sizes. There is no consistency orconstant in tick value fluctuations or dollar value in the price changes. Forexample, the CBOT mini-Dow contract is $5 times the overall Index. Whenthe Dow was at 10,500, the overall value was 52,500. The margin was setat $2,600, or just under 5 percent. E-mini–S&Ps are 12.50 per tick (fourticks per point). If the point value is $50, the overall value of the contractif the S&P is at 1,200.00 is $60,000. In the currency markets, the euro is12.50 per tick; the Canadian dollar is 10 per tick; the British pound is 6.25per point but trades in a minimum two-tick fluctuation. (In my first book[A Complete Guide to Trading Tactics, Wiley, 2004], I listed all the commodities and the contract sizes on pages 8 and 9; please refer to that for acomparison. Or you can ask your futures broker to provide the listing ofcontract specifications.)The exchanges where the individual futures products are traded setthe margin requirements. Generally speaking, an initial margin requirement
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on a futures product runs anywhere from 2 percent up to 10 percent of acontract’s overall value. So now a trader needs to know which exchangethe product is traded on, how much risk capital is needed to invest per contract, and how much each point value is. Let’s look at the New York Mercantile Exchange’s crude oil contract: The contract size is 1,000 gallons;every tick or point fluctuation equals $10. A $1 move per contract is a $1,000price move. When prices were at $65 per barrel, the contract value was$65,000. The margin requirement was, at one point, nearly $9,000 per contract, almost 14 percent of the overall market value. The extremely highmargin requirement reflected the extreme level of volatility and the inherent risk associated with that increased volatility.The futures markets also have a value for stock traders to make decisions on asset allocations to their stock portfolios. In the agriculture sector,for example, you can study the price direction of soybeans, use traditionaltechnical analysis tactics to determine the strength of a trend, and see ifcorresponding stocks linked to that market are worth switching or allocating funds toward. In Figure 1.27, we see soybeans making a seasonal harvest bottom at the end of November.Another advantage futures have is that you can trade signals to diversify in other investments. Anticipating that the market may establish a seasonal bottom, you may want to explore stocks directly linked to theagriculture industry, instead of being exposed to potential risks due to whatmight appear to be an overleveraged investment vehicle, such as a futurescontract. After all, every penny in soybean futures was $50 at the time thatI was preparing this book, and the minimum margin requirement was$1,148. That means that on a small 20 cent move, you could lose nearly 95percent of the initial investment per contract.There are other considerations you could use, such as an options strategy, to effectively reduce risk exposure, such as going long a futures contract and buying a put option for protection; but in this strategy, you needto time the right option expiration. An alternative strategy would be goinglong a related market, such as stock in Monsanto shown in Figure 1.28.Notice that this stock exploded in early November. The best part hereis that there were seasonal factors to support a buy signal; and the technical picture shows what I call a “high close doji trigger,” which we will disclose in this book. In fact, this is a great example to demonstrate why usinga like or related market analysis approach can help you achieve better results in your trading. Cycle and seasonal studies can really help you in selecting stocks. The futures markets can certainly aid in that analyticalprocess. Not only do commodities move in cycles, but the economy andbusinesses do as well.There is one man who sticks out above the rest as the premier expertin the field of intermarket relationships—John J. Murphy. He has written
FIGURE 1.27RealTick graphics used with permission of Townsend Analytics, LTD.
FIGURE 1.28RealTick graphics used with permission of Townsend Analytics, LTD.
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FIGURE 1.29RealTick graphics used with permission of Townsend Analytics, LTD.
many books on the subject; the latest, titled Intermarket Analysis: Profiting from Global Market Relationships, will really help you in your educational journey.Let’s look at two more agriculture related stocks: One in Figure 1.29 isArcher Daniels Midland, which as you can see did rise but not significantly;however, it did rise in tandem with the soybean market. The other stock isBunge Limited, shown in Figure 1.30, which mirrored the chart pattern inFigure 1.29 and moved higher at almost exactly the same time that the bottom in the soybean futures was formed.
Tandem Trading TechniquesIntermarket relationships have existed for years. It is very easy to track andlook for trade setups in futures from a historical perspective, but timing atrade can be difficult due to the magnitude of the leverage as previouslydiscussed. Don’t get me wrong; futures are a very viable investment vehicle. I have made a very lucrative living trading commodities for the past 26years. I just want you to learn that you can use futures to help make diver-
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FIGURE 1.30RealTick graphics used with permission of Townsend Analytics, LTD.
sified investment decisions on a broader scale. The key to making money inthe markets is managing risk . . . end of story. Knowing the right strategyand having exposure to other markets and strategies can help you achieveyour financial goals. Using similar or like markets or those that trade in tandem, especially markets that have strong relationships, traders can developtrading techniques or strategies by using signals based on one market andapplying them to another, such as commodities and stocks or an ETF.Keep in mind that not all relationships work all the time. Look at past market relationships, such as the dollar and gold: Generally when the dollargoes up, gold goes down; but that certainly was not the case in 2005. Howabout when the Fed raises interest rates? Generally, long-term bond yieldsrise as well; but that did not occur in 2005 either. In fact, commodities andbond yields usually trend together; and that did not occur in 2005. FederalReserve chairman Alan Greenspan called the decline in long-term yields a“conundrum.”As we saw commodity prices rise, we saw the Federal Reserve raiserates at a “moderate” pace, acting at 16 consecutive meetings to adjust theFed funds rate by 0.25 percent each time. This was in response to the per-
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ception that inflation was rearing its ugly head. (As of the printing of thisbook, the Fed was still in rate-hiking mode!) Due to higher energy costs andas reflected in the Producer and Consumer Price Indexes, we had seen apickup in inflation; and historically, many commodity prices rise besidesgold and silver, such as sugar, coffee, and cotton.The Reuters/Jefferies CRB (Commodity Research Bureau) Index, originally developed in 1957, is one of the most often cited indicators of overallcommodity prices, offering investors a broad and reliable benchmark forthe performance of the commodity sector. It is traded on the New YorkBoard of Trade and started trading back in 1986. The “RJ/CRB” Index wasrevised in 2005 to reflect 19 commodity futures prices: aluminum, cocoa,coffee, copper, corn, cotton, crude oil, gold, heating oil, live cattle, leanhogs, natural gas, nickel, orange juice, silver, soybeans, sugar, unleadedgasoline, and wheat.If you examine the chart of the RJ/CRB Index shown in Figure 1.31, thestratospheric rise is obvious and would indicate that inflation was or will be
FIGURE 1.31Used with permission of esignal.com.
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trickling down to consumers. Again, price increases in commodities historically signal a rise in inflationary pressures.Investors and traders can use stocks or ETFs to capitalize on commodity plays; but at times, it pays to diversify and have a commodity account. Not all stocks offer participation in all commodity moves, so it iswise to explore using commodity markets as an investment.
A Case in PointA fundamental event, besides an increase in demand, that helped create ashortage of supplies in energy and other commodities in 2005 was theweather. Hurricanes Katrina, Rita, and Wilma gave a lift to sugar and orangejuice futures while harming certified coffee facilities in New Orleans and, toa lesser extent, Miami. These weather-related events were pure commoditymarket plays. Let me walk you through one of these 2005 events: The daybefore Hurricane Wilma passed through Florida, my wife and I had watchedthe Weather Channel intensely and decided to stick around because all thenews reported that the hurricane would be downgraded to a tropical depression by the time it crossed over Naples and exited on the other side ofFlorida, in Palm Beach. The day before, we had played golf; and it was asplendid day: 83 degrees or so, a light breeze, and not a cloud in the sky. Wewere planning to leave for Chicago the following Sunday, and we couldhave easily changed our tickets and left early. Well, at 6 A.M. on October 24,we woke up and discovered that Wilma had gained strength and mergedwith another storm, named Alpha; and Wilma had turned into a low-gradeCategory 3 hurricane! All I could think of at the moment my wife turned theTV on was, “I better make some coffee because we are going to losepower.” By the time the coffee had finished brewing, click, all the lightswent out.However, we were prepared: The cars had gas, the shutters were up,and we had a generator; so life was not so bad for that week. The morningof the hurricane, CNBC had called to see if I was in Florida and asked mewhat I thought would happen to the orange juice crop. I did a live interview via my cell phone, reporting on the weather conditions and whatmight happen to the orange crop. I stated that “we could see at least a 10percent price gain from the 1.11 level to possibly as high as 1.25, as thestorm would pass through sections of Indian River County.” It was alsothat storm that devastated the soon-to-be-harvested sugar cane crop. As itturns out, that was a solid prediction and exactly what played out in themarkets. If you had a commodity account, you may have taken up that opportunity in orange juice. In fact, orange juice eventually moved as high as164 by May 11, 2006.
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FUNDAMENTAL EVENTS INFLUENCEPRICE DIRECTIONThere is an old saying, “Think like a fundamentalist, but trade like a technician”—a great line that applies when trading commodities or any marketfor that matter. Here is how that line applies to the hurricane situation. Theorange juice crop was slightly damaged; there was a reduction in suppliesin the southern growing region in Florida. Prior to the hurricane, pricesmoved higher in anticipation of a loss of inventory; what was unknown washow much higher. The market traded higher after what appeared to be asignificant damaging hurricane.Fundamentally, the market was vulnerable for any further priceshocks. Then, as we approached the traditional seasonal frost scare periodin mid-January through February, the market would be more vulnerable toincreased volatility. In fact, that was what occurred in 2006, as Figure 1.32
FIGURE 1.32Used with permission of www.GenesisFT.com.
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shows. The fundamental supply/demand report outlook, as shown in theU.S. Department of Agriculture’s (USDA’s) monthly crop report, did not reveal a major supply/demand imbalance to warrant higher prices. But a frostscare would! The anticipation that crops would suffer from frost damagepropped prices sharply higher. The point is that you need to be aware ofwhat fundamental factors influence a market. Markets do not always movewhen they should on facts presented, but there are circumstances that canand do make markets move! A hurricane in South Florida before harvesttime is one such situation.
NOT ALL NEWS AFFECTS MARKETS EQUALLYHurricane-related damage in 2005 played a major role in the reduction ofsupplies to the sugar market more so than it did in orange juice. Also, thefundamental backdrop of the sugar market was more significant than theorange juice market because it has a dual role: Sugar is a food product, andit is used as a biofuel to make methanol. It set record price gains in 2005, especially as energy prices surged. Raw sugar prices more than doubled in2005, climbing and making new 24-year highs. Brazil, the world’s largestproducer, uses most of its crop to make fuel because of the high cost ofgasoline. With that information, we would expect that after Hurricanes Katrina and Rita impacting the Louisiana crops and then Hurricane Wilmamaking a direct hit on Florida’s crop, prices would take off like a rocket!But don’t forget that sugar is produced all over the world and that there aresugar beets and sugar cane. It is almost impossible to measure inventoriesfrom all growing regions of the world, and the market knew that after Hurricane Wilma hit. The fundamental event that impacted the orange juicemarket had a different effect there than it did on the sugar market.As you examine Figure 1.33, notice that prices actually decline afterHurricane Wilma. It took almost one month for the market to realize thatthere was a significant loss in Florida’s crop, and speculative money poredinto the market to take advantage of higher prices. A Trend Traders technical price break signals to get long this market, and substantial profits weremade. It may appear that the fundamental and technical outlooks were notin sync; and by late January/early February of 2006, traders started to sensethat the market was getting slightly ahead of itself, or overbought. Traderswho were long started to liquidate some positions in preparation for theUSDA’s monthly crop report. If you look closely at Figure 1.33, the veryhigh of the market was formed by a candle pattern named a shooting star.(Chapter 7 focuses on how to spot reversals like this one.) The market did
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FIGURE 1.33Used with permission of www.GenesisFT.com.
not behave according to what the fundamentals dictated. Prices rallied in adelayed effect and then continued higher on speculative buying interest.What I want to illustrate next is how markets do not act according tothe following:• What fundamentals dictate.• Common sense.• Rational emotional intelligence.The high was made in the sugar market on February 3 at 19.65, oneweek earlier than the USDA crop report. Table 1.1 shows the actual government report, the boldface type indicating that total sugar supplies increased from 11,870 to 12,026! But best of all, total usage declined from10,523 to 10,365! Ending stocks show there are more surplus inventories.Since that report, prices have declined significantly.Therefore, remember: Fundamentals do not always jibe with whatthe charts show. Think like a fundamentalist but trade technically.
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TABLE 1.1U.S. Sugar Supply and Demand Report 2-9-2006 (1,000 short tons, raw value)2004/2005Previous
2004/2005Feb 9
205/2006Previous
2005/2006Feb 9
Beginning stocksProduction 2/Beet sugarCane sugarFloridaHawaiiLouisianaTexasImports
1,8977,8774,6113,2661,6932581,1571582,096
1,8977,8774,6113,2661,6932581,1571582,096
1,3477,5934,4353,1581,4552601,2631802,770
1,3477,5934,4583,1311,4282601,2631803,090
Total SupplyExportsDomesticFoodOtherMiscellaneous
11,87025910,21510,04616949
11,87025910,21510,04616949
11,71017510,21510,0501650
12,02617510,19010,0501400
Total UseEnding StocksStocks/Use ratio
10,5231,34712.8
10,5231,34712.8
10,3901,32012.7
10,3651,66116.0
Item
FOLLOW THE MONEY FLOWFundamental events are not the only factors that drive prices. We see evidence of increased participation from speculators as reflected by the increase in volume and open interest levels. Most commodity markets,besides orange juice and sugar, showed massive money inflows by hedgefunds, pension funds, and individual investors in 2005 as commoditiesprices rose. The Reuters/Jeffries CRB Index, as shown back in Figure 1.31,is a great illustration of that fact. This trend may continue in 2006 and possibly beyond into 2008. The hurricanes in 2005 affected not only the agricultural markets described here but also the energy markets, as previouslymentioned. In 2005, natural gas prices skyrocketed, and unleaded gasolineprices exploded. Many stock analysts may not have been trading commodities directly, but they certainly were watching their price movementsand using that data to track their portfolios.My point is that we have entered a time period in which our civilization
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and culture are entwined in a very complex financial relationship in whichcommodity markets play a serious role. Think about this: Ten years ago, wedid not trade freely or openly as we do now with China; in fact, China nowhas its own exchange, the Zhengzhou Commodity Exchange. Then thereare India and other parts of Asia; as their commerce and economic growthdevelop, so will the need for trading.More and more investors are participating in the markets around theglobe, even in Latin America. Markets have become more confusing totrade, and therefore we need to look for opportunities and to keep our defense up to be more risk averse. Using spread trading in the futures marketscan help you achieve those goals; the opportunities are endless. Keep inmind the important principles of trading that depend on these elements:• Prices reflect forces influenced by supply and demand factors.• Prices represent the collective action of buyers and sellers who aredictating what the current price of a given product is perceived to be ata given time.
Stocks Influenced by CommoditiesNow that commodities are moving and have attracted the attention of sophisticated hedge fund and commodity trading advisors, money has beenflowing back to this investment industry. Investors use fundamental information such as weather conditions and apply technical analysis techniquesto time entries and exits. Corporations, banks, and institutions are usingthe markets to hedge against losses incurred in the cash markets, for example, the airline industry, where some companies were buying energy futures contracts to lock in prices prior to the big price surge. Smart move!Higher prices in commodities such as crude oil certainly have an influenceon the airline stocks. Therefore, tracking commodity prices is important forstock traders.We will go over specific trading strategies as well as some back-testingresults that will substantiate a pretty good method for trading the futuresmarkets. This introduction was designed to show you that there is more tocommodity trading than meets the eye and to show you not only how youcan utilize price moves in the futures to profit from a futures contract butalso how you can apply that knowledge in other areas of investing. In fact,stock traders can greatly benefit from information unique to the commodity markets. One such bit of information is released by the Commodity Futures Trading Commission (CFTC) and is known as the Commitment ofTraders (COT) Report. It is referred to as legal “insider trading” information, which is covered in the next few pages; so read on!
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FOREX, THE CURRENCY CASH MACHINEForeign exchange currency trading, otherwise known as the forex market,offers an investment asset class that is completely different from stocks offutures and offers leverage and virtually unrestricted access 24 hours a day.Forex trades virtually around the clock, from when the Asian market openson Sunday night until the U.S. markets close on Friday afternoon. One ofthe attractions from an individual trader’s perspective is that there is thisconstant access to make a trade.Forex is the simultaneous buying of one currency and selling of another.In other words, currencies are always traded in pairs; in every transaction,a trader is long one currency and short the other. A position is expressedin terms of the first currency in the pair. For example, if you have purchasedeuro and sold U.S. dollars, it would be stated as a euro/dollar pair.The foreign exchange market (forex, or FX) is the largest and most liquid financial market in the world, with a volume of over $1.5 trillion daily—more than three times the aggregate amount of the U.S. Equity andTreasury markets combined. This means that a trader can enter or exit themarket at will in almost any market condition with minimal execution risk.The forex market is so vast and has so many participants that no single entity, not even a central bank, can control the market price for an extendedperiod of time. Unlike other financial markets, the forex market has nophysical location, no central exchange. It operates through an electronicnetwork of banks, corporations, and individuals trading one currency foranother. The lack of a physical exchange enables the forex market to operate on a 24-hour basis, spanning from one zone to another, across the majorfinancial centers.
Margin and LeverageThe forex market allows traders to control massive amounts of leveragewith minimal margin requirements; some firms offer as much as 100-to-1leverage. For example, traders can control a $100,000 position with $1,000,or 1 percent. Obviously, leverage can be a powerful tool for currencytraders. While it does contribute to the risk of a given position, leverage isnecessary in the forex market because the average daily move of a majorcurrency is about 1 percent, while a stock typically sees much more substantial moves.Leverage can be seen as a free short-term credit allowance, just as it isin the futures markets, allowing traders to purchase an amount of currencyexceeding that of their account balance. As a result, traders are exposed toan increased level of both risk and opportunity. Due to the nature of the
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leverage in the forex markets, positions are normally short-lived. For thisreason, entry and exit points are crucial for success and must be based onvarious technical analysis tools. While fundamental analysis focuses onwhat should happen, technical analysis is based on what has or is happening at the current time.Identifying the overall trend, whether it is short-term or long-term, isthe most fundamental element of trading with technical analysis. A weeklyor monthly chart should be used to identify a longer-term trend, while adaily or intraday chart must be used for examining the shorter-term trend.After determining the direction of the market, it is important to identify thetime horizon of potential trades and to apply those strategies to the appropriate trend. Therefore, the techniques covered in this book are highly effective in trading the forex markets.Technical analysis is the study of historical prices in an attempt topredict future price movements. There are two basic components on whichtechnical analysis is based: prices and volume. By having the proper understanding of how these two components exploit the impact of supplyand demand in the marketplace, with a stronger understanding of how indicators work, especially when combining candle charts and pivot analysis,you will soon discover a powerful trading method to incorporate in theforex market.
Long or ShortOne of the advantages that the forex market has over equity markets is thatthere is no uptick rule, as exists in the stock market, if one wants to take advantage of a price decline. Short selling in forex is similar to that in the futures market. By definition, when a trader goes short, he is selling acurrency with the expectation that the price will drop, allowing for a profitable offset. If the market moves against the trader’s position, he will beforced to buy back the contract at a higher price. The result is a loss on thetrade. There is no limit to how high a currency can go, giving short sellersan unlimited loss scenario. Theoretically, a short seller is exposed to morerisk than a trader with a long position; however, through the use of stoploss orders, traders can mitigate their risk regardless of long or short positions. It is imperative that traders are well-disciplined and executepreviously planned trades, as opposed to spontaneous trading based on a“feeling that the price will decline.”
Benefits for Selling ShortThere are obvious benefits to short selling. This aspect of the forex marketallows traders to profit from declining markets. The ease of selling con-
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tracts before buying them first is in contrast to typical stock trading. Market prices have a tendency to drop faster than they rise, giving short sellersan opportunity to capitalize on this phenomenon. Similarly, prices willoften rally gradually with increasing volume. As prices trend toward a peak,trading volume will typically taper off. This is a signal that many short sellers look for to initiate a trade. When a reversal does occur, there will typically be more momentum than there was with the corresponding up move.Volume will increase throughout the sell-off until the prices reach a point atwhich sellers begin to back off.
Famous Short PlaysThere have been quite a few milestone memories from famous currencytrades, with both short positions and long. For example, famed financierGeorge Soros “broke” the Bank of England by winning an estimated $10 billion bet that the British pound would lose value! How about DaimlerChrysler, the parent company of Chrysler and Mercedes Benz—reportedlyit made more money in the forex markets than it did selling cars! On thenegative side, in early 2005, Warren Buffett announced the U.S. dollar wasin trouble and stated he was heavily short the U.S. currency. That did notturn out well for him, as the dollar rallied for the most part during all of2005. What turned the market around? There were many issues—mainlypolitical, geopolitical, and economic developments—that influenced thedollar’s value. For starters, many U.S.–based multi-conflomerate corporations were prompted to bring money back into the United States due to theHomeland Investment Act (HIA). The HIA is part of 2004 American JobsCreation Act and was intended to encourage U.S.–based companies tobring money back home.The window of opportunity afforded by the HIA prompted companiesto increase the pace at which funds are repatriated to the United States.Since companies had only until the end of 2005, many analysts suspectedthat companies would rush to repatriate foreign profits by year’s end andthat there would be a high dollar demand to convert foreign currencies.Don’t forget, during the middle of 2005, there were riots in France. Thatcontributed to poor market sentiment toward the euro zone, thus givingground for a flight to safety, and helped foreign investors switch to buyingU.S. dollars. The tone was essentially dollar-positive and euro-negative,which is indicative of politics having a negative effect on the euro. Meanwhile, the broader market was also most likely influenced by the high-profile move by Berkshire Hathaway, Inc.’s, Warren Buffett to cut backspeculative positions against the U.S. dollar after losing big on it due to surprising dollar strength.Mr. Buffett had bet that the dollar would continue losing ground, as it
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did in 2004, as he felt the massive U.S. current-account deficit would be dollar negative. But instead, monetary policy dictated otherwise as the FederalReserve continued to raise interest rates. That was helping to drive demandas the interest rate differentials widened. In its third-quarter report in 2005,Berkshire Hathaway said it had cut its foreign-currency exposure to $16.5billion, down from $21.5 billion in June 2005.As you can see from the dollar Index weekly chart in Figure 1.34, on ayear-to-year basis, the dollar did make an outstanding run. However, keepin mind that the dollar was at a high of 120.80 back in 2002; so depending onwhere Buffett was shorting the dollar, he could still be in a lucrative position. The focus of this story is how shifts in monetary and fiscal policies canand do dictate price swings in the market, as happened in 2005.Forex trading is considered the juggernaut in the investment world,with more than 3.5 trillion in currency trading taking place per day, according to the Bank for International Settlements. There is more daily volume in the forex market than in all of the U.S. stock markets combined.There is no doubt that that is one reason why foreign currency has becomeso popular. Other reasons why forex attracts so many individual investors
FIGURE 1.34Used with permission of esignal.com.
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are that the market has liquidity and favorable trading applications, such asthe ability to go long or short a position, and that it trends and trades well,based off technical analysis studies.In the past, currency trading was accessible for speculators through thefutures industry when the central marketplace in the banking arena was forthe privileged few. This has all changed now, and the competition is fierce.The industry has expanded from what was an exclusive club of proprietarytraders and banks to a location where any and all individual traders whowant to participate have access in this 24-hour market from their home oroffice computers or laptops.The forex markets offer traders free commissions, no exchange fees,on-line access, and plenty of liquidity. Unlike the futures products, the markets are standardized contract values, meaning a full-size position is100,0