June 2023

Watching "smart money" commodity trading could pay

Fed cattle prices marked record highs in early June. Normally, prices sag seasonally through the third quarter (Figure 1). Some fundamentals suggest prices could continue higher, as happened in 2021 and 2022. Both years the nearby live cattle futures price peak occurred at year end.

The flow of money in and out of the market provides insight on potential price moves. Futures and options positions that traders take, and are holding, provides insight on how money is flowing.

Figure 1.

Watch the smart money

"Smart money" in sports betting is money wagered by professional bettors. Professional bettors have a better understanding of teams, and players, than regular or recreational bettors. Professional bettors spend hours reviewing data, statistics, reports, updates, etc. to get an edge for their bets.

Recreational bettors can learn from watching where smart money is being bet. Professional bettors focusing attention on one team provides a reason for recreational bettors to also take a closer look, or to perhaps look away from "weaker" teams not getting attention.

Data on where professional sports bettors are putting their money are hard to get. Not so in agriculture. Every Friday the Commodity Futures Trading Commission (CFTC) publishes a Commitment of Traders (COT) report.

COT reports capture 70% to 90% of the market

COT reports provide the previous Tuesday’s open interest for futures, and options on futures, for markets in which 20 or more traders hold positions large enough to meet the CFTC’s reporting level. These are large traders. The aggregate of all traders’ positions reported to the CFTC usually represents 70% to 90% of the total open interest in any given market.

Open interest is the total of all futures and/or option contracts entered into and not yet fulfilled by an offsetting transaction, by delivery, by exercise, etc. Open interest is the amount of cash flowing within the market. Net money flowing into futures and options boosts open interest. Money flowing out reduces open interest. Knowing who holds what positions may be useful in predicting price moves.
Traders view COT data as all market participants having access to insider information on positions of big traders. Some say, "If it wasn’t for the CFTC requiring it, no trader in their right mind would share this information freely." And, "It offers a whole new level of transparency into the big players!"

Analysts seeking meaning among all of the market “noise” routinely scrutinize positions of traders. COT reports can help participants better understand the psychology of the market.

Market has hedgers and speculators

Speculators, or non-commercial traders, strive to profit solely from price moves. They anticipate risks and can instantly shift positions based on changes in fundamental and technical outlooks.

Commercial traders deal with the physical commodity. They hedge price risk. In live cattle, the net commercial position is the balance of hedging by cattle feeders, who initiate hedges with short contracts, and hedging by users (e.g., beef packers) who initiate hedges using long contracts.

Like speculators, commercials attempt to anticipate price moves. But they have less flexibility than speculators to shift their buying and selling patterns.

Four types of traders hold reportable open interest

The disaggregated COT report classifies major traders into four groups. The remaining small positions are classified as non-reportable.

  • Producer/Merchant/Processor/User – Entity that predominantly engages in the production, processing, packing or handling of a physical commodity. Commercials use the futures markets to manage or hedge price risks associated with those activities.
  • Swap Dealer – Entity that deals primarily in swaps for a commodity and uses the futures markets to manage or hedge the risk associated with those swaps transactions. The swap dealer’s counter-parties may be speculative traders, like hedge funds, or traditional commercial clients that are managing risk arising from their dealings in the physical commodity.
  • Money Managers – Traders engaged in managing and conducting organized futures trading on behalf of clients. They include registered commodity trading advisors, commodity pool operators, and unregistered funds.
  • Other Reportables – All other reportable traders who are not included in one of the three other categories.

Cattle numbers down, open interest up

USDA’s National Agricultural Statistics Service estimated US feedlots with over 1,000 head capacity held 3.4% fewer cattle on May 1, 2023 than a year prior. But recent trading shows open interest in live cattle futures is higher than a year ago. Producers may be hedging more cattle compared to 2022. This would seem prudent as more dollars are certainly at stake.

However, feedlots are not the only market participants. Relative positions of other players, and how they compare to past data, may offer insight into prices going forward.

Open interest held by Producers/Merchants/Processors/Users has been declining among those with long positions and rising among those with short positions. Long hedgers exiting suggests fewer packers are interested in using live cattle futures contracts to hedge their purchases of live cattle. On one hand, one would think recent high futures prices would be enticing packers to buy futures to establish purchase prices before prices possibly escalate anymore. On the other hand, packers buying cattle in the cash market may think that prices are due to decline and hesitate to lock in high prices on the futures market.

Now could be a good opportunity for producers

Analysts often view the position of Producers/Merchants/Processors/Users as the "smart money." Rightfully so, these traders are constantly in these markets. They conduct extensive analysis and understand what’s going on better than anyone else. But they aren’t the only people that put their money at risk based on their judgment of the market.

While commercials have been becoming more short, the opposite has been happening with managed money (Figure 2). Money managers are establishing more long positions and fewer shorts, suggesting more bullish speculation is in the market. When the managed money has an increasing long position and commercials have a growing short position, a top may be near, or has just passed, and would be a good time for producers to place hedges, buy put options, or buy price insurance. Why? At some point the speculative longs will have to offset their positions, which could pressure prices.

Figure 2.

Understand COT report limitations

While COT reports can provide valuable information, they also have limitations. One big limitation is that the CFTC only publishes data once a week, which means the information may be outdated by the time it is released. This complicates using COT reports for real-time trading decisions.

Another challenge is that the CFTC only provides information on futures and options markets, not cash market transactions. Local cash prices and futures market prices are usually positively correlated, but not always. Another limitation is the reports provide no information on the reasons behind the traders’ positions. For example, COT reports do not explain why a trader is holding a long position, or why a trader is closing out a short position. This means market participants must use other tools, data, and information to gain additional insight into what underlying factors are driving the market.

A bit about COT report complexities

COT reports give either the futures data or the combined futures and options data. Thus, you must back out the options open interest. In the COT reports, options are on a futures-equivalent basis. Technically the open interest for options is weighted by the delta for specific types of options, their maturities and strike prices. Delta is the change in the option’s price or premium due to the change in the underlying futures price. Calls have positive delta between 0 and 1.00, while puts have negative delta between 0 and -1.00. The delta of a futures contract is 1.00. Many analysts use the futures-only data citing the high correlation between the futures-and-options-combined data and futures-only data.

The CME Group has a Commitment of Traders website with a tool that provides several breakouts and ways to summarize the data.

 

Lee Schulz, extension livestock specialist, 515-294-3356, lschulz@iastate.edu

Author

Lee Schulz

extension economist
515-294-3356
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