Notice:
  The views and information expressed in this document reflect the opinions and experience of the author Robert C. Pelletier.  Neither CSI nor the author undertake or intend to provide tax advice or trading advice in any market or endorse any outside individual or firm.  All recommendations are provided for their informational value only.  Readers should consult competent financial advisors or outside counsel before making any software purchase or investment decision.  CSI does not stand behind or endorse the products of any outside firms.

Copyright (c) 1999 Commodity Systems Inc. (CSI).  All rights are reserved.

Capturing Intermarket Trading Opportunities

Capturing Intermarket Trading Opportunities

    The underlying purpose of preparing this CSI Technical Journal each month is to alert customers to the many salient features of CSI's market data services in ways that might help the user make more effective trading decisions. We attempt to produce material that is unique and original in scope and content and do not wish to fall into the convenient rut of preparing material that is a recapitulation of the works of others.

    Just as we do not wish to write about material that is the property of others, nor do we set out to trash others' ideas merely because we did not invent the concept, idea or methodology ourselves. The author of "A Complete Guide to the Futures Markets" seems to delight in finding fault with CSI's concept of constant-period-forward Perpetual Contract® , without understanding how they should or could be used successfully in tracking various markets. We aim to avoid writings such as those found in that book, which, in our view, alternate between simply reporting commonly practiced trading principles (without bringing anything new or original to the table) and presenting biased, unfounded criticism of others' works. We see our readers as thoughtful traders who seek a different point of view on how best to explore financial opportunities. With these thoughts in mind, we present some ideas to consider in your trading pursuits.
 

Trend Following Versus the MultiMarket Approach

    A great many traders jump on the long-term trend with plans to hop off before the ride takes a turn in the opposite direction. Although the exact turning point is difficult (if not impossible) to call in advance, the routine of following trends and capitalizing on market movement is worthwhile. That is, provided sufficient trading capital is available to take and maintain positions in various markets. There is certainly abundant room for profit in following trends, so long as you follow time-proven methods that can balance the inevitable risk of loss with the potential for reward.

    Trend-following procedures have wide appeal, but they are not necessarily preferred as a method of capturing profits from trading. Last month we presented material on CSI's new MultiMarket Analyzer (MMA), which was developed by staff Mathematician Steven Davis as part of the Unfair Advantage® (UA) database/analysis system. MMA's systematic trading procedure is much more than just a typical market study because it delves deeply into mathematical statistics. The MMA is a mechanism economists might employ to uncover the market forces that produce the most favored trading opportunities -- the kind that do not involve excessive risk. Adopting market positions where the odds favor a profitable outcome is much preferred over the routine 50:50 (or worse) prospects one might obtain from less sophisticated trend-following procedures.

    The MMA has been enhanced during the last month through the inclusion of still another indicator called the Davis Elasticity Index. It identifies the effective percentage level that any one market is out of step with all others, making it readily apparent which market is most overpriced and which is simultaneously most underpriced, given their respective historical norms. This added indicator simplifies the task of selecting the market pairs that offer the best opportunity for profits in spread trading. I cannot over-emphasize the potential for market insight one might derive from making full and complete use of the MMA tool. It is highly unlikely that you will find such sophisticated analytical power in the pricey, though uninspired, products offered by our competitors.

    Unfair Advantage's newest release (version 1.76.0) contains an altogether new charting/portfolio facility. It permits the display of chart pairs, together with a tabular display of the user's portfolio. Appropriately scaled pricing information on both charts facilitates the study of spread trading opportunities between markets, even when they possess differing conversion factor properties.

    The MultiMarket Analyzer supports analysis of the many opportunities one might find in the futures/commodity domain for intermarket spreads. Below is an overview of a few of the market pairs that might present opportunities for intermarket analysis. Some have been expansively exploited by traders and technical writers; others may not be widely known, and many others may be awaiting your discovery before they can be mined for profits.
 

The Crude Oil Spreads
 
    Crude oil (traded as Light Crude and Brent Crude) has a very prominent influence over the world economy. The abundance or scarcity of energy products has made this commodity a very important contributor to market forces around the world. Intermarket analysis has readily and regularly benefited from the crude oil influence, which has long been an intermarket participant. It has been paired with gold, T. Bonds, the CRB Index, aluminum, the grain complex, electrical energy futures and many other products. Look for numerous opportunities in positively or negatively correlated markets paired with this resource.

    Why was aluminum included in the above list? In case you may have forgotten, 95% of the value of aluminum comes from the electrical energy needed to produce it. (Crude oil and coal are used around the world to fuel electrical power plants.) The residual balance of the price value of aluminum comes from bauxite and transportation, the latter of which depends heavily upon the crude oil needed to move the product to market. Spread relationships between crude oil and lumber, orange juice, sugar, cotton, other precious metals and coffee might also be explored.

Treasury Bonds, Bills and Interest Rate Spreads Versus Stocks, etc.

    The CRB Index, gold prices and other forms of interest rate products move together or inversely with the cost of money. I would urge all readers to explore the opportunities in these areas when searching for market opportunities. The UA database and the vast data resources available to users of QuickTrieve® offer a depth of market resources. Prospective traders are likely to find fruitful opportunities for profit among one or more of these spread pairs on a daily or weekly frequency.
 

Currency Spread Opportunities

    Given the slow reaction of governments to the valuation of their respective currencies versus the balance of the world or with any given country, the currency spread or outright naked currency position has regularly been a winner for many traders. When a government finds its currency suffering versus the dollar (or the reverse), it is typically very slow to react to the conditions at hand, thereby awarding the trader with an abundant opportunity to benefit. Countries are slow to react because of the red tape, the internal legislative delays and their reluctance to admit that their currency is in jeopardy or subject to official devaluation. For all of these reasons, the currency trader has been seen to excel in the markets by using fairly simple trading approaches.
 

A World of Interrelationships

    Just about every major stock, commodity and futures market on earth is widely represented in the UA database. The U.S. Dow Jones Index, the S&P 500 Index, the NASDAQ Index, the FT-30 Index, the Hang Seng Index, the All Ordinaries in Australia, the PSE Technology Index, the DAX MidCap Index, the JSE Industrial Index, the Russian Index, the Czech Index, etc., etc., are all part of the immaculately precise UA database presented for daily review. They give the trader the opportunity to balance multiple economies within a single portfolio. UA gives the trader the unparalleled ability to effectively analyze this abundance of data with surprisingly little effort. The many and varied interrelationships between the markets become very apparent to the initiated observer using UA's MultiMarket Analyzer or the dual scale charting facility found in the most recent release of Unfair Advantage.

    The spread trader must recognize and be prepared to act on the simple fact that raw materials are the building blocks of the world economy. As the cost of raw materials goes up or down, the stock market often reacts inversely. A high cost of raw materials is considered bad for stocks, which often depend upon low priced and readily available raw materials for optimal production. Capturing the effects of price relationships and misalignments in raw materials through MMA analysis can help the trader capitalize on lucrative spread trading opportunities.

    We hope this edition of the CSI Technical Journal gives you food for thought on your trading as well as worthwhile information to help you get the most from CSI's products. Feel free to check our website at http://www.csidata.com for past issues of this journal discussing related topics. 
 

Chart Caption: A new facility in Unfair Advantage version 1.76.0 permits the creation of intermarket charts displaying two markets simultaneously, each with its own scale. The above chart illustrates the S&P Index (the right scale) vs. the CRB Index (the left scale).The combined chart exhibits the inverse relationship between these two markets. Your UA software uses pixel color coding to distinguish one chart from the other. The volume relationship, not so evident in black and white, is also in color for a clear on-screen view.

1 See the Unfair Advantage and/or QuickTrieve® User Manuals or contact CSI marketing at (800) 274-4727 for more information on CSI's Perpetual Contract Data. 

For a very substantive presentation of intermarket trading opportunities, may I suggest you consult John J. Murphy's book, "Intermarket Technical Analysis" published by John Wiley & Sons, Inc., copyright 1991. The charts shown in that book go through early 1990. Use Unfair Advantage to carry the many candidate intermarket relationships forward through 1999 to see how well his predictions have held up. 
 

Correction

    The explanation of low negative values on MMA's Correlation Coefficient Table in the July 1999 CSI Technical Journal should have said, "A low negative value (near -1) indicates a high negative correlation, where the paired markets are moving in opposite directions. High absolute readings of the correlation coefficient represent good predictability between any pair of markets." 

    The caption under that table should have read, "In this example, (taken from the MMA help screen) Eurodollar and Treasury Bills have a high correlation coefficient of 0.981; Dollar Index and Deutschemark also have a high correlation coefficient, albeit negative, of -0.925 and US Treasury Bonds and the Dollar Index have a minimal coefficient of -0.027."  We regret these errors.