Last Updated on 17 November, 2020 by Samuelsson
When trading algorithmically, you have the immense benefit of having the computer taking care of your orders for you. You could be trading a range of different markets at the same time, and expand to markets the typical trader wouldn’t even dream of trading!
One such market is the cotton market, and in this short article, I wanted to share with you what I stumbled upon when testing some new ideas!
Discovering a Cotton Strategy!
As usual, I tried my idea on many markets, and found that the Cotton market showed some merit.
Finding something on markets like cotton tends to be much harder than something in, for instance, the S&P 500. Therefore this finding was a welcomed addition to my collection of trading strategies.
Here you see how the strategy performed during the last 20 year. The curve keeps going up throughout the 20 year-long test period, with some eventual hiccups now and then. However, for the Cotton market, this isn’t bad at all! The strategy goes both long and short, and can be used with a tight stop loss(as in the graph below), without impacting the performance too severely!
(With Slippage $40 round turn)
What you probably recognize here, is that the middle part of the curve produced a lot of the profit of the whole period. This is something that you need to be cautious about. If you don’t pay attention to the distribution of profits, you could easily end up with a strategy that made a huge amount during a few years, while it just produced break-even results during the rest of the period.
However, in this cotton strategy, we clearly see that the curve continues up, so this shouldn’t be an issue!
But why did this cotton strategy perform so much better during this short period? Well, let’s have a look!
Why The Cotton Strategy Produced Uneven Equity
In order to understand why this very cotton strategy went wild during the short period between 2009-2010, we need to take a closer look at the cotton market as a whole. To do this, I pulled up the monthly chart of the Cotton Futures contract
If there was anything here to catch our attention, it would be the outsize monthly moves in the middle of the chart. We have some crazy market action, and the volatility explodes over the course of just a few months.
And, the increase in volatility fits very well with the performance of the cotton strategy. During this peak period, it surely made some incredible profits!
What Does This Tell Us About the Cotton Strategy?
Well, one of the goals we have as strategy makers, is to ensure that our strategies are as robust as possible. That also means that we want to see that our strategy survives as many market conditions as possible.
The fact that this cotton strategy managed to not only survive this period of extreme volatility, but also thrive, is a very good sign that it will be robust going forward. Even if the market conditions change drastically, I can be a little more certain that the cotton strategy will cope with it, since it already has done so once!
In fact, when studying the cotton market for some longer time, like 45 years in the chart below, we see that the Cotton market regularly has experience volatility explosions like this one.
So, having a cotton strategy that manages to survive conditions like this may even be a necessity if we want to remain in the game!
Why Did the Cotton Market Explode in 2009-2010?
During the first years of the new millennium, a nearly one decade long period of record cotton production, both in the US and worldwide, lead to the amassing of sizable supplies.
The surplus of cotton and high stocks made mills take on a more short term strategy. This basically meant that they wouldn’t buy raw cotton until they needed it. This reduced the stocks of raw cotton.
Later in 2009, with the advancing prices of oilseed and high grain, producers turned from cotton production to the aforementioned crops to increase their profits. This, coupled with poor weather lead to the 6th lowest world crop since the year of 2003.
Now, this meant that there was low supply. However, in 2009 we also saw how the consumption rebounded in the period following the 2007 financial crisis, which increased the demand for cotton.
In other words, we had low supply and rising demand. The perfect recipe for rising market prices!
Making Further Improvements to the Cotton Strategy
Since the strategy in the form presented above only consisted of simple entries, with no filters, I assumed that there was room for some further improvement!
After testing some different filters, I found a simple price action filter that worked very well! It practically cut the number of trades in half, but left the total profit at the same level. Impressive!
Was This Just Curve Fitting?
No, I don’t think so. While the added filters are not symmetrical for long and short trades, they work with practically any parameter settings.
And they really make sense when considering what type of strategy this is, and what market tendency it makes use of!
Will The Strategy Survive?
Yes, I’m very confident it will! It is incredibly robust in its parameter, and works across many settings. In addition to this, it only consists of an entry and one filter, with a simple time exit. It indeed looks promising!
As an algorithmic trader, you can find interesting strategies in many different markets. The cotton strategy shown in this article is a great example of such a strategy.
If you are interested in knowing more about algorithmic trading, we recommend that you have a look at our massive article on algorithmic trading.
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