VIEWPOINTS OF A COMMODITY TRADER

I have posted several articles on what I believe to be one of the best opportunities to make money in quite some time. The theme is to invest in agriculture for the long term. This is not a trading idea, and in fact there is technical evidence as well as cycle pressure that indicates a correction into March of this year before staging another advance.

When I first started to point out some of the supply/demand imbalances and how the relentless injection of money into the system could produce higher agricultural prices down the road, prices were depressed. Now the fundamentals seem to be playing out and we have seen a major advance over the last year or so.

In my opinion any weakness into March should be another great opportunity for investment.

Daily Wealth newsletter reports that the “U.S. Crop Stock Forecasts Deepen Fears of Food Crisis” read a recent Financial Times headline. The U.S. government cut its estimate for key crops. This came only a week after the U.N. warned that the world faces “food price shock.” Corn and soybean prices jumped and now sit at 30-month highs. Inventories are very tight. Corn is up 94% since June.

And the world worries about a repeat of 2008, when food riots erupted in poor countries around the world. (We are already seeing this)

This is no real mystery when one considers the following:

1- Population increases around the globe
2- Decreases in the ratio of arable land mass (land that can be farmed)
3- Potential inflation from the root cause of excessive money printing
4- Gains in crop yields are slowing creating tighter and tighter supplies
5- Shifting diets in emerging countries due to income growth

So, it’s not just about the supply and demand issues, it’s also about major shifts in what’s going on in the world today.

The Daily Wealth report goes on to say “Food prices will have to rise: There is no way around this. We are all going to pay more for food. Wells Fargo predicts U.S. retail food prices will rise about 4% this year. Some things will go up much more. Pork and beef could rise more than 10%.

Emerging markets are vulnerable: This follows from the above. It doesn’t really faze the typical American to have to pay 4% more at the grocery store. Food is still such a small part of the typical American’s budget. I think Michael Pollan in The Omnivore’s Dilemma points out that the U.S. spends 9% of its income on food, which is among the lowest percentage of any people anywhere at any time in history.

The same is not true in India or China or many emerging markets. In China, people spend 50% of every incremental dollar on food. And in India, it’s more like 70%. So the rising price of food is felt more keenly in these markets.

The price of food is rising faster in emerging markets too. In India, food prices are up 18% and at there highest level in a year. China has the same problem. Prices rose 5% in November alone. All around the world, emerging markets have a big problem with rising food prices. Indonesia’s president is trying to get people to grow their own chili peppers. And the South Korean government recently released emergency stores of cabbage, pork, mackerel, radish, and other staples. I could go on and on.”

So, the moral of the story is, on any weakness I believe a position in agriculture would be a very smart move for the long term, both as a hedge against future inflation and as a way to build net worth. Please read these previous posts for more research on the subject:

Previous Post on Grains 1

Previous Post on Grains 2

Previous Post on Grains 3

Previous Post on Grains 4

Previous Post on Grains 5

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There has been much tragedy in my life; where at least half of it actually happened – MARK TWAIN

Why do we always feel so bad when we are in a trading slump, or in a draw down if we are trading a system? Do we not realize that this is part of the process of being profitable in the long run?

While some kinds of suffering are inevitable and can’t be avoided others are self inflicted. The answer is that even though we know there are periods of draw down, we don’t really accept them when they arrive. We sometimes feel victimized, or fall into a high anxiety worry role. It always seems no matter how many draw down periods we have been through, that this one is different. The current one always looks like the one that’s going to break us.

We need to realize that trading and building an equity curve for the purpose of building net worth is in fact a game. Part of that game are set backs. No different than any other games we watch on any given Sunday. We don’t necessarily think our favorite football team has lost the game if the opponent is in scoring position.  We realize that’s part of the game, defending ourselves in the process of our own scoring. Even if they score, we then have the opportunity to score back on them. In fact, with out this threat, the game would cease to be a game and we would lose interest in playing.

We also add to our pain by being overly sensitive and taking ourselves way too seriously. We have a tendency to take a routine part of the game and blow it out of proportion. In other words I think that to a large extent how much pain you go through is directly correlated with how you respond to the situation. How we will respond will depend on whether we have really accepted set backs as part of the game, which are routine pauses in an ongoing process.

It really is a simple concept, but like most important things it’s anything but easy. It takes constant reminding. If we carefully examine the situation in an unbiased and honest way, we will realize that WE ARE RESPONSIBLE for how things will turn out. We are responsible for realizing a set back and playing through, or throwing in the towel in the grip of anxiety.

Human emotions are very powerful, and if not kept in check will cause us to make some pretty poor decisions. So if you find your emotions getting the best of you, go through this quick checklist. Remember what Helen Keller once said,
“Character cannot be developed in ease and quiet. Only through experience of trial and suffering can the soul be strengthened, ambition inspired, and success achieved.”

1- RELAX. Tell yourself it’s ok to be anxious. Welcome to the human race. You’re not supposed to feel good about draw downs, but if you want to win the game, going through draw downs is the price you pay to win. It is the difference between the winners and the losers.

DO WHAT’S RIGHT NOT WHAT’S COMFORTABLE.

2- Remind yourself of where your overall uncle point is, and if you are not there, then tell yourself that this is another routine set back, part of the process of winning.

CHANGE YOUR PERSPECTIVE ABOUT WHAT IS REALLY GOING ON.

3- DONT TAKE THE SITUATION OR YOURSELF TOO SERIOUSLY.
Have you ever noticed that once you’re through a draw down and your account is at new equity peaks you can’t even remember the pain in the same way? It seems like it was just another routine part of playing the game to win.

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I have written a number of times about the opportunity for investment in the agricultural sector of the commodities markets, if one has patience for a long term investment. I think it is postured to compete with any other asset class for risk adjusted returns over the next several years.

Global governments have gathered debt so massive that there is now concern whether it can be paid back at all without major disruptions for these countries, the U.S. included.  It’s easy to imagine that the value of currencies will be inflated down so dramatically that it presents a major opportunity for owning REAL THINGS that will become more valuable over time.

We have arable land issues and poor water conditions for growing, potential inflationary pressures and potential shortages that could fuel higher prices for quite some time to come. Of all the commodities that I can think of nothing is more valuable than food, especially in an inflationary environment, and particularly if there are demand driven shortages.

In a previous “Viewpoints” post, the foods were drifting in consolidation but lately prices are beginning to confirm the fundamental backdrop. Since the summer corn has appreciated by 47%, soybeans 30% and wheat 43%. There have also been major rallies in cotton and sugar.

I was reading an interesting article at DailyWealth.com on the subject and thought I would share some of the more salient points.

“In 2009, U.S. farmers grew 39% of the world’s corn – 307.4 million metric tons. The crop was worth $48 billion. Our corn exports totaled $8.7 billion. Here are some of the interesting excerpts.

“Most harvested corn in the U.S. is used to feed livestock – 43% of 2009 production. Almost as much (41%) was used for food, consumer, and industrial products (toothpaste, adhesives, cosmetics, starches, sweeteners, oils, beverages, industrial alcohol, fuel ethanol, etc.). The remainder was exported. The U.S. sent most of its corn to Japan, Mexico, and South Korea.”

“The second-largest corn grower, China, produced 165.9 million metric tons, or half the U.S. production. The European Union was a distant third, harvesting 62.7 million metric tons. Brazil checked in fourth, at 51 million metric tons.”

“In 2009, a severe drought in China killed millions of bushels of corn. Stockpiles dwindled to alarming levels as the government sold corn to keep the price from rocketing higher. Into 2010, the situation hasn’t improved. The Chinese have become net importers of corn for the first time in 16 years. Experts predict China will require 6 million to 8 million metric tons of corn this year.”

“The Chinese corn crunch reminds the world of the food shortages of 2006-2008. Average global prices for wheat, corn, and soybeans spiked more than 100%. Rice prices surged more than 200%.”

This chart of the Power Shares Agriculture Fund (DBA) shows the sharp rise in agricultural commodity prices from 2007 to 2008…

“This price rise resulted from changing diets in developing countries and the U.S.’s move to use corn as a fuel source (ethanol). From 2006 to 2008, total global grain consumption increased 3% per year, up from 2% per year from 2000 to 2006. People were eating more meat. You need seven pounds of feed grain to produce one pound of beef.”

“Increasing affluence leads to a desire for greater luxury in everything, including food. Developing and developed countries are now competing for what they want to eat. And that means prices are going up again. ”

“The U.S. produced $31 billion worth of soybeans in 2009. It’s our largest agricultural export. Total exports in 2009 exceeded $16 billion, setting a record.”

“The U.S. produced almost one-third of the world’s soybeans in 2009 (91.4 million metric tons). Brazil and Argentina combined for 50% more of the globe’s production. China produced 7%, and India produced 4%.”

“Soybeans are also used for animal feed. They have twice as much protein content as any other major vegetable or grain. Their protein also makes up many common meat and dairy substitutes, including soymilk and tofu. Soybean oil is used for food and industrial applications.”

“China has overtaken the U.S. as the leader consuming 45 million metric tons of soybeans compared with the U.S.’s 51 million metric tons. Last year, China consumed at least 60 million metric tons. The U.S. consumed less than 50 million metric tons.”

“Unfortunately for China, its domestic production can’t begin to satisfy its growing soybean consumption. In 2009, the Chinese imported more than 45 million metric tons of soybeans. Almost half came from the United States. Chinese producers harvested a little more than 15 million metric tons on their own.”

“The China National Grain and Oils Information Center is projecting total Chinese imports for 2010 will total 60 million metric tons. That would be a 33% increase over 2009. The U.S. will likely supply half of this. This demand is already driving soybean prices back toward their record 2008 levels of $16 per bushel…”

“The combination of increasing global demand coupled with the Fed’s quantitative easing makes a huge move higher in these commodities (and funds like the DBA) likely. Prices could soar high enough to trigger a global crisis.”

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Perhaps it is better to be irresponsible and right, than to be responsible and wrong – WINSTON CHURCHILL

I don’t know about you but I think it’s pretty confusing out there right now. How are the government interventions to the financial crisis going to play out? Is the result going to be rampant inflation? Are we going to be crushed under the debt? Should I buy gold and silver or are they in a bubble? How am I supposed to figure all this out? How do I make money?

The truth is no one knows what’s going to happen. On the other hand, do we really need to know what is going to happen to make money? I don’t think so. What we need to do is focus on the things that matter and the things we can control.

Even though we are poorly calibrated in estimating probabilities, we just love to do it. We think we are smarter and have better information than we actually do. Unfortunately most of the information has been discounted in the market or just plain doesn’t matter.

Carl Richards from behaviorgap.com says, “Overconfidence is a huge problem when it comes to making investment decisions. In fact, it’s a huge problem when we’re dealing with any issue that has an unknown outcome. It’s clear that we’re very bad at dealing with unknown outcomes, but the biggest problem is that we actually think we’re good at it. We think that we can control much more than we can, and we can actually forecast the future. Often we point to what we view as clear evidence and wonder how anyone that doesn’t see it the same way can be so stupid. Focusing on the things that matter and the things we can control will go a long way to avoiding investor overconfidence.”

Good trading requires flexibility and since predictions have an inflexible outcome, they can change our focus. If we get attached to our predictions our focus will shift from being profitable to being right. Being profitable “matters”, being right does not matter. Also we have no control over what the future may bring, but we can control our risk. We need to stay focused on what matters and what we can control.

It’s practically impossible not to have opinions on the markets, but the trick is to bankroll the opportunity that may be there and not the need to be right. Usually the academic predictor won’t predefine his risk because it doesn’t cross his mind that it’s necessary. As Mark Douglas said in Trading in the zone “the only way he could believe it is not necessary (to define risk) is if he believes he knows what’s going to happen next. The reason he believes he knows what’s going to happen next is because he won’t get into a trade until he is convinced he is right. At the point where he’s convinced the trade will be a winner, it’s no longer necessary to define the risk (because if he’s right there is no risk).”

Try not to be a bull or a bear but an opportunist. The opportunity seeker is influenced by the same endless opinions that dominate the news, yet he doesn’t allow himself into an inflexible point of view. He explores various scenarios and designs low risk trades to exploit the possible outcomes. He focuses on things he can control.

In the end, making money is a different game than being right or wrong. I know a lot of smart guys who were right about a market’s outcome but still went broke because they were inflexible. In short, they got too invested in being right and lost focus of the real goal, which is to make money.

Vincent Ryan Ruggiero, in his book Critical Thinker, says that one way to avoid falling into a committed trap is to train ourselves to think in terms of exception. Once the “case” has been made, begin to run through your mind the exceptions that could upset the case.

One exercise that I use all the time is to think in reverse. Whenever I feel very strong about a scenario, and find myself assuming I’m right, I take the exact opposite posture to see if there is a case there. The more exceptions that I can find, the less impact the original case has, and therefore the more cautious I am about my position. I try and stay focused on making money and not being right about my scenario. I concentrate on what I actually do have control over.

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 Common sense is the knack of seeing things as they are, and doing things as they ought to be done – C.E. Stowe  
 
I commented back on August 31^st about the fact that we see bubbles everywhere, and that the US Bond market was the next victim. My opinion was, that although I would not buy bonds myself at those levels, I could certainly understand the logic that yields could go lower. I believe we are in somewhat of a war where one opponent is the deflationary forces and the other inflationary. There is no doubt to me that we are living through a massive de-leveraging in the U.S., and on the other hand the massive government injections of money has inflation drooling in the background, hungry to pounce.

Markets have a tendency to continue their trend even after the fundamentals fail to support the continued advance. This is the definition of a bubble- a market running solely on speculation of higher prices. On the other hand you will see times where the market does not react to fresh fundamentals and in fact can begin heading the other way.

I think there is a very good possibility that the bond market is in camp number two here, ignoring good fundamental news for a continued advance. The inability to make new highs on the announcement of QE2 and the fact that the 10-year Treasury bond auction had the strongest demand in at least 16 years, is disturbing for the bull case.

In addition another warning sign is that the public feels more comfortable owning corporate paper as opposed to AAA U.S. Government paper. Mike Larson of Money and Markets pointed out months ago that “The relative behavior of different types of bonds — and the credit default swaps that reference them — tells you everything you need to know about who is really in good shape, and who isn’t. And right now, the trading action proves the U.S. is guilty of running a profligate, debt-ridden operation, one that’s in worse shape than some American corporations”

He noted where Berkshire Hathaway notes due in February 2012 dropped to 0.89 percent, 3.5 basis points below comparable-maturity Treasuries, in mid-March. Berkshire is officially rated AA+ by Standard & Poor’s, one notch below AAA. He also shows where Proctor and Gamble paper, rated AA-, due August 2012 notes, slipped to 1.12 percent, beating Treasuries by 6 basis points. Finally Johnson and Johnson’s August 2012 notes yielded only 3 basis points less than Treasuries. Unlike the other companies, it is rated AAA.

Also bothersome was when the  “U.S. Comptroller of the Currency (OCC) reported that America’s largest banks now hold $172.5 TRILLION in derivatives that are directly linked to interest rates, the most of all time. That’s over THIRTEEN times the amount they hold in credit derivatives — a primary cause of the 2008-2009 debt crisis.” said Martin Weiss of Weiss Management.

Another extreme development was seen recently when on Oct. 25, the U.S. Treasury auctioned $10 billion in treasury inflation protected securities, or TIPS, at a negative yield. In other words, it seemed that bidders were prepared to pay the U.S. government to own its debt.

Finally we have seen where the Thomson Reuters/Jefferies CRB index — a closely watched barometer of commodity prices — which has climbed to two-year highs recently, with some commodities exploding in price. See Related Post

So here we are, close to 60 years after the 1950 bottom in rates (around current levels) and 30 years after the 1980 peak at 15%. We have retraced the entire cycle from 1950. I’m not sure exactly what that means, but I do know that 30 years puts us in a rather mature trend, and more importantly we don’t have much further to ease rates where it makes any sense to take on the risk.

That’s what I think the bond market is saying. You don’t have to have a bubble to have a market go down. Bubbles imply ownership is irrational and I don’t think owning bonds is irrational. I just think it is a terrible risk reward investment at these rates of return.

Here is the old “a picture is worth a thousand words”-The interest rate cycle from 1950 to the present, compliments of Money and Markets.

 
Claus Vogt of Money and Markets points out that, “the huge money inflow has bond mutual fund managers so excited. Bond fund monthly inflows are rivaling those of stock mutual funds during their record year of 2000. Unfortunately financial history is telling us that whenever a market is being discovered by the masses it’s in the final stages of a secular bull market. Second, the chart pattern for Treasury yields may very well turn out to be a major bottom formation — a huge double-bottom. The first was a panic low associated with the banking crisis of 2008. The second low is currently in the process of being formed. Speculating on a new round of what the Fed has named “quantitative easing,” that is buying Treasury bonds with newly created money, seems to be behind the strong down move in yields during the past months. This move looks like front running of the Fed. Buy the rumor sell the fact” may well be the credo of many astute buyers.

“Knowing that another buyer with very deep pockets and no loss aversion is coming in later, recent buyers have driven prices up, determined to dump their holdings to market participants like the Bernankes of the world. Therefore, I believe there is a real possibility the planned effects of QE2 have already taken place in anticipation of the Fed’s next policy step. And the monetary bureaucrats may be in for a nasty surprise. Third, there are obvious divergences in the behavior of different maturities. Up to five-year yields have declined below the December 2008 low, as shown in the following chart …
 

Source:www.decisionpoint.com

But longer maturities haven’t…. look at 10-year yields in the chart below …

Source:www.decisionpoint.com

Divergences between maturities like divergences in different stock indices are a warning of a possible trend change. The inability of all maturities to confirm is characteristic of the last stages of a bull or bear market. This is important because interest rates are probably the most important market. They affect every other important market we must deal with, and have a major impact on our everyday life. So I would prepare for higher rates, possibly sooner than we think, and definitely for much longer than we would care to see.

Traders and more speculative investors may want to stalk a short position on the current rally.  Look at the yields up to the five year maturities and compare them to the 10 year and the thirty year to see if they can all make yield lows on this rally. Also look at the 10 year and the thirty year to see if they confirm each other by both going to new yield lows. A failure to do so and a turn up in rates would signal that a rate bottom is already in place.
 
 
 

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Well, you’re on your own, you always were, In a land of wolves and thieves, Don’t put your hope in ungodly man, Or be a slave to what somebody else believes – BOB DYLAN

Most traders and investors that I know are quicker to accept data processed from a computer than they are their own intuitions. I think the logic is that our intuitions are a bit mysterious; they seem to pop up out of nowhere and have little quantitative support to make an important decision. In reality however, our instincts and intuitions qualify much better to make investment decisions than a computer, providing you have enough investment or trading experience.

As I said in my post I like my information sliced thin, “These feelings are natural and should not be second guessed or ignored. After all, they are based on the culmination of all our experiences, just like data stored in a computer. Yet somehow we tend to think they are not as valuable as quantitative analysis. The gut feel and snap decision are just not taken seriously in the decision making world. In fact, we unconsciously make things up to substantiate our behavior in a more scientific fashion.”

The “adaptive unconscious” is a set of mental processes, thought to be involved in “high-level” cognition, influencing judgment and decision making. These processes are quite different from conscious decision making. We act faster, without effort, and are focused in the present. It is much easier to see this in action when watching a football game during a broken play or a musician in the depths of a jam session. Somehow the more experienced seem to know instinctively what to do. Even though this has nothing to do with the original game plan, it has everything to do with the cumulative experience of playing football or the saxophone. As Picasso once said, “Painting can’t be taught, only found.” In tennis, basketball, and Jazz, these instinctive reactions from the subconscious can sometimes dominate the play, and often prove to be some of the greatest matches or the greatest of art.

According to Sigmund Freud “the unconscious mind stored a lot of mental content which needs to be repressed. The term adaptive unconscious reflects the idea that much of what the unconscious does is beneficial to the organism; that its various processes have been streamlined by evolution to quickly evaluate and respond to patterns in an organism’s environment.” So in reality decisions made from intuition are anything but snap and irresponsible and actually have more empirical support than computer driven suggestions.

Perhaps a more thorough approach to trading would be to rely on statistical back testing and computer generated suggestions to a point, but also keep an open mind that these suggestions have limitations and need to be monitored constantly in the real world. Good instincts and intuitions are a great way of recognizing red flags. The trick is to sharpen those tools and act on them.

Malcolm Gladwell reveals in his book Blink, that “great decision makers aren’t those who process the most information, or spend the most time deliberating, but those that have perfected the art of “thin slicing”- filtering the very few factors that matter from an overwhelming number of variables.” A good reliable set of statistics that back a trading methodology is a great way of filtering a few factors that matter from an overwhelming number of variables. In addition a heightened awareness toward our instincts and intuitions will help us monitor our more quantified game plan for possible failures.

The famous painter Jackson Pollock once said, “It is only when I lose contact with the painting that the result is a mess. Otherwise there is pure harmony, an easy give and take, and the painting comes out well.”

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As one watches the day to day advice on CNBC, you will notice that we are inundated with stock advice. Bank of America this, Goldman Sachs that, and of course Apple Computer will run the world shortly. But when it comes to commodities, they are rarely explored with the exception of gold, copper and oil.

Granted, there have been some great single stock performances over the last 12 months, but as a whole the S&P has grossly underperformed most commodities. The S&P for the 12 month look back is up 8.3%. Also worthwhile mentioning is that this brings us into territory where we are trading at 21.57 times earnings with a dividend yield of 1.87%. Although there is always room for more stock upside, this is not a “cheap” market as we are told daily on CNBC.  

Now, let’s look at some commodities for that same period. Palladium is up 73% and Cotton is up 55%. In fact 21 different commodities have outperformed the S&P, and 17 of them are up 0ver 20% for the 12 month period. Natural gas and cocoa are the only commodities that are tracked here that are down over the last 12 months.

I don’t know what fools the Government takes us for, but they want us to believe that there is no inflation. The most recent inflation numbers posted by Robert Schiller reflect inflation running at 1.4%.

I have a question. Can we really expect a new cotton shirt to be up only 1.4% when cotton has gone up 55% in the last year? Will I still pay the same for breakfast when Pork bellies and OJ rose over 25%, and coffee over 38%? Can I expect my grocery bills to go up only 1.4% when wheat and oats went up over 30% and corn is up over 45%, Cattle up over 19% and hogs up over 29%? I doubt it.

I don’t think there is much question that commodities have been the place to be over the last year, and my guess is that they will be the place to be for some time to come. I think that if we are truly in a recovery then commodity prices will reflect the recovery and lead the way out. On the other hand, if this is a false alarm recovery boosted by the government QE1 and potential QE2 aid, then you will want to own “real things” and not paper or fiat currency.

So, wake up and smell the coffee as they say.
 
 

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Here’s the thing. If you can’t spot the sucker in your first half hour at the table, then you’re the sucker   – MATT DAMON from the movie Rounders
 

I think most of us will agree in order to be successful trading we need some kind of an edge. A good friend or relative who is willing to give us inside information where he is employed always works well, but most of us have to rely on something more fundamental or technical. I realize there are gifted people out there who have the ability to disseminate large amounts of information and draw accurate conclusions based on fundamental analysis, but I have always used technical analysis to gain my edge.

We use a model that is comprised of multiple trading systems, money management strategies and psychological disciplines, each of which give us an independent edge in that respective area. The combination of the three however is what really adds up to very playable over all edge.

When building an edge one must first consider what will drive the performance. Is it volatility, overbought and oversold counter trend conditions, or trends? Also how will you protect the capital when these conditions are not dominant?

Let’s examine one of the models that we use which is dependent on trends. It was developed in a joint effort between Angus Jackson, Inc. and Traders Tech., Inc. For all intent and purpose it is a trend capturing approach.  The first basic concept that needs to be understood is we need trends to succeed and a way of protecting the capital when markets are not trending.

Dean Hoffman, system developer and president of Traders Tech said “When you think about it, trends can be seen everywhere. Temperatures gradually trend from warm to cold as winter approaches. The demand for gasoline gradually trends higher during the summer driving months. Ground moisture trends from moist to dry when a drought approaches, and interest rates trend from high to low or low to high over time, and so on. All these events, whether seemingly natural or unnatural, can create sustained price trends in the futures market, and it is from these trends that we can try to profit.”

The real difference among traders is how they determine the beginning and end of a trend. A trader may define the starting point of a trend as something as basic as a change in the direction of a moving average. Counter-trend traders, on the other hand, might use this same indicator as a sign that the market is overbought and getting ready to head lower. Both are potentially correct depending on their exits. The real question is how can we quantify these trading approaches and code them into profitable trading systems.

Along with entry and exit methods, a trader must also have a position sizing and money management plan. Even if his entry and exit points are 90% accurate, if a trader risks it all on every trade, at some point the odds are substantially in favor of him losing all his money. By the same token, a system that is only accurate 10% of the time but has proper money management could do well. The bottom line is that traders need to know precisely how much of their account to put at risk in any given trade. It is also necessary to know how many positions to buy or sell whenever there is a signal. An expert system should provide traders with all this information and therefore an edge.

The final piece of the puzzle is proper trading psychology. It does not matter how brilliant a trader’s systems are, if he is unable to take the heat during the inevitable drawdown periods, he will fail. By the same token, if he gets too ecstatic during winning periods, he will also tend to fail. The key is emotional consistency. A trader must have complete confidence in his approach. This is where extensive (and proper) testing can help. Testing can help to build up solid proof that what a trader is doing works over the long run.

The more small edges a trader can build, the greater the probability of success. The small edges built into each system combined with those built into the money management and the psychological discipline will add up to enough total edge to trade with success.

In our model we use 5 different systems simultaneously, that will give a trader an advantage over only trading one. All these systems are essentially trend capturing, yet they also incorporate features that signal counter-trend following.  These different systems also communicate with one another and trade together as one integrated unit. For example, if one system has already invested heavily in Japanese Yen, the other four systems know not to take any more trades in that market. Doing so would not help to diversify but only raise the risk in the same trading idea.

Another unique edge that we have built is called “dynamic portfolio logic.” Unlike most systems that predefine a smaller portfolio to trade, our model trades almost every liquid commodity. The reason is because the systems rank the markets into percentiles on a daily basis. It then narrows the list down to only those few markets that have the highest relative trending potential. The net result of this filter is an edge that shows us where the best opportunities lie. It also guards us against the possibility that the best trends may surface in markets that are not in a static portfolio we may have chosen.

We have also paid close attention to position sizing and money management. It specifically manages how many contracts to enter when a trader gets a trading signal. This is essential because different futures contracts have different volatilities and trading them all in equal numbers would not be properly diversifying. If a contract, for example, tends to have high-volatility, a trader should trade fewer of those than another whose volatility is lower. We use a trader’s account size to determine the proper position size for each trade he makes.

Frequently the right position size is simply zero, and there are four reasons for this:

First, if the trade occurs in a market that is not strong enough in rank to be in the dynamic portfolio. Second, if, given the account size, the risk in the trade is just too high. Third, if there is already enough risk held in that given sector. And finally, if there is already enough risk across all the current positions in the portfolio.

The model does not risk more than 1.5% of a traders account size in any given trade. It will also not risk more than 5% of his account in any given sector. Let’s suppose, for example, that a trader purchases crude oil for his account. If the risk in that trade amounts to 5% or more, the model will not take new trades in any markets that are highly correlated such as unleaded gasoline.

The model will not risk more than 15% of a trader’s entire account at any given time. Meaning, if every trade a trader is in were to hit its stop price simultaneously, the total should represent no more than about 15% of the entire equity of the trader’s account. Once the risk level either reaches or goes past this 15% level, it will reject all new trades and return a position size of zero.

In summary, this was our attempt to build a model of small edges in each category of method, management and psychology, so when combined, we would have a large enough edge to trade with confidence.

The goal was to capture trends in trending periods, while protecting the capital in trendless periods.

Now, as we know, no matter how much precaution a trader takes, money can be lost and therefore any model should be monitored daily for red flags. After all, in a profession of such uncertainty, anything can happen, so we have to prepare for this before putting our money on the line.  Having an edge (or a series of them) is essential.

In the movie “Rounders,” Matt Damon who plays a skilled poker player, says in the opening scene:

“Here’s the thing. If you can’t spot the sucker in your first half hour at the table, then you’re the sucker.”

So don’t get taken. Ask yourself “what is my edge and how will I be protected when my edge is not working.”

If you would like to receive a detailed research report on our model please email me at charles@viewpointsofacommoditytrader.com or call (800) 858-2340 Toll Free.
 
 

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By Charles Maley and Nick Pingitore
 
 
I don’t know how to sit outside myself and test against a hypothetical self who stayed home – THOM GUNN 
 
I have had the great pleasure of working with Nick Pingitore for the last 10 years. After being a client of mine for over five years, Nick and I decided to team up and further research our ideas about building “real world” trading systems.

Nick is an engineer by degree and therefore has a great background for the mathematical challenges of “back testing.” In fact, of all the system developers that I have worked with (and there are plenty) I think Nick has one of the best grips on just how challenging it is to build a reliable trading system.

It’s not what you think though. It’s not because he has found ways around the limitations of “the back test,” it’s because he knows you can’t. Therefore he must build in strict money management to address the inevitable surprises of randomness.

Nassim Taleb, in his book The Black Swan, coined the phrases Mediocristan and Extremistan to distinguish between two types of randomness. All randomness is not created equal and must be dealt with, as it is what destroys most trading systems in the “real world”.

In Mediocristan, everything has boundaries and limits that can be easily measured. Things like IQ scores, height, and weight, and how much people smoke would be examples of Mediocristan.

If we were to randomly select 1000 people and calculate the mean weight, we can be reasonably assured that no one sample will dominate the distribution. In other words, you may find the average weight of 1000 men to be 200 lbs, but you won’t find a man weighing in at 200,000 lbs. Even the heaviest man in the sample will not materially affect the mean value of a distribution.

In Extremistan, the variation within distributions is quite different. In Extremistan, one sample can affect the entire distribution.

Let’s say that instead of weighing the 1000 men we find out their incomes. Now, even though the mean income might be $75,000 for 999 men, what if the final entry made 75 million a year? Now we have one event that’s 1000x the mean and also doubles the mean value.

This one sample (event) can change the entire distribution, and in some ways makes it meaningless to depend on. After all, if I am trying to get some idea of what to expect from sampling, and one event can ruin the whole thing, what good is it?

Joan Baez once said “hypothetical questions get hypothetical answers.” When building a trading system, we need to be aware of the limitations of the back test and not buy entirely into the hypothetical suggestions. We not only need to be aware of potential extreme randomness, but we also need ways of protecting ourselves when it happens.

In a recent article about building trading systems Nick said, “Traits that make a good system developer are often the opposite of those that make a good trader. A developer always wants to improve their methods and make them as efficient as possible in regard to risk and reward. A trader understands that there is no efficiency in making money and takes profits when the market gives it to them, while continually managing their risks.”

Most system developers constantly evolve their systems to produce better and better backtests (with hindsight, of course). Our strategies, however, were not developed prior to trading, but only after several successful years of trading and analyzing what consistently works in real-world trading.

In other words, we built our systems around our “real world” trading that was successful as opposed to creating something in the computer that “should work in the real world.”

Nick goes on to say, “Unfortunately, there is no perfect system that works in all market environments. The key in trading is to use the right system in the right market environment, but this is an art based on years of experience and insight. There are, however, some robust methods that can be used to implement commodity trading systems or strategies into the real world and make the crossover from hypothetical to reality as least painstaking and unexpected as possible.”

“We focus on two main priorities in implementing commodity trading systems into the real world. The first is on breaking down the robustness of the performance and the second is on managing risk and exposure, including keeping the maximum drawdown within reason.”

To break down the robustness of a system, we do two types of tests. The first is to obtain a set of robust metrics on the commodity trading system. The second is to test across a large set of data followed by several subsets.

The metrics that we feel are the most reliable are:

1. High positive Mathematical Expectation
2. Large average trade
3. Low standard deviation of daily returns
4. High MAR Ratio
5. Low leverage and exposure
6. Low or positive tracking error
7. High profit /cost ratio

(Note: for any test to be of any value, testing on markets only liquid enough to trade and realistic slippage and commission assumptions must be used.)

In the trading world we have a duel edged sword. On one hand we are unfortunately held hostage to the same extremistan surprises that could blow us up. On the other hand these are the events that can make us wealthy. In trading, it is the same extreme moves that make the effort worthwhile.

It is one of those businesses that one or two big events (trades) can make your whole year. Just like authors or rock stars where a handful of stars generate most of the revenues, a handful of trades do the same thing.

The trick is staying alive long enough to be there when they come.
 
 
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Filed under: Trading Methods by CN

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Here are some excerpts from our readers favorite posts over the last year or so. If you like the sample just click to read the full post:

“Analysis can be equated with poker. Security analysts carefully follow the table talk of the game and examine the up-cards. Although analysts effectively follow and communicate these two aspects of the game, they either ignore or ineffectively guess at the other major element-the down-cards.” Read Full Post

“The most important rule of trading is to play good defense, not great offense. Every day I assume every position I have is wrong. I know where my stop risk points are going to be. I do that so I can define my maximum possible draw down.” Read Full Post

“Gamblers think they are betting on red or seven but in reality they are betting on the clock. The loser wants a short run to look like a long run so the odds will prevail. The winner wants a long run to look like a short run so the odds will be suspended.” Read Full Post

“Many major problems people have in trading are caused by their expectations – of where the market is headed, how much money will they make from this trade, etc. One thing I learned that has helped me: it is wrong for a person to enter any market with any preconceived expectations.” Read Full Post

“The great danger is in confusing courage with bravery. The market is no place for heroics. That is for another battlefield. In the market place it often takes more courage to live than it does to die. The greatest courage is the one that lets you graciously admit that you are wrong when you no longer have a good reason to trade. The courage associated with the hero often destroys the courage that is needed to be successful. I have witnessed cases where temporarily successful traders have lost their touch because they lost their courage.” Read Full Post

“As people find out more about a situation, the accuracy of their judgments is not likely to increase, but their confidence does increase, as they fallaciously equate the quantity of information with its quality.” Read Full Post  This can cause us to put the blinders on when we see negative information. It can also cause us to have a larger position than we should, or be over weighted to one position. Most important, it seems the more we overestimate what we think we know, we simultaneously underestimate what we don’t know ……the downside risk.  

“Great decision makers aren’t those who process the most information, or spend the most time deliberating, but those that have perfected the art of “thin slicing”- filtering the very few factors that matter from an overwhelming number of variables.” Read Full Post

“We have seen how good we are at narrating backwards, at inventing stories that convince us we understand the past. In spite of the empirical record we continue to project into the future as if we were good at it, using tools and methods that exclude the rare events.” Read Full Post  Funny isn’t it, since the big, rare, unpredictable events are precisely what shape the world. Events like the automobile and the World Wars, the internet and the Beatles.

“Systems trading is ultimately discretionary.  The manager still has to decide how much risk to accept, which markets to play, and how aggressively to increase the trading base as a function of equity change.  These decisions are quite important, often more important than trade timing.” Read Full Post
 
 
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