To find the best trades, I look at a number of trading systems. One of the lessons I have learned from this study is that commodities behave differently than stocks. Until recently, that meant systems designed to trade commodity futures would not work well with stocks.
Exchange-traded notes (ETNs) now make it possible for stock market investors to trade commodity futures. An ETN is similar to an exchange-traded fund (ETF) except that the ETN holds derivatives (options and futures contracts) instead of stocks in its portfolio.
With ETNs, traders can now buy and sell cocoa, coffee, sugar and other commodities just like they trade stocks. While commodity futures carry a high amount of risk, ETN risks, like stocks, are limited to the amount of money you invested. One of the most popular ETNs is iPath S&P GSCI Crude Oil Total Return Index ETN (OIL), and I have two buy signals on OIL this week.
The first signal comes from my 26-week rate of change (ROC) system. This system is designed to buy the strongest ETFs when the market is rising and avoid positions in markets that are weak. Right now, the system is showing that OIL is a buy. This signal is in the alternative asset class, which has been in cash for some time. OIL and other commodity ETNs are included as alternative investments in this system since they have a low correlation with stocks and fixed-income investments.
Alternative investments have been in cash because the system identified a high level of risk among these assets. Real estate is also included in this group, and Vanguard REIT Index ETF (VNQ) has fallen about 10% in the past two months.
The system was right when it signaled risk was high among alternative investments in the market, and now it is signaling that risk has decreased. Not all alternative assets are a buy, and REITs are still not giving buy signals. But OIL is giving a buy under this relative strength (RS) system, as well as under a commodity trading system that I follow.
The chart below shows the buy signal on OIL from a commodity trading strategy that has a long history of success.
Commodity markets tend to move in extended trends after they break out of long-term trading ranges. OIL has been in a relatively narrow range since early 2009.
The chart above shows that the price has finally moved above its upper Bollinger Band. The Bollinger Band uses 20 weeks in its calculation, and after breakouts like this, OIL has gone on to deliver gains 61% of the time with the average size of the win being about 20%. This strategy exits when the price closes below the four-week moving average.
This is a simple trading strategy, but buying new highs works in commodity markets. Using a diversified basket of commodities, this system provides an average gain of more than 30% a year on accounts of $30,000 or more. This system does not do as well with stocks, and additional rules are needed to create a stock market trading system based on Bollinger Band breakouts.
In the past, when OIL breaks out on high RS, like it has in the setup we have now, we have seen a trade with a high probability of success and a slightly lower-than-average loss on losing trades.
After OIL is added to the 26-week ROC system, the portfolio will have three positions.