A Lesson From...
WHO ARE THEY?
HOW DO THESE FUNDS WORK?
Long-Only Commodity Funds (LOCF) and ETFs are the 800 pound gorilla in the room that can no longer be ignored. These funds are big, slow, and powerful. By understanding how they function an investor can profit from the inherent predictability of these funds.
Long-Only Commodity Funds invest in a variety of futures contracts, creating a basket of commodities. Energy related commodities comprise the largest percentage of the contracts held totaling 50-75% of the total portfolio. This is due to the significance of the products both domestically and globally. Energy contracts included in the “basket” are Crude oil, heating oil, and natural gas. Other commodities included in these funds are precious and base metals, grains, meats, sugar, and coffee. The largest of these Funds is the Goldman Sach’s Commodities Index (GSCI) with approximately $55 Bil dollars invested. Other notable LOCFs include the Dow Jones AIG Commodity Index, the Deutsche Bank Liquid Commodity Index (DBLCI) and the Rogers Commodity Index.
To understand how these funds operate, let’s look at the GSCI. This Fund holds long positions in the nearby futures contract for every commodity in it’s portfolio. As expiration of the futures contracts approaches, the fund will liquidate (sell) it’s entire position in the current month and establish a new position (buy) in the next active month. This action of selling the nearby futures contract and buying the next contract month is called “the Goldman Roll” and is done between the 5th and the 9th of every month.
CAN THE COMMODITY BULL MARKET CONTINUE?
CAN THESE FUND HOLDERS CONTINUE TO MAKE MONEY?
In the author’s opinion, these Funds are a terrible investment and you should stay away from them. Yes, commodity prices may continue their rise in the future. However, it’s inevitable that prices will get too high and the weight of higher production, will force prices back down. The commodity bull market is very much like the bull market in stocks in the late 1990s. During that time, money was pouring into Mutual Funds at an unprecedented rate. This caused stock markets to move higher and higher until they greatly exceeded any reasonable fundamental valuation. The same is true for commodity prices. Investor demand rather than true supply/demand fundamentals are constantly driving prices higher. Eventually, commodity producers will dramatically increase production to profit from higher prices and prices will violently correct downward.
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THE GOLDMAN SACHS COMMODITY INDEX MONTHLY CHART: AS MONEY HAS FLOODED INTO THIS INDEX, PRICES HAVE CONTINUED HIGHER. HOW LONG CAN THIS TREND CONTINUE?
A better alternative is to stick to a profitable trading program, or a Commodity Trading Advisor (CTA) that can profit from large moves but will liquidate their position in the commodity before the price crashes back down. The best alternative is to find an experienced CTA that will go short the market and profit from a price crash.
HOW TO PROFIT FROM LOCF!
When trying to profit from LOCF, it is important to know the characteristics of these funds. First, these funds make up a large percentage of the open interest in many commodity futures contracts but they rarely adjust their position sizes. Therefore, during periods when investors holding short positions are likely to reduce their position size, these Funds will continue to hold their massive long positions. This can cause an explosion in prices to the upside. As buying pressure intensifies due to a lack of sellers, many participants holding short positions are forced to cover as the rally intensifies. During this period, very few participants (led by the LOCF) holding long positions are taking profits and are often increasing their long positions.
Example:
Copper: See weekly chart below.
For most of the last 30 years, copper has traded in a range between 60 cents and $1.60.
In 2003-2004, prices moved slowly but steadily higher, reflecting strong worldwide demand for copper and the emergence of LOCF which began accumulating long positions. However, in 2005 and 2006, LOCF grew by leaps and bounds. This resulted in large steady buying of copper futures, which sent prices rocketing higher. Compounding this was the fact that these funds never took profits and stayed with their positions no matter how high prices reached. Copper prices were forced to constantly move higher in an attempt to find new sellers to meet the demand. Eventually, prices will stay high enough for l ong enough to allow copper mining companies to dramatically raise production, which will eventually cause a total collapse of the price.
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As LOCF continued to grow in size in 2005 and 2006, they bought large quantities of copper contracts. This mixed with positive fundamentals led to an unprecedented rally in copper prices.
PROFIT STRATEGY #1: Always buy upside breakouts in these commodities and exit quickly if the momentum ends.
PROFIT STRATEGY #2: Sell Short commodities under the following conditions 1) Prices have gone to an excessively high level and stayed there long enough for producers to increase production 2) Momentum is turning negative. 3) Exit short positions if momentum turns positive again.
PROFIT STRATEGY#3: Find a unique strategy for spread trading that is not well known and that can profit from the movement of money caused by LOCF.
The final and potentially most powerful strategy for profiting from LOCF is through spread trading. When these funds roll their long positions from the nearby futures contract to the next one (“the Goldman Roll”), the impact on the spreads between contract months is dramatic. Many professional traders have made fortunes over the years by trading in advance of the Goldman Roll. However, with so many traders aware of this opportunity, it is crucial for traders to find unique and creative ways to profit from this market moving event.
One unique and profitable spread trading program is the Platinum Commodity Spreads Program or PCSP offered by Platinum Trading Solutions and traded by VanKar Trading Corp. This program uses state of the art software that tracks the movement of money in and out of the spreads affected by the LOCF. In doing so, it is able to identify profitable spread trading opportunities. In 2007, this program has completed a total of 23 actual trades in customer accounts using a variety of commodity spreads with the following results.
2007 ACTUAL TRADES
Total Trades 23
Profitable Trades 17
Losing Trades 6
Total of Profitable Trades $14,863.90
Total of Losing Trades $ -2,252.95
Total Net Profit $12,610.95
Average Profit per Spread $ 548.30
These results are based on trading a single spread per trade. Because spreads typically have much lower margin rates than outright futures positions, traders are able to hold larger positions and therefore make substantial profits should the current winning ways continue.
CONCLUSION
The Long Only Commodity Funds are a powerful force that is likely to dominate the market for years to come. Like any major force in the markets, full understanding and creative thinking will allow you to profit handsomely from this market condition.
For more information, please visit:
http://www.ino.com/specials/platinum/spread4.html
Hello, my name is Adam Hewison, I am the president of INO.com one of the oldest (we have been on the web since 1995) and most respected investor websites in the world.
