Welcome to the TradingMarkets Big Saturday Interview. This week, we're fortunate to have Floyd Upperman join us. Floyd is recognized as the foremost analyst of Commitment of Traders (COT) data. Floyd studied mathematics, statistics, and computer programming in college and has a degree in electrical engineering. He became interested in commodities in the early 90’s and used his statistical knowledge and programming abilities to develop a revolutionary approach to identifying price trend changes and large-profit opportunities.

His proprietary system, Individual Market Participant Analysis, has an unparalleled record of success in applying COT data to futures trading. A registered commodity-trading advisor, Floyd provides daily analysis of his IMPA system on his Web site, www.upperman.com. The IMPA trading system is an innovative way to use the Commitment of Traders reports by breaking the data into producers, consumers, and funds. By monitoring the activities of these key market participants, a trader can gain an edge by detecting position imbalances that could be a forerunner of major trend changes.

Floyd recently published his first book, "Commitment of Traders: Strategies For Tracking The Markets And Trading Profitably" (John Wiley and Sons, December 2005).

The COT data is provided to the public every Friday on the CFTC's website www.cftc.gov.

Click Here for an introduction to how Floyd uses the COT data.

Ashton: Hi Floyd, welcome to the Big Saturday Interview.

Floyd Upperman: Hi, thanks for inviting me.

Ashton: Let’s get started by talking about how you got into trading.

Floyd: Well I always wanted to invest, for a living if I could. Back when I was in high school and college I wanted to be self-sufficient and independent, either by owning my own business or by trading on my own. I graduated from high school in 84, and at about that time a movie came out called "Trading Places." That was my first introduction into what futures were. You remember that movie?

Ashton: Yeah, I remember it! They were trading futures on the floor.

Floyd: They traded the Orange Juice futures in that movie, and that really sparked my interest in trading futures. You don’t really know a lot about futures unless you know someone who is involved in them. I started out trading stocks, as most people do, after I got out of college. I went to work for a high-tech company, Intel, which of course everyone has heard of. They gave me some stock, and I made quite a bit of money, and I saw that you could make a lot of money real quick if you had the right one. But when I went out and tried to trade different companies on my own, I couldn’t get consistent results. I would make some money and lose some money, but I couldn’t find the consistency. I also didn’t have a lot of money back then, so I migrated into options, where you can get 100 shares of stock for a small amount of money. But I still couldn’t find any consistency.

Then, in the early 90’s I heard about futures again on a TV station out in California on WKHY, which was kind of like CNBC before they had CNBC. They used to have a lot of stuff about futures on there; Epstein was always on there talking about futures. The first trade I ever did was in Wheat and I made $1700 in two days, and I thought, “Hey there might be something to this.” So I started investigating it, and I heard about Larry Williams sometime in the early 90’s, and that’s how I learned about the Commitments Of Traders report. I got a couple of his books and some tapes, and that was my introduction in the COT’s.

"...I found some very interesting patterns with the COT and the price of different commodities..."

Ashton: Were you still working at Intel?

Floyd: I was still in the semiconductor industry but working for a different company, Western Digital. I had access to a lot of computers and computer programs. This was before the Internet, so computing power was in mainframes, and I had access to a digital VAX mainframe. I started pumping the COT data into the mainframe and running different programs that we use in the semi industry to analyze wafer chips. So I started using programs that analyze wafer data to begin analyzing the COT data. In there, I found some very interesting patterns with the COT and the price of different commodities, their price structures and behavior of different commodities. So that’s how I got going into the direction of the COT’s.

Ashton: What did you discover?

Floyd: When I just analyzed price, I found what most people find, that you’re almost always late, and with the COT you’re often early. So it’s a great mixture there because you have confirmation with the price movement, and then the COT data act as an early indicator. The two mold together really well to give you a real-time view of what’s going on.

Ashton: So the COT data sets up your trade or bias, and then you look for an entry using technical indicators?

Floyd: What it does is validate and act as an actuator to the technical indicators. Some good price derived indicators only work 50% of the time. But when they work, they really work well! The performance of most technical indicators can be enhanced (the signals validated) by combining them with indicators that are not derived from price. In the book I mention seven key technical data points of which the majority of technical indicators are derived. The 7 data points that most technical based futures trading systems are created from are: (1) Opening price, (2) Intra-day high, (3) Intra-day low, (4) Closing price, (5) price range for the day, (6) Volume for the day, and (7) The daily open interest. These 7 data points are used in the majority of technical trading systems in futures. Indicators derived from the COT, however come from an entirely different pool of data. And that makes them very valuable when combined with traditional technical indicators. When the price indicators fail we often ask ourselves “Why did they fail”? We typically don’t find the answer by simply looking at the price data. All we are doing in that case is re-examining the failure itself. To see why the indicators may have failed we have to look beyond the failure and behind the 7 data points that make up most technical indicators. The market participants are behind the daily price movement. Together, all participants are responsible for the outcome (failure or success) of all technical indicators. Collectively, all the buying and selling is what determines the failure or success of any technical based indicator. If you get a buy signal then you need more buying by participants to push prices higher; you don’t want selling. If you get a sell signal you need selling to push prices lower. The trading activity of the participants is what drives prices and that’s what drives the indicators. Thus the answers can be found in the study of the participants. Why and when they buy or sell. What positions they in at the time of the failure for example? This is where some answers can be found.

Ashton: What should we be looking for?

Floyd: If you look at the participants and what they were positioning for, then you can find reasons why the technical indicators might have failed. Maybe the market wasn’t structured the right way; there weren’t a certain number of longs in the market, or a certain number of shorts. We find by looking at the COT data, when certain conditions have existed in the past, it often leads to some kind of rally or decline in price. It’s the liquidation process that leads to the initial decline or rally in the beginning. The trend that begins under these conditions may continue as well, until the fundamentals that enabled it to occur in the first place have changed.

If the commercials have a big position in the market, then the funds usually have an opposing position. And the funds have to get out of the those positions because they’re just like large traders, just like any other trader trying to make money through speculation. So they have to liquidate those positions, and the market has to absorb that liquidation, and that is what we call fuel for a new trend. So if there are a big bunch of fund longs in the market, and we’re getting indicators that say sell, there is a lot of fuel behind the sell signal that could push the market much lower. Commercials don’t have to get out like that; they can roll the contracts forward, which they often do. Or they can just let them expire and go into cash settlement, or they can take delivery/make delivery, but that’s not something that traders normally do. One of the interesting things traders don’t do is they don’t often roll losing positions. They’ll hold losing positions for too long, but when its time to get out, they’re very unlikely to go into another contract with a losing position. In addition, small traders tend to favor the long side (or being long) versus short.

"...The commercials are always balancing positions in the cash market, so they may have what appears to be a losing position, but their cash position is working out..."

Ashton: Contract expiry very often acts as a wake up call to traders with losing positions. They are forced to deal with a bad trade that they have been psychologically unable to accept.

Floyd: Right, but Commercials don’t work like that; they roll losing positions all the time, and that makes them very different. When they don’t roll the losing positions, that’s a different move too. They may have losing positions only on the futures side; we don’t see what’s happening on the cash side. The commercials are always balancing positions in the cash market, so they may have what appears to be a losing position, but their cash position is working out. So then it balances it out, and they don’t have any losing or winning positions. They are neutral, and that is exactly what they are trying to do.

Ashton: So they have a very different goal than traders. There aim is to eliminate risk.

Floyd: The Black Scholes options model teaches to take a position of equal size in the opposite direction in order to eliminate risk. Their theory has been proven right: If you trade more, you reduce risk because if you put on positions that are hedged against existing positions, you neutralize the risk. Even if you have an enormous amount of positions on, if they are balanced, there is no risk.

"...we break the data apart--we look at the consumers, which are usually the long ones, and the producers, which are usually the short..."

Ashton: Do you cover these trading strategies in your book?

Floyd: Absolutely. I discuss a lot of things in the book, technical indicators I created, my IMPA methodology (Individual Market Participant Analysis). The IMPA is our method for looking at the individual market participants, not just the commercials. We also look at the funds, and the commercials are broken down into consumers and producers. The traditional view just looks at the net commercial position, and that’s fine, but in recent years there have been changes making that less potent. You’ve heard about all the pension funds entering the commodities, and this is distorting the commercial data. This has been going on for a long time, but most recently, the pension funds have been hedging a lot more in the commodities because commodities are the markets that have really moved in the past five years.

There has always been some cross-contamination in the data. In the commercial category, there could be some non-commercials in there; because of the way the CFTC calculates it. First they have the position limit; if you have a number of positions that meets or exceeds their limit, then you get reported, as a speculator or fund or whatever. But if your account is set up as hedging, then you get reported as a commercial. Some commercial banks that are hedging for pension funds can end up in there, and they’re not traditional commercials’, that is, they aren’t traditional consumers or producers of the commodity. Take grain for an example. They aren’t producing corn or soybeans and they aren’t consuming it for their business needs. They’re hedging against the possibility of rising inflation from rising commodity prices. Some of these hedged positions end up being lumped together in the commercial category with the traditional commercial producers and consumers in the COT report. This is distorting the traditional data. In recent years the stock market hasn’t performed that well; some pension funds are getting into commodities (primarily from the long side) to benefit from rising commodity prices and inflation while stocks struggle under these conditions. That is why we see more distortion in the data today than occurred in the recent past. The pension funds are also much larger today and time is running out for them to recover from poor performing markets as in 2008 the first of the baby boomers reach age 62. The pension funds must pay out promised benefits regardless of market conditions.

As I discuss in the book there has always been some cross contamination between commercials and funds (specs). But we break the commercial data apart--we look at the consumers, which are usually the long ones, and the producers, which are usually the short. We use separate indicators for each categories. These pension funds that are ending up in commodities being counted as commercials are primarily in long positions. The only way you hedge against rising commodity prices is to be long the commodities. They get into commodities using the GSCI as their guide for establishing weighted positions in individual markets to mimic the long-term performance history of the GSCI. I’ll talk more about this subject in New York during February 2006 at the Trading Expo.

"...we haven’t been interested in buying wheat because it’s only the long positions in the commercial category that have driven the net commercial numbers to the extreme..."

Ashton: Could you talk us through a recent example?

Floyd: Wheat, for instance. If you look at only the net-commercial position, it has appeared bullish for a long time. But we haven’t been interested in buying wheat because it’s only the long positions in the commercial category that have driven the net commercial numbers to the extreme. That may be changing now, but for months it has been driven by longs only. I’d like to see the short positions influencing the extreme position as well. I want to see both sides, in other words bullish or bearish, not just one side, and certainly not just the long side because of the distortion issue. Wheat is also a GSCI market too. So, during this time the short positions have been very big as well, and we need to see those moving away from the extreme, which would mean that those short positions are becoming bullish too. Ever since we’ve been having this extreme net commercial position in the wheat market, the producers have been indicating that its not a bullish situation as far as they are concerned (and producers know a great deal about supply), thus its been driven by a lot of fund hedging in my opinion.

Ashton: So anyone just looking at the net commercial position isn't seeing the whole picture.

Floyd: Yes, that is correct. Another problem with the COT data is that it’s not a good timing indicator at all. You have to use technical indicators for that. If you get into a trade when the commercials say bullish or bearish, you’re going to be early almost always and you’re going to get hurt that way. You can’t jump the gun. You’re always going to have technical indicators that fail and some that work. But if you’re going to that next step when you see the net commercial is bullish, you need to go further, look at the producer side, and see if the net commercial numbers are confirmed there.

Ashton: I know you’ve been bullish commodities for a long time, looking ahead to next year, are you still bullish? What about the long-tem?

Floyd: For some of the markets yes. The energy markets are still bullish longer-term, although we could definitely go through a sideways period in some of these markets as well. But the fundamentals are also driving these markets as well because of the limited supply and the fact that we are running out of fossil fuels and will eventually be all out. In addition China has a booming economy and there’s a lot of people there, and there’s a lot of people in India as well, and Japan’s economy has turned around in a big way in the last year. Japan's economy is booming, which means they’re going to want things and need things, and that’s going to put more strain on some markets where there is limited supply. When it comes to energy, you don’t renew those things. They don’t re-grow. Once you burn up all the crude oil, it’s all gone and it doesn’t come back. Some markets you have to look at individually and others you don’t.

The metals have come a long way; we had a sell recently in gold and silver. We had a big topping pattern on Dec 12. Prior to that we had a setup for a sell with the IMPA, and it looks like it topped, short term at least, on Dec 12. So now I'm watching the IMPA; if it moves back to the bullish position, then we might have a rally later in 2006. Right now I don’t know about that; we’ve come a long way recently in a short period of time, and we could have hit the high there.

"...Look at the supply all over the world, and everybody is talking bearish. But we had a buy in soybeans recently, and they’ve been moving up..."

Ashton: Just the fact that gold has been getting so much media attention makes me cautious.

Floyd: Exactly. One market that isn't connected to the press is soybeans. Soybeans have been outright bearish. Look at the supply all over the world, and everybody is talking bearish. But we had a buy in soybeans recently, and they’ve been moving up, and there’s still no interest in it. And no one’s talking about it, so that’s a bullish market because there’s a lot of potential buyers out there, lots of people we could convince that the price is moving higher. In addition, the IMPA shows that we have a lot of fund shorts in the market, although they’re not as short as they were at the prior dip earlier in the year.

Another thing I look at when the prices come back to a certain level is, where are the funds? Are they shorting the market at the same level they did last time, or are they not willing to go as short. Recently soybean prices have come back down below $6 but the funds haven’t been really eagerly shorting. That tells me we’re probably nearing the low.

Ashton: Is there anything else you would like to add?

Floyd: Yes, price. What the commercials always look at is price. Commercials don’t care about price indicators or technical indicators. What they care about is how much it costs to produce. If it costs $4 to produce, then they care at that price. If they can’t get $4.50, $4.10, $4.20, then they can’t make a profit. They don’t care about any technical indicators; they care about how much they can sell their soybeans for. They care about the price. Technical indicators and technical traders don’t care so much about the price; they look at price structure. That’s the thing to keep in mind.

So when we look at price data, we do this thing called backward adjusting. To build a history of commodity prices, and you connect all the contracts together, you have to remember that some contracts are trading at different prices when they roll. So if you’re rolling out of Jan into March, and there’s a 20-cent difference in price and if you don’t do something about it, you’re going to have a big gap in your chart. And it’s going to look like all of the sudden, in one day, soybeans have shot up 20-cents a bushel, and that didn’t happen. So if you don’t do something about that, all of your charts and indicators are going to be flawed. So you have to do this thing called backward adjusting, where you pull up the old prices or pull down the old prices to remove the gaps. You have to move them up or move them down to get rid of the false gaps. We do that when we look at the technical data, but when you look at the commercial data, it is very important that you don’t do that. Leave the gaps there, because you want to see exactly what the commercials are doing at the specific prices in the past. You don’t want to see what they were doing at a fake price, you want to see what they were doing at specific prices in the past.

Ashton: Well Floyd, I just want to thank you for joining us and sharing some of your knowledge on the COT data. I've found it very interesting and thoroughly enjoyed talking to you, and I'm sure our readers will enjoy this too. All that's left is to wish you and our readers Happy Holidays and Best Wishes for a prosperous 2006.

Floyd: Me too, thanks for having me.