Reducing Risk by Using Hedges

One trait common amongst all successful traders is the ability to manage risk. Experienced traders ask not how much money a trade can potentially make, but how much money a trade could potentially lose. Put another way, not losing money is more important than making money.

When I first started trading, I would usually bet all of my account on a single trade. I have learned (the hard way) that this is not a wise strategy. What I like to do now is go long and short different markets simultaneously in order to reduce risk.

As an example, for the past couple of weeks, I was long gold and short Canadian financials. I did this because the trend for gold was up, and the trend for financials was down. My plan was to hold on to these positions for as long as the trend persisted, which could end up being a day, or a year.

I got blown out of my financials short last Tuesday, but am still holding the gold position. Since I like to have a long and short position on at the same time, I decided to off set some of the risk in my gold position by shorting natural gas. I decided to short natural gas because the trend has turned down.

Being long one commodity and short another substantially reduces risk, but still allows for profit if one of the following three outcomes occur:

1) Gold and natural gas both fall, so long as natural gas falls faster
2) Gold and natural gas both rise, so long as gold rises faster
3) Gold rises and natural gas falls. This is the ideal scenario!

The following chart shows an ETF that tracks gold, GLD, divided by an ETF that tracks natural gas, UNG. If you are long gold and short natural gas, you want this chart to be rising:

As the above ratio chart shows, there are clear times when gold outperforms natural gas, and vice versa. Using this type of ratio charting can help you spot trends that are occurring beneath the surface, which I think allow for an opportunity to profit at a reduced level of risk.

For example, there are times where commodities will correct dramatically, and every commodity will be in the red. If we get one of these days, it probably will not negatively affect my account.

Again, the goal of this position is to remain long gold and short natural gas for as long as the trend persists. If the trend turns around, I will be out.

Interview with Oil Expert Matt Simmons

I feel that when someone works hard, does research, and makes a bold forecast that eventually comes to fruition several years later, that person should be given credit. Along with Richard Heinberg, who I mentioned last time, Matt Simmons is one such person.

Matt Simmons, who spent his entire career working with the oil industry, is author of Twilight in the Desert. Simmons also appears frequently in interviews, such as the one done by Bloomberg above, and was featured in the documentary Crude Awakening, which I highly recommend.

Every weekend I listen to a radio broadcast that can be downloaded from the internet called The Financial Sense News Hour. You can download for free the interviews done with Matt Simmons on this show by clicking here and here.

The Financial Sense News Hour piqued my interest as soon as I began listening to it over 3 years ago now. The program is about 4 hours every weekend, and can be downloaded to an iPod or MP3 player.

Trend Following Using Renko Charts

Over the past year on this site, I have attempted to use technical analysis and intermarket analysis to help better understand the gold market. During this time I think I have made some fairly decent calls, but have also made mistakes along the way. One of the advantages of maintaining this blog is that I can go back and read old posts and see exactly what I was thinking. I can analyze what worked and what didn't.

One common theme of all my money losing trades is that they were made in the opposite of direction of the trend. Having learned from past mistakes and also from reading some excellent books along the way, namely from an author by the name of Michael Covel, I have formulated a series of rules that will prevent counter-trend trades from happening in the future.

The basic premise of trend following is that you want to be buying when prices are going up, and selling when prices are going down. This seems fairy logical, but, unfortunately, most amateur traders instinctively endeavor to do the opposite. Many beginners will stack up as many indicators on a chart as possible, and will start looking to buy as soon as one of them dips down past some arbitrary threshold to an oversold level.

Another common tactic amongst neophytes is to buy stocks making fresh 52 week lows. Like the previous tactic, this also results in buying stocks that are going down.

My trend following technique that I am now using uses Renko charts to help me avoid buying falling stocks. I used to maintain another blog called Trading With The Trend, and the technique there involved moving averages to define the trend. I still think that this is a valid method, but I discontinued this blog due to underwhelming demand.

Anyway, the advantage with Renko charts is that the only factor in their construction is price. They do not even factor the passage of time, which makes them distinct from moving averages. Moving averages can suffer from whipsaws in a sideways moving market, but Renko charts only react to changes in price and not time. If there is no price movement, then Renko charts will remain static. They are, in a sense, a Japanese version of Point and Figure charting.

Here is a chart of GLD over the past year and the signals that would have been generated:


The areas highlighted in yellow are the areas you would be long. The areas not highlighted you would not be in the market. You would not be permitted to short gold during this time. I am not willing to go through all the rules in detail for this technique, but here are the main criteria for any trend following technique:

1) Buy strength
2) Short sell weakness
3) Take small losses
4) Let winners run
5) Manage risk

Commitment of Traders Analysis of Crude Oil

The chart below shows a chart of an ETF that follows the price of crude oil, which has the ticker USO, on the top panel, and a chart breaking down oils COT structure on the bottom panel:

I explained the way I interpret this type of chart in this post. In a nutshell, you want to be buying when the commercials have a small short position, and you want to be selling when the large speculators are large long position. In the bottom panel, the commercials are in purple, and the large speculators are in blue.

If you click on the above image, and match up green circles on the bottom panel, with the green circles on the top panel, you will see that these are times where the commercials had reduced their short positions, and therefore a buy signal was generated. The opposite is true for the red circles.

Right now, the commercials have not only reduced their short position, but they were long for a couple of weeks, which is something I have not seen before. Commercial traders are generally those that physically use the commodity, and have access to more information that the public would have access to, so it makes sense to buy when they are buying.

I still feel that going long commodities and shorting equities is a prudent strategy based on the way my charts look right now.