Tag Archives: index

Swing Trading with the Commercial Traders

Do you like buying into pullbacks and selling into counter trend rallies? Do you get that little antsy, slightly queasy feeling in the pit of your stomach wondering if it really was just a counter trend move and not a major turning point? Do you watch the markets intensely waiting for confirmation of a turn back in your predicted direction?

I’d like to share something with you that helped my trading substantially. I’ve been trading for more than 20 years now and in that time span, I’ve come up with three original ideas that work. Two of them I’ve been using for more than 15 years and the third has been a puzzle I haven’t quite been able to put together for some time.

Some of you, who know me, know that I’ve been following the Commitment of Traders reports for at least 15 years. The foremost expert in this field is Steve Briese, publisher of “Bullish Review.” His weekly publication and explanation of the different groups of traders in the markets and their corresponding tallies of accumulation and distribution are like watching the “Old Boys Network,” on TV. It is a quantifiable report on how the big money moves.

Steve’s main methodologies involve the Commitment of Traders Index, which reads like a stochastic and the second is Major & Minor Signals, which are based on a static jump or decline in the aforementioned index.  His work and research is first class and parallel his character as a person. However, for any methodology to work, it has to be something the trader is comfortable with.

There are two main reasons I’ve never been able to implement this strategy as it stands. First, the problem with any stochastic or, index is that it is artificially bound between 0 and 100. There have been many times when the Commitment of Traders Index remains pegged at either extreme for months on end. This can happen in two completely different ways. First, the index can pick up a trend and remain locked onto it for an extended period of time. This is what we saw in many of the ’08 commodity rallies. The problem here is the equity swings. As a trader, I have to manage the equity in my account. Given the volatile nature of many of the markets, account equity fluctuates wildly, even in profitable positions.

The second problem with the index is that when a market retraces, commercial hedgers are quick to lock in their production and delivery prices. Their early action in these instances leads to an index reading that is the exact opposite of the market’s direction. Once they’ve bought all their raw materials and hedged all of their forward production, they’re done trading until the market moves back the other way, again. This leads to index readings of 100 in falling markets or, 0 in rising markets.

Thanks for bearing with me through the setup for my work. If you’ve read this far, you’re obviously looking for a more tradable solution. What I track is the momentum of commercial buying and selling. This eliminates the artificial boundaries of the index and allows me to compare the degree of buying and selling to the market’s history of commercial capacity for buying and selling. It also allows me to see, on a relative basis, whether there is more or less urgency in the market as we approach critical support and resistance levels. The advantage is that it helps put me on the right side of every trader’s number one question – “Resistance or, Breakout?”

When I combine the major market participants’ actions with my own proprietary trigger, I can pick off swing highs and lows with a greater winning percentage than I ever thought possible. When the Commercial Traders’ momentum is negative and my indicator says, “sell,” I use the most recent swing high as my protective stop point. This allows me to know what my dollar risk per contract is and allocate my equity more effectively. The opposite rules hold true for the buy side. When Commercial Trader momentum is positive and the market pulls back, I wait for the trigger to indicate, “buy.” I use the most recent swing low as my protective stop price. Again, quantifying the risk is one of the main keys to any successful strategy.

The last topic to address is, obviously, when to exit. This is a purely subjective task. In my quantifiable testing, trailing a stop one bar back has worked – once the market has moved in our anticipated direction. This is not how I trade it. I have the advantage of proximity on my side. I sit in front of the screens all day and watch the markets. I take profits on an experiential basis. Sometimes I’m early. Sometimes, I’m late. That is the nature of trading. There is no free lunch. I am happy to say that the more often I find myself on the right side of the market, the easier it is to be profitable and, after all, isn’t that the end game? I hope this helps put you on the right side of the markets more often and may your future trading problems be profit-taking issues.

Spread Trading the Russell 2000 Vs. S&P 500

The stock market has made a lot of noise this week with the Dow Jones Industrial Average climbing above 15,000 for the first time in history. In fact, all of the major averages are up about 18% year to date. There is a general consensus that the massive liquidity operations the Federal Reserve board has implemented are the primary contributor to the market’s rally. However, there are several competing theories as to where the top may be. This week, we’re going to take a look at seasonal tops in the Russell 2000 small cap stock index compared to the S&P 500 large cap index to try and lock in some profits while minimizing downside risk.

The Russell 2000 is a stock index made up of small companies with a median market capitalization value of around half a billion dollars. This compares to the S&P 500 market capitalization average of nearly 28 billion dollars. Another way of putting this in perspective is that the Russell 2000’s largest company by market cap is Alaska Air as compared to the S&P 500’s largest company, Apple. The important thing here is to differentiate the small cap growth stocks of the Russell 2000 from the large caps that make up the S&P 500.

The reason for this is that small caps and large caps tend to behave differently. Small caps tend to lead. Therefore, they overshoot the tops and the bottoms. The smaller nature of the stocks in the Russell 2000 means that it takes less money to move the underlying stock. Small companies are also easier to grow. Of course, extra growth comes with extra risk. The composition of the Russell 2000 changes regularly due to new companies being added while others are removed. The large cap indexes like the S&P 500 are more stable due to the massive size of the companies it’s comprised of. Steady, stable, predictable growth is what is hoped for in the S&P 500.

We’ve all heard the old adage, “Sell in May and walk away.” There is a bit of truth to this as the primary stock market gauges are typically flat through the summer with a bit of upside bias and lots of downside volatility. In fact, this seasonality is even more pronounced in the Russell 2000, which tends to bottom in August. In other words, growth is minimal while full risk exposure remains. This is not an ideal risk to reward scenario. Over the last ten years, the Russell 2000 has called the late spring / early summer top correctly eight times. The two years it was wrong were 2008 and 2009 when the markets had already been beaten down. The average profit on the trade I’m about to detail was $4,250 for the other eight years.

There are two different ways to lay this trade out. The complicated way would be to find the least common multiple of the underlying futures contracts and work out the rest of the equation as percentages and then translate the percentages back into dollars and cents. Fortunately, we can simply use the futures contracts as they are and buy an S&P 500 futures contract while simultaneously selling a Russell 2000 futures contract.

This application takes advantage of the Russell 2000’s larger built in multiplier. Calculating the value of the Russell 2000 futures contract is as simple as multiplying the index by its $100 multiplier. Thus, a June mini-Russell 2000 contract trading at 970.00 has a cash value of 970.00 X $100 = $97,000. Meanwhile, the mini-S&P 500 has a built in $50 multiplier. Therefore, the mini-S&P 500 futures contract has a cash value of 1625.00 X $50 = $81,250. Buying one mini-S&P 500 futures contract and selling one mini-Russell 2000 creates a net short cash value of  $15,750 worth of small cap stocks.

The maximum value for this spread position was $16,671 in May of 2011. This represents the farthest the Russell 2000 futures have climbed above the S&P 500. We recently made a high of $16,200 two weeks ago.  Currently, this spread is trading at $15,350. I expect the recent April high to hold. If the market trades above the recent high of  $16,200, I will exit the trade at a loss. Recently, the average price for this spread is around $11,500. Therefore, I will use this support as the first place to look for profits. This sets up a trade that is slightly short the stock market through exploiting seasonal and market capitalization biases. Furthermore, this trade has had a relatively high historical winning percentage and is currently providing us with a 4-1 risk to reward ratio.

This blog is published by Andy Waldock. Andy Waldock is a trader, analyst, broker and asset manager. Therefore, Andy Waldock may have positions for himself, his family, or, his clients in any market discussed. The blog is meant for educational purposes and to develop a dialogue among those with an interest in the commodity markets. The commodity markets employ a high degree of leverage and may not be suitable for all investors. There is substantial risk of loss in investing in futures.

Long Only is Not Diversification

The cycle of bubbles will continue. Assets will always chase higher returns. The markets in the United States that are available for the general public to allocate funds to are mostly, “long only.” The general investing public is provided with a number of choices as to what they can buy to invest in. We’ve seen the cycle rotate from sector to sector within the stock market or, between stocks and bonds. Arts, antiques, cars and real estate have all had their periods when ownership was lucrative. Fortunately, being able to short sell commodities with a phone call or a mouse click is much easier than selling a car or a house when the market turns.

Lately, commodities have taken center stage as the thing to own. We’ve seen it in gold and oil and more recently in grains, agricultural commodities and stock index futures. Thirteen commodity futures markets set new records for commodity index funds’ open interest in 2010. Over the last few weeks, we’ve seen commodity positions being transferred from the index funds to the small speculators. This transfer of positions from index and commercial traders to small speculators typically occurs near the end of a protracted move.

Bubbles are created through the over popularity of an asset class. The speed of the bubble cycle increases when leverage is involved. We’ve seen this in the stock market crashes of 1929 and 1987 and as recently as May of 2010 in the, “Flash Crash.” The world is still unwinding the over leveraged global mortgage debacle. The new vogue in leveraged assets has been the creation of commodity funds. Commodity funds have provided a long only investment entry into the futures markets for the novice investor. These funds have gone from non-existent to more than $370 billion in equity at the top of the first commodity bubble in 2008. We have since surpassed that total.

The commodity index fund market is no different than the mortgage backed security market was when it was marketed to the public as a way to, “ratchet up returns while providing diversification.” Investment office salespeople need products to sell. These products are usually a good idea at the beginning but, become overpopulated and over valued as a result of a good idea turning into the next big thing and eventually falling of their own weight.

I’ve suggested that the global economy is due to slowdown. Furthermore, the governmental response to the economic crisis has done little to right the long-term path of our economy. Over the last three years, the stock market is higher, reported unemployment is below 10% and gas prices have stabilized. However, it has taken a Herculean effort by the government, which has dropped the Federal Funds rate from 4.5% to 0, expanded the Treasury’s balance sheet by $1.5 trillion and printed $1 trillion on top of that just to bring GDP and our population’s complacency back to where it was at the end of 2007. This is the Government’s form of a leveraged asset, which is also becoming overvalued and overpopulated and is in peril of falling of its own weight.

Diversification among long only assets will not provide the type protection people expect when these markets begin to falter. Over the last five years, there have been 13 weeks when the S&P 500 closed more than 5% lower from week to week. Conversely, there has only been one week in the last 5 years when bonds have closed that much higher. That was the flight to quality run of November 21, 2008. That was the height of the panic of the meltdown. The truth is, when liquidation hits the market, it tends to cross all classes. These are the days when the commentators lead in with, “There’s a lot of red on the board today.” Gold, copper, oil, grains, cattle, etc. have all averaged at least as many large losses as the stock market. Forty percent of these losses coincided with large stock market declines. In this day of instant everything, instant liquidation to cash is only a few mouse clicks away in the futures markets rather than end of day fund settlements.

The futures markets were meant to be traded from the long AND the short side. Commercial traders use this feature to manage their own production and consumption concerns. Individual traders can also have this direct link to the commodity markets. The liquid flexibility of the futures markets allows individual traders to hedge their holdings through the direct use of short selling just as it allows leveraging of outright exposure on the way up.  The right brokerage relationship can make them the perfect tool in the hands of the individual managing their own portfolio as opposed to the long only fund salesman seeking out the next tool in the general public.

This blog is published by Andy Waldock. Andy Waldock is a trader, analyst, broker and asset manager. Therefore, Andy Waldock may have positions for himself, his family, or, his clients in any market discussed. The blog is meant for educational purposes and to develop a dialogue among those with an interest in the commodity markets. The commodity markets employ a high degree of leverage and may not be suitable for all investors. There is substantial risk of loss in investing in futures.