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MartinKronicle: Commodity Report
Report for the Opening of markets on November 9, 2015
by Andrew Hecht

Summary:

Last week, two big issues weighed heavily on commodity prices. First, the dollar exploded higher. The active month December dollar index futures contract has moved from 93.83 on October 15 to settle last Friday at 99.26 — an increase of 5.43% in just over three weeks. This is a huge move for the currency and the dollar index now looks like it will challenge the 100 level and recent highs made in March of this year. I continue to believe that the greenback will move higher and to parity against the euro currency. The move in the dollar was negative for commodity prices given the historical negative correlation between the two.

Second, the employment report last Friday indicated strength in the labor markets in term of job growth and wages the U.S. This increases the chances of the Fed raising rates at the upcoming December meeting. Both a rising dollar and rising U.S. interest rates are bearish for raw material prices. The prices of many commodities moved lower this past week.

Highlights:

Precious Metals- Both gold and silver put in bearish key-reversal trading patterns on weekly charts the previous week and they continued to move lower this week. Gold moved lower to close the week at $1088.90; it was down $52.50 or 4.6% on the week. Silver also moved lower, closing the week at $14.74 down 82.70 cents or 5.3% lower on the week.

Inter-commodity spreads between silver and gold and platinum and gold both continue to point to long-term divergence. This tells us that both platinum and silver are too cheap or gold is too expensive on a historical basis. Gold is now just under $20 above key long-term support, which a target given the trajectory of price and the bearish factors that weigh on its price.

Energy- Crude oil moved lower on the week but processing spreads showed a sign of life as both the gasoline and heating oil crack spreads rallied. Term structure in crude oil remains in contango but the level of the deferred premium has been tracking rather than leading underlying price movements; this week contango widened in both WTI and Brent spreads given the bearish action in crude. The Brent premium over NYMEX crude moved slightly higher to just above the $3 premium for Brent over WTI level. The move higher could be the result of fears of increasing turbulence in the Middle East after the downing of a Russian passenger plane traveling from Egypt to St. Petersburg. There is some evidence that ISIS was responsible for the action, which could further inflame an already dangerous situation in the region.

Natural gas recovered a bit this week with December futures closing at the $2.3550 level as the market prepares for winter. Inventories rose to the November 2012 all-time highs of 3.929 tcf. It is likely that increasing inventories have caused price weakness as we head into the winter season but inventories are at a level that is close to full capacity. Natural gas open interest is rising, which could be a sign that the market has become very short. The contango remains high with February futures trading at an 18.3 cent premium to December futures reflecting that demand will rise this winter.

Base Metals- Nonferrous metals on the LME all moved lower this past week, with the exception of aluminum, which rebounded after falling the previous week. On COMEX, the price of active month December copper futures declined on concerns about China and the prospects for an interest rate increase in the U.S. in December. Copper now stands just 2.05 cents above key support at the August 24 lows. The strong dollar has caused weakness in this sector over recent sessions.

Grains- Lethargic trading in corn and soybeans continues to push prices lower as the harvest season is supplying the market with a third straight year of bumper crops. CBOT wheat is showing signs of strength as the market rose to the upper end of the trading range as concerns about El Nino could cause prices to move even higher in the weeks and months ahead. December CBOT wheat closed at $5.23 1/4 per bushel with resistance just above at $5.315.

Soft Commodities- El Nino related weather events in the coming months could cause increasing volatility in the sugar, coffee, cocoa, cotton and frozen concentrated orange juice markets. The biggest volatility this week came in the FCOJ futures market, which moved to highs of over $1.40 per pound on Friday before pulling back. Sugar was close to unchanged this week after making a new high and failing. The March-May 2016 sugar spread, which I highlighted in last week’s report, closed unchanged at around a 35-point backwardation.

Animal Proteins- Meat markets moved lower this past week. The E-coli issues facing Chipotle may have created fear and induced selling in these markets. Cattle futures fell sharply on the week and lean hog futures traded to the lowest level since October 2009. The long-term average of the live cattle versus lean hog spread has been around 1.4 pound of pork value in each pound of beef value. This spread, on December futures, closed at 2.46:1 last Friday. In October, this spread moved higher before collapsing down to 1.8:1 as the contracts neared expiration.

Final Comments:

There are plenty of profitable opportunities in the weeks and months ahead in the commodity markets for those who understand these markets. The strong dollar and deviation between U.S. interest rates and others around the world will surely create volatility in all assets classes, particularly in commodities, which tend to be the most volatile of all. The majority of these opportunities will come from spread relationships.

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Interesting historical story on cornering the onion market in 1955. The main culprit, Vince Kosuga, bought all the physical onions around the country as well as all the longs in the futures markets. He sold and made a killing. It didn’t end there…

Then he kills the competition a second time by bombing the markets with sell orders. Since he owned the physical, and the shorts control the market, he had all the onions physically delivered to Chicago, and that’s when all hell broke loose.

He didn’t break the law, but obviously acted unethically. The result: The Onion Futures Act which was proposed by then Michigan Congressman Gerald Ford (later President of the United States) and signed into law in August 1958 by President Eisenhower.

The ban on onion futures trading remains in tact today. The aftermath no price discovery, no transference of risk, AND an increase in price volatility in physical onion prices.

A report by Fortune magazine in 2008 showed the volatility in onion prices was significantly greater than those of physical corn or crude oil – two commodities that have liquid futures contracts.

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By Jason Pearce

Did the Fall Finish in Autumn?

Decent autumn harvest weather and large US crops caused soybeans, corn, and wheat to drop from their summer peaks into new contract lows for 2015. In the case of beans and wheat, the futures markets traded to their lowest prices in several years.

Now that the dust has settled, the grain markets have somewhat stabilized. For the most part, they have been confined to trading ranges for the last few weeks. Perhaps the barn-busting 2015 crops are now factored into the market prices. There’s reason to believe that things could start moving again soon, though.

Gearing Up For Action

The wheat market may be the one to start moving as new fundamentals develop. The reason is because wheat actually gets planted twice a year in the US. The spring wheat crop was just harvested. Now US farmers are planting the winter wheat crop. This is the crop that will be harvested next the spring.

Not only does the new crop plantings mean that wheat could start trending again, but it also means that inter-market grain spreads could see some increased trading activity as well. This may provide informed traders with an opportunity in the soybean/wheat spread. If you are not familiar with this one, read on.

Birds of a Feather

Despite the fact that beans have only one crop per year in the US and wheat has two crops, the price trends in the two markets are highly correlated. This is not a new development, either. One can look at nearly half a century of monthly closing prices and see that beans and wheat often peak and bottom at or near the same time.

Soybean Wheat overlay (nearest-futures) monthly

Soybean Wheat overlay (nearest-futures) monthly

Of course, there are exceptions to this observation. But the exceptions have always proven temporary. This means two things: First, the strong correlation between soybeans and wheat makes it a tradable spread relationship. Second, the divergence in the price trends between the two markets is likely to be a temporary event and, therefore, an opportunity to get positioned for a bet on the return to the historic correlation.

Historical Spread and Ratio Levels

One way to identify a trading opportunity in a spread is to locate price levels that have historically been extreme events. By that we mean prices that the spread rarely makes it to and prices that have been unsustainable for prolonged periods of time.

Soybean Wheat spread (nearest-futures) monthly

Soybean Wheat spread (nearest-futures) monthly

In terms of the price difference between beans and wheat, $6.00 (premium beans) appears to be the outlier on the high side and $1.50 (premium beans) appears to be where the rubber band is stretched too far on the low side. Whenever the spread has gone to or beyond these price levels in the past, there has ultimately been a reversal.

Over the last few years, though, we’ve seen the soybean/wheat spread clear six dollars several times. It even hit a new record high in 2013. Part of the reason for this is because the grain markets themselves posted historic highs. When that happens, the spreads reach record highs as well. The record prices can distort the extremes in the relative value between markets. To remedy this, viewing the ratio between the beans and wheat can clarify whether or not the market relationship is historically out of whack.

Soybean Wheat ratio (nearest-futures) monthly

Soybean Wheat ratio (nearest-futures) monthly

The 30,000 foot view of the bean/wheat ratio shows that the beans are unsustainably overvalued when the ratio reaches 2.4:1 or higher. Whenever this level has been reached or surpassed, the ratio would ultimately reverse. Conversely, the bean/wheat ratio is undervalued whenever it has dropped below 1.4:1. Prior excursions to this level or lower have all been followed by a major recovery where beans outperformed wheat for months and even years afterwards.

The Value of Seasonal Patterns

The nearest-futures soybean/wheat spread is currently around $3.62 (premium beans). Historically, this is no man’s land. The spread would have to move over two dollars from here in either direction in order to start probing the historical boundaries where a trend reversal setup becomes more favorable.

Furthermore, the current bean/wheat ratio is at 1.7:1. This is uninspiring to the spread trader who scouts out levels in the relationship between beans and wheat where the difference has experienced enough of a divergence to trigger crop rotation, relative value plays, or something fundamental that would act as a catalyst for an eventual reversal.

The absence of an outlier in current price levels does not mean that the hunt for opportunity is off, however. We still have another weapon in our trading arsenal that could serve us well: the seasonal pattern.

A seasonal pattern shows the typical route that a market or a spread follows during the year. This makes perfect sense. After all, we know that grains will be planted in the spring and harvested in the fall every year. And it’s no secret that refiners will switch from producing heating oil to producing gasoline as they anticipate the warming temperatures and the start of the US driving season. Therefore, we have a pretty good idea of what the supply and demand trends for various commodities should be at certain times of the year.

The seasonal pattern is not the Holy Grail of trading. Nothing works all the time in every market. But knowing the seasonal patterns can still give you a very tradable edge. Some markets are more compliant with their seasonal patterns than others, so you really want to pay attention when you find one with a consistent track record. Those should be your weapons of choice. In the case of the soybean/wheat spread, the seasonal pattern might just be the silver bullet that compels us into taking the shot.

Remember, Remember the Fifth of November

Now that the 2015 harvest is over and planting for the 2016 winter wheat crop is in progress, the spring 2016 bean/wheat spread is in our crosshairs. Seasonally, you will be looking to buy the spread this week and sit on it for about two months.

Moore Research Center, Inc. has already done the work on this trade. According to their research, you should buy the May 2016 soybean contract and simultaneously sell the May 2016 wheat contract on November 5th and exit the spread on January 8th. I repeat: Buy the spread on Guy Fawkes Day and hold it through the first full week of the new year.

This seasonal spread trade has worked every single year since 2000. For the mathematically challenged, that’s fifteen consecutive years of winners. Will it work for the sixteenth year in a row? We don’t know. The future is not guaranteed, especially when trading futures. But would you want to bet against something that has worked for a decade and a half straight?! There’s a sign on the wall of a local Irish pub that says, “The race does not always belong to the swiftest nor the battle to the mightiest, but that’s certainly the way to bet”. There’s wisdom in those words. Always bet with the odds.

In addition to the success rate, the payout on the seasonal May soybean/wheat spread has been a respectable +$2,042 in profits (on average). On a 5,000 bushel-per-contract spread, this represents a gain of nearly 41-cents. Since the 2015 price range for the May 2016 bean/wheat spread has been $1.11 so far, 41-cents represents just over one-third of the year’s entire range to date. That’s not an insignificant move.

Technical Outlook

The plot thickens as the chart pattern on the May 2016 bean/wheat spread indicates that price support may have been established. Technically, this lays the foundation for a move higher.

Depending on how picky you are, one could say that a double bottom-type pattern was established on the daily chart between the December 17, 2014 low of $3.59 1/2 and the September 23, 2015 low of $3.56.

If the three and a half cent difference between the two lows bothers you, we could alternately refer to it as a Wash & Rinse pattern. This occurs when a market undercuts an important price low, sees little or no follow-through, and then quickly reverses higher. The mechanics are such that any sell stops or algorithm sell patterns below the price bottom are initially triggered on the break. The lack of a continued decline indicates that the sellers were suckered in, subsequently forcing them to start buying on the recovery. This is considered a bear trap, which is a bullish pattern.

May 2016 Soybean Wheat spread daily

May 2016 Soybean Wheat spread daily

Furthermore, the May 2016 bean/wheat spread has not been able to close below $3.70 for more than four consecutive sessions. This indicates that demand keeps coming in down around this current level. As a buyer, you want to locate the levels where demand has been consistent and take advantage of it. One you identify this area, you know where to buy. You will also be able to monitor the level for any important changes in the behavior pattern.

Balancing the Probable with the Possible

We discussed the setup and entry/exit parameters for the May 2016 soybean/wheat spread trade. It’s a no-brainer that you want to find seasonal trades with a long track record of success. This indicates that there are strong and consistent underlying fundamentals that drive the spread. It means the odds of bagging a winner on the next go-around are favorable. That’s what trading with the probabilities is all about.

However, your trading plan is not complete until your addressed the possibilities. This is where risk management comes in. You have to determine your position size (how many contracts) before you take the trade. Make sure it is small enough to withstand the inevitable losing streaks that come with the territory. Risk management is the Yin to the Yang of trade selection. Just like the ancient Chinese philosophy, it is complementary to trade selection, not opposed to it.

In the event that the May 2016 bean/wheat spread breaks the current contract low of $3.56, it’s probably time to go on the defensive. Where do you throw in the towel? Will it be on a 10% break of the contract low at $3.20? Will it be on a two or three-day close below the September low? Will you take a close below the September low as a sell signal with a close back above it as a reentry signal? If so, how many trades in a row like this will you take before you have endured enough whipsaw and call it a day? Take inventory of your trading capital, confidence levels, and emotional makeup to determine the answers to these questions. Then get ready to pull the trigger and buy the May bean/wheat spread.

By the way, some of the best research that you can ever find on commodity spreads can be found at MRCI.com.

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by Andrew Hecht

MartinKronicle: Commodity Report

Report for the Opening of markets on November 2, 2015:

 

Summary:

Last week, the U.S. Fed announced, once again, that they would leave interest rates unchanged. This came as no surprise to the market. However, the comments from the Central Bank did provide surprise to the market as the Fed upped the stakes for a liftoff in rates in December. The Fed has been saying all year long that the Fed Funds rate will increase in 2015, now they have one meeting left to raise the short-term rate. Markets response created many divergences. Divergence among asset classes has been the hallmark of 2015.

 

Highlights:

 

Precious Metals– Both gold and silver put in bearish key-reversal trading patterns on weekly charts last week. Gold made a higher high at $1183.10 on Wednesday and closed below the previous week’s highs. Silver exhibited the same bearish trading pattern.

 

Inter-commodity spreads between silver and gold and platinum and gold both point to long-term divergence. This tells us that both platinum and silver are too cheap or gold is too expensive on a historical basis.

 

Energy- Oil recovered slightly this past week but processing spreads remain weak. Term structure in crude oil remains in contango but the level of the deferred premium has been tracking rather than leading underlying price movements. The Brent premium over NYMEX crude moved slightly lower indicating supply fears about increasing sales of Iranian crude.

 

Natural gas made a new low this week below the $2 level as the market prepares for winter. Inventories are now approaching the November 2012 all-time highs of 3.929 tcf. As of October 23, stockpiles of natural gas stood at 3.877 tcf according to the latest report from the EIA. It is likely that increasing inventories has caused price weakness as we head into the winter season.

 

Base Metals- Nonferrous metals on the LME all moved lower this past week. On COMEX, the price of active month December copper futures declined on concerns about China and the prospects for an interest rate increase in the U.S. in December. The strong dollar has caused weakness in this sector over recent sessions.

 

Grains- Lethargic trading in corn and soybeans continues as the harvest season is supplying the market with a third straight year of bumper crops. CBOT wheat is showing signs of strength as the market rose to the upper end of the trading range as concerns about El Nino could cause prices to move even higher in the weeks and months ahead.

 

Soft Commodities- El Nino related weather events in the coming months could cause increasing volatility in the sugar, coffee, cocoa, cotton and frozen concentrated orange juice markets. Perhaps the most interesting development in this sector is the change in term structure in sugar over recent months. The March 2016-May 2016 ICE sugar spread has moved from contango to backwardation over recent months. This signals tightness in the sugar market. Many soft commodities are trading a low levels compared to recent years. The action in sugar could be the first sign that this sector will become exciting in the months ahead.

 

Animal Proteins- Cattle futures have been strong while hog futures have shown weakness recently. The long-term average of the live cattle versus lean hog spread has been around 1.4 pound of pork value in each pound of beef value. This spread, on December futures, closed at 2.35:1 last Friday. In October, this spread moved higher before collapsing down to 1.8:1 as the contracts neared expiration.

 

Final Comments:

 

There are plenty of profitable opportunities in the weeks and months ahead in the commodity markets for those who understand these markets. The majority of these opportunities will come from spread relationships.

 

Andrew Hecht teaches a 12-session course on market structure and spreads in the commodity markets. You can learn more about commodity spreads, including how to research and locate these opportunities, including how to trade them and… More Info….

 

 

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