I look for potentially profitable trading opportunities every day. Right now, one market--cocoa--looks particularly interesting to me.

Why? I’ll explain shortly, but first let’s talk about how to identify those profitable trades.

September 2006 Cocoa



Source: Commodity.com

An old-time trader once told me, “If you can correctly determine the trend of a market, you will make money.” This might sound simple, but it’s actually quite profound. The reason: Even if you’re wrong in your timing, but right on the trend, the trend will tend to bail you out (in most cases). If you’re good at timing (picking a short-term bottom in a major downtrend, for example), the trend will have a tendency to eliminate your paper profits in short order, despite your excellent timing.

My approach to analyzing the markets is predominantly technical. In the long run, fundamentals will determine price. However, as Lord Keynes said, “In the long run, we're all dead.”

My primary goal in Futures Market Forecaster is to determine the true trends of the markets we trade. My premise is if you are able to accurately determine the trend, then you will--over time--make money. It’s easier paddling downstream than up, it takes less effort walking with the wind than into it, and it’s my belief it’s generally more profitable trading with the trend than against it.

I think we have a tendency to make this whole trading thing more difficult than it needs to be. We’ll ask if the supply is tight or plentiful, if the demand is poor or strong, if a price is cheap or expensive. But the answers to these questions aren’t always that easy to determine. 

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Because this company’s stock price has more to do with political developments than with international demand.

Since the election of Evo Morales, my favorite silver stock has become grossly undervalued, but that’s just preparing it for its next major leg up.

An easier question to answer is: What’s the trend? I can make this very simple for you. A market will be, at any specific point in time, trending up, down or sideways. For example, look at coffee this year; while it could make a bottom at any time now, for this entire year at least, it’s been trending down (evidenced by lower highs and lower lows).

Coffee 2006



Source: Commodity.com

Bottom line: Accurately determining the trend is the key to making money in the markets.

The best tool I’ve found for determining the trend with a fair degree of accuracy is the moving average. Here’s an excerpt from my book, Trading Commodities & Financial Futures: A Step by Step Guide to Mastering the Markets discussing the basics of this valuable tool.

A moving picture: Any one price is like a snapshot in time that can never tell us what the trend is. It does tell us something, but hardly the whole story. When you take 10 photographs in rapid succession, you can get a better picture of the whole story. If the story is the market, you get a better picture of the true trend looking at the last 10 prices, as opposed to looking at just one. When you put together a series of say, 20 blocks of 10 photos each, you then have a movie that will be infinitely more informative than a photo or two. This movie is analogous to a moving average line, one that can be superimposed on a price chart. By observing the direction this line is moving and the strength (or velocity) of the move, the line can give you a sense of which faction is stronger at the time, the bulls or the bears. If the bulls are stronger than the bears, the moving average line will appear to move up and the current price will trade above the M A, and visa versa. The tough question when using MAs is how many prices give us the best feel for the trend. If we use too many, the old data can tend to put the true trend out of focus. Too few and we cannot really tell what it is we’re looking at. It’s important to remember that when we utilize any trend-following method, we’re not trying to forecast when a market move will start or end. Rather, we are using a totally technical approach that relies on a specific type of indicator to tell us what the trend is. Then by taking a market position in sync with this trend we are attempting to place the odds in our favor. We also would like to have this indicator alert us, with some degree of reliability, when the trend has changed before we give back too big a chunk of our paper profits, or before any unrealized losses become too serious. Moving averages can tell you when the trend changes. More importantly, they will keep you on the major portion of a major trend, and thi s is where the big money is made. Still, nothing worthwhile is ever easy. In trendless markets, moving average techniques will generate false signals, and there are those periods when there will be strings of smaller losses. There will also be those periods where strings of smaller losses can add up to bigger losses. When using moving averages, it is extremely important for you to never lose the winning qualities of patience & discipline--particularly when the bad strings occur. This is the key to success.

A moving average primer: Moving averages come in various flavors and sizes. They range from simple, to weighted, to smoothed and exponential. Traders use them alone, or in combinations as crossovers, even triple crossovers. They use them in oscillators as moving average convergence/divergence, and in bands. Our basic underlying assumption here is that, more often than not, markets move in a trending fashion. I should mention, not everyone believes this is a true statement. There is a contingent of academics that feel market movements are random in nature (the “random walk” theorists) but I believe you can fairly easily prove to yourself that “random walk” is bunk. While markets can be random in a short period of time, just look at any chart of any commodity of at least six months in length. When demand for a particular commodity, or a financial asset, is stronger than supply, prices (and therefore the market) will move in an up-trend. When supply is overwhelming deman d at any particular point in time, the market will trend downward.

It’s easy, of course, to determine trends after the fact by looking at a chart. For example, isn’t it easy to determine the trends (looks like up then down) in this year’s gold chart?

Gold Trends



Source: Commodity.com

However, it’s not all that easy to determine the trend in the thick of the battle, and the news--the fundamentals--won’t help you at all because it’s always most bullish at the top and bearish at the bottom. Plus, while markets will trend up or down, they can certainly move sideways as well. An erratic up/down type affair, a trendless market, will temporarily wreak havoc with any trend-following system.

These are the periods during which you’ll need to use your discipline and patience to persevere. The good news is I’ve found markets are engaged in up and/or downtrends for longer periods than they’re engaged in sideways trends. This is why moving average methodologies can put the odds in your favor.

Now back to cocoa. Why does it look so interesting to me? Here’s the same chart of September 2006 cocoa with the 50-period exponential moving averages superimposed on the price chart.

September 2006 Cocoa/50-Period EMA



Source: Commodity.com

For the past few weeks, this market has stopped trending downward--note the sideways-type action, the consolidation. This is one reason this market looks interesting. A market will tend to consolidate after a trend (in either direction) has run its course. During these periods, neither the bulls nor the bears are winning, but the smart money is either liquidating or adding to long-held positions.

Are they cashing out? The key will be how the market breaks out of the consolidation. My guess is the breakout will be to the upside in cocoa (after all, this market’s historically cheap and came down a long way from the top), but I’ve been burned too many times anticipating. It’s much better to let the market tell us.

Watch for a break and close above the 1,527 level first (the upper horizontal line) and then watch for a confirmation break and close above the important 50-period exponential moving average, currently at 1,550 (the maroon line). Note how a similar breakout above a consolidation and the moving average in June resulted in a major and lucrative rally for the buyers.

I’ll keep you updated on trade setups like these in Futures Market Forecaster. My recommendations are very specific; I provide exact entry levels with specific stops and profit objectives for all trades.

Good luck and good trading.

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.