Commodity Trading Strategies

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A few insights on how commodities behave, a few time tested strategies to trade commodities successfully and profitably.

Transcript of Commodity Trading Strategies

  • CommodityStrategies

  • Founded in 1807, John Wiley & Sons is the oldest independent publish-ing company in the United States. With offices in North America, Europe,Australia and Asia, Wiley is globally committed to developing and marketingprint and electronic products and services for our customers professionaland personal knowledge and understanding.

    The Wiley Trading series features books by traders who have survivedthe markets ever-changing temperament and have prosperedsome byreinventing systems, others by getting back to basics. Whether a novicetrader, professional or somewhere in between, these books will provide theadvice and strategies needed to prosper today and well into the future.

    For a list of available titles, please visit our Web site atwww.WileyFinance.com.

  • CommodityStrategiesHigh-Profit Techniques for

    Investors and Traders

    THOMAS J. DORSEY

    TAMMY F. DEROSIER, SUSAN L. MORRISON, PAUL L. KEETON

    OF DORSEY, WRIGHT & ASSOCIATES

    WITH JOSHUA B. PARKER

  • Copyright C 2007 by Thomas J. Dorsey, Tammy F. DeRosier, Susan L. Morrison, Paul L. Keeton,and Joshua B. Parker. All rights reserved.

    Published by John Wiley & Sons, Inc., Hoboken, New JerseyPublished simultaneously in Canada.

    Wiley Bicentennial Logo: Richard J. Pacifico

    No part of this publication may be reproduced, stored in a retrieval system, or transmitted in anyform or by any means, electronic, mechanical, photocopying, recording, scanning, or otherwise,except as permitted under Section 107 or 108 of the 1976 United States Copyright Act, withouteither the prior written permission of the Publisher, or authorization through payment of theappropriate per-copy fee to the Copyright Clearance Center, Inc., 222 Rosewood Drive, Danvers,MA 01923, (978) 750-8400, fax (978) 646-8600, or on the web at www.copyright.com. Requests tothe Publisher for permission should be addressed to the Permissions Department, John Wiley& Sons, Inc., 111 River Street, Hoboken, NJ 07030, (201) 748-6011, fax (201) 748-6008, or onlineat http://www.wiley.com/go/permissions.

    Limit of Liability/Disclaimer of Warranty: While the publisher and author have used theirbest efforts in preparing this book, they make no representations or warranties with respectto the accuracy or completeness of the contents of this book and specifically disclaim anyimplied warranties of merchantability or fitness for a particular purpose. No warranty may becreated or extended by sales representatives or written sales materials. The advice and strategiescontained herein may not be suitable for your situation. You should consult with a professionalwhere appropriate. Neither the publisher nor author shall be liable for any loss of profit or anyother commercial damages, including but not limited to special, incidental, consequential, orother damages.

    For general information on our other products and services or for technical support, pleasecontact our Customer Care Department within the United States at (800) 762-2974, outside theUnited States at (317) 572-3993 or fax (317) 572-4002.

    Wiley also publishes its books in a variety of electronic formats. Some content that appearsin print may not be available in electronic books. For more information about Wiley products,visit our web site at www.wiley.com.

    Library of Congress Cataloging-in-Publication Data:

    Commodity strategies : high-profit techniques for investors and traders/Thomas J. Dorsey . . . [et al.].

    p. cm.(Wiley trading series)Includes index.ISBN 978-0-470-12631-8 (cloth)1. Commodity exchanges. 2. Speculation. 3. Investment analysis.

    4. Commodity futures. I. Dorsey, Thomas J.HG6046.C662 2007332.644dc22 2007012415

    Printed in the United States of America

    10 9 8 7 6 5 4 3 2 1

  • Contents

    Preface ix

    CHAPTER 1 Developing a Trading System 1

    CHAPTER 2 Patterns, Trends, and Price Objectives 13

    Chart Patterns 14

    Trend Lines 15

    Price Objectives 25

    CHAPTER 3 Using Spot Charts 31

    Commodity Market Indexes 32

    Spot Currency Charts 41

    Other Useful Spot and Continuous Charts 48

    CHAPTER 4 Relative Strength with Commodities 59

    RS Calculation Example 60

    CHAPTER 5 Other Strategies and Tools 71

    Support and Resistance 71

    Big Base Breakouts 75

    Changing Box Size 77

    Using Pullbacks and Rallies to Improve Risk-Reward 82

    Momentum 85

    Trading Bands 90

    v

  • vi COMMODITY STRATEGIES

    CHAPTER 6 Putting It All Together 95

    Part One: Old Friends with a New Trend 95

    Our Approach 97

    True DiversicationYou Dont Have to Go Far to Find It 98

    Putting It All Together 100

    Part Two: Initiating and Managing a Position 102

    Risk Management 102

    Diversication 103

    Stop Loss Points 105

    Risk-Reward 106

    Putting It All Together: Specic Trading Examples 110

    CHAPTER 7 Exchange-Traded Funds (ETFs) and

    Commodity Markets 129

    Timing Is Everything 129

    History of Exchange-Traded Funds 131

    Todays Commodity/Currency ETF Market 133

    Evaluating the Point & Figure Chart of Commodity ETFs 136

    Relative Strength Comparisons 139

    Know What Is Inside 147

    What Does the Future Hold? 151

    CHAPTER 8 Mutual Funds and the Evolution of the

    Commodity Markets 153

    From Fruit Baskets to Baskets of Fruit 153

    Oils Well That Ends Well? 155

    Soft Dollar? Try Franklins Hard Currency Fund 168

    Thinking Tactically about Cash 172

    Contemplating Cash 174

    The Big Picture? 177

    Commodity/Futures-Related Mutual Fund Vehicles 178

    CHAPTER 9 Final Thoughts 179

    APPENDIX : Commodity and Futures Reference Sheet 191

    Index 193

  • Preface

    For those who were investing at the time, it was the most remarkable,previously unfathomable, day in market history. For those who werenot yet investing, it was still a day of mythical proportions. The day

    I am referring to, naturally, is Monday, October 19, 1987. At Dorsey, Wright& Associates (DWA), we came to work expecting business as usual, but bydays end we experienced the largest one-day percentage drop in the DowJones Industrial Average ever recorded. The Dow Jones dropped roughly23 percent in one day, and after that the media began proclaiming a replayof 1929. DWA had been in business exactly 9 months and 19 days when thishappened.

    That day was significant to our corporate history because that singlesession changed the entire direction of DWA. It was as if we were movingfrom one train track to another. You see, we started out as an OutsourcedOptions Strategy Department, primarily servicing firms that did not oth-erwise have this type of department in-house. The blame for the crash of1987 was initially placed squarely on the shoulders of the options market,however, and in particular portfolio insurance strategies and naked put sell-ers. Some firms were said to be on the verge of going under because of theoptions liability exposed on that fateful day. For most firms, though, thingsworked out. The market eventually rebounded, and today the tales of thatone market session are legendary. Most advisers havent been in the busi-ness long enough to have firsthand knowledge of October 19, 1987, but forthose of us who have, it is a day that will not soon be forgotten.

    That day could be looked at as Wall Streets Big Bang. It marked thefinancial end for some, but the beginning for others. DWA survived, just asmost firms on Wall Street did, but that one day marked a new beginningfor Dorsey, Wright & Associates. For us, it meant moving away from theoptions business almost entirely, as I knew wholeheartedly at the end ofthat session that the options business would never be the same again. Iknew many firms would be enmeshed in litigation for years to come, thatI was likely to become an expert witness for my clients during this pe-riod, and that few firms would be increasing their options resources in the

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  • viii COMMODITY STRATEGIES

    near-future. That one day caused us to turn DWA around 180 degrees, push-ing the options business from the engine to the caboose of our train, andthe Point & Figure technical work to the front as our locomotive. It was anatural move for us, as we had employed the Point & Figure technical workin my Options Strategy Department at Wheat First Securities for years prior.But on that day, we were forced to begin marketing ourselves as technicalanalysts instead of options strategists.

    On October 20, 1987, I created the first Dorsey, Wright & Associatescommodity report. I knew that if we were going to move out of the optionsbusiness, we would need to fill that hole with something. Commodity pricesare governed by the irrefutable law of supply and demand, making it aseamless application for our Point & Figure work. I look at most things inboth life and business in the most simple of terms. Copper is, quite simply,a hunk of metal. Cocoa is simply a bean that grows, primarily on the IvoryCoast, and from time to time the locusts will come and wreak havoc. Coffeeis similarly a bean that Juan Valdez and others cultivate down in Colombia.By the same token, IBM is simply a stock that moves about on the New YorkStock Exchange, its prices governed by supply and demand imbalances.What makes the movement of cocoas price different from the movement ofIBMs price? One could offer that there are no cocoa CEOs to be carried outof their offices in handcuffs for various improprieties. There are no claims ofcorporate malfeasance thrust upon live cattle. But in terms of what causesa change in price, there is nothing different between a share of IBM and acontract of coffee. IBM is to cocoa as coffee is to copper, and so on.

    There is