Quotes and Nuggets from a Trading Seminar!!

Psychology is the most important component of successful trading. Regardless of whether a trader uses discretionary methods or a mechanical trading system, the proper mindset differentiates successful traders from others.

Six Keys to Success in Trading Futures
1 Correct Mindset
2 Commitment
3 Proper Capitalization
4 Position Sizing
5 Money Management
6 Be Responsible for Your Own Trading

Gordon Gecko was wrong. Greed is not good. (Gecko was the character in the movie "Wall Street.") Greed, fear, anger and all emotions can be a trader's downfall.

Success in trading is its own reward. The money is merely a by-product of that success--not the goal.

Discipline is the one quality that all traders must possess. This is the ability to master your mind, your body and your emotions. Know yourself. Your risk tolerance, your experience and your capitalization will play the biggest parts in determining what you will trade, and how. Lose your ego. Letting your ego influence your decision-making is the easiest way to end your career as a trader.

Five Common Trading Mistakes
1 Trading without a plan or with a poor plan
2 Losing your discipline. Not enough patience.
3 Trading without stops. Canceling stops.
4 Hanging onto a losing position. Turning a winner into a loser.
5 Too much risk. Not enough capital.

A great trader who has made tens of millions of dollars from the stock and commodities markets said the one individual universal reason for failure in trading is the inability to take a loss. The true path to riches lies not with the wins but managing the losses in a prudent and confrontational manner.

The true path to success always must journey through failure. The true winner in futures trading is the one who perseveres. The race is a marathon, not a sprint.

Why to traders and investors fail?
1 Limited trading capital.
2 No experience
3 No psychological preparation.

You are responsible. Win or lose, you are responsible for the outcome. Don't blame the market or your broker. Losses are an opportunity to focus on the problem. Don't get caught up in personal denial.

There is no Holy Grail. There is no get-rich-quick scheme. There is no free lunch. No one else can do this for you. If something sounds too good to be true, it probably is. When it comes to trading, there is no "hoping," no "wishing," and no "praying." There is just the cold, hard reality of the market.

Looking at timeframes when trading a market, start out with the longest first. This would be the monthly charts, then the weekly charts, then the daily charts, and then even the hourly or minute charts. You begin with the bigger picture and work your way down to smaller timeframes.

W.D. Gann's Four Essential Trading Qualities:
1 Patience
2 Knowledge
3 Guts
4 Health and Rest

There you have them. Of all the seminars I have attended, and all the books I have read, and all the successful traders I have personally interviewed, there is a common and very important theme that comes to the surface: Trading success comes less from the specific types of trading methods you employ or the types of markets you trade, or what trading timeframes you use. Trading success comes more from knowing yourself, knowing how to control your emotions, and forgetting about your ego.

Commodities and Portfolio Returns

Do Commodities Enhance Portfolio Returns?

Commodities as a group, measured by the long-only indices, have a low correlation to traditional asset classes such as fixed income and equities, we would expect a diversification benefit by adding an allocation to commodities to a traditional portfolio. This diversification benefit is often cited as a key reason for making an allocation to commodities. The degree to which commodities provide a hedge against inflation depends largely on the index used to represent commodities.

While we recognize that a tactical allocation to commodities may be beneficial during inflationary periods, over the long-term most commodity prices do not keep pace with the CPI (again, energy being the key exception). For this reason, we believe commodities are better viewed on an individual basis with a focus on those commodities or areas of the commodity market that provide the greatest potential for long term gains.

The Case For Commodities

Recent gains in the commodity markets have been substantial and many are asking if now is a good time to allocate assets to this area of the market. As seen by the returns in the graph below, the major long-only commodity indices posted annualized gains approaching 20% over the past five years. Indeed, rising commodity prices seem to dominate the headlines as of late. Proponents of investing in commodities point to increased demand from emerging markets as a key factor that could drive higher long-term prices. Proponents also point to the time lag in bringing new supply of certain commodities to the market. There can be significant time required to build new oil refineries, steel production facilities and mining operations, all of which are capital-intensive investments and could contribute to supply shortages.

Other points made for investing in commodities include strong performance by financial assets over the past 20 years, driven largely by falling interest rates. While a number of factors could contribute to inflationary pressures going forward, including excessive monetary liquidity and supply/demand imbalances, most commodities, as we have seen, do not constitute a good long-term inflation hedge.

Given the recent gains in commodities, most notably energy-related commodities, it is difficult to make a case that now is a good time to take a long position in an index with a significant weighting in energy. Crude oil has increased five fold since 1998, rising from $10 a barrel to over $50 today, and continues to press toward new highs almost daily. Likewise, natural gas has more than doubled since the end of 2001.

While we recognize that there are a number of factors that could increase demand for natural resources and commodities, we also recognize that current record high prices of many commodities may not be sustainable and may present significant risk. We are also mindful that a slowdown in emerging markets could result in a slowing demand for commodities and put downward pressure on commodity prices, as emerging markets are a primary source of demand for many commodities.

Conclusions and Recommendations

We believe that individual commodities should be evaluated based on their relative attractiveness in order to fully capture the benefit of investing in this area. Based on historical data, energy-related commodities have outpaced inflation and have provided the most attractive returns while agricultural related commodities have failed to keep pace with inflation.

Our conclusion is that accessing commodities through long-only indices is not the most effective means to benefit from this area of the market. While long-only commodity indices provide a simple way to gain exposure to a cross section of the commodity market, we believe that commodities are better viewed on a sector-specific basis to determine which commodities may make compelling investments. Other vehicles, such as managed futures strategies, may be more appropriate when seeking to gain exposure to commodities.

We also recognize that macro economic trends will likely favor real assets going forward and that some commodities will benefit from increased global demand. We recommend that clients consider the available long-only alternatives to protect portfolios from rising inflation.

While commodities represent an opportunity to add exposure to an asset class with a low correlation to equity and fixed income, their ability to act as a long-term hedge against inflation remains unclear because most commodities have not kept pace with inflation over the long-term. Additionally, the diversification benefit to an already diversified portfolio that results from their low correlation to other asset classes does not appear compelling enough to warrant a strategic allocation to the long-only indices. The same diversification benefit could be achieved by adding other asset classes to a portfolio with lower volatility. Additionally, much of the returns offered by these investments come from sources other than the underlying commodities themselves. By approaching physical commodities and natural resources from a sector basis we believe investors can benefit from those areas that have the most potential for producing the greatest returns and benefits to the portfolio.

Commodities:A Distinct Asset Class

As we have seen, commodities encompass a wide range of products including basic and precious metals, agricultural and food products, and energy related products such as crude oil and natural gas. We view an asset class as a group of securities with similar characteristics and properties that tend to react in similar way to economic factors.

For example, equities, fixed income and real estate are examples of pure asset classes because their returns are driven by similar factors. Additionally, securities in these different assets classes are mutually exclusive of one another indicating that an equity security is distinct from a fixed income security and vice versa. Given this framework, do commodities represent a distinct asset class?

We believe that commodities are most accurately viewed individually or on a sector basis, rather than collectively as one asset class. The reason for this is that the returns of one type of commodity may have little correlation with the returns of another type of commodity. An example would be an agricultural commodity such as wheat or corn and crude oil. Weather patterns in certain areas of the world will
impact corn or wheat prices, whereas these same weather patterns will have little or no impact on the change in oil prices, which may be driven by geopolitical events or other factors. Our analysis of the correlation between the prices of several commodities confirms this.

For example, the long-term correlation between the price of crude oil and gold is -0.03. Similarly, the long-term correlation between the price of sugar and crude oil is -0.37%. Therefore, when analyzing investments in commodities, we believe it is important to evaluate commodities individually or on a sector basis and determine which commodities make sense as tactical or strategic investments.

Sources of returns--Commodity Indices

Long-only commodity indices derive their returns from several sources

Collateral Yield: In a long-only commodity index, futures positions are unleveraged, meaning they must be fully collateralized, usually with Treasury Bills. Therefore, a portion of the return will come from the underlying cash position that supports the futures contract. Some managers seek to actively manage this underlying cash position in order to enhance the overall return of products tracking the index. Others simply invest the cash in short-term Treasuries, which are then rolled over at maturity. Depending on the type of fixed income security used to collateralize positions in the long-only commodity index, the return on the underlying cash position could range from 2-4%.

There is some debate as to whether or not the yield on the underlying cash position should be included as a source of commodity index returns, because an investor could theoretically achieve this return by simply allocating cash to Treasuries and because this portion of return has no direct relation to the actual commodities. If this portion of the return were not included in the long-only indices, it would alter their long-term performance.

Rebalancing Yield: A second source of return from long-only commodity indices comes from what is known as the rebalancing yield. This portion of the return is attributable to the fact that commodity prices are not correlated with each another due to the varying factors that affect the price of each commodity. Because commodities do not rise and fall together, an index consisting of many commodities that is rebalanced regularly on a price basis is able to extract a return based on the tendency of commodities to revert to their mean prices. Historical data confirm that a price-rebalanced index will tend to extract a return from “buying low” and “selling high” the uncorrelated commodities.

Robert Greer, senior vice president and portfolio manager for the PIMCO Real Return Fund, estimates that according to historical data, a commodities index can earn a rebalancing yield of approximately 2.5% on a long-term basis. The frequency of rebalancing is of particular importance, as data has shown that indices that rebalance more frequently are able to extract a greater return than those that rebalance less frequently.

Roll Yield: In addition to these two sources of return, a long-only commodity index will have gains associated with the change in price of the underlying commodities and the futures contracts on those commodities. For example, as a contract nears expiration, it will be “rolled over” to purchase new contracts on the commodity. At the time the position rolled over, there will be a gain or a loss depending on whether the underlying commodity has risen or declined in value. This portion of return is known as the “roll yield,” and will depend in large part on whether the underlying commodities are increasing or decreasing in value as well as the allocations of various commodities in the index.

Risk Premium: Finally, participants in the futures market can earn an insurance (or risk) premium since the long position is absorbing price risk that commodity producers, who are natural sellers, do not want. There may often be an imbalance between those wanting to sell futures contracts (like a farmer) and those willing to purchase futures contracts (such as a cereal manufacturer). The consumer (buyer of commodities) has less price risk than the producer because the end user can raise prices on the final product.

Investors in the futures markets serve to balance the market demand and in return, they are compensated for providing liquidity and assuming price risk.18 As a result, the investor is able to extract a return and profit from participation in the market and achieve an inherent positive return, or a compensation for the risk assumed by the investor. This component of return is closely related to the gain or loss on the underlying futures contract discussed previously.

An investor purchasing a futures contract and holding it to expiration will capture some risk premium in the marketplace and will also have a gain or loss depending on where the price settles at maturity. While these components of return are shown separately, they are closely linked and in some cases indistinguishable.

In evaluating the sources of long-only commodity index returns, we believe it is important to focus on those sources that relate specifically to an investment in commodities. As figure 1 shows, the key sources of return for a long-only commodity index are the gain or loss on the underlying futures contracts, the rebalancing yield, and a risk premium for providing liquidity to the market. The yield on the underlying cash position may or may not be considered as a source of returns to the index, although returns of the major indices include these in their total return calculations.

In the final analysis, the two main sources of return that relate directly to commodities are the gains and losses on the underlying futures contracts and the return that will come from providing liquidity to the markets due to the nature of futures contracts and the commodities markets. When analyzing long-only commodity index returns, it is important to focus on those sources that are related to commodities rather than those that are exogenous to the actual changes in prices of the futures contracts.

Investors who consider an allocation to commodities should also recognize the potential volatility of returns for long-only indices. In 1998, for example, the GSCI declined by 35%, a substantial one-year loss that was driven in large part by difficulties in the emerging markets. While this is comparable to the 30% decline in the Russell 2000 Growth Index during 2002, commodities do not provide the same long-term upside as small cap equities, with the key exception being energy related commodities, which have provided higher real returns. The longer-term standard deviation of the GSCI is close to 20% and, while this index has shown strong gains, the impact of the oil crisis of the 1970s heavily influenced the returns of this index. For example, from January 1970 through January 1980, the GSCI increased at an annualized rate of 21.8%, in large part due to the steep rise in oil prices during this time period.

Analysis of Commodity Indices!!

In calculating returns, the GSCI, RICI and the DJ-AIG indices use an arithmetic weighted average of the underlying commodities to represent the index. The CRB Index utilizes both geometric and arithmetic averages of the prices of the underlying commodities to construct returns. Geometric averaging creates lower overall volatility of returns than arithmetic averaging and, according to the CRB, geometric averaging “has the statistically attractive property that successive percentage changes in a component’s price do not alter that component’s relative weight in the index.”

Arithmetic averaging, on the other hand, causes the relative weight of a component to increase (or decrease) as that component appreciates (or depreciates) in value. The method used by the CRB allows the index to maintain equal weight in the 17 individual components so that no single commodity has undue impact on the index. The index is also less subject to the fluctuations associated with temporary supply and demand imbalances in any one commodity.

Compared to other long-only commodity indices, the DJ-AIG offers a more balanced mix of commodities and is not as impacted by the performance of the energy sector as the GSCI. In terms of liquidity, the GSCI and the DJ-AIG have several products that seek to replicate the returns of the indices, which makes them more accessible to institutional investors. These indices are also the most widely followed and considered proxies for the commodity market. In analyzing performance, the CRB Index has trailed the other indices over time by a significant margin. This is due in part to its larger weighting in “softs” and lower weighting in energy related commodities compared to the other indices.

Eminent International Indices-Commodities

The following is a brief summary of several long-only commodity index products that are available to investors seeking broad exposure to the commodity markets.

Commodities Research Bureau (CRB) Index: The CRB Index began trading on New York Futures exchange in 1986 and is the oldest of the indices. While futures on the index began trading in 1986, it was first calculated by the CRB in 1957 and has data going back to 1958. The index includes 17 individual components, which are equally weighted. This is one of the key drawbacks to the index because a product like corn or wheat will have the same weighting in the index as crude oil, when oil has significantly more economic impact than corn.

Goldman Sachs Commodity Index (GSCI): The GSCI index was created in 1992 and is available in the form of a single futures contract on the Chicago Mercantile Exchange. While it was launched in 1992, the GSCI has back-tested data going back to 1970. The index consists of 24 individual components and weights are assigned based on a five-year moving average of world production values. The result is that the index has a heavier weighting in commodities with more economic importance and higher liquidity. Consequently, the GSCI has a weighting of nearly 70% in energy related commodities making its performance highly sensitive to the energy markets and fluctuations in energy prices. The GSCI is rebalanced annually, and utilizes an arithmetic average in constructing returns for the index. Given its liquidity and longer performance data, the GSCI is often used as a proxy to analyze commodity returns.

Rogers International Commodity Index (RICI): Jim Rogers, a private investor and former hedge fund manager, created the RICI in 1998. Its weightings are based on world consumption patterns of raw materials and their relative importance in international commerce according to the research of Jim Rogers. The RICI is the broadest and most comprehensive index, consisting of 35 different commodities. Some of these components are less liquid and include obscure commodities such as flaxseed, azuki beans, canola oil, and raw silk. Weights for the individual components are fixed and the index is rebalanced monthly. The RICI is only available through a limited partnership and while it offers the broadest exposure of the major commodity indices, there could be some risk related to the liquidity of some of the index components.

Dow Jones AIG (DJ-AIG) Index: The DJ-AIG was established in 1999 and relies primarily on liquidity data and, to a lesser extent, dollar-adjusted production data in determining the relative weights of commodities in the index. All data used in both the liquidity and production calculations are averaged over a five-year period to determine component weights.11 The index holds 20 components and limits any related group of commodities to 33% in order to ensure diversified exposure to commodities. Like the GSCI, the DJ-AIG index is rebalanced annually. The reason for using liquidity data rather than production data is that liquidity is an important indicator of the value placed on a commodity by financial and physical market participants. Production data alone can underestimate the investment value that financial market participants place on certain commodities.