From the November 01, 2005 issue of Futures Magazine • Subscribe!

Old school, hard nose, softs market

For many newer traders, futures have become synonymous with interest rates, currencies and equity indexes. But it’s the agricultural commodities that have been traded in New York and Chicago for more than 100 years, and offer some of the best trending opportunities.

And while networking and cheap computing power has driven the wild growth of the electronic futures markets, which has expanded its user base, the reality of a commodity bull market and record low equity volatility has speculators looking at such things as coffee, cocoa and sugar.

Since 2001, the softs have achieved record levels of open interest and volume. These markets tend to be driven by fundamentals, dramatic events such as hurricanes, drought, floods and coup d’état, as well as more mundane supply and demand fundamentals like harvest reports and planting seasons.

“When I first started with these markets years ago, there was a story that rampaging elephants tore through Ivorian cocoa farms, and the market went limit up,” says Judith Ganes-Chase, president of J. Ganes Consulting LLC. “Now you have the rebel forces in a two-year civil war against the Ivorian government.” She remembers years ago, when recurring rumors of the Ivory Coast’s president’s death would move the market limit up. “He probably died five times,” she laughs. “Then, when the guy finally does kick the bucket, the market goes straight down!”

Old School markets

Orders in the softs markets can be entered on computer screens or called in to brokers who carry hand-held order entry devices, but all of the orders at the New York Board of Trade (Nybot) are executed on the trading floor. “They really don’t lend themselves to electronic trading as well as the financials do,” says C. Harry Falk, president and CEO of Nybot. “When you start dealing with softs, the differential between a July coffee contract, which is in the middle of the freeze period in Brazil, and a December contract has got nothing to do with interest rates or storage,” he says.

Roger Corrado, an orange juice and cotton trader, and vice chairman of Nybot, says the open outcry system better serves the need for price discovery and is favored by its membership.

“You want the edge your broker has had over the years,” and that includes the physicality of the open outcry pit, Corrado says. “Don’t think some of the old trade customers, and even the fund guys, would want to give up the edge of using the physical being, as opposed to just all being equal on an electronic platform.” When there’s been a freeze or a hurricane, he says, “You want to have someone to rely on. You don’t want to just be thrown in with everyone else in such an equitable way when you’ve had such an edge by doing it physically by open outcry.”

Where’s my wallet?

Perhaps Corrado’s description of the edge certain brokers have is what scares many retail traders away from the softs. To many, trading softs is a sucker’s game and the suckers are anyone who hasn’t developed those inside relationships. The New York futures markets in general have a reputation for slower executions and greater slippage.

“Slippage can be significant because of the lighter volume and lack of efficiency,” says one market analyst. He adds that if you don’t have a good relationship with a broker on the floor you can wait several minutes for a fill, “even longer in a fast market,” he adds. Some traders believe open outcry still has advantages. “It does have some downfalls as far as efficiencies, [but] electronic is terrific,” says Jeanette Schwarz-Young, president of J.A. Schwarz Market Analytics.

“If I put in an order on the S&P or Russell electronically, I’m going to get filled. And it doesn’t matter who I’m standing next to.” On the other hand, Nybot allows a trader to work the trade. “You can’t do that electronically. You’re stuck between screens. So, you may get one off right and one off wrong.”

The exchange’s commitment to open outcry trading doesn’t seem to be hampering growth, Falk says. The sugar contract reached an open interest of nearly 500,000 contracts recently and traded 285,000 contracts in a single week in late September. Volume and open interest are at an all-time high and October, a liquidation month, always sees a spike in volume. Falk says that since the dot-com bust and because of a growing leeriness about real estate, there is a growing awareness of commodities as a new investment vehicle for the public and hedge funds. “When you have oil prices the way they are, obviously you’ve got to begin to think about inflation,” he says. “And if you look back in the past, commodities have been a reasonably good hedge against inflation.”

The softs markets serve an important economic purpose for underdeveloped countries, allowing producers to effectively anchor returns on production; and the international trade of agricultural commodities are especially important to emerging economies such as China and India and other countries throughout the world. Brazil has become a major producer of oranges, soybeans and sugar and is the world’s largest coffee producer. Vietnam is the second. International producers and commercials are becoming more sophisticated about risk management as they both produce and consume more commodities.

Here come the funds

“We didn’t have the index funds participating to the degree that they are today. If you compare open interest today vs. open interest five years ago, you will see a significant difference,” says Jurgens H. Bauer, a cotton trader at the Nybot. He says there are four major participants in the softs markets: the index funds, which are always long; speculative funds, technical traders or black box funds that can be either long or short; the floor population, which provides liquidity; and the trade, which is comprised of merchants, co-ops, growers, producers, users, governments and mills.

More and more funds are trading the softs, adding liquidity and making it easier for producers to hedge more efficiently; and, as world production grows, even more speculators will be needed to take the other side of trades. “Now you’ve got these big funds and the growing recognition of commodities replacing stocks in their portfolio. People are starting to realize that commodities do return,” Corrado says, adding that large funds such as those based on the Goldman Sachs

Commodity Index (GSCI) or Dow Jones AIG Commodity Index and other hedge funds have been responsible for the growth in the last three years. “The funds are selling a percentage on certain commodity indexes, whether they are small indexes or large indexes such as the GSCI, they feel commodities should be a huge part of your portfolio. Years ago most guys that were managing money would insist the volatility of commodities wasn’t for everybody, so maybe they put 1% or 2% of a portfolio in that. That number has risen; it could be 10% to 24% of your portfolio invested in commodities. And we’re seeing that,” Corrado adds.

Indeed the volatility and trendability of Nybot’s markets draws speculators, even those who are apprehensive to jump in. While stories of large slippage on market orders and stops are common, traders can take precautions and exploit the trends these markets offer without getting chopped up.

Boyd Cruel, senior softs analyst at Alaron Trading, recommends entering softs markets on limit orders and maintaining a longer-term perspective as a way of to take advantage of trends in the softs.

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