From the December 01, 2006 issue of Futures Magazine • Subscribe!

Trading exotic softs

Systematic traders often use the same trade entry rules across all commodities, with the idea that the same system should work in all markets. Indeed, some systems are sold for a basket of markets when in reality they historically outperformed on only a couple of markets, creating an overall positive performance.

While the simplicity of this idea is appealing, the logic is questionable and may confuse trading with a numbers game of chance and statistics. Not all markets are the same, and neither are the underlying products, the participants nor the fundamental forces that ultimately play out in price.

When you hear the adage, “A good system will work in all markets,” ask if such a universal system has been put to the test and traded with individual markets. How does it hold up?

Is it based on a price series on paper or perhaps tested at a casino where there is no market, but instead a great game of numbers? Of course, the tools of statistics are invaluable, especially when it comes to the rules of money management. Yet an edge to successful participation in the commodity markets is not mastering a game of doctored dice, creating a slight edge through a long period, but instead understanding the idiosyncrasies of each market you trade and knowing how to exploit them.

STICKING WITH IT

Testing shows that often a series of trade entry rules that performs well across much of the agriculture complex will fail in the softs markets. The universal system trader might wonder how this could be. After all, human behavior is universal, and given similar information, most of us react in the same manner and so should markets. In fact, this idea is the basis behind much of technical analysis and behavioral finance.

But that doesn’t mean that only those with an in-depth grasp of the market fundamentals can find an edge in the softs markets. It is true that having reams of fundamental data and understanding may give a trader or hedger an edge, but the evidence

doesn’t support this. It is possible to successfully trade these markets. You do not have to simply discard these poorly performing markets from your basket of opportunities.

Rather than lamenting a hypothetical poor performance in the softs, we can examine how the unique fundamental realities, including the lack of reliable short-term information, play out in price action and create opportunity. To do this, we need to approach this market with the idea that each has its own information flow, participants and personality, which are ultimately reflected in price action.

The softs, also known as foods and fiber, are on the edge of the more actively traded commodity markets and include some of the oldest traded commodities such as cotton, cocoa, coffee and sugar, as well as frozen orange juice. We’ll focus on sugar and cocoa, which typically deliver the most dreadful results when traded with generally successful trading strategies and, which many agree, are among the most difficult commodities to trade.

FUNDAMENTALS

These everyday commodities are mostly produced far from the Northern Hemisphere and are sometimes called the “exotics.” They inspire images of the 17th and 18th century Dutch traders trolling the shores of the subtropical regions to cultivate and trade softs to bring them to European markets.

Then, like now, cocoa and sugar were primarily produced in regions where information was difficult get, quantify and didn’t help build reliable fundamental price forecasts — not to mention the often rapidly changing and fragile political forces that can wreak havoc for price forecasters. This reality makes for a personality of the exotic markets that’s in dramatic contrast to the rest of the agricultural complex where we have monthly U.S. Department of Agriculture (USDA) reports on everything from seed purchases, planting intentions, storage capacity and demand.

The bulk of production of exotics is outside the United States and centered in Africa and South America where statistics regarding production are not as regular or reliable as those of the USDA.

West Africa has been the center of most of the world cocoa cultivation for the last 60 years and now produces more than 65% of the world’s crop. The Ivory Coast holds more than 40% of the world market. Ghana, Indonesia, Brazil, Nigeria, Malaya and Cameroon account for most of the rest.

Cocoa has a seven-year production cycle, making it relatively easy, in the very long term, to forecast. Production statistics are released only once a year at the International Cocoa Organization meeting in London. This explains the often-extended price trends in cocoa with phases of short-term volatility, sparked by ever-changing cocoa grinding statistics or episodes of political unrest. Cocoa is traded in New York and London, where it is priced in pound sterling.

While sugar is produced all over the world, most comes from sugar cane in warm countries. Brazil is the largest producer. Sugar is a seasonal crop, but the heavy hands of governmental interference on production and trade play upon price cycles. World sugar is traded and priced in dollars in both New York (contract #11, raw sugar) and London (contract #5, refined f.o.b. sugar).

In recent years sugar also is playing a role as an energy commodity as it is now a factor in the emerging bio-fuels industry. Something for all traders to keep in mind is that this development may make sugar more important in the commodity mix in the years ahead.

How can we reasonably approach these exotics of cocoa and sugar that do offer opportunity? Could opportunity be in the very idiosyncrasies we find so difficult?

TRADING APPROACH

By taking advantage of the peculiarities of these markets we can develop a trading approach that leads to excellent short entry in these often volatile markets. A set of short-term trade entry tools that might be counter to the rules of trading that most of us work with can be effectively applied in cocoa and sugar.

A look at the weekly chart tells us where the trend is (see “Cuckoo for Cocoa spikes,” below). We do not need price indicators to help us make that call. Remember, cocoa has long cycles in accordance with the tree planting and harvest cycles.

However, with a closer look at this market on the continuous daily chart we see significant counter-cyclical or countertrend moves. These violent moves combined with the cost of carry and roll make it very difficult for profitable trading, even for the best and most well-capitalized trend-following strategy. Using a simple pattern recognition rule can identify possible exhaustion of these counter-trend moves and create a strategy to trade into what we’ve determined as the prevailing direction of the market.

Key to this idea is that short-term breakouts often fail in thinner markets or where information may not be reliable. We seek confirmation of a breakout failure and sell short at market and into the direction of the primary trend under the following three-day set up:

Day one closes at a 15- to 32-period new high.

Day two will not exceed the highs of day one and closes at or below the open.

The sell signal is given when day three opens below the close of day two. See “When to get in,” below.

What about the great sugar bull market of 2004-05? Using this same logic, it would appear that this was a trade into disaster during the ferocious sugar bull market of 2004 and 2005. This was the real test. Yes, this strategy did get us occasionally short against the obvious trend and lead to countertrend trades that must be taken only with the most rigorous risk management, if at all.

This shorting trigger kept us out completely during the strongest phases of this market, and then allowed us to identify and capture a market peak along with a series of high return, low risk short entries through the last months (see “Profiting against the grain,” above). Prior to this, and as sugar built a price base before the take-off of 2005, this trade entry strategy delivered frequent series of swing short signals.

To take this short trade entry tool further, experiment with long-term data along with additional short-term technical indicators such as overbought price oscillators or sentiment indicators.

Elaine Knuth is the portfolio and trading manger for Stewart Capital Management LLC,

a CTA located in Zürich Switzerland.

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