The primary motive for any trader, investor or speculator is to make trading as profitable as possible. Primarily two techniques, fundamental analysis and technical analysis, are employed for making buy, sell or hold decisions. The technique of fundamental analysis is believed to be ideal for investments involving a longer time period. It is more research based; it studies demand-supply situations, economic policies, and financials as decision-making criteria.
Technical analysis is commonly used by traders, as it is appropriate for short term judgment in the markets--namely, deciding a quick buy and sell, entry and exit points, etc. It is pictorial; it analyzes the past price patterns, trends and volume to construct charts in order to determine future movement. These techniques can be used for trading all asset classes ranging from stocks to commodities. In this article, we will concentrate on commodities, which include things like cocoa, coffee, copper, corn, cotton, crude oil, feeder cattle, gold, heating oil, live cattle, lumber, natural gas, oats, orange juice, platinum, pork bellies, rough rice, silver, soybeans, sugar, etc.
Identifying the Market
The most popular indicators for commodity trading fall under the category of momentum indicators, which follow the trusted adage for all traders, “buy low and sell high.” These momentum indicators are further split into oscillators and trend following indicators. Traders need to first identify the market i.e. whether the market is trending or ranging before applying any of these indicators. This is important because the trend following indicators do not perform well in a ranging market; similarly, oscillators tend to be misleading in a trending market.
Let’s take a look at some of these indicators which are considered well suited for commodity trading.
- Moving Averages
One of the simplest and most widely used indicators in technical analysis is the moving average (MA) which is the average price over a specified period for a commodity or stock. For example, a 5-period MA will be the average of the closing prices over the last 5 days, including the current period. When this indicator is used intra-day, the calculation is based on the current price data instead of closing price. The MA tends to smoothen out the random price movement to bring out the concealed trends. It is a lagging indicator and is used to observe price patterns. A buy signal is generated when the price crosses above the MA from below (bullish sentiments) while when the price fall below it from above is indicative of bearish sentiments hence a sell signal. The MA is smoother and less sensitive in case of a long period vis-à-vis a short time period. The crossover by a short-term moving average above a longer term MA is suggestive of an upswing.There are many versions of MA which are more elaborate like exponential moving average (EMA), volume adjusted moving average, linear weighted moving average, etc. MA is not suitable for a ranging market, as it tends to generate false signals due to prices moving back and forth. Remember, the slope of the MA reflects the direction of the trend. The steeper the MA, move is the momentum backing the trend, while a flattening MA is a warning signal as there might be a trend reversal due to reduction in momentum.
The blue line depicts the 9-day MA, while the red line is the 20-day moving average and the 40-day MA is depicted by the green line. Among these the 40-day MA is the smoothest and least volatile while the 9-day MA is showing maximum movement with 20-day MA in between them.
- Moving Average Convergence Divergence (MACD)
Moving Average Convergence Divergence popularly known by its acronym MACD is a commonly used and effective indicator developed by Gerald Appel. It is a trend following momentum indicator that uses moving averages (MA) or exponential moving averages (EMA) for calculations. Typically, the MACD is calculated as 12-day EMA minus 26-day EMA. The 9-day EMA of the MACD is called the signal line and helps in identifying turns. A bullish signal is generated when the MACD is a positive value as the shorter period EMA is higher (stronger) than the longer period EMA. This signifies increase in upside momentum but as the value starts declining, it shows loss in momentum. Similarly, a negative MACD value is indicative of a bearish situation and if this tends to increase further it suggests a rise in downside momentum. If negative MACD value decreases, it signals that the down trend is losing its momentum. There are more interpretations to the movement of these lines like crossovers; a bullish crossover is signaled when the MACD crosses above the signal line in an upward direction. (Further reading: Exploring Oscillators and Indicators: MACD).
In the chart, the MACD is represented by the orange line while the signal line is purple. The MACD histogram (light green bars) is the difference between the MACD line and the signal line. The MACD Histogram is plotted on the centerline and represents the difference between MACD line and the signal line shown by bars. When the histogram is positive (above the centerline), it gives out bullish signals as the MACD Line is above its signal line.
- Relative Strength Index (RSI)
The Relative Strength Index (RSI) is a popular and an easy to apply technical-momentum indicator. It attempts to determine the overbought and oversold level in a market on a scale of 0 to 100, thus indicating if the market has topped or bottomed. According to this indicator, the markets are considered overbought above 70 and oversold below 30; however traders use their desertion about setting their preferred parameters. The use of a 14-day RSI was recommended by Welles Wilder but overtime, 9-day RSI (trade short cycle) and 25-day RSI (intermediate cycle) have gained popularity.
The popular ways to use RSI is to look for divergence and failure swings in addition to overbought and oversold signals. Divergence occurs in situations where the asset is making a new high while RSI fails to move beyond its previous high, this signals an impending reversal. Further if the RSI turns down to below its previous (recent) low, a confirmation to the impending reversal is given by the failure swing.
To get more accurate results, be aware of a trending market or ranging market since RSI divergence is not good enough indicator in case of a trending market. RSI is very useful especially when used complementary to other indicators.
George Lane based the Stochastic indicator on the observation that, if the prices have been witnessing an uptrend during the day then the closing price will tend to settle down near the upper end of the recent price range while if the prices have been sliding down, then the closing price tends to get closer to the lower end of the price range. The indicator measures the relationship between the assets price closing price and its price range over a specified period of time. The stochastic oscillator contains two lines. The first line is the %K which compares the closing price the most recent price range. The second line is the %D (signal line) which is a smoothened form of %K value and is considered more important among the two. The main signal that is formed by this oscillator is when the %K line crosses the %D line. A bullish signal is formed when the %K breaks through the %D in an upward direction. A bearish signal is formed when the %K falls through the %D in a downward direction. In addition, divergence also helps in identifying reversals. The shape of a stochastic bottom and top also works as a good indicator. Say for example, a deep and broad bottom indicates that the bears are strong and any rally at such a point could be weak and short lived.
A chart with %K and %D is known as Slow Stochastic. The stochastic indicator is one of the good indicators which can be clubbed best with the RSI among others.
- Bollinger Bands®
The Bollinger Band® was developed in the 1980’s by John Bollinger. They are a good indicator to measure overbought and oversold conditions in the market. The Bollinger Bands® are a set of three lines; the center line (trend) with an upper line (resistance) and a lower line (support). When the price of the commodity considered is volatile, the bands tend to expand while in cases when the prices are range bound there is contraction.
Bollinger Bands® are helpful to traders to detect the turning points in a range bound market; buying when the price drops and hits the lower band and selling when price rises to touch the upper band. However, as the markets enter trending, the indicator starts giving false signals especially if the price moves away from the range it was trading. Among other uses, they are considered apt for low frequency trend following.
The Bottom Line
There are many other technical indicators which are available to traders and picking the right ones is crucial. Make sure of their suitability to the market conditions; the trend-following indicators are apt for trending markets while oscillators fit well in a ranging market conditions. Applying them in the opposite way can result in misleading and false signals resulting in losses. For those who are new to using technical analysis, start with simple and easy to apply indicators.
By Prableen Bajpai, CFA (ICFAI)