Hello and welcome back to this the 6th video in this theoretical course on commodity spread
trading, we are starting to gather a little pace now having already covered off the introduction
to commodities and the basics of spread trading with them.
Continuing where we left off in the previous session in this one we once again look at
the fundamental analysis that needs to be done when looking to identify the best trades
to make.
This is an important part of trading, analysis of data and understanding the results of it
assists in building out a strategy of when and how to trade
In this session, I will introduce another highlight relating to raw materials and spreads
namely seasonality.
As we delve deeper into the dynamics of spread trading you will notice that we are starting
to introduce more and more technical elements.
These need to be understood in order to be able to effectively trade in spreads, No one
likes to give away money, least of all the financial markets, so knowledge and preparation
is everything if we are going to succeed with winning trades.
I speak from experience, I made mistakes at the start of my career, unprepared and with
little knowledge, venturing into the markets, I ended up throwing money out of the window,
the probability of doing this without the understanding and knowledge is, I assure you,
very high.
But the great thing about trading spreads is that you do not have to learn a new job,
when starting employment or changing jobs it has normally meant that a good salary would
be a few years away, with spread trading you only have to have a little patience and determination,
especially in the beginning, Then when you start to get your first consistent profits
the road will start to open out, it will be easier for you to devote time in the right
way and find the right strategies to guarantee a salary, that is salary spelled with a capital
S. Looking at the image we see the seasons and
therefore the different climates associated with each of them.
We have already discussed in an earlier session the fact that materials have a recurring trend
in prices that can be called seasonal.
For example it is easy to see why the price of energy commodities tend to rise just before
winter when there is a greater need for heating fuel.
Did you know that the price and demand for coffee also rises in winter, the reason being
coffee is mainly used as a hot drink and more of it is drunk when it is cold.
We could also look at gold and the fact that its price rises during times of financial
crisis or falling stock markets, the prices of corn and wheat, however, are modified according
to the planting and harvesting cycles, that repeat every year, we know in advance that
the demand for pork and beef tends to grow in spring and summer, or as it can occasionally
be referred to “the BBQ season”, This may all sound a little far fetched, but
as you start making more and more profits based on seasonal trends it will become more
and more real.
These are just examples, but it is a statistical and predictive advantage that is only present
in the commodities market, understanding this and with the information and knowledge you
take from these videos, you will soon be able to provide yourself with another regular income
to replace or top up the one that you currently earn.
So having talked somewhat generically about the seasonality of commodities Let's now look
at a more specific example: We have already mentioned Heating Oil and the fact that the
price is exposed to the demands on the product and climatic factors.
As this chart shows 'Heating Oil has a bullish or upward trend from July to October.
People often believe that heating oil shows seasonal highs during the winter months, but
this typically does not happen.
In fact, most of the fuel oil purchases are done before the onset of winter, as people
prepare in advance for the colder times ahead.
Now You probably have questions, the same ones that every new spread trader has asked
before Knowing about seasonality is fine but where
do I find the details?
Where can I find different trends?
I’m going to have to do a lot of research to learn all the raw materials, so much for
not having to learn a new job, it looks like I am going to have to after all!
Well the answer to the last comment is a resounding NO
I have not studied massive amounts of data to try and detected a trend over the last
30 years on any of the commodities, this information is readily available, it is just a question
of knowing where to look.
The good news is that there are statistical databases provided by companies such as the
Moores Research Centre or Seasonalgo that can do this job for us.
These are companies that do the statistical analysis for us and produce reports on the
various commodities, highlighting the seasonal patterns and maturities of the individual
raw materials, which are good for developing directional futures and options strategies,
in addition on a monthly basis they also identify seasonal areas where there are already favorable
spread contracts to be traded The table is shown details one such proposal,
in particular one trade that suggests the purchase of a Lean Hogs (pork meat) future
maturing in February 2016 and the simultaneous sale of the same future (Lean Hogs), maturing
in December 2015 Taking the lean hogs suggestion we can then
look further at the opportunity it may offer us.
This table shows the performance of the same trade over the last 15 years, we will cover
off how you can use this information in a future episode, for now, let's look at the
information that is available to us from these database sites
Continuing with the lean hops proposal, we are also able to access a chart with information
relating to it, this shows us the seasonal trend in the spread on pork.
The black line identifies the spread in progress, while the blue line represents the average
of the trends for the past 15 years, with the red horizontal line showing the average
of the last 5 years.
Now observe the yellow band.
This identifies the seasonal window recommended by the Moore Research site as the preferred
time to carry out the trade, indicated by the specific date of entry and exit of the
trade shown by the dotted vertical green line at the start of the window and the corresponding
vertical red line at the end of it.
Remarkable info, isn’t it?
Here’s a tip relating to the data that you can see on the websites of Moore and Seasonalgo,
some really important information to remember, follow some simple and basic rules to help
you identify spreads that have the best features and therefore the best chance of success.
a.
Look at the interval of seasonality recommended to make the trade, it must be sufficiently
large, it is usually preferable to be not less than 20 days; That is to say, you let
the trade run for a minimum of 20 days.
b.
Next look at the current prices of the spread, if you want to buy the spread, this should
not be too high compared to the statistical average of the prices of recent years or you
may be limiting the possibility of movement and therefore profit you will obtain from
trading.
Make sure that you check the average trends for 5 and 15 years, they must be similar,
in fact, it is better if they are almost overlapping (related), as it means that the trend is linear
with few changes year on year.
The last point to consider is the volumes of the two futures, they must sufficiently
high to be able to trade them, we recommend that the volumes are at least 1,000 contracts
traded or you may struggle to execute one or both sides of the deal.
A common and, unfortunately, a big, if not huge mistake I've seen several traders commit,
and being honest one that I made when I first started, Is to completely rely on the information
of these statistical database sites, and start to trade on the back of it, without adequate
experience and training.
It is good that they show potential trades to be done and you may well be thinking great,
having possession of this statistical information you can make some easy money.
Wrong, the markets do not offer free money to anyone.
Trading based purely on the statistical analysis provided by sites like Moores and SeasonAlgo
is a sure-fire way to throw your hard-earned money away.
The statistical database can and should be considered as providing some good suggestions
and acting as a good starting point to learn about the seasons.
But it is clear that climate and other demand factors may experience temporary or systemic
lags, and therefore we should take the suggestions that come from the statistics and adjust them
based on current conditions.
Do not think that these sites are the magic formula, they aren’t, take them for what
they are simple statistical support to our trading.
So how do we adapt this statistical information and turn the suggested actions into a firm
strategy?
We will always start with the statistical information, especially if we do not have
much time to devote to research ourselves, But we then need to undertake some further
analysis using data on the current market conditions to ensure we have the right information
to work with.
Once we have all of the information we would move on to technical analysis.
This will help us confirm the viability of the trade, and determine the correct timing
to create a new position In the next episode, we will start to look
at the technical analysis and components used in undertaking it.
Specifically looking at signals the market data can give us and a measure of the strength
of the market that we want to trade-in.
But for now, time perhaps for a coffee, sit back, take a break and I’ll speak to you
soon in the next episodes on technical analysis, bye for now