Maximizing Returns through Fundamental Analysis - Arabictrader.com

240 HOW TO INVEST
There are many different approaches one could take to build a trading
system that combine more than one variable. One very good approach is to
use a regression. Simply regress the commodity’s returns on the variables that
you think might have forecasting power. If the fit is reasonable, the resulting
model might provide the basis for an investment strategy. Regressions are
often good choices when there is lots of data available and the data is well
behaved. (Keep in mind, of course, that there is no guarantee that anything
will work and that what has worked in the past may not work in the future.)
Commodity prices are very volatile and often have relatively short histories,
so we will try a different approach. We will build a very simple index
and implement a strategy that is long when the index is above a threshold
and short when the index is below a threshold. We will use the CME lean hog
contract n for our commodity and consider a trend variable, a curve variable,
and an anchor variable. The trend variable will be the average of the 60-,
80-, 100-, and 120-day moving average signals. Each individual signal can
either be a +1 or a –1. A positive trend is conjectured to be bullish for lean
hogs. The curve variable is the deseasonalized spread between a collection
of USDA cash prices and the price of the lean hog contract. A spot price that
is higher than the future price is considered bullish (i.e., when the curve is
backwardated). The anchor variable is the de-meaned gross feeding margin,
the difference between the price of the hog and the price of the corn and
soybean feed input prices. It is conjectured that it is bearish for hogs when
the price of hogs is high relative to the price of feed and vice versa.
In order to construct an index the variables must be made quantitatively
comparable to one another. The spread between spot and futures prices is
divided by its standard deviation. The gross feeding margin is de-meaned
and also divided by its standard deviation. These two variables are capped
at +3 and –3 to prevent either from having extreme influence. The trend
variable by construction is between –1 and 1, so no adjustment is needed.
Thus the index takes the form:
Index = trend + creep/σ (creep) + GFM/σ (GFM)
A trading rule also must be constructed: When do you buy When do
you sell We will implement a simple rule that is long hogs when the index
is greater than or equal to 0.25, flat when the index is between 0.25 and
–0.25, and short when the index is less than –0.25. Returns are computed
in terms of percent on the lean hog contract’s face value, o and a transaction
n At the end of 1996 this was switched from a live hog contract to the current lean
hog contract. Presumably, the hogs did not have a say in the switch.
o More precisely, daily log returns are computed based on the price of the lean hog
future’s face value. No interest is added to the return.