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.
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?
The first arrow in the next chart shows the timing of the assassination
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!