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Hedge Fund Positioning and Vulnerability in the Coffee Market - Part 1

Intro

The Arabica coffee market has experienced a major rally of ~22c in just 2 short weeks. The sudden and substantial increase has come as a surprise to many in the market, and the critical questions are: what is the driving force behind this rally, and what lies ahead for coffee prices? One way to get some answers these questions is by looking at hedge fund positioning.

Unlike the Commercials (like Roasters and Exporters), speculative fund positions are not a hedge against price volatility, but instead are designed to take on price volatility. This acquisition of price risk has some important implications, but ultimately it means that hedge funds tend to amplify price movements, exaggerating both rallies and sell-offs.

In this two-part article, we will look more deeply into these implications, and their effect on price action in the coffee market, we will examine the recent rally in the context of hedge funds, and finally we will look at how we can use this information to try and forecast potential outcomes for coffee prices.


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Context to Hedge Funds in Coffee

Let’s start our analysis by clarifying what funds are and how they operate. We can divide traders in futures markets into two distinct groups with contrasting strategies and objectives: Commercials and Non-Commercials (aka “Funds”, “Hedge Funds”, “Managed Money” or “speculators”).

Commercials are businesses who use the underlying commodity for commercial purposes, meaning they are growing, roasting, or trading the physical commodity. We can think of them as "Smart Money” because their business is intimately connected to the fundamentals and so they can be assumed to have some insight into the supply and demand.

The commercials business in physical coffee, requires protection against price volatility that can hurt their businesses. For this, they employ futures contracts as hedges to protect themselves against price volatility and adverse price movements.

Non-commercials, or hedge funds fall into the category of "Dumb Money." This name is a little misleading as specs are not “dumb” people (most of them aren’t anyway....) but rather they may trade in the market in regard to price movements as opposed to insights in the underlying supply and demand.

Funds engage in speculative trading with the aim of generating profits. However, despite the name “hedge funds”, their positions are not “hedges” but entirely speculative. This is an important distinction because it leads to two important implications for price action.


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First, when prices move against hedge funds, they must liquidate their positions. If a commercial loses money on a futures hedge, it is offset by a gain in the value of the physical. Thus they are under very little pressure to liquidate the hedge (with the notable exception of cash squeezes from large margin calls).





Second, hedge funds are inherently price trend followers, even if the trading philosophy of the fund managers is based on market fundamentals or contrarian trading. This must be true because commercial fund positions can only increase in size when a position is moving in their favor. For example: A hedge fund with a long position that is making money can use those profits to get longer, but a hedge fund with a long position that is losing money will have to sell their long positions. The losing fund must sell their positions to preserve their remaining capital or will soon go out of business and their positions liquidated for them. Therefore, all hedge funds and the aggregate positions of funds are Defacto trend followers.

Hedge funds are an important and necessary part of a well-ordered futures market because they take the opposite positions of Commercial traders. Commercials sell when prices are high (farmers like high prices) and buy when prices are low (roasters like low prices). However non-commercials buy when prices are high (remember they are trend following) and sell when prices are low. Without the funds, the commercials would have no one to sell to when prices are high, and roasters would have no one to buy from when prices are low.

For our purposes in understanding price action, the pivotal contrast between these two groups lies in how they manage their positions. Commercials' positions are less vulnerable to margin calls, as banks provide them capital to cover the cash flow needs because they are operating hedges, with physical coffee as collateral. They can therefore afford to hold losing positions (hedges) for longer.





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In contrast, funds are more exposed to being stopped out due to their limited resources for meeting margin calls. This limitation restricts their ability to hold positions that are incurring losses for an extended duration. Consequently, funds often magnify price movements due to their vulnerability to margin calls and their trend-following nature. These key insights shed light on the recent two-week rally in the market. More on it below.





In the second (premium) portion of this article, we will use this information to provide our predictions and analysis of the coffee market going forward. Sign up here so you don’t miss it!




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