Bears Falling on Cotton

07/26/04 03:03:33 PM

by David Penn

Since breaking down in the spring of 2004, cotton futures have lost a third of their value in four months.

Security: CTV4
Position: N/A

One of my favorite passages on Pristine.com founder Oliver Velez's trading/training video comes when he explains the basic duty of every bearish trader:

"If you are in a bear market, then your job is to sell every single rally. Not one of them, not some of them... all of them. The only question is: when?"

In some ways, this is an incredibly empowering statement. I'm reading a book by F.H. "Chick" Goslin called Trading Day by Day: Winning the Zero-Sum Game of Futures. Early on in the book, Goslin posits three "natural laws of trading", the first of which is "the future is unknown." When I combine this notion with what Velez insists is the mission of every trader who finds him or herself in a bear market, I take away the conclusion that in spite of the unknown that is the foundation of opportunity in trading, knowing what a trader is supposed to do in the face of that unknown (and, to steal from Defense Secretary Rumsfeld, in the face of "the unknown" unknowns) is the next best thing to being able know the future, to see in the dark.

So, assuming we have either established or are willing to make a bet that a market is headed lower, how do we answer Velez's question of "when"?

One of the more basic approaches to this problem is the use of declining moving averages as resistance in a market that has turned down. With a downwardly trending moving average, a trader can be reasonably assured that a bear market is in place. And given that, when going short, it is the objective to sell (i.e., short) high and buy (i.e., cover) low, the optimal time to bet against a stock, commodity or currency is to do so as close to a resistance area as possible. Sure, prices could drive higher--even temporarily--climbing above the resistance offered by a moving average. But, generally speaking, intermediate-term moving averages such as the 20- and 50-bar tend to do a relatively good job of providing resistance in downtrending markets.

Figure 1. Four different opportunities for swing traders to take advantage of the declines in cotton futures were scattered about the late spring and early summer.

Graphic provided by: Prophet Financial Systems, Inc.

Note the price action in October cotton futures in the late spring and summer of 2004. Prices broke down in April, concurrent with the exceptionally deep MACDH trough in mid-month. For me, as I have written frequently here and in Working-Money.com, such troughs are a significant signal for me that prices are headed lower going forward.

This was certainly the case by May--if it wasn't clear in April. While a sell signal based on a shift in the MACDH and a "hooking down" of the 7, 10 stochastic did occur in April (and would have provided a few cents worth of swing-scale profits), an even more profitable sell signal occurred in May as prices bumped into resistance at the 50-day exponential moving average (EMA). Once again, a downshift in the MACDH as well as a "hooking down" in the stochastic provided the signal for the short side.

Different "swing" entry/exit strategies would have yielded different results, to be sure, as would a "short and hold" strategy that (using futures or options) sought to ride a month or more worth of price deterioration. The swing approach I follow, for example, would have likely been stopped out for very small gains during the May trades. But these small losses would have been more than made up for by success in April and June. The important point is that by doing what a trader is supposed to do in bear markets--even if that meant spending the month of June getting whipped out of cotton short plays--a trader following cotton would have done quite well in the spring and summer of 2004.

David Penn

Technical Writer for Technical Analysis of STOCKS & COMMODITIES magazine, Working-Money.com, and Traders.com Advantage.

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