TRADING OFF SHOCKS
Periodic shocks to price are reliable indicators of trend reversal. For example, in July 2002, hog prices were trading around 55¢, right near the average price. Only one month later they plunged to close at 30¢, a 36% drop. By May 2003, prices had climbed back to the average of 59¢. In economic theory, it makes sense that a huge price drop will cause a tightening of supply that will eventually drive prices back up.
Indeed, price shocks are excellent trading tools for real commodities. The assumptions of this approach are:
1) price tends to move sideways much of the time;
2) periodically price shocks to the upside;
3) this will be followed by a gradual drop in price;
4) periodically the price will “shock” to the downside as a balance.
It is less frequent, but possible, to have a repeat shock in the same direction without the intervening opposite shock. But, in general, price acts like a pendulum swinging back and forth, and occasionally wildly out of control.
Our goal: develop reasonable trading rules for each commodity to mathematically, and mechanically, evaluate the shock. It’s also important not to enter the market prior to the completion of the shock to avoid getting caught in the maelstrom.
Starting with live cattle, we can develop and introduce simple and reliable trading rules that can be adapted to other commodities. The simpler a system, the easier it is to implement and more robust it will be.
Begin by recording the monthly closing price for the nearest futures contract. Then calculate the three-month moving average of momentum price change statistic, expressed as a percentage:
For live cattle, include indicator bands of plus or minus 4.10%. If the three-month moving average of momentum registers outside such a band, it will provide a trade warning indicative of a price shock. As long as price continues to follow this band, we sit on the sidelines. Once it reverses, indicating the shock has subsided, a trade is signaled.