Commodity Strategies: High-Profit Techniques for Investors and Traders

208 Pages·2007·10.37 MB·English

Commodity
Strategies
Founded in 1807, John Wiley & Sons is the oldest independent publish-
ingcompanyintheUnitedStates.WithofficesinNorthAmerica,Europe,
AustraliaandAsia,Wileyisgloballycommittedtodevelopingandmarketing
printandelectronicproductsandservicesforourcustomers’professional
andpersonalknowledgeandunderstanding.
TheWileyTradingseriesfeaturesbooksbytraderswhohavesurvived
the market’s ever-changing temperament and have prospered—some by
reinventing systems, others by getting back to basics. Whether a novice
trader,professionalorsomewhereinbetween,thesebookswillprovidethe
adviceandstrategiesneededtoprospertodayandwellintothefuture.
Foralistofavailabletitles,pleasevisitourWebsiteat
www.WileyFinance.com.
Commodity
Strategies
High-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(cid:2)C 2007byThomasJ.Dorsey,TammyF.DeRosier,SusanL.Morrison,PaulL.Keeton,
andJoshuaB.Parker.Allrightsreserved.
PublishedbyJohnWiley&Sons,Inc.,Hoboken,NewJersey
PublishedsimultaneouslyinCanada.
WileyBicentennialLogo:RichardJ.Pacifico
Nopartofthispublicationmaybereproduced,storedinaretrievalsystem,ortransmittedinany
formorbyanymeans,electronic,mechanical,photocopying,recording,scanning,orotherwise,
exceptaspermittedunderSection107or108ofthe1976UnitedStatesCopyrightAct,without
eitherthepriorwrittenpermissionofthePublisher,orauthorizationthroughpaymentofthe
appropriateper-copyfeetotheCopyrightClearanceCenter,Inc.,222RosewoodDrive,Danvers,
MA01923,[phone],fax[phone],oronthewebatwww.copyright.com.Requeststo
thePublisherforpermissionshouldbeaddressedtothePermissionsDepartment,JohnWiley
&Sons,Inc.,111RiverStreet,Hoboken,NJ07030,[phone],fax[phone],oronline
athttp://www.wiley.com/go/permissions.
LimitofLiability/DisclaimerofWarranty:Whilethepublisherandauthorhaveusedtheir
besteffortsinpreparingthisbook,theymakenorepresentationsorwarrantieswithrespect
totheaccuracyorcompletenessofthecontentsofthisbookandspecificallydisclaimany
impliedwarrantiesofmerchantabilityorfitnessforaparticularpurpose.Nowarrantymaybe
createdorextendedbysalesrepresentativesorwrittensalesmaterials.Theadviceandstrategies
containedhereinmaynotbesuitableforyoursituation.Youshouldconsultwithaprofessional
whereappropriate.Neitherthepublishernorauthorshallbeliableforanylossofprofitorany
othercommercialdamages,includingbutnotlimitedtospecial,incidental,consequential,or
otherdamages.
Forgeneralinformationonourotherproductsandservicesorfortechnicalsupport,please
contactourCustomerCareDepartmentwithintheUnitedStatesat(800)762-2974,outsidethe
UnitedStatesat(317)572-3993orfax(317)572-4002.
Wileyalsopublishesitsbooksinavarietyofelectronicformats.Somecontentthatappears
inprintmaynotbeavailableinelectronicbooks.FormoreinformationaboutWileyproducts,
visitourwebsiteatwww.wiley.com.
LibraryofCongressCataloging-in-PublicationData:
Commoditystrategies:high-profittechniquesforinvestorsandtraders/
ThomasJ.Dorsey...[etal.].
p.cm.—(Wileytradingseries)
Includesindex.
ISBN978-0-470-12631-8(cloth)
1.Commodityexchanges.2.Speculation.3.Investmentanalysis.
4.Commodityfutures.I.Dorsey,ThomasJ.
HG6046.C6622007
332.64′4—dc22 2007012415
PrintedintheUnitedStatesofAmerica
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
ChartPatterns 14
TrendLines 15
PriceObjectives 25
CHAPTER 3 Using Spot Charts 31
CommodityMarketIndexes 32
SpotCurrencyCharts 41
OtherUsefulSpotandContinuousCharts 48
CHAPTER 4 Relative Strength with Commodities 59
RSCalculationExample 60
CHAPTER 5 Other Strategies and Tools 71
SupportandResistance 71
BigBaseBreakouts 75
ChangingBoxSize 77
UsingPullbacksandRalliestoImproveRisk-Reward 82
Momentum 85
TradingBands 90
v
vi COMMODITYSTRATEGIES
CHAPTER 6 Putting It All Together 95
PartOne:OldFriendswithaNewTrend 95
OurApproach 97
TrueDiversification—YouDon’t HavetoGoFartoFindIt 98
PuttingItAllTogether 100
PartTwo:InitiatingandManagingaPosition 102
RiskManagement 102
Diversification 103
StopLossPoints 105
Risk-Reward 106
PuttingItAllTogether:SpecificTradingExamples 110
CHAPTER 7 Exchange-Traded Funds (ETFs) and
Commodity Markets 129
TimingIsEverything 129
HistoryofExchange-TradedFunds 131
Today’sCommodity/CurrencyETFMarket 133
EvaluatingthePoint&FigureChartofCommodityETFs 136
RelativeStrengthComparisons 139
KnowWhatIsInside 147
WhatDoestheFutureHold? 151
CHAPTER 8 Mutual Funds and the Evolution of the
Commodity Markets 153
FromFruitBasketstoBasketsofFruit 153
OilsWellThatEndsWell? 155
SoftDollar?TryFranklin’sHardCurrencyFund 168
ThinkingTacticallyaboutCash 172
ContemplatingCash 174
TheBigPicture? 177
Commodity/Futures-RelatedMutualFundVehicles 178
CHAPTER 9 Final Thoughts 179
APPENDIX: Commodity and Futures Reference Sheet 191
Index 193
Preface
F
orthosewhowereinvestingatthetime,itwasthemostremarkable,
previouslyunfathomable,dayinmarkethistory.Forthosewhowere
notyetinvesting,itwasstilladayofmythicalproportions.Theday
Iamreferringto,naturally,isMonday,October19,1987.AtDorsey,Wright
&Associates(DWA),wecametoworkexpectingbusinessasusual,butby
day’sendweexperiencedthelargestone-daypercentagedropintheDow
Jones Industrial Average ever recorded. The Dow Jones dropped roughly
23percentinoneday,andafterthatthemediabeganproclaimingareplay
of1929.DWAhadbeeninbusinessexactly9monthsand19dayswhenthis
happened.
That day was significant to our corporate history because that single
sessionchangedtheentiredirectionofDWA.Itwasasifweweremoving
fromonetraintracktoanother.Yousee,westartedoutasan“Outsourced
Options Strategy Department,” primarily servicing firms that did not oth-
erwise have this type of department in-house. The blame for the crash of
1987wasinitiallyplacedsquarelyontheshouldersoftheoptionsmarket,
however,andinparticularportfolioinsurancestrategiesandnakedputsell-
ers.Somefirmsweresaidtobeonthevergeofgoingunderbecauseofthe
optionsliabilityexposedonthatfatefulday.Formostfirms,though,things
workedout.Themarketeventuallyrebounded,andtodaythetalesofthat
onemarketsessionarelegendary.Mostadvisershaven’tbeeninthebusi-
nesslongenoughtohavefirsthandknowledgeofOctober19,1987,butfor
thoseofuswhohave,itisadaythatwillnotsoonbeforgotten.
ThatdaycouldbelookedatasWallStreet’s“BigBang.”Itmarkedthe
financialendforsome,butthebeginningforothers.DWAsurvived,justas
most firms on Wall Street did, but that one day marked a new beginning
for Dorsey, Wright & Associates. For us, it meant moving away from the
options business almost entirely, as I knew wholeheartedly at the end of
that session that the options business would never be the same again. I
knewmanyfirmswouldbeenmeshedinlitigationforyearstocome,that
I was likely to become an expert witness for my clients during this pe-
riod,andthatfewfirmswouldbeincreasingtheiroptionsresourcesinthe
vii
viii COMMODITYSTRATEGIES
near-future.ThatonedaycausedustoturnDWAaround180degrees,push-
ing the options business from the engine to the caboose of our train, and
thePoint&Figuretechnicalworktothefrontasourlocomotive.Itwasa
naturalmoveforus,aswehademployedthePoint&Figuretechnicalwork
inmyOptionsStrategyDepartmentatWheatFirstSecuritiesforyearsprior.
Butonthatday,wewereforcedtobeginmarketingourselvesastechnical
analystsinsteadofoptionsstrategists.
On October 20, 1987, I created the first Dorsey, Wright & Associates
commodityreport.Iknewthatifweweregoingtomoveoutoftheoptions
business,wewouldneedtofillthatholewithsomething.Commodityprices
are governed by the irrefutable law of supply and demand, making it a
seamlessapplicationforourPoint&Figurework.Ilookatmostthingsin
bothlifeandbusinessinthemostsimpleofterms.Copperis,quitesimply,
ahunkofmetal.Cocoaissimplyabeanthatgrows,primarilyontheIvory
Coast,andfromtimetotimethelocustswillcomeandwreakhavoc.Coffee
issimilarlyabeanthatJuanValdezandotherscultivatedowninColombia.
Bythesametoken,IBMissimplyastockthatmovesaboutontheNewYork
Stock Exchange, its prices governed by supply and demand imbalances.
Whatmakesthemovementofcocoa’spricedifferentfromthemovementof
IBM’sprice?OnecouldofferthattherearenococoaCEOstobecarriedout
oftheirofficesinhandcuffsforvariousimproprieties.Therearenoclaimsof
corporatemalfeasancethrustuponlivecattle.Butintermsofwhatcauses
achangeinprice,thereisnothingdifferentbetweenashareofIBManda
contractofcoffee.IBMistococoaascoffeeistocopper,andsoon.
There is no question in my mind that the Point & Figure method of
analysisisbestsuitedtoevaluatingthosebasicimbalancesbetweensupply
and demand. Charles Dow himself popularized this methodology in the
late 1800s because he wanted a logical, sensible way of recording supply
and demand in the market. This was the case in spite of the fact that he
wasafundamentalistatheart.ThePoint&Figurechartfitbeautifullywith
commodities and in very short order our company was in the commodity
businessnearly20yearsago.
At the time, I had never seen a soybean, or a cocoa bean, or even a
coffee bean that wasn’t already ground. Armed with the Point & Figure
chart, I was an expert in their price movement just the same. I knew that
ifthereweremorebuyersthansellerswillingtosellgold,thepriceofgold
would rise. Conversely, if there were more sellers than buyers willing to
buy gold, the price would decline. If supply and demand for gold was in
perfectbalance,thepricewouldremainthesame.Thereisnothingelseto
consider.InOctober1987,Icreatedourfirstcommodityreportandhadit
marketedtoafirmbythenameofInterstateSecurities.Theyhadoneofthe
mostprogressivecommoditydepartmentsinthecountryandimmediately
likedwhatwehadtooffer.
Preface ix
Still,itturnedouttobetherightproductatthewrongtime.Thestock
marketwasinthemiddleofa20-yearbullmarket,whilecommoditieswere
amidsta20-yearbearmarket.Thereportwehadcreateddidn’ttakeoffas
wewouldhavehoped;itwas,quitesimply,13yearsearly.
Hadwehungourhatonthissingleproduct,oranysingleproductre-
ally, we would have ended up in Wall Street’s graveyard, as Mr. Hamilton
suggestsinChapter1.ThebeautyofPoint&Figureisthatitisadaptiveto
anyfreemarket,andwhilethecommoditybusinesswasreadytocontract
significantly for the next 13 years, the Point & Figure Technical Analysis
skill we had developed for many years prior to Watson’s and my starting
Dorsey, Wright & Associates was applicable to many other facets of Wall
Street.
There was one more act to the commodity show before we allowed
it to atrophy back in 1987. There was a hedge fund manager in Europe
who was a client of ours on the equity side. I talked to him one day and
told him that his temperament was more suited to commodity trading. I
offered him our commodity report for free so that he could get familiar
withtradingcommoditiesonpaperbeforeventuringintotherealworldof
platinumandporkbellies.ThisbeganalongandintriguingstoryatDWA,
much of which I can only look back on and shake my head. It took this
client about three months to get used to commodities and then one day I
receivedacallfromhim,“Tommy,I’mready.”Ireplied,“Readyforwhat?“
Unabashedly,heoffered,“Commoditytrading.”Well,therubberhittheroad
thatsecond,andIwasimmediatelycalledupontoadvisethislargehedge
fundoncommoditytrading,andIhadnevertradedthefirstcommodityin
mylife.Ihadadisciplinedmethodologytofallbackon,butverylittleelse
atthattime.
I set up this client with an introducing broker to clear through and
we were off and running. If you can recall the last time you sat down to
watch the Kentucky Derby, the horses are all in the gates, the bell rings,
thecommentatorthenoffersheartily,“Andthey’reoff.”Well,thatwasus.
Thishedgefundmangerhadtheintestinalfortitudeofeitheragladiatoror
one of those “lovely apprentices” that allows someone to throw knives at
them. We started trading 500 lots of currencies at a time. A 500-contract
positioninsomethingliketheeurotodayisstillamassiveposition,over83
millionUSdollarsworthofeuros.AtthattimeIeitherdidn’torcouldn’tfully
conceptualizethescopeofthesepositions;itwassimplycolossal.Cometo
thinkofit,Idon’tthinkweeverhadacalculatorthatwouldquantifythat
amountofleveragebackthen,sowejustdidn’tgetthefullflavoroftherisk
weweretaking.Today,Iwouldbreakoutintoacoldsweatwithaposition
thatsize.Butbackthen,wedidit,diditregularly,anddidn’tflinch.Buying
600 gold contracts for this client became commonplace. At this writing,
eachcontractcontrols100ounces,or$50,000,worthofgold.Sixhundred