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March 21st, 2008

WARNING: This is not a recommendation to buy, sell or hold any financial instrument.

This may upset my libertarian and my commodity trader friends, at first, but I hope they hear me out. Although I’m 3/4 libertarian myself and a trader, leveraged speculation on commodities shouldn’t be allowed. Speculate on things like indexes, stocks, bonds and currencies until you’re blue in the face. None of those things are real anyway. But leveraged speculation on tangible goods actually makes a mockery of the market system by distorting prices.

If I buy a wheat contract, I should have to take delivery of the physical wheat on the specified date. If I sell a wheat contract, I should have to deliver the physical wheat on the specified date. I should not be allowed to buy or sell those leveraged contracts without having to take delivery, or deliver, physical goods. I shouldn’t be allowed to close my position without an exchange of goods.

The same should hold true for gold, coffee, palladium or any other commodity.

It is absolute madness that commodities are bought and sold using leveraged vehicles in markets that allow participation by speculators; individuals and organizations who have no interest or connection to the underlying physical commodity.

Guys, I know! I can hear you groaning. Several of you trade the gold futures. I made money on DBA, which is made up of futures contracts on wheat, corn, soybeans and sugar. I, just now, recommended gold mini futures contracts to a reader who’s using his BullionVault account for active trading—I mean, why not use the leverage that a futures account provides to trade and save money on commissions?

No sane person wants to wind up in a gun battle, but when you find yourself in the middle of one, you do what has to be done. As trader Dagobaz wrote, “If you any good at all at timing overbought / oversold conditions, you will be in the very rare position of being able to make money faster than even Bernanke can devalue it.” She’s right.

But think about what leveraged trading in real goods does!

Leverage is undead money. It’s zombie money. It can be conjured up and sent out to do the bidding of its master. What happens when infinite zombie money, in the form of leverage, enters markets where finite resources are traded?

Volatility increases and prices distort to the point where the underlying value of a thing gets lost in all the noise. This isn’t a free market; it’s a black magic trick, involving supercomputers, psychological operations and lots and lots of leverage.

Why is it allowed?

The Black Box people don’t make the big money in stable markets that are constrained by reality. They want to get in and out; fast. The more volatility, the more potential there is to pull money out of the chaos. What institutions need is a way to be upwind when they start a fire. LEVERAGE ALLOWS INSTITUTIONS TO CREATE VOLATILITY FOR EXTREMELY SHORT TERM GAINS. Participants who are trying to use the futures market in a legitimate manner, to secure supplies of goods, or to sell goods, at agreed upon prices in the future, are getting wiped out because the price action has little to do with the underlying supply and demand of the commodities!

After the Fed introduced a massive rate cut this week, gold gapped down 6%. There is a lot of head scratching in the gold bug community right now. I don’t see why. Cryptogon readers have been warned that gold is just another blinking number that updates in real time; traded with leverage. Don’t hold a scorpion in your hand and then blame it for stinging you. That’s just the nature of the beast. (On gold, I do believe the truth will emerge at some point. That’s why I’m not selling my physical gold.)

I rarely write, “This is how it should be,” posts because there’s absolutely no point. Pigs (Pork Bellies?) will fly before anyone takes my suggestion seriously. However, if you want to understand booms and busts in ANY market, you’ll find speculators who have nothing to do with the underlying assets, using leverage to create volatility for short term gains.

Welcome to fiat currency Hell.

Now… I need to go check out the collapsing grain futures to see if DBA is a buy again, or not.

Via: Forbes:

The largest price swing in the history of Chicago Board of Trade wheat futures Wednesday baffled market analysts and sparked frustration among long-time traders who have used the market as a tool to hedge risk.

The CBOT March wheat contract traded in a range of nearly $2.70 in a single day, from a low of $10.65-1/4 up to $13.34-1/2, a record spot price for wheat on the 160-year-old market. The contract ended up nearly 7 percent, settling 80-1/2 cents higher at $12.80 per bushel.

Until two weeks ago, the normal daily trading limit for CBOT wheat was 30 cents a bushel, either up or down.

“This is why a lot traders won’t trade this market anymore. This kind of volatility, and lack of connection to what’s happening fundamentally in the market, have a lot of traders saying there are other things to trade that have less risk,” said analyst Shawn McCambridge at Prudential Financial (nyse: PRU – news – people ).

“You can’t afford to participate in these markets if you’re a small or medium-sized guy, as far as an elevator or producer. You could be doing everything 100 percent correctly, and the market trades like this, you could get annihilated,” McCambridge said.

Most of the CBOT wheat trade is conducted electronically, with volume in the traditional open-outcry pit comprising only 6 percent of the total Tuesday.

Tuesday is the most recent day for which the CBOT has official data on electronic and pit totals.

Bullish supply-demand fundamentals have played a lead role in the surge in CBOT wheat prices, which climbed 77 percent in 2007 and are up 44 percent so far in 2008.

The U.S. Department of Agriculture says U.S. wheat stocks will drop to a 60-year low by the end of the marketing year on May 31. Global wheat stocks are projected at a 30-year low.

Soft red winter wheat, the par grade in Chicago, is in tight supply. Spring wheat, par grade on the Minneapolis Grain Exchange, is even more scarce, and MGE wheat prices well above $20 a bushel this week have helped frazzle long-time traders.

At the CBOT, expanded daily trading limits and sharply higher margin charges to trade wheat have added to the volatility.

Yet CBOT floor traders said the market’s latest violent gyrations reflect the increasing influence of hedge funds which have been pouring money into CBOT grains.

The price action Wednesday, they said, had more to do with fund maneuvers than with bullish fundamental factors.

“There is an enormous amount of bitterness down here,” one CBOT wheat floor trader said.

Soaring commodities have enticed Wall Street investors seeking a hedge against inflation. The U.S. Producer Price Index, an inflation gauge, Tuesday showed its biggest rise in more than 26 years, climbing 1 percent in January and 7.4 percent on a year-on-year basis.

Veteran traders note the large share of the market held by commodity index funds, which typically buy and hold long positions. The long positions held by index funds represented 36.4 percent of open interest in CBOT wheat as of Feb. 19.

Increases in margins, the performance bonds required to trade wheat, have been driving smaller players out.

“When I first started, we had 1/4-cent moves and an 8-cent range, and everybody was happy. Now we have $1 swings, and everyone is mad at each other,” a longtime CBOT trader said.

Another trader sounded more sanguine: “Big orders executed in a rapid fashion, coupled with spreaders there to help absorb some of the volatility, creates extreme swings.”

A spreader is someone who simultaneously buys and sells two different futures contracts, seeking to profit on a change in the difference in price.

He added of Wall Street investors: “Multi-trillion-dollar markets moving money into these type of markets … exacerbates the problem.”

CBOT March wheat was down 49-1/2 cents at $12.30-1/2 per bushel in Asian trading hours.

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