The Weekend Commodities Review

Presents:

Hot Market Analysis

By Head Analyst James Mound

February 27^th, 2004

            2004 has begun with two months of market extremes, with volatility in several markets near respective highs.  As volatility is expected to continue in sporadic fashion throughout the year, it is important to seek out markets with price action and volatility in order to find the better trade ideas.  The best traders not only play during times of volatility, they live and thrive in it.  This article will look at several ‘hot’ markets and a couple that could be heating up in the very near future. 

US Dollar

A solid dead cat bounce in the US dollar has many currency players running for cover.  As the Weekend Review has long forecasted, support in and around 8500 on the US dollar has seemingly held and offered two strong bounces, the current one exceeding the last and suggesting a move to strong new relative high in the near future.  Targets range between 90-92 for those believing this is a short term retracement or dead cat bounce in a long term depressed market environment.  The key here is whether intervention of any sort is occurring or will occur at these price levels.  While Greenspan, Bush and Snow are all offering a stand aside stance with the philosophy of letting the free market determine currency prices, much could be shown to argue against this reality.  The fact that the US has used the G-7 meetings to essentially force their economic needs on the rest of the world has certainly suggested the US has no intention of standing aside.  The general idea is that we need a weaker dollar to allow US exports to support a seemingly difficult economic recovery.  Nevertheless there is a limit to how much weakness is acceptable and for that matter necessary to make this happen.  For all intensive purposes the current bounce is occurring more on rumor than the fact, and until the facts become more prevalent I am inclined to call for a top in the 90-92 range and an ultimate test of the lows by year’s end.  Volatility will continue, however, and the more this current rally sets new highs the longer we will see strong price volatility.  Key price points are a close above 8850 or a break below 8485.  Psychological resistance might be seen just below 90.  Look to play opposite large one day moves based on economic indicators, rumors or speeches as recent trade action suggests quick retracements off those points.

Japanese Yen

The yen offers a legitimate bastion of hope for dollar bulls in the near future.  The yen is first beginning a retracement after significant rallying.  Japan represents a purely export based economy, far more than our own import/export ratio.  How much longer can Japan step aside to kiss US butt at the cost of their own economy?  Japan has come out of one of the worst depression and deflationary periods in recent global economic history.  I doubt they are seeking to fall back in.  Japan is cutting off their lifeline by removing a large percentage of the export business they have relied so heavily on since the second world war.  The fall of the yen, or for that matter the strengthening of the dollar/yen relationship is necessary for the good of this now global economic export powerhouse, and in desperate need of a quick and powerful retracement.  If anyone would step in and intervene for the sake of self preservation it would be Japan.  The only questions are do they have the nerve to try it and can they be successful?

Gold

Gold’s inverse correlation to the US dollar has become the focal point for its trading for some time.  It is interesting to note that the gold market’s movement occurs at critical large move days based on a fear of either confirmation or reversal of a particular trend in the US dollar.  By this I mean to illustrate that the gold market tends to downplay minor trend shifts and individual daily movement in the US dollar, but then overreacts when it appears a longer term shift is occurring in the dollar.  This offers gold traders some the most sporadic volatility around and suggests this relationship will remain timid and reactionary until a clearer pattern or trend is seen in the dollar.  On a technical level, gold continues to follow the two steps forward, one step back pattern it has exhibited for a year plus now.  As the up swings become more extreme, so will the retracements.  Gold is a long term bull market, but too often I see traders analyzing this market on a shorter term basis that will offer conflicting signals and combative trading.  See this market in terms of years and not months or days.  On shorter term charts this market has broken critical support.  On the longer term monthly chart, the best arc/saucer formation in history is still holding its relative pattern and suggest these price points as good value entry points.  An important technical observation to make, however, is that a large & long term saucer such as this one can often set the stage for a massive fallout should the pattern be thoroughly broken.  That said, long futures with a ratio of at least two OTM puts for each long futures will offer good protection as long as this is done on a long term basis.  Another interesting observation is that despite the current $40 pullback off the highs, gold calls still trade at roughly double the premium of equidistant out of the money puts.  This suggests a strong value in the puts and a reason to be a seller of call options.  Overall, I recommend an initial position of long futures, long at least twice the puts as futures, and selling OTM calls on a bounce.

Silver

Silver has followed the coattails of gold and has seen a 50% plus rally in under a year.  Silver volatility should continue to heat up as the dollar finds its course and gold brushes against long term support levels.  Silver bulls continue to argue that silver is rallying on stand alone merits, as silver stocks and usage demand are at respective lows and highs.  Critical levels on silver remain above current prices near $7.40, but one has to acknowledge that current prices have already broken through historically critical resistance.  Let’s ignore the Hunt Brothers for the moment and suggest we are nearing uncharted territory.  What is most appealing about silver is the ridiculous premium in out of the money calls over various time frames.  Dec. ’04 $10 silver calls for $1,000 or $15 calls for $500 seem like an option sellers dream.  For that matter, ratio spreading nearer term strikes (May $7 versus $8 for example) offer bulls a more reasonable value play.  Long futures players are encouraged to do covered call writing.  This market’s current volatility presents some once in a lifetime opportunities.

Soybeans

The past two years, most notably last year, have quite unique to beans.  Not only have they diverged completely from the other grains, but beans have shown resilience and relative calm during a rally to levels not seen in 15 years.  What makes the current situation even more unbelievable is the seasonal timing of the current price high.  We head into plantings with prices set to test all time high levels.  This is based more on the Brazil crop figures and the unquenched thirst for supply from China than anything else, but we nevertheless are entering a stage where beans have no theoretical limit.  One could also argue that a good start to the season would create a relief selloff that would be consistent with the current trend of unseasonal moves.  Historically, beans have seen plus $9 prices 7 times including the current run, and every time have retraced to under $8 within two months of hitting the high.  These drops, for the most part, have been more dramatic than the rally that set it up, and often offer more a profit potential for intermediate term traders than having caught the run up.  Put premiums are not structured properly in the market based on this analysis, which sets the volatility structure to downside at a minimum.  Therefore, near the money puts are over priced and distant out of the money puts are at a relative discount.  There are ways to play this.  First, you could simply buy deep OTM puts placed over several different time horizons (May, July, etc.).  Second, you could play a more aggressive reverse put ratio breakout spread (for example, sell one May $9 put and buy four May $8.30 puts for cost of a few pennies).  The latter example is about $2,000 less than the same spread on the call side.

Coffee

Coffee continues to have the potential to be explosively volatile, but has been under wraps for some time during this uptrend.  Coffee offers strong historical evidence of being a long term buy with the current technical and seasonal setup.  As farmers have been more on top of the weather trend, coffee farms have gravitated towards more reliable frost free areas and given coffee traders a lot less to talk about over the last few years.  Moreover, supply problems in Brazil have been made up by our Indonesia suppliers.  Nevertheless, this cyclical market suggests a more technical outlook that begs buyers at current levels.  In the three times in 30 years we sunk below $.50/lb, the market has never retested those prices after rallying over 25%.  Moreover, the two previous times the market only offered buying opportunities on dips as two out of the four largest rallies in coffee history occurred immediately off of these price lows.  One could also closely correlate the technical setup from 1993-94’s rally from sub $.50 prices to the current consolidation.  Not coincidentally, that run broke out at the end of Feb., early March of 1994 (exactly 10 years ago!).  Currently, coffee is showing price support above the top of a previous channel, and is consolidating ahead of another breakout move.  This has the look of a market set to explode with shorts covering a few months ahead of the frost season and commercials trying to lock in current prices.  Call premiums are relative to the market and could offer a good opportunity should the volatility pick up as expected.  Otherwise, long futures with half the positions with a stop below topside channel support at around 68.50 and the other half as a wider risk stop below 56.00.

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