Trader Dan's Market Views: 02/16/13

I have been receiving a fair amount of emails asking my opinion on a recent article chatting up "Gold Backwardation". The unspoken inference from the article is that this is bullish for gold.

Let me state two things before proceeding. Number one - I am a trader and make my living by so doing. If I am on the right side of the market, I make money. If I am not, I lose money. It is that simple.

Johnnie one notes cannot trade and make money because they are only always on one side of a market. IN the case of gold, that means that they are always long. Markets go up and markets go down and if you on the long side of a market going lower crashing through support levels, guess what.... You are losing money, sometimes lots of it. Leverage is your friend on the way up if you are long; it is the grim reaper if you are long and the market is dropping lower and lower.

My advice to those who are using futures to trade gold and are not getting out of losing long gold positions while their commodity trading account is imploding - be prepared to suffer large losses to the extent that your potential career as a full time trader will come to an abrupt and rather inglorious end. You have heard it said by myself and others who do this for a living; "Cut your losses and get out of a losing trade when support levels get violated". That is called sound money management. Failure to do that and instead rely on HOPE is a novice's error. HOPE is not a trading strategy.

Do you honestly believe that a hedge fund computer algorithm really gives a damn what yours or my opinion is of a market? Those things are going to sell as long as the signals tell them to sell. When they stop, the market bottoms.When they stop is anyone's guess. That is what the charts are for.

Sometimes as a trader it is best to simply head to the sidelines and do nothing rather than keep trying to catch a falling knife. The market will bottom when it wants to bottom and not because some guy writes an article extolling the virtures of a market in backwardation or someone else makes a statement that the market will bottom in exactly two weeks or some other such nonsense. Use technical chart indicators to tell you when a bottom is in. No exceptions. So what if you do not catch an exact bottom? The greatest profits are made by taking 70-80% out of a move (unless of course you are a guy who likes to play range trades).

The people who consistently brag about buying exact bottoms or selling exact tops are chronic liars. I can tell you that they DO NOT TRADE for a living because no trader can consistently get that right all of the time. We strive to do so but at our best we no more know the future than the next guy. We wait for a confirmation before risking our precious trading capital. Oh yes, it is no where near as sexy as hitting an exact bottom when buying, but then again, after 2 decades plus, we are still surviving. I have seen more casualities in this business than I care to remember. Their last words are always: "I told you I was right - see the market is now going higher". The problem is that they ran out of money before the market turned! So what if they were right. In the short term, they were dead wrong and that is why they lost their money to someone on the other side of the trade who was the "right" one.

There is an old trader's saying that goes like this: "He bought the first break in price. He bought the next break in price. He bought the third break in price. He bought the fourth break in price and after that, He became the break".

Second - that assumes that the backwardation is actually there. Guess what - it is not. When a real backwardation structure exists in a market it is OBVIOUS from the structure of board. That front month futures contract will be trading at a PREMIUM to the next month contract which will also be trading at a premium to the contract following that and so on. The normal structure of (Most - not all) the futures board will be one of CONTANGO. Translated this means that the front or near month will be trading at a DISCOUNT to the next closest futures contract which will be trading at a discount to the contract following it and so on. Without getting too technical for the sake of getting lost in the weeds, markets such as livestock and grains are a bit more complex because of the nature of the commodity being raised or produced but even the grains will show this pattern when dealing with the OLD CROP against the NEW CROP.

Back to our BACKWARDATION structure however. When the near month trades at a premium to the next month and the one after that, the market is sending a signal that IT WANTS THAT COMMODITY AND IT WANTS IT NOW AND IT IS WILLING TO PAY MORE TO GET IT RIGHT NOW instead of waiting to take it further down the road. All VERY STRONG bull markets will show this pattern although it is not necessary for a market to be in a backwardation structure even during a bullish phase. It all depends on the SEVERITY of the DEMAND and SUPPLY situation. Markets can move strongly bullish even without a shift into backwardation occuring because an imbalance in supply and demand that it expects to continue for some time. However, when there is a supply shortage or huge demand spike, the move towards BACKWARDATION will occur.

Generally this is the result of a type of concern that can easily move to FEAR or outright PANIC on the part of those who need the commodity that they are not going to be able to secure enough supply of that particular commodity that is necessary to conduct their business. Minneapolis Grain some years ago always comes to my mind. More recently, last year CORN prices did the same in the face of a near panic brought on by a drought ravaged crop.

All this being said, the structure currently present in the gold market is normal. Here are the CLOSING PRICES for the four main gold contracts from last Friday:

February 2013   $1607.50
April 2013        $1610.30
June 2013        $1611.60
August 2013      $1613.30

As you can clearly see, each contract is trading at a discount to its successor. This is a normal market structure which is indicative of the COSTS of storage over those months, plus interest and insurance. There is not the least sign of backwardation.

Those who like to quote the spot price of gold and then compare that to the delivery month and claim backwardation exists simply do not understand the term nor the board structure. Basis is the difference between the spot or cash price of a commodity and the price of the nearest futures contract. Trying to nail that down can be tricky however because basis can be all over the place depending on the one quoting it. For instance, the basis in the corn market right now is swinging wildly. I have seen it quoted as high as $0.50 over. The problem is the corn price is imploding lower all the while the cash market is at a premium. All this means is that farmers here in the US are reluctant to turn loose of their corn right now and that is making supply for old crop scarce. What is happening however is that buyers are not willing to pay them this much for it and are instead sourcing from S. America or holding off on filling their needs until the harvest ramps up down that way. I could just as well make the argument that corn prices should not be moving lower because the cash corn market is trading above the corn futures market that the writer of the article about gold being circulated is making. What matters is the BOARD STRUCTURE. Nothing else.

Besides, there is also the issue of liquidity issues in the front month contract as it prepares to go off the board. Trade dries up and often the contract will not trade at all with bids and offers moving farther apart as the liquidity shrinks. The trades that do occur need to be noted for the exact time of the trade during the day and then obtain the price of spot gold at the exact same time to get anything close to an accurate basis.

This was part of the same nonsense being touted by those claiming that Deutsche Bank was stopping all the gold at the Comex and was moving it back to Germany and cleaning out the Comex warehouses in the process. Guess what, Gold prices have collapsed since that theory has come and gone. Again, no change in board structure; it was just more foolish HOPE masquerading as FACT. Deutsche was indeed doing some large stopping but how the hell do we know where that gold was going. Quite frankly, who even cares. If the board structure had changed as a result of all that, then we would have had something to chew on.

It comes down to this - SUPPLY and DEMAND - when an imbalance exists that is severe, it will always show up on the futures board. Everything else is just market noise. Sort it out and you will be a good trader; act blindly on it as if it is fact and you will join the ever growing ranks of those who become road pizza on the floor of the futures exchanges.

Trader Dan's Market Views

Saturday, February 16, 2013

Gold Backwardation Chatter

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