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Commodity spreads 15: Why the seasonality is not enough?

18 Jul 2018,

In the last part of the commodity spreads series, we started with seasonality. Every spread trader should know why it exists, but also know its advantages and disadvantages. At the end of the previous lesson I wrote the sentence: “But the seasonality itself is not enough for me!” Today I will give you few examples why this is the case and why my trading system puts more importance to other analysis.

 

 

When seasonality fails

We already know that there is one main thing behind seasonality – weather cycles. Yes, the weather changes during the year are very similar. But can we rely on it every year? I think we certainly cannot. As you know, the weather is largely unpredictable. For 10 years, we can experience absolutely normal and expected weather every year, but then one year can be completely different. This may be due to oceanographic phenomena known as El Niño or La Niña for example. They have the power to cause major changes in temperatures and also in rainfalls in key parts of the year in important agricultural areas. Of course, these changes have an impact on future harvests, which will also be reflected in commodity price development.

One typical example was the drought in 2012, which caused a sharp rise in grain prices. Do you think seasonality played a role there? Unfortunately, no. Proof is the following chart with detailed seasonality of the well-known and popular bear spread on corn July – December of the previous year. The curve that surpasses such a wonderful growth tendency is obvious at first glance. If a trader would rely only on seasonality while having badly controlled risk, he would have to suffer a lot.

 

 

Nothing works forever

Many of my students and my colleagues traded only based on a seasonality. Often, the trades were working perfectly, basically without hard work, just based on watching different seasonal signals. They have been so confident that trading is easy, and it will be forever so. Then came an abnormal year when seasonality suddenly ceased to work, and their losses were often very large. Till the end of the season, they relied on seasonality and expected turnover. They said, “Seasonality must eventually show up.”

These traders often did not even know exactly they were doing. They did not know why there are inter-delivery spreads. What it means to hold bear or bull spread (especially with regard to risk) that there is a contango or backwardation effect, etc. But if you have gone through this commodity series from the beginning, you have a big advantage. Spreads are pretty much understandable, and you can see deeper to the markets. That’s why you will not be seduced by a beautiful curve of seasonality.

Seasonality as a rear-view mirror

I often compare seasonality to the rear-view mirrors in the car. No doubt they are very important when driving. We see what is behind us, if somebody is not passing us, etc. Without them, we cannot imagine driving a car. But can you imagine driving only by the rear-view mirrors, for example with a darkened windscreen? I do not think so. You need to know what’s ahead of you, what to avoid, whether you can afford to add gas or rather slow down. Exactly the same is true in trading. We need to see the current state of the market! Keep following indicators that tell us what’s ahead of us. Driving with just past or historical success is not enough!

Seasonality is like a look into the past. It can tell us how the given futures contract or spread tends to behave in a certain period. But we do not see what’s happening right now. Entering or exiting from positions only based on a seasonality does not lead to stable results for a long time.

What if a market changes?

In addition to weather, there may also be some fundamental long-term change on the market, whether on the supply or demand sides. Here are just a few examples:

– new mining technology / growing of a particular commodity – higher offer

– new sectors that will increase the demand for a particular commodity

– a new more resistant breed, method of processing, etc.

Seasonality gives us zero information about the changes that are happening on the market. For this, we need to work with other analyzes. These include, for example, COT analysis, market structure analysis, storage cost analysis, and others. We also need to understand how spreads work. Why to choose a specific strategy, what are the advantages and disadvantages, what to watch out for, etc. Many of these things you already know, and we will also present you many others.

 

Finally, I attach seasonality of one bear oil spread, particularly between February and January. You may notice a perfect growing tendency. Despite that, one year is clearly out of this tendency.

 

 

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