Investing in futures markets is very different than trading stocks. Due to the high degree of leverage in futures, there is much more risk for individuals, and the need to constantly monitor market positions makes these markets the wrong investment choice for the majority of individual investors.
Many hedge funds and large investment firms learned that leverage is a double-edged sword in last year’s financial crisis. While it dramatically increases profits on the upside, it rapidly destroys wealth on the downside and can lead to bankruptcy.
Unless human nature changes, this lesson will soon be forgotten, and most likely has already been by some of the largest trading desks. This tendency was noted by President Barack Obama in mid-June when he noted, “Wall Street seems to maybe have a shorter memory about how close we were to the abyss than I would have expected.”
In talking with investors on Main Street, it seems that they also have short memories. It is surprising how many of their memories seem to begin in early March, and the ugliness which destroyed 50 percent of the stock market's wealth seems to have been forgotten.
Since emotion and action drive market prices more than logic at times, we need to analyze what Wall Street and Main Street are actually doing rather than what we think they should be doing.
While the futures markets are not the ideal investment for everyone, they should be studied by anyone trying to profit from the markets. These markets offer an opportunity to gain valuable insights into market trends by using easily available data to see what large futures traders are actually doing with their money.
Once a week, the Commodity Futures Trading Commission releases the Commitments of Traders Report, known as the COT, and astute market observers can spot shifts in money flows among the largest players.
Traders in futures markets are actually required to report their positions to government regulators. Large traders are considered to be either commercial hedgers or non-commercial speculators. Hedgers include farmers and food manufacturers locking in prices. Hedge funds would be included among the speculators.
Individual traders do not report their positions, but the government is able to report their activity by looking at what’s left after accounting for the big guys.
With this clear breakout of activity in the futures markets, we are able to spot some interesting trends at times. Analysts usually consider the hedgers to represent the “smart money” as a group. Individuals can be thought of as “not so smart.” The large speculators, consisting mostly of hedge funds, are somewhere in between, and are smart at times while not so smart at other times.
Sometimes clear trends emerge from this report. Looking through this data now, we can see that producers seem to think the lows are in for many agricultural products. Corn, wheat, cattle, and hogs all show that commercial hedgers have large long positions while the individuals seem to be betting that prices will fall.
Interestingly, soybeans show no clear trend. This market has been distorted by government ethanol policies and speculation is driving its volatility. This may indicate that government involvement in markets will make trading more difficult in the future, a worrying trend given the recent political rhetoric.
For stock investors, the lesson to draw from the most recent COT report is that the smart money is bullish. While this trend can reverse at any time, large speculators have been buying futures contracts on the S&P 500 and the NASDAQ. There is some selling in the Dow Jones Industrial Average, which is probably due to the fact that this index contains a relatively large number of stocks under the scrutiny of politicians.
The COT report comes out every Friday and is read by some of the wisest investors every weekend.
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