We often state that commercial traders are value players. They take action in the futures markets when there's alpha to be gained over and above their local cash offerings. The only real difference is whether we're discussing wheat growers hedging their forward production or, whether discussing the long hedging end users in the wheat market. Both of these participants are responsible for meaningful price discovery in the futures markets through their actions. However, their actions and their corresponding effects on the underlying market couldn't be more different quantitatively or, qualitatively. We'll examine the current situation and setup in the chart below.
Every market has a fear premium. There are built in concerns that manifest themselves through the pricing chains of their option markets. This is why a put option with the same expiration date and distance from the current market is priced higher than its call option equivalent in the stock market and why, inversely, call options in the wheat market are priced higher than put options again, all other factors being equal. This pricing difference is based on the collective fears of a stock market crash or a crop failure, respectively. Taking this analogy one step further and you'll notice on the chart below that the spikes higher in the wheat market look a lot like spikes lower in the stock market. These spikes in volatility typically occur when the market moves in the direction of its anticipated fear, lower in stocks and higher in grains.
This analysis accounts for the qualitative difference in the way the markets move now, we'll shift to quantitative evidence in the wheat market that explains the significantly different market behavior even within the context of the same multi-year long-term downward trend. We track both the net commercial position as well as the collective momentum of the commercial traders as a whole via the Commitment of Traders report. This allows us to compare current behavior to past behavior as well as telling us how eager the commercial traders are to act at a given price level thus, acknowledging price's importance. Since this downward trend began in the summer of 2012, commercial long hedgers have been willing to take on around 75,000 contracts per market decline. It's safe to say, based on the chart below that their net capacity lies somewhere near their current holdings. Given the protracted decline, the ensuing rallies have been relatively meager, roughly +/- $.75. However, there have also been four significant rallies during this downward trend, three of which were better than $1.50.
Each of the major rallies was sold dramatically by farmers begging for a chance to sell their forward production. It's no coincidence that commercial selling climaxes very near the actual tops of these moves. This loops us back around to the current situation as commercial buying is doing its best to stem the market's decline. Based on the commercial trader position and the market's recent behavior, once the commercial traders have reached their capacity, we expect a near-term rally. Will we get $.75? Will we get $1.75? We don't know what the market will give us. We do know that the odds are shifting increasingly in favor of those willing to trade the long side. Currently, the market is attempting to take out the recent lows around $4.65 per bushel and we fully expect it do so. However, we don't expect much fresh selling to come in under these lows. Therefore, we'll be watching closely for a turnaround to go long once it starts heading higher. As always, we'll place a protective stop at whatever this swing low turns out to be. Finally, we'll watch the commercial traders' actions for signs of when to take profits.
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