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Weekly Wizards

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How to Play the Commodity Bottom

Wed, Nov 12 2008, 05:52 GMT
by AdviceTrade.com Team

AdviceTrade.com

Larry Schneider of the Zaner Group (http://www.zaner.com/) invites you to read their Special Report Update; written by Zaner’s research partner, the Hightower Report:

One can't know if the measures to contain the credit crisis will ultimately result in a favorable resolution. One also can't determine if the political change in Washington will improve or impede the economic situation.

However, seeing a continued thaw in the short rate markets, progressively lower interest rates and additional stimulus packages should give the global economy a fighting chance. In fact, just seeing the euphoria leading up to the US election and the rather impressive 6-day run-up in global equity prices should go a long way towards tempering the impact of the crisis on the economy. What will be important is whether or not the talking heads in the press will be part of the solution or whether they will fan the flames of recession talk in the wake of data over the coming months that is sure disappoint most physical commodity markets.

In short, we suspect that many market have made their lows already, but until the "window of bad data" passes, traders should expect some back and fill action in most markets. Some might even suggest that getting beyond this coming Friday's unemployment data might be the most critical juncture for physical commodities, but unless the global economy is confronted with the double negative of frozen credit markets and significant slowing, we suspect that the worst of the crisis has passed already for those commodity markets that are strongly underpinned fundamentally.

In order to build a major bottom in physical commodity prices, there will need to be continued calm in short rate markets. We will also need to get beyond the late September/early October data, and see crude oil prices build a base above $65.00 and gasoline prices base above $1.40. A December dollar below 84.50 might signal an end to extreme flight to quality focus, and there will also need to be less negative weekly gasoline demand readings from the EIA.

Signs that confidence is returning will be persistent gains in commodity currencies and the lack of a massive stock market slide in the wake of US payrolls data. Treasuries climbing above 118-00 could be a sign that excess supply fears are overblown, and copper prices need to hold above $1.71 in the wake of US payrolls.

Given the prospect of a coming bottom, traders should consider long plays that either protect or finance a longer-term bullish outlook for certain commodities. For instance, short futures/long multiple calls; long futures/short call/long put; long futures/long two puts; or short out of the money near dated calls/long further dated calls.

As an example of these, let's look at three long-term bottoming plays. The first is to buy 3 March sugar 14.25 calls for 65 and then sell the March sugar futures. Look for an initial objective on the short futures of at least 11.50 and perhaps even 11.00 if the economic uncertainty returns to a fever pitch in the coming 4 sessions. In the event that you bank a short futures profit, don't re-sell the futures until a rally back above 12.55. Look for an ultimate upside of 14 cents basis the futures. If futures haven't regained the 14.00 cent level by the middle of January, look to roll the strategy out to the July 2009 contracts.

The second play is to buy January Canadian dollar 84.00 puts for 196 or better and then look to buy March Canadian dollar futures. Once in the long put long futures position, consider selling a January Canadian 92.00 call for 113. Risk the position to close below 80.50, or, more importantly, to a combined loss in excess of $1,000. Look for an objective of 40 in the short call, hopefully off time decay, and not a sustained slide in the Canadian Dollar.

A final play is to buy the January RBOB 175 calls for 1015 and then look to sell the December RBOB 172 calls for 660. Risk the combination to a net loss of 400 points. Use an objective on the short call of 200 and an eventual upside objective of 185.

Published on  Wed, Nov 12 2008, 06:38 GMT