Producers (also referred to as commercials) are one of the groups of Commitment of Traders report. They are dealers in physical commodity and they do not come to the market to speculate, they come to hedge their risks.
What is the meaning of that? Suppose a following situation – it is January and Nestle needs 1000 tons of cocoa by the 1st of July to secure their production of chocolate. Current price of cocoa suits them and they factor it in their business plans. However, they do not know what the price will be on the 1st of July. They come to futures market in January and buy 100 contracts of cocoa (standard contract is 10 tons) with delivery (contract expiry) in July. When time comes they sell this lot and buy physical cocoa from growers in Ghana and Ivory Coast. If price goes up between now and then they would get profit and use it to offset price growth on physical market. If price drops – they get loss on futures market but they buy cheaper cocoa on physical market. They always win and lose, so net effect is zero. This is hedging. This is why they trade futures. Processors of physical commodities buy futures, producers of physical commodity sell futures. And who is the other party trading with them? Whoever wants to buy.
Now let’s see why they are foretellers of the future price direction. As every business Nestle hates to lose be it a financial futures loss or physical commodity loss. If Nestle would know that crop prospects would be poor (and they would because they monitor market in-depth, they have eyes everywhere in cocoa market) they would anticipate price growth and they would buy futures to hedge their production. But if they would know that crop would be ample they would anticipate lower prices and they would not buy futures but accept the price “as is” when July comes. Therefore, if you see commercials buying – the price is expected to go up. If they are selling – they price is expected to go down.
So, shall you buy every time you see them buying? Absolutely… NOT. Wait, how come? NOT. Here is why:
You want to invest $5000 in cocoa. Futures exchange requires a deposit of $1000 for every contract. So you open your position and get 5 contracts of cocoa or nominal 50 tons of cocoa (remember - 1 contract is 10 tons). So, for every $1 movement in price your gain/loss is $50. Or 1% of your investment. Next question is – how much pain would you be ready to endure before you give up and close your position? Say, it is 20% - if you lose 20% (or $1000) of your $5000 investment you close the position no matter what. But 20% is just $20 move in price and price of cocoa moves $20-$60 during a normal day. You may be right about understanding a future price move but your timing may be wrong!
Therefore you should wait. The time window between producers commencing buying and the price beginning to rise maybe in weeks or months.
What should you do as a user of Commitment of Traders report? We shall discuss this in future articles.
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