Let's Skip this Trade

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Let's Skip this Trade

I know most of you are wondering why I would write about a trade I would rather pass on than show you one that works. The reason I am doing this is because when it comes to selecting a trade, I usually pass on the majority of them. My criteria for selecting a Commodity trade is more than just looking at support or resistance, indicators or anything else that the general public is looking at. Those tools do work, don't get me wrong; the problem is where is your edge? I try to select the ones that are offering me that edge that we all need to be consistently profitable.

My first choice for any Commodity Futures trade or Spread is using a Seasonal pattern. Commodities have regular seasonal patterns that tend to repeat year after year.

• Think of the grain markets that are planted and harvested annually
• Copper demand is stronger in the Spring for the upcoming housing start season
• Gasoline tends to rally into the Memorial Day driving season and tapers off into the Labor Day holiday as families return from vacations
• Gold has strong demand in the Fall for the upcoming India wedding season, then the Holiday seasons in December

These are just a few of the many seasonal patterns that occur every year. When I see these seasonal windows approaching, I already know that there is better than an 85% to 100% chance that the seasonal will work again.



Unfortunately, outside forces such as weather, war, labor strikes, etc., can throw even the best seasonal trade off for a year. Always know the fundamentals of any trade you are thinking of placing. Do they work all the time? No. We all know there are no absolutes in trading. But when I see these seasonal windows and use them in conjunction with support or resistance, indicators, trend lines, etc., I am much more confident. This allows me to sit through a drawdown and keep my emotions out of the trade because I know I have such high probabilities on my side.

There are many seasonal patterns going on in a variety of Commodity markets at any given time of the year. So when I see a pattern approaching, one of my tools I use to qualify the trade is Relative Strength.

Relative Strength is not the indicator RSI that can be found on many trading platforms. This Relative Strength is the measure of strength and weakness in relative terms between Commodity contracts. When using this tool, I prefer to use it on Daily charts, but you can also watch it on intra-day charts as well. We are looking for markets that are exhibiting strength so we may buy those contract months and ones that are showing weakness so we may sell those contract months.

Relative Strength:

• Buy the strong
• Sell the weak

I am going to show you a couple of ways to help identify the Relative Strength between Commodities:

• Trend Lines
• Bollinger Bands

A recent seasonal Spread pattern in the Lean Hog market was to buy the August 2010 Lean Hogs and, simultaneously, sell the October 2010 Lean Hogs contracts. The window is July 31 to August 12. This Spread has been profitable 14 of the last 15 years (93% successful), with an average profit of $709 per contract.

This Spread sounds like a sure thing, right? Let's looks at some charts using Relative Strength and see if it looks so good after the review. Many things can happen from year to year in a Commodity market that affect the Supply and Demand of that product. Since we may not have all the inside information or fundamentals that the large Commercial traders might have, we need to rely on what our charts are showing us. Keep in mind that these Commercial traders are in the markets on a daily basis hedging their products. The good thing about this is they are leaving footprints behind of their behavior in the markets. Where do we find these footprints? In the back months of the Commodity markets. The Near month Commodity contract always has the most volume and open interest. This is where speculators trade at because they need the liquidity to enter and exit their positions. In the Back months, the Commercials (also known as "the smart money") are hedging their needs for future delivery of a Commodity. As you look at the following charts, keep asking yourself who is moving these Back month contracts.





The seasonal Spread called for buying the August (near month) and selling October (back month). A Spread of buying the near month and selling a back month is also known as a Bull Spread. One way this Spread can be profitable is if the August contract goes up more than the October contract does. By looking at the next 4 trading months for Lean Hogs, we can see a market that is showing weak Relative Strength in the near months, and strong Relative Strength in the back months. This would be a red flag warning that this Spread may not work as well this year.

Figure 1 shows August Lean Hogs with a down sloping trend line across the June ñ July highs.

Figure 2 shows the October Lean Hogs with a down sloping trend line across the June ñ July highs, but notice the angle. October is showing more strength than August. Remember, the Spread called for buying August and selling October.

Figure 3 shows the December Lean Hogs and notice how strongly the trend line is sloping upwards compared to the previous contracts.

Figure 4 shows the February Lean Hogs and the market is showing even more strength than the previous three contracts.

By reviewing Relative Strength of the Lean Hog market, this is telling me that the Spread will have trouble being profitable this year. I would prefer to have seen the near months (August) having strong uptrend lines compared to the back months (October). This would show Demand for the Commodity now, and would make the August contract outperform the October contract.

Another tool I like to look at for a quick Relative Strength indication is the Bollinger Bands (standard settings 20,2). Notice how the August contract (Fig 1) is still a distance from the upper Bollinger Band. Now look at Fig 2 and notice how the price for October has touched the upper Bollinger Band. Fig 3 & 4 both show prices exceeding the upper Bollinger Bands, showing excessive Demand in the back months. Remember who is usually trading in the back months? That's right, the Commercials. For whatever reason, they seem to think there is a sufficient supply of Lean Hogs at the moment and have decided to do the opposite of our seasonal Spread setup.

Here is a chart of the Spread and the associated contract months.

The bottom third of Fig 5 is the actual Spread plotted as a Line chart. I placed a downtrend line across the highs of May and June. Notice how we are also at a good resistance point as the seasonal pattern is showing a buy setup. Not far above that is the June low that will have a good chance of becoming resistance, also.

Looking at Fig 5, you can see the August contract plotted in the top chart, and the October contract plotted in the middle chart. Notice how there is a longer term trend line from the May highs on each chart. The front month (August) is again showing weakness compared to the back month (October).

As I mentioned earlier, I like to use other tools to help give me an edge in trading. Relative Strength is one of those tools. As of this writing, the Spread is trading at 6.20 (Fig 5). Let's take a look at where it is on August 12. If the price is higher than 6.20, then you would have been profitable; if lower, you would have had a losing trade. Can this trade go to 8.30 (next resistance area)? Of course it can, I have been known to be wrong before.
This example should show you that even the best seasonal trade can fail at times, which is another reason we do not just blindly take a seasonal trade based on some statistical study over the past 15 years. However, by combining other tools, we can create trades that have a better than 50/50 chance.

Recently, a student and I were having a discussion on the sacrifices we make while learning to trade. As with any other endeavor you choose, there will be sacrifices you will have to make to become successful. To master trading, you will have to commit time, capital and patience. Below is a quote I hope you find resourceful regarding these sacrifices.

"You will come to know that what appears today to be a sacrifice will prove instead to be the greatest investment that you will ever make." Gorden Hinkley

I would like to thank all of my students and readers for helping me grow as I share my trading knowledge with you. Helping others really is the way to happiness.

- Don Dawson


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