futures nov.pdf

8/14/2019 futures nov.pdf

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WHATS

REVOLUTIONAG MARKETCAUSING THE

AGRICULTURE INSIDER PETE NESSLER DRAWS

GRAINS WORLD MAP

HOT NEW CTASNEW TRADERS

BEAT TOUGH MARKET

EXPLORING GANNSIFTING THROUGH

BREAD CRUMBS

NOVEMBER 20FUTURESMAGNO V EMBER F U T URE MA


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41 years

E D

U C A

T I N G T R A D E R S

F O

R

F U T

U R E S M A G A Z I

N E

CONTENTS

6 Ad Index

8 Editors Note Agriculture means business

10 Market Watch Shutdown likely to keeptapering at bay

12 Options Strategy Using a strangle or straddleto trade a moving market.

46 Trader ProfileThird Street Ag:Fundamentally sound

DEPARTMENTS

NOVEMBER 2013 // VOLUME XLII NUMBER 9

Pete Nessler is good Midwestern stock By Ginger SzalaEarning his stripes in the grain fields of Iowa, Pete Nessler has witnessedhow the agriculture markets have changed dramatically over the past 30

years. Now the CEO of FCStone, we talk with him about those changes,and how a small Midwestern firm grew and changed with them.

COVER STORY

14

4 FUTURES November 2013

For reprints and e-prints of FUTURES articles, please contactPARS International at [email protected] or (212) 221-9595.

FEATURES

MARKETS20 A winters tale: No dormancy for

grains or livestock By Rich Nelson With crops coming in better thanexpected, questions now turn to how welldemand will be able to accept this supply.

TRADING TECHNIQUES

26 Harvesting profits fromcorn fundamentals By Michael Gross With grain harvests nearly finished,

here are a couple of options strategiesto take advantage of fundamentallyand seasonally driven price changes.

30 The profitable, hidden and Markoviancouple of Swiss and gold By Donny Lee Hidden Markov models are makinginroads into institutional trading.Heres how using them in one marketcan help your forecasts in another.

34 Unlocking W.D. GannsThe Tunnel Thru the Air

By Pauline Novak-Reich Although W.D. Gann is well-knownamong traders, little is known aboutthe thought process behind hisapproach. Perhaps his 1920s science-fiction novel contains the hints we seek.

EQUITY TRADING TECHNIQUES

38 Using moving averages totarget the trends By Raghav Behani Every market has its time,including stocks. Heres how touse moving averages to get in earlywhen trends are changing.

MANAGED FUNDS

40 Hot new CTAs move beyondrough couple of years By Daniel P. Collins Although the last couple of years havebeen rough on traders, here are threeemerging managers who successfullyhave navigated the post-2008 chop.

For additional information,visit futuresmag.com

DIGITALEXCLUSIVE THIS EDITION INCLUDES

ADDED ARTICLES ANDEXPANDED COVERAGE.


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Check out the unabridged version of our interview withPete Nessler where we go intogreater depth on the changesin the agriculture markets andhow FCStone has adapted tothose changes.


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Agriculture means business

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Anyone who has seen Fieldof Dreams or any moviebased in the American

heartland has the vision of vastfields of grain blanketing thelandscape to the horizon. Non-Midwesterners still believe there

is nothing in the countrys center except corn, soybeans andwheat. In many ways they are right, as the Midwest still is theengine behind the agriculture business in the United States,but much has changed.

Although ethanol as a fuel source had been part of the lexiconfor decades, during the early 2000s ethanol plants began to be builtin earnest. In 2005, the Environmental Protection Agency (EPA)came up with Renewable Fuel Standards mandating that 7.5 billiongallons of ethanol needed to be blended into fuel by 2012. Thattruly set in motion the push to produce ethanol, and corn priceswent from a sleepy $2.50 to $3.00 per bushel to more than $8.00 abushel. Throw in some very bad weather years and price volatilityescalated for all agricultural products.

Step in market forces, which basically saw a jump in consump-tion both from a growing demand from Asia as well as the needto make ethanol, and this ignited a global move to produce graincrops that the world needed. South America always was a grainproducer, but today it is out producing the United States in soy-beans. The Black Sea region, again always a grain producer, now isan expanding force in wheat.

Another push came from the major agricultural trading compa-

nies, or the ABCDs, that is: Archer Daniels Midland (ADM), Bunge,Cargill and Louis Dreyfus. Although always giants in agriculturalprocessing and distribution, these groups went global in all aspectsof the business. Joining them on another end were the commod-ity trading companies, not there for the end user, but global trad-ers who would work to move world products: Firms like Noble,Glencore and Olan all grew over this period, over-lapping in someareas with the ABCDs, but basically focusing on trading for theircore revenues.

Today, other new players have joined the fray, including largehedge funds who are purchasing land to grow products. Add to thisother new players, such as high-frequency traders and prop houses,and it makes for turning the former U.S.-centric ag business into aglobal mega-industry that still is growing.

Despite this global explosion, the futures markets havent neces-sarily kept up; open interest has been relatively stable while deliv-ery points have yet to be expanded beyond the United States. Thismeans brokers who typically thrived on the futures side of the busi-ness began to look elsewhere to expand.

To get an insiders view of this change in the ag business, wespoke with Pete Nessler, CEO of FCStone, the commodities arm ofINTLFCStone. Pete has been in the ag business more than 30 years,learning early the realities of hedging globally when he began trading just as the Falklands war heated up. From there he worked with eleva-tors and farmers to hedge product, as well as pushed FCStone intothe ethanol revolution. (See Pete Nessler is good Midwesternstock, page 14). With FCStone being one of the largest clearingfirms in grain products, Pete has seen from the inside what changesoccurred, and what still needs to happen.

Because of the changing industry, FCStone has moved beyond American shores, working the ag business globally, as well asexpanding into other commodities, such as softs. And, MF Globalsdemise had one silver lining (literally) for FCStone; it picked upMFs London Metal Exchange group, and quickly became one ofthe worlds largest precious metals brokers.

Next month well be doing our Top Brokers review, but with thechanging makeup of the grain markets, we believed it was a good

time to look at how one firm changed with the business it grew upin, moving from the Iowa grain fields to new countries and new com-modities. No doubt, this is a template most firms would like to fol-low as the commodity business, especially grains, explodes.

E-mail me at [email protected]


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10/53

Much as the Federal Reserve relies on communicationand forward guidance, the task of clearly signallingits intentions to financial markets is not getting any

easier in wake of the Federal Open Market Committees (FOMC)surprise decision not to reduce asset purchases on Sept. 18.

At the best of times, it is difficult to assess and forecast theeconomy, and for a central bank thatclaims to be both forward-looking anddata-dependent testing its projectionsagainst reality that makes monetarypolicymaking tricky. These days, theexercise is further complicated by parti-san wrangling over fiscal policy that isclouding the outlook.

Fiscal drag has transmuted into fis-cal anxiety, making firms and householdsmore uncertain than ever and hence morehesitant to hire, spend and invest. Nevermind that the official data black-outattending the federal government shut-down makes it hard for the Fed even tomeasure the economy.

The debate rages on whether the Fedmisled financial markets about theFOMCs plans to reduce the $85 billionmonthly bond buying. In his post-FOMC

press conference, Chairman Ben Bernanke unapologetically toldreporters, I dont recall stating that we would do any particu-lar thing in this meeting. And he said, Fed actions are notdetermined by Wall Streets expectations of what we might orshould do.

New York Federal Reserve Bank President William Dudleyadvised markets to treat what we say as what we mean, dontthink that were hinting at something.

But even some insiders concede the Fed was less than per-fectly transparent.

Philadelphia Fed President Charles Plosser, among other offi-cials, took umbrage, telling me we did ourselves a disservice inthis (communication) process in September. He added, We

had set the market up for an expectation that we would startto wind down purchases in September. Plosser serves on anFOMC subcommittee headed by Vice Chairwoman Janet Yellen.

When rates rose sharply after Bernankes June 19 statementthat, if the economy performed as hoped, the FOMC expectedto begin tapering bond buying later this year, Fed officialsbecame concerned about the impact on housing. But Plossercontends they didnt clearly convey those concerns and pushback against market expectations of a September move.

While communication always can be improved, there are moreprofitable pursuits than laying blame namely trying to figure outwhen and under what conditions the FOMC will begin scaling back

its purchases of longer term Treasury- and mortgage-backed securi-ties. Of course, thats easier said than done in the current climate.

Since the FOMC said it wanted more evidence that progresswill be sustained in labor markets, officials have been renewingtheir commitment to data dependence. But that begs the ques-tion of how much more evidence and over what time frame.

Thats a tough question to answer ina data vacuum. Even when statisticalagencies start cranking out numbers onemployment, retail sales, housing, infla-tion and so forth, there are sure to be varying responses.

For those policymakers, such as St.Louis Federal Reserve Bank President James Bullard and Governor Jeremy Stein,who regarded the Sept. 18 decision tostand pat a close call, perhaps it wonttake much to support a modest tapering.But for others, the bar is higher.

Dudley outlined two tapering tests: (1)Evidence that the labor market has shownimprovement, and (2) informationabout the economys forward momen-tum that makes me confident that labormarket improvement will continue in thefuture. Meanwhile, he said the economy

still needs the support of a very accommodative monetary policy.Boston Fed President Eric Rosengren sounded even less eagerto taper. Asserting that he strongly and unequivocally voted todelay tapering and saying the economy is just treading water,the FOMC voter said we need to see data that compellinglysuggest that over the next three years we are indeed on a pathto reach full employment and 2% inflation.

Bernanke, who is expected to step down when his second termas chairman ends Jan. 31, 2014 and be replaced by Yellen, hashad little to say publicly since Sept. 18, but did lament in earlyOctober that the recovery remains frustratingly slow.

Frustrating indeed. Despite holding the federal funds ratenear zero for going on five years and expanding its balance sheet

by a further $1 trillion over the past year, the gross domesticproduct has continually fallen short of Fed projections, lan-guishing in a 2% growth slough that casts doubt on the econo-mys ability to sustain substantial labor market improvement.

True, the unemployment rate has fallen to 7.3% from a peak of10%, but thats in good part to a plunge in labor force participa-tion to 63.2%, its lowest level since 1978. Non-farm payroll growthhas slowed to an average 148,000 over the past three months. Andof course the inflation rate is running far below the 2% target.

Add the frustration of the fiscal stalemate and the damageit has done to confidence, and you have a prescription forfurther delay.

MARKET WATCH

BY STEVEN K. BECKNER

Shutdown likely to keep tapering at bay



11/53


12/53

Gold is going to move; we know that. Its the direction thatcan be the problem. Through government shutdowns, risinginterest rates and geopolitical impacts to the U.S. dollar justto name a few investors constantly are trying to figure outthe direction of gold.

If wrestling with the direction of precious metals isnt yourstrength, then move from directional to non-directionaltrading. Using GLD for example, you can trade the movement ,regardless of direction. This is done by buying either a strangleor a straddle.

Both strategies involve buying a call and a put. A straddlecombines the two options at the same strike price while a stran-gle involves buying out-of-the-money calls and puts. Here wellassume the use of a straddle.

The idea for either strategy is the same: Get enough move-ment so the profit of one option outweighs the loss of the other,thereby netting a profit. If gold rallies, then the call profits, butthe put has limited loss. If gold tanks, then the opposite happens,

with the put producingthe profit while the callhas limited losses.

Sounds easy, right? If gold moves up or down, you win. Butits not quite that simple. You can get hurt in a couple of wayswith this trade.

First, because the trade involves buying two options, it nowinvolves a time decay problem if the underlying doesnt move.Second, a drop in the implied volatility hurts this trade andcan overshadow any movement that otherwise might have ledto profitability.

Understanding two key elements can mute these risks and helpyou find potentially profitable trades without having to guessdirection correctly. Sometimes a decent move is preceded by com-mon consolidating wedge or pennant patterns. Thus, the firstelement is to look for these patterns, as in the chart to the left.

Pattern A preceded a fairly substantial drop over the nextseveral trading sessions, which is the kind of movement thatcan produce profits with non-directional strategies. Pattern Balso preceded a good move.

But the second element also has to be present: Low implied volatility. Volatility, shown in the lower chart, is the key. If the volatility is low and doesnt move much lower, then the onlything you really have to worry about is time decay.

In the above example, the implied volatility is near the low endof its recent range for both patterns A and B. Heres a straddletrade example for pattern B.

With 30 days until expiration and GLD trading at $123.32,the at-the-money (123) straddle is worth $6.00. The implied volatility isnt at its absolute lowest, but the risk of loss to a volatility crush is not significant.

Notice also that on this date, the stock appears to be break-ing out lower, but quickly reverses and five days later is trading

nearly $5 higher at $128.24. Thats a good reason to consider anon-directional trade rather than trying to guess the start of atrend. With this move in the stock, the straddle has increased to$7.55, generating a 26% profit for the straddle buyer.

Once GLD moves, then close or adjust the trade, and look foranother potential opportunity. But keep in mind the two keys:Look for consolidation patterns that might precede a move, andmake sure that the implied volatility is low. Now you dont haveto pick the direction as long as gold moves enough.

Greg Loehr is a former CBOE market maker trained by Susquehanna

Intl. Group, and founder of the education firm OptionsBuzz.com.

OUTCOME

30 days toexpiration

5 dayslater Change

GLD price $123.32 $128.24 3.9%

123Straddle $6.00 $7.55 26%

LOOKING FOR WEDGES

6/3 6/10 6/17 7/1 7/8 7/154/8 4/15 5/6 5/204/29 8/5

Question: How can I take advantage of a market thatsgoing to move, but I just dont know which way?Answer:

Trade movement using a strangle or a straddle.

BY GREG LOE HR

OPTIONS STRATEGY

For more options strategies: futuresmag.com/Options


0.35

0.3

0.25

0.2

0.15

0.2249

140

135

130

125

120

115

110

A

A

B

B 127.75

Lo: 114.68


13/53

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DIGITAL EXCLUSIVE 14 FUTURES November 2013

G R A I N S , S O F T S

FUTURES MAGAZINE: You grew up in Chicago but

went into agriculture?PETE NESSLER: I went to the University of Illinois [forengineering] but I was looking for something more,and met some guys in agriculture. I [then] started tak-ing Ag Econ and Ag Industry courses, which were trad-ing, hedging and basic marketing. I had great profes-sors, like Hieronymusall the old guys who wrote mostof the books for futures trading were the professors andthe people I got to deal with.

From there I went to Agra Industries and did cashtrading. At the time Agra Industries, which was one ofthe big regionals, owned Farmers Commodities Corp.Thats where I learned hedging; it was at the height of

the Falklands crisis so gold and silver were going upand down, soybeans were going up and down and withEngland and Argentina [at war], we had all the vesselstrading prices going up and down. So it was learningby fire. [I had] to make decisions, as small as they were,[quickly], but it did give me a chance to do see howhedging, trading and the markets really worked.

FM: How long were you at FCC before you startedthe commodity trading advisor?PN: As the markets started changing, I was trading alittle bit personally. I went to our CEO at the time and

said, what would you think if we started a commodity

fund? We didI was still an employee of FCC...and didthat for about seven years.

FM: What was your trading methodology ?PN: Im a fundamental approach trader, and I look at lever-aging options. I learned that optionality in the physicalmarket hedging and within the speculative market givesyou more leverage, at least a pre-notion of your risk. Idtrade a lot of long options, three-way options, vertical callspreads, trading maybe shorter dated options [during]crop reports, things like that.

FM: How new were ag options at that point?

PN: They started in the mid-1980s. I really looked atit as I looked at fundamental analysis, for where themarket can go and from there, looking at what posi-tion can be enhanced by going out longer term. I alsotraded the spread relationships and the cash market. And that is a big market that you dont get a lot of bigtraders in anymore because there isnt enough volume.High frequency could never trade spreads. Thats morethe fundamental trader. There is a cash connection tospreads, in theory,to the underlying commodity.

Then I went back into the elevator hedging world,and the evolution of ethanol started. I went to the CEO

Pete Nessler, CEO of FCStone, was raised in Chicago but earned his stripes in the grain fieldsof Iowa. Working with elevators and farmers, he helped turn Farmers Commodities Corp.

from a group of co-ops into the international brokerage firm INTLFCStone that it is today.

Along the way Nessler was a commodity trading advisor, jump started the firms move into ethanol

and opened and nurtured the firms global presence from South America to Europe to Australia. We

spoke with him about how the agricultural markets have changed during the past 30 years, and how

a small Midwestern firm grew and changed with them.

Pete Nessler is goodMidwestern stock INTERVIEWED BYGINGER SZALA

PHOTOGRAPHY BYSCOTT BELL

Q & A


15/53


16/53

DIGITAL EXCLUSIVE

and said this is a big business that is going to change how U.S.ag markets look, and a colleague and I literally got on the roadand started [visiting] the new wave of ethanol plants around2000, 2001, and grew that business for the company.

FM: How did you recognize that opportunity?PN: When we looked at ethanol plants and really [reviewed]the potential green sites that were going to be brand new andhow many plants were going to be built, we started [noting] theimpact locally, that is, how much corn wasnt going to go toexport or wouldnt go to an end user. We knew that there wasgoing to be a disallocation, number one, and number two, [therewould be a change in] the supply and demand curves [if] wemet the RFS (renewal fuel standard). I dont think people fullyunderstood the implications of how much more corn was goingto be used locally, domestically. A 100-million gallon plant usesalmost 40 million bushels of corn; that literally is one county inIowa production, and that county was feeding hogs, cattle andeverything else. So once (I) started going through the numbers,[I thought] something is not going to add up; corn is not [goingto continue to] sit at $2.50 [a bushel] anymore. That was thebeginning.

FM: So the ethanol business in the United States is still growing?PN: Its actually developed into a crush margin, like how a refinerlooks at a crack spread. In an ethanol or bio-diesel plant, withcorn youre making ethanol, DDGs (distillers dried grains), andif you have the third aspect, CO2. [Those are] the three productsthat come out of [the corn]. And you get corn oil off the DDGs,which theyve now refined, and corn oil can go into bio dieselor feed or pharmaceuticals. So the basic premise of an ethanol

plant from where it started to where it is vertically integrated,and at the end of the day its all margin related. And now with more plants than 10 years ago, theres more

competition. And pretty much were at full usage from a cornbasis; weve hit the top of what was mandated for corn for etha-nol. Were not in an upward slope anymore; weve peaked out at5 billion (bu.) of corn for ethanol.

But the rapid transformation on the upside is what I thinksurprised everyone in the corn market because the demand wasso exponential. And the mandate is nearly negligible now. Whenyou look at ethanol [the last few years], it was as big as the feednumber. And this year it is projected to be four times the exportmarket. Projected for ethanol in 2013-2014 [is] 4.9 billion bush-

els of corn; exports projected for corn are 1.225 billion bushels.So ethanol is now a driver. And with all the arguments of theRFS, and all the good and bad and big oil, we now have out ofthe demand base of 12.6 billion bushels of corn, almost 5 billionin ethanol. So if we got rid of ethanol, agriculture would have a[crash] and the land prices and everything [would drop]. So wehad to live through some of the heartache and misery, but nowits just part of the equation.

FM: So is food for fuel a bygone argument, like peak oil?PN: I think it is. Out of ethanol you do get distillers grain, andthat is fed to cattle and dairy, and now its even having inclu-

sion rates in hogs, and [were] getting corn oil off the back end. And depending on [type of plant] we get CO2, that goes intohydroponics and such.

And when you look at it, it was a local product; it was doneby a local community with local farmers, it was financed byMidwestern banks and such so it is exactly the root of what wedealt with. [And] it has reinvigorated middle America. Wevelived through the hysteria because we have globalized commodi-ties, [for example] we have corn being grown in Brazil and allover the world.

FM: What about the financialization of commodity markets?Are you seeing an impact on price discovery?PN: We are into a carrying charge market now. The backward-ation or inverted market we had was just fine when the carryout usage ratio charge of corn was 5%, now all of a sudden wereprojecting 14% carry out to use. So we are building carries.

Im not one to be a demagogue on high-frequency and algos,they have their places, and within agriculture, we dont havethe depth of the market you get in the dark pools in equities.We will get some spikes and literally the market comes back.More than not when you see that big trade blow in, as soon astheyre done, the market goes back to where it was. You dontsee that overall manipulation, [especially] with the CFTC andthe oversight today.

We had more issues back in the 1980s with some grain com-panies and different trading houses trying to corner soybeanmarkets, and the soybean trade. Remember the name Ferruzzi? You had more of that happening with squeezes in the market. Ahigh-frequency trader is just that, hes in and hes out. Hes nota position trader for more than a nanosecond. HFT is there just

to trade in and out, and in a commodity market where you havean underlying physical asset that is there, I dont see it as a bigissue. I mean, [HFT] is part of the market makeup.

FM: Beyond HFT, what about other players coming in, likeinvestment banks?PN: Within agriculture, I dont think youve seen as large of achange by the investment banks. The investment banks are morein the energy sector, which is a much larger globalized commod-ity. Beside your ABCDs, which all have a place in the business,you see new companies emerge that are into that, like the Nobles,Olams, Glencoreyouve got a lot of different trading housesand they are all part of the equation. At the end of the day, none

of them predetermine what the price of corn will be three or sixmonths from now. They are hedging, doing risk managementor trading on a perception, but [bottom line], agriculture is afundamental market and if we have another drought and lessacres, or big acres and a big crop, that will [determine the price].

You can get into how the world globalized soybeans, or theinverse or backwardation of soybeans this year. Thats some-thing that [we may be concerned with] because delivery pointsare within the U.S. [although theres] as big of a supply [of grain]now in South America as [we have] in the U.S., even bigger.Thats more of a fundamental key. Its projected now that nextyear Brazil will have 88 million metric tons of soybeans, which


Q & A ontinued


17/53

DIGITAL EXCLUSIVE

Go to futuresmag.com/nessler for an unabridged version of this interview.

would be bigger than this years crop in the United States. Thenyou throw in Argentina at 50-60 million metric tons, yet wereall trading Chicago, [and the] delivery points [are a problem].So like this past year, we may not have had a lot of soybeanshere, but theyre somewhere else in South America. Thats whereyou get the disallocation. [We dont] have a true delivery point.

FM: Is one problem that the delivery mechanism isnt setup in Brazil?PN: There are two ports being built in northern Brazil, theother port in the southern part in Santos. When these north-ern ports [are complete] it will work, but [Brazil needs] railingand trucking infrastructure. They are growing [all commodi-ties] but they dont have the [ports] like in the U.S. And we seecash basis swings in Brazil. Ive been there three times in the lastfive months , and the infrastructure [is not there yet]. Brazilianfarmers are driving 1000 kilometers (about 600 miles) to deliversoybeans, where in the United States that doesnt happen, its ona railroad or a barge. But this is actual farmers in trucks drivingfor a day to deliver soybeans because of this disallocation.

FM: It seems agriculture has been U.S.-based, but now isglobal. Was it always there and we werent paying attention?PN: [One reason for global growth] is we had very high pricesin 2005 and beyond that brought in more production globally.Plus new players that didnt really exist 15 years ago and playersbecoming larger have helped, such as Glencore, Noble, Olam,Gavillon, to name a few.

We differentiate our firm where we started as a clearing firmoffice in Chicago, but we were based in West Des Moines, Iowa. And then we opened offices [throughout the Midwest]. We have

taken an approach as a firm that we go to where the customersare. Instead of trying to pontificate from an ivory tower some-where, we get people locally in that area, we teach them whatwe do as a firm. Weve got guys from elevators, customers, farmkids, on the agricultural side at least. So when we went downto Brazil, we hired people from customers from that area. Weput a big emphasis 10 years ago on Brazil; we saw the evolutionand [now have] six offices, 60-plus employees down there. Inthe last three years we opened two offices in Paraguay, which is[the] third largest bean producer [in South America].

Also in Brazil, for instance, with the capabilities of the firmwe are doing the forex risk, and that differentiates us from otherpeople. So what we do is besides the risk management of the soy-

beans through our typical FCM unit, in our consultant unit wenow are utilizing our FX services to lock in forwards on them. Wehave a lot of customers that are shipping overseas or buying, andour global currencies[unit] is a treasury function within the com-pany. This is the integration of the FCStone per se with the legacyINTL business. So now we have a solution for the customer thatis not just going to the firm to clear through the firm, but is therealso to partake in FX risk, forwards risk and anything like that.

We trade 150 currencies more than any bank. We have a lotof relationships; many tier-one banks utilize us because its notworth their time to have these relationships; we do $2 billion amonth of global payments.

FM: FCStone saw the global expansion a long time ago?PN: When we did the merger (with INTL) on Oct. 1, 2009, INTLpre-merger was in Argentina, London, Dubai, Singapore, andin New York with their FX business. What we had in Brazil, theyhad put part of their business in Brazil that we had started. Theyhad Singapore and we took part of our business and put it backinto Singapore. It worked well, there was no overlap.

FM: Can you explain INTL?PN: Before INTL, it was called International Assets Holding; itwas a public firm doing precious metals, base metals, FX andequities. They do in equities what we do in futures. They areextremely large in the equities business [in ADRs]. They wereranked the number one market maker in dollar volume in 1,700securities in 2012. So if youre looking at a foreign stock, we arethe market maker in that. Its based out of Florida, and theymake markets in 10,000 securities. In precious metals, they did$67 billion in turnover last year.

When we merged four years ago, INTL had about 180 people,we had 420. Today we sit at 1,050. So it wasnt one of those puttwo together and cut half out; weve almost doubled in sizein almost four years. And thats where the synergies work: Wewerent into (forex) and they werent into ag.

futuresmag.com 17


18/53

DIGITAL EXCLUSIVE

They are trading in the debt market thats down in Florida.Its the same thing to a degree of what our swap dealer doesbut theyre doing it in the securities world.

FM: What about other groups entering the ag business, likehedge funds and private equity buying land, trading firms buy-ing processinghas this been good for your group?PN: Institutional land purchase is overblown; big farmers incor-porate anyway for tax purposes. I dont see investment banksowning a bunch of ground [a problem], I mean they still have tohedge. That hasnt hurt us at all. New players in the market? Nota big deal. What we have to offer as a swap dealer, we can offer awhole suite of services. Thats a big plus for us.

Of the original 65 swap dealers, we were the only non-bank.because we make markets in the FX world and within our agside, so we met the criteria of being a swap dealer. In talking topeople in that world, theyre seeing that, yes, they need to be

swap dealers as well. So besides big energy companies, I thinkyoure going to see big FCMs [become swap dealers as well].

FM: Your strength has been agriculture, but youve movedinto softs markets?PN: Yes, we felt expanding into Brazil was a core area of growth.So we looked at different firms (and continue to do so), smallerniche entities, and purchased a softs group and now were oneof the largest coffee traders. And piggy-backing off that, we pur-chased a group that just does coffee, so now weve covered bothentities. In natural gas we picked up a group [FC does 20-25% ofnatural gas commercial and residential consumption in U.S.], so

now we work with the big gas companies.Ill be very honest, when you look at FCMs today the grain

markets for the last two to three years: Weve had three years,almost four years of smaller crops, theres no carrying chargemarket, low open interest and we dont have the carry for theelevators. So what [FCStone has] done is disperse ourselves, andnow all of a sudden were a large player in coffee, sugar, palm oil,cotton all the other areas that are agricultural baskets thatarent Midwest-, U.S.-centric. We had to [get out of being toofocused on grains] because if thats your only card on the table,youre not going to survive [because] youre at risk of weather,and youve got other parts of the world that are going to be asbig or bigger than the U.S. in, for instance, soybeans.

FM: What are three biggest changes in clearing and broker-age over the last 30 years?PN: Obviously the notable fall of one FCM. Theres a lot of repu-tational risk at stake for everybody and the institution itself. Sothat gets people worried: Is their money really safe, is it reallysegregated?

The lower interest rate environment the last several years; wehave to diversify because in the old days we could break evenbut make money on interest income.

And the new Dodd-Frank compliance residual interest deal isa major discussion point of how soon margin calls or the T orT+1. Weve been, along with our cohorts here, trying to explainwhy we feel T+1 is suitable because from a credit line facility,you cant have enough money [for] a one-day exceptional call,doesnt matter if youre a big bank or a mid-size firm.

Its really the last four to f ive years [that have] been the larg-est change. Computers really came in, electronics really came

in, Dodd-Franks implementation going on right now, the rulemaking and then the couple of defaults by FCMs [havent] reallyhelped the case.

FM: Lets talk about that; you folks were using Sentinel as acustodian, and that didnt end well.PN : I cant get into that much because theres still legal issues,but that was a customer seg issue and thats why we have lawyers.

Were Midwest-based and I can tell you going way back wecarry credit insurance on many firms. Back when Enron was thesoup du jour, and when they went under, we had a small tradewe had done with them, nothing major, but guess what? Wehad insured [ourselves] against Enron. People asked us why do

you do that? and its because the structure of our board, if itsnot too cost prohibitive, why not insure it? Its a very differentthought process than some of the other [FCMs].

FM: Seems like you guys took a different path to growth thanthe MF Global mad dash.PN: We take an approach that may be more costly in [the] begin-ning, but weve realized that as we go into new frontiers the bar-rier of entry is either buy into it and either be right or wrongreal quick, or take your time with some prudence and build up,learn the business, know the local trade and work from there.


Q & A ontinued

Q & A: Pete Nessler continued on page 52


19/53

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20/53


G R A I N S , L I V E S T O C K

MARKETS

A winters tale: No dormancy for

grains or livestock BY RICH NELSON

Plentiful bounty may mean lower prices in many grains, but tight carry over and

potential weather and transport issues globally could mean volatility. And then theres

the government shutdown.

T he transition from fall into win-ter trading is an important turn-ing point for grain markets. Bynow the big questions on the years sup-ply are answered. Actual harvest resultscame in better than expected. The build-

up in soil moisture, because of heavyspring and early summer rains, was a keyfactor in alleviating late summer dryness.The question now is how well demandwill be able to accept this supply.

Grain supply fluctuations from plant-ing through harvest determine almostall of grain pricing from spring throughfall. During the winter, though, these

markets typically settle down. It is at thistime that outside market issues exert alittle more influence. Changes in theU.S. dollar, Federal Reserve policy andmoney flow between equities and com-modities are all issues to consider in theweeks ahead.

Corn: Abundant stocksWhile the trade has been dialing up itsexpectation of yields in recent weeks thisalso has been balanced by revisions in

acreage. Allendales most recent produc-tion estimate, of a record 13.827 billionbushels, is determined from a yield of158.2 bushels per acre and an acreagedecrease. On top of a record production,the U.S. Department of Agriculture

(USDA) recently recognized a higherrevision in old crop ending stocks. A sharp decline in corn prices normal-

ly will spur demand and, generally, 30%to 70% of a years increase in production

can be offset by rising demand. But worldfeed buyers finally are getting adequatecorn exports: At last count 45% of USDAs

whole-year sales goal was sold. That isan impressive total for this time of year.Livestock numbers will be slightly higherthan last year. Chicken and pork expan-sion almost will be offset by a 5% increase

Ethanol effect on corn

Wheat production in question

Live cattle and beef demand

For daily grains updates, go to futuresmag. com

Corn yields for 2013 have been higher than in years past, although feedlots have increasedusage as well. Still, ethanol needs are up only slightly, meaning corn heads lower.

DOES HIGHER CORN PRODUCTION MEAN LOWER PRICES?

Source: Allendale

14.5

14.0

13.5

13.0

12.5

12.0

11.5

11.0

10.5

10.0

U.S. corn production

13.1

14.1

12.4

14.0

12.4

14.013.8

10.780

13.84313.827

12.1

B i l l i o n

b u s h e

l s

2008 2009 2010 2011 2012 May Jun Jul Aug Sep ALDL


21/53

futuresmag.com 21

in cattle feedlots numbers for 2014. TheUSDAs models imply that quantity fedper animal fluctuates sharply with cornsupplies. Feedlots can switch to distillersgrains, wheat and other products basedon price. With a few more head, and morecorn per head feeding, we have no qualmsabout saying a 5.050 billion feed and resid-ual number, up 575 million bushels fromthe old crop numbers, is reasonable.

Ethanol will not help mop up this yearsextra supply. Although producers are mak-ing strong profits of 50 cents per gallon,they are limited by the blend wall. The EPAadjusted the 2014 ethanol blending man-date down from 14.4 billion gallons to13.0 in October. Allendale estimates thatwill limit corn use in the 2013/14 year toonly 4.7-4.8 billion bushels, assuming onlymoderate RIN (Renewable IdentificationNumber) usage.

An ending stock of just over 2.0 billionbushels could give down potential to$3.70 December corn. While corn futurescurrently have posted a minor reboundoff their early October lows, we look forone more attempt at sub $4.20 levels.

Soybeans: Tight ending stocksUnlike corn, soybeans are still just gettingby. Much of the U.S. picture actually will

be determined by the current soybeanplanting and spring harvest for South America. We currently forecast U.S. end-ing stocks at 160 million bushels. Thatis a little higher than the old crop stocksthat recently were revised from a tight125 million bushels to now 141 millionbushels. While these stock changes soundtrivial, the new crop forecast is based ona usage of 3.1 billion bushels. A minorchange in that U.S. demand picture canhave a sharp impact on these endingstock numbers. China had flocked to the

U.S. export market when Brazil focusedon corn exports this fall as exportablesoybean supplies started to run low.While the United States is the only shopin town right now, the trade expects anew record to be posted for Brazil anda near record for Argentina. Farmersin South America generally plant frommid-September through early November.With the corn planting delayed in thefirst four weeks of that window, the tradeexpects a good increase into soybeans.

Without any production problems, theU.S. export market would be only a tem-porary stopping point for world buyers.Soybean futures could fall to $12.50 perbushel in November, then even lower asspring rolls around. However this is not adone deal yet. The South American cropis not even fully planted. And even if bigsupplies are harvested, the trade has not

forgotten the port mess in Brazil fromthis past spring and summer. If graincompanies try to cram an even largercrop through those ports, which have notseen an increase in capacity, it certainly ispossible a few extra orders for U.S. prod-uct could be made. It does not take muchto turn a 160 million bushel ending stockand a slightly bearish forecast into a 120million bushel estimate and a sharplybullish forecast.

Wheat: Supply issues?

While corn and soybean markets havespent recent weeks revising yield estimateshigher, the wheat market has had to reviseits expectations of adequate supplies. Thesummer and fall of 2013 marked a returnto normal supplies on recovery from lastyears world production decline. In recentweeks there has been discussion sug-gesting supplies during this winter andbeyond may not be as good as expected. Argentinas wheat areas have seen con-tinued weather problems since June. The

trade feels they may go back to last yearslow production level of 10 million tonnesor perhaps even lower. Many questionwhether China, the second largest wheatproducer, will see further revisions lowerin the coming months. The newest area ofconcern is now Russia and Ukraine. Whilethey have just wrapped up a bountifulharvest, recent heavy rains have delayed

their normal September through earlyNovember winter wheat planting. Thosefields may be left unplanted over the win-ter and perhaps planted with a springcrop such as corn.

The result is that the world may leanon U.S., Canadian and European Unionsupplies more than expected. Instead of asharp resurgence in wheat stocks back toburdensome, they will simply be left as alittle less than average. Before the Russia/Ukraine planting issues, we felt $6.90 perbushel was an adequate upside target for

December Chicago wheat. With themincluded there is potential for up to $7.20per bushel.

Lean hogs: Lower prices?There has not been any agriculturalmarket more affected by the govern-ment shutdown than lean hogs. Overthe past 15 years, cash markets havebeen automating pricing decisionsbased on the various USDA summaryreports on pricing. In addition, with-

South Americas soybean crop is still in question, and that puts more pressure on U.S.ending stocks.

SOYBEAN CONUNDRUM

Source: Allendale

90

80

70

60

50

40

30

20

10

0

Soybean production

49.5 53.5

82.088.0

M i l l i o n m e

t r i c t o n n e s

1 0 1 1 12 1 3

Argentina Brazil


22/53


MARKETS continued

out the daily and weekly reports onslaughter levels, the trade cannot assess

accurately whether the USDAs recentHogs and Pigs report is correct. Thatreport implied that the recent run oflow slaughter levels would be fixedsoon. In fact, it suggested we may seeweekly kills running 1% over last year bythe end of October. This also is import-ant as October and November are theseasonal heavy supply period.

That report also suggested there wouldbe minimal impact from the hog virusPED. Much of the industry had previ-

ously been dialing in net year-over- yeardecreases from December through March

because of this problem. If the USDA iscorrect about the winter supply period,then December lean hog futures willdecline below $84.00 per cwt. Most ofthe industry is taking a wait-and-seeattitude on that potentially bearish idea.Hopefully, by early November we will seeif the USDAs survey of producers wascorrect. On a seasonal basis, hog futurestypically decline until mid-November.By then the trade has dialed in where thecorrect cash hog low will be.

Live cattle: Shutdown hurt demand?Placements of new calves and feedersinto feedlots have been lower than lastyear since May. The surprising mois-ture pattern in the Plains this summerrecharged pasture ground. This led tomany producers going for cheap weightgains while they wait for cash grain pric-es to fall. Some producers even have sug-gested that expansion is underway. Nineof the top 12 beef cow states have seenresurgence in pasture conditions. Thismeans females that would normally begoing to the feedlot will be held back toincrease the beef cow herd. This actual-ly helps lower beef production levels inyears one and two of this cycle. Whileexpansion is not completely agreed onin the industry, no one can argue thatQ1 and part of Q2 cattle slaughter willbe down sharply.

While we are clear supply bulls forcattle, we cant ignore some concernfor beef demand from the governmentshutdown. Government workers andmany companies that rely on governmentbusiness are affected. The last extendedshutdown, starting in December 1995,saw a 3.27% decline in live cattle futures.The other extended shutdown began in1978. Alhough there was only a minor

change in the December cattle price fromthe start to the end of the shutdown, wewere interested to see that the price highdown to the price low within the shut-down period was a huge 7.2%.

Just like this year, the first few days of ashutdown actually saw a rally that peak-ed on Oct. 6. For the short-term market,we are not out of line in suggesting theDecember contract could see weaknessthat pushes past $128.62 per cwt. becauseof this problem. We would prefer a bearspread in this example rather than out-

right shorts in futures. For the long-termpicture we still feel the deficit in supplyfor Q1 is too juicy to ignore. After ourexpected setback in prices in Octoberand early November we are looking at a$140.00 per cwt. objective for February2014 futures.

Rich Nelson is Director of Research at

Allendale, Inc. in McHenry, Ill. Allendale is

registered with the CFTC and NFA and is a

member of the NIBA.

The U.S. government shutdown has cut off the usual information available regardinghog slaughters, which had been seen as lower but actually could be 1% higher thanOctober 2012.

The U.S. wheat market has taken a hit because of higher corn production, so the worldis looking to South America, Russia and the Ukraine for supplies.

HOG SLAUGHTER IN THE BLIND

LOOKING EAST FOR WHEAT

Source: Allendale

Source: Allendale

2,500

2,400

2,300

2,200

2,100

2,000

1,900

1,800

1,700

50

40

30

20

10

0

Hog slaughter

The sharp decline on some weeks represents holiday shutdowns.

Reduced 2014 wheat harvest

22

50

15

42.5

M i l l i o n

t o n n e s

M i l l i o n

t o n n e s

Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec

2012 2013 2014

Ukraine Russia

201120122013


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26/53

W ith the summer of 2013 nowwell behind us, harvests are infull swing through much ofthe United States. Farmers are busy fill-ing their barns with the bounty of a hardsummers work.

For investors, however, its a differentstory. Many traders who have picked upa newspaper in the past 12 months areweary of playing the will they/wontthey game with the Federal Reserve.Every time Bernanke blinks, the stockmarket jolts one way or the other. Weveseen a fascinating bull run in stocks andyet investors still dont trust it. We reallywant to accept it, but for some of us, it just doesnt feel quite right.

Instead, you can leave the whims ofthe Fed behind and focus on a marketwhose price direction has less to do withunknown policy changes and more to dowith core supply/demand fundamentalsand seasonal cycles. The basic agricul-tural markets offer these qualities.

And none is more basic or more inter-esting right now than corn. For traderslooking to harvest some bounty of theirown this fall, they can consider a simple

strategy that can profit without takingwild risks, having perfect timing or evenpicking outright price direction.

Banner yearBefore you can understand how to make

money in the corn market, you must firstunderstand the supply/demand factorsdriving corn prices. These fundamentalsare paramount in establishing the long-term price direction of any commodity.

The 2013 season has been a banneryear for corn production in the UnitedStates. By late July, the U.S. Departmentof Agriculture was projecting the UnitedStates would produce 13.95 billion bush-els of corn this year the most ever.

It is true that corn farmers have increasedcorn acreage in response to record demand.

However, available supplies are likely tooutpace demand by a wide margin in the2013-14 crop year. Ending stocks for nextyear are pegged at a whopping 1.959 bil-lion bushels. This is almost double 2012ending stocks and eclipsing this years projected ending stocks by nearly 150% (seeLeftovers, right). Ending stocks representthe amount of the commodity left over ina given crop year (usually September) afterall demand has been met. This numbercan cast a wide shadow over price direction

throughout the year.The reasons for this increased corn

production are many. At $5 to $7 per

bushel, corn is a profitable choice forfarmers. As global demand gradually haspushed higher over the past several years,so have corn prices. Farmers respond bygrowing more corn to take advantage ofthe higher price brought on by demand.

The agricultural industry has morethan held its own in meeting rising glob-al demand for grains, corn in particular.The genetically modified seed industryhas produced higher-yielding, and pest-and drought-resistant crops. Along withbetter irrigation and farming skills, this

has resulted in not only higher yields but alarger growing region for corn. This is whycorn is now seen growing in the formerwheat fields of the Midwest and formercotton and peanut fields of the South.

Corn acreage accounted for 25% ofU.S. fields in 2000. This year it was 30%.More impressive, however, is the growthin yield. In the early 1980s, an acre ofcorn could be expected to yield about 102bushels per growing season. In 2013, thatfigure is 157 bushels.

Options strategies can be used to take advantage of fundamentally and seasonally

driven price changes in the agricultural markets.

Harvesting profits from

corn fundamentalsBY MICHAEL GROSS

TRADING TECHNIQUES

C O R N O P T I O N S


Ending stock impact

Selling corn options

For more from Michael, go to futuresmag.com/Gross


27/53

Weather is always a possible concern,but while hot temperatures and lowmoisture hampered conditions in 2012,this year has been much more favorable.

Opportunity knocksBefore you go running out to short corn,hold on. The analysis described here isprovided to give perspective; it is no secretto the market. Prices held at elevated lev-els through much of the spring while the2013 crop was planted. However, as itbecame apparent that weather was favor-able and the crop was developing nicely,prices fell. Corn prices tumbled more than15% from the highs in late June throughthe corn pollination period in July (seeCorn slide, right).

While there still may be opportunitiesfor traders to short corn on rallies thisfall, the greater opportunity may be to dothe opposite of the crowd and positionfor a harvest low. Here is why.

In commodities agricultural com-modities in particular we have a toolthat other markets dont enjoy: Seasonaltendencies. While not perfect, seasonalanalysis can help to illustrate certain sup-ply/demand fundamentals that tend totake place at different times of the year.

In corn, the U.S. harvest comes in the

fall, sometimes starting as early as late August and finishing in late October/early November. Prices tend to peak whensupplies are lowest and bottom whensupplies are highest. Thus, at harvesttime, when supplies are higher than theywill be at any time all year, economics dic-tates that prices should be at their lowest.

While seasonal charts are an admittedlyblunt instrument, the chart for corn seemsto bear out this economic phenomenon(see Seasonal trends, page 45). Whilethis chart is only an average of the past

15 years, it does seem to reveal a tendencyfor corn prices to bottom in early October.That this happens to be right in the heartof the corn harvest is no coincidence.

Thus, we have the term harvest lowused by ag futures traders around theglobe. Once a harvest low is achieved,prices often begin to increase gradually asdemand begins to eat away at new supplies.

Encouraging for traders who follow sea-sonals, corn appears to be correlating wellto seasonal averages in 2013. While there

obviously is no guarantee that prices willfollow the seasonal average, there may bean opportunity for investors to consider

during corn harvest time 2013.Picking a low in any market can bequite profitable for a trader who times itright. Unfortunately, it is also difficult.The road to riches from picking lows inbear markets is littered with the financialcorpses of those who got their timing offby even a hair. Its nearly impossible infutures unless you have deep pockets andnerves of steel. There is a better way toplay this without assuming the risk of anoutright futures position, however.

In most cases, buying options is asucker bet. Too many new traders getlured into it as a low-risk way to play the

futures markets. (Your losses are f ixed!)However, buying options has a low suc-cess rate. The odds are high that longruns of small losing trades eventually willempty your trading account.

A better route is selling options. Yes,you take on more risk than buying, andthe profit potential is limited. But by sell-ing an option, you put the odds of suc-cess in your favor. And the risk can bemanaged. You just have to do it yourself.

futuresmag.com 27

Corn prices took a precipitous fall when the trade began to factor in a record harvest.

Ending stocks in 2013-14 are expected to be nearly 150% higher than this seasons tally.

CORN SLIDE

LEFTOVERS

Source: Barchart.com

Source: USDA Wasde Report (July 11, 2013)

250K 200K 150K 100K

50K 0K

600-0

590-0

580-0

570-0

560-0

550-0

540-0

530-0

520-0

510-0

500-0

490-0

480-0

600K

500K

400K

300K

200K

80%

70%

60%

50%

40%

30%

20%

10%

0%

Feb 13 Mar Apr May Jun Jul

73 75 77 79 81 83 85 87 89 91 93 95 97 99 01 03 05 07 09 11 13

Corn, daily

Ending corn stocks as % of total usage

USDA 2012/2013 estimate assumes plantedacreage of 97.4 million acres

% o

f p r o

d u c

t i o n

Trading Techniques: Gross continued on page 43


28/53


29/53


30/53

Ask anyone on Wall Street, Whatis the state of the market? andchances are youll get one of threeanswers: Bull, bear or sideways. To thecasual trader, these terms paint a roughpicture of where the market is moving.

But to a certain concept in mathemat-ics, these terms precisely describe whereprices are heading.

This concept is hidden Markov mod-els (HMM). It was developed by HarvardPh.D. mathematician Leonard E. Baumand his co-workers. The premise of themodel is that the market is in one of fivestates super bear, bear, sideways, bull or

super bull at any given time and tran-sitions between states obey the Markovproperty. That is, transitions are depen-dent only on what the markets state wasone time interval before and not any ear-lier. How the market switches betweenthe five states is indicated by transitionprobabilities that tell us the probabilitiesof one state transitioning to another.

The assumption that the market obeyedthe Markov property occasionally wasthought of as a good one because it removes

the problem of lag. This occurs when a cur-rent calculation holds little value because itis based on price action much further in the

past. The further back you go, the less of aneffect price action should have on currenttrading decisions.

Hidden Markov models are making inroads into institutional trading. Their

applications are broad. One, forecasting future indicator values, can give you

an edge trading the currency and commodity markets.

The profitable, hidden and

Markovian couple ofSwiss and goldBY DONNY LEE

TRADING TECHNIQUES

F O R E X , C O M M O D I T I E S


Markov models

Five states of the economy

Trading intermarket relationships

The basis of HMMs is that the market is in any one of five states and switches toother states at a probability that depends on its current state: When the market is ina bull state (wb), it has a 0.15 probability of switching to a bear state (wu) and 0.3 toa sideways state (r).

STATE TRANSITIONS

Source: Donny Lee

P (wu|sb )

P ( sb|wb )

P (wb|sb )

P (wu|wb ) = 0.15

P (wb|wu ) = 0.1

P (r|wb ) = 0.3 P (r|wu ) = 0.6

P (wu|r ) = 0.25

P (wb|r ) = 0.35

P (r|su )

P ( su|wu )

P (wu|su )

Super bull

Bull

Super bear

Bear

Sideways


31/53

Just as how we know a bear and a bullmarket behave differently, each state isgiven a different probabilistic distribu-tion of the observations it can output.Observations are any form of physicalquantity we can measure from the market,namely price and indicators. Their uses aretwo-fold. One, if we know that the marketis in a certain state, we can infer from thatstates distribution what the next observa-tion could be. Two, a sequence of observa-tions can be used to figure out the state ofthe market (see State transitions, left).

Over the last decade, HMMs have beencreeping into the arsenals of some hedgefunds. Because of their logically soundmodeling process and subtle applica-tion of the Markov property, quants havefound good use of HMMs in generatingprofitable trading signals.

However, HMMs showed their limita-tions when the time came to incorporatethe next wave of trading techniques. Hedgefunds experienced a gradual realization thatmore than one dimension of data was need-ed to outwit the market. Multi-time frametrading techniques in which two time frameswere studied together were explored. Pairstrading in which prices of two assets wereanalyzed at the same time was the emphasis.Intermarket analysis in which the forecast-

ing of an asset in one market considering thedynamics of another asset in another mar-ket was developed. The early form of HMMswerent conducive to integrating these newideas and needed to be extended to allow forthis possibility. Thus, the coupled hiddenMarkov model (CHMM) was born.

Unlike Baums original HMM, which isstandard literature in applied mathematics,the CHMM is new research starting aroundthe mid-2000s and doesnt have a canonicalformulation. While the CHMMs developedby researchers from different universities

vary in their specifications, all of themshare a common underlying theme: Totake two HMMs and couple them by wayof their transition probabilities.

Lets start by giving our two HMMsnames. HMM1 will model the currencymarket, and HMM2 will model the com-modity market. Both of them make upour CHMM. Just as before, as time pro-gresses, the state of each market willswitch to another state with certain prob-abilities. Unlike before, this probability now

depends on that markets and the othermarkets current states. Therein lies thecoupling between both markets (see TwoHMMs coupled, above).

With the two markets represented inour model, we also need two observationsto track, namely the price or indicators

of our currency and of our commodity.We feed both observation sequences intoour CHMM to have it reconfigure itselfto best represent each market.

The result is a model with the predic-tive power to forecast the next observa-tion for both the currency and the com-

futuresmag.com 31

Glimpsing the price action of USD/CHF and gold, we reasonably can infer that theyare inversely correlated. CHMMs are utilized best when working with pairs of assetswith this kind of relationship.

USD/CHF VS. GOLD

Source: CQG Integrated Client

1750

1700

1650

1600

1550

1500

1450

1400

1350

1300

0.97

0.96

0.95

0.94

0.93

0.92

0.91

0.98/2/2013 0:00 27/2/2013 1:40 15/3/2013 22:00 4/4/2013 19:20 23/4/2013 17:00 10/5/2013 14:20

Price of USD/CHF and Gold (08/02/2013 to 13/05/2013)

P r i c e o

f U S D / C H F

P r i c

e o

f g o

l d

USD/CHF Gold

In coupled hidden Markov models, state transitions in one market are dependent onthat markets and the other markets previous state. As seen here, the currency mar-ket has a 0.5 probability of switching to wb when considering its previous state of wubut a 0.3 probability when considering the commodity markets previous state of wu.

Seen differently, an r state in the commodity market gives a 0.15 probability that thecurrency market switches to wu and a 0.2 and a 0.4 probability that its own marketswitches to wu and wb respectively.

TWO HMMS COUPLED

Source: Donny Lee

P (wb1|wb 2) = 0.15

P (wb1|wu 2) = 0.3

P (wb1|wu 1) = 0.1

P (wu2|wu 1) = 0.5

P (wb1|r 1) = 0.25

P (wu2|r 1) = 0.3

P (wu1|r 2) = 0.15

P (wb2|r 2) = 0.4

P (wu2|r 2) = 0.2

P (wu2|wb 2) = 0.3

Currency market Commodity market


32/53

modity markets. Throughout couplingthe two HMMs, we have not removedthe Markov property when switchingbetween states. The positives of HMMsare retained, the problem of lag kept bur-ied and the possibility of incorporatinganother dimension of data made avail-able. Quants were quick to explore pairsof assets to couple for the CHMM.

For us to capitalize on the predictive

powers of a CHMM, it is best to use it tomodel two either strongly correlated orstrongly uncorrelated assets.

The fundamental relationship betweengold and the Swiss franc helps us choosethese markets. One, it is believed that dur-ing times of economic unrest, investorstend to dump the dollar in favor of gold.Because gold maintains its intrinsic value,it implies a negative correlation between

the dollar and itself. Two, following agold-selling program, the Swiss NationalBank held 1,290 tonnes of gold in reserves,which amounted to 20% of Switzerlandsassets. Therefore, the Swiss franc and goldshould move in opposite directions. Bothof these relationships has us believe thatUSD/CHF and gold are negatively corre-lated; the rise in one implies a fall in theother (see USD/CHF vs. Gold, page 31).

We now devise a trading strategy involv-ing USD/CHF and gold coupled with aCHMM. First, we define the observablequantity. This would be the physical mea-sure of the asset used in the rules whengenerating trading signals. If we are trad-ing the tails of a distribution, it would bethe CCI indicator. If we are riding a trend,it would be the ADX indicator. In linewith our strategy, we define the observablequantity to be the RSI indicator. Thus, thedynamics of USD/CHF and gold will berepresented by their RSIs.

Second, we need to construct our strat-egy. With our goal being to illustrate thefeatures of the CHMM, well use a simplefour-period 10-minutes RSI, buying whenit crosses over 20% (oversold) and sellingwhen it crosses under 80% (overbought).

Well use the CHMMs forecasted USD/CHFs RSI value instead of the actual RSI.

While it seems we need to decide on a fil-tering rule when incorporating golds RSI,we dont. The beauty of the CHMM is thetheory behind state switching nurtures thisrelationship: The coupling between USD/CHF and gold. By periodically loading thefour-period RSI values of USD/CHF andgold into the CHMM, itll reconfigureitself during each load, figuring the rela-tionship between USD/CHF and CHMMthat best makes sense. Any prediction madefor USD/CHF will then take into accountboth the dynamics of USD/CHF and gold.

Finally, we set a one-to-three risk-to-reward ratio using two-times and six-times the 12-period average true rangefor the stop loss and profit target, respec-tively. Furthermore, well run our strat-egy first with fixed sizing and then withdynamic sizing where the size is definedas a fixed amount multiplied by the prob-ability at which the CHMM switchesstates. Basically, we are aligning our con-fidence in each trade with the modelsconfidence in predicting the next state

TRADING TECHNIQUES continued


Looking at the 10-minute chart for USD/CHF on Feb. 7, we see how well the CHMM pre-dicts a change in market state. A switch in the CHMMs state from super bear to super bullat 20:30 foreshadows the actual turn in the market where USD/CHF does a large movefrom a low of 0.9288 at 20:30 to a high of 0.9401 at 23:50. Signal-wise, the CHMMs RSI

turns away from an oversold level at 20:20 before the actual RSI turns at 20:40. That theCHMMs signal occurs two bars earlier, and just in time for the big move, is evidence thatthe CHMMs RSI has that predictive power that the standard indicator lacks.

STATE SWITCHES AND RSI VALUES


9400

9380

9360

9340

9320

9300

9280

9260

80

70

60

50

40

30

20

10

100

80

60

40

20

0

4

3

2

1

2:10:00 AM7/2/2013

3:30:00 PM7/2/2013

4:50:00 AM8/2/2013

6:10:00 PM8/2/2013

CHMMs prediction of a highprobability going into superbull market is correct.

CHMMs RSI leadsactual RSI.

CHMMs state

USD/CHF

Probability oflikeliest state

CHMMs RSI Actual RSI


33/53

(see State switches and RSI values, left).The measure of success of our CHMM

strategy is based on whether it is more prof-itable when trading based on the CHMMsforecasted RSI values than on actual RSI values. Such a comparison will be made.

With the interest of investigating therobustness in the CHMM model accu-rately forecasting values, we will use themodel to trade on another setup, one thatuses the Commodity Channel Index (CCI)indicator. For space reasons, we wont gointo the details of the CCI strategy, butit has been optimized over a test periodto perform well using actual CCI values.The goal then is for the CHMM model toregister an improvement in profits whentrading the same already profitable strat-egy, but using its forecasted CCI values.

We compare the performances ofthe standard RSI and CCI systems withthose enhanced by the four variants ofthe CHMMnamely predictions madeby a Viterbi algorithm and a non-Viterbialgorithm, each using fixed or dynamicsizing. The test period is 10-minute pricebars over the first four months of 2013.(Viterbi and non-Viterbi algorithms arebasically two different ways to get the nextmost probable state.)

Trading based on the CHMM fore-

casted RSI and CCI values performedbetter than the standard systems. Theperformance difference is pronouncedfor the RSI setup where implementing theCHMM turned a losing system of 4.55%to 5.51% returns for Viterbi with fixedsizing. The CHMMs performances tracestandards fairly closely in the first month,after which they start to make gains whilethe standard RSI starts to record losses(see CHMM RSI system, right). TheSharpe Ratio has improved to between+1.670 to +1.923 among all four variants.

Running our comparison for the CCIsetup, we see that returns improved acrossall four CHMM variants. The CCI stan-dard pulled in a return of 0.35%. Thereturns for CHMMs are 0.36% to 0.49%(see CHMM CCI system, right). Further,comparing the Sharpe Ratio betweenfixed sizing and dynamic sizing acrossCHMM variants, we see an improvementof about +0.2 for the RSI and +0.03 forthe CCI. This hints to us that theres even value in the models confidence in the

prediction of the next state.Having witnessed the CHMMs ability

to generate a profitable trading strategyby coupling the USD/CHF with gold, weare left to wonder what other assets theCHMM can couple to make money.

If we stick to the general rule that thecoupled assets either need to be stronglycorrelated or uncorrelated, the CHMMshould preserve its profitability. Thetheory behind the CHMM and HMM isrobust enough to decode the relation-ship between two assets and also deducehow the transition probabilities in eithermarket affect the other. Be it equities inthe same sector, rates and indexes, crossyen currencies, currencies and commodi-ties, bonds and economic indexes, or even

macro and micro price movements, thereare a number of possibilities. It boilsdown to choosing the assets and defin-ing the observations.

Can the CHMM combine three assetstogether? Of course it can. But just as it

takes two to tango but three is a tangle,combining three assets becomes a mess-ier mathematical sight.

Donny Lee is a quantitative developer at

a hedge fund trading forex in Singapore.

He currently is refining trading strategies

largely centered on Markov models. You

can download the technical and supplemen-

tary code, as well as data sets, from www.

financeberry.com/chmm.html. Reach Donny

at [email protected].

Given an already profitable CCI trading system, the CHMM is able to make it slightlymore profitable.

CHMM CCI SYSTEM


80000

60000

40000

20000

0

-20000

1/1/2013 21/1/2013 10/2/2013 2/3/2013 22/3/2013 11/4/2013 1/5/2013

Performance of various CCI systems

C a p i t a

l o

f U S D C H F

Standard Viterbi NonViterbi Viterbi w/Dynamic NonViterbi w/Dynamic

futuresmag.com 33

Using the CHMM to predict RSI values, we have turned a losing strategy into a win-ning one.

CHMM RSI SYSTEM


60000

40000

20000

0

-20000

-40000

-60000

1/1/2013 21/1/2013 10/2/2013 2/3/2013 22/3/2013 11/4/2013 1/5/2013

Performance of various RSI systems

C a p

i t a

l o

f U S D C H F

Standard Viterbi NonViterbi Viterbi w/Dynamic NonViterbi w/Dynamic


34/53

H ad it not been for the valuablesecret W.D. Gann pledged tohave clothed in veiled languagein his book, The Tunnel Thru the Air, itcould have passed for just another roaring20s science-fiction novel. However, stu-

dents have pored over the words, hopingto unlock the philosophy behind Gannstechniques. Are they on a path to enlight-enment or merely chasing a white rabbitinto Alices Wonderland?

Robert Gordon, Ganns fictional per-sona in The Tunnel, predicts the com-ing of World War II, which he believeswill be fought in the air. Gann was a par-

ticularly religious person, and he basedthis belief on predictions attributed tothe prophets Daniel and Ezekiel. TheTunnel is replete with biblical citationspertaining to astrological time cyclesthat Gordon uses to predict the future,including future commodity prices.

In Gordons world, this works, andas a professional futures and commodi-ties trader, he follows these time cyclesto generate a fortune from trading cot-ton. The rest of the plot covers Gordons

plans to use his trading proceeds to buildan invisible airship and air tunnel toensure America wins the war. The air-ship is to keep the movements of the American army out of the enemys sight,while the air tunnel is to trap and disable

the enemys aircraft. The blueprints forthe designs are based on a biblical com-mand to the prophet Ezekiel to build achariot drawn by four creatures; besideeach is a wheel within a wheel with talland awesome rims.

Gann writes that he considers the Biblea scientific text on some level, and he sug-gests that his book borrows biblical con-cepts that will demonstrate the processby which man may know all there is toknow, including the stock market. Atthe same time, he reveals that his mar-

ket predictions are based on geometryand mathematics, just as an astronomerdoes, based on immutable laws and reit-erates that his calculations are based onthe cycle theory and on mathematicalsequences. Its important to note, how-ever, that scientific explanations of thesesequences do not appear in the book.

What the book does include, how-ever, is Gordons meticulously datedand priced trading log. The log spanspages 103-172, and is the only example

of Ganns trading activity in the book.Given that these pages contain numeri-cal data, it is where the secret to Ganns

elusive time factor should be found.Lessons learnedHowever, The Tunnel is light on trad-ing details. Surprisingly, Gann makes noreference to the Square-of-9, geometricangles or charts, and even omits Dec. 1,1926, the date cotton prices bottomed,from Gordons trading log. While helaces the book with numerous referenc-es to wheels within wheels, possibly aloose allusio

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