Various Market Musings

Tonight’s post is an attempt to put thoughts on a few different topics in writing so that I can avoid conversations on Twitter like the one I found myself in this afternoon.  Twitter is fantastic on any number of levels for traders but it is not a great medium for discussion on topics that should go beyond sound-bites.  In my opinion this is a better place for those operating in markets to engage with me on these topics.  Feel free to leave any comments or feedback here and I’ll be happy to respond to them as soon as possible.

Hedging

Normally I don’t like to get textbooky when discussing markets but in this case I think it is warranted because I believe this term is tossed around incorrectly on a daily basis on Twitter.  Holding a cash position and then operating in markets does not necessarily mean your operation was a hedge.   Forgive me if this section is all review for you, but I generally have a hard time biting my tongue when people use market terminology incorrectly.

In the broadest sense hedging is the transfer of price risk from one party to another.  An unhedged cash market position is a speculative position.  It bears the full brunt of price changes occurring in the cash market.

Hedging proceeds in one of two ways:  Sell or short hedge and buy or long hedge.  Let’s go through an example of the sell or short hedge and from there I trust my readers are smart enough to generally understand how a buy or long hedge works.  There are many ways to hedge but I’m not going to write a book on the topic nor am I going to dive into discussion of using options to hedge so let’s keep this simple so that I can quickly get to the point of this section.

Sell or short hedge:  A producer or someone with an inventory (lets say a farmer since I have a good deal of farmers following me on Twitter) who has or will have a commodity for sale in the future transfers the risk of price change by selling short that commodity now in the futures market.   Selling short is the present sale of a futures contract with the promise to deliver the commodity or repurchase the contract at a future date.  If a contract is sold short for $70, the seller will profit if prices decline before they are obligated to deliver the underlying commodity or repurchase the contract.  If the price drops from $70 to $50 and the seller opts to repurchase the contract at $50 then they keep $20 as profit.

When a hedger sells short they have two positions:  a long cash position (the physical commodity being held) and a futures position (short).  Cash and futures prices tend to move in parallel so if prices decline the value of their cash position also declines but the value of the short futures position increases by a similar amount.  It is appropriate to think of a short hedge as a substitute sale.  The short hedger may be said to have fixed a sale price for their cash commodity when they sold short in the futures market though the final price received depends on any change in the price difference between the two positions (called basis) during the term of the hedge.  Basis is the difference between cash and futures prices (cash – futures = basis).  Thus, a hedge in futures may or may not give full protection against an adverse price movement because of the changes in basis.

When producers and users hedge they can set prices they will receive or pay within a roughly determinable range.  Reducing their exposure to market surprises allows them to plan their operations more confidently.  This form of “insurance” allows for more efficient product pricing and more efficient inventory management.  I assume at this point everyone is following along, many of you probably already knew this or this is your job so feel free to nod at your monitor now or simply skip ahead to the conclusion.

Hedging is made possible by the speculator who assumes the risk of price change when he takes the futures position opposite the hedger.  A speculator doesn’t have a cash position – normally we (I’m a speculator) intend to resell or repurchase the futures contract in the hopes of realizing a profit.

So what is the point?

  • Generally, anyone engaged in a business that is subject to price change is a speculator in the cash market.  This includes a livestock producer raising cattle or hogs for slaughter, a banker who lends money at fixed interest rates, and a processor who buys grain for milling and marketing to consumers.  I know its popular for politicians and their minions to constantly pound the table over “evil speculators” but reality is what I just described.  Speculators are all over the place using many job titles other than trader.
  • For those of you on Twitter constantly claiming to be entering into “hedges” where you are deliberately trying to realize a profit (indeed many of you are very likely putting these on without matching the hedge to your cash position and you are doing so for the sole purpose of trying to make money rather than to transfer risk, some of you have been open enough to admit this) please understand why I’m telling you that you are not hedging.  You are a speculator and now you have speculated twice….once with your cash position and again in futures.  The hedger’s primary motive in the futures market is risk transfer.  End of story.

Technical and Fundamental Analysis

Technical analysis refers to the study of the action of the market itself as opposed to the study of the goods in which the market deals.  Technical analysis involves recording the actual history of trading and then deducting from that history the probable future trend.  Thanks to computers the use and application of technical analysis has expanded well beyond the classical techniques that have been used for hundreds of years.  Has TA really been around that long?  Yes, indeed.  The history of candlestick methods can be traced back to Munehisa Homma who built a fortune trading the rice markets in the 1700’s in Japan.

Fundamental analysis is study that is based on things that are removed from the market itself.  In the stock market for example, the most common application of fundamental analysis is estimating companies’ earnings for this year and the next year and then recommending what to buy and sell based on these estimates.  Thus, the fundamental analyst assumes causality between external events and market movements.  What should also be noted is that fundamental analysis almost always requires a forecast of the fundamental data itself before any conclusion about the market is drawn.  Allow me to provide two recent examples of this statement to attempt to provide evidence of this claim.

I was involved in discussion today that was referred to as fundamental regarding Soybeans and frost.  The general idea is not hard to understand, as follows:  Soybeans have sold off a good deal of late, the weather forecast is calling for a frost, frost will make bean prices go up.  Note the following:

  • The frost forecast has not completely played out yet, thus, the idea that it will eventually play out is itself a forecast.
  • Assuming the frost does occur we don’t know exactly how frosty it will get or what kind of damage the frost will cause.  Thus, the analyst has to predict how many areas the frost will touch and then also estimate how bad the damage will be.
  • Finally, after forecasting all the events above the fundamental analyst is forced to take a final step in coming to a conclusion about how those events will affect the market.  They of course would also consider forecasts on all the other fundamental factors since the frost is only one of them.

Ok….you don’t like my example?  How about I post a quote that a friend sent to me only yesterday.  The quote was apparently stated by a well-known market analyst and was making the rounds all over social media and the financial networks.  The quote was given to me as follows, analyst name is withheld:

“However, assuming that the U.S. avoids a recession–and no other global factor causes a significant decline in S&P EPS–and that US interest rates climb slowly and rise to a level that plateaus below historical norms, then 2500 is within reach for the S&P 500 by 2018.”

I would guess that even if you have only been around markets for a very short period of time you have seen dozens of these sort of forecasts made daily.

This is by no means a comprehensive discussion on the two forms of analysis but I think that I’ve provided a basic outline of the differences between the two.  I’m not going to spend any time discussing which one is “better” or “works” as so many people still do because I couldn’t imagine a bigger waste of time.  Like many other students of the market I have read every single book in the Market Wizards series multiple times.  What should be beyond obvious when reading the interviews with the greatest traders in the world is that they approach markets using BOTH of these methods.  Some use them in tandem while others prefer TA or FA in isolation.  Regardless of the method used it is the act of trading or investing itself that matters to your bottom line, which leads me to my next topic.

Trading and Forecasting

Ok, now we are about to enter the beliefs portion of this post.  What you are about to read are my opinions.  Enter at your own risk.

Forecasting the markets is orders of magnitude harder than deciding whether or not you are going to be long, short, or flat.  The decision to place a long or short trade gives the trader a 50/50 chance of being correct over any chosen time period.  Forecasting the shape or slope, the extent, and the time element of any market is a process that will always produce some degree of failure since no forecast could ever be perfect.  The market has an infinite number of paths it can take in making either longs or shorts profitable.  If you accept that to be true then it should follow that the act of trading must therefore be different from forecasting.   I trust that most of the people reading this have traded enough times where they had forecast something that ultimately came to be in markets.  A forecast that wasn’t perfect but generally prices got to where you thought they would in roughly the amount of time you thought it would take.  Yet, for one reason or another you didn’t capture the trade…maybe you changed your mind half way through the trade and got out early or cut it for a quick loss….maybe you started analyzing as your entry point approached and second guessed yourself and never even got in the trade at all.  I know if you have traded for more than a month you’ve been here….everyone that ever traded that was not fully automated has been here.

Forecasting and trading are two very different skills.  I gather from being on Twitter for a while now that most people operate under the belief that the way to make money in the markets is to predict the future and then to position yourself ahead of that outcome.  This is the part where I point readers back to the about section of the blog and to read point 8 under the listed beliefs.  Point 8 states that the outcome of my very next trade is random.  I know that many of you out there think you are putting on trades when they become “risk free” because everything has lined up perfectly under your methodology.  I know many of you operate under the illusion that the next trade “will work” because there are some variables present that you just know will go in your favor, you know….. most of the time, which you convince yourself is this time.  These are denials of reality when it comes to trading and I would highly suggest if you insist that I’m wrong about this that you conduct many coin toss experiments over the next several days and record them to test this belief.

What Are Markets Doing?

My intent in this section is not to write a research paper about how markets work nor should I even try to suggest I hold that knowledge.  I want to instead try to address what was at the core of the discussion I had today which were some seemingly different conclusions about how markets operate within the context of news, in this case unknown news about the extent of Soybean damage due to frost.

I will state plainly that I think (again, opinions!) generally following the latest news for clues about market direction is a waste of time.  I also do not find that creating forecasts about potential upcoming news and then taking a market position based on those forecasts is a valuable use of my time.  If that is your approach that’s fine.   This is not to say that news and other extramarket events are irrelevant and never have any meaning for prices for a trader like myself.  As an example, Twitter followers know that I will not trade directly in front of a major news release such as a USDA report because the markets can get so volatile directly before and after those periods that as a hand trader I can’t control my risk properly.   I also would suggest that events such as the potential for frost can certainly provide the basis for the rationalization of a market opinion formed simply by one’s emotional state and therefore represent other potential dangers to me as a trader.

The reality of news events is that sometimes markets spike higher, sometimes they spike lower, and sometimes they don’t really respond at all.  One might go so far as to claim that on all time horizons greater than a few minutes the news lags the market.  Perhaps you remember an example of this I showed on my stream once, which I had recalled seeing years ago from EWI.  Here it is with their commentary for review:

The chart below shows the DJIA around the time when President John Kennedy was shot. First of all, can you tell by looking at the graph exactly when that event occurred? Maybe before that big drop on the left? Maybe at some other peak, causing a selloff?

djia chart 1

 The first arrow in the next chart shows the timing of the assassination

djia chart 2

The market initially fell, but by the close of the next trading day, it was above where it was at the moment of the event

There are many examples of this happening in markets on a regular basis with what would generally be considered “big” news events.  This in turn leads many to claim the market must be “discounting” things.  That sounds appealing because you can also point to other events where the market appeared to have sensed changes before the events occurred.  I would suggest the idea that investors are clairvoyant is a little crazy and if you spend a lot of time researching this topic it’s probably not something you’ll hang your hat on.  Consider a most extreme example….did investors panic in 1929 because they suddenly realized that the worst depression in history was coming and that in the decade ahead a World War was going to take place as well?  Not to mention, by 1930 the collective perception had moved back to complacency again.  Did we really do a better job at discounting things in 2000 or 2007?  How about when Corn was priced at..well, you probably get the point I’m attempting to make.

I subscribe to the idea that the markets don’t see into the future.  Instead, markets simply record perceptions in real-time much like a barometer does.  That’s it.   Increasingly optimistic people expand operations in various markets and increasingly depressed people contract them.  The results show up later as what sometimes appears to be a discounted future.

At this point I think this post has probably gone on long enough.  My hope is that the post will serve its intended purpose and as stated earlier feedback or questions are certainly welcome in the comments section.

As always, good luck with your trades!

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About Fat F1nger

Full time futures trader.
This entry was posted in Broad Market Observations, Hedging, Trading and Forecasting and tagged . Bookmark the permalink.

15 Responses to Various Market Musings

  1. tchedger says:

    Brutally honest, well done, your comments are much appreciated

  2. Walt Jeter says:

    Excellent post, very good for your farmer followers to read. Nice work and thanks for sharing!

  3. Fat F1nger says:

    @TC and Walter,

    thanks for the kind words guys, much appreciated.

  4. Anonymous says:

    “I subscribe to the idea that the markets don’t see into the future. Instead, markets simply record perceptions in real-time much like a barometer does.”

    I was watching Chris Marker’s Le joli mai the other night, in which the film maker interviewed random subjects on the streets of Paris in 1962 – including a couple of brokers outside the Paris Bourse. The smart guys in the room pretty much alluded to the same precept. Some things never change. As for trend up in “abc co.” – the Rothschilds were buying…lol

    Great post. I’m saving it.

  5. Fat F1nger says:

    @someone….hahah yes, those pesky Rothschilds are always on the right side aren’t they?

  6. Richard B says:

    Re hedging, you say:
    “The hedger’s primary motive in the futures market is risk transfer. End of story.”
    Not really true. His motive is to mitigate risk, he is not really trying to make someone else take is. Indeed the other side of husctrade could also be a hedger, or more likely someone clisingva position.
    Sorry to pick holes but as the article seems to be written for the layman I thought it worth clarifying.

  7. Fat F1nger says:

    @Richard B,

    thanks for posting. since we are going to discuss the usage of words as opposed to the key point of that section (message: stop calling your deliberately speculative positions hedges) I, perhaps wrongly, thought I made it rather clear that “transfer of risk” does not necessarily mean “elimination of risk”. I suggested hedgers mitigate risk (mitigate: to make less severe, serious, or painful) rather than eliminated it completely when I stated the following:

    “Thus, a hedge in futures may or may not give full protection against an adverse price movement because of the changes in basis. When producers and users hedge they can set prices they will receive or pay within a roughly determinable range.”

    The word transfer itself does not imply a total elimination of risk either, it simply means moving from one place to another. It doesn’t imply how much is being moved. As a simple example, people might commonly state that they have “transferred money from their bank account to their brokerage account”. If someone said this to me I would not assume that they transferred “all of” their money to their brokerage account unless they specifically stated as much.

    Anyway, this isn’t an English blog and the language I used is rather standard Series 3 material and widely accepted as really true. Also, to be clear…I wasn’t intending to give a lesson to the layman on hedging, which is exactly why I didn’t walk through numerous examples showing that in reality there is rarely a perfect hedge or how to place one. Finally, I don’t think distinguishing who exactly is on the other side of the hedgers position upon opening is relevant to the point of this section of the post.

    I’ll be a bit more careful with my wording next time as to avoid this type of potential confusion. I had assumed most people would be able to clearly understand the wording used but perhaps that is not the case. Hey…its my second post.

  8. Art Liming says:

    “The market has an infinite number of paths it can take in making either longs or shorts profitable. If you accept that to be true then it should follow that the act of trading must therefore be different from forecasting.” – I see now how you differentiate between the two. However, I still contend that your trading is based upon your price series analysis which produces a forecast of some degree. I agree, after the trade is executed, the outcome of the trade is essentially random, but you are entering into the trade based on your expected edge which is based on your analysis.

    “One might go so far as to claim that on all time horizons greater than a few minutes the news lags the market.” – I very much agree as this is the result of imperfect transmission of information. At all points along the curve someone has and acts upon “news” first.

    “Instead, markets simply record perceptions in real-time much like a barometer does. That’s it. Increasingly optimistic people expand operations in various markets and increasingly depressed people contract them.” – I also endorse this view which led to my comment, “with markets resting on the lows, I believe you can infer something about market expectations.” The barometer was low as upward pressure from frost expectations decreased and was not able to overcome downward pressure from no-frost expectations and increasing larger crop expectations.

    Of course, I could be wrong . . . .

    I think one of the problems with forums like Twitter and this blog is lack of context other than words themselves which make up communication. I hope my comments here and there are taken in the spirit in which they are intended; respect, curiosity, and occasionally tongue-in-cheek.

  9. Fat F1nger says:

    Hey Art! thanks for stopping by and I appreciate you leaving a comment. I’ll come back to this tonight. Gotta watch the close and flatten up.

  10. Fat F1nger says:

    @Art,
    right, I agree that there are problems in all social media due to lack of context. On Twitter I especially have trouble when this sort of thing comes up because it doesn’t seem to thread the conversation together in the order I’m responding to tweets in…so I end up all over the place trying to respond. Gets especially difficult when it’s a convo with several people at once. I very much enjoy having these kinds of discussions with other traders but not on Twitter….imo a blog is better…not perfect, but better than being limited to sound-bites and at least here I can follow a consistent timeline.

    To respond to the forecasting/trading point as we seem to basically be in agreement elsewhere… First, Much of my thoughts about this topic come from my trading mentor and so I will borrow from him and use an analogy to explain why I think you can trade profitably without making any forecast at all. As a quick aside my mentor happens to be a well known forecaster as well as he submits to Timer’s Digest which measures forecasts and not actual trades. In Feb of this year TD ranked him #1 in bond timing over the last 3 and 5 year periods, top 10 in the S&P for the last 3 years and top 5 for the 8 and 10 year periods. He’s also been ranked several times in gold. What he found in his own career that as his forecasting got better and better his trading was not getting better at the same rate. After 30 years in markets he finally understood that they are mutually exclusive activities and then his trading really took off. So, here’s how my mentor explained this to me:

    Picture a scenario where you are lost in a jungle, paddling in a small boat in a river and your goal is to reach the ocean. In this scenario it doesn’t make a whole lot of sense to predict where the ocean is (north, south, east, or west) so that you can decide how to paddle. If you did this you are certainly going to fail (you hit the edge of the river banks and stop, you run into a rock instead of avoiding it, you hit another boat and put a hole in your boat in the process, etc.) The direction you have to paddle the boat to get to the ocean doesn’t have anything to do with how a bird might go about doing this because to achieve our goal we need to do something moment by moment to navigate the river properly to avoid all the things that can stop us from getting to the ocean. This is trading versus forecasting in a nutshell. Finally…you don’t really need to predict where the direction is anyway to reach to ocean….if you navigate the river eventually it just pushes you there.

    Maybe we won’t ever see completely eye to eye on what is going on here but the larger thing is that we do agree on the idea that trading and forecasting are two mutually exclusive activities. The purpose of the charts I’m using is to eliminate the idea of what is “supposed to happen” and they are not producing any kind of forecast. The chart automations I use are the barometer, that’s all. The can’t tell me exactly what is going to happen next they can only provide me a reading of what has happened and they do so in a repeatable, organized manner. This particular barometer has 6 primary measurements it can take, all of which tell me how to “navigate the river”…as in: this is how I’m going to execute trades. Hopefully over time the blog will further document this process and what is going on once a trade is on in order to provide the right context for these comments.

    Thanks for following…pretty pumped the blog has gotten a decent response so far and I hope to attract other active traders for discussion.

    Btw…what are you trading in grains? Outrights? Spreads? Options?….all of the above? You trade any other markets?

  11. Timothy says:

    Greetings, FF! Great post — thank you for sharing. I am a new to the futures market and currently trading soybeans (since August). I am ‘learning as I go,’ which quite honestly scares the hell of out me. By reading daily reports, researching, and following you plus several other traders/analysts on Twitter I have been ‘successful’ thus far (in learning and in my trades) …but I can’t shake the feeling that I am gambling and my luck will run out sooner rather than later. I’ve read through your blog and I like your approach to trading; I am curious to know if you are willing to point me to a few sources (literature, videos, etc) in order to expand my knowledge and understanding of trading/analyzing. Currently I am looking to buy ‘Technical Analysis for the Trading Professional,’ and possibly ‘All about Technical Analysis’ by Constance Brown. Any other suggestions are welcome! It is my belief that if I begin to fill these knowledge gaps, and discontinue trading based solely on fundamentals, this ‘gambling’ feeling will at least begin to lessen. Thanks again for the information you provide in your tweets and on this blog; it is all much appreciated. Good luck out there!

  12. Fat F1nger says:

    Hi Timothy,

    Thanks for the kind words. You certainly picked an interesting time to start trading the beans….been some serious swings in that market since August! I can give you a few suggestions on books but I think it would be good for me to tell you up-front that no matter how many books you read or instructional videos you spend money on there isn’t a single one of them that will truly teach you to trade and how to deal with your own personal issues in trading that you will need to identify and avoid acting impulsively on. That can only come through experience and all traders must go through this before they become consistently profitable. Since I’m always drawing comparison to sports I would suggest you think of it this way:

    If you wanted to be a good golfer you might buy some fancy clubs and balls, get yourself a real top notch glove and the best shoes you can find. Now that you have your equipment then you go out and buy all kinds of books and instructional videos. You even sign up for lessons at your local course with the golf pro there (and the pro is nationally ranked!). Then, the first year that you play, you go out 12 times and you shoot at least 30 over par every single time you are out there and you don’t have a single game under 100. The next year you play 35 times and you break 100 in 2 of those rounds near the very end of your 35 rounds. The year after that circumstances are such that you can play 50 rounds of golf…and near the end of those 50 rounds you are starting to consistently shoot in the 80’s. You are finally consistent as a golfer. I think you probably understand what I mean by this….it wasn’t the golf books or the lessons or the equipment that really pushed you to your goal…it was you practicing and gaining more actual experience.

    I consider trading a performance endeavor and so it is just like this. I think its important for new traders to read and try to absorb as much information about markets as possible in the early going but in the end you have to understand that reading all this stuff is not what is going to turn you into a great trader. You’ll only do that by trading and the harsh reality of trading is you are going to make a lot of mistakes and unlike in golf where a mistake means you have an extra stroke or three on a hole…trading mistakes mean losing money, which invites a whole host of other psychological factors into what you are doing.

  13. Fat F1nger says:

    2nd follow up:

    Ultimately up to you but I might suggest instead of buying any of Connies books that instead you try to get a base knowledge of the technical analysis she’s going into much more detail about in her books. After that if you decide you want to refine your basic TA knowledge I’d suggest books like hers. Please understand that after reading her books you will probably spend many months trying to implement and understand some of her concepts…at the very least. The best way to learn some basic tech stuff is to simply go to stockcharts.com and read through all the material they have there at the chart school. Pretty much every indicator or general TA idea is right there on that site and you do not need to pay for it:

    http://stockcharts.com/school/doku.php?id=chart_school

    A system doesn’t have to be complex at all in order to make money with it….but as a discretionary trader the real challenge is having the discipline to execute even the simplest of systems.

    When it comes to trading books here are some that I normally like to suggest if people ask:

    1. All the Stock Market Wizards books…but especially the very first one, which is more focused on futures traders. These books are excellent and the wisdom shared in them is timeless imo. If you continue to read these as you develop your trading skills more of the commentary in the books will make sense to you over time.

    2. Trade Your Way To Financial Freedom, Van Tharp.

    3. Trading In the Zone, Mark Douglas

    4. Trade Stocks and Commodities with the Insiders, Larry Williams

    I would also highly suggest two other on-line resources. One is by a trader you may follow on Twitter “FuturesTrader71”. Check out his website futurestrader71 / simplicity in trading. Under the resources tab you can go to the chat archive. There is a huge amount of information there that I think you will find beneficial. Similar to this there is a traders forum called “Big Mike’s Trading” and there are tons of webinars there. Some of the best traders and trading coaches have webinars there you can watch for free such as Linda Raschke, FT71, and Brett Steenbarger.

    So, I hope this helps..I probably just gave you 2-3 years worth of reading material!

  14. Timothy says:

    Beans have been interesting, indeed! My head is still reeling from the past few days since the report. Thanks again for taking time to answer my request, I will begin looking into those resources asap. I know exactly what you are referring to when you say “dealing with your own personal issues and avoid acting impulsively.” I’ve made several mistakes recently because I traded on impulse, allowing the ‘greed’ mindset to cloud my vision and make me think I would miss out on a few cents. I never thought I would learn patience and humility by trading soybeans, ha!

  15. Art Liming says:

    Many will tell you that you’ll learn patience and humility by trading . . . regardless of the instrument!

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