By Kevin Kerr –
BALTIMORE (MarketWatch) — In the world of commodities trading, several things are vital for a new trader to learn right away. But the experienced trader also needs to constantly review these same things.
As a trader we have a toolbox — some have more tools than others, but we all have a toolbox. As our trading experience grows we add and subtract tools, keeping what we can use and leaving the rest behind. One of the most vital tools for commodities traders is the “seasonals.”
No doubt about it commodity trading can be difficult! Many people involved in commodity trading lose money, this is a fact. However, a basic understanding of the natural supply and demand cycles of commodities markets is a good first step for a new commodities trader to up their odds of success.
Some futures contracts are based on annually produced commodities, which tend to rally and break based on the certainty of supply. Other futures contracts are based on commodities which are demand driven, with the certainty of future demand driving prices.
A season for everything
Seasonality is found in pretty much every commodity, but none more than in agriculture. Crops, despite the major technology advances in recent years, are still dependent on weather conditions. Farmers have to wait for the snow to thaw before planting corn. Soybeans must be harvested before the first hard frost or the crop will be severely damaged. Orange juice citrus is dependent on warm temperatures in winter. And the list goes on and on.
Seasonal analysis presents often repeated scenarios. It’s not a crystal ball — though just because a market’s done something for the past 30 years in no way guarantees that the pattern will repeat itself every time. The point of seasonal analysis is to find situations where the environment is such that when a trade is going to be placed, you have an even better chance at profiting. You’re increasing your odds of winning.
Certain commodities tend to exhibit the most strength historically at the beginning of their production cycle. For example, grain futures are typically the most likely to rally during field preparation until planting is completed. This is because if planting goes poorly- too much rain, or drought, too hot or hard freeze, then yield will be lower, and supply will be less. Due to all the uncertainty, the market tends to build a “risk premium” into prices, to compensate producers for the risk involved.
Historically the weakest time of the year for these commodity futures contracts is when the risk associated with the crop lessens and the volatility dries up. For example, most grains are much less vulnerable to weather — rain and temperature — after they pollinate. So after “normal” pollination, prices tend to be weak as market attention turns to the eventual onslaught of supply.
Examples of annual production cycle commodities are: Corn, Wheat, Soybeans, Cotton, Cattle, Hogs, etc. An annually produced commodity tends to have supply available when the product is harvested, then demand is variable, and segmented throughout the year.
Other futures contracts are based on a market with variable production cycles, and more constant demand components: Such as the energy complex (crude oil, unleaded gas and heating oil) and metals (gold, silver, platinum).
Certain commodities tend to have constant year round production, so instead the demand or usage cycle is more important. These commodities are affected more by distribution network, and wholesalers who dictate prices. Historically the strongest times of the year for these types of commodities are the period when wholesalers begin to build inventory.
For example, heating oil dealers start to build up inventory in March through May. They need to purchase the heating oil for distribution before the public starts to buy it. Therefore, prices have historically been strongest well before the cold weather arrives, like right now.
Gold wholesalers buy in July and August ahead of Christmas jewelry demand.
Seasonals: Great roadmap but no Holy Grail
Seasonals have very distinct messages and can provide incredible insight for traders to examine.
Of course, just because a market has reacted a particular way in the past doesn’t mean it has to do it again. Often seasonals correctly foreshadow highs and lows in a given year and other years they don’t! Traders should always use other forms of analysis along with seasonality, because seasonal events can be premature or too late depending upon the specific year.
That said, by gaining an understanding of the seasonal patterns, and the strong tendencies of the market to move in a particular direction at a certain time of year can be a huge asset. When this tool is used in an overall strategy along with other methods to make an informed decision, it can ultimately lead to even more profits.