Don’t Get Stuck in This Commodity Trade

06/15/2012 3:30 pm EST

Focus: COMMODITIES

Scott Andrews

CEO & Co-Founder, InvestiQuant

Gap trading works nearly as well in the commodity space as it does in equities, says Scott Andrews, but getting on the wrong side of a limit-up or limit-down move could quickly spell disaster.

We’re here with Scott Andrews. Scott, you are one of the masters of fading the gap, and you’ve discovered some new and interesting opportunities trading gaps in commodities. Could you tell us what you’ve found and what the caveats are of doing this?

Sure. A little bit surprisingly to me, gaps in commodities, specifically the agricultural commodities where my research has been focused lately—corn, soy, wheat—they can be faded.

Historical win rates from the financial indices for fading gaps, meaning shorting up gaps and buying down gaps and looking for that reversion to mean, is about a 70% win rate using an end-of-day stop. With commodities—and I didn’t expect this—it’s about a 65% win rate; so nearly the same.

They do trend a little bit more, but there’s certainly some fadeable opportunities for the opening gap in commodities.

Now, the caveats: you’ve got to be a little bit more careful, because a couple of things are happening with agricultural commodities that don’t happen in the financial indices.

One, because they’re more trending, you can get in a situation where they have what are called “locked-limit days,” where the price will move so far that the market will close. That’s not good; you don’t want to be stuck on the wrong side of the locked limit.

The CME Group posts the lock-limit amounts. It’s $0.40, for example, in corn right now, but that does vary from day to day. I think it’s $0.70 in soybeans and $0.60 in wheat. So $0.40 to $0.70, which is a huge move. That’s equivalent, for example, to 40 points in the E-mini S&P 500, and it’s pretty unusual to get a 400-point move.

It’s an unusual day, but the market can actually close intraday where it won’t trade anymore, and you don’t want to be stuck on the wrong side of that trade.

If you’re trading gaps in the commodities, you can fade them, but only focus on, say, up to 40% of the five-day average true range.

So average the high to the low range of the past five days, inclusive of the opening gap, and then take 40% of that. That’s about as big a gap as you want to trade using what I would consider to be a reasonably sized stop, which is 30%, or a little bit smaller than that.

If you do that, you can still capture a large number of winners by fading the gap and avoid the risk of being locked limit in the position against you.

Are there any other caveats to mind, or is this it?

Well, the gap size actually helps you stay out of that. Probably the only other thing that stood out to me in my research was that Mondays through Wednesdays are good for fading the gap, which means by definition, Thursdays and Fridays are neutral to weak for fading the gap.

The market is more likely on those days to trend against you, so you might want to follow the gap on those days. Or, at least be cognizant that those are riskier days where you are probably more likely to be locked limit against you than, say, Monday through Wednesday.

Right. So you just get a long weekend now if you trade the ag gaps.

Yeah, whether you want it or not!

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