PART ONE: OLD FRIENDS WITH A NEW TREND

By this point in our journey we hope that at a minimum we agree on two things: (1) that simply having a set of rational tools at your disposal is quite helpful in deciphering the commodities markets, and (2), that none of these tools need be hoes, pitchforks, or McCormick's famous reaper. Rather, while remaining attentive to a few key ingredients, which pertain to any commodity, we can begin to train ourselves to find consistent opportunity in the futures market. Certainly, there are times that seemingly present great opportunity, a bumper crop if you will, and others that reflect a market wedged between trends; however, a trend-following system can be the biggest contributor to success in commodities. When trading with the trend it is as if the wind is at your back, filling your sails. Mistakes can still be made, but often it would take a series of mistakes to cause major damage as long as you stay with the prevailing trend. However, the process of forming a long-term top or a long-term bottom can be the most painstaking, and profit-killing, part of trading. This is the period where trends are changing, and most investors are either reluctant, or oblivious, in admitting this possibility.

This takes us back to what is simply the nature of trends. Like any natural process, a trend consists of a series of stages. Like infancy and death, the birth and demise of market trends are typically the most difficult to endure. Think back to the top of the technology stock bubble in late 1999 and early 2000, a key inflection point that marked both the death of one trend and the infancy of another. This type of trend change is likely most confusing for some because the market was not topping for lack of optimism, as that was one commodity that was certainly not short of supply. Amazon.com's CEO Jeff Bezos was named Time magazine's “Person of the Year” in late 1999, and no other magazine cover seemed complete without an unswerving blessing being placed on some four-letter stock symbol. It was not a lack of demand that caused the tech bubble to reverse course out of a stern upward trend, it was a lack of new demand. It wasn't that there were no investors willing to jump on shares of Cisco Systems, or Lucent Technologies, or even Pets.com for that matter; it was just that practically everyone with the capacity (or margin) to do so already owned these stocks. If Worth magazine went to the presses with a bold cover featuring Cisco Systems CEO John Chambers and the statement “BUY HIS STOCK,” which they did in 2000, the few investors that didn't already own CSCO shares likely dropped what they were doing and piled in like sheep. But, to do so, they had to first sell some Microsoft stock because in early 2000, not only were most investors fully invested, but likely on margin. So adding demand to one tech stock meant adding supply to another; the end result was no new demand being added to the market on a net basis—the kitchen pot is simply stirred but no heat is being added.

Bottoms in the market happen similarly, but with a lack of new supply able to be generated rather than a lack of new demand. A great example of this process taking place recently on a large scale is right here in the commodities market. As the technology bubble was bursting, those who escaped with their shirt still firmly on their backs (though I think every-one lost at least a few token cufflinks) hid assets in “safer” areas of the market. The massive move higher in market indexes during the late 1990s, much of which was propelled by a handful of technology stocks, meant that there was an unprecedented amount of capital in the stock market when the tech stocks began to fold their hand. Investing had become mainstream you might recall, and everyone was tied to the market—or “married to the market,” as a memorable cover of News week magazine quoted at the time. At any rate, some (we should say many ) of those assets never made it past the stage of “unrealized” returns, but those that did began flowing into other areas of the market, creating bull markets in sectors like health care, energy, and real estate. This was also the beginning of a trend of out-performance of small-cap value stocks over the floundering large-cap tech behemoths. The rampant inflation ceased with the tech bubble, sparking a massive bull market in bonds that has outlasted most any pundits' original estimations. So, while those living on Planet Technology felt as if an asteroid had just hit and wiped out life as they knew it, another door opened to many other forms of life in the markets. And in some cases, it was a chance at a second life for some stodgy old assets like commodities. This “chance” was available to anyone who was willing to be open-minded about the possibility that trends were achangin'. Those that weren't watching for trend changes went down with whatever ship.com they were on at the time.

Earlier in the book you saw the very same charts that we saw developing from mid-1999 to mid-2001. These were commodity indexes finding bottoms and beginning to show very clear indications of just what the technology stocks were lacking over on the NASDAQ—new demand! Charts of gold, copper, crude oil, and many other assets placed distinct bottoms throughout the years of 1999 through 2001, and it happened in many cases because so many investors simply threw in the towel and gave up on the idea of making money in these assets. Crude oil was at $11 per barrel in 1999, hardly a precious commodity at that price, and The Economist magazine even ran a cover with the title, “Drowning in Oil.” Meanwhile, gold stocks had long since become the stepchildren of Wall Street by 2001. The shares of gold-mining companies still traded (occasionally), but those who traded them were treated with about the same esteem as those “New Economy” supporters were at the top of the dotcom bubble. There were roughly 20 gold and silver stocks that traded on the major exchanges when gold began to bottom, and in an act that perhaps personified the level of disdain that Wall Street held for this band of misfits, the great wirehouses on Wall Street actually began to halt fundamental coverage on the sector. If that isn't a sign of a bottom forming, I don't know what is.

While it wasn't one particular event that drew our attention toward the commodity market during this time, it was the culmination of these many developments that caused an almost unconscious fascination with this changing environment; indeed, it was the weight of the evidence presented by the commodities market that drew our gaze. In fact, for years we had held a small corporate commodity account open with REFCO in New York, and this account was essentially forgotten until tax time every year. The changes we began seeing in the commodities market in 1999, however, were decisive enough for us to dust off the trading hats and begin actively investing that account in early 2000. At the time, this account carried a balance of only $18,891 into the year 2000, but as you will see that is a suitable stake to begin diversifying into the commodities market.

Our Approach

Now, as a form of disclosure, we should mention here that we have not withdrawn any money from this account, nor have we contributed any new money, since becoming active with it in 2000. While there may have been instances along the way where margin was employed, this would be very rare indeed and the account by and large maintained a very low-risk approach toward commodities trading with typically only a few positions on at any given point in time. We weren't overly active with the trading—after all, we each had day jobs—but when we found opportunities where the weight of the evidence suggested we play it, we did so. We carried no emotional attachment, which you will find is a discipline far easier to employ with commodities than with stocks. We played the market both long and short, but making certain that just about every trade was with the prevailing trend at the time. We always placed stop loss orders on our trades and very rarely risked any more than $1,000 on any given trade. The results of this portfolio over the last five years are what we would expect from a disciplined trend-following application of the Point & Figure methodology, simply applying the tools we have discussed in previous chapters (see Exhibit 6.1).

In the end, the Dorsey, Wright & Associates (DWA) account essentially serves as an example that there are always opportunities to be found in the markets, if one is willing to look where others can't or won't. This willingness can have an extremely positive impact on one's portfolio over time. With relatively little activity, and little, if any, margin employed over the past five years, that account had grown to a value of $89,156 at the end of 2004. Not every trade worked and not every year was positive, but risk was always managed and the vast majority of trades were “with the trend.” The result was nice performance during a stretch when equities were not nearly as buoyant as their long-term historical returns. There is always an open door somewhere, and while many investors continued to ram their head into the closed door of technology stocks, commodities were an area of tremendous opportunity. If nothing else, it has served to do just what the common perception of commodities loves to contradict—it has smoothed out returns from a more volatile stock market!

True Diversification—You Don't Have to Go Far to Find It

There are many sound reasons for adding commodities to your investment process, not the least of which being a time-tested lack of correlation between stocks and commodities. This will be discussed in more depth later in this book, but suffice it to say this lack of correlation gives investors a valid way to diversify assets by using the commodities market. The more common approach toward diversification is to allocate funds toward large-cap stocks, small-cap stocks, international stocks, and so on, to achieve an overall portfolio allocation that doesn't simply swing harmoniously with the ups and downs of the Standard & Poor's (S&P) 500. However, this is a task much easier explained than implemented, as many “diversified” investors found out the hard way in 2002, when nearly every area of the equities market finished solidly in the red. It was particularly obvious in that year that simply spreading money around different regions or style boxes is not true diversification, but that was because everyone was losing money. The truth is that it is simply a fallacy of composition to assume that foreign stocks are not correlated to U.S. stocks, or that small-cap stocks are in no way correlated to large-cap stocks. As we see in Exhibit 6.2, a “diversified” portfolio of some of the largest, most widely held mutual funds in existence can still fall prey to a deceivingly high correlation with the S&P 500.

EXHIBIT 6.1 Reducing Volatility with Commodities?

A tremendous benefit that commodities can provide to an account is true diversification, that is, diversification by means of a noncorrelated asset. There are naturally times when commodities should play a larger role in an investor's portfolio, and times when their weighting should be muted. As Jim Rogers explains in his book Hot Commodities (New York: Random House, 2004), the commodities markets have tended to trend in roughly 20-year cycles; meaning a generally strong 20-year period has historically been followed by a generally weak stretch of similar duration. This is why changes in trend are so important, and also why you are reading this book now and not 10 years ago, when commodities were still entrenched in a long-term negative trend. You've seen the tools, and you've seen the results of these tools being put to use in a disciplined fashion—let's now put it all together and walk through some of the trades we implemented in recent history. Not all of them worked, but they never all will.

Putting It All Together

For those of you already familiar with Point & Figure analysis, what you have read thus far should help make it readily apparent that many of the tools we use to analyze stocks, mutual funds and market indexes are the very same that we apply toward a commodities account. Point & Figure is a trend-following approach first and foremost, and within that broad stroke we apply other tools that help us to time entry points and exit points to better manage risk. Whether you choose to actively use Point & Figure within your own personal investment game plan or not, hopefully the tools discussed in this book will at least decloak some of the many myths regarding technical analysis and the general complexity of markets. The most basic laws of supply and demand that are taught early on in any economics curriculum are indeed the same which govern price movement in futures markets. Just as this approach has provided many investors and professionals the skill and confidence to manage assets in the stock market successfully, it can do the same for those interested in adding another investment option to their process—commodities. We've certainly been very pleased with the returns we've seen in the commodities account over the last five years, but it is also quite humbling in the sense that it is very clearly just the system at work. Many of the trades haven't been big winners, plenty of the trades resulted in stops being hit, but there were a good number of trades that were huge successes, and no trades that were crippling losses. We attribute this to our trend-following system, managing risk with stop loss points, and using the tools we have to time entry and exit points. For those who may be struggling with tying the loose ends of those concepts to-gether, hopefully the following examples will help you “put it all together.”

EXHIBIT 6.2 How Diversified Are You?

PART TWO: INITIATING AND MANAGING A POSITION

Before we actually go through specific examples of “putting it all together,” we want to address a few topics germane to initiating and managing positions in the futures market. In a nutshell, we want to delve into the topic of risk management, as it is a key component to success in investing, be it in stocks or commodities. It is interesting that at the 2006 Winter Olympics in Torino, Italy, Bode Miller, an American downhill skier, said this about the downhill race: “It's all about risk management. You have to know when the risk-reward ratio was right to either attack the course or lay back.” And so it is with investing. Now, as we just discussed, diversification into non-correlated assets—commodities in this case—can itself provide enhanced performance and in a sense mitigate risk; but in the following discussion, we want to deal with risk management as it pertains to taking individual positions in the commodities market.

Risk Management

Risk is basically the amount and probability or possibility of incurring a loss (of capital), or series of losses. There are several types of risk inherent to trading commodities:

• Avoid ablerisk is risk that can be reduced or eliminated without any reduction or compromise in reward (see Robert Rotella, The Elements of Successful Trading, Englewood Cliffs, N.J.: New York Institute of Finance, 1992). A couple of examples of this type of risk would be trading an illiquid market, and not properly diversifying your commodity portfolio. Illiquid markets can provide a great deal of slippage and bad fills on trades. Diversification typically will serve to reduce risk.
• Unavoidable risk is risk that cannot be reduced or eliminated. In other words, there will always be some risk involved in trading commodi ties, stocks, or any investment, for that matter, given that there is an expected return or profit.
• Controllable risk is risk that can be reduced or mitigated as a function of your entry and exit points. This will be dealt with in more detail below in our discussion on stop loss points, and risk-reward.

As mentioned, with any investments, and in this case with commodity trading, there is risk involved. To a large extent, you can reduce or mitigate your risk with smart risk management techniques. Truly, over the long haul, it is proper risk management that will be the key to your success in commodity trading. You must always be aware of the risk you are taking on any given trade – the risk of loss. Bottom line: Never get consumed with the potential “reward.” This was all too much the case with technology stocks back in 2000. Everyone thought those stocks would go up forever. Many never bothered to evaluate the risk of owning those stocks, but instead were overly consumed with profits. “What, me lose money on Cisco? Never!” As a result of this lack of respect for “risk,” many people still own a plethora of “fallen tech angels,” with hopes of one day just getting back to even.

The good news is that through the use of the Point & Figure method, risk can be controlled (and probabilities of success increased). Over the course of this book, you have learned about many tools that can help in this reduction of risk. Now you must take these tools and make them work for you because they are just that—tools—concepts and methods for analyzing the commodity market, but not a “black box.” These tools can have a “starring” role in your commodity research, or you may choose to augment Point & Figure with other forms of analysis, such as adding fundamental research to your decision-making process. The larger goal is to develop your own system, or working set of rules, for managing commodities exposure.

Diversification

Overall investment diversification is achieved via asset classes that are not highly correlated, as we discussed earlier in this chapter. But diversification is something to consider within your “commodity” asset class, as it can reduce “avoidable risk.” One way to provide diversification in your commodity account is to trade different markets. For example, having exposure in livestock, softs, grains, energy, and so on should tend to reduce your risk. Ideally, your goal here is to trade markets that have a low correlation to the others. Typically speaking, the price of orange juice is not going to be highly correlated to the price of live cattle, unless you are talking about your breakfast plate of steak and eggs with some juice!

The question then becomes, how many markets should be traded to gain proper diversification? According to Robert Rotella, “diversification increases with more markets but at a decreasing rate,” as shown in Exhibit 6.3. Rotella displays in this graph that risk is dramatically reduced with just a few different markets, but is only “marginally reduced as more markets are added.” So, again, how many markets are needed? He states that “diversifying with greater than 8 commodities does not provide any substantial difference in reducing risk.” Rotella goes on to explain that “different theoretical studies suggest as few as 3, or as many as 15, unrelated markets are enough for a well diversified portfolio” (Rotella, The Elements of Successful Trading). The key phrase is unrelated markets. What do we mean more specifically? We mean you are not going to gain proper diversification by being long crude oil, natural gas, and heating oil, or being long soybeans, corn, and wheat. A better example of being diversified in your account would be to have exposure in, let's say, soybeans, live cattle, crude oil, sugar, copper, gold, Treasury bonds, and the British pound. Also notice in this example that we have representation by all the major markets in commodities—eight groups or commodity market sectors therefore eight positions. Another important consideration is liquidity. You want to be wary of trying to gain diversification in markets that are less liquid, as this can actually increase risk. For example, a distant-month lumber contract or the New Zealand dollar may not be the best choice for increasing your diversification, while trying to decrease your avoidable risk. So you will want to be sure to consult the open interest and volume figures on any given contract you are considering to ensure proper liquidity.

This leads us to another point we want to make. You can gain proper diversification by having representation with one commodity per commodity market group—such as being in live cattle for your livestock position. But the other benefit that can be harnessed is in the simplification of commodity research. In other words, if you are just starting out investing in commodities, you may find it helpful to narrow the playing field. Given that corn, soybeans, and wheat will tend to move similarly, why not follow only soybeans for your grain representation. Basically, you could merely follow eight different commodities, doing analysis on each of those, rather than being inundated with 25 or 30 charts. This is something to consider if just starting out in the commodities markets, but without sacrificing proper diversification.

Before we leave this discussion on diversification, we wanted to make one last point. Of course, an easy way to gain diversification is merely through the use of the commodity index futures contracts (discussed in Chapter 3), using the Commodity Research Bureau Index (CRB), Goldman Sachs Commodity Index (GSCI), or the Dow Jones–AIG Commodity Index (DJAIG). The only thing to remember here is that the weighting of each index is different.

EXHIBIT 6.3 Decreasing Benefit of Increased Diversification. Source: Robert Rotella, The Elements of Successful Trading, Englewood Cliffs, N.J.: New York Institute of Finance, 1992.

Stop Loss Points

Stop loss points are another way of saying risk control. Recall our definition of risk: the probability of significant loss of capital. One of the best ways to provide a control mechanism on risk is through the use of a stop loss. That is why we always determine where we are getting out before we even get in (to a trade). So to determine if the risk is acceptable on any given trade, you must know “where you are getting out”! At DWA we must deem the risk to the stop (the potential loss) acceptable before we place the trade. But then once that trade is executed, a stop order is placed good-until-canceled (GTC). This serves a pair of purposes: (1) you don't have to constantly watch each tick of trading for fear of missing your exit point, and (2) it removes the emotion from the trade. Having a predetermined exit strategy (a GTC stop) can protect you from large losses because you can't procrastinate or rationalize staying in a losing trade that has negated your reasons for entering. Avoidance of severe losses, truly, is the key to success in any trading. Using a stop loss point reduces this possibility of a severe loss. In fact, there has been plenty of research conducted on this subject, with the results showing that the key to a successful trading program is the size of your winners versus the size of your losers, not the number of winning trades versus the number of losing trades. So cutting your losses short, while letting your winners run is really what it's all about. This is why a trend-following system based on Point & Figure analysis can be so helpful in achieving this goal.

To that end, how do you know where to stop out using Point & Figure? If the entry point is where risk is low and the potential reward high, then the exit point (stop loss) is where the risk is high and the potential reward low or uncertain. So, where would risk be high and potential reward uncertain? Turning to the Point & Figure chart, it would be where the commodity will break a significant bottom or violate its trend line—basically, a point at which the chart suggests supply has won the battle, not necessarily the war but the battle, and therefore suggests you no longer want to be long the commodity. In Exhibit 6.4 we provide you with two such stop loss examples. The main point to remember is that you should always have an exit strategy for each and every trade you enter. The beauty of using the Point & Figure chart is the ease with which you can determine this exit point, or stop. Also, the Point & Figure chart allows you to raise (or lower) the stop as the chart unfolds. This serves to reduce risk further and, as price continues to rise, allows you to protect a profitable trade, ensuring a gain.

Risk-Reward

To a great extent, risk on any given trade, the potential for loss of capital, is a function of both your entry point and exit point. You will recall that we dealt with this subject in Chapter 3 when we taught you how to calculate a risk-reward ratio. In looking at entry points and exit points more closely, they can, for the most part, be classified into two categories. With respect to the entry point for long positions (or exit for shorts), you are either buying on strength after an upside breakout through resistance; or you are buying on weakness into support—a pullback. Conversely, when determining the exit point for longs (or entry for shorts), you are selling on weakness after support has been broken—a breakdown or trend line violation—or you are selling on strength into resistance. The point depends on the risk-reward scenario; there will be times when you will want to initiate a position on a breakout, yet other times when a pullback is ideal for entering a trade. Some of the factors that go into this decision have already been discussed, such as distance to the stop, where support resides, the chart pattern, momentum, where overhead resistance lies, or where the contract is on its trading band. All of these factors go into making a sound decision as to where you enter and where you exit a trade. In the end, you must look at the weight of the evidence, and stack the odds of success in your favor. An example may clarify this for you; see Exhibit 6.5.

EXHIBIT 6.4 Examples of Selling Stop Loss Points.

Another issue with risk-reward is the percentage of total funds allocated to a given trade. Awareness of this detail can increase your longer-term probability of success in trading commodities. Basically what we mean by this is the amount of funds at risk on any given trade, as a percentage of the total equity of the account. We recommend that you limit the maximum risk on any trade to 3 percent or less of the total equity. So, for smaller-sized accounts, this limit requires that you restrict your trading to less volatile markets, mini-contracts, and therefore suggests that you may often have to buy on a pullback. So if you have $30,000 in total equity in your commodity account, it implies that you risk no more than $900 per trade. This will serve to dictate which trades you can take and when. For example, natural gas may not be the best choice for a smaller account, given its volatile swings in prices and dollar value per point move ($1,000 per .10 move). As a sidebar, our broker at Man Securities warned me one time when I was considering trading natural gas in my own account, “You know on the floor they call natural gas the widow maker!” Instead, I chose to buy the mini crude oil contract. I am happily married. This issue of risk-to-equity suggests that you may not necessarily, depending on the size of your account, be able to have positions, for example, in Treasury bonds, several foreign currencies, coffee, and crude oil all at the same time, given the dollar value per point for each of those commodities. Now, if the account grows, much like our DWA in-house account has from $18,000 to $89,000, the dollar amount you can risk on each trade increases to whatever the 3 percent benchmark becomes. When we started out, our risk per trade was limited to $540, but by the end of 2004 our risk per trade was $2,670. In all, by restricting your risk per trade to 3 percent, you live to play another day.

The maximum risk per trade can also be used to determine the number of contracts that can be initiated with a trade. For example, if the maximum risk per trade is 3 percent of total equity and the account size is $50,000, then the risk you are willing to take on the trade is $1,500. If you want to buy soybeans with a triple bottom sell signal as your stop loss point, which is 10 cents away from your entry, then you could buy three contracts.

10 cents/bushel risk to stop × $5, 000 value per $1 move (or $50/penny) = $500 risk per contract

This same math can be applied when considering adding contracts to existing positions—pyramiding—as the trade works in your favor. The main point to glean from this is the importance of evaluating risk on each and every trade. There will be times that you will have to pass on a specific trade because of unacceptable risk, but as we like to say, we would rather lose opportunity than lose money.

EXHIBIT 6.5 Taking that Breakout or Waiting for a Pullback?

Putting It All Together: Specific Trading Examples

In the examples that follow, we are dealing with applying the tools to the purchase and sale of individual commodities. But as you will see in the ensuing chapters, you can parlay your commodity research, using it to invest in alternative, commodities-related instruments.

In selecting trades for this case study section of the book, we tried to choose examples that comprise multiple facets of applying the Point & Figure method to commodity trading. Our hope is that this “practical” exercise will serve to solidify the concepts you have learned in previous chapters, and will provide you with the confidence to “do it yourself.”

Let's start this discussion by looking at the euro FX. Recall in Chapter 3 how we laid out the technical picture for the U.S. dollar and the euro by looking at the longer-term spot charts. That analysis showed how the dollar topped out in early 2002, changing its overall trend to negative by April. At the same time, the euro was making a bottom, having stopped its precipitous decline. The euro began trending upward and this trip north persisted, and as a result any trades in the euro were focused on the long side. That posture was continually reaffirmed by consulting the relative strength (RS) chart of the dollar versus the euro. The U.S. dollar RS sell signal given in June 2002 remained in force (until May 2005), acting as further confirmation of a short dollar, long euro stance. Given the overriding long-term trend of the euro and the positive RS versus the dollar, we chose to repeatedly play the euro long in our DWA account.

After having bought the euro in early August, very little transpired over the course of the next few weeks; the euro worked sideways, staying in a fairly tight trading range. The technical picture of the September contract had not changed—the buy signal and trend remained positive. But as with all currencies and financial contracts, the expiration months are on the March calendar cycle. So, with our long position remaining when we flipped the calendar to September, we chose to roll out to the next contract—December 2004. By selling the September contract and buying the December contract we maintained the exposure while the technical scenario suggested this was the proper course. The base-building consolidation phase eventually gave way to an upside breakout in early October, as shown in Exhibit 6.6, allowing the patience of this trade to yield fruit. The euro December broke out of a big base at 1.2450, giving a triple top buy signal at that level. From there it was like a Roman candle heading upward into the July 4th night sky. The 1.2750–1.280 area proved to be the first resistance and with the contract extended, and 90 percent overbought on its 10-week trading band; we chose to lock in profits. No stop point was at hand, risk had thus increased, while the reward was largely realized after the quick move up. We locked in profits of $8,950 for one contract, having exited at 1.2786.

But the euro didn't stop its ascent until 1.3450. Hmm, remember that number—it was the vertical price objective! In hindsight, it was no coincidence that this happened. First, a big base had been broken, which as you learned can often elicit a big move up out of the base. Second, in analyzing this trade, we noticed that the weekly momentum turned back to positive the first week of October after having been negative for 10 weeks! Recall our earlier point of how the currencies and financials tend to perform coincidentally with their weekly momentum readings. That weekly momentum stayed positive for the next 11 weeks, until early December when the contract topped out and subsequently broke down at 1.3170 (on the .0025 box chart). Also not surprising is the fact that the euro had become 122 percent overbought on its 10-week trading band by early December, about the same time the momentum was waning and the contract was meeting its bullish price objective.

EXHIBIT 6.6 Example Trade—Euro FX.

Now you may recall in our conversation on “changing the box size,” that we used the euro for example purposes. Although exiting the euro when we did had merit, where we failed was not going back to the well again—reentering on the shakeout pattern on the .0025 per box chart. This would have allowed us to capture another sizeable gain.

While we are on the subject of currencies, let's turn our attention once again to the U.S. dollar. We have spoken numerous times about the green-back throughout this book, yet there are further points to make and practical lessons to learn. The dollar is a prime example of how a commodity can trend relentlessly lower—more specifically, we speak of the downtrend beginning in mid-2002. So just as our trading bias henceforth from 2002 has been long the euro, it has required a bearish posture with respect to the dollar. We specifically want to now examine the U.S. dollar, December 2004 contract, yet before doing so, realize that we traded the dollar many times over the course of the past several years. For that reason, we are going to refrain from itemizing particular trade entries and exits, but nonetheless wanted to make some key points through the use of the December dollar.

So, what is there to glean from this practical example of the U.S. dollar position? It once again displays the importance of staying with the overall trend, but like the euro trade shown earlier in this chapter, it also shows how weekly momentum can be of great use. Notice how the decline really got into full gear once the weekly momentum turned negative in early October. The downward spiral persisted for close to three months, until momentum turned to positive in mid-December; culminating with a contratrend bounce off the bottom. Perhaps the most important point we want to make with this example pertains to setting stop loss points on a trade, and finding multiple opportunities to reenter positions.

In dealing with the issue of stop loss points, notice again the series of lower tops and bottoms. Each time a lower top was recorded, the stop loss point could be adjusted. This serves to reduce your risk in the position, and as the chart unfolds, puts you in a position to protect what has then become a profitable trade. The only way this happens is by regular review of your open positions—analyzing the chart patterns each and every day—to evaluate if the technical picture has changed. As seen in Exhibit 6.7, if you had been short the dollar even since October 2004 when the weekly momentum turned negative and the triple bottom sell signal was given, you could have initiated with a buy stop of 88.80, but then lowered it to 86.00, then 85.80, to 84.80, then 84.00, and finally to 82.80; where you covered your short on the double top buy signal off the bottom (which also came in concert with the weekly momentum turning back to positive).

EXHIBIT 6.7 Adjusting Stop Loss Points.

This trade also shows how a chart will often give you many chances to get in. There was ample opportunity to short the dollar. Starting back in September 2004, but obviously the breakdown in October was noteworthy in that it brought a violation of key initial support, but also penetrated the July bottom. From there, it was a quick drop to where? The 85.00 level—remember the support from January 2004? But here is the interesting thing: The dollar continued to give you opportunities to short it there-after, with an orderly series of lower tops and bottoms. A lesson to take away from this is how a trend can become reinvigorated (in this case to the downside) once old standing support is penetrated. So in early November when the 85.00 longstanding support level was violated, it should have been a sign to grab a seat on the “dollar short bandwagon” if you weren't already on it! As from there, the U.S. Dollar proceeded to fall off a cliff. Also, by adding to positions as the chart allows, like the dollar did, you provide the account with another form of diversification—that of different time frames of entry.

Although we will be touching upon the topic of stop loss points again in this next case study, there are other lessons to learn, too. The goal, ultimately, is to show you different applications of the same tools—for you to see that trading commodities doesn't have to be a mysterious, dangerous, and highly complex task. Instead, it can be relatively straightforward if operating out of the right toolbox. Let's now direct our attention to gold. For this discussion, we turn to gold, December 2003 and December 2004. Gold is another commodity that has enjoyed a bull market after putting in a definitive bottom back in 2001 at $256 (per the London P.M. Gold chart). Given the persistent bullish trend in gold, we traded gold successfully and frequently on the long side. One such trade occurred in October 2003, when we traded the gold, December 2003 contract.

This trade is yet another example of the importance of longer-term trend analysis. In addition, it provides another illustration as to the benefit of buying on a pullback, serving to greatly enhance the risk-reward characteristics of the trade. At the same time, it displays how you can couple your research on the spot commodity with the near-month contract. In this case, gold spot suggested a renewed upward push was in the making for this metal. A triangle pattern had been completed, a slightly oversold condition existed, and momentum had turned to positive. December gold, shown in Exhibit 6.8, lifted as the technical data suggested, rallying in an orderly fashion to $384 per ounce before pausing. Throughout this run, we were able to raise our stop loss point several times during the trade. It wasn't until the breakdown at 374 that we exited the trade. All told, a handsome profit was recorded—$2,320 per contract (23.2 points ×$100 per point).

Before we leave our discussion on gold, we want to take a brief moment to analyze the gold, December 2004 chart. There really is only one important point we want to make here, and it deals with setting, and adjusting, your stop loss point. Notice in Exhibit 6.9 how gold trended higher the latter part of 2004, generally showing a series of higher tops and higher bottoms, repeatedly holding its bullish support line. But take a closer look and you will see that gold, while able to hold its uptrend line, also gave brief double bottom sell signals along the way. At no time did the contract string together more than one sell signal at a time and, following each sell signal, gold was able to regroup and rally to a new high. So what's the point? In this example, you can see how setting your stop loss point requires a discriminating eye and an adaptive approach that provides logical options to the trader. Merely stating that you must exclusively take the first sell signal as your stop point doesn't necessarily make sense in certain circumstances. Gold, December 2004 illustrates how sometimes using a violation of the trend line can be more logical, especially when it is close at hand, so long as the risk is palatable for the trader. The point we want to make is simple: Your stop loss point needs to “make sense.” Closely examine the chart and apply your best judgment to the situation. While a trend line–based stop loss point would have kept the trade alive for a prolonged move higher, a tighter stop loss strategy may well have caused much higher turnover and subpar returns.

EXHIBIT 6.8 Example Trade—Gold, December 2003.

Before leaving the issue of stop loss points in a practical application, let's take a glance at the Swiss franc, March 2005 contract. It will probably come as no surprise that the longer-term trend of the Swiss franc was positive coming into 2005, as it is measured as a function of the U.S. dollar, which declined precipitously for the three years prior. In this instance, we actually shorted the franc based on the technical picture of the March contract as it developed. Let's explain the scenario.

The reasons to short the franc are evident in Exhibit 6.10. Probably the most glaring of these details is the change in trend to negative upon the violation of the bullish support line. Add to that the negative chart pattern established with multiple sell signals, while the risk-reward ratio was extremely conducive to placing a short position, and there is sufficient data there to make the case for a play to the short side. Pretty standard stuff in keeping with what you have learned throughout this book. But where this trade takes a different kind of twist is in the exit strategy.

EXHIBIT 6.9 Another Glance at Gold.

For all intents and purposes, this short position was in conflict with the longer-term trend of the underlying franc spot chart, shown in Exhibit 6.11. Given the right conditions, contratrend trades can be taken, yet that fact came into play when considering where to exit the trade. As Exhibits 6.10 and 6.11 show, the March franc (and franc spot) sold off quickly. Witnessing this unraveling, we could see the franc becoming statistically oversold. No direct support on the March chart was evident, yet by consulting the franc spot chart (Exhibit 6.11), we could see the likelihood for support around .8200. Why was this considered support? Well, this was the level at which the spot chart had broken out of a big base. Remember our discussion on this from Chapter 3, and the statement, “What was resistance becomes support.” It was our opinion that the franc would likely garner support around this .8200 level, we chose to place a buy stop at .8200, under the current market price at the time. In other words, we were willing to lock in our profits should the franc drop to .8200 and this is in fact what eventually transpired. We closed the position, recording a profit of $2,637.50 per contract. From there, the franc rallied straight back up from what was a 100 percent oversold condition on its 10-day trading band, and 86 percent oversold reading on its 10-week band, which would have erased a significant portion of the gains established. This is yet another example of how to be flexible with your exit point, and given the prevailing conditions (spot in overall uptrend), taking profits on the dramatic short-term moves is acceptable.

EXHIBIT 6.10 Example Trade—Swiss Franc.

EXHIBIT 6.11 Long-Term Spot—Swiss Franc.

Now let's finish up our “putting it all together” section by revisiting the copper, December 2004 (HG/Z4) example. You may recall that we have mentioned copper numerous times along the way, pertaining to its correlation with the CRB Index, its notable multiyear uptrend, and in connection with changing the box size in Chapter 3. As has been the case with many commodities, playing copper from the long side over the past few years has primarily been the right course of action, or at least the more profitable. One trade in particular that we wanted to review was initiated in mid-September 2004.

As Exhibit 6.12 shows, we were the beneficiaries of a windfall rally in copper that didn't take long to materialize. But that is why when you “buy right,” you can feel comfortable with the trade and the money at risk, and set yourself up to catch these kinds of trades that can make the difference in your returns for the year. As the technical data supports, we did in fact buy copper “right.” The pullback after the spread triple top buy signal offered an attractive entry point, with a very palatable risk-reward situation. We were trading with the trend, which was also confirmed by the long-term continuous chart. Momentum was supportive in our decision, as was the trading band. Again, it is just a process of stacking the odds in our favor, making a decision based on the weight of the evidence. Based on the technical picture, the decision to buy copper was fairly straightforward. After a swift rally, we came upon the best kind of problem to have in our business—what to do about the massive short-term profits.

Copper quickly vaulted up to a new chart high of 148.00, moving through all overhead resistance. This then presented a very tenuous situation—the risk-reward had quickly become very unattractive by this point—recall that our price objective was 138.50, after all. We had substantial unrealized gains, but the chart showed an extended condition, well above any support with no viable stop loss point visible. The contract was more than 100 percent overbought on its 10-day trading band, and was actually 100 percent overbought on its longer-term 10-week trading band as well. Given this new technical data at our fingertips, the evidence suggested that we take profits or somehow protect these gains. As susceptible as the chart looked to a rally only a few weeks prior, it now appeared equally as likely to pull back from that overbought condition. There was too much risk in holding this position from our perspective, with too much reward on the table. We sold copper at 147.60, just barely off the top tick. In doing so, we recorded a profit of $5,275.00 per contract.

That finishes up our practical exercises of applying the Point & Figure method to specific commodity trades. Hopefully, this case study approach has served to solidify the concepts you have learned in previous chapters, and has provided you the confidence to “do it yourself.” You can clearly see that the overriding theme in these example trades was adherence to the overall trend. When going against the trend (Swiss franc), we expect a lower probability of success and thus are more willing to take quick profits when we see them. However, just think about gold, crude oil, copper, the U.S. dollar, and the euro—all have had very definitive trends in place for years, presenting massive opportunity to commodity traders. This knowledge played a part in each trading decision, be it entry or exit. So remember, the key to your success over the long haul will be in the identification of trend, and then playing the direction of the trend for as long as it stays in force.

That said, over the years as you trade commodities or commodity-related products, you will likely catch a handful of long-lasting trends. There will also be times when the trends will not be so clear-cut, where trading ranges are more the norm, rather than the exception. We saw such an environment in the equity markets in 2004. It is not to say that money can't be made in such a condition, it is just tougher to do, but faith in a logical disciplined system will help you ride out such stretches with confidence. Your horizons typically have to be more “trading oriented,” creating a reliance on such tools as momentum and trading bands, key resistance, and support. Either way, you have been armed with a Point & Figure toolbox that provides a solid foundation and will help you to build a sound commodity “house,” regardless of the prevailing market conditions.