Technical Analysis with Commodities

Technical analysis covers a broad range of strategies and techniques which all use price to make trading decisions. The only way to trade without using any technical analysis is to completely ignore movements in price and just rely on something else, an opinion on the fundamental outlook of the asset being traded for instance.

Some commodities, gold for instance, can be held with no regard to anything other than a future personal need, in the same way that currency is held for instance. With commodities trading, rather than investing, the shorter time frames that they are generally traded in does necessitate that we use something related to the asset itself to guide our trades, because these trades will need to be regularly evaluated to how long our positions should be maintain, and when we do exit, decisions will need to be also made as to what to do with the invested money next will always come up.

One could completely ignore price when trading commodities, as so many people do with their stock investments, where ignoring here means not having a plan based upon managing the risk of the trade. While people do close their stock positions based upon price, particularly during large movements against them, this is driven by considerations other than technical analysis, fear mostly.

When we use technical analysis, we are monitoring the conditions of trades and potential trades to some degree to help us decide when to enter and when to exit. While one can enter trades without regard to price movements, when we don’t have an exit strategy based upon price, we are exposing ourself to unlimited downside risk.

This is why, regardless of one’s approach to trading commodities, it is wise indeed to incorporate some form of technical criteria in our trades, even if it is only looking to limit our risk by using some form of stop loss. Otherwise, when our beliefs about the trade end up being incorrect, we will not have a plan to keep ourselves from getting hurt too much from these trades.

Even Fundamental Movements Can Be Measured Technically

The main difference between using fundamental analysis and technical analysis in trading is that fundamental analysis is involved in beliefs about what may happen, while technical analysis is more focused on what is happening now.

Technical Analysis with CommoditiesIf a trader had a belief about a certain commodity that came to pass, and traded upon that belief, this may provide the opportunity to get in on the action sooner than waiting until the news hit the market and the movement that was expected began.

Once this did begin though, a technical trader would see the movement if it were significant enough and look to get in on it then. While this would result in capturing less of the move than if you acted upon the event before the news hit, waiting until the move does increase your chances of being right about it, since you’re just reacting to it instead of needing to anticipate it.

Unless someone truly has some inside information though, what is already known and expected generally is already going to be priced into the commodity, because people will action information that is available for the most part. Trying to outwit commodities markets on the basis of fundamentals is an extremely difficult task in fact.

If one is seeking to do this, one must be honest with their appraisal of their skills here and contemplate what makes their skills measurably better than the best in the industry, which is pretty much required to make such a strategy work in the long run. One can guess and get lucky, but to do this often enough to make a profit is another matter, particularly when one has neither the expertise nor the resources to compete with the large institutional investors that trade this way.

While movements based upon fundamentals do play a significant role in the price action of commodities, it is far easier to just look to determine which way the tide is flowing and then to look to swim with it. This is what a technical approach to commodities markets seeks to do.

By seeking out patterns and momentum in the price of a commodity, one can look to take advantage of changing fundamentals in commodities without having to predict these moves in advance, which is again extremely difficult to do. There is still prediction involved with technical analysis, but it’s easier to decide whether a move has significant momentum or not than it is to figure out if and when this will happen on top of the other decisions that we need to make.

A Lot of Movement is Of A Technical Nature

While a lot of the bigger moves in commodities are inspired by changing fundamentals, much of it is not, and while these technical moves based upon the supply and demand of the trading itself may not be as large, they still can be pretty significant.

Given that one can trade commodities with a lot of leverage, these moves, which may otherwise be not very significant if one was trading with cash, can be amplified such that they can be very worthwhile to pursue.

This is how money is made in the forex market for example, where moves such as a quarter of a percent your way won’t add up to much if you’re just buying and selling the currencies, but if we amplify these moves many times over, 10 or 20 or more times, then we can go from a market that isn’t really worth bothering with to one that can deliver returns several times greater than less leveraged trades such as stocks.

Commodity markets tend to be as fractal as any market, where prices move back and forth in the very short term, the longer term, and periods in between, and one can trade commodities very frequently if one desires, where meaningful money can be made in trades lasting as short as just a few minutes.

As long as your average gain per trade net of trading costs is positive, any time frame can be used, although certain time frames do lend themselves to more overall profit than others. Just because you can make a profit trading with 5 minute bars for instance doesn’t mean that this time frame yields the most profit, and depending on one’s strategy, longer time frames may provide you with the ability to earn more per day on average while still managing risk well enough.

Volatility is the Stock in Trade with Trading Commodities

Since commodities are more linked to fundamentals than some other types of assets, they do tend to be less volatile from a short term perspective, meaning that the influence of the supply and demand from traders can be of a lesser influence. With the amount of leverage commonly available in trading commodities though, there is plenty of volatility to work with generally, although this does also depend on the commodity, as some are more volatile than others of course.

Volatility is what traders seek generally, and this is especially the case with commodities. Stock investors for instance tend to look for stocks that will go up, or ones they hope will, but commodity traders don’t care about whether they go up or down, provided that they move enough in either direction.

There is essentially no long or short side to commodities trading, if long and short is to be understood as buying something to go long and borrowing it to go short, as all commodity trades have both a long and short side to them. Depending on whether you are expecting something to go up or down, you just place a trade in that direction.

Volatility measures the tendency for something to move in either direction, and the more volatility that a security has, the more potential for profit there is, as well as the more potential for risk. These risks can be managed though, by limiting how much risk one is prepared to take on in a trade, although one does not want to manage the volatility on the gain side the same way.

This is why one of the most popular axioms of trading is cut your losses and let your profits run, because this allows for risk to be managed without placing such strict limits on the profit one may obtain for a trade.

A lot of the money made and lost with trading is centered around trades that move a lot, where one may either make a lot or lose a lot. Making a lot is good, losing a lot certainly is not, and we need to strive to prevent this happening.

The volatility that traders are after though is predictable volatility, and we don’t want sharp quick moves, ones that are more difficult to manage. Steady moves are preferable here, of a sufficient length to both be tradable and profitable.

Using Technical Analysis to Trade Commodities

Trading commodities with technical analysis isn’t much different from using it to trade other assets, although one must always look to adapt one’s approach to the particular behavior of the commodity being traded.

With some commodities, a certain approach may get you in and out of trades too soon, while with another, which tends to move more in the period being traded, it may be appropriate.

The key with trading commodities successfully, as well as anything else for that matter, is to look to match your trading cycles with the cycles of the commodity’s charts as best you can. This can only really be accomplished by first looking at the way a commodity’s price moves on various time frames, to decide which would be more easier and more profitable to trade.

At that point, one then would look to discover which approach would best capture these moves profitably within the chosen time frame, and one may use the usual wide variety of indicators and other technical criteria to compare.

Being that commodities tend to be more range bound than most securities, meaning that there is more back and forth than in one direction than another, oscillators such as stochastics tend to work fairly well, measuring overbought and oversold levels where one can then look for confirmations in price or other indicators to determine points where the price is more likely to reverse significantly than not.

The right oscillator indicator setup and strategy can also serve traders well in markets that are moving a lot as well, and it really comes down to using the right time frame such that more significant moves will have a chance to play out more before you get your exit signal. If you’re looking to capture bigger moves and are using 5 minute bars for instance, there really isn’t an indicator short of a very long moving average that will ever keep you in trades for very long, and if that is sought, a longer time frame is required.

At various points, traders will take profits or cover losses, and with commodity markets, you do see profit taking on moves down as much as you do on moves up. Ideally, we can stay on board during trends and get off the bus when it changes direction or is likely to,  This is the essence of profitable trading with anything or with any strategy, you want to be in as much as you can when the price is moving with you and out as much as possible when it is moving against you.

Technical analysis, used properly, will serve commodity traders well, and is the backbone of not only commodity trading but any trading.

Ken Stephens

Chief Editor, MarketReview.com

Ken has a way of making even the most complex of ideas in finance simple enough to understand by all and looks to take every topic to a higher level.

Contact Ken: ken@marketreview.com

Areas of interest: News & updates from the Federal Reserve System, Investing, Commodities, Exchange Traded Funds & more.