A common question here would be, "What do gold and soybeans have to do with each other?" The short answer is that they are both the most speculatively overbought commodities we trade. The deeper answer is that both of these products come from the ground, and the producers of these commodities have used this rally to lock in bonus money as there is no way they collectively subscribe to the inflation thesis suggesting structurally higher commodity prices in a near zero percent interest rate environment. Our experience has shown that the huge imbalance in positions between the commercial producers selling forward production and the speculators' buying of anticipation typically resolves itself in the fundamental direction of the commercial traders' collective prediction. The gold and soybeans rallies are about to find themselves out of gas.
Bubble markets, parabolic markets and manias are all manifestations irrational herding behavior. We believe that human beings are generally rational as individuals. However, human beings in groups or crowds can be exceptionally irrational. This is the nature of a bubble and it happens in two ways. First, there are the cheerleaders and "fearleaders." These are the ones we hear on TV telling us it's going to pull a Buzz Lightyear "to infinity and beyond" or the Chicken Littles claiming that the sky is falling. Either way, their noise plants the seeds in speculative minds. The second step occurs within the speculator. Their mind starts working against them as they see the markets move higher without them. They question whether it's too late to get in. Will it really go to a million? As this worm turns through their heads, they go through all the phases of internal conflict resolution. At this point, the only thing left to do is scratch the itch or buy the market which is inevitably the top.
There have been tons of investor psychology studies and they all follow approximately the same pattern. This is why we consider both the size and rate of growth within the large speculators category of the Commitments of Traders report to be such crucial variables. We balance this against the rational behavior of commercial traders who are the producers and consumers of the commodities in question. Their actions represent value plays in the commodities in which they deal. The farther a market moves beyond the commercial traders' collective sense of value, the more attracted to the market they become as it relates directly to locking in greater profits for their business endeavors. As you can see, the rationale behind their collective actions is the exact opposite of the speculators through, "locking in futures profits" rather than "betting on a million."
The more a market moves beyond its value envelope and is fueled by public mania, the more tension builds between the two primary trading groups. Finding and quantifying this tension is fundamental premise behind Commitments of Traders swing trading methodology. The greater the tension, the greater the possibility of a violent reversal as the bubble bursts. We've been following the growing positions in the gold and soybean markets and view both of them as prime examples of our application.
We've written extensively on the background behind both of these markets. Here is the gold setup and here is the soybean situation. Today's piece focuses on the tension buildup in two ongoing market situations, which provides a fascinating real-time case study.
We'll begin with a classic example of Commitments of Traders strategy application. Below is a weekly soybean futures chart. First, we want to be on the same side of the trade as the commercial traders' momentum in the third pane. Second, we want the speculators to push the market into an overbought or oversold condition against the commercial traders' momentum. We need a sell-off if the commercial traders are long or a rally if they're short. This is the buildup of tension we focus so keenly upon. Once we have the setup intact, we wait for a reversal. Exponential, manic bubble markets are not rallies one should sell or breaks on should buy without sufficient cause and appropriate risk management. Waiting for a reversal provides us with a trigger and a protective stop placement point. If the market has reversed, the recently made swing high or low should hold. Therefore, this is where our protective stop is placed.
The weekly soybean Commitments of Traders chart shows just how much of this rally has been speculatively driven.
You'll note that there are only seven trading signals over a two year period. The Commitment of Traders data is reported weekly by the Commodities Futures Trading Commission. Therefore, its classic application has been to weekly bars. However, weekly bars create two primary problems for retail traders with smaller accounts. First, the risk is typically too high. Weekly soybean movement is currently averaging around $.65 or $3,250, far too much for a small account. Secondly, it limits the number of trading opportunities. Small accounts need to control risk and recapitalize frequently to be successful.
Moving to the daily chart below, you'll note that there are many more trading signals. Also note that the market entries are also usually the swing highs, which we use for protective stop placement. Also, note that these are entry points and that's why the buy and sell signals don't match up as trades. Each point is a new trade. Finally, the average movement is closer to $.30 or $1,500 per day.
The daily chart addresses many of the typical weekly COT application's shortcomings.
As you can see by the right hand side of the chart, the reversal of more than $1 in the last two days in the soybeans has already begun. How far behind can gold and its even more imbalanced market be?
How long can speculative buying continue to prop up the gold market?
Speculators in the gold market have set a new net long record. This surpasses their recent record set in May and pushes the market into even more precarious territory. Furthermore, in the case gold, commercial hedgers have set their own new record on the short side. This is because they are hedging their forward mining production and locking in profits now because they don't believe these prices will be available at the contract's expiration.
The gold market is ripe for a substantial reversal based speculator vs commercial data in the Commitments of Traders report.
Our thesis lies in the commercial traders understanding the value of their markets better than anyone. Their record breaking forward selling tells us that the miners don't believe they'll be able to get these prices on the open market come the futures contract's expiration. Hedging forward risk is the purpose of the futures market.
No approach is without its problems. One of ours lies in markets' ability to bring in new money and continuing to set new records. We've updated our performance data on our mechanical commitments of traders program through the end of June. This includes the trades we were stopped out of through the Brexit volatility. However, as long the disconnect between the commercial traders in their respective markets and the speculators continues to grow, we'll keep looking for reversal opportunities to short these markets in line with the commercial traders' outlook. The bigger the imbalance, the bigger the reversal.
This material has been prepared by a sales or trading employee or agent of Commodity & Derivative Advisors and is, or is in the nature of, a solicitation. This material is not a research report prepared by Commodity & Derivative Advisors' Research Department. By accepting this communication, you agree that you are an experienced user of the futures markets, capable of making independent trading decisions, and agree that you are not, and will not, rely solely on this communication in making trading decisions.
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Disclosure: I am/we are short SOYBEAN FUTURES.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.