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Probabilities Win Again

dondawson
Don Dawson
Instructor

As many of you know, my preference for swing trading Commodity Futures are Seasonal Spreads. I have found these to be more reliable and less manipulated than trading outright Futures. Perhaps because we don’t place physical stops in the Spread markets, we don’t experience the volatility of market participants running stops. Mostly, the reason is that these Seasonal Spreads tend be repeated year after year unless some fundamental reason disrupts the normal cycle. These fundamentals could be:

  • Weather
  • Political Events
  • Supply / Demand Disruptions
  • Catastrophic Events

These are just some of the things that can cause even the best Seasonal Spread pattern to fail on any given year. When firms like Moore Research (www.mrci.com) conduct their computer back-testing to find these Seasonal Patterns, they are looking backwards in time. This means if a Seasonal pattern has occurred 100% of the time, or 15 of the last 15 years, that this year could still fail.

As a reminder, when a trader uses Seasonal patterns, they should be reminded to not take this research blindly. I prefer to find a Commodity that has an upcoming Seasonal tendency and then do my own homework using technical and fundamental analysis. This way, I can enhance these already powerful signals.

An example of fundamental research might be just looking at the weather. Let’s say a trader finds a Natural Gas Seasonal pattern that has been profitable for 15 of the last 15 years by shorting (selling) the market in August and buying it back sometime in September. Before taking this trade, I look at the weather for the Gulf of Mexico (largest number of offshore Natural Gas platforms) and see that there is a Category 5 hurricane swirling around. This type of hurricane could easily damage the Natural Gas platforms causing them to shut down, in essence, disrupting the flow of Natural Gas. This could cause prices to rally very strongly. With this type of information, I would not want to be shorting Natural Gas even though the Seasonal pattern has been right 100% of the time. I can assure you that the year after this, the report will be 14 out of 15 years.

For Natural Gas traders, one might be keeping an eye on Congress looking to see if they pass a tax break for trucking companies that convert their fleets from Diesel fuel to Natural Gas. This will also cause a rise in prices that could disrupt a perfectly good Seasonal pattern.

Once we research the fundamentals, we need to look at technical analysis and determine where the Seasonal Spread or outright is trading in relation to its long term charts, trends, Support (Demand) / Resistance (Supply) levels, liquidity and anything else that would help give us an edge for the upcoming Seasonal pattern.

One such pattern just occurred in a Seasonal Spread that I watch. The Spread pattern called for buying March 2012 Corn Futures, and simultaneously, selling a March 2012 Wheat Futures (C H2 / W H2). In the past 15 years, if you had entered this Spread on January 3rd and exited on February 1st, you would have been profitable 14 of those years. That is a 93% success rate and you might think this is a slam dunk trade (no way to lose).

Looking at the fundamentals first, one would have found a weather condition in Brazil causing a drought that will reduce the Corn output this year. Less supply of a Commodity creates higher prices. The United States Department of Agriculture (USDA) has been reporting very short supplies of Corn in the United States. Since Corn has been used for Ethanol production, Corn prices have been trading much higher. China has been importing pork at a record pace and this is creating a large demand for Corn as livestock feed. Here in the United States, Cattle prices are at record levels because of excess demand, and again, farmers need extra Corn to feed livestock. These are just some of the fundamental factors driving Corn prices higher that may not have been occurring during the last 15 years when these Seasonal patterns were found.

The Seasonal Spread we are looking at involved buying Corn and selling Wheat; as you can see with the extra demand for Corn, this could easily cause Corn prices to rise faster than Wheat prices. This would cause our Spread to move higher much earlier than our optimal Seasonal window entry time and we could lose money by getting in too late.

Now, let’s look at some technical analysis and see how the Spread looks. Figure 1 is a daily line on close chart of the Spread, compliments of Moore Research Center.

Seasonal Spreads Figure 1

The black line is the actual Spread price and the blue line is the 15 year average. Immediately, you can see that the current price has not been following the historical pattern and had begun its rally about 7 months early this year. This could have been the results of the Corn fundamentals being so bullish. The Spread had rallied earlier in the year and had stalled at the zero line. If the Spread is trading above the zero line, this would mean that Corn prices are higher than Wheat prices.

Figure 2 is a monthly chart of the same Spread. This chart shows data back to 1982 and we can see that in the last 30 years, Corn prices traded higher than Wheat only two times. Armed with this information, a trader must remember that trading is an analysis of probabilities. Personally, I would think that if a market has not been beyond these levels in 30 years, then this year most likely will not be any different. This would be a Spread trade that I would pass on, which I did.

What is a seasonal spread? Figure 2

Looking back at Figure 1, you will notice a vertical yellow channel. The left side of the channel is the optimal entry date of the Seasonal Spread and the right side is the optimal exit date. Notice how the black line (Spread value) came into the yellow channel and continued to trend down. For a Spread to be profitable, it must trend up.

Each one cent move in Corn and Wheat equals $50. The entry price would have been 1.50 and the exit price would have been -27.00. Your loss on this trade would have been 28.00 points, or $1,400 had you taken the trade without doing your homework.

As much as I think that Seasonal trading is the best enhancement a trader can have, it is not perfect. Always do your homework and never ever assume because you read about a statistic that it has to repeat.

“Judge your success by what you had to give up in order to achieve it.” Dalai Lama

Protect your profits,

– 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.