How to Tell When a Commodity is Too Expensive or Too Cheap
How to Tell When a Commodity is Too Expensive or Too Cheap
Most traders, when trying to determine if a market is overbought or oversold, rely on an indicator. Some of the more popular indicators are tools used to measure momentum or trends.
Popular Indicators:
- Stochastics
- Relative Strength Index
- Commodity Channel Index
- Moving Average Convergence Divergence
And the list goes on and on...
These indicators can help you time your entry, but one thing they cannot do very well is tell when a Commodity is too expensive or too cheap in the big picture. Wouldn't it be nice to know that the Commodity market you are trading is at one extreme or the other? This type of extreme trading can see very strong trends develop as the market corrects too much bullishness or bearishness. The type of Commodity markets we want to apply this to are the ones that are grown, produced or raised. Financial Futures (interest rates, stock indexes, currencies, etc.) will not work with this concept.
One of the steps I like to do when selecting a Commodity to trade is to look at a monthly chart and see where it is in relation to where it has been to form a macro view. Some traders like to look at daily charts for these extremes, but I don't feel like you get enough data points. Daily charts serve well for identifying trends and demand/supply levels for entry and exit prices. Figure 1 shows a monthly Orange Juice chart dating back to 1972. I would like to thank Moore Research Center for allowing us to use these historical charts. They are available for your viewing as well at www.mrci.com.
Figure 1
Commodity markets were created for companies that have price risk exposure due to the changes of price. These participants are referred to as commercial traders. There are two types of commercial traders:
Producers ñ grows, mines, drills for the Commodity (usually sellers)
Processors ñ purchases the Commodity to refine for resale (usually buyers)
Commercial traders know everything there is about the Commodity they own or plan to purchase. Besides knowing the seasonal tendencies of the Commodities, they also know how much it costs to produce or process these Commodities and still make a profit.
In Figure 1, notice how the Orange Juice market has stayed in a zone of about $40 to $200 since 1972. There is a reason the markets trade to these extremes and then move aggressively away from these levels. Notice how the market usually goes to the other extreme once one extreme is hit.
Commodity markets are driven by supply/demand (not the technical levels, but the economic version). When prices of a Commodity become too cheap, the profit margin for the producers shrinks. This causes less production of the Commodity and thereby reduces the supply. At some point, lower prices will cause demand to pick up and with the producers reducing their output, the price will rise. Once an event like this happens, it causes the supply/demand equation to shift and prices must rise because there is less supply than demand.
An example would be the Corn and Soybean market. If the profit margin is higher for Corn, then farmers will naturally plant more Corn to capitalize. At some point, the Corn market will become over supplied due to higher prices and less demand. Prices will then fall to compensate for the supply & demand imbalance. Meanwhile, Soybean production was very low because the farmers did not have a good profit margin. Now there is less supply of Soybeans and lower prices. This imbalance of supply & demand will drive Soybean prices higher as farmers race to replace the now expensive Corn with the cheaper Soybeans.
The other extreme is very high Commodity prices which results in very high profit margins for producers of these Commodities. This imbalance occurs because the production level is pushed to its limits because of the higher prices (much more supply coming to the market than usual). As you can see, this will quickly cause supply & demand to become imbalanced resulting in price changes. When opportunity arises for higher profits, there is a natural tendency for new competition (more supply) to come on board. Once this overabundance of new supply hits the market and the demand is not there to support it, then prices will retreat.
Looking at Figure 1, we see these extremes in Orange Juice since 1972. An important point to looking at where price is in relation to where it has been is identifying zones at these extreme prices. Let's face it, for price to retreat to an extreme price every time would be highly unlikely. I have found that if you make these zones between 20 & 25% of the total range, you will create good zones at the tops and bottoms of the extreme price action. Here is an example of how the zones would look for Orange Juice.
Moore Research Center posts the lifetime high and low of each Commodity in the upper right corner of the chart.
Lifetime High (209.50) - Lifetime Low (37.40) = Total Range (172.10)
To find a 20% zone, we simply take Total Range (172.10) * .20 % = 34.42.
We now have a zone of 34.42 points to be placed at the top and bottom of the chart.
Upper Zone = 209.50 (Lifetime High) down to 175.08 (Lifetime High ñ 34.42)
Lower Zone = 37.40 (Lifetime Low) up to 71.82 (Lifetime Low + 34.42)
Armed with these Upper and Lower Zones, a trader/investor will know if the particular Commodity is expensive or cheap. The commercial traders are aware of these extremes and so should you.
If you notice, the rally in 2006 and 2007 was stopped at about the same price level from 1988. Why was this? Perhaps because the processors overpriced the Commodity causing demand to dry up and supply to increase. Price aggressively retreated back to the Lower Zone where once again producers reduced their output of Orange Juice and this caused the supply to dwindle, and this, combined with lower prices, brought the processors back into the market and drove prices right up to the Upper Zone. And this cycle just keeps repeating itself over and over.
Eventually, prices are forced outside the zones and we create new zones for the market to trade in. This could be caused by factors such as the production cost has gone up and the price needs to reflect this new cost of doing business. The point is if you see price trading beyond an established zone, then look for a new zone to develop and trade it accordingly.
"It isn't sufficient just to want ñ you've got to ask yourself what you are going to do to get the things you want." Richard Rosen
Trade well, Don Dawson
About Don Dawson
Don has been trading the futures markets for 20 years. His perseverance through the ups and downs of trading, openness to experience of others, balanced tolerance for risk and patience to wait for his setups are a few of his strengths as a trader. He is excited about sharing his passion for trading with others. A quote he likes is "A candle loses nothing by lighting another candle." He is now looking for a balance in life between trading and teaching others what he has learned from 20 years of trading. He acknowledges that the best teacher is a student ñ always in learning mode and wanting to learn more by teaching. He looks forward to working with each of you in one of his E-mini Futures classes. He is also writing articles for Online Trading Academy's free newsletter "Lessons From the Pros" and hopes students find this a valuable resource.
View Don Dawson's post archive >
