This has been a tumultuous week in the equity markets as news events and political leveraging have sent markets in China and Greece down by more than 5% and 11%, respectively. Here in the US, Wednesday's action attempted to mimic the global markets but was met by a solid bid in the S&P 500 and Dow Jones Industrial Index around the Thanksgiving lows. Meanwhile, the Russell 2000 found support near the critical 1150 level that has propped it up since late October. We published a short take in Equities.com earlier in the week projecting expected weakness in the equity markets due to the shift in the commercial traders' position over the last couple of weeks. This has led many to ask exactly how we use these reports to forecast trading opportunities in the commodity markets. We'll use this week's piece to explain our approach in detail within the context of today's equity markets.
We frequently describe the discretionary portion of our COT Signals advisory service as a three step process. First of all, we only trade in line with the momentum of the commercial traders. It has long been our belief, three generations worth, that no one knows the commodity markets like those who whose livelihood's rest upon the proper forecasting of their respective market. This includes the actual commodity producers like farmers, miners and drillers along with the professional equity portfolio managers using the stock index futures to hedge and leverage their cash portfolios. Tracking the commercial traders' net position provides quantitative evidence of both the long and short hedgers' actions within an individual market. The importance of their net position lies in the collective wisdom of this trading group. Their combined access to the best information and models is summed up by their collective actions. The final part of the commercial equation lies in tracking the momentum of their position. Their eagerness to buy or, sell at a given price level is equally important as the net position. We only trade in the direction of commercial momentum. Finally, commercial trader momentum is the bottom indicator on the chart below.
The second step of this process is how we translate the weekly commitment of traders data into a day by day trading method. Commercial traders have two primary advantages over the retail trader. First of all, they have much deeper pockets and they have the ability to make or, take delivery of the underlying commodity as needed. Secondly, they have a much longer time horizon. Think, entire growing season or their fiscal year on a quarter by quarter basis. Therefore, we have to find a way to minimize risk and preserve our capital. We do this by using a proprietary short-term momentum indicator on daily data. The setup involves finding markets that are momentarily at odds with the commercial traders' momentum. If commercial momentum is bearish, we are waiting for our indicator to return a short-term overbought situation. Conversely, if commercial traders are bullish, we wait for a market to become oversold in the short-term. The short-term momentum indicator is labeled in the second graph.
Once we have a short-term overbought or, oversold condition opposite of commercial momentum, an active setup is created. The trigger is pulled when the short-term market momentum indicator moves back across the overbought/oversold threshold. Waiting for the reversal provides two key elements to successful trading. First of all, it keeps us out of runaway markets. Markets are prone to fits of irrationality that catch even the most seasoned of commercial traders off guard. News events, weather issues and government reports can all wreak havoc unexpectedly. Waiting for the reversal also provides us with the swing high or low that is necessary to determine the protective stop point that will be used to protect the position. Everywhere there is a circle, red or blue, was a trading opportunity in the S&P 500 this year. Within each circle, the highest or lowest value was the protective stop point. It is imperative to know the protective stop prior to placing any trade. This allows the trader to determine the proper number of contracts to trade relative to their portfolio equity. Risk is always the number on concern of successful trading. Currently, the protective stop levels are 17980 in the Dow, 1189 in the Russell 2000 and 2079 in the S&P 500.
Currently, the Dow, S&P 500 and Russell 2000 all contain this same set of circumstances. Given the lofty valuations, the speed of the recent rally and recent global economic developments it seems prudent to expect a retreat from these highs. Clearly, that is what the commercial traders, who were MAJOR buyers at the October lows believe is about to happen. We'll heed their collective wisdom as they've successfully called every major move in the stock market for 2014.
