Some of the most successful trend-following technical analysts focus purely on commodities, for several reasons. One, commodity futures are liquid, highly traded and driven by global considerations. So, price discovery is, by and large, good. Two, when commodities go into trends, those can last for months or even years. Three, these contracts are margin-traded and it is as easy to go short as to go long.
Price trends in non-precious metals are driven largely by global supply and demand. Last year was bad for metals. Downbeat economic conditions meant iron ore declined a little over 15 per cent in price, globally. Copper prices on the London Metal Exchange dropped nine to 10 per cent. Aluminium hit a five-year low.
Indian prices reflected the situation and natural metals producers were hit by the fall. The CNX Metal index, which tracks listed metals producers (and Coal India) was down a little over 20 per cent in 2013. It is down 10 per cent in 2014 and most base metals are trading at 50-day lows. The 2014 downtrend has been reinforced by two new factors. China, by far the world's largest consumer of metals, has weak economic projections. Second, the taper announced by the US Federal Reserve has meant money is pulling out of global commodity markets and back into US treasuries. This means a stronger dollar and weaker commodity prices. The downtrend is likely to continue and could be severe. The Metals Index and many of its constituents bottomed in July-August at levels 20-25 per cent lower than current prices. Given the speed at which global commodity markets lost ground, stocks in the metals sector could easily drop to test supports at the 2013 lows or move even lower.
The index itself cannot be shorted. However, many of its key constituents are available in the stock futures segment and it is easy to build short futures positions in these. The trader could pick a few stocks to ensure coverage of ferrous and non-ferrous metals and go short. He should keep a stop-loss loss at three per cent or so above the entry price levels. It is impossible to set targets on the downside, so the stop-loss can be moved down as the positions move into profit.
While such short positions across metal counters appear marked, it is a fairly high-risk strategy. During such downtrends, technical snapbacks occur when bears book profits and the short covering sends prices up. Since the trader is hoping for big gains, he has to be prepared to ride out a reasonably large burst of short covering. These are all margined positions and if a three per cent stop-loss is struck, it would imply losses of 20-25 per cent of margin. A turnround could result if there was a major improvement in global growth prospects. Or, if metals prices fall to a point below cost of production. At that stage, producers will start cutting output, creating a positive imbalance, where demand exceeds supply and price starts recovering. Such changes cannot occur overnight. This is why a technical trend in a commodity tends to stay in force for extended periods.