Follow the Money Flow

FOLLOW THE MONEY FLOW

Fundamental events are not the only factors that drive prices. We see evidence of increased participation from speculators as reflected by the increase in volume and open interest levels. Most commodity markets, besides orange juice and sugar, showed massive money inflows by hedge funds, pension funds, and individual investors in 2005 as commodities prices rose. The Reuters/Jeffries CRB Index, as shown back in Figure 1.31, is a great illustration of that fact. This trend may continue in 2006 and possibly beyond into 2008. The hurricanes in 2005 affected not only the agricultural markets described here but also the energy markets, as previously mentioned. In 2005, natural gas prices skyrocketed, and unleaded gasoline prices exploded. Many stock analysts may not have been trading commodities directly, but they certainly were watching their price movements and using that data to track their portfolios.

My point is that we have entered a time period in which our civilization and culture are entwined in a very complex financial relationship in which commodity markets play a serious role. Think about this: Ten years ago, we did not trade freely or openly as we do now with China; in fact, China now has its own exchange, the Zhengzhou Commodity Exchange. Then there are India and other parts of Asia; as their commerce and economic growth develop, so will the need for trading.

More and more investors are participating in the markets around the globe, even in Latin America. Markets have become more confusing to trade, and therefore we need to look for opportunities and to keep our defense up to be more risk averse. Using spread trading in the futures markets can help you achieve those goals; the opportunities are endless. Keep in mind the important principles of trading that depend on these elements:

• Prices reflect forces influenced by supply and demand factors.
• Prices represent the collective action of buyers and sellers who are dictating what the current price of a given product is perceived to be at a given time.

Stocks Influenced by Commodities

Now that commodities are moving and have attracted the attention of sophisticated hedge fund and commodity trading advisors, money has been flowing back to this investment industry. Investors use fundamental information such as weather conditions and apply technical analysis techniques to time entries and exits. Corporations, banks, and institutions are using the markets to hedge against losses incurred in the cash markets, for example, the airline industry, where some companies were buying energy futures contracts to lock in prices prior to the big price surge. Smart move! Higher prices in commodities such as crude oil certainly have an influence on the airline stocks. Therefore, tracking commodity prices is important for stock traders.

We will go over specific trading strategies as well as some back-testing results that will substantiate a pretty good method for trading the futures markets. This introduction was designed to show you that there is more to commodity trading than meets the eye and to show you not only how you can utilize price moves in the futures to profit from a futures contract but also how you can apply that knowledge in other areas of investing. In fact, stock traders can greatly benefit from information unique to the commodity markets. One such bit of information is released by the Commodity Futures Trading Commission (CFTC) and is known as the Commitment of Traders (COT) Report. It is referred to as legal “insider trading” information, which is covered in the next few pages; so read on!