Commodities-Market Revealed

Determine the Trend and Follow It
Using Price History, Current Price Level, and the Mechanical Trading System.

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The theories expressed are taken from a consensus of opinions express by Bruce Babcock, Bruce Gould and other like minded commodity-futures traders.

Technical Analysis and Mechanical Trading System

One reason people shy away from commodity trading is that they assume that in order to be successful, they will have to become an expert on all the markets they want to trade. By using technical analysis and the mechanical trading system you do not have to know anything about the fundamentals of any particular commodity.. Although supply and demand determine the price level, as a speculator you do not have to be concerned about figuring out these numbers.

Predicting Future Supply and Demand

In commodity trading, the market’s perception of supply and demand is even more important than the actual figures. Public perception is supersedes reality.

Everything that market participants currently know about supply and demand and the market’s perception of supply and demand is already reflected in the price.

The key is to analyze the price history and current price level. You can then determine the current trend, if there is a trend

The better strategy is not to anticipate what will happen, but to wait for the market to agree with his analysis by changing to a downtrend.

You will save yourself much wasted effort (and perhaps trading losses) if you accept the idea that it is impossible to predict future market action with the precision necessary to be useful in commodity trading.

No one knows the future direction of prices. Following trends rather than try to anticipate ithelp you be a more successful commodity-futures speculator. One does not need to know details about supply and demand or anticipate the market’s reaction to the latest political or economic news to determine whether to buy or sell. Just determine current price trend and position yourself appropriately.If the trend is up, you always buy. If the trend is down, you always sell.

Suppose that at the time of this chart an alleged orange juice expert presented you with a comprehensive research report (in commodities, he would probably want to sell it to you) demonstrating that the price of orange juice must go down in the near future because there was too much supply and too little demand. Would you be convinced and sell the market? I would not.Do you think he is the only one in the world who understands the true fundamental situation in orange juice?

Those who are closest to the market and know the most about it are active traders. They have been bidding the price up. If the price is so surely going to go down soon, why is it now going up? The expert could as easily have told you the same thing any time in the last two years and he would have been wrong every time. The better strategy is not to anticipate what will happen, but to wait for the market to agree with his analysis by changing to a downtrend.

Over the years there have been many “expert” traders who have packaged and sold numerous schemes for predicting price movements and anticipating trend changes. To date no one has been able to predict trend changes with a reliability that is better than chance. In other words, you might as well just flip a coin.

Fortunately, it is not necessary to predict the markets to be successful as a commodity trader.

Determine the trend and follow it.

There are no market codes or inside secrets only the professionals understand. The principles of successful trading are well-known, but few can implement them consistently. The reason is that natural human emotions interfere with the trading process and are extremely difficult to overcome. To offset this natural human emotional tendency, the completely mechanical trading system approach has consistently proven to be the best route to profits.

Systems and Markets

There is one commodity trading methodology developed by Bruce Babcock. that has been remarkably consistent in identifying and profitably following trends.

Three Steps

1. Correct combination of locking in on highly volatile markets

2. Using appropriate systems

3. Applying smart money management techniques

Knowing these three steps will better enable you to determine when to trade, what to trade, and how to trade.

However, there are no 100% guarantees. Systems created can only reflect the past. We trade for profits in the future which is like the past, only different.”

There is much randomness in market behavior which will always make trading a challenge.

Commodity-Futures-Trading Challenge

In this introduction we will attempt to answer the following questions:

• What is involved in trading commodity futures?

• Why it can be risky but need not be?

• What principles you will need to follow in order to be more successful?

The term “Commodity-Futures Trading” involves all speculation in the futures markets including traditional agriculturals and precious metals; as well as futures contracts based on financial instruments (foreign currencies, T-bonds, Eurodollars, and stock market indexes)

(“Commodity Options” are not included in this discussion. .. The public always buys the options; it never sells them. The more astute commodity-futures traders find it impossible to make money in the long term through the buying of puts and calls.In other words, traders involved with commodity options know what they should do, but cannot do it consistently enough to make money over time. )

Commodity-Futures Traders Do Not Buy or Sell Anything.

“Long” Position (Buy)

When you call a broker and buy 100 shares of Microsoft stock, you are actually buying a small piece of the company. You can take delivery of the share certificate and hold it in your hand as proof of your new possession. You hold a small part of the profit-making potential of the company and are entitled to participate in managing the company as well as to receive dividends.

On the other hand, a commodity-futures trader who calls his broker and tells him to buy 10,000 bushels of March soybean does not intend to own any soybean. He places the order because he believes the price of soybean will soon rise. If it does, he will profit. If it does not, he suffers a loss.

“Short” Position. (Sell)

Simultaneously, someone else may call another broker and place an order to sell 10,000 bushels of March soybean. He is not a farmer with a soybean crop in the fields. He does not own any soybean. When he tells his broker to sell, he is betting the price of soybean will drop. Lifewise, if it does, he will profit. If it does not, he suffers a loss. Neither trader will ever own any soybean.

Commodity-futures trading is nothing more than (theoretically) calculated gambling on the future direction of price movement. One of the purposes of the commodity exchange is to match up traders with opposite opinions who wish to “make bets” by taking a position. Every time you take a position, someone is matched with you, taking the opposite position.

Your broker works through the exchange on your behalf. In the above example, the buyer’s broker and the seller’s broker would relay your orders to the floor of the exchange, where their orders would be executed at the current price.

“Contract” = One Trading Unit

Assume that price of soybean contract is $1. The buyer will be Long One March Soybean contract at $1;

The seller will be Short One March Soybean Contract at $1. In order to participate in commodity-futures trading, you must deposit money in an account with a brokerage firm. The brokerage firm sets a minimum deposit for your account as a whole. As a general rule, most commodity brokerage firms require that you make a meaningful deposit; typically an amount of several thousand dollars to open an account.

The money in your commodity account is the guarantee that if you are wrong about the price change, the broker will have the money to pay off the person on the other side of the transaction. It is not used to buy anything.

Margin For each commodity, the exchanges and your brokerage firm set an amount that you must have available in your account for this guarantee before initiating a trade in that market

Margin = Guarantee

Board of Trade in Chicago

The Board of Trade in Chicago is the principal exchange where the major agricultural commodities are traded. It sets a minimum margin that every trader must have in his account to trade. Your brokerage firm may set a higher amount at its discretion. The amount of the margin is based upon the value of the contract.

A contract of corn for example involves 5,000 bushels and is quoted in cents per bushel. The value of the contract is the current price times 5,000. If corn has been averaging about $3 a bushel, the value of the corn contract has averaged around $15,000.

Volatility The distance price moves in a given time period.

Another factor determining margin is a commodity’s daily volatility.

Corn = Low volatility market

Corn does not have very large daily price moves and is considered a low-volatility market.

In contrast, coffee has a margin of $2,000. A coffee contract involves 37,500 pounds of coffee and is quoted in cents per pound. Coffee has been averaging about $1.55 per pound, so that the average value of a coffee contract has been $58,125. Because coffee is a more volatile market, its margin is considerably higher than corn.

Commercials Growers or users of the product who trade futures contracts to take delivery of the product or deliver the product to someone else.

Commercials want to guarantee a certain selling price for their corn or other commodity. Or they may be users of the product, such as cereal manufacturers, who want to guarantee a certain price for the corn they need to buy.

If the corn buyer was a commercial, he would have guaranteed that he could take delivery of 10,000 bushels of corn in March at a price of $3 per bushel. If the seller was a commercial, he would have guaranteed that he could deliver 10,000 bushels of corn in March and receive $3 per bushel.

Introduction to the Commodity-Futures Trading Challenge

The typical speculator who buys and sells futures contracts does not want to deal in the product. He wants to deal only in money. He is betting on the direction that price will move. If he is right, he makes a profit in proportion to the size of the price move.

If he is wrong, he suffers a loss.

The terms “Buy” and “Sell” are just shorthand expressions for “I bet the price is going up” or “I bet the price is going down.”

To avoid dealing with the product, the usual practice is to exit the position prior to what is called “First Notice Day.” When brokers place their orders, reference is made to the month and the commodity. i.e. March corn.

Each contract traded is connected to a particular delivery month in the future. On a certain day of each, the contract expires, and the final closing price on that day fixes the delivery price for the contract.

Commercials who are short and still hold their positions must deliver the appropriate amount of the commodity at the final closing price. Commercials who are long must accept delivery and pay the final closing price. These deliveries often handled by exchanging warehouse receipts. Speculators invariably exit their March positions no later than the last trading day in February to avoid any problems with delivery.

To exit a position, you would contact your broker and place the opposite order from your entry. If you have a long position,(you originally bought); you would now sell the same amount. If you have a short position, you buy the same amount. Again, you are not actually buying or selling anything. It is merely bookkeeping entry to notify your broker to close out your original position.

Your Final Profit or Loss on a Trade

Difference between the value of the contract when you entered (bought) and when you exited (sold)

If the price of corn rose $1 between entry and exit, the buyer would make a profit of $10.000($1 times 10,000 bushels) and the seller would suffer a loss of $10.000 for each contract traded.

Leverage in Commodities-Market

It is the principle of leverage that allows such stupendous profits.

Exchange Margin Ratio = $350: $1 Deposit

A $5,000 deposit will enable you to trade 14 times the amount of deposit ($5,000 divided by $350 = 14) it is this principle of leverage that allows such enormous profits or losses. The Trader Controls His Risk.

The trader decides how many contracts he will trade. He is the one who decides how long he will hold a position that is moving against him. He controls his own destiny. The amount of profit or loss will depend on the amount of money he decider wager. Commodity-futures trading like in roulette is no riskier than you want to make it.

The reason commodity traders lose big money is because they get impatient and take big risks. In trading, like any investment, the risks are commensurate with the rewards. If you control yourself and have a limited goal, the risk will also be limited, and you will have a reasonable chance to achieve your goal.

If you get excited about the possibilities and try to get rich too quickly, you will increase the risk to the point where you have virtually no chance of success. A wipe out will result. This is precisely what happens to a majority of new traders. What is a reasonable return for trading commodities?

Among professional commodity-futures traders,
50% return per year is considered a reasonable rate of return.

According to a consensus of professional traders, this is an amount they would be comfortable with if they could do it consistently year after year. In good years, they would hope to do better. In bad years, they would not want to do much worse. Certainly they would not like to see any net losses for an entire year. But even a very good professional trader will experience this sort of losses.

If you demand unreasonable returns from your trading, you will probably fail. If you have only limited capital, your best chance of success is to play conservatively, settle for a reasonable return from your trading. Rely on the power of compounding to build a significant portfolio. The leverage available to commodity traders is what permits large profits in relation to capital. Likewise, you can suffer large losses when the market is moving against you. Choosing the Future Direction of Price Movement
is vital to a profitable trade. In addition,Timing Must Be Precise because there is little margin for error. The greater the loss you are willing to take before admitting you were wrong, the less likely it is to recover your loss. On the other hand, if you try to avoid catastrophic losses by exiting losing trades quickly, there is a much greater chance your exit points will be hit.

The objective is finding where your exit point will result in acceptable losses when you are wrong, but with a reasonable likelihood that you will not take too many losses.

Thus, high leverage adds vital dimensions to the price-prediction problem:

1 Choosing the direction of future price movement correctly. 2 Timing your trade so that price moves in the correct direction and you take your profit before price moves against you to the extent that you must abandon the trade.

Three Cost of Trading Commodities

1. Brokerage Commissions,

2. Slippage

3. Bid/asked Spread.

You will pay two of these costs on every trade and often all three. Although they are relatively insignificant on a per trade basis, they add up quickly over time and will significantly affect your profits. You must to remember to include them when analyzing the profitability of a trading system.

Brokerage Commissions

You pay your broker a commission on every trade for his work in completing the transaction. As a comparison, stock market brokerage commissions usually depend on the number of shares involved and the dollar size of the transaction. The bigger the transaction, the more commissions you pay. Stock brokers charge a separate commission on both the buy and the sell side. The bigger your profit, the bigger their commission.

In the commodities market, on the other hand, the trader has an advantage since commissions are fixed at a certain amount per contract. It does not matter how much the contract is worth, the commission is the same.

Also, there is only one commission for both the entry and exit, which you do not pay until you complete the trade. (A few brokerage firms charge half the commission after the entry and the other half after the exit, but the total is the same.) Thus, you can make a huge profit and still pay the same small commission. Standard commodity commissions range from $100 per contract per trade, charged by some full-service firms can go down to under $25 charged by discount firms for clients who do not require any advice or assistance from the broker.

In addition, you are free to negotiate the commission rate on the basis of the size of your account and the amount of trading you conduct.

When opening a brokerage account, negotiate the lowest possible commission rate regardless of the firm with whom you decide to do business. Individual commissions are small, but over the course of a year’s trading they add up. Every dollar you save in commissions is as good as a guaranteed dollar in profitable trading.

Slippage

Slippage Difference between the price at which you want to execute your trade and the price at which it is actually executed.

Slippage can reduce profits or increase losses significantly Assume you are watching the corn market on your computer quote machine. It is trading at 2.98. You decide that if it goes up to 3.00, that will confirm an uptrend, and you want to buy. When you see it hit 3.00, you call your broker and place an order to “buy at the market”. He calls you back and tells you your order was executed at 3.00 V2. The market moved up another half cent in the time it took to transmit your order to the floor. The difference between where you wanted to enter and the actual price where the order was filled is slippage, in this case $25 per contract.

You could have prevented the possibility of slippage by placing an order to buy at “3.00 or better” instead of “at the market.” Then you would have been guaranteed that if your order was executed, the price would be no higher than 3.00. However, if after your order reaches the floor, the price is over 3.00 and never goes back down to 3.00, your order will not be filled. The market may then move up without you.

“Stop” Order

“Stop” Order instructs the broker on the exchange trading floor to hold your order until the price hits the price at which you want to execute the order.

“Stop” Order is vital to minimizing losses. Experienced traders almost always use stop orders to exit a trade automatically when the market is going against them. In addition, this is one tool that can reduce the incidence of slippage.

The Bid/Asked Spread

The bid/asked spread is a hidden cost to traders off the exchange floor When a price is being quoted in the trading pit, there are actually two prices, the bid and the asked. The public trader always buys at the asked price and sells at the bid price, while the floor trader (who takes the other side of the transaction) will be buying at the bid and selling at the asked. They are usually, but not always, one tick apart with the bid being the lower of the two.

Trends

Markets tend to trend. That means that there is a stronger probability that a market will continue its current trend rather than reverse it. Secular trends are caused by long-term fundamental forces that tend to persist. Short-term trends are caused by shifts in market psychology. Such shifts are usually precipitated by news events relevant to the particular market.

Trend can only be discussed in relation to a given time frame. The trend for the last two years, the last two weeks, and the last two hours may have been up. At the same time the trend for the last one months, the last day, and the last hour may have been down.

There are a variety of trends. There are strong trends, in which price moves steadily in one direction for an extended period. There are weaker trends, where the market’s main movement is slow and shows significant, periodic countertrend reversals. Often there is no significant trend in a particular time frame although there will be trends in longer and shorter time frames.

Historically commodity traders will do the best when he positions himself in the direction of a strong trend and stays with the trade as long as the trend persists. However, he can never be sure when the periodic countertrend moves, which always occur, will mark the beginning of a trend reversal.

Each trader must operate in the time frame which matches his trading personality. If you have an impatient personality type you may seek the excitement of numerous trades. There are many traders who feel most comfortable trading in a very short time frame. Known as “day traders,” they enter and exit their trades on the same day, often within an hour or even less. This kind of trading generates a large number of trades that result in relatively small individual profits and losses. As we have seen, each trade you make has a cost. The smaller your average profit per trade, the larger will be the percentage of those profits offset by that cost. The more often you trade, the less likely your trading profits will not be large enough to surmount the costs of trading.

You as a public trader have the greatest chance to overcome the costs of trading if you trade infrequently and shoot for long- term trades and large profits. This means watching trends on weekly and daily charts.

Predicting the Market

Everything that market participants currently know about supply and demand and the market’s perception of supply and demand is already reflected in the price. The principal factor is determining the trend.

Price History and the Current Price Level.

One reason people shy away from commodity-futures trading is that they assume that in order to be successful, they will have to become an expert on all the markets they want to trade. While supply and demand determine the price level, you as a trader do not have to worry about trying to figure out those numbers.

To date experts have not been able to predict future supply and demand with enough precision or reliability to aid in commodity trading.

In commodity-futures trading, the market’s perception of supply and demand is even more important than the actual figures. Even if you knew something about supply and demand, you would still have to figure out how the market would react. As a commodity-futures trader your task is to predict from a chart the probable future direction of a given commodity – up or down

The aggregate of all information – rumors, insider information, the latest political or economic news, expert opinions, government and academic reports – will all be reflected in the price chart.

The strategy is to wait for the market to change towards a trend, not to anticipate what will happen, You will save yourself much wasted effort (and perhaps trading losses) if you accept the idea that it is impossible to predict future market activity with the precision necessary to be useful. Determine the current price trend and position yourself accordingly.

If the trend is up, you always buy.

If the trend is down, you always sell.

Determine the trend and follow it.