...and many others.

Like any tool in our trading toolbox, these reports can help us make an educated trading decision, but remember they are only one tool. Putting all of your eggs in one basket is never a good idea. Take the numbers with a grain of salt and try to anticipate how the market will react to any given number release. It's a good rule of thumb to be on the sidelines for any major announcement because trading ahead of a number is highly risky and often very unpredictable, but then again that's what many investors want. As you gain experience, you'll be able to see where you want to be.

Regards,

Kevin Kerr
for The Daily Reckoning Australia

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