Coffee Memo | Rob Talks COT Report for Coffee Ep. 10

Posted in: Culture

By Coffee Memo with Rob Stephen

Coffee Memo | Rob Talks COT Report for Coffee Ep. 10

Episode Summary
Rob talks about the Commitment of Traders (COT) report for coffee and it's function and value as a tool for understanding the coffee market. He explains how and why the report is segmented by market participants, what the numbers mean, and shifts and patterns to look for when reading the report weekly.

Episode Notes

Pay attention to rapid position changes in the market.
Extreme open interest can indicate significant market shifts.
Accumulated positions may signal potential risks for investors.
Identifying trends in investment vehicles is crucial.
Effective risk management is essential in volatile markets.
Market dynamics can change quickly, requiring adaptability.
Understanding open interest aids in making informed decisions.
Investment strategies should evolve with market conditions.
Trading psychology influences market behavior and decisions.
Continuous analysis of market trends is vital for success.

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"All that this report does is tell them, are they long or are they short? If they're long, they are hoping or betting that the prices will go up. And if they're short, they're hoping or betting that the price will go down. And so what we do then is look at these different types of participants in the market and the report tells us if they are long or if they're short. And it tells us if that position has changed from the prior report. Because if a change, a significant change, like either less long or less short or going from net long to net short, it would be an indication of a change in sentiment. So this segment of the market now believes that prices will go up or this segment of the market now believes that prices will go down. Does that mean they will go up or down? No. It does not. But it's important for you to know and helpful for you to know if the people who basically make their living looking at the market and have skin in the game."

MIKE FERGUSON: Welcome to Coffee Memo with Rob Stephen, a podcast where we talk about coffee industry news and current affairs. This is episode 10 and the topic is the COT Report for Coffee. The what, you ask? The COT Report for Coffee. COT being an acronym for Commitment of Traders and, well, that's all I had to say about that. But fortunately, Rob has more to say about this important tool for understanding the market.

So Rob, all the topics that we've covered. This one to me is the most intimidating. I honestly have almost nothing to say about it. When I look at the COT reports, I just have massive anxiety. So that's true with most charts. And you can look at versions that aren't charts, that are just numbers, and that's even worse. So just keep that in mind as you explain that I really need to know what these things are.

ROB STEPHEN: I love it. No, I was thinking about this. So one of my favorite books or series of books is a book called Hitchhiker's Guide to the Galaxy by Douglas Adams. And there's so many great concepts in there that he writes to be funny but end up just being really wise. He had this concept of a translator was a fish you would put in your ear. It was called the babble fish. Now, that's the name of a company that does translation. And it turns out that they made the next generation of AirPods that basically does that. But anyway, he had this concept of a thing called an SEP field, which stood for somebody else's problem. And you would apply it to something, and that would basically become invisible. And that's the way I've always looked at the COT report, which is, it's somebody else's problem. And so I've had a similar level of intimidation about the COT report.

It's one of those things where, as I became more involved in trading, I realized I needed to understand it. And I've been surrounded by people who are good mentors and people who have used it for a long time. So I've been able to sort of pick it up and understand what it is. And so really today, I want to sort of give a distilled version of that.

MIKE: Cool.

ROB: So I think before we start, I should say it's November 24th. And so it's Monday and it is the Monday after the Friday where they removed the Brazil 40%... The punitive tariffs, which has created a free-for-all on Brazil coffee. I think our Brazil team had quite the day last week. So, I don't think I have anything wise to say about that yet. think we'll see. I would expect Brazil differentials to...to go up given the demand, but we'll see what happens. And I think that the market dropped, but it didn't drop as much as people thought it was going to drop. I still think that the wide inversion or the wide switch and the high market is reflective of coffee still not being in the right place. Fundamentals continue… we still need crops to come in right, we need coffee to ship, we need coffee to be in the right place. Coffee still isn't, so the market's doing what it can to get it here.

Anyway, so let's go back to COT. Let's start with what does it stand for? COT is an acronym for Commitment of Traders. So it's a report. It's a US-based report and it is done by the US Commodity Futures Trading Commission. It's published weekly, but it was not published at all during the shutdown. And it created a lot of angst amongst the people who sort of run trading desks and want to know what's in it because they use that information to sort of make decisions. So, what it does is it shows open-interest positions in futures and options markets. And it's not just for coffee, it's done for all the soft commodities, right? It is done for a very specific reason. It is to increase market transparency and help participants understand who holds what positions. So, when you look at that report, the people who are in the market are grouped into four different categories, which we'll get into, and what kind of positions do they have? Are they long? Are they short?

MIKE: People are in the market doing different things for different reasons.

ROB: Exactly, right, which we're gonna get into, right? So this report sort of puts it all together and says these are the positions that people have taken, right? So the people in the market are the traders. These are their commitments. It's not what they want to do. It's what they've done. So, because they have bought or sold a contract they've made a commitment and now it's when you when we add that all up What does that mean? Right and at any given point the market doesn't mean it's not 50% of the people in the market are bulls and 50% are bears, you could have 100% of one or the other or some mix between. And this basically allows you to see what that sentiment is by the number of different participants and which side of the coin they seem to fall on by their positions.

MIKE: So somebody that takes physical possession of coffee is going to act different in the marketplace than somebody who's a speculator. But we want to understand what both of them are doing.

ROB: Yeah, right and a speculator just like someone who's in the crypto or someone who's buying you know stock in Apple or something like that They have a position on which way the underlying asset is going to go. Yeah, right and so that's important to know. So how it is created I think is the first question we should come up with because when we talk about the report we want to talk about the you know, where it comes from so we know it comes from the CFTC it is a report where everyone who actually has permission to actually enter trades into The Exchange has to submit information for this report. And then that data is aggregated and it's released every Friday and it covers the positions as of the prior Tuesday. So it's about a three-day delay.

MIKE: Every Friday at 3.30.

ROB: Oh! Every Friday at 3.30. We talked about there's different kinds of people in the market doing different things. So let's talk about the four main categories of participants in the market that the COT report captures data on. So the first one is commercials. And those are people who are exposed to the physical product. They buy and they sell, and they're trying to manage risk about the underlying physical commodity. So that's going to be producers, exporters roasters and importers. All right, so anyone who's actually involved at some level with the physical delivery or receipt of coffee is going to be a commercial. So, we're commercials right as a specialty coffee trading company we're commercials roasters are commercials. Exporters who are big enough to do hedging their commercials. So all those people are in and in general the people in the commercial category are short when prices are high which means they're protecting the price of what they've sold. And they're long when prices are low, which means they're protecting the price of what they bought.

And then the next category of people are non-commercials. And so, they're listed in the report as non-commercials, but you can read that as speculators. Speculators can be very small, can be somebody who's got a trading account in their living room, and they can be very big, like an index fund or a money market fund or something like that.

MIKE: Yeah. and they never put their eyes on coffee.

ROB: Right. And they're very interested in getting out on first notice day because they certainly do not want the container of coffee showing up in their driveway. So they trade for profit, not for physical delivery. If there's enough of them doing the same thing, they can move the market. If a whole bunch of them are long, that can drive the price up. If a whole bunch of them are short, it can drive the price down, especially if they're all sort of like a school of fish swimming in the same direction. Which is, the same as can happen with a stock. Everyone buys Amazon, it goes up, that kind of thing.

Then there's this third category called non-reportable. I love that, we report on the non-reportable, it's fantastic. But it's basically an aggregation of all the people who are too small to have to report. So it's basically like after we take all the people who are big enough to report what's left over, let's lump them all together. That's basically a residual category. I think it's more to make sure that for the math people that, hey, these numbers need to add up. These are people that didn't neatly fit.

And then the last one, which is probably one of those things that makes us not want to look at this report because it makes our minds hurt, is what's called swap dealers. So, if you've seen The Big Short, this will be easier. If you haven't seen The Big Short, you should go see it because it's an amazing movie. But I would say that in a nutshell, a swap dealer is someone who creates custom financial products for institutions, whether it's a big company or a roasting company in Europe, a big massive global brand or something like that. They sort of say, all right, you want to buy coffee for the next three years at $2.50? We can make that happen for you. It's going to cost you. There's a fee for the thing. But then what they do is they do a mix of, all right, we'll go long on this and we'll go short on that and we'll invest in this and we'll just sort of create this risk pool that allows us to offer you these contracts. It's very complicated and very big business kind of stuff.

But one of the things that happens is they'll make this commitment to a client and then say, well, in order for us to protect ourselves on this, to get insurance for this deal that we've made, we need to go long May futures or something like that. And they can go very big when they need to do these kinds of deals. So you'll see a lot of them get in the market. They are also not going to ever take delivery of coffee. So they like speculators, they're using the market to hedge the risk on the deals that they've made. Makes sense?

MIKE: Sure, let’s say it does.

ROB: OK. I'll give you an aspirin. I'm hurting Mike here, folks. I'm so sorry. Anyway, so those are the four people that are sort of participating in the market. And then... all that this report does is tell them, they long or are they short? If they're long, they are hoping or betting that the prices will go up. And if they're short, they're hoping or betting that the price will go down. And so what we do then is look at these different types of participants in the market. And the report tells us if they are long or if they're short. And it tells us if that position has changed from the prior report. Because if a change, a significant change, like either less long or less short or going from net long to net short would be an indication of a change in sentiment. So, this segment of the market now believes that prices will go up or this segment of the market now believes that prices will go down. Does that mean they will go up or down? No. It does not. But it's important for you to know and helpful for you to know if the people who basically make their living looking at the market and have skin in the game, think that.

All of these other things that we've talked about in Coffee Memo, just things that make the market go up and down, things that have to do with the inversion, certified stocks, all these sorts of things, they all look at those things too. Weather, huge thing, right? We're gonna talk about weather in an upcoming episode. I think that you've got all these smart people looking at all these things and they have the ability to make their own opinion and then they execute against that opinion in trades. So this report is a distillation of all that, which is why it's important.

MIKE: Yeah, right got it

ROB: So there's a couple of things in there that are sort of code and it's worth talking about. So one of them is: Is the net long or short position, right?

MIKE: The net, meaning all four categories?

ROB: So it's categories yeah, but even within the category. So like for commercials it can be, this is how many people were long, how many people were short. Add them together, you're going to get a net one way or the other. But for the people that were short, then they break them out. OK, this is how short they were last week. This is how short they are this week. This is the change in the short position. This is how long they were last week. This is how long they are this week. This is the change in long position. So if you look at the report week after week, it's sort of like watching a river go by. You have to just jump into the data at some point. Anything that's trendy, like a stock graph or anything like that, you watch it over time and you see the movements of it. You get to this point where you just basically go, okay, the commercials keep getting longer or they keep getting shorter and the speculators keep getting shorter or longer. And they usually work in the opposite. Speculators usually go the opposite from where the commercials are.

MIKE: Okay, yeah.

ROB: Right? So, you look at the directionality of it. You also look at the size of the positions. Market participants, whether they're commercials or speculators, will get into the market more if they sense a clear trend or lots of volatility or if they have big need of the services. So if roasters really need to get price cover because they have a lot of business, they will go really long. And if producers are really selling, they'll go really short. Same thing if speculators really smell that and like, wow, all these factors are pointing towards a very volatile but very bullish sentiment, let's put our money in there. That's where we can make some money. Right? You basically are looking at a figure in this report called the open interest. An open interest is how many contracts in total are outstanding.

MIKE: Okay, so that when you look and you see the numbers, that number is a number of contracts.

ROB: Right. And if you have a really large open interest, it means there's a lot of people in the market with a lot of contracts. Or it could be, because they also list how many participants are in the market, how many individual clearing members are in that. It could be a huge position taken by a very small number of companies. So you have to look at them both. Right. But we call it the OI, which is open interest. And that's one of the numbers that gets talked about a lot by people who look at the market. Look at the open interest on December. Look at how many outstanding contracts there are in December that need to be closed before first notice day. This is how much market activity is happening against that. And so open interest is a huge component of that.

So obviously we're going to have a COT report in the show notes. If you hopefully can go take a look and follow along with this. But there's a few sort of cheat sheet kind of things.

So one of them would be if the non-commercial longs are very high, okay, so non-commercial speculators, if the speculators are very long, then that would indicate a bullish sentiment in the market. So right now, as we look at the COT report, and as we have looked at it over the last year, the non-commercial longs have been very high. And the market has been steadily going up. It's not its correlation not causation, right? It's them saying, hey this everything we're looking at looks like a market that's going up. It's not making the market go up, right? It's just them saying this is what we're seeing and this is what we're betting. So because we're seeing that and we're betting on it, it can create some effects. Enough people bidding on something can drive the price up. But it's not the fundamental reason why the price is up, right?

MIKE: Right.

ROB: And similarly, you can have big commercial shorts, right? And so that's going to be producers being afraid that prices will fall. So let's lock up our prices up here and that way if they do fall and we end up having to sell physically lower, we'll be able to take the profit from the hedge. Make sense?

MIKE: Yeah. Okay. I have big commercial shorts.

ROB: We're live, folks. No, okay. And then the last thing to look at in terms of just skimming the report is big position changes, right? So if you go from, last week commercial longs were 50,000 lots, and this week it's 100 lots. What happened? It causes you to ask questions. Why would the positions change so much? Sometimes it's a big player got out of it. Sometimes it's because people got scared and they said, we're worried that that position is going to go against us, so let's get out. There's a third thing that can happen, and I've always found it super interesting, which is that a lot of our institutional money is tied up in the non-commercials. And so, I'm talking about any sort of funds where people aggregate money as an investment vehicle that's managed by somebody. So they call it managed money sometimes, right? And these are index funds and things like that. And a lot of them take commodity positions, and they especially take commodity positions when the stock market is in trouble or is not performing well. And they tend to have an inverse relationship if the coffee market, if the commodities market is doing well, stocks are maybe not doing so well, and then vice versa. Commodities are seen as safe, but not necessarily, usually the best investment vehicle.

MIKE: Right. Okay.

ROB: And when there is a lot of volatility, which there has been in coffee, that attracts traders and investors because in volatility, there's opportunities to make money. There's big swings between highs and lows. So you buy low, sell high, you make some money. And so periodically, I think it's maybe four or five times a year, the commodity funds will rebalance just like you would redo your 401k. You know, I'm 10 years older, maybe I shouldn't be in these kinds of funds. I should be in these kinds of funds right now, they have this period where they just roll their funds, okay, we want to be a little shorter coffee, we want to be a little more in cotton, we want to do this and that and then and when they do, it creates these massive swings in the COT report. But they say when they're going to do it. They publish like hey, this is when the index funds are going to roll and you'll see them all exit or largely exit one of the futures contracts and then the positions will change. And it's good to know that because otherwise you might think wow, everyone is getting out. It's like no, just your retirement fund is getting out. Which it doesn't really care about the price of coffee, right?

That is it in a nutshell, so I would say that when we're looking at the COT chart you don't there's a lot of numbers and you just want to get a broad sentiment and you want to look at it weekly so that you see the changes from from week to week. So you're looking at net positions, you're looking at who's long, who's short, how has that changed since last week, how has that changed maybe over a month, who is of the people who are long and short, are they speculators or are they commercials? And again, remembering they usually have opposite positions from each other and speculators tend to congregate in the area where they think it's going, whereas commercials are trying to protect where they are.

And then I think that anytime there's a rapid position shift, it's something to pay a lot of attention to. Also, anytime there's an extreme open interest, like where just all of a numbers just get really huge, just like in stocks or other sort of investment vehicles there can be bubbles, like the housing market or things like that, it can happen where if you get enough people accumulated in a position, it can change explosively. So, it's something that we also look out for. The thing about bubbles popping is if you could pop it yourself or you could tell when it was going to, then you'd be very wealthy, right? So no one knows when that's going to happen, but it's helpful to know that it might exist. When we look at open interest also, I think we just tend to look at it with, is it reflecting a trend in one way or another? So I look at open interest over a long time horizon. And I just tend to look at it and say, more and more people are participating in the market or less and less people are participating in the market. That's a function to me of how useful the market is to people. As we've been talking about things like the certified stocks are shrinking and shrinking and shrinking, is the market useful to people or will it continue to be useful for people if there's no liquidity? So, you should see declining open interest as less and less people use the market. Now I think with these tariffs gone, you'll see increasing open interest because coffee is going to start moving.

Right? So how did I do? Was that way too much?

MIKE: No, that was good. The only question I think I have is the government puts out the report. Why? I don't understand, what is the public interest?

ROB: Public interest is the transparency, right? So, if you're a small investor, this is the kind of thing where big companies could put this information together on their own or have close to it. And then they would have an edge in trading. So, I think markets that are especially regulated markets that have a lot of transparency are usually the highest functioning.

What I do here, and I would recommend this for anyone who's trying to understand the market and how it works, which is sort what we're talking about, that I use this as an also, right? So I'm looking at certified stock levels. I'm looking at weather. I'm looking at crop reports. I'm looking at the COT report. I'm talking to lots of people. I'm looking at even things like currency trends. How's the Brazilian Reale doing? Because if you are a coffee producer, you want your costs in the weak currency and your sales in the strong currency. And so as they approach parity, costs go up. Those kinds of things. I look at all those things. And there is no formula. This plus whether plus this plus that equals this price at the end. It's very Zen. It's very like, well, these are all the things I know. Let's see what we think about that. And then let's add in a bit of our gut. And then let's make a decision. It unfortunately isn't any better than that.

MIKE: Well, I mean, if you walk into your room, your bedroom, you know if somebody's been there, somebody's something's been moved. If you're looking at all these factors on a regular basis, you'll know when something's out of unusual. And then you pay attention to that.

ROB: Exactly. Yeah, if you stare at data long enough, you notice when something is different. right So, I would encourage everyone who has looked at the COT report as someone else's problem to take a look at ours on the site or just you know, look one up It's easily accessible on the internet and see if what we've talked about here makes sense.

Yeah, and you have a great Thanksgiving, man.