The days of placing a hedge and then forgetting about it are over. Hedgers are now more sophisticated and technically aware thanks to an increased information stream. Hedgers are consistently deciding when and how much of their cash exposure to hedge. These decisions translate into the bottom line of profitability. We’ll examine how candlestick techniques can provide a valuable tool to assist in the decision-making process. This is because many candlestick indicators are trend reversal indicators and, as such, can provide valuable assistance in timing the placement or lifting of a hedge, and when to adjust a hedge.
A hedger seeks to offset his current or anticipated cash price exposure by taking an opposite position in the futures or options market. A short hedger is one whose underlying cash position is at risk of declining prices. A short hedger, for example, could be a copper producer or a farmer. To help manage this risk of lower prices, the hedger may initiate a short position by selling futures or by buying puts. If prices fall, the decreasing value of their cash position will be at least partially counter balanced by profits in the futures or options position.
An ultimate user of the cash commodity can become a long hedger. Such a hedger is one whose underlying cash position is at risk of rising prices. An example of a long hedger is a shirt manufacturer who has to buy cotton to use in the production of shirts. To assist in managing this risk of higher prices the manufacturer can place a long hedge by buying futures or calls. If prices move up, the higher price needed to purchase the cash commodity would be offset, at least partially, by the gains in the futures or options positions.
In many instances, the underlying cash position may not be fully hedged at one price. The hedger may intend to scale into the hedge position. Thus, the question a hedger must frequently address is what percent of his exposure should be hedged. Candlestick techniques can help answer this question. By exploring the following examples, it should offer insight into how candlesticks can be used to furnish clues as to when to adjust the hedged portion of the cash position.
Candlestick techniques can also be used for those who are 100% hedged. For instance, let’s say that you are a corn farmer and the corn market is trending against your cash position (corn prices are falling). This should mean, as a short hedger, your futures hedge position is profitable. If a strongly bullish candlestick reversal formation appears, and you believe prices will rally, you might want to ease back on the hedge. In some instances, early lifting of a profitable hedge may improve cash flow. However, no hedge should be viewed as a strategy to generate profits.
As shown in Exhibit 19.1, an explosive rally unfolded in 1988 as prices nearly doubled from $6 to $11. In mid-1988, near the peak of the rally, the candlesticks gave a reversal signal a la the bearish engulfing pattern. This would have not been seen as a Western top reversal formation using traditional Western techniques. A top reversal formation would have required a new high for the move and then a close under the prior week’s close. The black candlestick session of the engulfing pattern did not create a new high. Thus, while not a Western top reversal pattern, it was a reversal formation with candlesticks. This bearish engulfing pattern, for a soybean farmer, could have been used as a warning to either initiate short hedge positions or, if not already fully hedged, to raise the percentage hedged.
In 1989, another bearish engulfing pattern warned of a top (this also was not seen as a top reversal pattern using Western technicals). Short hedgers could have placed hedge positions here. The window a few weeks later was another bearish candlestick signal which would have told short hedgers to add to their short hedge position (if not already 100% hedged). October’s bullish piercing pattern could have been used as a signal to ease back on short-hedge positions. For those looking at a long hedge, the piercing pattern could be used as a signal to initiate such a hedge.
As illustrated in Exhibit 19.2, a confluence of bullish candlestick signals emerged the last week in September and the first week in October in 1988. The most obvious was the bullish engulfing pattern. These two weeks also created a tweezers bottom. Additionally, the white candlestick was a bullish belt hold which closed at its high. It also engulfed the prior five candlesticks. For long hedgers, these would have been signs to start, or add to, their hedges.
In early 1989, the harami cross (an important reversal signal), could have been used by long hedgers to scale back on hedges. Also, the fact that this harami cross was formed by a long white candlestick and a doji would indicate that the market was in trouble. A doji after a long white real body is often a sign of a top.
Exhibit 19.3 explores how a long crude oil hedger could use a candlestick signal to get an early signal of a bottom reversal and then use Western technical tools to confirm. a bottom and add to the long hedge. The first tentative bottom reversal clue came with a hammer on July 5. Since this hammer session gapped under the prior lows, it should have not been taken as a bullish sign unless it was confirmed by other bullish indicators during the next few sessions. The next clue was the bullish engulfing pattern which provided bullish confirmation to the hammer.
This engulfing pattern was also an extra important bottom reversal signal. This is because the white candlestick on July 9 engulfed not one but two black real bodies. At this point, crude oil end users (that is, long hedgers) should have seriously considered placing hedges or adding to their hedge position.
The next clue came when price lows at areas A, B, and C were not confirmed by lower momentum values. This revealed the fact that selling velocity was slowing (that is, experiencing diminishing downside momentum)
The reasons above were more than enough to expect a price bounce, but there is another added feature. A traditional Western falling wedge pattern was broken to the upside about the same time the momentum oscillator crossed into positive territory (see arrow). Based on the falling wedge, there was a target to where the wedge started. This, depending on how one views this wedge, could have been the June high near $19 or the May 18 high near $20. On the piercing of the rising wedge, more long-hedge positions could have been added.