EVALUATING THE COMMODITY MARKET FOR OPPORTUNITIES

EVALUATING THE COMMODITY MARKET FOR OPPORTUNITIES

It was October 19, 1987, another typical Monday morning, we prepared for the normal call volume of questions on which stock to buy, which to sell, what sector to consider, and all the other typical questions professionals in the brokerage business mull over each day. We had already shaken off the hundred or so points the previous Friday. That was about all we expected for the cor- rection, in fact we even bought into it. I bought call options on the OEX (S&P 100) that Friday expecting a nice snapback trade on Monday. That Monday morning didn’t experience the snapback though, the selling pressure continued from Friday’s session. It never backed off all day. We watched in amazement as the Dow Jones Industrial Average fell 22 percent in one day. There was only one other day that saw more carnage in one day than Octo- ber 29, 1987, and that was December 12, 1914, when the Dow Jones fell 24 percent. In today’s numbers as I write this book, a 22 percent decline in the Dow Jones would be 2,431 points. Can you imagine the field day the media would have with a number like that? Heck we’ve already been there, done that, and got a T-Shirt. But the New York Times would probably lead in the feature arti- cle with a title “Chicken Little’s Revenge.” Well, that day changed our life at Dorsey, Wright (DWA). You see we were in

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324 The Point and Figure Methodology—A Complete Analysis Tool

essence the only outsourced Options Strategy firm on Wall Street. When Watson and I started DWA, we simply moved the Options Strategy Department I developed and managed for Wheat First Securities, down the road. Following this fateful day in Oc- tober, I knew the options business would never be the same again. Some firms were rumored to go under because of options expo- sure. We immediately moved away from options and puts as the locomotive for DWA, to the Point and Figure Technical Analysis we had done for so many years. I also knew we needed an alter- nate source of income. Commodities were a natural extension for us so I created a commodity report and sold it to Interstate Secu- rities who had one of the best commodity departments on Wall Street. They were located in Atlanta, Georgia. It was simple to me. Commodity prices are governed by the irrefutable law of sup- ply and demand, making it a seamless application for our Point and Figure work. I look at most things in both life and business in the most simplistic of terms. Copper is, quite simply, a hunk of metal. Cocoa is simply a bean that grows, primarily, in the Ivory Coast, and from time to time the locusts will come and wreak havoc. Coffee is similarly a bean that Juan Valdez and others cul- tivate down in Colombia. By the same token, IBM is simply a stock that moves about on the New York Stock Exchange, its price governed by supply-and-demand imbalances. What makes the movement of Cocoa’s price different from the movement of IBM’s price? One could offer that there are no cocoa CEOs to be carried out of their offices in handcuffs for various improprieties. There are no claims of corporate malfeasance thrust upon Live Cattle. But in terms of what causes a change in price, there is nothing different between a share of IBM and a contract of coffee. IBM is to cocoa, as coffee is to copper, and so on.

At the time I had never seen a soy bean, or a cocoa bean, or even a coffee bean that wasn’t ground already. Armed with the Point and Figure chart, I was an expert in their price movement just the same. I knew that if there were more buyers than sellers willing to sell gold, the price of gold would rise. Conversely, if there were more sellers than buyers willing to buy gold, the price would decline. If supply and demand for gold was in perfect bal- ance, the price would remain the same. There is nothing else to consider.

Evaluating the Commodity Market for Opportunities 325

Still, it turned out to be the right product at the wrong time. The stock market was in the middle of a 20-year bull market, while commodities were amid a 20-year bear market. The report we had created didn’t take off as we would have hoped; it was, quite simply, 13 years early. The stock market instead began to make up all the ground it lost in that one Black Monday and was on its merry way by year end. Commodities went back to being the red-headed stepchild of investing once again.

Had we hung our hat on this single product, or any single product really, we would have ended up in Wall Street’s graveyard, as Mr. Hamilton suggests. The beauty of Point and Figure is that it is adaptive to any free market, and while the commodity busi- ness was ready to contract significantly for the next 13 years, the Point and Figure Technical Analysis skill we had developed for many years prior to starting DWA was applicable to many other facets of Wall Street.

There was one more act to the commodity show before we al- lowed it to atrophy back in 1987. There was a hedge fund man- ager in Europe who was a client of ours on the equity side. I talked to him one day and told him his temperament was more suited to commodity trading. I offered him our commodity report for free so that he could get familiar with trading commodities on paper before venturing into the real world of platinum, pork bel- lies, and currencies. This began a long and intriguing story at DWA, much of which I can only look back upon and shake my head. It took this client about three months to get used to com- modities and then one day I received a call from him, “Tommy, I’m ready.” I replied, “Ready for what?” Unabashedly he offered, “Commodity trading.” Well, the rubber hit the road that second, and I was immediately called upon to advise this large, very nim- ble, hedge fund on commodity trading, and I had never traded the first commodity in my life. I had a disciplined methodology and an operating system to fall back on, but very little else at that time.

I set this client up with an Introducing Broker to clear through and we were off and running. If you can recall the last time you sat down to watch the Kentucky Derby, the horses are all in the gates, the bell rings, the commentator then offers heartily, “and they’re off.” Well, that was us. This hedge fund

326 The Point and Figure Methodology—A Complete Analysis Tool

manager had the intestinal fortitude of a gladiator. We started trading 500 lots of currencies at a time. A five-hundred con- tract position in something like the Euro today is still a mas- sive position, over 62 million Euros worth of leverage. At that time I either didn’t, or couldn’t, fully conceptualize the scope of these positions; it was simply colossal like King Kong hold- ing Ann Darrow in his hand. The commodity was King Kong and I was Ann Darrow. Come to think of it, I don’t think we ever had a calculator that would quantify that amount of lever- age back then, so we just didn’t get the full flavor of the risk we were taking. Today, I would break out into a cold sweat with a position that size, but back then we did it, did it regu- larly, and didn’t flinch. At any one time, we could be long and short a combination of currencies totaling $250 million in value. Buying 600 gold contracts for this client became com- monplace. At this writing, each contract controls 100 ounces, or $50,000, worth of gold. Six hundred contracts is then $30 million in leverage. Still, this client didn’t even breathe heavy with a position of this magnitude, and so eventually, neither did I. While my experiences trading currency futures 500 lots at a time makes for a good story, the comfort I feel today in the commodities market is far more a function of simply hav- ing a logical, disciplined approach toward managing risk to fall back on. I feel as comfortable trading commodities as I do stocks, I still don’t know what a soybean or a cocoa bean looks like, but I have been very successful trading them over the years nonetheless.

We would suggest that you familiarize yourself with some of the basics of commodity trading, such as hours of trading, contract sizes, and other environmental influences. All of this information is readily available on the Internet, much of it on our web site, or in various other commodity books. We won’t rehash that work, but will rather focus specifically on why this asset class might add value to your investment game plan, and on using the Point and Figure tools to develop a disciplined trading plan for commodities. We also won’t focus on only fu- tures contracts as the vehicle for commodity exposure as there are many commodity-related vehicles that are present in today’s markets outside that of strictly futures contracts. I

Evaluating the Commodity Market for Opportunities 327 think you will be both amazed, and delighted, to see the various

instruments available to you in today’s market.

Futures Contracts

It was in the 1840s that Chicago became a commercial center where farmers and dealers could meet to deal in “spot” grain. At the time, it was simple to exchange cash for immediate delivery of wheat. This was the point in time when railroads, telegraphs, and the McCormick reaper provided a confluence of both supply and widespread demand. The reaper lead to exponentially greater wheat production, while the railroads and telegraph allow farmers of the Midwest to sell their wheat to dealers who then shipped it all over the country. Where previously the farmer was at the mercy of a city with very few storage facilities for such a supply of wheat and the limited availability of dealers (demand) standing ready to purchase his crop, the technology of the time allowed for both supply and demand to establish a more liquid equilibrium.

This liquidity allowed the futures contract to evolve toward essentially what we know it to be today: farmers (supply) and dealers (demand) committing to future exchanges of grain for cash. Then as today a farmer can agree with the dealer on a price to deliver to him 5,000 bushels of wheat at a point in the future; the end of December, for example. As with any free and open market, the price goes up and down depending on the supply /demand relationship of wheat, which could be influenced by any combination of weather, soil conditions, or a change in eating habits.

Trading Futures Contracts

While we’ll discuss a number of different market vehicles in this chapter, we’ll begin with commodity-based futures contracts, and the statement that they are first and foremost about trading; not investing. Most people (other than hedgers) trade commodities

328 The Point and Figure Methodology—A Complete Analysis Tool

for the purpose of profiting from relatively short-term swings either directly or by investing with a commodity trading advisor or in a commodity pool. In the latter case, the commodity trad- ing advisor or commodity pool operator does not invest in com- modities either; he trades commodities for the purpose of profiting from relatively short-term swings. Why does this make a difference? Because the shorter your time horizon, the more critical it is to select the correct entry point and the more impor- tant it is to pay attention to the technical characteristics (as op- posed to the fundamental characteristics) of a stock or commodity. Always remember that following trends and near- term Point and Figure signals are imperative for those using fu- tures contracts because both the leverage and the time horizon make this of paramount importance.

Using Spot Charts

Spot refers to a cash market price for a physical commodity that is available for immediate delivery. The Spot Month is basically the futures contract month closest to expiration, and is also re- ferred to as the “nearby delivery month,” or simply “near- month” contract. A continuous chart uses the current nearby futures contract price data, continually rolling to the next near month as the earlier one expires. So, the price of a futures con- tract at expiration and the cash or spot price of the underlying asset must be the same, because both prices refer to the same (physical) asset. By consulting a spot or continuous chart, you will be provided perspective as to what the longer term trend of a given commodity is, thereby directing your overall trading pos- ture. Spot charts are useful for establishing a posture on individ- ual commodities, as well as commodities as an asset class, both of which we will examine in this chapter.

The spot or continuous charts are generally considered long term in nature. For instance, the NYMEX crude oil (CRUDE) chart reflects the spot price of West Texas Intermediate light sweet crude and has maintained a generally positive technical picture since early 2002. We’ll revisit the merit of trend lines in a

Evaluating the Commodity Market for Opportunities 329

moment, but clearly the price action of crude oil has trended nicely since 2002, creating an advantageous backdrop for the commodity trader willing to explore exposure there. Over the years, we have found it very helpful to follow spot charts for gold, crude oil, and copper. These specific commodities all carry no- table importance on an economic basis, so close monitoring of them can serve you in more ways than one. London Gold (UK- GOLD) is a chart that we have been keeping since 1987, posting it by hand for many of those years. The chart is now available on our web site under the ticker UKGOLD. In essence, this chart is the London Gold PM Fixing. Copper is another commodity we tend to follow very closely. Copper, like gold or crude oil, is often considered a barometer of economic (industrial) health. I like to view both the spot chart as well as the future I intend to trade. It just provides more perspective (see Figure 11.1).

Figure 11.1 NYMEX Crude Oil P&F chart (CRUDE).

330 The Point and Figure Methodology—A Complete Analysis Tool Trend Lines

So whether we are talking about shares of IBM or bushels of corn, one of the main premises of technical analysis is that prices tend to trend. Therefore, one of the main purposes of a chart is to help in the identification of the overall trend of a given vehicle—and to then play the direction of that trend for as long as it stays in force. Just like stocks, there are two main trend lines that are used: the Bullish Support Line (BSL) and the Bearish Resistance Line:

1. Bullish Support Line:

• Also known as the Uptrend Line.
• Suggests the commodity is recording higher prices.
• The Bullish Support Line is always a 45-degree line, which

  is upward sloping to the right.

• In an overall uptrend, your trades should be limited to long

  positions.

  Drawing this Uptrend Line is very easy—once the first buy signal is given, off the bottom or after a period of accumulation (moving sideways), you then go to the lowest-reaching column of O’s in that pattern on the chart and begin drawing the trend line by placing a mark in the box directly below the lowest O. You then move up and over a box and place a second mark, and repeat this process which will result in an upward sloping 45 degree an- gled line—this is your Bullish Support Line:

  2. Bearish Resistance Line:

• Also known as the Downtrend Line.
• Suggests the commodity is recording lower prices.
• The Bearish Resistance Line is always a 135-degree line,

  which is downward sloping to the right.

• In an overall downtrend, your trades should be limited to

  short positions.

  As a general rule of thumb, if a commodity is trading above its Bullish Support Line, in an overall uptrend, your trades

Evaluating the Commodity Market for Opportunities 331

should be limited to long positions. This is hard to do some- times. There are times when a shorter term trend line can allow you to fine-tune a position, which we will discuss later, but your overall bias—long or short, will be determined by whether the commodity is trading above or below its Bullish Support Line. A violation of the Bullish Support Line, coupled with a sell signal (recall the discussion on chart patterns) on a commodity chart is quite simply a “call to action.” It is a sign that you must change your current course of action with that particular commodity. Long positions, generally speaking, should be sold or some type of protective action should be taken; as well, short positions could then be considered. That’s the interesting thing about commodity trading that is unlike stock trading. Once a com- modity proves you are wrong in the direction of the trade, you can close it and execute an opposite trade going in the proper di- rection as dictated by the price action. By adapting your posture to the overall trend, you can let your winners run, staying with and catching a long-term trend. Or should a trend change, it al- lows you to, more importantly, cut your losses short. Over time, this is one of the keys to success in trading both stocks and com- modities. (See Figure 11.2.)

Chart Patterns

Chart patterns such as the basic Double Top and Double Bot- tom break, as well as more developed patterns like the triangle or catapult formation, were discussed in depth earlier in this book. These patterns are simply a record as to whether supply or demand is winning the latest battle in price, and they are as applicable to commodity trading as they are to stocks. Bullish patterns within a positive trend are a strong signal to be long a futures contract, and bearish patterns within a negative trend are strong signals to sell short a futures contract. Signals that are counter to the prevailing trend (buy signals within a bearish trend, or sell signals within a bullish trend) are most often used as stop loss points, which will be discussed shortly, but are rarely used to establish a new position. A sell signal that is

332 The Point and Figure Methodology—A Complete Analysis Tool

Figure 11.2 March 2005 Sugar Contract (SB/H5).

given within a positive trend (counter trend) is typically a sign of consolidation or a pullback toward the next significant level of support, but not of a long-term change in direction. Such a condition is most likely to produce a move toward a previous bottoming area or long-term trend support, and can simply pro- vide an opportunity to reenter the position at lower prices. When trading futures contracts, focus on entering positions

Evaluating the Commodity Market for Opportunities 333

that are on buy signals within positive trends or shorting con- tacts that are on sell signals below trend. These are the situa- tions that present the greatest probabilities for success in commodity trading.

A look at the Gold Continuous Chart (GC) over the past few years shows numerous buying opportunities when implement- ing the concepts recently discussed in this chapter. There were a number of occasions where we witnessed gold prices retrace to its long-term Bullish Support Line only to hold support and give a Point and Figure buy signal, this happened in February 2002 at $328, again in June 2005 at $448, in November 2005 at $480, and still again in June 2006 at $592. As well, pattern recognition proved profitable over the years by identifying the Bullish Triangle patterns that were completed in August 2003 at $380 and April 2006 at $640, each of which foreshadowed moves higher of more than 10 percent in the price of gold in short order. (See Figure 11.3.)

Risk Management

Risk is basically the amount and probability or possibility of in- curring a meaningful loss (of capital), or series of losses. There are several types of risk inherent to trading commodities.

Avoidable risk is risk which can be reduced or eliminated without any reduction or compromise in reward. A couple exam- ples of this type of risk would be trading an illiquid market, and not properly diversifying your commodity portfolio. Illiquid mar- kets can provide a great deal of slippage and bad fills on trades. Diversification typically will serve to reduce risk.

Unavoidable risk is risk which cannot be reduced or elimi- nated. In other words, there will always be some risk involved in trading commodities, stocks, or any investment for that matter, given that there is an expected return or profit.

Controllable risk is risk that can be reduced or mitigated as a function of your entry and exit points. This will be dealt with in more detail in our discussion on stop-loss points, and risk-reward.

334 The Point and Figure Methodology—A Complete Analysis Tool

Figure 11.3 Gold Bullion Continuous chart (GC/).

As mentioned, with any investments, and in this case with commodity trading, there is risk involved. To a large extent, you can reduce or mitigate your risk with smart risk management techniques. Truly, over the long haul, it is proper risk management that will be the key to your success in commodity trading. You must always be aware of the risk you

Evaluating the Commodity Market for Opportunities 335

are taking on any given trade—the risk of loss. Being aware of your risk is important, as is defining that risk in our experiences.

Stop-Loss Points

Stop-loss points are a key element of risk control. Recall our def- inition of risk—the probability of significant loss of capital. One of the best ways to provide a control mechanism on risk is through the use of a stop loss. That is why we always determine where we are getting out before we even get in (to a trade). So to determine if the risk is acceptable on any given trade, you must know what you will do (and where you will do it), if things go wrong. At DWA, we must deem the risk to the stop (the poten- tial loss) acceptable before we place the trade. But then once that trade is executed, our approach dictates that a stop order be placed GTC (good til cancelled). This serves a couple of pur- poses. One, you don’t have to constantly watch each tick of trad- ing, for fear of missing your exit point. Two, it removes much of the emotion from the trade. Having a predetermined exit strat- egy (a GTC stop) can protect you from large losses because you can’t procrastinate or rationalize staying in a losing trade that has negated your reasons for entering. Avoidance of severe losses, truly, is the key to success in any trading. Using a stop- loss point reduces the possibility of a severe loss. In fact, there has been plenty of research conducted on this subject, with the results showing that the key to a successful trading program is the size of your winners versus the size of your losers, not the number of winning trades versus the number of losing trades. So cutting your losses short, while letting your winners run is re- ally what it’s all about. This is why a trend-following system based on Point and Figure analysis can be so helpful in achieving this goal.

To that end, how do you know where to place stops using PnF? If the entry point is where risk is low and the potential re- ward high, then the exit point (stop loss) is where the risk is high and the potential reward low, or increasingly uncertain. So, where would risk be high and potential reward uncertain?

336 The Point and Figure Methodology—A Complete Analysis Tool

Turning to the PnF chart, it would be where the commodity will break a significant bottom or violate its trend line—basi- cally, a point at which the chart suggests supply has won the battle, not necessarily the war but at least the battle, and there- fore suggests you no longer want to be long the commodity. In Figure 11.4, we provide you with two such stop loss examples. The main point to remember is that you should always have an exit strategy for each and every trade you enter. The beauty of using the Point and Figure chart is the ease with which you can determine this exit point, or stop, and then the fact that you may design a trade with a defined risk up front. As well, the PnF chart allows you to raise (or lower) the stop as the chart un- folds. This serves to reduce risk further as price action develops in your favor, allowing you to protect a profitable trade and its related gains.

In general, sell signals given above trend suggest the poten- tial for a meaningful breather for the commodity, while sell sig- nals that involve a violation of trend suggest a structural change in the supply-and-demand relationship for that com- modity. So while a near-term sell signal for a commodity that occurs within a positive trend may setup a re-entry point at lower prices in the near future, a violation of trend suggests that any trade in that commodity in the near future will likely be in the opposite direction.

Relative Strength with Commodities

We now want to turn our attention to the application of Relative Strength (RS) within the commodities realm. When in- terpreting an RS chart, there are two main points to deter- mine—the most recent signal given on the chart, and the current column. In other words, was the last signal given on the RS chart a buy signal (a previous top broken) or a sell signal (a previous bottom broken)? As well, is the chart currently in a column of X’s or a column of O’s? So go back to our discussion of chart patterns.

337

Figure 11.4 Setting Stop-Loss Points: Trend Stops versus Signal Stops.

338 The Point and Figure Methodology—A Complete Analysis Tool

We first want to ascertain if the RS chart is on a buy or sell signal. This will demonstrate the long-term implications for the underlying commodity. If that last signal on the RS chart was a Double Top, the RS is said to be “positive”; if the last signal on the RS chart was a Double Bottom, then RS is “nega- tive.” Positive RS implies outperformance, while negative RS suggests underperformance. In measuring RS on a shorter-term basis, we want to focus on which column the RS chart is in. If the current column is X’s, the commodity is said to have “pos- itive” RS on a short-term basis; if in O’s, the short-term RS is “negative.” Ideally, you want to focus your buying on those commodities exhibiting positive RS, while avoiding or shorting those commodities that are exhibiting negative RS. With stocks we most commonly employ RS charts that compare the stock to the S&P 500 Equal-Weighted Index, whereas the Con- tinuous Commodity Index (UV/Y) is the closest counterpart among commodity-based indexes. In sum then, the strongest RS reading is one in which the most recent signal on the RS chart versus UV/Y was a buy signal and the most recent col- umn is in X’s.

Copper is an interesting example of RS. The RS chart for copper continuous (HG/) remained on a sell signal versus the Continuous Commodity Index (UV/Y) for three years from March 2000 through March 2003, suggesting this particular commodity was most likely to underperform a more diversified allocation toward commodities. Over that time, copper not only underperformed on a relative basis, but copper prices actu- ally fell 2 percent during a period where raw material prices generally rose by 7 percent. That’s not to say that a commodity trader couldn’t have produced short-term gains in copper fu- tures over that time, but the bias was for copper to lag other commodities. Upon seeing a change on the RS chart, however, it was clear that something had changed within that dynamic and that copper was ready to enter a period of likely outperfor- mance. The results since March 2003 have been dramatic as copper prices have inflated 300 percent from March 2003 through June 2006, versus a gain of only 61 percent in the com- modity index. See Figure 11.5.

Evaluating the Commodity Market for Opportunities 339

Figure 11.5 Relative Strength: Copper versus the Commodity Market.

The key to consistent success is to use chart patterns, trend lines, spot and continuous chart evaluation, and RS together to arrive at the best decisions for your commodity trading. You want to focus long exposure on strong trends, bullish patterns, and areas that are most likely to outperform the broader commodities market, while short exposure should

340 The Point and Figure Methodology—A Complete Analysis Tool be concentrated upon just the opposite to stack the odds in

your favor.

Support and Resistance

One of the keys to trading commodities on a technical basis is being able to properly analyze the technical condition of the un- derlying commodity. Support is basically a level where the commodity begins to gain buying pressure and significantly slows it’s decline. Conversely, resistance is a level at which a commodity loses buying pressure and selling pressure takes over. It’s the point where the commodity begins to slip back. As a general rule of thumb, scale into purchases on pullbacks close to support; or scale into short sales on rallies to resistance, pro- vided your macro analysis of trend, relative strength, chart pat- terns, and so on has already been completed and corroborates your posture.

The Soybean Meal, July 2005 chart is a good example of resist- ance and support. In particular, Bean Meal displays why you must recognize where significant resistance lies before embarking on a trade. Notice in early January 2005 that a Triple Top buy signal was given at 169. Technically speaking, you could have drawn a short-term Bearish Resistance Line from the December peak at 172, so the move to 169 would have violated this downtrend line, suggesting you could have considered a long posture. But such a trade would not have been in your best interest. Here’s why. Eval- uating Bean Meal more closely, you would have seen that formi- dable overhead resistance resided at 172—a level that it retreated from three previous times. This information might have pre- vented you from initiating a position. (See Figure 11.6.)

Price Objectives

We’ve discussed the concept of price objectives earlier in this book and they are by no means a guarantee as to where a given commodity will rise or fall anymore than they are for a stock, but it does similarly provide a guideline as to where you might expect to see prices travel. These price objectives provide a use- ful component in ascertaining the risk versus reward of a given

Evaluating the Commodity Market for Opportunities 341

Figure 11.6 July 2005 Soybean Meal Contract (SM/N5).

trade, particularly so after seeing a significant technical break- out in one direction or the other. To assess a risk-reward sce- nario for any trade we need to both define the reward potential of a trade as well as the risk we are exposing ourselves to in any given position. The approach is no different than it is with stocks, an example of which can be seen using the horizontal price objective after witnessing a “Big Base Breakout” on a chart of a commodity futures contract.

342 The Point and Figure Methodology—A Complete Analysis Tool Big Base Breakouts

In keeping with the premise of a horizontal count, the bigger the base, the larger the price objective; or said another way, the bigger the base, the bigger the potential move (or “bang for your buck”) up out of the base. You would not want to be a buyer of a com- modity when it has rallied up to resistance, but instead want to see it penetrate that key resistance. The only exception to this would be if you are merely trying to trade the “range” of a base— meaning you buy on the pullback to the bottom of the base (sup- port), and sell on the rally to overhead resistance (or the top of the base); such a posture would be considered more of a short-term trading tactic. Generally speaking, the greater upside potential is found on seeing a commodity break through a major resistance level. July 2005 sugar futures provided such an opportunity on breaking out of a sizable base in late-2004. The base, which took three months to develop in this case, allowed us to generate a horizontal price objective and more effectively quantify the risk- reward parameters of a long position in sugar, which produced an advantageous scenario for the commodity trader in this example. (See Figure 11.7.)

Changing Box Size

When analyzing a commodity on a technical basis, your main tool is the actual trend chart of the commodity. Often, the com- modity chart will progress in a very orderly fashion, showing a se- ries of higher tops and higher bottoms (if in an uptrend), or a consistent series of lower tops and lower bottoms (if in a down- trend). But there are times when a commodity will experience a straight spike up (or down) in price, resulting in an extended con- dition with no apparent support (or resistance) at hand. This can be troublesome for a pair of reasons—no viable stop loss point is apparent for managing risk, nor are any pullbacks shown to allow for potential new entries into the commodity.

This is where a change in box size can be useful. When neces- sary, reducing the box size on the chart can be a very helpful method to employ in order to gain insight as to levels of support and resistance, areas of consolidation, potential entry levels, and viable stop loss points. If the default box-sized chart appears or-

Evaluating the Commodity Market for Opportunities 343

Figure 11.7 July 2005 Sugar Contract (SB/N5).

derly use that chart. If on the other hand the chart seems to be very slow in reacting to price change, that is only a few columns on the chart, it would make sense to lower the box size and speed up the chart. It’s very helpful to look at lower box-sized charges as well as longer-term higher box-sized charts. It can only help. Lets look at a chart of the Euro FX December 2004 (ECZ4) chart as an example of a chart with no discernable resistance or near-term support. The Euro FX, December 2004 contract (ECZ4) broke out

344 The Point and Figure Methodology—A Complete Analysis Tool

of a big base in mid-October at 1.245. This was a strong buy sig- nal, and one that we actually took in our in-house commodity in- vestment account. The Euro quickly spiked straight up to 1.283 without a breather. The chart obviously displayed an extended condition, with the contract well above any near-term support. At this point, new entries would have been tenuous given the lack of near-term support or a viable stop-loss point. This is where bumping the box size down, cutting it in half from .005 per box to .0025 per box, could help with the management of trading the Euro. By doing this, the chart exhibited a textbook shakeout pattern that wasn’t apparent on the .005 per box chart. Therefore, had you consulted the smaller box-size chart, you were afforded an entry point on the reversal up from the shakeout pattern, and a very reasonable risk with a stop-loss point of 1.2625. The smaller box size also gave you a slightly tighter stop-loss point of 1.317 if you adjusted that stop point as the chart developed, as that is where it broke a Double Bottom to give its first sell signal. (See Figure 11.8.)

In the end, as a result of bumping the box size down, you could buy the December Euro at 1.275 on the reversal up from the shakeout pattern, whereas no reasonable entry level presented it- self on the default chart. In this example, the risk of not consult- ing the smaller box-size chart was one of opportunity risk rather than capital risk, but buying the December Euro at 1.275 and sell- ing at 1.317 resulted in a sizable profit of $5,312.50 per contract. Not only that, but gaining exposure to that trade came at a risk of only $1,875, which would have been the loss resulting from buy- ing at 1.275 and selling at 1.2625; the initial stop-loss point. Rather than totally missing out on the trade, an enviable risk- reward scenario presented itself by simply changing the scale and consulting the more sensitive chart.

Momentum

We’ve discussed the use of Point and Figure signals for near-term guidance and the use of support and resistance lines for long- term guidance. Weekly momentum is what we would call a sec- ondary indicator and one that we turn to for guidance in terms of intermediate-term price direction. We keep both monthly mo- mentum and daily momentum calculations, but with commodi-

Evaluating the Commodity Market for Opportunities 345

Figure 11.8 December 2004 Euro Fx Contract (EC/Z4).

ties specifically we rely most heavily on the weekly momentums. Weekly momentum tables are constructed using a one-week and five-week moving average that is exponentially weighted and smoothed. When the shorter-term average (one week) is above the longer-term average (five week), the momentum is “positive” and we would expect to see strength from the commodity (or at least a pause if in a downtrend). When the one-week moving average falls below the five-week moving average, it represents a turn to “negative momentum” suggesting weakness in the commodity, or at least a breather if in a strong uptrend. Momentum becomes most useful once you have established your overall posture on the commodity (as a function of trend, chart pattern, risk-reward, etc.), which is why we refer to it as a secondary indicator. (See Figure 11.9.)

346 The Point and Figure Methodology—A Complete Analysis Tool

Figure 11.9 U.S. Dollar Index Weekly Momentum table. Moving beyond Trading

Commodity Market Indexes

There are four commodity market indexes that we turn to when evaluating the general picture for the commodities market. You may consider these to be the Dow Jones Industrial Average of com- modities, and similar to stock market indexes each commodity market index is constructed a little differently. The one we have focused on the most over the years is what is now labeled the Con- tinuous Commodity Index (UV/Y). This is an equal-weighted index of 18 commodities that has actually been around since the 1950s, though under a different name. The CRB Futures Index was origi- nally designed to reflect, in a dynamic fashion, the broad trends in

Evaluating the Commodity Market for Opportunities 347

overall commodity prices and to serve as a price measurement for macro-economic analysis. In 2005, the Reuters/Jeffries CRB Index (CR/Y), considered the standard in the industry, made its tenth major revision since first being calculated by the Commodity Re- search Bureau back in 1957. This revision, however, caused the index to move away from equal-weighting its components and in- stead began overweighting the more heavily produced raw materi- als. And so it was that the Continuous Commodity Index (UV/Y) came into existence, essentially carrying the torch passed on by the “old CRB Index.” This gives us an equal-weighted commodity index that is diversified across all major commodities.

The Goldman Sachs Spot Return Commodity Index (GN/X) has become a favorite among institutions as a premier global commodity benchmark for measuring investment performance in the commodity markets. The GN/X is currently composed of 24 commodities that meet certain liquidity requirements and are weighted by the world production quantities; and the index is re- balanced annually. So for use as an economic indicator, the appro- priate weight to assign each commodity is in proportion to the amount of that commodity flowing through the economy (i.e., the actual production or consumption of that commodity). The GN/X is not only a valuable commodity index to use for eco- nomic analysis, but it is also tradable via futures contracts on the Chicago Mercantile Exchange (CME), and exchange-traded notes (ETNs) on the NYSE.

The Dow Jones-AIG Commodity Index (DJAIG) was estab- lished in July 1998. Originally, it was only available as an OTC product, but then the CBOT introduced futures contracts on the Index, making it easier to invest in this commodity index as an asset class. The DJAIG is composed of futures contracts on 19 dif- ferent exchange-traded physical commodities and uses a combi- nation of liquidity and production data to determine its component weightings. Like the GN/X, the DJAIG is rebalanced annually. Unlike the GN/X, which has close to 73 percent of its weight in energy, no related group of commodities may consti- tute more than 33 percent of the index. As well, no single com- modity may constitute less than 2 percent of the index. The DJAIG is also available in an exchange-traded note (ETN) that trades on the NYSE. (See Figure 11.10.)

Figure 11.10 Commodity Index Weightings. 348

Evaluating the Commodity Market for Opportunities 349

It is important to stay abreast of the specific weightings within commodity indexes, as their price action can be greatly af- fected by one group in particular, such as Energy in the case of the GN/X. Not only can these indexes provide knowledge on a macro-economic basis, but as we’ve mentioned, both the Gold- man Sachs Commodity Index and Dow Jones AIG Index can be traded as an asset class via their individual futures contracts, open-end mutual funds, or ETNs. The later providing access to this asset class much in the same manner as S&P Depository Re- ceipts (SPY) provide access to the S&P 500 as a large-cap equity asset class. Given this, you want to keep in mind how these vehi- cles will correlate with other asset classes as well as specific groups within the commodity realm. (See Figure 11.11.)

Figure 11.11 Commodity Index Correlation Example.

350 The Point and Figure Methodology—A Complete Analysis Tool

Invest in Commodities as an Asset Class

Diversification

There are many sound reasons for adding commodities to your in- vestment process, not the least of which being a time-tested lack of correlation between stocks and commodities. This will be dis- cussed in more depth later in this book, but sufficed it to say that this lack of correlation gives investors a valid way to diversify as- sets by using the commodities market. The more common ap- proach toward diversification is to allocate funds toward large-cap stocks, small-cap stocks, international stocks, and so on to achieve an overall portfolio allocation. However, this is a task much easier explained than implemented, as many “diversified” investors found out the hard way in 2002, when nearly every area of the equities market finished solidly in the red. It was particu- larly obvious in that year that simply spreading money around different regions or style boxes is not true diversification, but that was because everyone was losing money. The truth is that it is simply a fallacy of composition to assume that foreign stocks are not correlated to U.S. stocks, or that small-cap stocks are in no way correlated to large cap stocks. A “diversified” portfolio of some of the largest, most widely held, mutual funds in existence can still fall prey to a deceivingly high correlation with the S&P 500. (See Figure 11.12.)

A tremendous benefit that commodities can provide to an account is true diversification; which is to say diversification by means of a noncorrelated asset. Diversification is something to consider within your “commodity” asset class, as it can reduce “avoidable risk.” One way to provide diversification in your commodity account is to trade different markets. It is important to keep in mind that diversification increases with more mar- kets, but it does so at a decreasing rate as more and more mar- kets are added. The added diversification provided by tangible goods, such as agriculture or petroleum, is rooted in the premise that these goods are impacted by different factors than stocks or bonds. That doesn’t mean that when stocks are going down, commodities will always go up, but it does mean that if they both go down it is likely for very different reasons, which is as

351

Large

Amer Funds Washington Mutual Inv 0.96 Dodge & Cox Stock 0.93

Vanguard 500 Fidelity Magellan

1 Amer Funds Growth Fund of America 0.97 0.99 Fidelity Capital Appreciation 0.95

Mid

T. Rowe Price Mid Cap Value 0.91 Goldman Sachs Mid Cap Value 0.83

Fidelity Mid Cap Stock Vanguard Extended Market

0.91 Fidelity Aggressive Growth 0.9 0.88 T. Rowe Price New Horizon 0.88

Small

Scudder Dreman Small Cap Value 0.73 Vanguard Small Cap Value Index 0.77

Amer Funds Small Cap World Fidelity Low Priced Stock

0.83 Van Kampen Small Cap Growth 0.72 0.84 Aim Opportunities 0.81

Global

Amer Funds New Perspective Dodge & Cox International

0.96 0.87

Bonds

Pimco Total Return Bond Federated Bond

−0.24 0.08

Equal Weighted Port Avg Equity Correlation

0.88

% Strategic EQ Weighted Port 100 Large 60 Mid 7.5 Small 7.5

Value

Blend

Growth

Figure 11.12

Portfolio Correlation Example.

Correlation to the S&P 500 for 2005 3 Year Range

Global 25 ——————————————————–

Estimated
EQ Weighted Correlation 0.934

352 The Point and Figure Methodology—A Complete Analysis Tool

far as diversification is meant to go. As evidence, it is worth pointing out that there have only been two years since the Gold- man Sachs Commodity Index was established (1970) that both stocks and commodities have been down in the same year (see Figure 11.13).

Inflation

The second valid reason to consider commodities as part of a portfolio is as a hedge against inflation. Typically, when inflation rises, the cost of both producing goods and borrowing funds in- creases, each of which can have a negative impact on stock and/or bond investments. Commodities, however, can benefit in this en- vironment, as rising prices for raw materials (which are com- modities after all) benefit the investor who owns a mutual fund invested in these same raw materials.

Figure 11.13 Non-Correlated Comparison: Goldman Sachs Commodity Index versus SPX.

Evaluating the Commodity Market for Opportunities 353

In such an environment, when inflation may or may not be led by rising energy prices, an investor may seek a commodity in- vestment less correlated with crude oil at times, and more corre- lated to a broader investment in raw materials. Currently, the most evenly diversified option among commodity-based indices that are traded via open or closed-end funds is the Dow Jones AIG Commodity Index.

Opportunities for Capital Appreciation —The Exchange Traded Funds

In recent years, we have seen a growing number of market vehi- cles begin trading that allows access to the commodities market on an exchange-traded basis. Both broad-based commodity index products have been introduced, as well as focused products that allow participation in individual commodity markets. In either case, these exchange-traded products allow investors to gain ac- cess to these markets without the leverage of commodity-based futures contract. For instance, Barclay’s Global introduced the iShares COMEX Gold Trust (IAU), which is an exchange-traded fund that is indexed to the price of gold. One share of IAU repre- sents ownership of 1⁄10 of an ounce of gold bullion that is actually held in a vault. If gold is valued at $600 per ounce; one share of IAU will trade at roughly $60 per share. For an investor to gain ex- posure to 100 ounces of gold, he must buy $60,000 of IAU. This is contrary to an investment in gold futures contracts where one gold contract represents 100 ounces of gold but requires only an initial margin requirement of $3,000 to be met on purchase. That, in essence, is how future contracts create such leverage. A 10 per- cent move in the price of gold would represent a 10 percent change in value for IAU shares ($6,000 fluctuation on a $60,000 investment), but a 200 percent move relative to that $3,000 initial investment in the futures contract. (See Figure 11.14.)

Most exchange-traded commodity vehicles are created simi- larly, allowing dollar-for-dollar exposure to a commodity index or individual commodity market. The analysis for buying or selling these funds is no different than that described previously for enter- ing a futures contract; it is primarily the leverage that is different.

Figure 11.14 iShares COMEX Gold Trust (IAU).

354

355

Ticker Symbol

Fund Title

Fund Type

Fund Description

SLV iShares Silver Trust
IAU iShares COMEX Gold Trust

ETF ETF ETF ETF ETN ETN ETF

Represents ownership in 10 ounces of Silver Bullion
Represents ownership in 1/10th of an ounce of Gold Bullion
Represents ownership in 1/10th of an ounce of Gold Bullion
Represents ownership in DBLCIX, an Index comprised of 6 commodities Represents ownership in DJAIG, a diversified commodity Index Represents ownership in production-weighted GSCI Index
Designed to replicate, dollar for dollar, price movement of Crude Oil

GLD StreetTracks Gold Trust
DBC Deutche Bank Commodity Index
GSP iPath Goldman Sachs Commodity Index DJP iPath Dow Jones AIG Commodity Index USO United States Oil Fund

QRAAX PCRIX RYMBX

Oppenheimer Real Asset Fund Pimco Real Return Fund Rydex Commodity Fund

Mutual Fund Mutual Fund Mutual Fund

Primarily tracks GSCI, production-weighted, heavy in Energy Primarily tracks DJAIG, diversified commodity exposure Primarily tracks GSCI, production-weighted, heavy in Energy

ETF, Exchange Traded Fund
ETN, Exchange Traded Note
Mutual Fund, an Open-End Mutual Fund

Figure 11.15 Commodity-Based Index Funds.

356 The Point and Figure Methodology—A Complete Analysis Tool

The existing commodity-based open-end (mutual funds) and ex- change-traded products available as of this writing are found in the attached table, a list that will no doubt grow substantially in the coming years if the bull trends in commodity indexes remain in tact (Figure 11.15).

Summary

By this point in our journey, we hope that at a minimum we agree on two things, the first of which being that simply having a set of rational tools at your disposal is quite helpful in deciphering the commodities markets, and second, that none of these tools need be hoes, pitchforks, or McCormick’s famous reaper. Rather, while remaining attentive to a few key ingredients, which pertain to any commodity, we can begin to train ourselves to find consistent opportunity in the futures market.

POINTS AND FIGURES BY DORSEY, WRIGHT MONEY MANAGEMENT

Daniel Goleman, in his book Emotional Intelligence, distinguishes between intellectual intelligence and emotional intelligence. Our intellectual intelli- gence is a function of the IQ we were born with and how that intellectual intelligence is cultivated. Emotional intelligence, according to Goleman, in- cludes self-awareness and impulse control, persistence, zeal and self- motivation, empathy and social deftness. His book goes over many examples of people who, intellectually speaking, are brilliant. He cites many examples of these people doing really stupid things, due to a lack of emotional intelligence. One such example is as follows:

Exactly why David Pologruto, a high-school physics teacher, was stabbed with a kitchen knife by one of his star students is still debatable. But the facts as widely reported are these:

Jason H., a sophomore and straight A student at Coral Springs, Florida, high school, was fixated on getting into medical school. Not just any med- ical school—he dreamt of Harvard. But Pologruto, his physics teacher, had given Jason an 80 on a quiz. Believing the grade—a mere B—put his dream in jeopardy, Jason took a butcher knife to school and, in a confrontation with Pologruto in the physics lab, stabbed his teacher in the collarbone be- fore being subdued in a struggle.

A judge found Jason innocent, temporarily insane during the incident- a panel of four psychologists and psychiatrists swore he was psychotic

Evaluating the Commodity Market for Opportunities 357

during the fight. Jason claimed he had been planning to commit suicide because of the test score, and had gone to Pologruto to tell him he was killing himself because of the bad grade. Pologruto told a different story: “I think he tried to completely do me in with the knife” because he was infu- riated over the bad grade.

After transferring to a private school, Jason graduated two years later at the top of his class. A perfect grade in regular classes would have given him a straight-A, 4.0 average, but Jason had taken enough advanced courses to raise his grade-point average to 4.614—way beyond A+. Even as Jason graduated with highest honors, his old physics teacher, David Pologruto, complained that Jason had never apologized or even taken re- sponsibility for the attack.

The question is, how could someone of such obvious intelligence do something so irrational—so downright dumb? The answer: intelligence has little to do with emotional life.

Goleman argues that just as intellectual intelligence can be changed by experience and education, so too can emotional intelligence be learned and improved. Goleman proposes a number of methods for improving emotional tendencies that decrease the quality of life one enjoys. Such methods include catching worrisome emotional episodes as near their be- ginning as possible. With practice, people can identify the worries at an earlier and earlier point in the anxiety spiral. People also learn relaxation methods at the moment they recognize the worry beginning. One’s mind can also be trained to more thoughtfully consider the consequences of dif- ferent emotional responses.

The same principles apply to portfolio management. Unmanaged emo- tions lead investors to sell their winners too quickly, hold on to their losers too long, and overtrade. Academic intelligence alone does not lead to great investment results. It comes down to a question of execution. Do we have enough intellectual intelligence to develop a winning investment strategy? If not, more research and extensive testing is required. Then, do we have enough emotional intelligence to execute?