COMMODITY CENTRAL
Dealing With The X Factor
Spread Analysis And A Look At Unknown Fundamentalsby Darin Newsom
How do you know what the underlying fundamental situation is when the supply and demand factors remain unknown?Basically, commodity market analysis can be broken into two categories: fundamental and technical. Fundamental analysis focuses on the supply and demand situation of the market, or all the various factors that affect the price of a particular commodity leading to the discovery of that market's intrinsic value.
Technical analysis studies price action over time or the price trend of the market. Where fundamental analysis assumes the study of supply and demand numbers will lead to the true value of the market, technical analysis is based on the idea that market action discounts everything.
This point is central to the discussion of the relationship between the two and should be restated. Anything that can possibly affect price direction of a particular commodity and be considered a fundamental factor -- supply and demand, political unrest, natural disasters, and so forth -- is reflected in the price of that commodity (that is, the market action).
UNKNOWN FUNDAMENTALS
Taking that thought one step further, it can be stated that the known fundamentals (government reports and so on) have already been discounted and priced into the particular commodity market. This means the current market action reflects fundamentals not known by the masses, or unknown fundamentals. Therein lies the question: How do you know what the underlying fundamental situation is (bullish, bearish, and neutral) when the particular supply and demand factors remain unknown?
To a technical analyst, the answer may be in the study of spreads. For this discussion, spreads will be confined to price relationships between contracts in the same commodity market (for example, December and March corn, October and November crude oil).
The idea is that those trading interests involved in the cash side of a particular market will establish price protection for themselves in the futures market. If they are in need of securing enough supply to meet demand, they will push the nearby or spot-month futures contract in hopes of generating sales. On the other hand, if supply is adequate to meet demand, these traders will build premium into the deferred contracts to keep cash sales from moving onto the market.
...Continued in the December 2006 issue of Technical Analysis of STOCKS & COMMODITIES
Excerpted from an article originally published in the December 2006 issue of Technical Analysis of STOCKS & COMMODITIES magazine. All rights reserved. © Copyright 2006, Technical Analysis, Inc.
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