While the longs are able to sit back and enjoy the 'roll gains' they collect on their journey into the future, the shorts have a gun to their head as they need to get out of a huge amount of shorts over the next five months, whether they like it or not. Unfortunately for the shorts, the current set-up may create a potential nightmare for them.
As long as there is plenty of liquidity for shorts to get out, everything will remain orderly. It may take a higher price to entice sellers, which is what we have been seeing this week, but whoever wants to get out still has a chance to do so at this point. However, we don't like that open interest has remained so stubbornly high and is actually increasing at the moment and that unfixed on-call sales are basically at the same level as two months ago.
The longer the shorts procrastinate in covering their position, the greater the potential for an explosive short-covering rally at some point down the road. There is a big difference between liquidating a long and liquidating a short position in a panic situation. A long cannot drop below zero and at some point opportunistic buyers will step in to stabilize the market. Not so in a short covering rally!
Finding willing sellers to take over a big short position when the market is on fire is a lot more challenging, because the sky literally is the limit. History is replete with examples of such panic induced rallies, during which prices doubled or tripled in a matter of weeks.
Once markets go into melt-up mode they are no longer connected to any economic or common sense reality. At that point short-covering feeds on itself like a wildfire until the last short that needs to get out is finally out. The events of March 2008 and November 2010 gave us a preview of what can happen.
So where do we go from here? Based on the high open interest and the nearly unchanged on-call position, traders seem to have missed last week's opportunity to get out of harm's way. Cash prices have remained high, with the A-index at 177.70 cents this morning and the Chinese CC-index at over 191 cents. Meanwhile, the September futures contract at the ZCE closed at over 204 cents, projecting high prices well into the 3rd quarter.
From a technical point of view, May, July and December futures all posted new closing highs and are within striking distance of their intra-day contract highs. Only March remains a little over 6 cents below its record close. Nevertheless, the market has regained its upside momentum and seems poised to take out the remaining overhead resistance. If it does, the shorts will likely find themselves in troubled waters!
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.jpg?tr=w-120,h-60,c-at_max,cm-pad_resize,bg-ffffff "UBM China (Shanghai)")
-Ltd..jpg?tr=w-120,h-60,c-at_max,cm-pad_resize,bg-ffffff "Thermore (Far East) Ltd.")
