Hedging concepts

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Raw material investing has returned. History is being made for the commodity procurer, producer and market participant.

• Technical analytical concepts
• Cycle Series Analysis CSA

A Commodity Hedge Concept (a work in progress)

By Rich Posson, technical analyst 315-329-0294, rich@ag-financial.com

Components

1) Concepts and management of hedge

2) Analysis and trading of a hedge

  I. Concepts

In or out of the market?

A commodity firm may use hedging techniques to either place one's pricing exposure into the market or out of it.  For the "in the market"  trader or business you would use futures/options or other business contracts to allow future prices to be unknown.  An example would be a grain or milk firm who has to buy cash grain/milk now but will not have it  sold and thereby know the final price until sometime in the future.  This firm can pre-sell said commodity with futures or other derivatives.  The final price of procurement then would not be known until the  commodity is processed, sold and the hedge is lifted.  The exact opposite is a firm that wants "out of the market" they would rather know today tomorrow's procurement price.  But perhaps the cash commodity is  not available or there is an opportunity now for forward sale.  This firm then would use a hedge as a temporary buy.  The future price becomes reality, today.  They have a locked in or protected price,  they are no longer "in the market' riding price fluctuation.

Cash flow or revenue?

A cash flow hedger is one who is concerned about margins and cannot risk a deterioration of such by market price fluctuation.  This form of hedger would be willing to miss out on some of the better low or highs in the market.  They want to know where they are going for future business planning.  The revenue hedger however is more interested in locking in very profitable prices.  They are willing to miss out on a few lesser advantageous hedges and within the realm of market risk they can stand more and willing to accept more risk.

Long term vs short term

A hedger should assess as to the length and amount of a hedge.  For some only one or two contract months may suffice to provide the proper protection or  locked in feature.  To others the ability to lock in for long periods of time may be required.  Here several contract months may be desired or perhaps a rollover feature should be implemented.  To assess  long term vs short term one needs to address needs of the business vs the market.  The use of strip analysis may add value to addressing long term positions.

Strips

A strip is a  consecutive series of futures contract months that are then averaged and traded and or analyzed as one.  (i.e. an average of Jun, Jul, Aug contracts etc)

Rollover

A rollover  strategy or concept is where one chooses to hedge long term needs but rather than use a strip of contracts the hedger uses perhaps only one contract month.  As the futures approach first notice day or expiration  the hedger will exit and then immediately re-enter in the next available or next preferred month.  This action essentially keeps the trader hedged for as long as desired but unlike with the strip fewer contract  months are used.

Management or trading of a hedge

Counter hedge

There are times that a hedger sees counter productive moves coming in the futures.  By temporarily protecting or  offsetting a portion or the entire amount of the hedge the trader is able to step aside the adversarial market fluctuation.  This form of hedging is counter trend or a counter hedge.  It is short term in  nature.  An example might be that a hedger buys grain for the next 6 months, but for the next 30 days the hedger is concerned of lower prices due to an upcoming report or a short term technical sell signal.   The hedger can sell a different month to protect some or all of the 6-month purchase or sell some of the same months in a different account.  This technique allows the hedger to leave on the original hedge for  accounting and goal setting purposes.  The counter hedge is in fact hedging the hedge.

Selective hedge

A hedger may at times wish to exit a hedge because of changing market  conditions or because a goal of profitability or even loss has been met.  By exiting the hedge early the business is placed once again at risk of market speculation.  So goals need to be defined and some firms  will not allow a hedge to be prematurely terminated.  But should such businesses entertain counter hedging then?

II. Analysis and trading  (when do you hedge) note for an in the market  hedger the following discussion may not apply.  The in the market hedger probably has little need to consider market conditions and future fluctuation.

Three parts:

1) Statistical

2) Fundamental

3) Technical

1) Statistical

The use of statistical studies can help point out to the hedger potential advantageous prices.  Such studies can include cost of production (cop) and cop plus a  return.  Statistical studies can include seasonal (what time of year does the commodity trend higher, more often than not) and standard deviation or percentile price ranks. (If a commodity  is at a low price  that appears only 5% of the time than could it be that there is a 95% chance of higher prices?).  These studies cannot only be made of individual contract months but of continuous price series and averages  (yearly?) including those of cash prices and strips as well.  Again the thought here is to locate advantageous price levels in relation to historical terms.

2) Fundamental

The use  of fundamental analysis can help locate periods and forecast periods of increased or decreased supply and demand.  Some studies can assist or even incorporate commodity valuation opinions (what is the commodity  worth, overvalued or undervalued).

3) Technical

The use of technical analysis helps to time trades and with some methods can assist in trend forecasting.  Technical analysis can  address the non- standard economics and market psychology other wise known as behavioral economics/finance or behavioral science.  Some forms of technical analysis are statistical in nature such as overbought and  oversold indicators.  Others are pattern related and are used to forecast trends as well as timing agents.

 Technical analysis: the new age of economics and the psychology of markets

by Rich Posson, technical analyst RF Posson & Company

In today's  freer and more volatile market place many a trader is having difficulty with the use of standard economic based analysis and trading.  Under standard economics if a market price falls then demand should  increase.  And, even today this is so but today's trading environment is more complex in that as prices drop, demand will actually drop first and then increase later.  This scenario is best explained by the  new economics that is rapidly replacing the old and that is behavioral economics.  Behavioral science, behavioral finance and market psychology and socio economics are all "buzz" words in today's economic,  political and business discussions.

Technical analysis has been around for perhaps centuries but only now is it being recognized as a behavioral science or behavioral economic study in regards to markets.  Indeed  even several prestigious universities have launched not only technical analytical curriculums but also even entire foundations for the study of such.

There are many types of technical analysis just as there are many  types of traders and analysts.  I will discuss some of the major forms of analysis that I use but first I wish to discuss a little of the psychological side.

The emotion sequence cycle:

To a buyer (who did not buy) as prices begin to run up there is first an emotional response of "denial and shock", followed by the second phase of "anger" and then still a third phase on explosive prices  that is "depression".  The final phase is that of "acceptance", one learns to live with the pain of higher prices for one's inputs or missing out on an investment.

This same sequence could be applied to the  seller of a commodity in that they did not sell when they should have and prices dropped drastically.  An investor could also experience these emotions in being on the wrong side of the market.

There is no doubt  a positive side of this sequence in which one may very well reach the emotional peak of "ecstatic" by basically being on the right side of a large price movement.  The point is that there is indeed emotion involved  in the markets and the different types of emotion leads to different responses to trading.  Such as we buy and then the price drops and we are mad and so we buy more because we are right and it is a "better bargain  now".  And then, the price drops some more and we panic perhaps even dump the position.  We all know what happens next---the bottom arrives!  A summary phrase is as old as the markets and that is "fear  and greed".

(These emotional phases were adapted from the work of Sharon Danes, Professor at UMN in regards to helping farmers, families and non-farm businesses cope with change and rapid change such as today's  business environment.)

The market participation sequence cycle:

Dr Pruden of GGU and whom I have had personal instruction in regards to Wyckoff technical analysis and behavioral finance  has put together another form of market behavior.  It is referred to as the Pruden Adoption Diffusion model which essentially says that the growth of market participation for an up move or down move in prices is  bell shaped and can be classified in phases or types of traders.  First are the innovators or "insiders", followed by the early adopters, then the early majority, the late majority and finally the laggards.   By time the laggards arrive the market has been saturated with buyers if an up movement or by sellers if a down move.  Essentially it is over by time the laggards arrive and of course the insiders are long gone.

Our analysis

The insider?

Richard D. Wyckoff was a very successful trader and market educator who grew up in the days of where big money could run manipulative "campaigns" in selected  markets.  Mr. Wyckoff realized a pattern to this kind of trading and adapted it to the non- manipulated markets.  He believed that a trader ought to view the market as if it were being traded and under control  of one person--the composite operator. From this view point he believed one could tap into the psychology of the market and grasp a feel for the demand and supply elements of a market.

Under Wyckoff thinking there are  3 laws: supply/demand, cause and effect and effort vs result.  Essentially if you don't have demand taking over supply then you can't have higher prices, but you need to build a cause and trigger a response or  effect and finally the effort from the prevailing buyers or sellers needs to have a related response.  With Wyckoff one believes markets must spend some time in a guiet range where the "smart money" accumulates a  position (accumulation phase).  The "crowd" eventually wakes up to the fact that prices should head higher and it is their buying that creates the "mark up phase".  The smart money then eventually unloads on  the crowd in a phase of "distribution" which can evolve into a "mark down phase" of prices.

Cycles

I am not sure anyone knows what creates cycles which are repetitive bottoms and tops  viewed in relation to time not price.  An example is a cycle of 20 weeks simply implies that the market for some strange reason will stop going down and reverse upwards.  In relation to market psychology I  hypothesize that cycle bottoms or tops are extremes of market psychology, that they are also periods of reality or in fact a reality check point.  We simply ask ourselves why are we paying or selling at that price  or more important at that time.  Everything in between is the up trend or downtrend and I believe the trend is the actual phase of illusion.  An entire cycle then encompasses the psychological phases and the  conflict between reality and illusion.  Why cycles are also repetitive I do not know and people are afraid to acknowledge that their lives, markets or businesses may operate in a repetitive manor.  But a chart  is worth a thousand words in regards to opening one's mind to cycles.

Cycle series analysis

I finish this discussion with the primary form of analysis that I use and that is what I have  called and discovered as Cycle Series Analysis  CSA.  To be brief as possible, this form of cyclical analysis states that we should throw out all cycles that will not work as an integrated system or if you  will a family of cycles.  What we want to do is build models that incorporate short term to long term cycles.  We want these cycles to work together in that a certain number or range of number of say a short  term cycle should equal the length of a larger long term cycle.  This allows us to time the large cycle by tracking the smaller cycles.

These models then help to explain all fluctuations in the market and can  provide a wide variety of buy or sell signals in relation to the user's needs.  The bigger the cycle the bigger the expected move.  These cyclic models should be able to link with the various degrees or  magnitude of market psychology, fundamental news and the type of traders.  There are many different types of traders in the market place, those who trade for only a few days to those who trade for months or  years.  So should we not expect many different lengths of cycles?

One can see the economic side of cycles when one views the long cycles of 3 years to 36 years or more.

In Joseph Schumpeter's Business Cycles he  too showed cycles within cycles and believed in cyclic economics.  And his work has seen a renewed interest as of late.  It is interesting to see a say a top of a 9 year cycle will bring about more serious  economic impact and more importantly negative sentiment/psychology than say what a 3 year cyclical top can create.

Is this then the new economic analysis?  For now all I know is that it brings an interesting  opinion of the markets and their future fluctuations.

" a cycle is a summary of history, statistics, innovation and economics.."

We can assist in education and design of hedging/marketing programs.  We also  consult in business risk management in regards to hedging or commodity marketing.  Our research also includes market timing and forecasting methods.  Call 386-785-1585 for details.