Dollar Cost Averaging Spreads a.k.a Value Investing In Commodities a.k.a Trading Like Evel Knievel
Here’s something coming out of left field for spread traders. It’s an idea I’ve been pondering for some time, so I’ll go ahead and spill it in this post.
I started my career at a commodities firm in 1991. At the time, it seemed like commodities could only go in three directions: sideways…down…and down even more. I can definitely tell you that learning how to trade commodities -an asset class traditionally favored during an inflationary environment- during a prolonged deflationary environment will certainly teaches one how to play good defense.
One trading strategy that became popular with our largest clients at the brokerage firm was scale trading. Some guys paid several thousand dollars to attend a weekend seminar in Europe that taught them how to do it. Other guys spent a whopping $20 or $30 to buy a book called You Can’t Lose Trading Commodities that taught them the exact same thing.
The gist of the method was to find a commodity that was trading in the lowest 10% of its historic trading range (20 years or more) purchase contracts in progressively lower intervals (“scale in”), and sell the contracts at progressively higher intervals (“scale out”) for a modest profit on each contract.
There are a few important rules that you absolutely had to adhere to. First, scale trading was only to be done with futures contracts on tangible, consumable commodities. The reasoning was that a commodity could never be priced at zero –like a stock or a currency- because it would always have some sort of intrinsic value. A commodity cannot go bankrupt like a stock nor have a radical and permanent devaluation like a currency.
The lower the price, the more likely it was that the commodity was to an absolute bottom. This is because supply would (theoretically) get restricted as suppliers cut back, demand would start to increase as buyers would stockpile inventory, and producers would even tap out if prices got near or below the cost of production. Ultimately, the market had to turn around at some point.
The Deadliest Catch
As many traders in the ‘90s found out the hard way, there is a way that your account can suffer as though commodity markets actually can go to zero…or even lower. That catch is the carry charge.
Carry charge is the storage costs, interest charges on borrowed funds, insurance, and other related costs on a commodity. This is why the longer-dated futures contracts are normally trading at a higher price than the closer-dated contracts.
For example, on Monday the August crude oil contract closed at $45.24 and the November contract closed at $47.22. So the November contract is price at a premium of $1.98 (4.3%) over the August contract because it is being stored for three months longer.
The February 2017 contract closed at an even higher price of $48.92, which is $3.68 (8.1%) more than the August contract. This is six months further out.
Notice that the carry charge annualizes at a little over $7-per-barrel, which is a whopping 16%. So if you own the August crude oil contract, keep rolling it over for the next year, and the nearest-futures price of oil does not increase, then you will lose seven dollars of 16% on a market that does not even go anywhere!
This is the hidden danger to scale traders. To combat this, you have to scale trade the contracts that are several months out until delivery and have the price intervals set tight enough to generate enough sales to compensate for the carry charge. We’ll discuss the intervals in a bit.
Better Be Capitalized
Get this: You don’t use any stop loss orders in the strategy! Instead, you hold the losing positions and add even more when the market goes against you. It’s similar to dollar cost averaging. Therefore, the second rule was that you had to anticipate this and have a huge bankroll to scale trade in a market.
Let’s say you were buying crude oil contracts every dollar lower and you started at $20-per-barrel. Suppose the price dropped an additional 25%. By the time the market hit $15 and you bought another contract, you were behind a total of $15,000 on all of the prior contracts that you had purchased at $20, $19, $18, $17, and $16.
Another one dollar drop to $14-per-barrel and your drawdown would increase another $6,000 to $21,000. This is because you would now have six contracts that you are behind on…and you are still buying more!
Take Some Off the Table
The next rule was that you had to sell each contract when it hit a predetermined profit objective. Once that happened, you would place an order to buy it back at the original entry price.
This is where scale trading is different from dollar cost averaging. Both strategies have you buying in intervals as a market moves against you. With dollar cost averaging, however, you don’t intend to liquidate any of your holdings once the market turns around. It’s usually a long-term strategy that’s often part of a Buy & Hold strategy. With scale trading, the trader is trying to take advantage of the markets fluctuations by buying and selling.
Suppose you had 50-cent profit objectives on the crude oil scale. The contract you bought at $20 would be sold if it hit $20.50, the contract you bought at $19 would be sold if it hit $19.50, etc. So each contract would be up for sale $500 better than the purchase price (each contract controls 1,000 barrels of oil, so a 50-cent move = $500). As soon as you sold the $19 contract at $19.50 you would immediately place an order to buy again if the market dropped back to $19.
Determining the Price Intervals
When deciding how close together the purchase and sale levels for your scale should be, you have to consider two things: Bankroll and market volatility.
The tighter together the purchase points are, the more contracts you will possibly accumulate and the more money you will need to back it up. A scale that is setup to buy crude oil every 50 cents lower is going to need double the capitalization of a scale that is setup to buy crude oil every dollar down.
The volatility tells you how much the market swings around. If crude oil often makes 50-cent fluctuations a wise scale trader will set profit objectives of 50 cents or less. This will generate more activity. If the trader uses profit objectives of two-dollar intervals instead, the scale would not be nearly as active.
Shooting for a two dollar profit instead of a 50-cent profit when the market is only giving out 50-cent profits can mean little or no trading activity. This means there are no profits being generated that will pay down the carry charge. If this goes on too long the impact of the carry charge will felt after a few rollovers and the trader could be down double digits in an inactive position.
My personal belief is that the volatility trumps bankroll. A scale trader should determine what size price intervals are appropriate based on the market volatility and then determine the correct bankroll to trade it. If the bankroll is beyond the trader’s capacity, skip the scale trade campaign for that market and look for the next one that does meet both the volatility and bankroll criteria.
Don’t Get Caught Short
Here’s a “set in stone” rule for scale trading commodities: Never, never, never scale trade a market from the short side!
The foundation of scale trading is built on the idea that commodity prices cannot go to zero. On the flip side, there is no guaranteed limit to how high prices can go. So it is impossible to be fully capitalized for a short sale in a bull market run that has theoretically unlimited upside. It may work a time or two, but it only takes one runaway market to rob you of your wealth.
Let me give you an example of how that could happen. Suppose you started shorting crude oil every dollar higher once it reached $30-per-barrel in 2000. Back then you might have assumed that $40 was the max it should go. After all, it barely poked its head above $40 during the Gulf War in 1990 and collapsed into the teens just three months later. But just to be safe, you might have capitalized for a run to $60, which is 50% above the Gulf War high. No way oil could ever get that high, right? The global economy would collapse before then.
As it turns out, oil reached a peak of $37 in September of that year. It was back down under $26 by the end of the year and trading below $18 a year after that. You would have made a nice profit.
A year later in September 2002, oil hits $30 again and you do the same scale. The market runs to nearly $38 over the next six months. It finally breaks and drops to nearly $25 in April of 2003. You’ve made another pile of money. Since you are capitalized for a run to $60, you did not get too deep into your reserves and you never broke a sweat.
Two months later, crude pops above $30 again. It traded both above and below $30 every single month for the rest of the year. It feels like your printing money as you keep pulling profits out of the market during this choppy period. What color of Mercedes will you buy your wife for Christmas this year?
When 2004 begins, oil is elevated to nearly $36-per-barrel. You’re not the least bit worried.
Four months later, oil breaches the 1990 Gulf War high. This is record territory and you have a ton of contracts on.
In the autumn of 2004, oil rips through the psychological fifty-dollar barrier and rockets to just above $55-per-barrel by October. Now you should be sweating! You’re capitalized for a run to $60. It’s getting awfully close.
Relief comes in the form of a Q4 break to just below $41. Since you kept scaling up, several contracts were cashed out with profits on the price break. You congratulate yourself for sticking to your guns.
Then 2005 rolls around. The market surpasses the October 2004 record high in March.
Four months later, crude oil hits and even breaks the $60-dollar mark. Game over. All of your money is gone. One bad run and everything you made in the prior scales in this market is evaporated.
Even if you stockpiled all the winnings…even if you recapitalized for a run to $100…it doesn’t matter. Crude oil hit $147 by the summer of 2008. Nobody shorting this market on a scale up basis could have survived that.
Like any rule, though, there actually is an exception. You could scale trade the interest rate products from the short side. We actually did that for a while in the 90s.
The reason for this exception is because the price of interest rate products are inverse to interest rates, so shorting the futures contracts is really like “buying” or scale trading the long side of the actual interest rates. And anyone who ever took a class in economics knows that interest rates could never go to zero. That’s absurd. Banks would be giving out free money at that point. Ain’t gonna happen.
As we all know now, interest rates can go to zero. Heck, we currently live in a world where interest rates go negative. Who woulda thunk it twenty-some years ago?! Best stick to tangibles like commodities for scale trading.
I will admit, though, that I am tempted to scale trade the short side of the Swiss 30-year bond. The yield is negative right now, but I just have a feeling that Swiss interest rates could poke their head above zero sometime between now and the year 2046…
Drive Your Accountant Cray-Cray
When you trade commodities, the accounting is done on a FIFO a basis. This “First In, First Out” procedure means that, if you own multiple contracts of a commodity, when you sell a portion of them they will offset the sale with the oldest position.
When we scale traded back in the ‘90s, we used LIFO (“Last In, First Out”) accounting to track our trades. This is because we sold our lowest-priced contract first, which means the most recent one that was purchased. So we had to call the accounting department at the clearing firm for every single trade that we wanted offset this way. It helped us clearly track the scale trades, but the accounting department sure didn’t like us.
Scale Trading Spreads
So I got to thinking, “What if a trader scaled into a commodity spread that was near or at historic lows?” The reasoning is that the spread is mean-reverting and it’s already at an historic extreme. Therefore, it’s a strong candidate for an inevitable recovery.
In addition, I would want to target a spread that does not have seasonal patterns price in like grains, livestock, etc.
Furthermore, I would pick a spread that has a very low carry charge. That way, being stuck in the scale for a prolonged period of time would not crucify me if I have to endure several rollovers.
In light of this, the blog is going to run a little experiment. In addition to the normal spec trades, we are also going to run a scale trade in the copper/gold spread. Better buckle up for this one! Oh, and bring some money, lots of money.
The Gold/Copper Spread Scale
We’ve established in previous posts that copper and gold are highly correlated and that the spread between the two metals is extremely undervalued. Nonetheless, here are a few highlights worth noting before venturing out into the deep waters with a scale trade campaign.
First of all, the copper(x2)/gold spread has been a screamin’ buying opportunity whenever it has dropped to -$10k or lower. At this level, two copper contracts are valued at a ten thousand dollar discount to one gold contract. The spread is currently sitting below -$21k. In addition, just a couple of weeks ago the spread breached the weekly 2009 financial crisis low by a few hundred dollars and closed at -$29,915. This puts the spread on record as the lowest price in history.
Second, the ratio between the value of the sum of two 25,000 lb. copper contracts and the value of one 100 oz. gold contract is historically cheap when it drops below 1:1. At that point, it means that two copper contracts are worth less than one gold contract. Recall that we look at the ratio to normalize a spread relationship in order to help us determine if the spread is truly priced at an historic extreme.
Furthermore, the ratio closed at a multi-year low of 0.78:1 on a weekly basis at the start of the month. This level nearly matched the weekly 2009 financial crisis low of 0.71:1, which was the lowest close since 1987.
Now hold on to your hats for this one…there’s almost no carry charge to speak of. As a matter of fact, you could even say that the carry on this spread is inverted!
That’s right, ladies and germs. The July-Aug 2016 copper(x2)/gold spread closed at -$20,155 and the December 2016 copper(x2)/gold spread closed at -$20,440. That’s $285 lower.
And if you go out a year further to the December 2017 copper(x2)/gold spread, it closed at -$21,135.
What’s that saying about a gift horse?
So here’s how we’re gonna play it:
The scale will be done on the December 2017 copper(x2)/gold spread. Notice this is Christmas of next year. The contracts are not up for delivery for nearly a year and a half. So we won’t be talking about rollovers anytime soon.
The scale will be run with $5k intervals. This means we will buy a spread every $5k down and sell it for a profit out every $5k up.
In addition, the intervals will be done on a closing-basis. No intra-day trading going on here. This not only means that we don’t have to watch stuff on a monitor all day, but it also means that we have the opportunity to get bonus fills on the entries and exits. Any close that’s better than the actual interval (i.e. if we want to buy a close at -$15k and the spread closes $1,500 lower at -$16,500 or if we want to sell a close at -$20k and the spread closes $750 higher at -$19,250) is considered a bonus fill.
Furthermore, we will start the scale at -$5,000 (premium gold). That way, the top spread position is liquidated whenever the spread closes as ‘even money’ or better. This is where the sum value of two copper contracts is equal to or more than the value of one gold contract. This puts the ratio between the value of the sum of two 25,000 lb. copper contracts and the value of one 100 oz. gold contract back up at 1:1 or higher. When the ratio is above this level, we do not want to be in any scale positions.
Now, since the December 2017 copper(x2)/gold spread closed at -$21,135 today, we should already be holding four spread positions in the scale. This is because it closed below the -$5k, -$10k, -$15k, and -$20k intervals. Therefore, the blog will buy the four positions at today’s closing price and consider them bonus fills. Based on the $5k profit objectives, they will be sold on closes above -$15k, -$10k, -$5k, and even money and reentered on closes below the corresponding interval.
The next purchases occur on closes below -$25k, then a close below -$30k, and so on. And just to make sure we are clear, one spread consists of two December 2017 copper contracts and one December 2017 gold contract.
Good luck and good trading!