In part B of my #SugarMarket Report Focus on the #COT we will look at the #Disaggregated COT, how to read the COT, and my "Secret" Metric. (See part A here)
Disaggregated COT:
The final COT that is used is the Disaggregated. This report is the most recent and it "disaggregates" swap dealers from the commercials and is the report that I use when I discuss the COT (and what I publish to my subscribers).
The old Commercial/non-commercial dichotomy is still here, but in this version the specs are rebranded as "managed money" and the commercials as "producers/merchants/processors".
The New category "Swap dealers," show what is generally considered to be commercial positions (although specs hold positions with swap dealers as well), but with an important twist: these positions are more volatile than standard commercial positions.
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Swap dealer positions have grown in size and importance over the last decade so the fact that these positions are more volatile then standard commercial positions, is increasingly relevant for price discovery.
Let's examine the two primary reasons why these are more volatile.
First, Swap dealer positions tend to have more complex risk profiles that often get larger when they are losing money. This isn't always the case, and it doesn't necessarily mean swaps are "bad". A smart hedger will often have swap positions on that protect them when losing money, but sometimes the hedger chooses to sacrifice downside risk in exchange for more premium in a stagnant market. This can cause problems and position liquidation when markets move in an unexpected direction.
The second reason for the volatility has to do with credit. Swap dealers usually have similar margin requirements to FCMs, and many have arrangements to cover margin calls with a credit line. However, as mentioned above the positions are often more volatile and the banks that provide Swap Dealers with credit are risk adverse. Since swaps are considered by banks to be more risky then traditional futures and options, they may not have the same access to credit lines that FCMs will have.
This means that clients of the swap dealers may have less credit to cover margin calls in the case of adverse price movements. This has the potential to cause premature position liquidation. Therefore, when we look at the Swap positions, we can get some clues not only to hedging by commercials, but also if the market is causing some forced liquidations.
How To Read the COT:
There are 2 primary readings of the COT, "vulnerable Positions" and "Min/Max".
Vulnerable Positions
When a market participant has a position on (either long or short) they are vulnerable to margin calls when the price moves against them.
Since specs (or "non-commercials" as they are called in the original COT) are not hedgers, they are vulnerable to adverse price movements. If a spec has a long position and the price collapses, the margin calls will force the spec to liquidate before long.
A commercial is vulnerable to margin calls as well, but only at the extremes, they tend to have more capital and deeper pockets then the specs, since their futures positions are offsetting physical positions. However, the commercial short position is always observed during large rallies because if the price rallies fast enough, trade houses and exporters will be forced to liquidate or can even go bust if the price rises enough.
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Min/Max Positions
The other primary way to read the COT is to look at the minimum and maximum ranges. We can look at what the recent highs or lows of a position (for both commercial and spec) and guestimate that when that level is reached the participant will run out of money and be unable to add any more to their positions.
This is a useful heuristic, but it should be used with extreme caution. Since the amount of sugar produced is by and large increasing every year, the amount of sugar hedged (and speculated against) is also increasing every year. This means that max positions can always get bigger than you think.
The opposite is not true though, the gross longs and shorts cannot go below zero, so when a spec long position gets very low, we can pretty safely deduce that they won't be able to liquidate any more (although they could add to short positions).
The Secret Metric:
The last metric that I use when evaluating the COT is spec position as a correlation with price. As mentioned above, the spec position tends to drive price movement and as the spec increases their involvement, we can observe the net spec position approach something like 95% correlation with price.
When the specs lose interest this can drop to 50 or 60%. Tracking this is a useful heuristic to understand how active the spec is in the market and how vulnerable the market is to have adverse movements cause liquidation events.
We also want to watch this metric for the reversal. A market with a very low or very high spec correlation with price could indicate that the market is ripe for a reversal.
Conclusion
At the end of the day, the COT is publicly available information, so this report on its own is rarely the key to making money in sugar. However, the COT does highlight the most fundamental relationship in a commodity market: the relationship between the spec and the commercial.
Over the long term, the commercials are the key to price discovery, they represent the producer (supply) and the consumer (demand). The speculative trader is very often the key driver of short term prices. When the spec puts positions on or takes them off, the speed and size can move the market dramatically.
Having reports that present the data in a clear and meaningful way is important to be able to evaluate the market quickly and efficiently. That is how I aim to orient my reports, so if you are interested in evaluating them you can sign up for a free or low-cost subscription here.
There you have it, everything that you wanted to know about the COT. Feel free to comment below any other ways that you use this report, or if you have any questions. Stay tuned for more insights on key Sugar Market Reports.
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