Lumber and momentum crashes

Lumber futures prices are significantly higher than March levels as of the current close. Prices have increased more than 50 percent since April 1; however, prices have fallen nearly 25 percent since the high at the end of August. It will be noted that the lumber futures are not a very liquid contract so price moves can become exaggerated on limited trading.

Big moves and reversals define the life of trend and momentum followers. Follow the trend, but the more extreme and more money made will place greater risk of a reversal. These reversals are natural, but they are especially violent and can be called crashes when associated with a long strong price move. Momentum strategies can see negative skew on a trade basis which has been offered as an explanation for the momentum risk premium. We highlighted the lumber move and risks almost on the date of the high. See A surprise commodity demand shock - the case of lumber.

Very strong trends, usually up trends, lead to violent fast reversals. Call it a reverse of herding, liquidity cascades, crowded trades, or bubbles, trends often end poorly even with a strong long-term gain. Late trend entry can be devastating. Pyramiding can also be painful. However, the early trend identifier can be rewarded even with a crash on reversal. The reversal risk is a cost of following trends.  

The key solution to this crash risk is some form of stop-loss risk management.  Fixed risk rules provide a binding constraint on behavior that may want to hold positions for too long. It is not by accident that stop-loss structuring is so critical for trend-followers relative to other strategies. In fact, the risk management and trend reversal analysis are the two areas often overlooked but clearly critical to differentiating trend-following firms. 

The impact of higher lumber prices is still present for the housing industry. Lumber price are significantly higher than 5 and 10-year averages and still at levels impacting supply and demand decisions. The news for traders is still the same - if you follow longer-term trends, always have an exit strategy.