Commodity Investing: Top Technical Indicators

In any asset class, the main objective of any trader, investor or speculator is to make trading as profitable as possible. In Commodities, which includes everything from coffee to crude oil, we will analyze fundamental analysis and technical analysis techniques, which are employed by traders in their decisions to buy, sell or hold.

The technique of fundamental analysis is considered ideal for investments involving a longer time frame. It’s more research-based; it studies demand-supply situations, economic and financial policies as decision-making criteria.

Traders commonly use technical analysis, as it is appropriate for short-term judgment in markets, and analyzes past price patterns, trends, and volume to construct charts to determine future movements.

Identify the commodity market

Momentum indicators are the most popular for commodity trading, contributing to the confidence adage, “buy low and sell high”. Momentum indicators are further divided into oscillators and trend following indicators. Traders must first identify the market (ie whether the market is trending or ranging before applying any of these indicators). This information is important because trend following indicators do not work well in a varied market; similarly, oscillators tend to be misleading in a trending market.

Moving averages

One of the simplest and most widely used indicators in technical analysis is the moving average (MA), which is the average price over a specified period for a product or stock. For example, a five-period MA will be the average of the closing prices for the last five days, including the current period. When this indicator is used intraday, the calculation is based on current price data instead of the closing price.

The MA tends to smooth random price movement to bring out hidden trends. It is considered a lagging indicator and is used to observe price trends. A buy signal is generated when the price crosses above the MA from lower bullish sentiments, while the reverse indicates bearish sentiments, hence a sell signal.

There are many versions of MA that are more elaborate, such as exponential moving average (EMA), volume-adjusted moving average, and linear weighted moving average. MA is not suitable for an extended market, as it tends to generate false signals due to price fluctuations. In the example below, note that the slope of the MA reflects the direction of the trend. A steeper MA shows the momentum supporting the trend, while a flattened MA is a warning signal that there may be a trend reversal due to a drop in momentum.

In the chart above, the blue line represents the nine-day MA, while the red line is the 20-day moving average, and the 40-day MA is represented by the green line. The 40-day MA is the smoothest and least volatile, while the 9-day MA shows maximum movement, and the 20-day MA lies in between.

Moving Average Convergence Divergence (MACD)

Moving Average Convergence Divergence, also known as MACD, is a commonly used and effective indicator developed by fund manager Gerald Appel. It is a momentum indicator that follows trends and uses moving averages or exponential moving averages for calculations. Typically, MACD is calculated as 12-day EMA minus 26-day EMA. The nine-day EMA of the MACD is called the signal line, which distinguishes between bullish and bearish indicators.

A bullish signal is generated when the MACD is a positive value because the shorter period EMA is higher (stronger) than the longer period EMA. This means an increase in bullish momentum, but when the value starts to fall, it shows a loss of momentum. Similarly, a negative MACD value indicates a bearish situation, and an increase further suggests increasing bearish momentum.

If the negative MACD value decreases, it signals that the downtrend is losing momentum. There are more interpretations to the movement of these lines such as crossings; a bullish crossover is signaled when the MACD crosses above the signal line in an upward direction.

In the chart above, the MACD is represented by the orange line and the signal line is purple. The MACD histogram (light green bars) is the difference between the MACD line and the signal line. The MACD histogram is plotted on the center line and represents the difference between the MACD line and the signal line represented by bars. When the histogram is positive (above the center line), it gives bullish signals, as indicated by the MACD line above its signal line.

Relative Strength Index (RSI)

The Relative Strength Index (RSI) is a popular technical momentum indicator. It attempts to determine the level of overbought and oversold in a market on a scale of 0 to 100, thereby indicating whether the market has peaked or bottomed. According to this indicator, markets are considered overbought above 70 and oversold below 30. The use of a 14-day RSI was recommended by US technical analyst Welles Wilder. Over time, the nine-day RSIs and the 25-day RSIs have grown in popularity.

The RSI can be used to look for divergence and breakout variations in addition to overbought and oversold signals. Divergence occurs in situations where the asset reaches a new high while the RSI fails to break above its previous high, signaling an impending reversal. If the RSI falls below its previous low, a confirmation of the impending reversal is given by the failure swing.

For more accurate results, be aware of a trending market or a ranging market, as RSI divergence is not a sufficient indicator of a trending market. The RSI is very useful, especially when used alongside other indicators.

Stochastic

Famous stock trader George Lane based the stochastic indicator on the observation that if prices have trended higher during the day, the closing price will tend to stabilize near the end upper end of the recent price range.

Alternatively, if prices have fallen, the closing price tends to approach the lower end of the price range. The indicator measures the relationship between the asset’s closing price and its price range over a specified period of time. The stochastic oscillator contains two lines. The first line is the %K, which compares the closing price to the most recent price range. The second line is the %D (signal line), which is a smoothed form of the %K value and is considered the more important of the two.

The main signal formed by this oscillator is when the %K line crosses the %D line. A bullish signal forms when the %K crosses the %D in an upward direction. A bearish signal is formed when the %K crosses the %D in a downward direction. Divergence also helps identify reversals. The shape of a stochastic low and high also works as a good indicator. Let’s say, for example, that a deep and wide bottom indicates that the bears are strong and that any rally to such a point could be weak and short-lived.

A chart with %K and %D is called Slow Stochastic. The stochastic indicator is one of the good indicators that can best be clubbed with the RSI among others.

Bollinger Bands®

The Bollinger Band® was developed in the 1980s by financial analyst John Bollinger. It is a good indicator to measure overbought and oversold conditions in the market. Bollinger Bands® are a set of three lines: the middle line (trend), an upper line (resistance), and a lower line (support). When the price of the product under consideration is volatile, the bands tend to widen, while in cases where prices are range bound, there is a contraction.

Bollinger Bands® are useful for traders looking to detect turning points in a range-bound market, buying when price drops and reaches the lower band and selling when price rises to touch the upper band. However, as the markets enter the trend, the indicator begins to give false signals, especially if the price moves away from the range it was trading in. Bollinger Bands® are considered adept at following low frequency trends.

The essential

There are many technical indicators available to traders, and choosing the right ones is crucial to making informed decisions. Ensuring their suitability for market conditions, trend following indicators are suitable for trending markets, while oscillators adapt well to varying market conditions. However, beware: improper application of technical indicators can lead to misleading and false signals, leading to losses. Therefore, it is recommended to start with Stochastic or Bollinger Bands® for those who are new to using technical analysis.

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