The commodity futures markets are different now than how they've been for more than two decades. As a result, my suggestion is don't heed the advice of people telling you they can easily predict what the markets will do. They can’t--the world has entered newly chartered territory beginning in fall 2005.

Don't rely on the past to predict the future. It’s a better strategy to be a follower of the prevailing trends then to try to predict trend changes. The commodity markets have, in general, performed in one way during the past 25 years, but it’s different now--and this difference will most likely continue for the foreseeable future.

What’s different?

Price moves are generally (there will be exceptions) more dramatic, extended and exhibit much greater volatility. Because of this, it has become necessary to change the way we trade.

The reasons for this heightened volatility began with China, India and the billions of newly created consumers who now want what they’ve been manufacturing and exporting to the West. These consumers are increasingly able to acquire these goods themselves.

These products require the purchase and consumption of copper, aluminum, energy and food. As global wealth increases, so does the demand for commodities like gold. On top of this newly created monstrous demand is an excess of liquidity.

According to Mary Cashman of Global Market Intelligence, the US money supply, as measured by M3 during the tenure of recently departed Federal Reserve Chairman Alan Greenspan, grew at an astounding 179 percent--from $3.6 trillion to more than $10 trillion. A lot of this money has found its way into pension, hedge funds, and index funds, and now they have all discovered commodities. This is the catalyst for a major difference because it adds paper demand to the physical demand of the Chinese, Indians and others who are competing for the same materials as Americans and Europeans.

Pension funds are now willing to place up to 5 percent of their assets into commodities (many via commodity index funds); this number is up from zero, as they traditionally remained in stocks, bonds and real estate. Last week, for example, Deutsche Bank listed a new commodity index fund. Because Deutsche Bank decided to buy wheat and corn, these markets surged for days despite large supplies and bearish news. On Friday, while it was raining in South America, improving the crop, the soybean market rallied dramatically, and not for any reason I could see other than fund buying.

There's a lot of money floating around, creating a new paper demand source on top of a new physical demand source. Combined with diminishing supplies of a particular commodity, the net result is explosive.

So what do you need to do differently?

Trade smaller positions. Be prepared for sharp and unexpected swings as money flows in and out. Use option strategies. Since the increased volatility has bloated option premiums, sell options rather than pay the high premiums. Strategies such as covered positions (where one buys the underlying asset and sells premium against it) make sense today.

Bottom line: Look at the markets with new eyes. Let’s forget about the concept of what is high and what is low. WD Gann once said a market is never too high to buy or too low to sell. Let’s put aside buying cheap and selling dear and turn our attention to momentum. As one example, sugar is acting much like it did in 1980. It’s a money play right now, and we have to view it in this way. But you tell me it just hit a new 25-year high and looks expensive, right?

Take a look at the chart of October 2006 Sugar (the contract closed Friday, just above 18 cents per pound, which is actually a penny discount to the spot price right now).

October 2006 Sugar

www.commodity.com

It does look high, but what’s the meaning of high? In early 1980, when October sugar first traded at 18 cents, it appeared to be very high. However, in hindsight, it looks cheap--it traded above 37 cents per pound by the fall of that year.

October 1980 Sugar

www.commodity.com

How to play a market like this? It’s not easy, but the trick is to go with the flow. Just as it’s easier to paddle downstream rather than against the current, it’s easier to trade with the trend than against it.

The keys are smaller positions, wider stops and adding to positions with the flow, as the market is making new highs (this way your unrealized profits in earlier positions will cushion the additional risk involved in taking on new length).

It won't be easy; you must go against your instincts to buy cheap. But it might be more lucrative to buy high and sell higher.

© 2006 George Kleinman
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Risk Disclaimer

Futures and futures options can entail a high degree of risk and are not appropriate for all investors. Commodities Trends is strictly the opinion of its writer. Use it as a valuable tool, not the "Holy Grail." Any actions taken by readers are for their own account and risk. Information is obtained from sources believed reliable, but is in no way guaranteed. The author may have positions in the markets mentioned including at times positions contrary to the advice quoted herein. Opinions, market data and recommendations are subject to change at any time. Past Results Are Not Necessarily Indicative of Future Results.

Hypothetical Performance

Hypothetical performance results have many inherent limitations, some of which are described below. No representation is being made that any account will or is likely to achieve profits or losses similar to those shown. In fact, there are frequently sharp differences between hypothetical performance results and the actual results subsequently achieved by any particular trading program. One of the limitations of hypothetical performance results is that they are generally prepared with the benefit of hindsight. In addition, hypothetical trading does not involve financial risk, and no hypothetical trading record can completely account for the impact of financial risk in actual trading. For example, the ability to withstand losses or to adhere to a particular trading program in spite of trading losses are material points which can also adversely affect actual trading results. There are numerous other factors related to the markets in general or to the implementation of any specific trading program which cannot be fully accounted for in the preparation of hypothetical performance results and all of which can adversely affect actual trading results.