Developing a trading strategy is a complex art and science; it is impossible to cover the whole topic here. However, we can recommend three excellent books on the subject. [Kaufman 1998], [LeBeau Lucas 1992] and [Pardo 1992]. Briefly, there are three main trading strategies:
Counter-trend systems and arbitrage are relatively short-term in nature; counter-trend traders and arbitragers typically hold positions for a few hours to a few days. Since the Multi-Market Analyzer works with long-term relationships, on the order of years, we will not cover using MMA for counter-trend trading or arbitrage.
Let's look at spreads first. As we saw earlier, the Stretch Index and the Unstretched Indicator for a collection of markets can be used to locate potential profitable spreads. As a rough rule of thumb, if the Stretch Index is greater than 2.0 and two markets are highly correlated (correlation coefficient of 0.70 or higher), look for spread opportunities in the directions given by the Unstretched Indicators for the two markets.
So let's look at the Current Inter-Market Situation again. The Stretch Index is 2.758, comfortably above 2.0. Looking at the correlation table, we see there are six market pairs with high correlation. We've already looked at corn versus soybeans; let's look at corn versus wheat.
As with corn and soybeans, there are no obvious trades indicated by this chart. Before leaving spreads, let's look at coffee versus cocoa:
When you look at this chart, a pattern starts to emerge. Notice that the turns in the Unstretched Indicator for coffee track the turns in the price of cocoa and vice versa! You can see this effect in the other charts of highly correlated pairs, but it's more obvious here because KC and CC are less correlated with the other markets in our input set. It should be noted that coffee is a very volatile and risky market in dollar terms; for example, in November of 1999, the March 2000 coffee contract ranged from 104.5 cents a pound to 137 cents a pound. The coffee contract is for 37,500 pounds, which means that a single contract varied over a range of $12,187.50 during the month! Cocoa, by contrast, ranged from $812 per tonne to $935 per tonne. The cocoa contract is for ten tonnes, making the November range only $1230. A cocoa / coffee spread will be tricky given this disparity in dollar risk and is not recommended.
Moving on to trend following, we see that one possible way to use MMA is to find a market where the Unstretched Indicator tends to turn before the price turns, as it has for cocoa. Another possibility is to use the difference between a market's price and its Unstretched Indicator as an overbought/oversold indicator, taking a position when the price begins to move in the direction indicated and closing the trade when the two lines meet.
As with any trading system, we emphasize that backtesting is mandatory and some forward testing is recommended before risking real money on any trading idea. And once an idea tests out and is put into use, it must be monitored carefully and quickly abandoned if it no longer works as expected.
