By Don Dawson, Online Trading Academy Commodity Futures Instructor

This week I would like to discuss a few steps I like to use when selecting a commodity to trade. These tools will help you stay with your trades a little longer by having several fundamental factors in your favor, instead of just getting in the trade and taking a few pennies out of the market.

Step 1: Seasonal

The first thing I like to do is review the Moore Research Center, Inc. (MRCI), weekly trade selections based on seasonality. There are usually 7-8 Futures trades or 6-7 Futures Spreads to choose from each week. These are trades that have had a seasonal tendency to either rise or fall during a certain window of time each year. The seasonal patterns posted on the updates have worked at least 80% of the time over the last 15 years. I recently wrote about seasonal trading and warned against just trading these recommendations without any supporting tools. I am going to show you some of those tools in this article. Having this information really narrows down your weekly search of a market to trade. Instead of having to go look at 50 different Commodities each week, you can be given the ones with the highest probability to move in the near future. If you do find that seasonal trading seems helpful, MRCI is still offering their free trial service. Please contact Melissa Moore at Melissa@mrci.com or (800) 927-7259 and tell her you read about this offer from Online Trading Academy.

Note: For this article, I intentionally selected a Commodity that has already entered its seasonal window pattern. This article is for informational purposes only and is not to be considered a trade recommendation.

This week had a selection from the Dow Futures, Gold, Live Cattle, Crude Oil, Lean Hogs, Cotton and Gasoline. You can see this is a very diverse selection. Remember, part of risk management is diversifying your portfolio so you have markets that are not correlated with each other. For example, you would not want to be Long Soybeans and Soybean Oil at the same time. These markets are very closely linked together and will normally track each other. However, a trade like Long Lean Hogs and Short Corn would be a good trade for diversification.

I chose the Gold market for a setup based on seasonality and other tools that I will describe later. MRCI called for selling August Gold on Monday, July 20th close to initiate a short position. This trade has been profitable 12 of the last 15 years with an average profit of $836. The average profit on winning trades was $1,194 and the average losing trade was $597, pretty close to a 2:1 risk/reward. The best equity amount during the open trade was $2,960 and the worst equity amount during the open trade was $1,390. Below is a seasonal chart provided by MRCI of the Gold market. The exit date is Friday's close July 31st.

Figure 1

Step 2: Commitment of Traders Report

Keep in mind that these reports are released every Friday by the Commodity Futures Trading Commission (CFTC) around 3:30 pm EST. These reports provide a breakdown of each Tuesday's open interest. Open interest is the number of outstanding contracts that have not been offset at the end of the day. These are positions that are held overnight. If you think about the people who hold these positions overnight, you would have to agree that they have a very strong conviction to take on this extra risk, unlike a day trader who is in and out very quickly.

I like to go to this website www.nowandfutures.com to look at the Commitment of Traders Report (COT) each week. Here we find a graph of the last 12 months of the commodities life with each week's COT report.

Figure 2

Normally we would like to see the large speculators in control of the market we are about to enter. On the other side of that trade we would like to see the small speculators heavily betting against the large speculators. The commercials are usually hedging and don't have much of a directional bias to them until they over-extend their hedges. Yes, even the pros can get a little greedy and cause market imbalances. Since the commercials are usually hedging (selling in up trends and buying in down trends) and the large speculators are speculating (buying in up trends and selling in down trends), you can sometimes find a market where both groups have become too long or too short. That is just what we have found in the Gold market at this time. Just look back across the extreme peaks of the above chart and compare them to a daily Gold chart. You will notice that Gold peaked around the times that the commercials were too heavily short and the large speculators were too heavily long.

Step 3: Premiums and Discounts

This tool is used to find inverted markets that typically will lead to big bull markets. Usually a commodity that is to be delivered in December of the current year will sell for more (at a premium) than for a commodity that is to be delivered in March of the same year. The reason for this premium is that the person holding the commodity until December will have to pay storage, interest and insurance from April until December, whereas the person taking delivery in March does not have all these fees. This is considered a normal market structure with no real immediate demand for the commodity. When this pattern is reversed, you have a very important change in the markets occurring. So when the nearby contracts start trading for more than the distant months contracts', you have excess proof someone is willing to pay a premium price for that commodity. This shows that there is an immediate need for this commodity and people do not want to wait until future delivery dates. The table below shows our Gold market and the current price structure we are in.

The above table shows us that the Gold market at this time is in a "normal structure." Each price going out into the future is getting a little more expensive. This normal market is a better market to short than an inverted market that is displaying very short supply and very high demand.

Step 4: Fundamental News

Knowing something about the market you are trading is very important. For example, if you are getting a sell signal in a market and you did not know that the recent supply/demand report released from the government showed a severe shortage of the commodity, you could lose money pretty quickly. Another factor about knowing some fundamentals about your market is that most all trending markets have a catalyst that is propelling them along. Markets in trading ranges typically don't have any catalyst at the moment and are just marking time.

• For our Gold trade there are a couple of fundamentals that could help us out.
• The Gold market tends to decline into August deliveries Along with the European jewelry manufacturers on vacation with the rest of the European continent

In summary of our Gold trade:

• We have an 80% chance that the market will decline during this time period as it has over the past 15 years using our seasonal analysis from MRCI.
• The COT report is showing that the large speculators are close to being over-extended to the long side and the commercials are close to being over extended to the short side. Compare where we are to the previous peaks on the COT chart. This is showing us we could have a good reversal from these levels.
• The market is trading in a normal pattern according to the price structure of the future delivery contracts. If you are going to short a market, make sure it is not inverted.
• We have some fundamental news that could give us a catalyst to the down side

Once you have this information, you will now have to use your charts to apply technical analysis so you may time your trade entry better with the least risk you can get. Let me ask you, if you were to enter a trade with this type of information, wouldn't you be a little more confident that the market is going to go your way? Remember, in trading we have to tame the mind to become successful traders and if the mind is at ease with the extra information you can gain from these tools, then you will be a better trader.

Best wishes for successful trading,

- Don Dawson

DISCLAIMER:
This newsletter is written for educational purposes only. By no means do any of its contents recommend, advocate or urge the buying, selling or holding of any financial instrument whatsoever. Trading and Investing involves high levels of risk. The author expresses personal opinions and will not assume any responsibility whatsoever for the actions of the reader. The author may or may not have positions in Financial Instruments discussed in this newsletter. Future results can be dramatically different from the opinions expressed herein. Past performance does not guarantee future results.

Reprints allowed for private reading only, for all else, please obtain permission.