Monday, November 23, 2009

Over the last few years, commodity marketing has been incredibly challenging for producers, largely due to a major increase in price volatility. This increase in price volatility signals a changing marketplace and has affected how many producers feel about using the futures’ market to manage price risk. One factor that has changed is the addition of new futures’ market participants. The purpose of this article is to define and describe one of these new participants – the commodity index trader. Commodity index traders take long positions (i.e., they buy futures) and purchase an index, or a basket of different commodities. Commodity index traders are more important today than ever, as they represent traditional stock market investors who are now diversifying their portfolio in the commodity market. Currently commodity index traders represent about 22% of open interest for corn and 24% of open interest for soybeans, which means they have a significant impact on market direction.

Commodity index traders view the return to commodities as negatively correlated with stock market and bond returns, and positively correlated with inflation. Therefore, the investment portfolio is viewed as being better balanced if it includes exposure to commodities in addition to stocks and bonds. The commodity index trader enters the futures market for exposure to commodities for the long-term. Positions are rolled from one contract month to the next, using a predetermined methodology. As a result, their actions are not based on reacting to fundamental supply and demand signals, but rather are a function of this predetermined method.

A commodity index trader can be classified as being either commercial (i.e., a hedger) or noncommercial (i.e., a speculator). A commercial commodity index trader manages hedges of cash transactions – private transactions that are not traded on an exchange. A non-commercial commodity index trader represents pension funds, endowment funds, and other institutional investors. A non-commercial commodity index fund is both passively managed and unleveraged.

Figure 1 shows the percent of open interest (i.e., the number of futures and options contracts that have not been settled) held by commodity index funds for corn. Commodity index traders, as a percent of open interest, ranged from almost 30% in April 2006, to just fewer than 15% in December 2008. For the last week of October 2009, commodity index traders represented almost 25% of open interest. Figure 2 illustrates the percent of open interest held by commodity index traders of soybeans; interest ranged from 30% in July 2006, to just less than 20% in October 2008.

During the commodity price run up in spring/summer of 2008 the percentage of open interest did not increase relative to other positions. In fact for corn, the percent of open interest by commodity index traders decreased overall during 2008. For soybeans a slight overall increase in percent of open interest occurred during 2008. Understanding their purpose and how they work will help the producer in making better hedging decisions in the future. (Cory Walters,

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