(03/16/09) How to Read the Signs of Change

I have been trading for many years. I traded successfully through the Arab oil embargo, the Hunt Brothers silver debacle, the tough economic times during the Jimmy Carter years, and the inflation and high interest rates that plagued Ronald Reagan's early Presidency. I've seen periods where trending markets were the norm, and periods where range trading dominated most markets. I am lucky to have seen and traded during so many different types of markets because I have no short or long bias in my trading and I trend trade as well as I trade ranges. Where does this flexibility in style come from?

George Santayana, a US philosopher and poet, wrote: "Those who cannot remember the past are condemned to repeat it." This is true in all facets of life, and trading is no exception. I use "chart replay" after trading hours to study the markets on a regular basis. After exceptional trending moves in the markets, I spend countless hours studying my hand-drawn charts, analyzing what happened, why it happened, how it unfolded, and what clues were there for me to recognize a potential set up before the large trending move unfolded. Trading is hard work and it takes countless hours of studying and practicing if you want to be a successful trader. Many people tell you there are "easy methods" and "simple indicators" that can make you a successful trader. The truth is simple: Hard work, studying, and preparation can help you become a successful trader. There are no short cuts, there are no magic indicators. There is no "Holy Grail" of trading. There is only hard work, studying, and good trading habits.

We have seen some momentous moves in the past year. In fact, most of you have never seen market moves as dramatic as we have seen in many markets in the past year. There are many analysts and commentators in the media telling you all that these moves are over and a return to "normal" markets are at hand. In my experience, when the markets are in their large trending mode, they tend to stay in that mode for years, not months. I will be surprised if we have seen the end of extreme volatility and large moves.

What can you do to prepare yourself to successfully trade in the current environment? George Santayana said it all: Study the past for clues about how you can trade successfully if this volatility and trendiness continues. Let me go through a handful of the large moves we experienced in the past year and point out the signs I saw on my hand-drawn charts, and maybe that will give you some insight into what I look for when trading in these types of markets. As you study each chart, look for the signs that a trend has begun, a sign that the trend is continuing, and a sign that a change in behavior has begun. The signs are all there for you in the charts as price unfolds, but you have to work hard to attune your eyes to see them and recognize them for what they are.

Let's start with soybeans:

The grain markets have been in an up-trending market for a handful of years. Prior to 2007, it was rare to see CBOT soybean futures above $7.50 a bushel. The natural trading range was $4.25 a bushel to $7.25 a bushel. For many years, the bulk of trading took place within this range, and successful traders would use those value areas as part of their entry and exit strategies. But in 2002, several changes occurred in the grain markets. First, people began thinking about Ethanol and biodiesel fuels. Second, the expansion of the Chinese economy accelerated and the Chinese government became an aggressive buyer of grains to meet the demand of their newly emerging middle class.

Even though soybean prices occasionally traded above the $7.50 a bushel area prior to 2007 (see the brief run up to $10 a bushel in early 2004 on the chart), these higher prices were rare and never lasted long. In fact, every time a rally over $7 a bushel was underway in the beans, futures traders could be heard chanting "Beans in the teens!" at the Chicago Board of Trade. But when the underlying fundamentals changed in late 2006, grains began a multi-year run higher that took soybean prices above $15.00 a bushel in mid-2008!

What were the signs that a significant rally was coming in the soybean futures? Soybean prices had a nice rally between 2002 and 2004 and briefly broke above $10 a bushel. The selloff in soybean prices formed a base just above the area that had acted as resistance, at $7.50 a bushel. Once the base line was broken, a deeper selloff occurred and prices consolidated in their normal trading range (roughly $4.50 a bushel to $7.50 a bushel through the end of 2006). This long consolidation allowed price to restore its energy, and when the fundamentals shifted to support higher grain prices across the board in early 2007, soybean futures exploded higher. The key to recognizing that the new uptrend was underway was noticing that price had broken back above the $7.50 base line. If you look at the chart one more time, you'll see that prices were range bound when they were below $7.50 a bushel and they were trending strongly once they broke above this key base line.

Here's a quick tool to help measure the potential of these geometric explosive moves. Take the low of the prior trading range, marked A, and measure how far price traveled to the high of the first leg of the rally, marked B. If you take the distance price travelled in the first leg higher, multiply it by 1.618, and add the results to the low made at the beginning of the second rally higher, marked C, you'll have a very accurate target for a geometric rally. In this case, it predicted soybean futures would top out at $16.00 a bushel, within 50 cents of the actual high.

Will you ever see a move this far, this fast in the soybeans again? If you trade long enough, you'll begin to see that all things repeat. And of course, those who learn from history will also profit from it! Let's see what happened to soybean futures after they made a high over $16 a bushel in late 2008.