Copyright © 1995 by Garry Madrone. All rights reserved.
I’ve been watching commodities since February 1994. This is my attempt to describe what I’ve learned in this time. The best analogy I’ve come upon for the movement of commodities is the ocean. There are the tides, or large movements over weeks and months, and the wave action which is the smaller up and down movements that occur daily and hourly. There is a rhythm that is always changing because of the interaction of the tides and the waves. No two movements are exactly alike, but they all share common forms. What we are actually watching is changing beliefs and the interaction of beliefs. The beliefs of long term players produce the tides and the beliefs of day traders supply the waves. The tools I use help me discern the changing of the tides. I try to buy at the low tide and sell at the high tide and use the wave action to determine my best entry points.
After awhile you can tell which commodity you are looking at just by the chart pattern. For example, cotton moves in long sweeping formations, the changes from uptrend to downtrend and visa versa are relatively slow and deliberate. I say that it “charts well.” That is, it doesn’t swing back and forth very often in a short time period, and if it does, it is probably telling you that it is near a trend change. Others like heating oil are just all over the place. They don’t trend in one direction for any length of time generally. You have to be nimble to trade them and even then, it is hard to make any money because the moves are not long enough before it switches directions again. My list of commodities that seem to chart well are: wheat, corn, cotton, soybeans (sometimes), copper (over a long term, it does not chart well on a daily basis). Some others chart well for some periods of time, but generally have erratic movements every so often that can ruin a seemingly good trend.
The difficulty in making money trading commodities is that you not only have to be correct about the upcoming trend, meaning you have to be correct in your assumption that it is going to begin trending and that the trend is going to be in a particular direction. But you also have to have the timing right. For example, you could project that corn is going to start trending upward beginning sometime in the next week. Corn may: begin trending upward, begin trending downward, move sideways. In two out of three scenerios, you lose. So, to protect yourself, you try to:
I use the standard technical analysis formations to identify potential buy or sell points. I use them as described in “Technical Analysis of Stock Trends.” Although their focus was on stocks, most of the information is appropriate for futures as well. I use triangles, gaps and rectangles mostly. Triangles often form at tops or bottoms, which is when they are of interest to me. Gaps can give you an idea as to how far a move might go or if it is likely to end soon (exhastion gaps). Rectangles are trading ranges and I watch for breakouts from extended rectangles as a sign of a potential large trending move.
Trendlines I find very valuable. In many cases just when a technical indicator turns from bullish to bearish or bearish to bullish, a trendline is broken. This is often an excellent entry point. Also, often at major trend changes, when the trendline is broken, the price will move back up or down on the other side of the trendline and touch it from the other side presenting an extremely low risk entry point. The very best, in fact. I also use trendlines to exit a trade. When you are in a trending market, prices will generally move in a parabolic pattern. That is, rising prices will move up at a stronger and stronger angle until, if it is a real strong trend, they move almost straight up (wonderful if you are long). The same holds in reverse for downtrends. I have observed that trends tend to be more uniform on the long side. Downtrends are more frequently interrupted by rallies that break trendlines. So, as the trend strengthens, you can draw steeper and steeper trendlines and exit when the first one is broken. Sometimes this is premature, but generally, it turns out to be as good a point to exit as any one that you would have later. Sometimes, in a rising trend, you will get stopped out with a steep trendline, only to see a consolidation and then another up move. Usually, this move is short lived and the next time you get a sell signal the price is back down to near where you sold anyway. I find trendlines as valuable as any single indicator despite their wide use (or maybe because of it).
I use a momemtum indicator to determine the strength of the current trend. Trends do not generally go from being strong in one direction to being strong in the other direction. The best trends show a change of momemtum over some period of time (weeks usually) before taking off in the opposite direction. For example, if a commodity was trending strongly upward and then seemed to have gone too far too fast, I would not consider going short until the momemtum had turned from positive to negative. If the momentum is still strongly positive, it probably means at least some sideways movement, if not a pause and then another up move. The same holds true in reverse for downtrends.
I use a trending indicator called DMI (Divergent Momemtum Indicator, I think) that consists of three lines. I have the lines set up in SuperCharts to be red, blue and cyan. When the red line is rising and the blue line is falling and the cyan line is rising, you are in a rising trend. When the blue line is rising and the red line is falling, you are in a downward trend, regardless of the direction of the cyan line. When the red and blue lines cross you are possibly at a trend change. On a daily chart, these crossings occur fairly often and may give false signals. On a weekly chart, they are more reliable. The most reliable pattern is this: The red turns up and crosses the blue, which is heading down. Then they come back together and just touch before the red again turns up and the blue turns down. At the same time, the cyan is low and turns up. This is a buy signal generally. It is very reliable if combined with a slow stochastics value over 80 for %k and %d. If the red and blue are criss-crossing back and forth, it is a trading range and not a good time to take a position. You should only take a position if the red and blue cross decisively after some period of consolidation. As I mentioned before, markets rarely turn from a strong uptrend to a strong downtrend overnight.
At times, the cyan line, which is the trending indicator, can confirm a buy or sell signal by turning down from a peak or up from an extreme low. For example, when a market is trending very strongly, the cyan line will be rising. Often, at the very peak of the price trend, the cyan line will also peak and turn down sharply. This can be a low risk entry point for at least a partial retracement of the previous trend. In most trending markets, however, the cyan line will rise to a peak, then level out for a time, then peak again at a lower level while the price peaks at a higher level. This divergence often signals the actual change of trend.
I use slow stochastics as a trigger and as a confirmation. If a market has been trending strongly for some time, the slow stochastics %k and %d lines will be above 80. This is a good sign if you are long. If, on the weekly chart, you have such a trend displayed on the slow stochastics, and then the stochastics values drop below 80, it is a sell signal. In fact, if the faster of the two lines (the red one, by SuperCharts default) crosses over the blue and breaks below 80, it is a good early sell signal, or a signal to go short. This is on a weekly chart. On a daily chart, the values often rise from under 20 to over 80 before you get a buy signal from other indicators. If the DMI gives a buy signal and the daily slow stochastics has risen to above 80, this confirms the buy.
I look at the cash prices as well as the contract month prices. The cash prices give me a long term view of the particular commodity and the contract month chart is the one I use to make trades. They usually run the same, but at times the cash price and contract price will move differently in relation to each other. This also happens between different contracts of the same commodity. One month may show a larger rise or fall from another, so the patterns, though similar, are different and may show different technical patterns. I look at the cash prices on a daily and weekly basis. The weekly basis gives me a picture of the likely direction on a longer term. I use the same indicators for both daily and weekly charts. So, to locate a likely trade, I would first look at the cash weekly charts to locate a commodity that appears to be near a 6 month to a year high or low. Then I would look at the two closest contracts for the commodity to see what the immediate future looks like. If the weekly chart looks like a change is due and the contract charts show a corresponding change occuring, I will look to see if there are any long term trendlines soon to be broken or any chart formations that would give a good entry point. For example, the following chart shows the weekly price for cotton. Note the period around the last week of October 1994. The weekly stochastics (the bottom indicator) were very low and started rising. By early November, the red DMI line crossed over the blue, the ADX (cyan) line turned upward (the top indicator), and the downtrend line was broken (white arrows). This was a good buy signal.
Now let’s look at the daily contract for May cotton for the same time period.
During this same period, we see that the daily slow stochastics had moved up over 80 for both %k and %d. The daily DMI was clearly bullish, and the downtrend beginning in June 1994 was broken to the upside. On October 24, the daily chart gave a buy signal. The weekly chart confirmed the signal about a week later when May cotton was at 73. By March of 1995, the May cotton contract was at 108 for a $17,500 gain per contract. That is the ideal scenerio.
Such opportunities may occur once or twice a year within the entire group of commodities. Last year (1994) saw copper go from 75 to 140 for a $17,500 gain per contract also. Coffee had a major move that took it from 80 to over 200 for an even larger gain. Wheat had several good moves, both up and down. It went from 390 down to 303 and then back to 410 all within a year.
There are several distinct areas that need to be considered when trading commodities. There is the trading techniques such as the indicators or information you are going to use to make your trading decisions. There is the money management area where you decide how to best limit your risk and maximize your gains. And, there is the psychological area where you learn what kind of risk you can accept and how you react to gains and losses. All three of these areas work together to form your trading approach. You also have to decide whether you are going to be a very short term trader, an intermediate term trader, or a longer term trader. Short term is one day, or several days. Intermediate term is weeks to several months. Long term is a period longer than about 3-6 months. I haven’t worked with the short term trading methods although it appears that they are just the same methods used on data periods of an hour or less. Whole trends occur within a single trading day. To trade this period, you need to have a data feed and charting software that is nearly constantly updated. You also have to watch the markets you are trading almost constantly. The long term trends do not seem to occur very frequently, so I trade the intermediate trends. If they happen to extend into a long term trend, then I try to stay aboard until it turns.
I think that all three areas are of equal importance. If you don’t have good indicators, you won’t know when to enter or exit. If you don’t have good money management techniques, you are liable to lose all of your capital before you have a chance to succeed. If you don’t maintain a steady psychological outlook, you will operate out of fear and either won’t be able to make a trade, will exit a winning trade too early, or will hang on to a losing trade too long. All can be fatal to your capital.
Once I take a position (one contract) I watch to see if it follows through in the direction I anticipate. If it does, and the indicators show the trend strengthening, I will add to my position. I use trendlines to identify good entry points and to use as points to close out my position. The trend should accelerate. If it does not, I’m suspect and would not increase my position any further. I would tighten up my stops to limit my loss should it reverse. Normally I put in a stop for each order and try to limit the potential loss to under $400 for each contract. If it goes my direction, as soon as it looks reasonable, I move my stop to further reduce my potential loss. If it continues to move in my direction, soon I can move my stop to beyond my entry price and be fairly certain that I won’t lose any on that contract. So, next, I incrementally increase my position as the trend moves in my favor.