Trend following technicians like commodity futures. There is a nice match between commodity movements and trend following methods. Trend following methods exploit the situations where prices move in one direction for an appreciable amount and an appreciable period of time.
Prices can either be mean-reverting with ranged trading. Or they can move in long-term trends. The former situations - mean-reversion - is more common. Any trend-following system will lose more often than it gains, whether it trades stocks, commodities or currencies. Trend followers hope that when a trend arises, it will generate enough in the way of profits to over-compensate for the losses of multiple failed trends.
A good trend-following system will do several things. It will mechanically identify situations where trends are likely to develop. It will enable the setting of initial stop-losses to exit in case of trend failure. It will incorporate a method of setting trailing stop-losses to follow a successful trend, while maintaining exit options for trend reversal. In a “pure” trend-following system, a position could stay open for months, until such time as the trailing stop-loss is hit.
Any trend follower has to keep taking the mechanical entry signals whenever these arise. There is no way to tell which move will work, and which one will fail. The initial stop-losses mean that relatively, small sums are lost in failures.
Ideally, the trader must be able to take a position in either direction with equal facility. This is not really possible in the stock market. Shorting equity is more difficult. However, short/long are equally easy in the stock futures market and in index derivatives, commodities, currencies, etc.
Some financial assets are inherently more likely to be range-trading. Currencies, for instance, tend to move within established high-low bands. On rare occasions when big trends arise, regulatory authorities and central banks often step in because there is a collapse, or the threat of a collapse in some currency. That can suddenly affect liquidity just as a position is reaping profits. However, high leverage in currency contracts means that even a small currency movement generates large gains (or losses). So, modified trend following systems can work.
Commodities tend to have very favourable trading dynamics for trend following systems. Many commodities have long trending cycles where prices can multiply, or fall by large amounts, over a period of years. Once a commodity cycle is established, a trend following system can reliably generate profits through a long period. Importantly, commodities are traded as futures with high leverage and strong linkages across global markets. This means, long and short positions are taken equally easily and rolled over at minimal cost.
Crude is one example of a commodity, which has yielded good returns on the short side. Prices are down by about 35 per cent in the past year. Metals are also offering attractive returns on the short side. Global GDP growth is likely to be muted for at least a year, going by consensus expectations. Chinese trade data suggests that the world's largest metal consumer (and re-exporter) is in the middle of a slowdown. So non-precious ferrous, and non-ferrous metals should see soft prices.
Producers of metals should also see soft prices and India has several blue-chip metal companies traded in the futures and derivatives segment. The generally bullish nature of Indian stock prices might be a dampener for bearish futures plays. However, the Indian CNX Metals Index is down six per cent in the past month and it could slide a lot further.
The author is a technical and equity analyst
