Copper Getting Overbought?

10/28/10 09:09:35 AM

by Donald W. Pendergast, Jr.

Commitment of Traders' net position analysis suggests that a intermediate-term top may arrive sooner rather than later in the copper futures market.

Security: HG, JJC
Position: N/A

Copper has been on a tear since cratering at $1.41 at the end of 2008, a year that many commodity and stock index traders would rather just forget -- especially if they had on a plethora of long positions when the markets all collapsed in unison in July 2008. But is this astounding rebound rally running out of steam? Using some basic Commitment of Traders (COT) chart analysis, the answer may be "maybe." Figure 1 is a closer look at the weekly chart of continuous copper futures.

FIGURE 1: COPPER, WEEKLY. Anytime you witness a massive selloff in a commodity futures market, always check the net positions on the commercial interest side of the market. If you see them buying in manic proportions, holding near-record net long positions, you can be relatively sure that a major bullish turn is not far away. This is exactly what happened in late 2008 in the copper futures market.

Graphic provided by: TradeStation.

Any commodity that can go from $1.41 to $3.72 in an 18-month time span must have some pretty impressive fundamentals that are driving the price higher, and that has indeed been the case in the copper futures market.

However, since launching a second wave higher in June of this year, the net long positions of the large speculator interests (green line in lower window) for this market are not as bullish as they were at the January 2010 high.

This has caused a negative divergence with price to form, one that could be an early warning signal of an upcoming pause/consolidation and/or trend reversal in the works. Copper prices have managed to retrace more than 79% of the complete 2008 decline, however, and that is still a very bullish dynamic on this chart, still offering much hope for bulls that a full 100% retracement will be the next target price for copper. It could happen, but wise traders and speculators will want to keep a close eye on the negative divergence of large spec positions with price regardless. Substantial price support exists in the area of the green oval on the chart, roughly between $3.10 and $3.25, and that could be one place to expect a minor bounce in case of a trend reversal lower.

Here's a minor tutorial on typical commercial and large spec buying activity. If you look at the left side of the chart, you see the gigantic head & shoulder pattern, one that took more than 2-1/2 years to resolve. And resolve it did with a bang, taking copper futures from $3.40 down to the sub-$1.50 level in a matter of weeks. But guess who was buying all the way down, in ever-more aggressive quantities? It was the commercial interests in the copper futures market -- the miners, refiners, fabricators, and consumers of copper -- all of the folks who were near certain that a critical industrial product like copper was more likely than not to stage a meaningful rebound after such a momentous decline.

With hundreds of millions of dollars in buying power, it's relatively easy for big-money interests to aggressively scale into long positions. Maybe a heavy copper consumer decides to buy 100 contracts at $2.85, 200 more at $2.45, 400 more at $2.10 and then 600 more at $1.80 before calling it quits, figuring this would provide them with more than enough copper for a two-year period. In this way, they end up with a net cost of approximately $2.07 for all 1,300 contracts. Such a copper consumer would be very glad (and wise) to have acquired his metal at a price that is far below the current price of $3.89. Of course, at some point they'll need to enter the market again, picking their scale-in points on subsequent declines.

Large speculators use similar tactics, only in reverse. Large specs typically use trend-following systems to jump on board emerging bullish trends, and that's when you normally see the commercial interests (copper producers) start to progressively unload their long copper positions in hopes of obtaining a solid profit. At the same time, they may also be selling longer-term copper contracts for ore that is still in the ground at the mine.

Both the commercial and the large speculator interests are essential to the efficient operation of a given futures market, and the copper market is no exception. Blaming speculators may have some merit from time to time (the big runup in crude oil in 2007-08 is a prime example of excessive speculation), but just try to run an efficient commodity market without the liquidity that both the large and small speculators bring to every market that they participate in. It would be an inefficient, chaotic mess, one that would put a real crimp in the operation of the industrial and agricultural sectors that generate much of the wealth of developed and developing nations around the globe.

Overzealous speculation may be bad for individual traders and their families (if they're losing a lot of money, for example), but for the most part, these profit-oriented traders are an essential and valuable component of the free enterprise system that has helped make modern living so simple and enjoyable.

Donald W. Pendergast, Jr.

Donald W. Pendergast is a financial markets consultant who offers specialized services to stock brokers and high net worth individuals who seek a better bottom line for their portfolios.

Title:	Writer, market consultant
Company:	Linear Trading Systems LLC
	Jacksonville, FL 32217
Phone # for sales:	904-239-9564
E-mail address:	lineartradingsys@gmail.com
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Copper Getting Overbought?

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