As long as markets exist, there will be debates about their future direction. Are they too cheap? Too high? Predictions abound--after all, that’s what makes a market, right?

My philosophy is not to get cemented into an opinion I need to defend should the market prove me wrong. Rather, I try to let the market tell me if it’s too cheap or too expensive. Easier said than done? Well, perhaps we make it harder than it needs to be. Let me share with you a simple methodology that can help us determine if a market is “cheap” and if it has in fact bottomed out and is on its way back up.

I trade commodity futures. With futures we have a valuable statistic available to us that stock traders don’t have--open interest (OI). OI is the number of outstanding contracts open at any one time. This number will rise and fall as new players enter the marketplace or old players leave. One valuable trading methodology combines analyzing the level of OI with the trend of the market in question (as determined by moving averages).

Here’s my premise: Markets will generally make a bottom when OI levels are low, indicating a time when the public isn’t heavily involved and overlooked markets can be “cheap.” When OI is high, indicating feverish activity generally brought about by significant media attention, it’s time to be wary as a market top could be forming. The public is usually fully invested at the top, not the bottom.

Moving averages can help us determine the trend of a market. Just because a market is cheap doesn’t mean we’ll make money. A market can remain cheap for a very long time, and we want our capital to be working in a market that’s moving higher. So the idea here is to find a cheap market that's started moving up. This is known as the “accumulation” phase, where the smart money is entering the market before the general public.

Let me give you an example of what we’re looking for before we get into new potential targets.

June 2006 Gold



Source: Commodity.com

OI figures are relative by market; what’s high for one could be low for another, so we have to evaluate levels by history and market. In March, OI for gold (represented by the orange line below the price chart, above) was at the lowest levels for the year. When the market broke above and closed above the 30-day (red line) and 50-day (green line) moving averages (at about $570), it didn’t look back until it topped out at $730--concurrent with a lot of media hype and high OI levels.

So this is what we’re looking for: low OI and a breakout above the 30- and 50-day moving average band.

Let’s take a look at the current gold chart.

August 2006 Gold



Source: Commodity.com

OI has collapsed from the high levels reached in May and can now be considered low and rising, indicating a bottom could be in formation. However, the market is still well below the moving average band. Silver looks the same.

July 2006 Silver



Source: Commodity.com

Sugar looks interesting. OI is at the lowest levels seen this year, and the market is very close to breaking out above the moving average band.

October 2006 Sugar



Source: Commodity.com

This is a market to keep an eye on for a fresh buy signal. Copper is showing a similar formation.

September 2006 Copper



Source: Commodity.com

Finally, cocoa looks to have recently broken above the moving average band with OI levels that could be considered low by historical standards.

September 2006 Cocoa



Source: Commodity.com

Finally, cocoa looks to have recently broken above the moving average band with OI levels that could be considered low by historical standards.

September 2006 Cocoa



Source: Commodity.com

I’m not saying this simple methodology is the Holy Grail; there’s no such thing in commodity trading. I’m saying that many times, simple is just fine. I absolutely do use moving averages and OI in my trade analysis for Futures Market Forecaster.

These are useful tools you should consider employing.

George Kleinman is editor of Commodities Trends.

Risk Disclaimer

Futures and futures options can entail a high degree of risk and are not appropriate for all investors. Commodities Trends is strictly the opinion of its writer. Use it as a valuable tool, not the "Holy Grail." Any actions taken by readers are for their own account and risk. Information is obtained from sources believed reliable, but is in no way guaranteed. The author may have positions in the markets mentioned including at times positions contrary to the advice quoted herein. Opinions, market data and recommendations are subject to change at any time. Past Results Are Not Necessarily Indicative of Future Results.

Hypothetical Performance

Hypothetical performance results have many inherent limitations, some of which are described below. No representation is being made that any account will or is likely to achieve profits or losses similar to those shown. In fact, there are frequently sharp differences between hypothetical performance results and the actual results subsequently achieved by any particular trading program. One of the limitations of hypothetical performance results is that they are generally prepared with the benefit of hindsight. In addition, hypothetical trading does not involve financial risk, and no hypothetical trading record can completely account for the impact of financial risk in actual trading. For example, the ability to withstand losses or to adhere to a particular trading program in spite of trading losses are material points which can also adversely affect actual trading results. There are numerous other factors related to the markets in general or to the implementation of any specific trading program which cannot be fully accounted for in the preparation of hypothetical performance results and all of which can adversely affect actual trading results.