What Do You Make of Wheat?

Associated Press

Wheat has gone parabolic on the confluence of news in Russia: a horrible drought, Russian wheat fields have gone ablaze and Glencore’s Russian unit is pushing for a grain ban on exports. All are fundamentals that cause tightness in supply, thus higher prices.

There are a few ways that you could have gotten long, but I’m more interested in how you are going to keep your paper profits before they go ablaze also. Below is a great study on how systems will get you into a trade, but can give back sufficient gains to leave you scratching your head.

Your clients and potential clients don’t need you to ride the wheat all the way up, and then give a significant portion back. They can do that without even trying. They bring the money, you are supposed to bring in the alpha.

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The wheat trendline is very steep. I’ve seen them ramp up like this and come back in 1/5 of the time. This poses a significant problem for the trader, especially the system trader. Why?

Well you’re supposed to follow your rules (if you’re listening to that judge in your head). My guess is you’re following a set of rules first introduced by Donchian – which means you’re looking at liquidating a long position on the ten-day low or when the faster moving average crosses the slower one. Let’s take a look at this mess.

Click to enlarge.

If you’re waiting for the trailing stop of a 10-day low or something like that to come around, you’re going to give back at least $1 per contract based on the levels today. That’s $5,000 per contract.

The settlement price was 6820 and the red line 10-day low is all the way down at 5822. And that’s a long way down. Easy to see. Easy to talk about. Hard to feel emotionally if you watch it come all the way back.

How do you reconcile the feelings of having the discipline to follow your rules with the feeling of not doing something proactive to preserve your capital when the market has given you such a gift?

Click to enlarge.

Above is the Donchian moving average calculations. Notice the black 5-day (the faster) crossed the blue 20-day (the slower) in mid June at about 4680. Settlement is the same at 6820. The 5-day is at 6560 and the 20-day is at 5924. Only God knows at what price the faster will close below the slower.

Keep in mind the trendline, which depending on the trendline you’ve drawn, appears to cross under the market at about the 6300 level – a full $0.50 or $2,500 per contract below the settlement price. You can use this to measure how overbought (or oversold in the case of a downtrend) the market might be.

When markets go parabolic like this or when they spike, you’re most certainly better off by utilizing one of two exit strategies – and the first one might surprise you.

Choose a point on a discretionary basis where you feel that you will be both emotionally stable with getting stopped out AND where you’ve preserved a great portion of the gains, which heretofore are only paper gains. This is about tradeoffs.

The second is staying long and utilizing an exit based upon a reversal pattern. At this moment, you have the fundamentals and the technicals going for you. Although the fundamentals might take several months to sort out – the total damage to the Russian wheat crop is unknown – the technicals might suggest a short-term downtrend before the longer-term uptrend continues.

It may be emotionally expensive for you to stay in for that ride, so there is nothing wrong with trading long then flat – in and out – until the trend has changed.

For the record, I would not be getting cute with this market either and try to trade a counter-trend position. If you think the world has gone nuts, then buy longer-dated OTM Puts on December wheat and let it play out. At least you can define your potential losses.

A good reversal pattern is the 2B Reversal Pattern that Victor Sperandeo wrote about in Methods of A Wall St. Master. From the book: “In an uptrend, if a higher high is made but fails to carry through, and then prices drop below the previous high, then the trend is apt to reverse…This observation applies in any of the three trends; short-term, intermediate-term, or long-term.”

So in this case, you’ll be looking for SEP to trade up to 7112 and fail. Then it could be lookout below.