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In any asset class, traders, investors, or speculators aim for profit. In commodities like coffee or crude oil fundamental analysis and technical analysis are employed by traders in their buy, sell, or hold decisions.
Fundamental analysis is best for long-term investments. It studies demand-supply situations, economic policies, and financials as decision-making criteria. Technical analysis is appropriate for short-term market decisions and analyzes the past price patterns, trends, and volume to chart future movement.
Key Takeaways
- Fundamental analysis and technical analysis help traders decide to buy, sell, or hold.
- Momentum indicators are used for commodity trading.
- The moving average (MA) is the average price of a commodity over a specified period.
Identifying Market Trends
Momentum indicators are commonly used when individuals trade commodities. Commodities are goods interchangeable between producers, such as grains, gold, beef, oil, and natural gas.
Momentum indicators are divided into oscillators and trend-following indicators. Traders first identify whether the market is trending or ranging before applying any of these indicators. The trend following indicators do not perform well in a ranging market; similarly, oscillators tend to be misleading in a trending market.
Moving Averages
A widely used indicator in technical analysis is the moving average (MA), the average price over a specified period. For example, a five-period MA reflects the average of the closing prices over the last five days, including the current period. When this indicator is used for intra-day pricing, the calculation is based on the current price data instead of the closing price.
The MA tends to smooth out the random price movement to bring out the concealed trends. It is seen as a lagging indicator and used to observe price patterns. A buy signal is generated when the price crosses above the MA from below bullish sentiments, while the inverse is indicative of bearish sentiments and a sell signal. Versions of MA included the exponential moving average (EMA), volume-adjusted moving average, and linear weighted moving average.
The slope of the MA reflects the trend direction in the chart. A steeper MA shows the momentum backing the trend, while a flattening MA is a warning signal there may be a trend reversal. The blue line depicts the nine-day MA, the red line is the 20-day moving average, and the 40-day MA is the green line. The 40-day MA is the smoothest and least volatile. The 9-day MA shows maximum movement, and the 20-day MA falls in between.
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Moving Average Convergence Divergence (MACD)
MACD, moving average convergence divergence, is an effective indicator developed by money manager Gerald Appel. It is a trend-following momentum indicator that uses moving averages or exponential moving averages. Typically, the MACD is calculated as a 12-day EMA minus a 26-day EMA. The nine-day EMA of the MACD is called the signal line, which distinguishes bull and bear signs.
A bullish signal means the MACD is positive because the shorter timeframe EMA is stronger than the longer period EMA. This signifies an increase in upside momentum, but as the value starts declining, it shows a loss in momentum. Similarly, a negative MACD value is bearish and has a growing downside momentum. If the negative MACD value decreases, the downtrend is losing momentum.
In the chart, the MACD is represented by the orange line. The signal line is purple. The MACD histogram (light green bars) is the difference between the MACD line and the signal line. When the histogram is positive (above the centerline), it gives bullish signals, as indicated by the MACD line above its signal line.
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Relative Strength Index (RSI)
The relative strength index (RSI) attempts to determine the overbought and oversold level in a market on a scale of 0 to 100, indicating if the market has topped or bottomed. According to this indicator, the markets are considered overbought above 70 and oversold below 30. The use of a 14-day RSI was recommended by American technical analyst Welles Wilder.
RSI can be used to look for divergence and failure swings in addition to overbought and oversold signals. Divergence occurs when the asset makes a new high while RSI fails to move beyond its previous high, signaling an impending reversal. If the RSI falls below its previous low, a confirmation of the impending reversal is given by the failure swing.
Investors should be aware of a trending market or ranging market since RSI divergence is not a good indicator in a trending market. RSI is very useful when used as complementary to other indicators.
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Stochastic
Securities trader George Lane based the Stochastic indicator on the observation that prices with an uptrend during the day, then the closing price will tend to settle near the upper end of the recent price range. Alternatively, if the prices have been sliding down, the closing price settles closer to the lower end of the price range.
The indicator measures the relationship between the asset’s closing price and its price range over a specified period. The stochastic oscillator contains two lines. The first line is the %K, which compares the closing price to the most recent price range. The second line is the %D (signal line), which is a smoothened form of the %K value and is considered the most important among the two.
A bullish signal is formed when the %K breaks through the %D in an upward direction. A bearish signal is formed when the %K falls through the %D in a downward direction. Divergence also helps in identifying reversals. The shape of a Stochastic bottom and top also works as a good indicator. A deep and broad bottom indicates that the bears are strong and any rally at such a point could be weak and short-lived.
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Note
A chart with %K and %D is known as Slow Stochastic.
Bollinger Bands®
The Bollinger Band® was developed in the 1980s by financial analyst John Bollinger. It measures overbought and oversold conditions in the market. Bollinger Bands® is a set of three lines: the centerline (trend), an upper line (resistance), and a lower line (support). When the price of the commodity considered is volatile, the bands tend to expand, while in cases when the prices are range-bound, there is a contraction.
Bollinger Bands® are helpful when traders try to detect the turning points in a range-bound market, buying when the price drops and hits the lower band and selling when the price rises to touch the upper band. However, as the markets enter trending, the indicator starts giving false signals, especially if the price moves away from the range it was trading. Bollinger Bands® are considered apt for low-frequency trend following.
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When Should Traders Avoid Using a Moving Average?
Moving averages are unsuitable for a ranging market, as they may generate false signals due to price fluctuations.
How are Commodities Traded?
Commodities trade in spot markets or financial commodity or derivatives markets. Spot markets are cash markets where investors buy and sell physical commodities for immediate delivery. Derivatives markets involve forwards, futures, and options. Forwards and futures are contracts that rely on the spot prices of commodities. These contracts give the owner control of the underlying asset at some point in the future at an agreed-upon price.
What Is a Crossover?
One strategy using MACD is the crossover. A crossover occurs when the signal and MACD line cross each other. The MACD generates a bullish signal when it moves above its nine-day EMA and triggers a bearish signal when it moves below its nine-day EMA.
The Bottom Line
There are many technical indicators available to traders in the commodity market. Trend-following indicators are apt for trending markets, while oscillators fit well in ranging market conditions.
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