Commodity Investing: Top Technical Indicators

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

The technique of fundamental analysis is believed to be ideal for investments involving a longer time period. It is more research-based; it studies demand-supply situations, economic policies, and financials as decision-making criteria.

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

Identifying the Market for Commodities

Momentum indicators are the most popular for commodity trading, contributing to the trusted adage, “buy low and sell high.” Momentum indicators are further split into oscillators and trend-following indicators. Traders need to first identify the market (i.e., whether the market is trending or ranging before applying any of these indicators). This information is important because the trend following indicators do not perform well in a ranging 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 commodity or stock. For example, a five-period MA will be the average of the closing prices over the last five days, including the current period. When this indicator is used intra-day, the calculation is based on the current price data instead of the closing price.

The MA tends to smooth out the random price movement to bring out the concealed trends. It is seen as a lagging indicator and is used to observe price patterns. A buy signal is generated when the price crosses above the MA from below bullish sentiments, while the inverse is indicative of 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 a ranging market, as it tends to generate false signals due to price fluctuations. In the example below, notice that the slope of the MA reflects the direction of the trend. A steeper MA shows the momentum backing the trend, while a flattening MA is a warning signal there may be a trend reversal due to falling momentum.

In the chart above, the blue line depicts the nine-day MA, while the red line is the 20-day moving average, and the 40-day MA is depicted by the green line. The 40-day MA is the smoothest and least volatile, while the 9-day MA is showing maximum movement, and the 20-day MA falls in between.

Moving Average Convergence Divergence (MACD)

Moving average convergence divergence, otherwise known as MACD, is a commonly used and effective indicator developed by money manager Gerald Appel. It is a trend-following momentum indicator that uses moving averages or exponential moving averages for calculations. Typically, the 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 bull and bear indicators.

A bullish signal is generated when the MACD is a positive value, as the shorter period EMA is higher (stronger) than the longer period EMA. This signifies an increase in upside momentum, but as the value starts declining, it shows a loss in momentum. Similarly, a negative MACD value is indicative of a bearish situation, and an increase further suggests growing downside momentum.

If negative MACD value decreases, it signals that the downtrend is losing its momentum. There are more interpretations to the movement of these lines such as crossovers; 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 shown by bars. When the histogram is positive (above the centerline), it gives out 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 overbought and oversold level in a market on a scale of 0 to 100, thus indicating if the market has topped or bottomed. According to this indicator, the markets are considered overbought above 70 and oversold below 30. The use of a 14-day RSI was recommended by American technical analyst Welles Wilder. Over time, nine-day RSI and 25-day RSIs have gained popularity.

RSI can be used to look for divergence and failure swings in addition to overbought and oversold signals. Divergence occurs in situations where the asset is making a new high while RSI fails to move beyond 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.

To get more accurate results, be aware of a trending market or ranging market since RSI divergence is not a good enough indicator in case of a trending market. RSI is very useful, especially when used complementary to other indicators.

Stochastic

Famed securities trader George Lane based the Stochastic indicator on the observation that, if the prices have been witnessing an uptrend during the day, then the closing price will tend to settle down near the upper end of the recent price range.

Alternatively, if the prices have been sliding down, the closing price tends to get closer to 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 smoothened form of %K value and is considered the more important among the two. 

The main signal that is formed by this oscillator is when the %K line crosses the %D line. A bullish signal is formed when the %K breaks through the %D in an upward direction. A bearish signal is formed when the %K falls through the %D in a downward direction. Divergence also helps in identifying reversals. The shape of a Stochastic bottom and top also works as a good indicator. Say, for example, a deep and broad bottom indicates that the bears are strong and any rally at such a point could be weak and short-lived.

A chart with %K and %D is known as Slow Stochastic. The stochastic indicator is one of the good indicator that can be clubbed best 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 centerline (trend), an upper line (resistance), and a lower line (support). When the price of the commodity considered is volatile, the bands tend to expand, while in cases when the prices are range-bound there is contraction.

Bollinger Bands® are helpful to traders seeking to detect the turning points in a range-bound market, buying when the price drops and hits the lower band and selling when the price rises to touch the upper band. However, as the markets enter trending, the indicator starts giving false signals, especially if the price moves away from the range it was trading. Bollinger Bands® are considered apt for low-frequency trend following.

The Bottom Line

There are many technical indicators available to traders, and picking the right ones is crucial to informed decisions. Making sure of their suitability to the market conditions, the trend-following indicators are apt for trending markets, while oscillators fit well in ranging market conditions. However, beware: applying technical indicators improperly can result in misleading and false signals, resulting in losses. Therefore, starting with Stochastic or Bollinger Bands® are recommended for those who are new to using technical analysis.

Investopedia does not provide tax, investment, or financial services and advice. The information is presented without consideration of the investment objectives, risk tolerance, or financial circumstances of any specific investor and might not be suitable for all investors. Investing involves risk, including the possible loss of principal.