The first step to a profitable commodity trade is coming up with an accurate commodity futures forecast. Next is to select the right trading vehicle to turn the forecast into cash. There are countless option and futures strategy combinations to choose from. For a particular market forecast, some vehicles will work and some will not. Do I use options or futures contracts or a combination? Here's my tips to increase your odds with the overall trade selection process.
Let's look at some methods.
First let's make up an UNBIASED two-month time-cycle forecast for each of the twenty-two major commodities. "Unbiased" means we try not to pay attention to the commodity name or media news, but rely only on the time cycle patterns. Also study the major trend, double and triple tops and other considerations. When in doubt, the forecast takes precedence over all other indicators.
The next step is to narrow down the twenty-two forecasts to ones that show promise. A time cycle forecast that shows a strong up-move or down-move gets put in the "possible" pile.
The time cycle forecast should be based on at least four combined individual time cycles that sometimes synchronize to produce big moves. The forecast gives time duration as well as direction. They may derived using spectral analysis and combined with a neural network, if one is so inclined; or a simple pair of dividers estimating lengths will do. The question is how strong the move will be. If all cycles are in synchronization, look for a strong, directional price move. If the cycles are conflicting, then a choppy range is more likely. Knowing when to expect a choppy market is valuable information for option writing strategies when collecting eroding option premiums.
Let's say our initial screening gives us three market candidates forecast to trend strongly up and three to go sharply down. We now have two categories with six markets. We want to eliminate the markets that are often redundant, like soybeans and soybean meal, or silver and gold, etc.
For the trending candidates, eliminate the markets that are approaching major tops or bottoms or may have problems getting through an obvious barrier. Trending bull or bear markets that look old and tired are also dropped.
We may want to sell high priced option premiums. Take a peek at the option premiums for each candidate to see if they are historically low. If so, eliminate them for option selling.
Finally, if you are left with more than three total candidates, narrow them down again using the raw time-cycle forecast. Remember that the cycles takes precedent over other methods.
We are now down to a few markets. Next, one market at a time, use a piece of option analysis software to search for the best strategies based on the expected market move. Compare these option to option combinations against futures to options combinations for trending markets. For selling options, we will look at option spreads. Generally, spreads are used only for risk reduction, if needed.
For each forecast, there can be many strategies to screen. The computer does all the grunt work. Screen the choices down to a strategy for each forecast that is a compromise between risk, profit and simplicity. Use your market experience and intuition to pick the very best one. In hindsight there is always a best strategy we could have used. Keep this is mind when narrowing down the choices. When finished, we want to have two to three potential trades to work with. We call the selected few, "high probability, low risk trades."
In the end you will have an optimized entry, exit and vehicle strategy for these selected market forecasts. This is the type of planning you want to do. If the trending trades work out well, you will want to implement other strategies that let you lock in profits while still holding for the big move. With the option selling strategies, you want to be able to make "adjustments" if things start out poorly. If thing go well, take profits and resell the options again if the premiums deflate quickly and leave the next strike or month series attractive. This assumes the time cycle forecast is still predicting a continued favorable move.
Remember there is more to planning a trade than just coming up with a forecast. The market may move as forecast but you can still lose by choosing the wrong trading vehicles. Pick the right vehicles and strategies that will allow you to stay in the market without excessive fear, but still carrying risk. You NEED to take on risk or the market will not pay you for your services. In addition, the vehicle has to move far enough to make a profit without letting the expense of protection eat it up. Protection can come in the form of option premiums, stop loss orders and spread strategies. Matching a forecast to a strategy is an important skill needed to succeed in trading commodities.
One last point. I often see traders making trades "just in case" the market goes up, or "just in case" the market goes down, etc. based on media news and general fears. Unless you have a strong conviction for market direction or lack of it, (a good forecast) just throwing money at good strategies will eat you up in expenses, in the end.
It's really back to the old tripod. You need three legs to stand. The forecast must be good and have a real reason behind it. Just because the news says so is not enough. Next you need the correct strategy and trading vehicle. Vehicles, risk and survival are part of the vehicle strategy. And finally, you need the faith and confidence to carry out the plan to completion. There is a fine line between stubbornness and sticking to a plan. That's why we need to know when to bend the rules. Rules need to be bent only when it involves matters of survival. Other matters are usually noise and our own demons attempting to unravel a well thought out program.
You don't have to be perfect. Just plan and execute your program better than the majority and you're well on your way.
Good Trading!
There is substantial risk of loss trading futures and options and may not be suitable for all types of investors. Only risk capital should be used.
Thomas Cathey - 27-year trading veteran heads the managed futures division of Thomas Capital Management, LLC. View his TimeLine Trading market predictions and get his complete 44+ lesson, "Thomas Commodity Trading Course" - they're all free. http://www.thomascapitalmanagement.com/commodity/welcome.htm Main site: http://www.ThomasCapitalManagement.com
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