Conduct and Practices Handbook Course (CPH) Quiz 47

If it’s a false signal, look to reverse your course. I’ve found that a classic H&S failure often offers an excellent opportunity to get back in sync with the major trend. If the market again trades above the right shoulder’s top (or below the right shoulder’s bottom for a reverse H&S), odds favor, at a minimum, one last thrust to a new high or new low. I would buy the market at this point, with the objective of a new high, risking to under the neckline. For an inverted H&S failure, sell the market under the low of the right shoulder, with a minimum objective of a new low, risking to above the neckline.
10. After a false signal is confirmed, watch the market action closely as soon as a new high or low is registered. I’ve noticed that an H&S failure that turns out not to be the final high or low, ultimately leads to a new contract high or low in short order. The H&S was telling us we were close to the major top or bottom, but the bulls or bears were able to mount one last hurrah. If the market is unable to show much follow-through after this climatic top or bottom (following an H&S that didn’t work), be ready to take action because a major top or bottom is now in place.

Six rules for trading news
The following are six news rules:
1. If bad news is announced and the market starts to sell off in large volume, it’s a good bet that the market’s going lower.
2. If the market fails to react to good news, it has probably already been discounted in the price.
3. Moves of importance invariably tend to begin before any news justifies the initial price move. When the move is under way, the emerging fundamentals will slowly come to light. A big rally (decline) on no news is usually very bullish (bearish).
4. It is generally not a good practice to buy after very bullish news or sell after an extremely bearish report because both good and bad news can already be discounted in the price.
5. Always consider whether the trend is down or up when the news is made known because a well-established trend will generally continue, regardless of the news. As an example, I remember getting caught in the emotion of a very bullish corn report in January 1994. Looking back, this news was the very top. An opposite (very bearish) report the following year turned out to be the springboard for one of the biggest corn bull markets in history and led me to develop the SNI.
6. When unexpected news occurs (news that the market has not had time to prepare for) and the market opens in a wide range or “gaps” lower or higher, sell out your longs or cover your shorts and wait. Watch the market for 30 minutes to an hour. If the market opened sharply lower with heavy selling and was not able to trade much lower than that, it’s into support and you can buy it with a tight risk point. Watch the market closely at this point and note the tone of the rally. If it’s small and the market is able to again fall under the levels made when the bad news came out (or rise above the levels made when the good news came out), it’s safe to assume the market is going lower (higher).

When unexpected news occurs (news that the market has not had time to prepare for) and the market opens in a wide range or “gaps” lower or higher, sell out your longs or cover your shorts and wait. Watch the market for 30 minutes to an hour. If the market opened sharply lower with heavy selling and was not able to trade much lower than that, it’s into support and you can buy it with a tight risk point. Watch the market closely at this point and note the tone of the rally. If it’s small and the market is able to again fall under the levels made when the bad news came out (or rise above the levels made when the good news came out), it’s safe to assume the market is going lower (higher).

Four rules for trading SNI
Here’s how to successfully use the SNI in your trading:
1. If the news is considered bullish, the SNI is your major support number and, if acting properly, the market should remain above it. If the market is acting properly after a bullish event, you can enter a long position with a stop just below the SNI.
2. After a bullish news event, a move below the SNI generates an automatic sell signal, and you can immediately enter a short sale with a tight stop just above the SNI.
3. If the news is considered bearish, the SNI is your major resistance number, and the market should remain below it if acting properly. If the market is acting properly after a bearish event, you can enter a short position with a stop just above the SNI.
4. After a bearish news event, a move above the SNI generates an automatic buy signal, and you can immediately enter a long position with a tight stop just below the SNI.

A trader can select any number of days or periods and then use the SMA formula:
SMA = (P1 + P2 + P3 + … + PN) / N
where P is the price of the commodity being averaged, and N is the number of days (or periods) in the moving average.
The value of an SMA is determined by the values that are being averaged and the time period. For example, a 10-day SMA shows the average price for the past 10 days, a 20-day SMA shows the average price for the past 20 days, and so on. The time period depends on the trader’s time horizon—it can be years, months, weeks, days, minutes, or even ticks. You can calculate moving averages based on opens, closes, highs, lows, and even the average of the day’s ranges. I recommend using the close, or settlement price, for each day or interval. On daily charts, it’s the most important price of the day since it’s the price used to calculate margin calls. If the market closes on the high, or in the high range, most of the short players (unless they shorted right at the high[s]) will have funds transferred out of their accounts and placed into the long’s accounts. This action makes the shorts a bit weaker and the longs a bit stronger (at least for the next day). The same logic works on shorter-term intervals. Even on a five-minute chart, if a close is on the high of the bar this means that every short during the five-minute interval is on the losing side of that 5-minute price range…at least in the short run.

When the closing price turns down and under the average, a sell signal is generated.
You can connect each day’s value on a chart to produce a line. You can chart this line and overlay it onto a price chart to generate trading signals. A simple trading program would look like this: As long as the line on any particular day is under the closing price, the trader would stay long because the SMA has determined that the trend is up. After the line crosses over the closing price, the trader would go short because the trend has turned down. If the position is long
and the line crosses over the closing price, the trader would reverse the position by selling double the number of contracts owned. The problem with this simple
trading program is if you do this every time the line crosses price (especially when using shorter-term averages), you can easily get “whipsawed” (bounced back and forth, with small losses and commissions eating you up). A market can trade in a wild range, moving up and down wildly in the same session, but as I have mentioned before, I believe that the closing price is the most significant.

How many days should you use in your moving average?
The length of the moving average greatly impacts trading activity and, therefore, profitability. Some traders use 5-day moving averages, some 10-day, others use
20-day; I’ve seen funds use 50-or 100-day, and so on. The length is your decision, depending on the type of trader you are, but length directly determines the sensitivity of any moving average. The length determines how much time a moving average has to respond to a change in price. It is a matter of “lag time.” This is a simple but important concept: Shorter moving averages are more sensitive than longer moving averages. A 5-day moving average is more sensitive than a 10-day moving average, and both are more sensitive than a 20-day moving average. The more sensitive a moving average is, the smaller the loss will be on a reversal signal; however, there will be a higher likelihood of a whipsaw (a false reversal signal causing a trader to reverse a trade too soon). A false signal occurs when a minor movement, which ultimately does not change the major trend, is enough to push the moving average in the opposite direction of the settlement price, resulting in a false position change. It is false simply because the trader will subsequently need to reverse once again when the major trend reasserts itself.
It’s important to use a moving average that is long enough so that it is not overly sensitive. However, if the moving average is too long, the trader will tend
to take too big a loss (or give up too big a portion of unrealized paper profits) before even being aware of a trend change. A longer moving average will keep
you in a trade longer, thereby maximizing paper profits, but it can eat into realized profits because it moves too slowly. Like the porridge in the story of the
three bears, the moving average cannot be too hot or too cold; it needs to be “just right.” The most popular question I’m asked has to do with what is the “right”
moving average to use. “Just right” is not always easy to determine and will change with market conditions. Voluminous studies have been done to determine which length is right for which specific market, but I believe that these are useless because market conditions change for all markets. The silver market of the Hunt era is not the same as the silver market of today. Soybeans in a drought market act far differently than in a normal-weather market.

For a 20-day SMA, the SF is 2 divided by 21 = .096.

Entering a new pivot trade from the long side requires three steps:
1. Setup bar
2. Buffered entry price
3. Triggered entry

To determine the buffered entry price, you take the high price of the setup bar, multiply it by .05%, and add that to the high price. The resulting number is the
buffered order entry price.

Generating the sell signal
The process of generating the sell signal begins the same way as generating the buy signal—by calculating the 10-day SMA. The SMA is calculated based on the settlement (closing price). When determined, draw it on a daily chart. Entering a new pivot trade from the short side requires three steps:
1. Setup bar
2. Buffered entry price
3. Triggered entry

To determine the buffered entry price, you take the low price of the setup bar, multiply by .05%, and subtract from the low price. This number is your buffered
order entry price.

(Price X Tick size) 1.45 x .05 = .0725

1.45 – .0725 = 1.3775

There are two reasons a setup does not lead to an entry. The first is that the market just grazed the set up high or low and the buffer kept you out of trouble. The other is that there is no follow-through after setup and therefore no signal. If you magnify a typical signal, it will look as shown in Figure 10.4. In fact, a setup that is not triggered would lead to what I call a “reverse pivot.”

A reverse pivot occurs when a setup that is not triggered leads to a confirmed signal in the opposite trend direction. My experience has been that reverse pivots
more often than not lead to powerful signals with above-average reward-to-risk ratios.

To calculate how much money you could make or lose on a particular price movement of a specific commodity, you need to know the following:
• Contract size
• How the price is quoted
• Minimum price fluctuation
• Value of the minimum price fluctuation

The two major types of commission firms are discounters and full-service firms.

The basis
In these examples, I have kept the basis fairly constant, but in reality, it can change. If a short hedger (one who sells futures) experiences a widening of the
basis (where cash prices have fallen to a greater degree than futures—either cash has fallen faster or risen slower than futures), a basis loss may result. In other
words, the short hedger’s cash position loss may be greater than the gain realized on the futures side of the transaction. Or, in a rising market, the gain on the cash side of the transaction would not be as large as the loss on the futures side.
Conversely, a basis gain would occur with a widening basis on a long hedge. The futures would rise in price to a greater degree than the cash. A narrowing basis yields additional gains for a short hedger (the cash falls less, or rises more, in relation to the futures) and incremental losses for a long hedger (the cash falls
less, or rises more, in relation to the futures). Basis gains or losses are a risk to a hedger, but they’re not nearly as big a risk as what is called flat price risk.

Conversely, a basis gain would occur with a widening basis on a long hedge. The futures would rise in price to a greater degree than the cash. A narrowing basis yields additional gains for a short hedger (the cash falls less, or rises more, in relation to the futures) and incremental losses for a long hedger (the cash falls
less, or rises more, in relation to the futures). Basis gains or losses are a risk to a hedger, but they’re not nearly as big a risk as what is called flat price risk.

This option is as important in theory as in practice because it is what allows physical commodity prices and the Exchange-traded contracts to come together in price. If the price of the commodity is too high in relation to the futures price, then the people involved in the use of a particular commodity buy the low-priced futures contracts and take delivery. Their buying, in effect, pushes futures prices up to meet the physical price. If the price of a futures contract is too high in relation to the actual commodity, then producers of that commodity sell the contract to make a delivery because the higher-priced futures (in relation to the physical) just might be their best sale. Their selling pushes the price of the futures down to the cash price. This entire process is known as convergence. This potential process of convergence is what makes the system work; however, in practice, only 1% to 2% of all commodity contracts end in delivery.

How is the price determined?
Conspiracy theorists would tell you that price is determined by the big banks or the oil companies. A simpler explanation is supply and demand or, in other words, buyers and sellers. If the buyers are more aggressive than the sellers, prices go up. If the sellers are more eager, prices go down. In a free market, prices are determined by what the seller can get from the buyer. Prices are made by what someone is willing to pay for a given product. You might think any given price is too low or too high, but at any point in time, the market sets the price, and there’s an old adage that says that the market is always right.

Stop orders
Stop orders, or stops, are used in two ways. The most common method is to cut a loss on a trade that is not working (also known as a stop-loss order). A stop is an
order that becomes a market order to buy or sell at the prevailing price only if and after the market touches the stop price. A sell stop is placed under the
market, a buy stop above the market.

Market if touched
Also called MITs, market-if-touched orders are the mirror image of stops. MIT is placed above the market to initiate a short position and below the market to initiate a long position.

Types of options
Calls and puts are the two basic option types. Call options are bought by bullish traders. A call option gives the buyer the right, but not an obligation, to purchase the underlying asset at an agreed-upon price (known as the strike price) within a specified time.

Styles of options
Two styles of options are available: American and European. The basic difference is in the rules of exercise. A buyer can exercise an American-style option at any time before it expires. A buyer can exercise a European-style option only on the expiration date. All other factors being equal, a European option is generally slightly cheaper than an American option because it can be exercised only on the one date and, therefore, involves less uncertainty for the seller. The vast majority of Exchange-traded options are American style, and the vast majority of OTC options are European style.

Call options are primarily sold by bearish traders: Call options are also sold by traders who expect a market to go nowhere over the specified time period. Call options are also sold, at times, by bullish traders who wish to receive protection, or cover a long position or gain additional income from a long position.

Volatility
Okay, we have discussed how an option’s value is determined—time and the relationship of the strike price to the underlying futures price. And there is another component: volatility. Very simply, as the volatility of a market increases, so do option premiums. This is an important determinant of pricing options. Sleepy markets supposedly have lower potential price movements, and options buyers bid less. However, some of my best option purchases have been “cheap” buys. When everyone is buying, the smart money is selling. The reason premiums increase with higher volatility is very simple: Option sellers demand higher premiums to offset the higher risks their options entail in a more volatile environment.

If you trade options, you possibly will also hear the term delta, which is what I’m referring to above. Delta values range from 0 (for very deep out-of-the-money
options) to 1 (or 100% for options so deeply in the money that they move just like the underlying futures). At-the-money options have a delta value of 50% (or .5). Calls have a positive delta, whereas puts have a negative delta. If, for example, a 400 copper call trading for 1250 points (or 12 1/2 ¢) has a delta of .6, a 1¢ (or 100-point) move in the copper price results in a move of 60 points in the value of the call to 1310.

You will no doubt hear warnings against “naked” option writing. But just how risky is it to sell options? Well, it can be risky—certainly more so than buying—but it is actually less so than futures. It’s risky because you receive a premium, and in the case of writing out-of-the-money options, you have the additional cushion of the gap between the market and the strike price. Furthermore, an option writer can use defensive strategies to protect himself. The writer can always buy back his short position, just as a short futures trader can buy backers. He can use a stop loss in the options market, just as in futures. Some options are not all that liquid, and you need to take this into account, but many of them trade actively and are as liquid as the underlying futures markets. Finally, the option writer can buy (in the case of selling a call) or sell (for a put) a future against his option if he gets into trouble. In many cases, professionals use this strategy to become more neutral.

Calendar spreads
Also known as time spreads, calendar spreads take advantage of the tendency of nearby options to decay faster than distant options. This strategy involves the sale of an option in one month and the simultaneous purchase of an option (usually, but not necessarily, the same strike price) in a later month.
One of the potential pitfalls in this strategy is that the spread values of the underlying commodity can change, perhaps favorably, but contrary to expectations as well. Many times, the nearby month, which affects the short side of the spread, moves more dramatically because of higher open interest and greater speculative play. The risk cannot always be predetermined to an exact level like the vertical spreads; however, there is merit in this strategy if it is monitored and used correctly.