Event-Driven Strategy Focusing on Global Crisis

7 juin 2022

GC1!
While the US-China trade friction started in 2018, I quickly observed a pattern similar to chess moves by two Grandmasters. President Donald Trump first initiated tariff on Chinese goods exporting to the U.S. Then, President Xi of China responded by taxing imported goods originated from the U.S. Infuriated, Trump raised the stake by higher tariff rates on more Chinese goods, and China would impose counter tariff on additional US goods.

The tic-for-tac went on for six rounds in the following two years. When tension ran extremely high, the leaders would have a call and arrange for trade negotiation in Washington or Beijing.

Each move delivered a major shock in the global commodities market. Tariff, the offensive move, is a “Risk On” button. It sharply raised production costs, reduced consumer demand because of higher prices, and increased the risk of global recession if tension got intensified and prolonged. A phone call, the defensive move, is a “Risk Off” button. It helped put off flames in the smoking volcano and gave hope that a trade deal would be reached.

Based on these observations, I developed my theoretical three-factor commodities futures pricing model:
Commodities Futures Price = Intrinsic Value + Market Sentiment + Crisis Premium

Intrinsic Value is the baseline cash price of an underlying commodity, determined by available supply, demand, inventory, storage, shipping and transaction costs, as well as other factors affecting these variables.

Market Sentiment indicates if investors are bullish or bearish. While supply and demand factors determine cash price, investors’ market views (whether they hold long or short positions) affect the price of commodity futures contract. Market sentiment could be either positive or negative, resulting in futures trading above (at a premium) or below (at a discount) cash price.

Fundamental analysis could decompose intrinsic value, and help you gain a deep understanding of the underlying commodity. Technical analysis could recognize pattern of market sentiment. In normal time, you could develop effective trading strategies using either one. However, they are less reliable in crisis mode, as the driving force behind price movement has completely altered.

I created a new Crisis Premium factor to help understand and analyze the “Event Shock” during a global crisis. By crisis, it could be war, pandemic, natural disaster, or global economic crisis. It is a “black swan” event for which you can’t draw a chart and find similar pattern in the past. Each global crisis requires a unique way of analysis. The sooner you gain an insight into it, the better you could deploy a working strategy.

Circling back to the US-China trade friction, I have used Game Theory to anticipate the next moves by the two super powers and developed a Game Theory Matrix.

Each nation has two options, Talk or Fight. When both want to fight, they would keep raising tariff. When one wants to talk, it would initiate a phone call and request for negotiation. When the fight got out of control, they would back off and go back to the negotiating table. When talk became serious, a trade agreement could be reached.

In 2019, I started trading COMEX Gold Futures (GC) armed with insight learnt from the first two rounds, which sums up as “When Trump Tweets, Limit Up; When China Calls, Limit Down.”

My strategy was as follow: When the tariff fight intensified and gold price went up significantly, I would place a Short Futures order, anticipating a call for truce to come. When negotiation was underway and gold price fell off considerably, I would put in a Long Futures order, expecting a tweet from President Trump to end the party. My strategy focused strictly on trade conflict as it became the dominant factor moving gold prices in 2018-2019.

In the next write-up, I would elaborate on event-based trading strategy surrounding the trade conflict further. Besides Gold, CBOT Soybean ZS1!and CME Lean Hog HE1! were also significantly impacted by the trade friction and would be covered in this series.

Other “event shocks” to be monitored include the Russia-Ukraine situation, and China’s Zero-Covid policy and lockdowns. Event-driven strategies could be applied on GC1!, ZW1!, ZC1!, CL1!, NG1!.

Happy Trading.

Disclaimers
*Trade ideas cited above are for illustration only, as an integral part of a case study to demonstrate the fundamental concepts in risk management under the market scenarios being discussed. They shall not be construed as investment recommendations or advice. Nor are they used to promote any specific products, or services.