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Monday, December 7, 2009

Lesson 10 - How To Use Cycles

Everything in nature moves in cycles. . . the cycles of the seasons ... night and day... tides... phases of the moon. Each year animals hibernate... geese migrate... salmon swim upstream to spawn... and every seven years lemmings run into the ocean.

While nature's cycles are very visible, there are many cycles in the futures markets that are not quite as obvious. Often the reason some cycles are not easily seen is because the interaction of many large and small cycles makes individual cycles harder to see.

Cycles are the tendency for events to repeat themselves at more or less uniform intervals. One of the easiest cycles to see and understand is the seasonal cycle. Agricultural commodities have a repetitive annual price pattern called the seasonal price cycle. More than 70 of the time, the lowest cash prices of the year for corn, cotton and soybeans occur during the fall harvest period. Due to increased marketings, cattle and hogs also have price weakness during the fall. Wheat and oats tend to make seasonal lows during their summer harvest. Seasonal price trends are a reflection of regular annual changes in supply and demand factors caused by weather, production and demand.

Cycles

After a seasonal cycle has bottomed, a trader knows prices should not drop below the seasonal low until after the seasonal high has been made, normally several months later. After the seasonal cycle has topped, the uptrend is over and prices should move lower until the seasonal cycle bottoms. Traders who know the direction of the seasonal cycle are able to follow the profitable maxim of trading with the trend.

Keep in mind there are sometimes some surprising differences in the seasonal pattern of cash and futures prices for agricultural markets.Futures markets try to anticipate the cash market due to expected production and expected demand. Therefore, futures market may bottom as much as two months ahead of the cash market. For example, the hog futures market may bottom in August, anticipating the fall low for the cash market, but the cash hog market may not bottom until October.

July Wheat

While the causes of seasonal cycles are known, the causes of other cyclical patterns are not always known. The Foundation for the Study of Cycles (124 South Highland Ave., Pittsburgh, PA 15206), a nonprofit organization, has cataloged thousands of cycles using detrending processes. Some of the longer-term cycles they have identified include the 9-year wheat cycle, the 5'/2-year corn cycle, the 5'/2-year cycle for precious metals, the 25-month and 38-month soybean cycles, the 11-year cattle cycle, and the 4-year business cycle.

The theory of cyclical analysis is that events will occur within a cycle to move prices in the expected direction of the cycle. The basic drawback of fundamental analysis is that the events causing changes in supply and demand are not known until after the fact ? well after tops and bottoms have occurred. All fundamental information relative to supply and demand is in the market each trading day. But the market usually moves before the fundamental reasons are known. Cycles help traders pick the direction of price moves before the news comes out.

To analyze a futures market based on cycles, it is necessary to isolate the dominant cycles affecting price activity. Once these dominant cycles have been identified, future price expectations can be established by combining the effects of these dominant cycles. Long-term cycles, such as the yearly cycles identified by the Foundation for the Study of Cycles, tell you the direction of the overall price trend. Shorter cycles, weekly and daily, can then be used to determine when long-term cycles have topped or bottomed and when to enter and exit a market.

Most markets have a dominant short-term daily cycle which may be as short as 14 calendar days or as long as 35 days. Most of the meats and grains, for example, have a short-term cycle averaging 28 calendar days. Combing two or more of these short-term daily cycles forms a dominant intermediate-term weekly cycle which runs 6 to some 20 weeks from low to low, depending on the futures market. When the short-term cycles are combined with a larger cycle, the smaller cycles will look like the drawing at the bottom of this page.

May Wheat

Cycles are seldom symmetrical, and their patterns differ in bull and bear markets. In a bull market, the crest of the cycle tends to lean to the right because the highs are to the right of the midpoint of the cycle. This is called right translation. In strong bull markets, the length of the cycles tend to contract (shorten) slightly.

Just the opposite is true in a bear market. In bear markets, the cycles tend to be slightly longer than they were during bull markets. Cycles in bear markets tend to peak early in the cycle to the left of the midpoint - called left translation. Note the 13-week cycle from August to November on the K.C. May wheat had right translation up to the seasonal high and left translation coming down from the winter seasonal high. Right translation quickly followed by left translation is often the way a longer-term cycle high is made. Seasonal lows are often made the way Dec. hogs bottomed in September with extreme left translation followed by extreme right translation.

Trendlines are also an important tool to confirm cyclical tops and bottoms. Penetration of a trendline drawn from the crest of two cycles of similar length confirms that the next longer cycle has bottomed. In bull markets, breaking an uptrend line connecting the lows of two similar length cycles will confirm that the next longer-term cycle has crested.

The wheat charts on these pages are a good example of repetitive patterns which are helpful in profitably trading a market. For the long-term perspective, these charts show wheat when it was declining toward the 9-year cycle low, which is expected the next summer. The current seasonal cycle began in August, topped in December and is expected to bottom with the 9-year cycle the following summer.

Cycles Cycles

Near the 13-week cycle low in February, intermediate-term traders would be taking profits with plans to sell again as the next 13-week cycle crests. The next cycle high is likely to come early (left translation) because the dominant 9-year and seasonal cycles are pointing down. The crest of the 13-week cycle may be made with the crest of the first 28-day cycle out of the February low. This 13-week cycle should bottom again about 13 weeks from the February low, which would put the expected low in May (plus or minus 15). The next 13-week cycle low would be due in another 13 weeks in August, which would be the most likely time for the seasonal cycle lows.

On the Chicago July wheat chart, three 28-calendar-day cycles make up the 13-week wheat cycle. Breaking the uptrend line connecting 28-day cycle lows confirmed the 13-week cycle high in November. The winter seasonal high was confirmed during the January collapse when prices dropped below the previous 13-week low (Nov. 25 low). The 13-week cycle low in February was confirmed by breaking the downtrend line connecting 28-day cycle highs. Shorter-term traders would be trading the 28-day cycle highs and lows in the direction of the intermediate-term cycle.

Cycles are most accurately measured from low to low. It is not unusual for a cycle to have a variation of plus or minus 15 of the length of the cycle, and expectations should be established accordingly While the most probable times for cycles to top and bottom can be established, cycles do sometimes stretch, shrink and, on occasion, disappear. It is a common feature of cycles to correct themselves as time passes. A cycle that runs too short, for example, might then make an adjustment by running longer on its next repetition. Chicago July wheat had two short cycles in September and October, which was followed by a cycle that ran more than five weeks from mid-October to late November.

The Commodity Futures Trading Commission has asked us to also advise you that trading futures and options is not without risk. While there is opportunity for incredible wealth building, there is also the risk of losing even more than you invested. Of course, that's not unlike most other businesses. But informed traders are the best traders! Opinions expressed by Market Spotlight authors are not those of INO.com.

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