Coffee Futures and the Commitment of Traders

The Commitment of Traders report, for those who don't know, is a report detailing the positions of the three different trader groups in commodity trading. Those groups are made up of small independent traders like me, large institutional traders and hedge funds, and commercial traders who are not speculating but are actually using the futures markets to hedge their crops or forward sell product.

The relative positions held be these three trader groups is all the long term trader really needs to predict the long term direction of a market with a very high degree of probability. How is this so? The reason lies in the fact that these three groups are motivated by different things, and because of that, their trading behavior differs. So before we discuss coffee futures, let me explain a little further about the trading methods of those groups in the COT report.

Let's start with the least significant group, if one group could hold that title; the small traders. The small or independent trader is always the last to buy in a bull market, and the last to sell in a bear. This is because the masses are swayed predominantly by fear or hysteria, and are afraid to act alone or stick to a predetermined trading system. If you're going to consider this group, it'd be best to trade in the opposite direction...though this does also depend on the commodity in question, as some commodities have more educated small traders.

The second group, and those who have received copious attention over the last few years, the large traders, institutions, and hedge funds. This is big money that moves the markets for extended periods of times. Large traders are by and large trend followers. They tend to miss the tops and bottoms of markets, but catch the meat of larger moves up or down. Once a trend is in place, confirmed in the bull market scenario by higher highs and higher lows, you can check to see if it is validated by large trader net long positions, and even better, steadily increasing that net long position.

The last of these three groups, and by far the most valuable, is the commercial trader. Commercial traders are producers or users of a certain commodity at a commercial level. So in the case of coffee, your commercial sellers might be Brazilian or Vietnamese coffee producers, and your buyers might be Maxwell House or Starbucks, if they haven't yet switched to fair trade coffee. Commercial traders are not speculators, like the other two groups, and their priority is not to milk the futures market, but is in fact to hedge their product in order to secure a set and satisfactory price. So if they are short futures during a bull market, their futures losses will be cancelled out by price increases of the actual commodity they sell.

That said, there is no group out there more knowledgeable about the commodity in question than commercial traders. Their livelihood depends on it. And because of this, they trade differently than large traders. Commercial traders are scale traders. This means that as prices fall, commercial traders will increase their long positions and decrease their short positions, and vise versa in a rising market. Because of their insider knowledge, when commercial traders go long, it generally indicates a level of value for that commodity, and one that will hold long term. So what does all this say about Coffee futures you ask?

The commercial traders have picked and/or created every bottom in coffee futures over the last 8 years. Every one. That is a pretty remarkable success rate, and its no coincidence. Every time the commercial position has been net long, opposite to a net short large trader position, coffee has been within 2 to 12 weeks of a long term low, and within 10 cents of the market bottom. And following this bottom came an intermediate to long term rally that took prices 40 to 70 cents higher over the following 6 months.

If this is so, what are the commercial traders doing at present? They are net long (buyers). Heavily net long and supporting the market in the $1.05 to $1.15 range. They have been net long off and on since October. It makes a very compelling case for coffee futures this spring, as we are right now in the ideal seasonal timeframe for a sharp rally in coffee futures. That in conjunction with both Brazil, Columbia, and as of a few days ago Vietnam, all smaller than expected crops at a time of steadily rising demand and during a cyclically smaller crop season.

All factors are lined up for this market to fly. We just need to see if investors can control their economic fears long enough to buy the one commodity that has the tightest fundamental setup in thirty years. Think about it when you take a sip of your morning cup of Joe.

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