Now I trade futures contracts for profit.
The most common question I have gotten in the commodity business is the obvious: “What do you think prices are going to do.”
I understand the sentiment behind the question from producers, consumers, and even from traders looking to make a profit.
However, when someone with a financial interest in the answer asks what prices will do, they are actually asking three separate questions – the answers to each of which may, or may not, be helpful.
These questions are:
#3. When will prices go up or down?
#1. Will prices go up or down?
This is how most questions start. And, unfortunately, also where they end. “I think, based on supply this and demand that, quality, weather, something – that prices are either headed up or down.”
End of discussion. Cotton producer nods their head and walks away.
However, the answer to this question from most people’s point of view does not really help them.
Say you have 1,000 bales of cotton to sell. You ask me: “Will prices go up or down?” I predict up. And then slowly over the next six months, prices rise half of a penny per pound. I was correct in my prediction, but did that help you out?
Of course not.
#2. By how much will prices go up or down?
Simply knowing that prices are going to increase or decrease is not enough. In addition to the direction of prices, one also is interested in the magnitude of a coming price increase or decrease.
Right?
For a cotton producer holding cotton and asking, “What do you think prices are going to do?” the price of cotton needs to increase by about half a penny per pound each month for them to break even on storage and interest on their operating line.
So I predict higher prices to you, and higher prices come. Not only are prices higher but prices increase to a level that would be extremely profitable for you.
However, what if the price increase comes two weeks after your farm loan is due. That does not help either, does it?
#3. When will prices go up or down?
The timing of a move in prices matters too, doesn’t it? A large price increase for a producer that takes place after their crop is sold is not much help.
I knew prices were going up, and I knew they were going up by a large magnitude – but it happened too late to do you any good (at least for this year).
The same is true for an options trader. Does a profitable price increase or decrease help if the put or call option has already expired.
It turns out, learning how to predict oil prices is not difficult.
In fact learning how to predict the price of cotton (and all other prices) is about the same.
But now you can join me.
When someone asks: “Do you think prices are going up or down?”
You can smile and think: “I get the idea.”