At the end of the first week in May, a member of the discussion group received a “sell” recommendation from an advisory service for Dec13 corn, and asked if I had comments or suggestions. I assumed that the sell recommendation was for new crop. A quick glance at the chart indicated that MA(5) had crossed up through MA(35) with the close on Thursday May 2, which would suggest a potential buy signal rather than a sell signal. Therefore, my first suggestion was to get on the phone to the advisory service and ask 1) what was the basis for making the recommendation, 2) what was the window of time for the recommended sales, and 3) what was the price target for the sales. If those did not match up with the trend system I was using or provide new fundamental or technical information, I would ignore the recommendation.
For those of you practicing with the MA(5,35) system, the fact that MA(5) had crossed up through MA(35) would indicate that the trend might be turning up. Essentially this presented two probable outcomes. First, the trend had turned up and the “sell” recommendation did not match up with the MA(5,35) system. Second, the “sell” recommendation was correct and a few days ahead of the MA(5) crossing back down through the MA(35) to confirm a “sell” signal as the market headed south.
I am not certain of the exact date and time the “sell” recommendation was received, but to establish some points and prices for discussion, let’s assume the “sell” recommendation was issued after the close on Friday May 3. In hindsight, the market analyst correctly anticipated that the market was going lower. I have a close of $553.50 on Friday and an open of $535.00 on Monday May 6. Whether the suggested phone call would have confirmed the basis for the foresight is uncertain, but it was a good read of the market. Give credit where credit is due.
By the same token, the MA(5,35) indicator appears to have given a false signal — false signal in that it indicated the trend was turning up when that does not yet appear to be the case. False signals are a characteristic of all moving averages, and are issues that must be dealt with. The good news is that false signals with the MA(5,35) indicator are self correcting. Since we don’t know the basis for the “sell” recommendation from the advisor, we have no way to know if that was a self correcting signal if it turns out to be wrong.
Let’s use this as a learning experience and pair up the two approaches to price risk management so we can compare the strength and weakness of the two. The other two questions I would have asked the advisory service were 1) what percent of the crop were they recommending to sell, and 2) was this protection to stay in place until the corn was delivered. Here is where the rubber meets the road.
While I have acknowledged that the “sell” recommendation was a good read of the market at that point, the amount of sales that were recommended begins to expose how confident the advisor was about the longer term trend. Anything less than 100% suggests that the advisors were either anticipating higher prices later, or simply was trying to take a “safe” position because they do not know what the market is going to do. If this was to be a true hedge and stay in place, and the advisors anticipate higher prices later, then selling now when prices will be higher later is not nearly as good a call as the action on May 6 suggested. If this was is to be a true hedge and stay in place when prices will be going lower, then selling only a portion of the crop was also a questionable call.
We have no clue as to the method that was used to reach a decision about whether the market was going lower. Therefore, we have no clue as to whether that method would be self correcting if the market turned up, and we have no clue how long it would be before the method would self correct. That is certainly not to suggest that the advisor does not have a system in place that is self correcting in a timely manner. It is simply a statement to be taken at face value that we do not know how the decision was made and have no clue how future decisions will be made.
So in summary, the “sell” signal was a good short term call, but was down one cent per bushel as of the close on May 24 (assuming an entry at $535.00 on May 6 open). We simply lack the information necessary to determine how good it will be in a longer term context. If the recommendation was given as a traditional hedge to be left in place until delivery, it will depreciate in quality regardless of whether the market goes up or down — sold too much if the market goes up, and sold too little if the market goes down. If the advisors are willing to recommend lifting the hedge later, the quality of the recommendation improves but does not solve the weakness outlined above.
Now let’s focus on the MA(5,35) signal. Clearly the signal was in the wrong direction on May 4, but it automatically self corrected on May 8 when MA(5) crossed back down through MA(35). Assuming that you are using MA(35) as the long term trend indicator, it moved up very slightly after April 26 (less than one tenth of one percent) while the price and MA(5) were above it. On May 6, it was falling again, and ignoring the MA(5) crossover could easily have been justified. For all practical purposes, the system took only one day to correct. But let’s stay with the crossover as the correcting signal. The MA(5,35) indicator was a signal to put the hedge in place at the $5.32 close on May 8. In that case, the MA(5,35) indicator signaled a hedge opportunity at three cents less than the advisor’s “sell” recommendation ($5.35 on May 6).
We have no information about the advisor’s previous recommendations, so we can not make a comparison taking into account earlier hedge opportunities. In order to keep the big picture in focus, let’s step back and ask what the MA(5,35) was telling us on May 2. When MA(5) crossed up through MA(35), it could have been read as a signal to lift previous hedges. If that action had been taken, the system would have lead to lifting hedges at $5.59 on the May 2 close, and putting hedges back in place at $5.32 close on May 8. The cost of the false signal could have been as high as 27 cents per bushel plus transaction fees. No one wants to think about a 27 cent loss caused by a false signal, but losses will happen. However, it is the whole picture that counts. If you were using the MA(5,35) system as an indicator, you could have been hedged at something in the range of $6.30 depending on exactly when you started monitoring the Dec13 contract. So lifting the contract at $5.59 would have put $0.71 per bushel minus fees in the bank ($6.30 – $5.59), and have new hedges in place at $5.32 for a new realized price position of $6.03.
Switching to soybeans, another question was raised about a “sell” signal for soybeans which was received from an advisory service on May 14. Again, I don’t have the details of exactly when to sell or how much, but the soybean chart also presents an excellent learning opportunity. In this case, MA(5) was below MA(35) so the “sell” recommendation matched up with the MA(5,35) position. However, the best time to use the MA(5,35) as a sell signal is when the MA(5) first cuts down through the MA(35) at the top of the MA(35) trend, not after it has been falling for several months and could be approaching a bottom.
The “sell” signal for soybeans did not reflect the same foresight as the corn recommendation. I have a close for Nov13 beans on May 14 at $12.14 and open on May 15 at $12.13. The contract has basically traded up since, reaching a high over $12.52 on Thursday May 23 and closing on Friday at $12.43. Trying to decide how good that recommendation is rests directly on knowing how the decision was reached, whether the process is self correcting, and when would we know if the recommendation was wrong. Many of the issues are the same ones that were raised about the corn recommendations, and would have to be addressed before one can decide how good this recommendation is.
On May 20, MA(5) crossed up through MA(35) putting that indicator in conflict with the “sell” recommendation. For all practical purposes, as long as the price stays above MA(5), the average is going to continue to move up. MA(35) has turned up slightly after reaching a low on May 21, but the increase needs to be kept in context. The increase since the low is less than one tenth of one percent just like the corn contract, and corn clearly turned back down.
If you were following the MA(5,35) system, you should have been hedged some where above $13.00 several months ago. If you took the May 20 signal literally and lifted the hedge, you should have banked something in the range of $0.75 per bushel ($13.00 – $12.25). No one can foresee whether the market will continue up or whether the MA(5,35) system will reverse itself and signal new hedging opportunity, and certainly no on can tell yet whether that would be above or below the $12.25 price. What we do know is that if the market rallies, there will be an opportunity to hedge again above the $12.25 level and add to the hedging return. If the market turns down again, we will get a sell signal. A new hedge at any price above $11.50 would add to the hedging return.
The chart and MA(5,35) system suggest that you are at risk if you took action based on the “sell” recommendation. However, regardless of whether you placed a hedge with a cash contract or a futures contract, the real issue to keep in focus is what the implications are of being wrong. Let’s say the price does continue to rally from here. There will be losses in the hedging account, but remember that those will be offset by the cash value of the beans going up. If $12.25 is above your cost of production, the rally is a lost opportunity, but not an actual loss. There are really two questions to answer. Are you willing to maintain the margin necessary to maintain the futures position? If you lift the hedge, do you have reasonable expectation of selling again at a higher price?
If you have a profit locked in, and will have product to deliver, staying in the position is not a bad decision. The only question is whether you can improve the position with action that has reasonable high probability of success. Risk and reward are the key elements of any decision about lifting the hedge.
These are real time decisions and issues. The biggest issue is keeping the whole process in focus so you don’t over react to short term market volatility. The goal is to be correctly positioned to benefit from a SIGNICANT portion of any MAJOR price rallies, and to put protection is place for a SIGNIFICANT portion of any MAJOR price declines. Emphasis is clearly on the capitalized words, SIGNIFICANT and MAJOR. We have to anticipate slippage and potential false signals at the top and bottom of major price trends because no system is perfect at picking the exact tops and bottoms of major market moves. As frustrating as is it to look back and see a false signal, the key to success is having a system in place that will be self correcting and tell you in a timely manner when the previous signal was wrong so that you can adjust your price risk protection accordingly. Following a system that is self correcting is the key to success whether you are making the decisions yourself or whether you are retaining a marketing advisor to make the decisions for you.
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Written by Keith D. Rogers on 25 May 2013.
