In my July 26 and Aug. 9 columns, I showed how variations of Richard Donchian’s four-week trading rule produced profitable hypothetical trading results for corn and soybeans since 1995. As good as the results looked, I also tried to emphasize that following a simple system like this is not necessarily easy and is not for everyone. It takes discipline and commitment to follow Donchian’s rules while ignoring all other advice.
Donchian’s rules were originally designed decades ago with traders in mind. It was the success of traders such as Richard Dennis and his trained “Turtles” that gave this method a boost of popularity in the 1980s. My motive for writing about Donchian, however, wasn’t to urge more people to trade commodities, but to get us to think about how a simple system focused only on price often outperforms the best efforts of traditional market analysis.
I wondered, what if a soybean producer hedged his operation by only taking the short side of Donchian’s trades? Would that be an effective hedging strategy? After all, producers are typically long most, if not all, of the time with soybeans either held in storage or growing in the field.
Based on the research in last week’s article, I decided to look at a 25-day rule, meaning that this hedging test will go hypothetically short one contract of January soybeans whenever prices close at a new 25-day low and stay short until prices close at a new 25-day high. No long trades will be entered, as the whole point is to only protect the producer from falling prices.
As quickly as I could copy and paste the instructions, the spreadsheet spit out the final results: $33,317, or $6.63 a bushel gained in 64 trades. Keep in mind that this was for one 5,000-bushel contract tested from 1995 to July 1, 2016. Hypothetically, the gain came to a little over 30 cents a bushel per year and worked out to an average of three trades per year.
I have done enough back-testing to know that final results are just one part of the story. The real test of a hedging strategy is to plot the changes in equity of the hedge account and compare those changes to actual changes in soybean prices. After careful examination, I was surprised at how well the hedge account performed.
From 1996 to 2001 when January soybeans fell from $8.00 to roughly $4.25, the hedge account posted a $2.00 gain, offsetting roughly half of soybeans’ loss. Even as late as 2005 when January soybeans had returned to $6.00, the hedge account still showed a gain of roughly $2.00.
The times when the hedge account lost money were times when soybean prices had big rallies. The good news is that the gains on the futures side were much larger than the losses in the hedge account. For example, when January soybeans rallied from $6.00 in 2006 to over $15.00 in early 2008, the hedge account fell from a roughly $2.00 gain to an 85-cent loss.
At that point, some might have been tempted to quit hedging in early 2008. After all, 13 years into this effort, the hedge account was down 85 cents a bushel while soybeans were trading at the highest prices they had ever seen — but stopping then would have been a big mistake.
The 85-cent loss in the hedge account quickly became a gain of $5.65 when soybeans were blindsided by the financial meltdown in late 2008. The next up-cycle in soybean prices from 2009 to 2012 was matched by an equivalent decline from 2012 to 2015 and saw the hedge account gain roughly another dollar over that time.
When all was said and done, from 1995 to July 1, 2016, January soybean futures gained $5.32 a bushel while the hedge account added another $6.63 for a total gain of $11.95 a bushel. The real beauty that could easily go unnoticed is that the hedge account provided extra cash in times of down markets and did not lose as much as futures gained when prices went higher. The combined effect of both the futures market and the hedge account produced a less volatile path of gain over time. And isn’t that what one would want in a hedging strategy?
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Another benefit to note is that by having protection from falling futures prices, producers are free to make cash sales sometime during the summer when the basis is typically most advantageous.
In addition to the pros, there are at least two cons to consider. First, producers need to recognize if they are going to have the financial and emotional commitment to execute Donchian’s 25-day rule on a short-only basis. As mentioned above, it is not for everyone.
Second, there is no guarantee that the 25-day rule will do as well in the next 21 years as it has in the past 21 years. Certainty is not an option in any marketing choice you make.
For those who may be intrigued by the research, but don’t see themselves following a strategy like this, there is still one piece of advice I would offer: The next time corn or soybeans close at a new 25-day low, especially if it’s during the growing season, consider taking cover.
Todd Hultman can be reached at email@example.com
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