-
Trends (price direction over time) are set by the flow of investment money into or out of a market. Using a simple momentum indicator – the four-week rule – we can generally stay in step with the trend.
-
Markets indicate real supply and demand through spot/cash price, basis, futures spreads, and forward curves.
-
We can use filters – volatility, seasonality, price distribution – to theoretically manage risk.
I saw a discussion on the social media site LinkedIn recently with the poster stating he wanted a simple trading system, rather than one filled with all the equations and statistics that drive most algorithms these days. (It’s at this point I could veer off and discuss how unsophisticated – or stupid – the artificial intelligence behind the algorithm trade industry actually is based on how easily it can be manipulated by social media posts. We’ve seen over the past decade how this has become the game within the game, guessing what the next post – usually not quite true – will be. But that’s a bigger subject for another day.) This brings to mind the age-old debate of if the algorithm-driven investments side of the market is trend following or trend setting. Based on my application of Newton’s First Law of Motion applied to market analysis, a trending market will stay in that trend until acted upon by an outside force (from John J. Murphy’s “Technical Analysis of the Futures Markets”, 1986 edition, page 3), I’ll continue to hold to my belief algorithms are trend setters. This brings up another larger discussion of the value of technical analysis given algorithms do not use classic technical patterns.
With that as background, let’s start building our simple trading system based on my 7 Market Rules, starting with #6: Fundamentals win in the end. In the past I’ve mentioned something I call the Vodka Vacuity, the reality there are no Absolut(e)s in market analysis. But there is one: Eventually, markets come down to supply and demand. No, I don’t mean government related estimates and imaginary numbers, but rather real fundamentals shown to us through spot (cash) price, basis (differential between spot/cash and futures), futures spreads, and forward curves. One of the filters used by investors moving gains from equities (Rule #7: Stock markets go up over time) to commodities is looking for markets with bullish real supply and demand. A couple examples over the past year or so are live cattle (LEJ26) and the ongoing rally in soybeans ($CNSI). Both could be viewed as Rubber Band Dispositions; the former with bullish fundamentals and bearish social media posts driving algorithm selling, the latter what could be considered bearish fundamentals and bullish social media posts triggering algorithm buying. When the Rubber Band snaps, markets return to their base, meaning supply and demand.
Given this, our goal is to follow investment funds that are presumably evaluating real market fundamentals, or as Rule #1 tells us: Don’t get crossways with the trend. Based on this rule we will stay in step with the flow of investment money into and out of markets. How do we know when the trend – price direction over time – changes? One way is to use the Four-Week Rule discussed in Murphy’s book (page 268). This was the first thing that came to mind when I saw the initial social media post for Murphy wrote, “The system based on the four-week rule is simplicity itself”. Here’s how to use it: 1) Cover short positions and buy long whenever the price exceeds the highs of the four preceding full calendar weeks. 2) Liquidate long positions and sell short whenever the price falls below the lows of the four preceding full calendar weeks. Taking a step back to look at the big picture and we see: a) This is a momentum-based rule without all the complicated math and b) it fits with what I call the Goldilocks Principle – Daily charts are too hot, monthly charts are too cold, but weekly charts are just right.
Rule #2 tells us to let the market dictate our actions. Here is where our reads on real fundamentals come into play. If we use a variation of Peter Lynch’s advice and “trade what we know” (meaning we can buy long or sell short commodities) we can narrow our list of commodity sectors and/or markets to those we have a better feel for. As you might recall, in my case, it’s Grains, corn in particular. But others might be more comfortable with cattle (live or feeders), coffee, or heaven forbid natural gas (aka The Widow Maker). Once we’ve narrowed our scope, or in some cases even if we haven’t, we then evaluate the potential of a long or short position by using our reads on real supply and demand: short-term spot/cash price, basis, and nearby futures spread, long-term the market’s forward curve.
Even if we our analyzing fundamentals and positioning ourselves accordingly based on market momentum, we still need to limit risk as best we can by using filters (Rule #3). By this I mean volatility (high versus low), seasonality (a contra-seasonal move indicates supply and demand are different than normal), and price distribution (how often does a market hit current price levels and how long does it tend to stay). By using these filters combined with our understanding of trend and market fundamentals we can decide if we want to position ourselves in futures, and if so which contract, options (keeping in mind those who make a living trading options play chess while the rest of us play checkers), ETFs, equities, or a derivative market of some sort.
On the date of publication, Darin Newsom did not have (either directly or indirectly) positions in any of the securities mentioned in this article. All information and data in this article is solely for informational purposes. This article was originally published on Barchart.com
