One of the goals of many traders is to find a trading system that completely automates the trading process, and provides the trader with spectacular returns. Indeed, many successful commodity trading advisors (CTAs) employ a completely systematic approach to their trading. One reason CTAs do this is that it is easier to raise money from institutional investors if you employ a trading system without discretion. The thought is that traders who employ discretion are more prone to blowing out their accounts due to poor trading decisions.
Unfortunately, a historical review of systematic CTAs suggests that over reliance on a systematic approach to trading tends to lead to mediocre performance. The reason for this is that markets are cyclical, which means they change. For instance, during inflationary periods, large trending moves, particularly in commodity markets, can be expected. During deflationary times, when there is a smaller money supply chasing after risk assets, trends are less persistent, and tend to be choppy. As a result, CTAs who have employed mechanical trend following systems have had more difficulty in the last several years, compared to more inflationary periods such as the 1980s.
With this in mind, a more balanced approach to trading is recommended. A trader should have a mechanical system in place, but should have a thorough understanding of the history of the markets to know when the system will not likely perform very well. The price behavior in a given market will usually provide enough clues as to when the system should perform well and when it will not.
Let’s have a look at a couple examples. Below is the chart of Live Cattle for the last 18 months or so. As you can see, the market has traded in a very choppy range consisting of relatively wide price swings.
These wide swings in cattle with many peaks and valleys in price show many false breakouts. What we prefer to see is a market that begins to consolidate within a tighter range AND one that is showing a directional bias. Check out the chart of Cattle from early 2003 below.
On this chart, there are fewer wild swings as the time between peaks and valleys is greater. There also seems to be an underlying trend to the upside for most of the period exhibited on the chart, except for the correction from February to March. On the right side of the chart, there is a trend of higher highs and higher lows. At this point, the market is still a little choppy, but giving a better indication on direction. Finally, this market will break out to the upside and embark on a significant uptrend as seen on the chart below.
Ultimately, Live Cattle begins a multi-month uptrend that results in significant gains, and it offered multiple entry possibilities. Clearly, the character of this market has been different over the last 18 months compared to back in 2003. Since 2003, there have been only a handful of decent trending moves in this market, and this is usually the case, as cattle is not a market that usually trends well. A discretionary trader can weed out many bad trades, wait for the market to tip its hand, and then hop on board. He may miss some trends, but will better conserve his money for the better, lower risk opportunities.
The fact of the matter is that trading in the real world requires more than just a system that has been back tested and over optimized. I am reminded of one CTA who at one time had a top rated system that they sold as a vendor prior to trading money as a CTA. They had some early success trading the system during a huge bull market for commodities n 2008, but has had difficulty over the last couple years. This is pretty common in the world of futures trading.
Successful trading in the futures markets requires a methodology for entering and exiting trades, sound risk management, and solid judgment. Keep that in mind as you explore the possibilities of investing in the futures markets.
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- 2012 live cattle prices