One of the most exciting occurrences in the commodity markets is when the market trades at or below historic lows. We are talking about true commodities such as grains, metals, energies, and the softs. True commodities are products that are grown or manufactured and possess real intrinsic value based upon supply and demand unlike currencies, stock indexes, or financials.
True commodity prices fluctuate based upon supply and demand and travel back and forth in a long term trading range. Going from one end of the range to the other as the differential between supply and demand changes. To see a commodities long-term range, or what I refer to as the envelope, you use monthly charts, which should go back twenty years or more. The chart below is a monthly chart on Cotton. Its main trading envelope is between 50 and 80 cents. There have been occasions where the market traded beyond these prices when an abnormal disruption occurred between supply and demand causing the prices to push to outer edges of its normal range.
Cotton Chart
It is these “abnormalities” that we are looking for because they are relatively short lived and the market should eventually return back to its envelope. Now before you get all excited, look at the chart carefully. Each bar represents one month and it may take as much as two to three years for the market to adjust back to the range. Sometimes it happens fast, sometimes it doesn’t, and the whole key to taking advantage of these situations is being there when it does happen.
Scale Trading is based upon this type of strategy when a market is trading at or near its normal lows. Because any natural commodity will always have value (the price can never go to zero) and a definitive cost of production, the theory is that eventually a shift will have to happen in the supply demand relationship. This shift occurs due to economic factors involved in the production of that particular commodity. Basically, if the price drops below the cost of production, the growers or producers cut back the size of the crop because if they don’t they will lose money. They will usually produce a minimal amount just in case the current over supply situation ends due usually to some sort of natural disaster in another part of the world. Farming and speculation go hand in hand.
On the other side of the spectrum, when prices are at the high end of the range, growers and producers will go as far as growing crops in their front yards to take advantage of the current price, which leads to the supply catching up and satisfying the demand. That in turn will push prices back toward the bottom of the trading envelope.
Another factor that can change the direction or current market situation is a change in government’s economic policies. If you look on the Cotton chart during 1986, you will notice a sharp drop in the price. This was due to the government changing their stance on the subsidies they had provided for cotton growers since the beginning of time. It had been so long since the price of cotton had to stand on its own two feet, nobody was quite sure where the free market price would end up, as you can see, the market recovered. Another market that enjoys a situation similar to what cotton used to enjoy is the US Sugar market, or Sugar #14 Domestic Sugar. Notice that it is usually two to three times the price of Sugar #11 or World Sugar. No, you can’t buy World Sugar and sell it on the domestic market, but thanks for asking.
Yes, it’s an ongoing, never ending cycle that makes commodity trading so much fun as well as extremely lucrative for those who succeed in playing the moves correctly. Remember, commodity trading is a zero sum gain, which means that for every winning trade there is a losing trade and the actual percentage of winning traders to losing traders is about 3 out of 10 win.
Scary? You bet. But if you look at the big picture, you’ll see that most successful traders understand that losing trades is as much a part of trading as winning trades is. Most successful traders only win 45% of their trades, but because they cut losers relatively quickly and ride the winners, they try to maintain a win/loss ratio of 3 to 1. In other words their winners are three times bigger than their losers, you do the math.
How can you take advantage of these market situations when they become apparent? Innumerable ways, the key is to find a way to take advantage of the opportunity in a way that you can afford, understand, and stick with. All three of these things are essential to being successful. One without the other and your success probability falls greatly.
My suggestion is to set up a trading plan (in the case of cotton) using the infinite wisdom that it is impossible to pick the bottom of a market. Instead of trying to “out trade” the market like a majority of the traders try to do, do what the big guys do- “out last” the market. The big traders keep buying into every dip and hold the commodity until prices become more favorable. They feel if the commodity was a bargain at 50 cents, it’s an even better bargain at 45 cents and so on and so forth. Remember, the price of a commodity can never drop to zero, and to big traders that’s the key. There is no Enron here. These are goods, not bads. In the case of cotton trading at 50 cents, the most it can go against them is $25,000 per contract even if it did go to zero.
I know, to a zillionaire 25K is nothing, a one-night stay at the penthouse of the Palms here in Vegas, but to the rest of us it’s an uncomfortable amount to risk, never mind lose. This is where you have to become creative without becoming crazy, brave without becoming foolhardy, and most of all involved.
When markets enter into a situation such as cotton recently has, I look at strategies that rely heavily on options, the good old American Style Option.
The basic strategy is to just buy a call option. You pay a premium in exchange for limited risk (the premium) and unlimited profit potential. You have staying power, you are in the market until expiration, the market can go from where it is now all the way to zero without you being forced out for any reason, and if you're lucky enough for the market to bounce back and go beyond the strike price of your call enough to re-coop your option premium, you may even make a profit.
I have seen situations where a market went against an option so far that all involved just gave up hope and wrote it off as a loss. Suddenly, it came back to life because of some sort of turn of events and make money. Unfortunately, the number of times that this has happened pales in comparison to what happens a majority of the time- the option expires worthless.
In fact, studies have shown that over 75% of the options end up expiring worthless. Another strategy is to use a counter trend trade. In the case of cotton, the trend is definitely down. If you were to buy futures contracts, you would receive margin calls as the trend continued, if you bought a call option you would see your premium diminish due to the market moving against you and time erosion. A counter trend strategy employs a combination of long and short calls so that if the trend continues to go down you would benefit while taking advantage of a historic low price in that market.
The strategy is called a “Bull Call Ratio Spread.” You would buy one call and simultaneously sell two calls with a higher strike price. The rationale is that the premium you collect on the two calls you sold would help pay or totally pay for the call you purchased. If the trend continues down you would benefit by making money on the two short calls while only losing on one call. When and if the trend reversed (which is what you were hoping for) and the market started to trade higher, you would then need to adjust the position by either buying back one of the short calls, adding an additional long call or even possibly a futures position to cover the exposure to risk on the upside.
The key here is the spread between the long call (primary leg) and the short calls (secondary leg). You need to calculate your risk based upon the intrinsic math of the spread. This isn’t really that hard to do. You take the spread between your primary and secondary options, let’s say it’s 10 basis points, and then add the amount of the spread to your short calls. If you bought the 50/60 1X2 spread in cotton, that’s where your primary long strike price is 50. You sold two call options with a strike price of 60, and the monies collected on the sale of these options covered the cost of the option you purchased (excluding commission). Your “reverse” intrinsic breakeven would be 70. The trade would have accumulated 10 points of intrinsic ($5000) value at 60 and if the market kept rising beyond 600 the trade would be giving back the gains it accumulated at the same rate ($500 per penny) until it ran out of money at 70. Above 70 you would experience “out of pocket” losses at $500 per penny.
Another strategy would be to use a “Bull Call Spread with a Naked Leg.” Looking at the chart above, the idea would be to buy the 50 call and sell the 60 call and 40 put. The money collected by selling the put and call would offset most of or possibly all of the cost of the 50-cent call. A bull call spread has limited risk as well as limited profit potential by itself. If the market managed to get above 50 cents by expiration, your position's intrinsic value of $500, for every penny up to 60, would stop making money because of the short 60 call. The risk of this type of trade is if the market goes down. You know that of course if at expiration the market were below 50 you would lose whatever premium you paid out of pocket plus commissions. If the market went below 40 cents you would experience the same risk as if you were long the futures market risking $500 per penny that the market went against you.
A third strategy suitable for this type of market scenario is called a “Synthetic Call,” a synthetic call is created by going long a futures contract while simultaneously buying a put option. In the case of the market on the chart above, let’s say you went long Cotton futures at 50 cents. You would then buy a 50-cent put, let’s say, for $1500. This type of trade has no margin requirement and it has limited risk as well. Your risk would be the premium paid for the option, as well as whatever the spread is between where you went long the futures and the strike price. This type of trade has unlimited profit potential.
http://www.commoditytradingschool.com/lessons/lesson8.htm
http://www.commoditytradingschool.com/lessons/lesson8.htm
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