Understanding Hedged Scale Trading

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UNDERSTANDING HEDGED SCALE TRADING

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Other Books in The Irwin Trader’s Edge Series • Traders Systems That Work • The Encyclopedia of Trading Strategies CONSTANCE BROWN • Technical Analysis for the Trading Professional RICHARD DUNCAN • Agricultural Futures and Options WILLIAM GALLACHER • The Options Edge R. E. MCMASTER • The Art of the Trade THOMAS STRIDSMAN

JEFFREY OWEN KATZ AND DONNA L. MCCORMICK

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UNDERSTANDING HEDGED SCALE TRADING

THOMAS MCCAFFERTY

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TERMS OF USE This is a copyrighted work and The McGraw-Hill Companies, Inc. (“McGraw-Hill”) and its licensors reserve all rights in and to the work. Use of this work is subject to these terms. Except as permitted under the Copyright Act of 1976 and the right to store and retrieve one copy of the work, you may not decompile, disassemble, reverse engineer, reproduce, modify, create derivative works based upon, transmit, distribute, disseminate, sell, publish or sublicense the work or any part of it without McGraw-Hill’s prior consent. You may use the work for your own noncommercial and personal use; any other use of the work is strictly prohibited. Your right to use the work may be terminated if you fail to comply with these terms. THE WORK IS PROVIDED “AS IS”. McGRAW-HILL AND ITS LICENSORS MAKE NO GUARANTEES OR WARRANTIES AS TO THE ACCURACY, ADEQUACY OR COMPLETENESS OF OR RESULTS TO BE OBTAINED FROM USING THE WORK, INCLUDING ANY INFORMATION THAT CAN BE ACCESSED THROUGH THE WORK VIA HYPERLINK OR OTHERWISE, AND EXPRESSLY DISCLAIM ANY WARRANTY, EXPRESS OR IMPLIED, INCLUDING BUT NOT LIMITED TO IMPLIED WARRANTIES OF MERCHANTABILITY OR FITNESS FOR A PARTICULAR PURPOSE. McGraw-Hill and its licensors do not warrant or guarantee that the functions contained in the work will meet your requirements or that its operation will be uninterrupted or error free. Neither McGraw-Hill nor its licensors shall be liable to you or anyone else for any inaccuracy, error or omission, regardless of cause, in the work or for any damages resulting therefrom. McGraw-Hill has no responsibility for the content of any information accessed through the work. Under no circumstances shall McGraw-Hill and/or its licensors be liable for any indirect, incidental, special, punitive, consequential or similar damages that result from the use of or inability to use the work, even if any of them has been advised of the possibility of such damages. This limitation of liability shall apply to any claim or cause whatsoever whether such claim or cause arises in contract, tort or otherwise. DOI: 10.1036/0071382607

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This is dedicated to . . . The ones I love — Carol, Cynthia, Monica, Colleen, and Sadie

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CONTENTS

Acknowledgments ix Introduction xi

Chapter 1

The Derivative Markets—

Futures 1

Chapter 2

The Derivative Markets—

Options-on-Futures 21

Chapter 3

Traditional Scale Trading 47 Chapter 4

Understanding Hedged Scale Trading 61 Chapter 5

The Criterion for the Selection of Scalable Commodities 73 Chapter 6

Selecting the Perfect Commodities to Scale Trade 89 Chapter 7

Mechanics of Scale Trading 119 Chapter 8

Roll Me Over 129 Chapter 9

Starting a Scale Trading Business 141 Chapter 10

A Little Technical Analysis Can Go a Long Way When Scale Trading 165

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Chapter 11

Getting Ready to Scale Trade 179 Chapter 12

Summing Up the Rules for Successful Scale Trading 191 Appendix 1

Commodity Futures Contract Specifications 203 Appendix 2

Sources for More Information 209 Glossary 217 Index 235

Contents

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ACKNOWLEDGMENTS

F

irst, my thanks go to Stephen Isaacs, my editor at McGraw-Hill, for his patience. This project took much longer than anticipated. Several other valuable projects intervened, yet Stephen’s support was unwavering. There are two people who taught me much about scale trading to whom I owe a good deal of the content of this book. I am referring to the two commodity brokers I worked with at Securities Corporation of Iowa in Waterloo, Iowa — Paul Lovegren ([email protected] or 800-262-4643) and Monty Wambold. It was with these commodity traders that I saw the most positive and negative aspects of scale trading. If it were not for their service to our customers and their dedication to learning as much as possible about this valuable trading technique, many of our clients new to scale trading would not have succeeded. You guys did a great job and deserve all the success you have had. Thanks again. I would also like to thank David S. Nassar, President and CEO of Market Wise Securities, Inc., for teaching me a lot about trading. We have worked together for the past few years and it has been a joy. Thanks also to Stan Yan, who is a superior security broker, artist, and cartoonist. He created most of the illustrations included in this text. I am grateful for his assistance.

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INTRODUCTION

Who makes money trading commodity futures? The most definitive answer to this question can be found in two books by Jack Schwager—Market Wizards and New Market Wizards. Mr. Schwager, a world-class commodity trader in his own right, interviewed the most successful futures traders he could find. The common denominator is that each of these traders had found an edge on the market. Each had developed a trading system that put the odds, ever so minutely, in his or her favor. Profitable futures trading depends on getting an edge on the market, taking advantage of the edge whenever possible, and doing nothing when the edge is not evident. This book is all about teaching you where there is an edge in the futures market and showing you how to take advantage of it. I also attempt to instill a sense of paranoia in you. If you get lazy or cocky or disregard the rules outlined within, you will have your head handed to you. Futures trading is a lot like war. The winner is the one standing when the loser is forced to sign a treaty. The person standing is the one with an edge, the one who trades defensively. A good example of this is the technician. Most of us know the basic technical signals traders track. Some are so common they work because they are self-fulfilling prophecies. If major price support or resistance is violated, one exits or reverses one’s position. The professional trader does this and immediately takes a small profit, whereas the amateur follows suit but holds the position, hoping for a major profit and all too often taking a bath in the process. Scale trading can give traders an edge. By taking it one step further and hedging their positions, they can more than double that edge. Hedging means being on both sides of the market at the same time. A farmer-hedger, for example, produces corn. Therefore, he automatically becomes long corn on the cash side of the market when he plants a crop. When the futures price is high enough to make a decent profit (adjusted for local basis), he sells his corn on

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the futures side of the market. At this point in time (and price), he is hedged, which means his gross profit margin is fixed no matter how high or how low the price of corn goes as long as he can deliver the commodity. If corn prices plummet, his short futures contracts gain in value. If corn prices skyrocket, his cash crop becomes more valuable. Any gain or loss on one side is offset on the other side. When the futures contract expires or he decides to close out the futures side of the market, say, at harvest, he delivers his long cash corn against his short futures position. True hedging is all about risk management and locking in profit opportunities, as is hedged scale trading. This book teaches you how to reap the rewards of scale trading in the futures markets without the fear associated with traditional scale trading. As you’ll learn, scale traders buy into descending markets. The concept is “What goes down must come up,” and all positions eventually become winners. Theoretically, this is true. But time and again, I’ve seen good, experienced traders panic when the price of the commodity they are long limits down for 1, 2, 3, or more days in a row. Limit-down days are trading sessions when a futures contract immediately plunges to its daily trading limit without actually trading. The reason these seasoned traders lost was that they did not put any downside protection on their positions. If you are holding only a few contracts on the long (buy) side, not to mention having a multiple contract position, it is a most unpleasant sensation to watch prices dive without being able to do anything. It recalls the feeling you get when you are driving a car on an icy road and realize you are skidding out of control. Nothing responds. Trying to brake or steer makes the situation worse. Get the feeling? There are ways of managing this risk in the futures market. I’ll even teach you how to make money from these rare and frightening market moves. Until now, all the books and all the scale trading gurus, to the best of my knowledge, have not recommended the techniques described in this book. But the brokers I worked with used them, and they made a substantial difference! The trading strategies I teach are not macho, and they are not classical scale trading. They reduce the profit potential and interfere with the true essence of scale trading—or at least that is how the purist’s argument goes.

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We, meaning I and the brokers I worked with, bought into these arguments for a while. After we saw some of our good clients go belly up, financially and emotionally, when faced with margin calls they could not meet, we said enough is enough! Traders can make above-average profits in scale trading without suffering the abuse the market is capable of delivering. Used judiciously, the strategies taught in this book can often enhance the profit margin. Another purpose of this book is to show investors, especially those who have prospered in the stock market during the past decade, that there is an alternative investment opportunity worthy of consideration once the stock market retreats to its historical return of 11 percent per year. The general argument against futures trading is that it is extremely complicated, virtually esoteric. Others say it is no different from gambling. Scale trading the way it is taught in this book is more similar to trading securities than it is to trading futures. One of the most reliable ways to make money in the stock market is to purchase shares in well-run, well-financed companies whose earnings are growing, and holding them as the per-share price appreciates. If you hold them long enough, you are almost guaranteed to win. Scale trading is similar, but it works in the opposite direction. Following the rules detailed in this book, you buy futures contracts of commodities that are declining. Eventually, the prices of these commodities turn around, and you exit your positions at a profit. Best of all, you’ll understand the rules and why they work: They are built on the sound foundation of the laws of supply and demand. You will even learn how to incorporate methods to further manage your risk and enhance your profit potential. The book begins with an explanation of the two derivative markets you will be trading, including how and why they work. By the end of Chapter 2, you should be very comfortable with these markets. From time to time, you may find the Glossary useful. Next, traditional and hedged scale trading are compared and contrasted. Once you thoroughly understand the concept of scale trading, the rules you need to know to succeed are presented. There are two key issues you need to pay particular attention to—which commodities to scale trade and when to begin a scale. After that, advanced techniques—such as when to make small adjustments in trading that can substantially increase your return—are introduced.

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The backbone of scale trading is fundamental analysis of the futures market. You’ll learn how to do this analysis and to identify the critical factors impacting the commodities you will be trading. The source of good fundamental information is either your broker, the research department of the brokerage firm or clearing member, or the Internet. If your broker is not a scale trading expert, you could have problems. I discuss how to deal with this situation. Scale traders hold long futures positions, waiting for them to move into specific price ranges (referred to as the scales) before taking profits. Since no one can accurately predict when this might occur and since futures contracts expire on specific dates, the scale trader must occasionally transfer positions from the current contract month to a more distant one—from the May corn contract to the September contract, for example. This is called rolling positions over. You’ll learn the most efficient ways of doing this. There are some substantial differences between the protection you have as an individual investor in the futures market compared with what you have in the stock market. By the time you finish this section, you’ll be well informed, and I think you’ll be pleasantly surprised at the quality of the protection afforded futures traders. Last of all, you’ll get some good ideas and suggestions on how best to get started. These are solid ideas and approaches I have learned over years of working with scale traders and brokers. You will find they can save you time and money.

A WORD TO THE WISE . . . Investing in anything is risky, because you are attempting to predict what may or may not happen at some time in the future. Only hindsight is 20-20. What makes futures trading riskier than stock trading is the amount of leveraging available. If you trade stocks in a margin account, you can leverage 50 percent of the value of the stock. With futures, you may be required to put down only 5 percent or less of the value of the contract being traded as the initial margin. It is this high leveraging factor (20:1) that accounts for the high profits that commodity brokers brag about. But it is also this high leveraging that can create the major losses some traders experience. You can lose money in scale trading just as you can with any investment. And you can lose more than you invest as a result of leveraging.

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The hedged scale trading system attempts to manage the risk as much as possible. Unfortunately, there is no completely foolproof system. In my opinion, this system comes as close as any I’ve seen. Again, no one can foretell the future or what totally unexpected events (war, weather, politics, etc.) will impact the markets you trade. For this reason, I maintain that not everyone is suited to the futures market or scale trading. You do not have to trade; it is totally your decision. I do recommend you read this book, discuss the opportunities with trusted advisors, interview a few scale trading brokers, talk with some actual scale traders, and visit some of the Web sites devoted to the subject. Then decide whether scale trading fits your temperament and investment objectives. If you do decide that it is something worth pursuing, good hunting!

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The Derivative Markets—Futures

The purpose of this chapter is to give you insights into the minds of a large percentage of the derivative traders who will be driving the market you will be trading. Once you know where they are coming from and what they are trying to accomplish, you will be better armed to take advantage of their weaknesses. Understanding these markets will also give you the discipline needed to be a successful scale trader. The term derivative is generic and refers to a wide variety of financial instruments whose prices are derived from the value of an underlying entity. That entity could be a security, as in an option on a stock. Or it could be a debt instrument (bond futures contract), equity index (S&P futures contract), or a physical commodity (corn futures contract). The prices of derivatives rise and fall as the supply-demand equation of their underlying entity reacts to new information entering the marketplace. It can be either current or future projections that impact pricing of the underlying entity or even rumors or false or misleading information deliberately placed to disrupt the markets. The most important aspect traders new to futures markets need to grasp is that most derivative markets attempt to anticipate the future price of the underlying entity. Derivative traders use a variety of analytic tools, such as fundamental and technical analysis or a combination of the two, to predict where prices of the underlying entities will be a minute, an hour, days, weeks, months, or years into the future. 1

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Another key element is that derivatives involve either rights or obligations on the part of the owner of the derivative. This means the owner or trader has a right to the underlying entity at some time and price in the future or an obligation to deliver the derivative at some time or price in the future. The difference depends on whether the trader is the buyer or seller of the derivative. In the final analysis, a derivative is only a contract mutually agreed upon between market participants. To be a legal contract, all terms must be acceptable to both parties and money must be exchanged. Once this is complete, the buying party has rights that may be exercised against the seller. Conversely, the seller must live up to the obligations of the contract, which usually means prompt delivery of the underlying entity to the buyer. One of the socially redeeming values of derivatives is that they can be used to manage risk. For example, an individual owner of an underlying entity, such as a stock position or even an entire portfolio, who fears it will lose value over the coming months but does not wish to sell it, can buy a derivative. A put option on that security or an index matching the portfolio will gain value as the underlying entity loses value. As the security loses value, the put gains value. Properly done, the investor is hedged or neutral. The price or value of the underlying entity is frozen for a period of time. Hedgers can also be major consumers of the underlying entities. Typical examples are grain merchants who have contracts to supply corn, soybeans, and wheat to corporations that process these commodities into feed and food for human and/or animal consumption. Or it could be producers of gasoline and heating oil that use the futures markets in crude oil to lock up prices at advantageous times. Users of silver, gold, and copper do the same thing in the electrical, photographic, and jewelry industries. So do banks, pension funds, mutual funds, and other financial institutions that rely on financial futures to meet obligations they must prepare for in the near- to long-term future. Currency futures can take some of the sting out of importing or exporting. Second, derivative markets provide an insight into the future supply-demand situation of the underlying entities. By tracking contracts that expire in 3, 6, 9, or 12 months into the future, interested parties (users, hedgers, traders, government officials, the

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press, etc.) know what the market participants project regarding excesses or shortages in underlying entities. Another one of the most useful contributions of the derivative exchanges is price discovery. Thousands of traders, hedgers, speculators, and scalpers, representing every corner of the world and most major corporations, bid and offer contracts on hundreds of underlying entities. The consensus of this activity provides insights into the future pricing for all these entities—not just on the spot markets, but as far out as a year or more. Without these markets, the users of the commodities represented by futures contracts would not have a remote idea as to where price trends were headed, nor would they be alerted to future shortages or oversupply conditions. The derivative markets can be excellent planning guides for a wide variety of industries, even sovereign nations. Yet another function of the derivative markets is generating income via speculation, something near and dear to all our hearts. Many of these markets are extremely popular with speculators. Their objective is simply to generate short-term profits, betting on the near-term price fluctuations. Their value to the hedger and scale trader is that they add much needed liquidity to many derivative markets, making it easier to buy and sell derivative contracts. There is nothing new about the derivative markets. Market historians are proud to trace their use back to the Old Testament. The Book of Genesis, Chapter 29, tells the story of Jacob, who bought an option costing seven years’ labor. It gave him the right to marry Laban’s daughter Rachel. Unfortunately, Laban reneged on the contract, perhaps the first default on an over-the-counter option, and Jacob married Leah, Rachel’s older sister. Like any good options trader, Jacob jumped right back in the market and bought a second option on Rachel. (Multiple wives were permitted in 1700 B.C.) Again, the option cost him another seven years of labor. This time there was a happy ending, presupposing the sisters got along together, for Jacob. It could not have been too bad, since Jacob ended up with 12 sons, who became the patriarchs of the 12 tribes of Israel. In merry old England of the Middle Ages, records indicate a flourishing futures market. As early as the thirteenth century, active forward contract markets existed in wheat and wool in London. Forward contracting is the practice of producers agreeing

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to deliver a certain amount of a commodity of a predetermined quality to a dealer at a specific time in the future at a set price. These types of markets were the forerunners of our modern-day futures and options contracts. The Royal Exchange in London is usually credited as the first exchange to allow the trading of forward contracts in the seventeenth century, and it was forward contracts that helped fuel the Dutch tulip mania of 1637. As a matter of fact, 15 to 25 percent of trades executed on the New York Stock Exchange in its early years were classified as “time bargains” or forward contracts, rather than transactions for cash or next-day settlement. But credit for the first fungible contract is usually given to the Yodoya Rice Market in Osaka, Japan, around 1650. In the United States, the Chicago Board of Trade was the first futures market, opening in 1848. Necessity is the mother of invention, and at the time, the grain market was in chaos. The abundant crops produced in the Midwest poured into Chicago at harvest. More came in than could be handled and stored. There needed to be a way of bringing the crops to market in an orderly fashion. The grain storage facilities in Chicago and other key collection locations were overwhelmed at harvest and underutilized most of the rest of the year. Chicago, because of its location on Lake Michigan and the surrounding farm states of Illinois, Iowa, and Michigan, was a natural center for farm commerce. When Chicago was flooded with corn and wheat at harvest, prices plummeted. Storage facilities were bursting at their seams. Neither the farmers nor the grain merchants could make the money they deserved under those circumstances. A similar situation existed with the marketing of the livestock. A plan was devised to allow farmers to store the grain on their farms and bring it to market in an orderly fashion, while receiving an advance payment based on future delivery and locking in a decent price. This was known as the “to-arrive” contract. The grain merchants of Chicago also had the right to trade these contracts among themselves. If demand rose, these merchants would bid the price up of the to-arrive contracts. The price to the farmer did not change, but the farmer had transferred the risk of ownership, meaning lower prices, to the grain merchant. By 1865, the contract terms were standardized and a fungible contract was in place.

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In 1874, the Chicago Produce Exchange was organized to compete with the Chicago Board of Trade (the Board). It changed its name to the Chicago Mercantile Exchange in 1919. The “Merc,” as it is generally known, was followed by several other local exchanges, but the Board and the Merc remain the world leaders in futures trading to this day. Jacob’s option was an over-the-counter (OTC) option, some might even call it a forward contract like the ones first used in Chicago. Nevertheless, by this simple means the parties negotiated and agreed on all the terms of the contract. OTC options are still widely used, but it is exchange-traded derivatives that are important to the hedged scale trader. With exchange-traded derivatives, all the terms and conditions are set in advance by the exchanges, except price and the number of contracts to be bought or sold. Terms and conditions means the size of the contract (how many shares of a security or bushels, bales, pounds, tons, gallons, barrels, etc. of a physical commodity such as cotton, copper, or crude oil), the quality of the underlying entity, the location of delivery, and time of delivery. The term fungibility is used in derivative markets to denote that each contract is completely interchangeable. All the specifications—quality, quantity, date of delivery, and delivery location—are standard. Since the trader decides how many contracts to buy or sell, only price needs to be decided, and that is done traditionally through open outcry auctions in the trading pits. The term commodities was used initially because the only underlying entities being traded were physical commodities. In 1972, the Chicago Mercantile Exchange began trading the currency futures contract. This contract was followed by the interest rate futures contract on the Chicago Board of Trade (1975). The Merc countered with Treasury bill futures (1975) and the Board with T-bond futures (1977). The competition went on and on and still goes on. Now you can trade weather insurance and electricity contracts. Major exchanges developed in New York. By the mid-1970s, the term futures replaced commodity, for obvious reasons. These exchanges also developed options contracts, once they got up and running. The Roaring Twenties was as wild and unregulated a period in the commodities and options-on-commodities markets as it was in securities. Bucket-shop trading commodities and options abounded. Options were so abused that they were banned in 1936. Eventually they reappeared in 1973.

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As a scale trader, you will need to master two derivative markets—the futures and the options-on-futures markets. Let’s begin with an overview of the futures markets. I use the symbol of Janus, the ancient Roman god, to explain the futures markets. Janus was the god with two faces, one looking fore, the other aft. The god’s responsibility was to protect entrances. Janus’s main temple in the Roman Forum opened its doors during times of war and closed them in times of peace. The reason I use Janus is because there are so many dichotomies that must be dealt with when trading futures. First, you can buy or sell (go long or short) without any restrictions. In the securities market, an individual trader must have an uptick in price (New York Stock Exchange) or an up bid (NASDAQ) before being permitted to short a stock. Not so with futures. In addition to not having any restrictions, you can execute trades rapidly—you can get a fill on a market order while you are still on the phone with your broker. Or you can trade electronically. You can reverse your position just as quickly. For example, you are long one copper contract, you decide you want to be short, and you sell two. In an instant, you have reversed your position. But the most important dichotomy for the scale trader to understand is the one that drives the market for speculators; that dichotomy is fear and greed. Speculators are torn between the two. One drives the markets to exuberant highs; the other bursts the bubble, trashing the markets. When you begin to study price charts, you will see repeated examples of prices hitting highs only to immediately reverse to test the lows and visa versa. More important, you will see many instances where a market will oscillate within a range, moving up and down, over and over again, as the mood swings of the participants ebb and flow between confidence and insecurity. These periods of ambiguity are gold mines for scale traders, as will be explained in detail. Before we get into all that, let me define the basic concept of futures trading. When you buy or sell a commodity or a futures contract, exactly what are you buying or selling? A futures contract is a fungible contract. For example, you buy or sell one crude oil contract. By entering this contract, you agree to accept delivery of (buy side) or to deliver (sell side) 1000 barrels (42,000 gallons) of crude oil of a specific grade (quality) at a specific location or terminal on or by a specific date at a specific price. If you do not offset

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your futures position, you are truly expected to take (long) or make (short) delivery. Naturally, it is rare for individual traders to take or make delivery of the physical commodity. (Most financial futures settle in cash.) Those traders, short when a contract expires, deliver to those who are still long. If a short plans on delivering, the short files a notice of intent to deliver. A long would notify the clearinghouse of his or her intent to accept delivery. The clearinghouse matches up the shorts that want to deliver with the longs that want to accept a delivery. There are usually more longs than shorts. To avoid delivery, most traders simply offset their positions by buying or selling equal and opposite positions on the same futures exchange in the same contract month. If for some reason a long does not offset a position in time, the trader may be assigned a delivery notice. Additionally, when a trader receives a notice of delivery, he or she must deposit enough cash to pay 100 percent of the contract. If a livestock contract is involved, the trader is also assessed yard and feed fees. The trader who does not want to accept delivery in this situation can retender the contract. Retendering is the process of reoffering the contract to the open market. There is no guarantee as to what price the trader will be paid for the contract. This is a risk of retendering. The trader will also be assessed two additional commissions for handling the transactions. It is a rare occurrence, but it can happen if a scale trader hesitates too long in rolling over expiring futures positions, which is the subject of Chapter 8. This brings another important aspect of the futures contract: expiration. Unlike securities, which you can hold indefinitely or at least as long as the corporation is in business, futures have specific expiration dates. When a contract expires, it is known as “going off the board.” As one contract expires in a particular commodity, another one begins. For example, the corn contracts expire or are delivered in March, May, July, September, and December. As one goes off the board, another one begins, with at least three contracts trading at any one time. Other futures contracts, like crude oil, provide for delivery every month. My point is simply that you cannot hold a futures position indefinitely. The contract nearest to expiration is called the nearby and is usually the most active. The farther the contract is away in time from delivery or expiration, the less liquid it is, as a general rule.

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Liquidity is a measurement of how many contracts are being traded per trading session. Scale traders need a certain amount of liquidity to open positions. Additionally, scale traders need a certain amount of time for the scale they are trading to develop. As you will learn in Chapter 7, the contract month you decide to trade in will depend on the liquidity, the number of months to expiration, and the price differential (carrying cost) between contract months. Liquidity in the futures markets has a lot to do with the role played by the clearinghouse. When you buy or sell a futures contract, you are not entering in a contract with another individual or group of individuals in the case of multiple contracts. You are creating a financial obligation to the clearinghouse. The clearinghouse is the buyer or seller of all contracts. In securities parlance, it is the contra party. Therefore, when you buy or sell a futures contract, it is the clearinghouse that matches all the trades at the end of each day. You do not have to find a buyer when you want to sell or a seller when you want to buy. The clearinghouse is also responsible for licensing delivery terminals. Since your financial obligation is to the clearinghouse, it sets the amount of money you must ante up to hold a position. This, of course, is called margin money. Most clearinghouses are corporations owned by the exchanges they serve, and each exchange has a margin committee. You must trade through an FCM (futures commission merchant), who has a financial obligation to stand behind your trading activity. In other words, the clearinghouse sets a minimum margin requirement for each contract, which is usually accepted by the exchange’s margin committee. But your FCM and its IB (introducing broker) have the right to increase the exchange minimum at their discretion. The amount of the margin can be adjusted at any time to reflect market conditions. The more volatile the market, the higher the margin tends to become. Margins on futures contacts are considered low by most standards, which generally encourages liquidity. You might be required to deposit only 5 percent of the value of a contract. This creates enormous leverage, which can be a boon or a bust. I will provide some examples and more details in a later chapter. For a scale trader, it is important to know who the players are in the futures game. Each has a specific role that can be very beneficial to the trader.

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The players you generally hear most about are the speculators. Speculators come in two stripes—the professional and the amateur. If the pro trades on the floor of the exchange, he or she is usually a scalper. Scalpers seek SIPs (small incremental profits). They hold positions for very short periods of time (seconds or minutes) and rarely take positions home overnight. In the securities business, they would be the equivalent of day traders. In the pits, they perform two important functions. First, they are the price police. Whenever there is an imbalance in price, they jump on it, attempting to take advantage of the disparity. Second, they provide liquidity when it is most desired by the scale trader. There are certain times when the market as a whole is uncertain as to what the price of a commodity should be or whether a price trend should continue or reverse. At these times, prices oscillate up and down. These incidents often occur at areas of price support or resistance. It is at these times that scalpers become extremely active, providing liquidity. You will be taught in a later chapter how to take advantage of these opportunities to enhance your returns. Scalpers in the pits are also referred to as locals, simply because most of them are of local origin, unlike floor traders hired by larger firms, who are often recruited from other locales. The second type of professional trader either trades for his or her own account or for others. The best way to get inside the mind of these traders is to read Jack Schwager’s books Market Wizards and New Market Wizards. Both books are a series of in-depth interviews with several of the world’s foremost futures traders. None of them is a scale trader, but reading the books will give you a unique insight into how these people think and trade. Knowing this, you will eventually be able to feel when these pros are entering markets and why markets move the way they do. Price patterns are no more than a reflection of the emotions of everyone trading at that point in time and space, and the market wizards are often the leaders of the pack. Some wizards trade for investors. They become CTAs (commodity trading advisors) and trade very large pools of money. Other professionals trade for large trading firms and institutions, like pension funds. A few CTAs provide professionally managed scale trading programs. Trading large amounts of money, often tens of millions of dollars, magnifies the impact of the pros.

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The amateur speculators also fall into two categories—fullor part-time. They can be further divided by the time frames they trade. The full-timers tend to be nerds in the sense that they either have a computerized, technical trading system that they developed themselves or acquire a proprietary system, such as Traded Station by Omega Research. The trading systems this group uses may be of any time frame. The part-timers tend to be in the game seeking large, quick profits, but they are not, as a rule, serious students of the markets. Often heavily influenced by their commodity brokers, many of them are in reality gamblers. Their time horizon tends to be short term. Again, both add liquidity at just the right times, which is extremely important as you will see when I discuss strategies. The market segment of most importance to the scale trader is the commercials. These are businesses that actually use the commodities represented by the futures contracts being traded. They use the futures markets to manage risk and control the flow of the underlying entities they need in order to produce the products they make, sell, or own. As mentioned earlier, silver is used to make film and electrical devices. Grain merchants, livestock producers (beef, chicken, turkey, pork, etc.), bakers, and cereal manufacturers must have corn and wheat at reasonable prices and when it is needed to meet customers’ demands. Refineries cracking crude oil into heating oil and gasoline cannot leave price and supply to chance. Importers, exporters, banks, and even countries have a need to trade currency futures. Major stockholders, such as pension and mutual funds, banks, securities brokerage firms, and retirement plans, all hedge the risk of price fluctuation by trading stock index futures contracts. All these commercials have a strong financial use for what they trade, and most of them are large and well financed. They are staffed with well-trained professionals using the best trading tools money can buy, even to the point of having satellites photograph the key growing areas around the world. The futures contracts they buy are said to be “held in strong hands” compared with speculators who are nowhere near as flush and only seek a quick turnaround using their intuition more than anything else. For all these reasons, the commercials have the wherewithal to take more heat (adverse price pressure) than the amateur does. More important,

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these professional players are longer-term traders, as are scale traders. Therefore, you will learn how to find out what commercials and larger traders are doing and input their activity into your trading. Since many of the commercials use the underlying entity in their business, they are true hedgers. Once hedged, they hold their positions unless something extraordinary occurs. This is another sign of their strong hands and the conviction of their commitment to a specific contract. As you will learn, the commercials can tell you when the light at the end of the supply-demand tunnel is lit. You do not always find this steadfastness in the farmerhedgers mentioned in the Introduction. My personal experience with farmer-hedgers was not gratifying. They often started as legitimate hedgers, selling on the futures market when corn prices soared on a summer rally. But when the rally ended and prices retreated, they often wanted to offset their short positions and take profits. That made their long, physical position growing in their fields naked. Now they were speculators. Their hope was, of course, for another rally, giving them a chance to hedge again. This does not always happen. The problem, and something you will have to address yourself, is staying true to your trading strategy. The scale trader who gets lured away from scale trading into speculation will eventually regret that decision. But sometimes it is very tempting. For example, you have created a scale and you have five or six long positions. The market rockets north. The scale trader is supposed to methodically exit each position at a stated price, which was specified in the scale. But with such a bull market raging and six long positions on his or her hands, it is tempting to hold those positions for the maximum profit. More often than not, you will be whipsawed. This is when prices move in one direction and you attempt to react to that move. About the time you do, the trend reverses itself, producing a severe loss in your adjusted positions. If you are going to scale trade, then scale trade. If you are going to speculate, then speculate. Never try to do both at the same time, particularly in the same account. I will show you how to set this up later, if you have the inclination. The last player you should become familiar with is the broker. I describe later in detail what scale traders need from brokers and how to select them, but right now I want to make sure you

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understand their point of view. Brokers are primarily salesmen. Like all salesmen, some are helpful and interested in the success of their clients, and others are simply hyping trades for commissions. The brokers who will take scale trading accounts tend to be above average. Scale traders do not churn their accounts as speculators do. Often scales develop slowly. The broker is expected to keep track of a large number of orders and potential orders. Several markets must be monitored, and the scale trading customers demand large amounts of fundamental and technical information. Many brokers find scale trading too much work for them. The brokers who seek out scale trading business are the ones that believe that scale trading is one of the strategies that provides their customers a better-than-average chance of being successful. They look for longer-term relationships with their customers and have taken the time to learn how scale trading works. Joe Broker, whom you bump into on the World Wide Web or on a cold sales call, will not have a clue. The selection of a broker and his or her brokerage firm is one of your most important decisions. You will learn all you need to know shortly to make that decision successfully. Anyone who trades the market must have a strategy or a system. Yours is laid out in this book, but let’s look for a moment at how others do it so you will be able to recognize what is happening as price trends fluctuate. In theory, futures trading is simple. Buy low; sell high. Sell high; buy low (see Figure 1-1). The only fly in the soup is figuring out what is high and what is low, and doing this in advance of the next market move. Over the centuries, an enormous amount of time, energy, and money has been expended to answer this question. Judging by the fact that most futures trades lose money, it has not been solved. There are two main disciplines used to project future prices and trends—fundamental and technical analysis. You will be taught to use both in your scale trading. But now it is time to review briefly the key elements of both. Fundamental analysis is the study of all the underlying factors that can possibly influence the supply-demand equation. For example, fundamental technicians build models of the supply and demand chain. First, they define all the elements. Then they gather

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FIGURE

13

1-1

Just Buy Low and Sell High or Sell High and Buy Back Low

Sell @ $4.00/unit

Buy @ $2.00/unit

Sell @ $4.00/unit

Buy Back @ $2.00/unit

Futures trading is often described as simply buying low and selling high or selling high and buying back low. In practice, determining when a commodity is about to trend higher or lower early enough to take advantage of that trend has proved somewhat elusive for most speculators.

all the data and compare total supply and total demand to determine how much will be left over at the end of the year. This is called the carryover. A calendar year is rarely used. A fiscal year that closely resembles the supply-demand cycle replaces it. For example, for a field crop like corn, supply comes from harvesting the crop. Therefore, the U. S. Department of Agriculture (USDA) sets the crop year from October 1 through September 30 of the following year. Although some corn in southern states is harvested before October 1, the main crop coming out of the Midwest usually begins harvest on or about October 1. Once carryover is known, it is compared with historical price levels at similar carryover ranges. The analysts then forecast the next year’s production to determine demand and carryover for the next crop year. Using this equation and comparing how prices behaved in the past under similar circumstances, they project the coming year’s price ranges. It does not take a market wizard to realize that a lot can

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happen to modify either supply or demand over an extended period of time. Nevertheless, fundamental analysis tends to be very useful for projecting long-term trends, patterns, and cycles. Technical analysis is the study of all the underlying statistics generated from the trading on the various futures contracts. It is used by most traders as a trade-timing tool. If fundamental analysis is the “what” of where prices are going next, technical analysis is the “when.” Since most futures traders are short-term traders and timing is critical to them, most use some sort of technical analysis. On the other hand, most long-term traders use fundamental analysis. Leading among them are the grain merchants and commercial users. It is for this reason that you, as a scale trader, will pay particularly close attention to them. But you will also use technical analysis for timing and to be alerted to other trading patterns you can use to your advantage. Besides the timing factor, futures traders use technical analysis because it provides precise signals. Do not confuse precise with accurate. When foretelling the future, there are no fail-safe techniques. Experienced commodity traders rely on technical analysis to warn them when they are wrong or when a trade is going sour. They follow the axiom: “Cut your losers short; let your winners run!” Technical analysis is good at this, and fundamental analysis is not. For example, if a trader gets into a trade, technical analysis will indicate where to exit the trade if it is failing. There may be a key trend line or a price support level, and if either one of these is violated, the trader should exit the trade. On the other hand, if your fundamental analysis tells you copper is a good buy at 48 cents, it must be a great buy at 30 cents. But if you are down 12 cents or $3000 (25,000 lb.  $0.12), you may not be ready to open another long position, unless, of course, you are a scale trader, which I’ll get into in Chapter 3. My point is that there are only five possible outcomes to a trade. You can make a big profit, make a modest profit, break even, or take a small loss or a large loss (see Figure 1-2). Technical analysis is great at eliminating one of these results—the large loss. The theory then states that if you limit your trading exposure to only the other four possibilities, you will be a net winner. This does work for the most disciplined of traders. My experience has been that all too many traders hold small losers until they become

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FIGURE

15

1-2

The Possible Results of a Trade

Large Profit Small Profit Breakeven Small Loss Large Loss

There are only five possible outcomes for any trade: (1) a large profit, (2) a small profit, (3) breakeven, (4) a small loss, or (5) a large loss. A trader can substantially improve his or her chances of success by totally avoiding large losses. Technical analysis, used with discipline, can virtually eradicate large losses as a possible outcome.

account busters, and this is one of the primary reasons most futures traders are net losers. You will be happy to know scale trading eliminates this negative behavioral pattern. Still, I am not saying you cannot lose in scale trading. The most widely used tool of the technician is the futures price chart. There are basically three types of charts: line, point and figure, and bar. The one most used and the one used in scale trading is the bar chart; it is the only one we need to deal with in this text. To understand how to use charts, you must make a few assumptions. First, you must accept the concept that the market is efficient, meaning it immediately reflects all the news, facts, rumors, and developments impacting prices on a real-time basis. The trueblue technician does not have to look anywhere but to the charts to know everything there is to know about the price of a futures contract. Charts of course cannot distinguish between incorrect news and correct news, any more than the floor trader can. But it really does not matter, since either has the power to move the markets. Second, you must think of the charts more as a barometer than a thermometer. Rather than just telling you the temperature of a

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market, the charts tell you that upward or downward pressure is changing and that the prices you see indicate the future, rather than the present. This means the market anticipates where prices should be at some time in the future, as opposed to the cash markets, which tell you what they are at the moment. For the scale trader, the charts are prognosticating changes in the supplydemand equation. Finally, prices tend to trend, and the longer the trend, the more reliable it is. These are important assumptions for the scale trader. As you will see in Chapters 3 and 4, you will be looking for longterm trends and will be expecting them to continue for a period of time. Eventually, they will reverse, providing you profit opportunities at manageable risk levels. The reason markets trend is simple. They trend up because of greed and down because of fear. Fear and greed rule the futures market. You, as a scale trader, play into these two emotions without indulging in them. Along with fear and greed is the natural propensity of individuals to function as a herd when facing the unknown. Let me elaborate. One trader buys silver because he thinks it is going higher. Others in the pit follow because they do not know any better. The more it goes up, the more buyers there are. Everyone in the pit wants to make a fortune buying silver low and selling it high. Greed creates an uptrend. At some point, a few traders get nervous. Silver is getting expensive. The commercial users quit buying. Speculators halt their buying. Selling begins. The nervous get scared. Fear drives the market lower. Markets tend to fall faster than they climb because fear is a stronger motivator than even greed. At some price point, silver is really cheap. The commercials see profit opportunities and begin to buy again. They have a real use for silver. They can make it into jewelry, electrical components, and photographic film and sell those products at a profit. They do not give a damn what the futures traders think or how scared they are. The market reverses and the scale traders take their profits. When you study the charts, the length of the trend and other signals are important. Trends or trading ranges that are a year or more old are more important than those that are only days, weeks, or months old. The reason is simply that the longer ones enjoy more of a consensus from all the market participants. If wheat has been trading lower for the past two years, the wheat traders must

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have found a reason for that; maybe bountiful harvests worldwide due to excellent weather have kept the carryover from year to year high. Supply is higher than demand is strong. Inflation can play into this scenario as well with the physical commodities, which are the ones I recommend for scale trading. Scale traders look at the last 10 years of price activity in their selection of scale trading candidates. They buy as prices descend and sell as they recover. Over a 10-year period, inflation usually increases the base price of physical commodities, taking some of the risk of them setting new all-time lows. In other words, inflation should mitigate some of the risk of scale trading. But this is not a given. Now let’s take a close look at a futures price bar chart (see Figure 1-3). The vertical axis measures price, and the horizontal measures time. Only trading days are represented. Weekends and exchange holidays are omitted. A single bar, hence the name, represents a specific period of time. It could be a day, a week, or a

FIGURE

1-3

Basic Commodity Price Bar Chart

Commodity XYZ

High

Price

Trading Range

Open Close Low

Open Interest Volume

Time Bar charts are the most basic tool of most technicians. The vertical axis represents price; horizontal, time. Volume and open interest are located below the bar portion of the chart. Charts can be for any length of time, from minutes to decades. Scale traders begin studying charts of at least 10-year duration looking for scale trading candidates.

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month, or it could be just a portion of the trading session, such as an intraday chart generating a bar every minute or every five minutes. The high point of the bar marks the high price for the period. Conversely, the lowest point of the bar denotes the low. The length of the bar is the trading range. A tick extending to the right of the bar marks the close. Some charts have a tick on the left as well, denoting the opening price. Below the bar-chart portion of the overall chart is a series of vertical lines. There is one for each period of time, representing the trading volume for that period. Above the volume is a line designating open interest. Scales measuring the volume and open interest are on the right of the chart. The importance and use of this information to the scale trader is discussed later. Technical analysts study the charts looking for recurring patterns. They believe that certain patterns predict future movement of price. Some chart patterns are so familiar to so many traders that they become self-fulfilling prophecies. Others are more esoteric and less reliable. There are literally hundreds of patterns and formations, more than can be dealt with in this text. But the ones you need to know as a scale trader are covered in Chapter 10. If you wish to pursue this study, you will find some recommended texts in Appendix 2. Before we leave the subject of futures trading, you need to know a little about placing orders. Each exchange has its own rules regarding types of orders allowed and when they are permitted. Here is a brief overview of the possibilities: •

•

Market Orders—This order will get filled the fastest, but you have no control over the pricing. You relinquish your authority to buy or sell to the floor broker after specifying which contract and how many contracts you wish to buy or sell. Limit Order—This order specifies the medium price you will accept. Buy limit orders are placed above the market and tell the floor broker you will accept only a certain price, e.g., “Buy five November corn contracts at $4.57 or better.” Sell limit orders are placed below the market and specify your minimum price, e.g., “Sell 10 December copper contracts at 55 or better.” Or better on a buy order

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•

•

•

•

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means at the designated price or less than the limit price; on a sell, it means at the limit price or higher. Stop Orders—These orders become market orders when a specific price is hit, e.g., “Buy three June crude oil contracts at 33 stop.” When June crude hits 33, that order becomes a market order and can be filled at any price. Market-if-Touched (MIT)—These orders are similar to stop orders. They are activated when the price specified is touched and become market orders at that time. Stop Limit Orders—These orders combine the stop and the limit order. When the stop price is hit, they become a limit order, e.g., “Sell June gold, stop 410, limit 405 or better.” Time Limit Orders—Here you are putting time limits on when the order can be executed. Some of those limits are: Kill or Fill (fill immediately or kill the order); Market on Open/Close (each exchange has a designated time, such as the first or last 15 minutes of trading, during which this type of order must be filled); Good Till Canceled (GTC orders stay in the market until filled or canceled); or One Cancels Other (the second order cancels the first). The priority for filling the different types of orders is market orders, stop orders, limit orders, and time or price limit orders.

It behooves you to take the time to understand how the futures markets work and who the players are. As a scale trader, you must learn to take what the market gives you. It is almost a passive role compared with that of the more aggressive speculators. It is not unlike the commercials, who know what they want from the market and patiently wait for it to give it to them. All things come to the patient.

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The Derivative Markets— Options-on-Futures

O

ptions-on-futures are vital to a hedged scale trading strategy. You must master this subject; it is your insurance policy. In this chapter, I will teach you the science and the art of options trading. The science part of the equation is having an understanding of how options work for and against you, specifically time decay, volatility, liquidity, and the rules of trading. The art of trading is harder to share. It is the intuition that comes from years of trading and following the market. Nevertheless, I will attempt to get you inside the minds of the major players so you know how the pros look at options, compared with the way the general public does. Once you know how they think, you will be able to act, as opposed to react, to the market. This allows you to make more prudent selections of options. When you do that, you will buy better, cheaper options that will provide more protection to your futures positions. An understanding of options requires you to memorize the following 20 words: Long call  Right to buy Long put  Right to sell Short call  Obligation to sell Short put  Obligation to buy That is it. Memorize those 20 magic words and you will never get lost in an option maze. 21

Copyright 2001 The McGraw-Hill Companies, Inc. Click Here for Terms of Use.

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An option is simply a contract, just like a futures contract. There is a buyer and a seller. Money is exchanged to obtain certain rights, and money is accepted to assume certain responsibilities. The time frame and price are set, as are the details of what is to be sold or bought. Think in terms of a real estate transaction. You want to buy a 10,000-square-foot parcel of land in a shopping center. But you do not have your financing in place, nor do you have approval for the building you wish to construct. You really believe the location of the parcel is perfect for what you want to build, but you need time. What do you do? You go to the owner—or have your real estate broker do it for you—and see if he or she will give you an option on the land. You want three months and are willing to give the owner 5 percent of the asking price. Additionally, if you exercise the option, you agree to pay the owner a specified sum that you mutually agree upon in advance. You have now locked up the property for three months; no one but you can buy it during that period of time. In return, you have paid the owner a premium to hold the property for you. If for some reason you change your mind and can’t get the building you want approved or the financing, you can walk away from the option to buy the land. You lose your premium, but that is all. Or, if everything works out as planned, you exercise your option and buy the land. You might even negotiate a clause allowing you to assign the option contract to a third party before the expiration date. Now, if you were the owner of the land, you would be the grantor of the option. You would receive the premium. You would have the obligation of holding the land off the market for three months and delivering it to the owner of the option at the predetermined price. If the buyer of the option did not exercise the option at the end of the term of the option, you would keep the option payment or premium and put the land, which could be referred to as the underlying entity, back on the market. The option has expired. This is what is known as an over-the-counter option (OTC). All the terms are negotiated between the buyer and seller. Optionson-futures, like futures contracts, are exchange traded. The clearing firm sets all the terms, except price and quantity. The buyer and

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seller decide how many options to buy or sell and arrive at a price via an open outcry auction in the trading pits at the exchange. Naturally, you access the exchange through a commodity broker. Exchange-traded options offer one advantage not generally available to the OTC option buyers or sellers—the ability to trade the option. Conceivably, an OTC option can be sold or traded to a third party, but it is the obligation of the buyer or seller to find that third party. With exchange-traded options, there is usually a buyer or seller immediately available. The key word here is usually. At times and under certain market conditions, you can have a problem finding a buyer for an option, but you will almost always find a seller. All this will make more sense shortly, but it is important to learn why there is a difference. Another advantage of exchange-traded options is that you can play the short side of the market as easily as the long. Try going up to a land owner and telling him or her you think the property in question is going to lose 20 percent of its value and you would like to buy an option to buy it at a substantial discount to the appraised value. You would probably be thrown out on your ear! Now let’s begin defining specific terms of an option transaction. When you pay for the right to buy a long position in an underlying entity, in this case a futures contract, the option is referred to as a call option. A call gives you the right, but not the obligation, to take a long position in a specific futures contract. Since you want to be long, you must be bullish and believe the underlying entity is going up in value. When you acquire the right to a short position in a futures contract, you buy a put. You are bearish regarding the prospects for that futures contract. You think it is heading south (see Table 2-1). Now you must select a price at which you will decide to exert your right. This is called the strike price. The options committee on the exchange on which the options are traded sets the strike prices. They are set at even intervals, i.e., $3.00, $3.10, $3.20, etc., above and below the current market value (CMV) of the underlying entity. As the CMV increases or decreases, more options are added. If a strike price is equal to the CMV, it is described as at-themoney. If a call has a strike price that is below the CMV, it is said to be in-the-money. The strike price of a put would have to be above the CMV to be in-the-money. An in-the-money call or put has

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TA B L E

2-1

Obligations of Buyers and Sellers Option Buyer Pays for the right, but not the obligation, to a position in the futures market at a set price for a specific time period. Risk equals premium paid.

Reward equals maximum amount futures contract can move before expiring. Pays commission and fees.

Option Seller Is paid to assume the obligation to deliver a position in the futures market at a set price for a specific period of time. Risk equals the maximum amount futures contract can move before expiring. Reward equals the amount of premium paid. Pays commission and fees.

intrinsic value (see Figure 2-1). This simply means that these options have real value. You can exercise an option that is in-themoney for a long or short futures position, and that position would show an immediate gain. For example, you own a silver call with a $5.00 strike price. If the CMV of silver is $5.25, you could exercise it, and the seller or grantor of that option would deliver you a long position at $5.00. You have an immediate profit in that position of $0.25. If it is a COMEX contract for 5000 ounces of silver, your account would be ahead $1250. Don’t forget you would have to have enough margin money in your account to hold the new futures position or you would get a margin call. In addition, you pay a commission for exercising your option. The opposite of an in-the-money option is one that is out-ofthe-money. A call that is out-of-the-money has a strike price that is above the CMV. A put is out-of-the-money when its strike is below the CMV. Just think of it as the need for the CMV to catch up to the strike price. In the case of a call, the CMV or the underlying entity must go higher before the call is in-the-money. With a put, the CMV must go lower. As you would expect, an option with intrinsic value is more expensive than one that is out-of-the-money, all things being equal. When buying an option, you must pay for three things. The first is

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FIGURE

25

2-1

Silver Puts and Calls

$6.00

$5.50

$5.00

$4.50

SL $5.50 PUT

SL $5.50 CALL

In-the-Money

Out-of-the-Money

SL $5.00 PUT At-the-Money

SL $5.00 CALL

C U R R E N T M A R K E T V A L U E At-the-Money

SL $4.50 PUT

SL $4.50 CALL

Out-of-the-Money

In-the-Money

$4.00 A put or a call is at-the-money when the strike price equals the current market value (CMV). A call is in-the-money when the CMV is above the strike price. A put is in-the-money when the CMV is below the strike price.

the time to expiration. The longer the time the seller of the option gives you for the option you buy to catch up with the market, the more it will cost—again, all variables being equal. Then there is intrinsic value. If the option is already a nickel in-the-money, the seller will expect you to pay that on top of the premium for time. The last part is the potential of the option to get seriously in-the-money before it expires. This is a function of several variables, the primary one being the volatility of the underlying futures contract, to be discussed shortly. There is a very important negative side to buying options you need to be aware of and that is that they are considered to be decaying financial instruments (see Figure 2-2). In other words, they expire and become worthless. In mid-April, you buy a June $5.50 soybean put for 6 cents when June beans are trading at $5.53. It is 3 cents out-of-the-money. Note that you must always match up the option with the underlying entity by contract month. Options expire on the third Friday of the month. If beans do not drop over 9 cents, you will lose your $300 ($0.06  5000 Bu.) premium. It must be over 9 cents because you would have paid commissions of,

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FIGURE

2-2

Value

Options as Wasting Assets

5

9

8

7

6

5

4

3

2

1

0

Life of Option Options are wasting assets because they eventually expire. Their time value continually deteriorates as they move toward their expiration date. To make money or conserve losses, you must offset or exercise options before they expire.

say, $25 to buy and to sell or a cent per bushel on the transaction. Always figure your transaction costs, which are a commission to your broker, plus NFA (National Future Association) fees (circa $0.25 a contract) when calculating breakeven. Add this to the premium paid and the amount the option is out-of-the-money to arrive at the breakeven price. Key point for scale traders: Options normally expire in the third week of the delivery month, but the underlying futures contracts continue for approximately another week. The last week is often the most volatile, because traders are offsetting positions to avoid being involved in delivery, while those that are delivering or taking delivery are jockeying around. Many experienced traders, depending on the number of traders who have filed notice of delivery, are very active in hopes of catching a quick profit due to the volatility. Since options expire first, your long position would be naked or uncovered the last week if your options are in the same contract month as your futures contracts. In talking strategy in Chapter 4, I will discuss whether you should buy options in the

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next delivery month. For example, when you scale trade July wheat, should you protect those positions with August options? A large percentage of options expire worthless, or the amateur traders hold them until the cost of offsetting or exercising them exceeds their value. Floor traders just before expiration exercise many of these options. It makes money for them because their costs to execute trades are minuscule compared with those of average traders. This practice lowers the statistics on the percentage of options expiring worthless, making the numbers look better than they really are. Don’t let the thought of expiration bother you when we begin using options to protect futures positions as part of an integrated scale trading strategy. The function of the options is to absorb risk, serving as insurance. Like most insurance policies we buy—car, home, accidental death, etc.—we hope they are not used. Nevertheless, we dutifully pay the premiums to be able to sleep at night. Always remember why the options are being used. Speculation is not the answer for the scale trader, even though we can often offset our options at a profit as the price of the commodity moves toward a bottom. Now let’s talk about shorting puts and calls. This will give you a real insight into how the professionals use and think about the options market and how you can evaluate options more accurately. If you can buy an option, someone must be selling. The seller is called the grantor and receives the premium the buyer pays for the put or call. In the example just given, a June $5.50 soybean put was bought for 6 cents. The $300 went into the commodity trading account of the seller. The seller has the obligation to deliver the underlying futures contract to the buyer on demand. If the seller sold a put, he or she has the obligation to sell a short position to the buyer whenever the buyer exercises the option before the expiration date. If the seller sold a call, he or she has the obligation to sell a long position to the buyer whenever the buyer exercises the option at the option’s strike price. If you are a seller, you never know when you are going to be exercised against. Requests to exercise are assigned randomly by most clearinghouses against the sellers. What you do know is that the owner of the option normally needs a financial reason to exercise it. That means the option must be in-the-money far enough to repay at least the premium paid for the option and the transaction

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costs. Additionally, the owner must have a good reason for wanting to convert the option to a futures contract and assume the additional risk. Before this happens, most astute option sellers cover or offset their positions. This is a key insight. In my experience as a broker, the sellers were the ones that made money consistently in options. If a substantial percentage of options expires worthless, someone is the beneficiary. Obviously, it is the sellers. Therefore, you must pay close attention to them, because they set the prices. Think about the degree of differences in risk between buyers and sellers of options. The only risk buyers have is the premium paid for the option and the transaction cost. With the bean option discussed earlier, the buyer pays $300 premium plus $25.25 in commissions and fees. That is it. No matter what happens—soybeans shooting to $15 a bushel or plunging to zero—the buyer has only $325.25 at risk for this $5.50 June soybean put. The seller of that same option has substantially more at risk. The seller must sell a short soybean futures contract to the buyer on demand. Now the buyer owns the $5.50 put, which costs a total of approximately 61⁄4 cents. It will cost the owner one more commission to exercise the option, so soybeans will have to be trading below $5.431⁄2 to entice the owner to exercise it. Further, he or she will want more bearish news to entice him or her to exercise. But what if beans limit down for three consecutive days? The limit move for beans is 30 cents, or $1500 a day from the CMV of $5.53 at the time the put was purchased. At the end of three days, beans would be at $4.63 per bushel. All the owners of $5.50 puts would be screaming at their brokers to exercise (or offset) their options, and the put sellers would be clamoring to buy short positions to cover their exposure. This would naturally drive beans lower. At $4.63 per bushel, one party, the buyers of options, makes a $4050 profit and the other, the sellers, loses $4050 ($0.87  5000 bu.  $300 premium). Why on earth would sellers of options in their right minds risk losing $4000 or $5500 or more to gain $300? If the option grantor sold calls, it could be even more devastating. A short position can only go to zero, whereas long can go as high as infinity, theoretically. In reality, soybeans have traded at over $12 per bushel and silver at over $50 per ounce.

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To be blunt most options buyers do not understand options! This is my opinion, based on years of being a commodity and securities broker. Too many buyers do not take the time to evaluate the potential of the options they buy. There are many, many inexpensive software packages on the market that will calculate fair market value and rate all the options available as to their potential. Is this the silver bullet to trading options? No, there is none of course. But this is the minimum a trader should do. What all too many part-time traders do is listen to their broker. The broker raises their greed level while taking fear out of the equation. The option buyer has unlimited upside potential when buying calls, at least theoretically. Risk on the other hand is limited to the premium paid. I call the upside theoretically unlimited because I have never seen a commodity increase in value to unlimited heights. The closest I recall is silver when it hit $54 an ounce. But it took most of the Hunt family, with the help of a few Arab princes, in an attempt to corner that market to get it there. Even so, it did not reach $75, $100, or $500 an ounce. Brokers share overly rosy scenarios of the prospects for a commodity. Most are built on fundamental analysis, which is often easier than technical analysis for nonprofessionals to understand and believe. “The analysis of our research department, headed by Dr. Jones, indicates sugar, now trading at a dime, is headed to 60 cents a pound. You’ve seen reports in the paper about the draught in Cuba, haven’t you? For just a few thousand dollars you can buy a dozen 15-cent calls. You can’t lose! You have no downside risk!” Well, of course, they can lose. Their entire investment is in a wasting call option, meaning a potential loss of 100 percent of what is invested in options. Second, how much time will it take sugar to move up 600 percent? What are the odds that it will before the option expires? Worse yet, if the mark does not have “a few thousand” handy, the broker will sell him or her an option that is even more out-of-the-money at a lower price that has even a worse chance of getting into the money. Further, the premium and high commissions charged by such brokerage firms must also be recouped before this option player is ahead. My point is simply that there are an awful lot of options sold that have only a remote chance of making money for the buyer. Consequently, a high percentage expire worthless. You can bet

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the farm that the seller of the option facing the risk of sugar skyrocketing from 10 to 60 cents a pound—a 50-cent per pound loss (112,000 lb.  $0.50  $56,000)—gave some thought and did some analysis before offering to sell call options. Key insight: Buying is emotional; selling, intellectual. In the case of the sellers of options, fear of loss sharpens their analytic skills. Lack of fear on the part of the buyers dulls their senses. Buyers lose because they must predict exactly what will happen; sellers win because they must predict what most likely will not happen, which is far easier. The second biggest mistake amateur option traders make is holding their positions until expiration. They are always hoping their positions will miraculously appear in-the-money one fine morning. Too many think of trading options as gambling. They make a bet of a few hundred without ever considering offsetting losing positions to salvage at least some of their investment. After all, you cannot offset a bet. The pros are traders in the truest sense, constantly adjusting their positions as necessary. If an option they own is obviously not going to be a winner, they offset it to salvage what they can before it expires worthless. Finally, those new to options do not realize that investors can lose trading options even if their analysis of the direction of the market is absolutely correct. Why? Several things can happen. First, as alluded to earlier, they can get talked into an option that is too far out-of-the-money, one that is deep-out-of-the money by two, three, or four strike prices, which would require a move of at least 6 on the Richter scale to make it worth offsetting or exercising. Another possibility is that it does not have enough time left on it and it will expire before it gets into a profitable price range. Or the option in question is bought in a commodity that is trading in a tight trading range, meaning little or no volatility. It was “sold” to the investors because it was cheap, not a good reason to buy any investment. In this case, the price of the options remains dormant. In other words, there are several key elements that influence the price of an option. Let’s discuss the most important of them. Time value may be the easiest to understand, so let’s start with it. When it comes to time, I always imagine options as blocks of ice of various sizes—100-, 200-, or 500-pound blocks. The longer they sit in ambient temperature, the more they melt. Some last for hours

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and others for days. But before you know it, all you have is a puddle of water that is evaporating—then nothing. All options decay over time. Having a fix on the odds of an option moving into the money, particularly deep into the money, before expiration is crucial. Knowing the odds is one of the key reasons the seller is willing to sell. When time erodes, the seller keeps your premium. The next key element is the strike price. Where is it? In-themoney? Deep-in-the-money? At-the-money? Out-of-the-money? Deep-out-of-the-money? Obviously, the more it is in-the-money, the more you will have to pay for it. Out-of-the-money and deepout-of-the-money options tend to be inexpensive. Why? The sellers doubt they will be enough in-the-money by expiration to be exercised or offset. The fact that the majority of options expire worthless attests to the correctness of this assumption. The definition of a deep-out-of-the-money option, by the way, varies by exchange. But the most common way of defining it is as an option that is two strike prices out-of-the-money plus one more strike price for each month left to expiration. For example, corn strike prices are 10 cents apart. If the CMV of corn is $2.50 and it is September, any September calls with strike prices above $2.70 would be considered deep-out-of-the-money, as would any December calls with strikes above $3.00. Puts are classified the same way, but in the opposite direction. All September put strikes below $2.30 and December puts below $2.00 would be deep-outof-the-money. Keep in mind that deep-out-of-the-money options are considered so risky by most exchanges that they require brokers to get additional disclosure from clients who trade them. This disclosure states that these options have a very remote chance of becoming valuable. This procedure is also followed to prevent unscrupulous brokers from selling uninformed customers worthless options just because they are cheap. Remember, the broker gets the same commission whether an option has a chance of becoming a winner or not. There is another problem with deep-out-of-the-money options, which leads us to the next key element. Liquidity is the amount of buying and selling that is occurring, in this case the amount of demand for a specific option. With options, there is always a seller but not always a buyer. Take a second to look at the

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futures pages of the Wall Street Journal and Investor’s Business Daily. Find the options section and the volume of trades for some of the out-of-the-money options. You will be surprised at how low it can be on any given day. To speculate in options, you need liquidity to allow you to get in and out of trades. As a scale trader, you are buying insurance and waiting patiently for the market to come to you. At times, liquidity is not as important, which means you may be able to pick up some real bargains. I will discuss this further in Chapter 4. When you buy an option, you tie up your capital. You do not earn interest on the money used, and the holding period can be for several months or even longer. Therefore, the current interest rate can play a part in the traditional formula used to determine the fair market value of an option, particularly options of securities. Securities also pay dividends. With futures, because of the high leverage and lack of dividends, neither is an important consideration. The key element is volatility. I talk a lot about volatility in this book because it is the scale trader’s best friend. Without it, the scale trader withers and dies on the vine. Volatility is simply a measure of the tendency of the price of a futures contract to move up, down, or sideways. The more prices gyrate, the greater the volatility. The greater the volatility, the more valuable options become, because there is a greater chance of an out-of-the-money option becoming an in-the-money option. The best friend of the seller of options is no volatility at all or at least low volatility. Then the options price goes nowhere and the seller collects the premium. One of the most common ways of measuring volatility is calculating the standard deviation of price from the means. The classic example illustrating this concept is the flip of a coin to determine normal distribution of heads and tails. Extensive experimentation has proven that no matter how many times you flip a balanced coin, you have an equal chance of getting a head or a tail. Once you determine normal distribution, you can calculate deviation from the mean, thus providing a measure of volatility. For example, flipping a balanced silver dollar 225 times—15 separate series of 15 tosses each—produces the following theoretical results:

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Series #

# of Heads

# of Tails

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15

1 2 3 6 8 7 10 11 9 5 6 4 2 1 0

14 13 12 9 7 8 5 4 6 10 9 11 13 14 15

With each repetition of this experiment the results vary, but the majority of the time they will be remarkably similar. The most common occurrence will be somewhere in the middle of the spectrum. Flipping all heads or all tails would be a 32,000 to 1 event. It is the normal distribution that needs to be described. It can be charted on a graph generating the well-known bell curves (see Figure 6-1). Additionally, lognormal distribution is used to reflect inflation, skewing results slightly to the positive side. Normal distribution represents a statistically valid estimate of what can be expected. The key word is estimate. The peak of the bell curve represents the average price data. The mean is calculated by multiplying the number of event-results on one side (either the number of heads or tails in the coin flipping example or say, closing prices in the case of a futures contract) by the number of flips and dividing the total by the total number of event-results. Here are the results if we use the heads event-results: Flips 11 22

# of Heads Event-Results  

1 4

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33 46 58 67 7  10 8  11 99 10  5 11  6 12  4 13  2 14  1 15  0

            

Totals 75 563 divided by 75 

9 24 40 42 70 88 81 50 66 48 26 14 0 563 7.5067

The mean or average is approximately 7 1⁄ 2 or half of 15, as logic and experimentation dictate. That is what we expect when we flip a balanced coin. It also provides the data needed to construct a bell curve. The area within the bell curve defines all the random price moves that would fall within one standard deviation from the mean or 68.3 percent for all occurrences. Therefore, approximately twothirds of all price activity should occur within the bell curve, which is calculated using all the price data available over a selected period of time. It could be a day, a week, a month, a year, or all the price history available. It is important to study various time frames of volatility to establish patterns and determine what the normal ranges are for the option and the underlying entity being traded. This is a key insight, as you will see later. The flatter the curve, the more price diversification or higher volatility. Or the narrower the pattern, the less prices are diverse. There is no need to worry about learning how to calculate bell curves. You can find volatility charts on various Web sites on the Internet (e.g., www.optionetics.com). Additionally, there are other ways of evaluating volatility (see Table 9-1). My point is that as a scale trader you want to trade commodities with reasonably high volatility.

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Additionally, scale traders must become sensitive to the different types of volatility. Since it is basically a result of a mathematical calculation, it is a snapshot frozen in time. A minute, an hour, a week, a day, a month, or a year from the time the calculation is made, the bell curve could change, perhaps even drastically. Also, with physical commodities there are times of the year when their prices are more volatile. The price activity of grains, for example, increases when supply begins to dwindle and production is in question. In the summer, crops are growing to replenish supply, and natural disasters, such as draught, threaten production. This is referred to as seasonal volatility and provides the scale trader some excellent profit opportunities, as you will learn. There are also historical and implied volatility. I like to compare one against the other to see how the current situation reflects the long term. Historical volatility uses a long series of price data points in its formula—let’s say the closing prices for the last 200, 100, and 30 trading days. Has volatility increased, decreased, or remained constant? Are there any discernible trends? Take these charts and juxtapose them against implied volatility charts, which use only current data. How do they vary? Historical volatility charts tend to smooth out the data and give you an insight into your worstcase scenario. What volatility does not tell the trader is which way prices are likely to go. Millions of dollars have been expended over the years to create computer models that predict price trends. To my knowledge, none has been remotely successful over any sustainable time span. It is still a random walk down State Street as far as futures are concerned. There are two other conclusions most serious students of the futures market agree upon that reinforce the random price theory. First, prices defy artificial manipulation over the long term; eventually supply and demand come into balance. In other words, attempts to corner markets have failed, as have attempts by governments to artificially support or maintain prices over long periods of time. Eventually tides, time, and supply-demand conquer all. The second conclusion is that prices, in terms of dollars, should generally be skewed toward the positive side of the mean to be realistic, using lognormal distribution because of price inflation and other upward pressures. This is particularly true for real,

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consumable commodities, those that should be scale trading candidates. As you will see, taking advantage of these axioms is one of the strengths of scale trading, as is capitalizing on volatility to capture oscillating profits. All this discussion leads us to the concept of fair value. How do the professional options traders decide what the fair value of an option is? The most common answer is by using the Black-Scholes formula or a variation of it. Basically, the Black-Scholes model takes four known variables and solves for the fifth. The variables are 1. The time to expiration of the option 2. The price of the underlying entity (a futures contract for us) 3. The exercise or strike price of the option being evaluated 4. The carrying cost (interest rates, dividends for stocks) of the underlying entity 5. The volatility of the price of the underlying entity It is obvious that, for options-on-futures, four of the variables are immediately available—time to expiration, price of the futures contract, strike price, and carrying cost. The last one is negligible for futures because the amount traders are allowed to leverage on a futures contract is so high and no dividends are paid. That leaves volatility as the wild card. It is a problem because it is constantly changing and you can use implied or historical volatility. In most cases when calculating fair value, use implied volatility because it reflects the current market situation. Running the formula produces a price, which is called fair market value. All things being equal, that is what an option should cost. You then compare it with the current market price and see if the option is over- or underpriced. Seems simple, until you factor in supply-demand for that particular option and realize the fair market price you calculated is static while the market is dynamic. As a scale trader, knowing fair market value helps you evaluate options, as you seek to buy those that are undervalued. Buying the cheapest insurance you can get is important as long as the coverage matches your needs. Since we are dealing with fungible contracts, there is no problem. Also, there is no need to worry about being able to calculate the Black-Scholes model. There are many inexpensive software

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packages available that will do that for you. Many of these packages will even rank the options being appraised for you. See Appendix 2 for some sources. After comparing fair value to current market value and selecting potential option trading candidates, the speculator often calculates a breakeven price. How far will the underlying entity have to increase or decrease for the trader to get his or her money back? What are the odds of that happening between the buy date and the expiration date? Breakeven for buyers is determined by adding the premium and the transaction cost to arrive at a total investment. For call buyers, this figure is added to the strike price. Once the underlying entity reaches that price, the owner of the call is at breakeven (see Figure 2-3). For put buyers, it is just the opposite. The total investment is subtracted from the strike price. Once the underlying entity trades at that price, the owner of the put is at breakeven. For speculators, the breakeven point is a good place to totally reevaluate the trade. How has volatility changed? What is the trend of the underlying futures contract? How strong is momentum? Is the trade going as planned or is it weakening? The trader can bail out at this point and recoup the total investment. Combination trades, using calls and puts together, are a little more complicated, but basically they involve netting out what is paid out and what is collected. Now we are getting into some basic strategies. What is going on in the minds of the various option players? How do traders expect to make money trading options, and how does each help the scale trader? The simplest players to understand are the rank amateurs mentioned earlier. They are the dentists of Peoria and the florists of St. Louis, who can’t get away often enough to gamble. A broker gets hold of them, delivers a good story about why heating oil is about to skyrocket in price, raises their greed level, and sells them some calls. Buying a call is a bullish strategy. It has theoretically infinite upside potential and predetermined downside. The underlying entity can increase in price to any level (theoretically), but all that can be lost is the premium along with the transaction costs. Of course, what can be lost amounts to only 100 percent on the investment. Some brokers, sad to say, do not call this fact to the attention

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FIGURE

2-3

Breakeven Analysis

Buying an at-the-money call in the Futures Market Assumptions: Traders outlook is bullish for gold. COMEX $400.00 call priced at $12.00 per ounce. Commissions and fees amount to $25.00 Premium ($12.00 x 100 oz.) Commissions and Fees Total Investment

$ $

1,200.00 25.00 1,225.00

Breakeven — gold must increase $12.25 per ounce. Profit

$1,225 Breakeven $1,225

Loss 55

$340

$360

$380

$400

$420

Per Ounce Price Note: Analysis does not take time value into consideration, since it is virtually impossible to calculate with any exactitude. Maximum Gain, Loss, and Breakeven Chart: Basic Call*

Basic Put*

Long

Short

Long

Short

Maximum Gain

Infinite

Premium

SP - Premium

Premium

Maximum Loss

Premium

Infinite

Premium

SP - Premium

*SP = strike price

of their clients. They talk about limited risk involved in options trading, but this is misleading, to my way of thinking. These amateurs rarely buy puts, which is a bearish strategy. Again, the risk is predetermined, but the maximum profit potential is limited to the difference between the strike price and zero. The

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only futures contract that was estimated to have traded below zero was the onion contract. It once traded so low that the value of the bags the onions were packaged in exceeded the bids. Michigan farmers were so outraged that they got their congressman, Gerald Ford, to get the contract defrocked. Amateurs rarely sell options, which are considered by the industry regulators to be very high risk. If one sells a call, for example, the underlying entity (the futures contract) can gain an infinite amount of value by the time the grantor of the option is exercised upon and required to deliver a long futures position. Selling a put has a similar risk. The futures contract can drop through the strike price of the put sold all the way to zero, and the grantor would be on the line to deliver a short position priced at the strike price. In other words, the grantor of the put would be obliged to make up the difference between the strike price and zero in cash. Reality check: The pros who do the selling are often the traders who make the most profits. Remember, a large percentage of options expire worthless. In addition, the pros stay on top of their markets and cover naked positions the minute their positions appear to be in harm’s way. Responding rapidly and unemotionally is a hallmark of a professional trader. The pure amateurs add liquidity to the market. Since it is primarily on the long side, it does not provide much value to scale traders who buy puts to protect long futures positions. But there is another group of amateurs that is more helpful—the semiprofessional traders. These are the serious options players who work hard at understanding exactly how money can be made trading options. They are not professional in the sense of being licensed to trade as a broker or commodity trading advisor, but they are every bit as serious. Some derive their entire livelihood from their trading. These traders add liquidity to the market but do it with a much wider variety of strategies; they improve the liquidity of both the put and call sides of the market, often at the same time. They buy puts but, more important, they sell them and also use a variety of strategies that combine calls and puts simultaneously. I want to briefly outline a few of the most prominent of these strategies so you will recognize them in the market and understand the motivation of these key players.

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40

One characteristic of the serious options players is that they just do not see much value in time. When you study the option price quotes in the paper or on a computerized trading platform, you will see that the in-the-money and near in-the-money options on the nearby contract are the ones most in demand; they are priced the highest and have the most trading volume. Options that have six or nine months left on them are not priced two or three times higher. As matter of fact, they are lower; the demand is not there. Trading volume, again, is not high for the distant options. The majority of the trading action centers around options with less than a few weeks to expiration, whose strike prices are near the current market value of the underlying entity. Does that tell you where the scale trader should be looking for bargainpriced insurance? The pros trade the nearby options and the amateurs the distant because the pros need the liquidity and volatility the nearbys provide. To trade the nearby options, you must be in constant contact with the market, spending a good part of the trading day monitoring positions. Amateurs cannot devote that much time to the market. Therefore, they buy positions with two, three, or six months or more to expiration and sit on these positions. Another characteristic of the pros is that they often use strategies that have some risk management built into them. This is done through the use of combinations of puts and calls bought or sold simultaneously. There are five basic ways to spread commodities: Spread

Example

Intercommodity Intracommodity Interexchange Interdelivery Intermarket

Long corn/short wheat Short July corn/long September corn Long CBOT wheat/short KC wheat Long July/short December Short CBOT corn/long CBOT corn

One of the nice things about spreading futures and optionson-futures is that for the most active spreads, there are brokers who specialize in them. This means your broker can call an order to the floor and just state the spread desired. For example: “Spread August/December hogs calls 2.” The fill will come back buying August hogs and selling December calls with a two-tick spread. It

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is so fast in the most actively traded spreads that it is possible to day trade them. The first contract mentioned is the long and the second is the short. The following list names a few of the most common spreads and describes how they are used: •

•

•

•

Volatility Spread–—Buy a put and a call at the same strike price at-, near-, or in-the-money. The expectation is that news will hit the market and drive prices up or down, but the direction is unknown. The news causes increased buying and selling, moving the market one way or the other. You close the losing position and ride the winner. If the news does not materialize, you lose. Time Spreads—Sell a put or a call near to expiration and buy a put or a call in a more distant month at the same strike price. The intent is to sell time. The more distant option loses value at a slower rate and covers the short position. When the short expires, you offset the long. The trader profits if the underlying commodity stays relatively stable, but loses if the futures price moves against the option position (i.e., higher for puts and lower for calls). Bull and Bear Spreads—Bulls are long the nearby deliver month and short the distant. The expectation is that the underlying commodity’s price will rise, driving the nearby higher faster than the more distant, yet the nearby position is protected from a catastrophic move in the opposite direction. When the nearby gains against the distant option, both options are offset and the net gain is the profit. Bear spreads are run in just the opposite manner. Straddles and Strangles—Long straddles involve the purchase of a put and a call for the same commodity at the same strike price and expiration date. Like the volatility spread, the objective is to take advantage of a major move without knowing the direction. With the short straddle, you sell instead of buy, anticipating little or no price movement, so you can collect the premiums. Yet you have some protection from the unexpected by being on both sides of the market. The strangle strategy is similar to the straddle, but the options are out-of-the-money and at

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different strike prices. This is most commonly played on the short side. Its advantage over the straddle in very volatile markets is that the options are out-of-the-money, which provides a cushion. Synthetics—This is an option position that creates the same effect as trading the underlying futures. A scale trader could use synthetics in place of futures positions, but the doubling up on commissions might make it inappropriate, not to mention keeping the delta in line. We’ll get to deltas in a second. A long synthetic position is contrived by the purchase of a call and the sale of a put with a common strike price and expiration date. If price goes up, the call gains value, and the premium for selling the put enhances the return. If price goes down, the premium paid for the call is lost, and the put is exercised against. The synthetics short is the opposite (i.e., buy the put and sell the call).

There are a lot of other option strategies, such as butterflies, condors, call ratios, etc., but this should be enough to provide a feel for where the liquidity is coming from. Now let’s turn our attention to a couple of measurements you need to be aware of when opening option positions. The first one that should be covered is the delta, which was just alluded to. The delta measures the difference between the price movement of options compared with the price movement of the underlying futures contracts. It is calculated by dividing the price difference of the option by the price difference of the respective futures contract over the same period of time. For example, the price of an option increases 20 cents when the price of the futures contract climbs 40 cents. Dividing 20 by 40 yields 50 percent. Since the prices of both the option and the futures contract are constantly in flux, so is the delta. It stands to reason that an option that is in-the-money would have a delta of 1 or 100 percent because it could be exercised for the underlying entity. At-the-money options have deltas in the 50 or 50 percent range, depending on the volatility of the underlying futures. Out-of-the-money options or deep-out options have deltas ranging from 50 to zero. The percent sign is usually dropped from the number. Deltas do not exceed 100, since the option cannot be more valuable than the underlying entity.

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Speculators use deltas when evaluating which option to buy or sell. For example, a trader believes soybeans are headed $2.00 higher and wants to buy a call. The delta of one is 50 and another is 60. This means the value of the first option will increase $1.00 and the second $1.20 per bushel. If the latter option costs a dime more, it is a better buy. Or, if the trader is long two call options and is ready to offset one, then the one with the lower delta, equating to lower profit potential, is the one to dump. Now the hedger has a special use for deltas. The term hedger, in the general sense, includes scale traders who use options. To be 100 percent hedged, using options to cover futures contracts, the hedger must buy enough options to cover all his or her risk. Therefore, if the option to be used had a delta of 50, the hedger would need to buy two options to cover each futures position. This provides dollar-fordollar coverage. The tricky part, since the deltas constantly change because the prices of the options and the underlying entities are in flux, is adjusting them to stay 100 percent covered. A useful exercise to further your understanding of deltas is to plot the price of a volatile futures contract (lean hogs for example), the price of the corresponding option, and the delta on a daily basis for a month or so using closing prices. Draw three lines on a single sheet of graph paper, and you will quickly begin to get a feel for the relationship and when you would have to adjust your positions to stay 100 percent hedged. As you do this, you will notice the rate at which the delta increases and decreases as volatility fluctuates. The rate of change of the delta is called the gamma and is calculated in delta points. For example, if an option has a gamma of 10, for each point increase in the price of the futures contract, the option’s delta gains 10 points. That means that if an option has a delta of 25 and the underlying futures contract gains a point, the delta would increase to 35. If you know the gamma, it will alert you to which options are most volatile. A high gamma means a big opportunity for speculators—and big risk. Not what the scale trader is seeking. As discussed earlier, the relationship between the price of an option and the volatility of the underlying futures contract is a key issue. The term to describe this is the vega. You may also come across the term rho. It measures the sensitivity of an option to interest rates. This is usually relatively unimportant for options-onfutures but comes into play when pricing options-on-securities, so

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you may stumble across it. Don’t panic about all this sounding Greek to you; a good option-pricing software package will calculate all these measurements for you, which is something I would strongly recommend. Should you, as a scale trader, try to stay 100 percent hedged? I will discuss the pros and cons of this in Chapter 4, which covers strategies. One of the most important requirements of an option speculator is liquidity. As with any type of trading, you must be able to enter and exit expeditiously. For almost any option, even deep-outof-the-money, you can almost always find someone willing to sell it to you. Finding a buyer, however, can be much more difficult. It is common for amateur option traders to get into, or be talked into, positions they cannot get out of. Another problem with thinly traded options is the use of stops. When you begin to trade futures, you are almost always taught to use protective stop loss orders. These are orders placed below long positions (or above shorts) to offset your position in case the market moves against you. They are necessary because of the volatility of the futures market and the amount of leverage allowed. Traders often carry over this safety precaution when they begin trading options. The problem with using stops in options markets is that some of the options are so thinly traded that floor brokers or locals will spot the stops. They then drive the market down to them and immediately offset them for a risk-free profit at the current market price. When speculating in options, stops are still very important, but they must be mental stops. If you cannot constantly monitor the market, you need the services of a good broker. The scale trader, on the other hand, will often buy thinly traded options. But since the objective of ownership is protection and not speculation, it is not a problem. Additionally, when the scale trader is ready to offset these out-of-the-money options, they are now in-the-money and the market is thick. More on this later. When it comes to the types of orders you can use to buy and sell options, you do not have as much flexibility as you do with the much more liquid futures markets. Most conditional types of orders (price and time limits, market if touched, stops, etc.) are not accepted or not effective. Option traders are usually restricted to

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market or limit orders; the latter are the ones to use on most occasions. You will often hear brokers tell you that your order is not held, meaning that they cannot guarantee a fill. Just keep in mind that most of the liquidity in most options markets occurs during the last few weeks before expiration, particularly the last week. Scale traders will be buying options with months left to expiration that are out-of-the-money. In other words, the markets will be very illiquid, but this will not be a handicap. Chapter 3 takes a look at how traditional scale trading works. As it is taught traditionally, it is very inflexible. The scale trader is expected to begin opening positions at specific prices and to hold them as long as need be for them to become profitable. As you will come to learn, I have a problem with this philosophy.

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Traditional Scale Trading

The theme of most books and articles describing traditional scale trading has been “you cannot lose trading commodities.” This is true if—and this is a giant if—you have an unlimited amount of capital you can tie up indefinitely. Think about that for a second. To the traditionalist, the scale trader is expected to begin buying a commodity, or more accurately futures contracts on that commodity, once that commodity reaches the lower one-third or one-quarter of its 10-year trading range. (I’ll discuss in detail in Chapter 7 when to use the one-third or one-quarter as the starting point.) The scale trader buys on a scale down and sells on a scale up. For example, a scale may call for buying a futures contract on a specific commodity, say corn, every time the commodity’s futures price drops 5 cents. As the commodity descends to make a low, the scale trader adds to his or her inventory of futures contracts. Once a bottom is in place and the commodity begins to move higher, the scale trader sells every time the current market price is 10 cents above the most recently purchased futures contract. The scale trader buys in an orderly fashion on the way down and sells in an orderly fashion on the way up. The objective is to take a modest profit, in the range of $300 to $500, per contract. Discipline replaces fear and greed. The logic behind the program is also sound, to my way of thinking. Properly selected commodities are always in demand by companies that use them to produce the products that they sell. The price is a matter of availability. If supply is too high, prices fall. 47

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At some price point, the commodities become too cheap. Demand builds, while producers of that commodity have been cutting back due to the previous period of low prices. The commodity works its way out of the cellar. The natural law of supply and demand wins. Sounds like a perfect system, doesn’t it? It even suited my previous experiences in the futures market, because it relies on using a combination of fundamental and technical analysis. The fundamentals provide the long-term analysis, while technical signals are used for timing the entry point. Since I had some experience with both types of analysis, I felt right at home with scale trading when I became a commodity broker. Like a lot of brokers, I never set out to be one. I got into the futures industry by working for two firms that specialized in commodity price forecasting, but they were diametrically opposed in philosophy. Thus, I had a wonderful opportunity to master their totally opposing approaches to analyzing commodity prices and acquired the background needed to understand scale trading. A successful scale trader needs to have a good feel for both and know how to distinguish between real, physical commodities and futures contracts. Note that I usually use the term commodities from now on, rather than the more popular futures or futures contract. I do this to get you thinking about real, honest-to-goodness commodities you can feel, smell, eat, and make things out of. I recommend you scale trade only those types of commodities. The term commodities is the old terminology for futures, referring to grains, oil, coffee, sugar, gold, silver, copper, livestock, and the like. As mentioned earlier, the term futures came into vogue when futures contracts on financial instruments (e.g., interest rates, bonds, the S&P, currencies, stock indexes) came into existence. One of the companies I worked for was Doane Agricultural Services, Inc. (DAS). It had three divisions—farm management, market research, and publishing. My work involved publishing, specifically the company’s weekly newsletter, The Doane’s Agricultural Report. The editorial objective of the newsletter was to assist farmers in the management of their operations. This included all forms of help, from information on the latest seed varieties to reports on the annual Nebraska tractor tests, a consumer report on tractor performance.

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The weekly newsletter was the flagship of the publication division. It dealt only with the cash side of the farm commodity markets, and its price forecasters used only fundamental analysis. They had no use for futures; they thought it was gambling and that technical analysis was witchcraft. In the five years I was there, I never once saw a chart of futures prices. Every scrap of fundamental information on the world’s grain and livestock markets was studied and evaluated. DAS even did primary research, through its market research division, into farmers’ planting intentions each year. This figure provides a major insight into the size of the coming year’s crop, which impacts prices throughout the growing season. Additionally, DAS had a superb Washington (D. C.) Bureau headed by Jim Weismeyer (now with Sparks). Reliable intelligence from Washington alerts farmers and traders to what is coming from the Department of Agricultural (USDA) in the way of farm programs. Will acreage be taken out of use and farmers paid to leave land idle? This impacts supply and tells the scale trader the market will eventually be going higher, which is good news. By the time USDA recommends such drastic action, the scale trader is well into a grain scale. USDA also provides reports from agricultural attachés in key crop-producing countries. Again, these areas can have a major impact on commodity prices because they can help the analyst peg supply and demand numbers on a worldwide basis. The other firm I worked for was Oster Communications, Inc. It had two primary products—Professional Farmers of America and Futures magazine (originally Commodities magazine). Professional Farmers of America’s primary product was the newsletter entitled Pro Farmer. It had the same basic purpose as Doane’s Agricultural Letter—predicting farm prices and income—but its philosophy was drastically different. Pro Farmer preached that futures prices are the harbinger of cash prices and the only accurate way to project prices is by studying and analyzing the futures market. The primary analytic tool was technical analysis. One of Pro Farmer’s preeminent missions was to teach every farmer in the country how to use technical analysis to determine when to hedge crop production. The most advantageous time most often occurs during the summer, when commodity prices often soar due to weather scares. Technical analysis can be used by

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farmers as a time tool. It provides a way of selecting the most advantageous time to sell on the futures market. Too many farmers, in the newsletter’s opinion, were strictly cash marketers and sold their production out of the fields at harvest when prices are traditionally at lows. As a scale trader, you will learn to play the seasonal game to your advantage. In other words, I spent five years saturated in fundamental analysis of the cash markets followed by five years of technical analysis of the futures markets with the same objective—to project the prices of the major commodities months into the future. Which approach was the most effective in forecasting prices 3, 6, or 12 months into the future? This question became even more important to me when I joined a commodity brokerage firm. My clients expected me to know, or at least have a firm opinion on, the direction futures prices were headed. By that point, I knew that both technical and fundamental analysis had strengths and weaknesses. Fundamental analysis was an excellent tool to view the long-term situation. It attempts to quantify the supply-demand equation, so producers and users of commodities can anticipate periods of overabundance or scarcity. One of the problems with fundamental analysis for the average futures trader, or the typical broker, is that big fundamental news usually seeps into the market, tidbit by tidbit. By the time the whole story is available, the market has already made its move. This occurs because the people aware of the big changes taking place in the supply and demand equation—the major grain companies, for example—are trading in the futures markets extensively. The news is traded by the time it becomes totally public; the market often moves before the information is available to the average trader, even on the floors of the futures exchanges. A classic example is the Great Grain Robbery perpetrated by the Russians in the early 1970s. Soviet futures traders operating out of Switzerland bought millions of bushels of U.S. grains on the Chicago markets before it was revealed that their crops were having severe problems. There is no such thing as insider information in futures, as there is in the stock market. Most of the big grain companies, for example, are privately held and most are owned by overseas interests, out of the reach and jurisdiction of U.S. regulatory

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agencies. Major importing-exporting countries also trade on the futures markets using “top secret” information regarding their needs and/or production estimates. Another phenomenon that occurs when trading fundamentals is the time it often takes for a major correction in the supply and demand equation to take place. For example, it may be common knowledge that a commodity is in short supply and that demand is building, but how long will it take for a new crop to be produced and fill the need? Will there be weather or disease problems if it is corn, wheat, cocoa, or coffee? Will the local government intervene? It can take months or more for a new supply of a commodity to come to the market—so much can happen in between! When will the market impact be felt? When will the bulls stampede? It is not uncommon to be dead right using fundamental analysis of a market but bleed to death from margin calls while waiting for “the move of a century.” A major grain company went bankrupt building inventory of wheat, knowing that a shortage was coming. The company was dead right, but could not finance its inventory long enough. That company ended up dead broke. This is also one of the risks a scale trader must learn to manage. You will often hear me say: “Have a good feel for when there is a light at the end of the supply-demand equation before entering a scale!” You occasionally find situations when a commodity is in position to scale trade, except the supply side is way out of line. These are times to wait for clarity as to when the supply-demand equation appears to be moving your way. This does not mean you must absolutely know when a market will bottom and start trading higher; you can never know that for sure. It just means you must have a reason for believing that prices will not remain at their lows indefinitely. You can make a lot of money with scale trading by being near right, as opposed to pure speculation in the futures market which requires you to be much more precise. This will become much clearer in Chapter 5, which delves into supply and demand. With fundamental analysis, there is also the problem of gathering, sorting, storing, processing, and analyzing the enormous number of facts and figures required to properly conduct it. Usually only countries, or very large firms, have the capability. Massive computers and large staffs of analysts are required. Information must be collected and deciphered from all corners of

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the world. To create an econometric model utilizing all the facts influencing just one commodity is beyond the capabilities of the individual trader. Consider the fact that the USDA publishes over 300 separate reports, many of them weekly. The process becomes even more complex given that some countries deliberately release false information about the commodities they produce to influence markets in their favor. To try to overcome this problem, fundamental analysts must rely on satellite technology. Governments can do this type of research, and even some of the major grain companies can, but what chance does the average trader have of competing in an arena like this? There are satellite photographs available on the Internet, but they have been seen, researched, and probably traded before they hit the World Wide Web. Then there is the classic question posed by technical traders to fundamental traders: “If a commodity is a good buy at its current price, do you buy more when it drops another 5 or 10 points?” Fundamental analysis is not a self-correcting system, as is technical analysis, claim the technicians. In comparison, technical traders are trained to exit trades when trend lines are broken, for example. For all these reasons, I dove into technical analysis when I joined Oster Communications. It was going to solve all my analytic problems. The assumption is that the futures markets are efficient. All the pertinent information moving the markets is already in the markets. If a Cargill-type grain company were to know about a crop problem anywhere in the world, it would protect itself by taking futures positions, long or short. You may not know what the problem is, but you could trade it nevertheless because it would be reflected in price fluctuations. As unknown buyers open increasingly larger long positions, an uptrend in prices would develop. Even amateur technicians would spot the move and jump on the bull bandwagon, adding fuel to the move. This is the theory. If this is true, as the theory goes, some genius out there in futuresland must be able to develop a technical analysis system that can make sense of the daily price activity in the major markets. Futures magazine was a magnet for every trader or system developer with a trading system. For five years, I watched them pitch their trading software, track records, and secrets. Everyone wanted to be recognized as the trader with the most accurate system in the

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world so he or she could either sell it or attract investors. We referred to it as the search for the Holy Grail, since it was about as difficult and fruitless. System after system was tested and evaluated. Some would seem to work for a while and then fizzle. Most common were the systems that worked well with historical data, creating impressive, but simulated, track records. When traded in real markets, they bombed. The problem often was that these systems were designed by their creators to work based on historical trading patterns. If very similar patterns did not occur in actual trading, the losses piled up. Close analysis of other systems revealed that many of them did not make allowances for bad fills (slippage), limit up or down days, exchange holidays, or other common market aberrations. In plain words, none of them worked satisfactorily. I came to believe two things about technical analysis. First, one of the major problems is that it always deals with past price action. All the information comes from the historical records, even if the data is only minutes old. Can you predict specific future price activity based on what has already happened? It always seemed to me that much of the success occurred because enough traders saw the same price patterns or signal and then reached the same conclusion. Technical analysis can become a self-fulfilling prophecy. These magic systems or silver bullets, as they became known, may work for short periods of time or occasionally, but they never proved to be very dependable in my opinion. It also became obvious that certain systems were suited to trending markets and others to choppy markets. The software would look good for a while and then the complexion of the market would change, resulting in serious losses. It seemed impossible to find a system that could adjust to all types of market conditions. The other problem relates more to human nature. If you developed a trading system that consistently made money in the futures market, would you share it with anyone? Would you sell it for a few hundred dollars or even several thousand? Would you want it described in a magazine being mailed out to 50,000 commodity traders and brokers? Personally, I think I’d be quietly sitting on a tropical island, sipping Singapore Slings, trading my brains out, and wiring trading profits to my Swiss bank account. How about you?

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In defense of both fundamental and technical analysis, I have seen professional and nonprofessional traders use either one or both systems in combination successfully. Is this a contradiction to what has already been said? I do not think so. There are two reasons why these systems can make a trader successful. First and foremost in my mind is that having a system and religiously following the signals given by that system brings discipline to trading. For example, most technical systems include the use of stop loss orders. If a trade goes against the system a certain percentage or a specified amount of money, the trader automatically exits the trade. This protects the trader from catastrophic losses. Traders can’t trade if they lose all their money. Preservation of capital is one of the key elements of trading. Speculators are like fly fishermen; they must constantly be casting into the market. If they do not get a bite, they must reel in their lines promptly to preserve their lures. Most casts produce little or nothing. Winning trades are the catch. Most are below the limit and must be thrown back, equivalent to a breakeven trade. But when a keeper, or better yet a trophy fish, is landed, it makes up for all the cold feet and wet clothes. With traders, the monthly gains are often attributed to a small percentage of trades. A good system instills the discipline needed to be able to stay in the market without losing all your trading capital. The second reason good systems help traders make money is the challenge of dealing with the unknown. Uncertainty robs traders of confidence. Belief in their system encourages them to go back into the market daily. It gives them the courage to recover from a drawdown of equity, to get back on the horse that threw them, and gives them the faith needed to make them trade based on something that is going to happen in the future. As scale traders, you must become part of the faithful. You will need to bend your will to the will of the system and have the faith to follow it with the discipline of a monk. I call that Zen trading. You will be asked to buy, buy, buy when the market you are trading is low and headed lower on the blind faith that the market will turn in your favor at some unknown time in the future. Having faith in the system is your only consolation at times. But do not become one of the faithful on blind faith alone. Read, study, and experiment. Start slowly and build your faith on sound results.

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The next question is why did I write this book if scale trading is such a perfect system? Why am I not sitting on the beach in Tahiti? First of all, scale trading is not a new subject. A lot of people are scale trading; you can find a dozen Web sites and several books on the subject. Next, I am more a writer than a trader. Or you can say, there are “thems that do it and thems that teaches it!” Last of all, I think the system deserves someone to speak up and tell traders that there is a better way of doing it than is described in the material currently available. As I mentioned earlier, my uncertainty about how best to trade the futures markets came into very sharp focus when I joined a brokerage firm. I watched the other brokers and how they dealt with their customers. The vast majority of the time, our clients had their own trading strategies and relied on us for information, occasional advice, order execution, tracking trading activity, and resolution of any account problems. There were some clients who asked for trade recommendations, which the brokers were prepared to supply. But the vast majority, by my observations, used a technical analysis system of some sort and by and large were net losers when they closed their accounts. These observations are critical because, no matter whether you are new to the futures market or have been trading a while, you must face the dilemma of deciding how to pick your trades. I have spent considerable time researching and observing these questions and hope you can profit from these insights. I first became aware of scale trading when one of my fellow brokers called my attention to some of his traders. They were taking substantial losses in their initial positions, yet they continued to buy no matter how low the commodity appeared to be headed. They even seemed happy about it and talked of adding inventory when they entered a trade that immediately began to lose money. Eventually they offset virtually all these losing positions profitably. How could that be when the first thing you are taught as a trader is to cut your losses short and let your winner run? These guys let their losers run and cut their winners short. They had patience, discipline, and sufficient trading capital to wait for the market to come to them. This was my first exposure to scale traders—a new breed of trader for me. Let me begin by describing in detail how scale trading traditionally works. Then, in the next chapter, I’ll describe how the

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brokers I worked with modified it to get a better handle on the risks. Our approach has been called heresy by traditionalists, but the group of brokers I worked with always recommended it because we never believed in, or enjoyed, financial self-mutilation. By the end of Chapter 4, I hope you’ll agree. Scale trading attempts to extract a modest profit from each trade by following the most basic of economic laws—that of supply and demand. If a commodity is plentiful, the price decreases. If it is scarce, the price rises. The law works just as smoothly on the demand side. Strong demand translates into higher prices; low demand causes prices to head south. When these laws work in tandem—reduced supply with increasing demand or abundant supply with weak demand— prices will soar or plunge, respectively. Prices consolidate when these forces are in opposition, i.e., strong demand with plentiful supply or weak demand and scarce supply. A corollary to these economic laws states: “The surest cure for low prices is more low prices.” This simply means that smart people find or devise uses for any commodity available at bargainbasement prices. Every real commodity has a price at which it is just too cheap. When it gets to that level, someone will figure out how to turn a profit from it. Corn is a good example. When prices languished at lows for extended periods of time, entrepreneurial types developed processes to convert corn to a sweetener for diet foods and drinks or to alcohol as a gasoline additive. Increased demand or reduced supply eventually leads to price recovery. Scale traders seek to take advantage of these “natural” laws. They buy commodities trading in the lower third or quarter of their long-term—10 years or more—trading range. The theory is that these commodities are near bottom and once they bottom, prices will begin to recover. Scale traders listen to their wives and believe there are always buyers for true bargains. They also believe there is less risk buying a commodity once it is already at or near its historical low. In other words, much of the downside risk is in place already. This trading system gets its name from the method of entering and exiting the market. The trader buys each futures contract based on a predetermined scale, and he or she closes (sells) each open position using another predetermined scale. For example, a scale

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might call for buying corn each time the price drops 4 cents once corn is trading in the lower quarter of its 10-year trading range. The profit objective might be to sell each position once there is a 6-cent profit, which would be $300 for corn (5000 bushel contract  $0.06). Notice that scales, even for the same commodity, can vary due to market conditions. Here is an example. Studying the 10-year corn price chart, it is determined the high is $4.00 per bushel and the low is $2.00, or a $2.00 trading range. The lower 25 percent would, therefore, begin at $2.50 per bushel. In this example, corn drifts lower for the next two months, eventually coming to rest in the $2.00 area. Using a 4-cent down and 6-cent up scale, the first position opens (or the first “buy” occurs) when corn trades at $2.50. The second is acquired at $2.46; the third at $2.42; the fourth at $2.38; the fifth at $2.34; the sixth at $2.30; and at each 4-cent interval until $2.02 (see Table 3-1). If corn stopped at $2.02, the trading account would contain 13 positions that must be financed. Of these, 12 are losing money and the last is at-the-money. Two types of margin are required to hold these 13 corn contracts. First is the initial margin, which is needed for each contract. Margin requirements are always subject to change. They can go up or down depending on how volatile a market is trading. Margins will be discussed in detail in a later chapter. In this example, a margin of $500 per contract is used, or $6500 in total, Column 4, Row 13. The total loss or drawdown on the first 12 losing positions amounts to $15,600. The total capital required is $22,100. When corn moves off the $2.02 low and advances 6 cents higher, the last position is offset for a $300 profit. If corn steadily climbs to $2.56 over the next month or so, all 13 positions close for a total profit of $3900. This is a gross return on equity of approximately 18 percent ($3900/$22,100) over a reasonably short period of time. That is the theory behind scale trading. Unfortunately, it is rare for any commodity to move smoothly to a low and retrace itself just as smoothly to a new high. The more common pattern is for a commodity to stair-step its way down and then up. Prices will drop a nickel or a dime, only to retrace this move. Then they may lurch down again, followed by another recovery, making lower lows and lower highs set each time on its journey to the low of the cycle.

3-1

Columns

$2.18

9

$3,900.00 18%

$2.22

8

Profit % Return

$2.26

7

$2.02

$2.30

6

13

$2.34

5

$2.06

$2.38

4

12

$2.42

3

$2.14

$2.46

2

$2.10

$2.50

1

$500.00

$500.00

$500.00

$500.00

$500.00

$500.00

$500.00

$500.00

$500.00

$500.00

$500.00

$500.00

$500.00

Margin

$6,500.00

$6,000.00

$5,500.00

$5,000.00

$4,500.00

$4,000.00

$3,500.00

$3,000.00

$2,500.00

$2,000.00

$1,000.00

$1,000.00

12

11

10

9

8

7

6

5

4

3

2

1

0

Losing Contracts

Total Margin $500.00

5

4

$200

$200

$200

$200

$200

$200

$200

$200

$200

$200

$200

$200

$0

Loss per Contract

6

$2,400.00

$2,200.00

$2,000.00

$1,800.00

$1,600.00

$1,400.00

$1,200.00

$1,000.00

$800.00

$600.00

$400.00

$200.00

$0.00

Total Loss/ Contracts

7

$15,600.00

$13,200.00

$11,000.00

$9,000.00

$7,200.00

$5,600.00

$4,200.00

$3,000.00

$2,000.00

$1,200.00

$600.00

$200.00

$0.00

Total of Losses

8

$22,100.00

$19,200.00

$16,500.00

$14,000.00

$11,700.00

$9,600.00

$7,700.00

$6,000.00

$4,500.00

$3,200.00

$2,100.00

$1,200.00

$500.00

Drawdown

9

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11

Buy Price

Number

3

Down 4, Up 6 Cents

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10

2

1

Corn Scale

TA B L E

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Once a bottom is put in place, a period of price consolidation or base building occurs. At some point, a bull market—along with its share of false starts, resistance points, and retracements— begins. Prices move higher. Now there are higher highs and higher lows. The stair-stepping price movement can be good or bad news for scale traders. For example, the intermittent bull (upward) rallies during the bear (downward) market phase generate additional profit opportunities. This occurs when prices move high enough, 6 cents in the corn example, to offset the most recently established position. When the market resumes its movement south by 4 cents, the position is reestablished. This type of price action can occur often on either the down move to the low or on the up move. In scale trading terminology, these welcome gifts from the market are called oscillating profits. Normally, over the course of a scale, there will be enough of them to add 20 percent or more to the total return, which offsets brokerage commissions and increases the total return. The negative side of oscillating prices is that they can draw out the amount of time it takes to complete a scale. Complete means closing out all positions. If a scale is drawn out too long, the initial positions may expire. Remember, futures contracts have set expiration dates. If a contract expires, it must be rolled into a more distant contract or closed out at a loss. Theoretically, a scale trader could roll expiring positions into more distant months, e.g., roll May corn into September and September into December, etc., until every position is closed at a profit. Some people use this theory to create the myth that scale traders never have losing trades. Don’t believe it! Another reason for having to roll positions is that the price never recovers enough to liquidate all open positions. This can happen when an unexpected event disrupts the normal supplydemand equation or if an important factor is overlooked or miscalculated. In Chapter 8, I will detail how and when to roll expiring contracts. That is the traditional theory of scale trading. It all sounded simple enough. The broker group I was working with dived right in. As it turned out, scale trading was not all that simple once we began actually doing it, but it was as profitable as expected.

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Understanding Hedged Scale Trading

Now let me describe how to incorporate a few basic option strategies into traditional scale trading to manage some of the risks the traditionalists brush off as immaterial. Once you have completed all your research—which will be covered in detail in later chapters— and a commodity has been selected to scale trade, it is time to begin opening positions. The first risk to consider is entering a scale too soon. If you start a scale trade too soon, one of two things could happen. First, the entry point of the scale, which would be the lower third or quarter of the 10-year trading range for the commodity being scaled, could turn out to be the low. No problem here, since any positions you opened will be closed out at a profit as prices move higher off the low. If any protective puts had been established, which will be discussed in detail shortly, they can be offset or they will expire worthless. This should amount to a breakeven proposition at worst. No harm, no foul. The second possibility is that the downtrend that took the commodity to the entry point might stall. Prices oscillate up and down in a tight trading range but are basically moving sideways. The positions that are opened are offset as the price of the commodity bounces off resistance. These are called oscillating profits. This is good, but precious time is being wasted. If this continues too long, the contracts you are in will be approaching expiration. If this happens and it is obvious the scale is not developing because prices are stabilizing as a bottom is being established, 61

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offset any protective puts acquired to salvage any time value they may have left. Simultaneously, offset all long futures positions or sell some covered calls against them. Covered calls are options that have long futures positions backing them up. These are hedged positions. For example, you have a long corn position at $2.50. You sell a $2.60 call for a dime a bushel. When you sell that call, you are paid the premium. If the market moves higher to the point the owner of the option you sold exercised, say $2.65, you can deliver your long position and keep the premium. If the market stays flat, the option you sold expires before the futures. You then offset the futures and use the premium from the call or calls to cover any losses on the futures positions and any puts that might have been purchased. If for some reason the market breaks through the resistance, moving lower, you still have a hedged long position. You can resume the scale, but you might want to use a more distant futures contract. At least you are not stuck with a naked long as the market heads south. As expiration of the option approaches, you close both positions simultaneously. Any loss on the futures is offset by a gain on the short call. Now study the scale in Table 4-1. It is a corn scale, similar to the one in Chapter 3, beginning at $2.50 per bushel, but prices go lower and it has a different scale. Remember, the scale you create will vary, even when trading the same commodity. The reason for this is volatility, which can be measured several ways. One measurement is the size of the average daily price move—the bigger the move, the greater the volatility. There are times when, from the opening price to the closing price over a given period of time, corn can move as little as a penny or two per bushel to as much as a dime or more. The reason is in the minds of the traders. Are they confident they know what the true supply-demand situation is? Or are they confused and uncertain? Are “scary” news stories, like summer droughts or excess rain at harvest, bombarding the trading pits? Keep in mind that this pattern of thinking about corn fits all commodities, and it is key to developing a scale. With any commodity you scale, you will be concerned with the uncertainties of production and demand. What can possibly disrupt supply? Flood? Drought? Transportation? Strikes? War? Acts of God?

4-1

Columns

$1.52

15

$1.94

9

$1.59

$2.01

8

14

$2.08

7

$1.66

$2.15

6

$1.73

$2.22

5

13

$2.29

4

12

$2.36

3

$1.87

$2.43

2

$1.80

$2.50

1

$500.00

$500.00

$500.00

$500.00

$500.00

$500.00

$500.00

$500.00

$500.00

$500.00

$500.00

$500.00

$500.00

$500.00

$500.00

Margin

$7,500.00

$7,000.00

$6,500.00

$6,000.00

$5,500.00

$5,000.00

$4,500.00

$4,000.00

$3,500.00

$3,000.00

$2,500.00

$2,000.00

$1,500.00

$1,000.00

14

13

12

11

10

9

8

7

6

5

4

3

2

1

0

Losing Contracts

Total Margin $500.00

5

4

$350

$350

$350

$350

$350

$350

$350

$350

$350

$350

$350

$350

$350

$350

$0

Loss per Contract

6

$4,900.00

$4,550.00

$4,200.00

$3,850.00

$3,500.00

$3,150.00

$2,800.00

$2,450.00

$2,100.00

$1,750.00

$1,400.00

$1,050.00

$700.00

$350.00

$0.00

Total Loss/ Contracts

7

$36,750.00

$31,850.00

$27,300.00

$23,100.00

$19,250.00

$15,750.00

$12,600.00

$9,800.00

$7,350.00

$5,250.00

$3,500.00

$2,100.00

$1,050.00

$350.00

$0.00

Total of Losses

8

$44,250.00

$38,850.00

$33,800.00

$29,100.00

$24,750.00

$20,750.00

$17,100.00

$13,800.00

$10,850.00

$8,250.00

$6,000.00

$4,100.00

$2,550.00

$1,350.00

$500.00

Drawdown

9

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11

Buy Price

Number

3

Down 7, Up 7 Cents

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10

2

1

Corn Scale

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What can unexpectedly increase supply? High prices? Favorable weather? Government incentives? You must ask yourself the same questions about demand. How will that change for the better or worse? This is uncertainty. The market does not know what to expect. Uncertainty breeds indecision, and indecision erodes confidence. Lack of confidence encourages herd psychology. The market gets choppier and choppier. The average daily price move widens. The opposite can happen just as easily. In this situation, the market has a high level of confidence that the supply side is more than sufficient for whatever commodity is being scale traded. Prices are moving slowly lower; the buyers are evaporating. Only commercial users of the commodity are buying hand-to-mouth, since they must keep their production facilities stocked. When the market recovers, you can see demand momentum pick up as more and more buyers enter the market. This would spur the speculators to jump on the bandwagon, driving prices even higher. In either case, there is confidence as opposed to chaos. Understanding the personality of the market at the time you are creating a scale is critical. Certainty or uncertainty—that is the question. The answer is your first clue on how to structure your scale and how much protection you think you will need. If your answer is certainty, your scale must be tight because the average daily price move will be smaller. If you do not use a tight scale, you will not build an inventory of long futures contracts. For example, if the daily price move is less than 3 cents per bushel in the case of corn and your scale calls for adding a new position every 10 cents down, it could take a while to get a scale going. Remember, the average daily price move is not omnidirectional. It will be 3 cents up one day and 3 down the next. Further, it is an average—up 4 one day and down 2 the next for an average of 3, and a million variations of that refrain. As a commodity moves toward the starting point of a scale, you begin to watch the market even more closely. You study volatility charts, which calculate the velocity of the average daily movement, and begin to track the 20-day moving average (this is an important indicator, explained in Chapter 7). The price trend will be down. If it weren’t, the commodity would not be coming into scale trading range.

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All these indicators provide insights into when to begin a scale and what interval to use between limit orders. Most important is the volatility level. If there is a high level of uncertainty, you run the risk of entering a scale and being faced with a few or even a series of limit-down days. These are trading sessions during which the commodity being traded opens at or below its daily trading limit (see Appendix 1 for specifications) or quickly reaches its daily limit, halting trading. As a scale trader, you may have one or more orders in the market. These orders will be filled. Immediately the price drops, and you are faced with a margin call. Other orders may be caught in the market and will be filled when trading resumes. At that time these positions will have a margin call. Or you might have one or two positions on by the time the limit day(s) occurs. Again, you would be facing large margin calls. I have seen hogs limited down six straight trading sessions in a row, causing major margin calls. Let me give you a quick example, which is based on a real situation. Several clients were in a live cattle scale. If I remember correctly, they had from four to six long positions in inventory and another four or five limit orders in place. At that time, some negative news hit the market. I think the USDA adjusted the cattle-onfeed numbers substantially to the high side, putting the supplydemand equation out of whack. The market crashed, limiting down for three days straight. The five limit orders already in the market were filled, even though there was little trading. In other words, some locals took out all the long limit orders in the hopper as shorts when prices plunged, despite all our efforts to cancel them (the pits are a private trading club at times). The guys scaling the cattle now had nine long positions. The limit move for live cattle is $600 per day. That amounted to $5400 a day. Additionally, four of the positions had been opened before the limit move started, so the margin on them was higher. One of these clients was trading five lots (five contracts at a time). His daily loss on the three limit-down days was $27,000. My point is that the margin calls were heavy over that threeday period of time, ranging from $10,000 to $50,000. As per the account agreement of most brokerage houses, margin calls must be met within 24 hours. The shock of this violent move caused two of the traders to exit the market with major losses once trading resumed.

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They could not meet their calls. Even when you close your positions and your account, you are legally liable for any debit left in the account. The sad part of this story is the market recovered almost as swiftly as it fell. The traders who had prepared for the possibility of such a situation made substantial profits. Futures markets overreact to news and negative (or positive) information. Once an overreaction occurs in one direction, the market often overreacts in the other. The herd stampedes north as a direct response to a bolt of lightning coming out of the south, only to stampede south when a second one streaks across the northern sky. Handling margin calls is not easy on the brokers, not to mention the clients. It sincerely bothered us to see good clients lose substantial sums because they were not prepared or did not have deep enough pockets to withstand these limit moves. You will see these reactions and overreactions time and again. They are the modus operandi of most open outcry markets, even electronic ones like NASDAQ and Globex. This specific event motivated us to begin experimenting with various option strategies to somehow manage this kind of risk for our clients. The moral is as follows: As you are sizing up a market, think about the worst-case scenario and plan a defensive strategy. This means selecting the proper scale for the type of market and some options to cover at least your initial positions. The lower prices go, the less risk, because you are closer to the bottom. By trading commodities with real, intrinsic value, there is always a point at which they get too inexpensive for a commercial user of the commodity to resist. You should not open a scale and then think about adding a few options to manage the risk that can arise if the market you are trading becomes more volatile. You can do this, but it usually works better if you develop a plan with your broker before you enter a scale. Remember, when a market gets volatile, the price of options accelerates, making your insurance expensive. You do not want to be trying to buy puts in a limit-down market. The key element in the Black-Scholes equation that calculates the fair value of an option is volatility. Let’s take another look at the corn market. I will continue, for the moment, to use the corn market. It is an easy one to understand,

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and investors new to futures will not have to worry about learning the contract specifications for a number of commodities. It should be less confusing this way, and the strategies detailed can be used for any commodity. Appendix 1 includes the contract specification for the commodities I recommend for scale trading. To refresh your memory, the key facts on corn are: Contract Size One-Cent Move Equals Limit-Down Day Equals

5000 bushels $50.00 $0.12 or $600 per contract

In this discussion, I describe three levels of risk taking. As with any investment strategy, there is no absolute right or wrong choice. The more risk, the more gain. The less risk, the more comfort. You must decide for yourself what is the right way to approach the markets. As always, much of the decision depends on what you are willing to risk and how you tolerate risk. Your decision may also depend on how confident you are in your fundamental analysis of the market in which you plan to scale trade. Is there light at the end of the supply-demand tunnel? The traditional scale trader accepts the entire risk, which is the extreme other side of the risk tolerance range.

THE JIC-TRADER The first level is what I call the “just-in-case” scale trader, or the JIC-trader. This type of trader is one risk level below the traditionalist described in Chapter 3. He or she firmly believes in scale trading and is after the maximum profit. The JIC strategy entails buying an occasional put option as insurance. A put gives the trader the right, but not the obligation, to take a short position in the futures market. Therefore, if the JICtrader opens a scale by buying a long futures contract, that trader can hedge that futures contract with the put. The put gains value as commodity prices go lower. This gain offsets the losses the JICtrader will experience from the long futures contract as the long position loses value. If a put that is at-the-money or in-the-money or has a strike price that is very close to the price of the futures position is bought, the JIC-trader is fully hedged. The option will have a delta of 1 and

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move penny for penny with the futures contract to the down side. But a put that is at-the-money is usually expensive insurance, because it is in greater demand. As with any insurance decision, the JIC-trader must decide how much of a deductible to take. This is done by buying an out-of-the-money option. These options only have time value and no intrinsic value. Most futures markets, like other securities markets, give little value to time. Some savvy scale traders, who plan their scales well in advance of the price point at which they are going to enter a scale, buy their insurance first while it is still inexpensive. For example, they plan on beginning a scale when the commodity reaches the lower 25 percent of its 10-year trading range. They begin buying put options when the commodity hits the lower 30 percent. This way they can keep ahead of the option market and buy cheap, deep-out-of-the-money options. In our example, we have corn trading between $2.00 and $4.00 over the past 10 years, or a $2.00 price range. The lower 25 percent is $2.50 and the lower 30 percent is approximately $2.67. Strike prices are generally a dime apart, so there would be strikes at $2.70, $2.60, $2.50, and $2.40 for the puts needed to cover the first long position at $2.50. When the futures price is at $2.70 moving to $2.60, it would be a good time to buy a $2.40 strike price put. Next is the selection of the contract month. Corn contracts are deliverable in March, May, July, September, and December. If it is April or early May and the scale is planned for the September contact, my first choice of an option would be the December $2.40 put. Remember options expire before futures. By using the December options, there is some slippage if the scale is started late and it is decided to scale the December contracts rather than the September ones. Scale trading works, but not necessarily on a tight schedule. The beauty of it is that it will cut you some slack. The December $2.40 put is my first choice, but what if it looks expensive. For some reason, it looks like the market is willing to pay a little for time, which it isn’t as a rule. I would then compare it with the $2.40 September put. How do you compare them? If you do not have a software package to price options, your broker will. It is a function of all of the real-time price quotation services serving the futures industry (CQG, CSI, DTN, Futures Source, etc.), which are in front of every broker. Compare fair market value and deltas. Your broker’s software should also indicate

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which is overbought or oversold. Then make your decision, as was discussed in Chapter 2. The real concern of the JIC-trader (or of anyone trading the long side) is a series of limit-down days. The loss could be $600 per contract per day for corn. Further, there could be a series of days when the commodity limits down and the scale trader has multiple positions at risk. The margin calls pile up. What is the worst-case scenario? How far could corn fall? The famous commodity trader, William D. Gann, might say ”to zero,“ but that is probably too pessimistic for a physical commodity with intrinsic value. A more realistic answer would be the $1.50 area. My rationale is that corn has not traded on the Chicago Board of Trade for any period of time at $1.50 for over 20 years. Don’t confuse the price of corn at a local elevator near your home with the price on the exchanges. During the past decade, it has bounced off of $1.50 only twice, and it immediately recovered. Let’s call the low $1.52 as we work through this example. If $1.52 is the potential bottom, how much risk will the JICtrader take? A quick glance at Table 4-1 gives you an idea of what losses could be sustained. The traditionalist, trading a single contract, faces a maximum drawdown of approximately $50,000, including commissions. Let’s say the JIC-trader opts to buy one put when it is about a strike price out-of-the-market for every third futures position established. This would amount to five options. A reasonable price for an option would not be more than a nickel each, if the market were not extremely volatile. The more volatile the market and the closer the option’s strike is to the current market value of the underlying futures contract, the more expensive the insurance. The JIC-trader would have five put options, four of which would be in-the-money and would have various amounts of intrinsic value when corn hits $1.52. Once a bottom has been established or the JIC-trader decides the risk of limit-down days has passed—in other words, the market volatility has subsided, and it is clear the market is bottoming— the puts are sold, and the profits are used to supplement the funds used to meet the margin that was needed to hold the long futures positions. Using puts this way is not intended to mitigate all risk. The strategically placed puts are to protect against limit moves. The

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JIC-trader plans several scale trades, looks at the price action and volatility, and then decides when and how many puts to buy. If the market is orderly, the trader may be lulled into skipping insurance. But just like a tsunami, a series of limit-down days can hit fast, hard, and unexpectedly. Options can take the sting out of this kind of event, especially in the early stages of a scale.

THE C-TRADER The next level of trader, the conservative or C-trader, seeks to define the risk as exactly as humanly possible. To do this, a put is bought for each long futures position opened at a strike price below the current market value and as close to the CMV as possible. The amount of the risk depends on the strike price of options, and the cost of the insurance depends on when they are acquired. Let’s say the C-trader wants the risk limited to a nickel, or $250 a contract. Therefore, 15 puts would be bought at a strike price that is 5 cents below the CMV, or as close to that as possible, to match each futures position. In this example, if corn hits a near alltime low at $1.52, the C-trader would have 15 futures contracts and 15 puts. In reality, even the most conservative trader would probably stop buying protection after the price of corn hit some level. If you look at the long-term charts, the risk that corn will make a new contract low or an all-time low diminishes substantially some time after it trades below $2 per bushel. Most traders would stop buying options somewhere between $2 and $1.80, depending on how it was trading and the overall outlook of the supply-demand equation at the time. Needless to say, there is a point when insurance is not costeffective, as with a 15-year-old car with over 200,000 miles. The actual clue as to when to cease buying protection is when you spot the commercial buyers returning permanently to the long side, as you will learn in Chapter 10. The insurance (i.e., premium used to buy the puts) would be $3750 (5000 Bu.  $0.05  15), if the puts were bought at an average of a nickel each, which is probably on the high side. On top of this would be 30 commissions to buy and sell (offset) the 15 options. Let’s say they would cost $25 (if you are doing this kind

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of volume, most brokers will give you a break on commissions) each times 30, or $375. The total would be $4125, which would be added to the drawdown (see Column 6 of Table 4-1). Keep in mind that 14 of the 15 puts would be in-the-money and could be sold at a profit. At this price level, I doubt if even the most “nervous Nellie” trader would be too worried about further declines. Once corn hit $1.70 or $1.60, you can bet I would be selling some of the older puts with the most intrinsic value to cover my drawdown.

THE UC-TRADER The ultraconservative or UC-trader wants the insurance protection of the puts FREE! That’s right, the UC-trader’s strategy includes selling covered calls above the CMV of the futures price (i.e., outof-the-money calls) to pay for the cost of the puts purchased. These calls could be sold at the price at which the trader plans to close the positions based on the scale selected. The trader holds the long futures positions and the short calls until the futures are called away when the owner of the calls exercises them or they expire. If this is done right, the UC-trader can even make a little money on the spreads between what the calls sell for and what the protective puts cost. For each futures position opened on the corn scale beginning at $2.50, the UC-trader buys a $2.40 put to cover the downside risk. If this put costs a nickel, the UC-trader sells a call, perhaps at $2.55 or $2.60, to pay for the put. Calls tend to be more valuable than puts, since most traders favor the long side of the market‘s increasing demand. With a little luck, the UC-trader would get 7 cents for the call and net a 2-cent profit. The exit price in the scale for the first position opened is $2.57. Strike prices are at even intervals, usually a dime or a nickel apart. Therefore the trader decides, based on the best-priced option ($2.60 vs. $2.70) and the outlook for the commodity at the time, which strike price makes the most sense. Conceivably, the call could be sold for more than a nickel, netting the trader a small profit on the deal to help pay the commissions. Again, if you are opening three positions each time you trade (a futures and two options), you should be able to negotiate a good commission rate.

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What if the market goes up instead of down? If it goes high enough, the owners of the calls will start thinking about exercising them. This is a very important issue. The UC-trader must unwind the entire position at one time. Do not leg out of this type of trade. Leg out means to close each part at different times, perhaps the put first because it is losing value quickly, then the call, followed by the futures. Instead, the trader might try selling off the options, calls, and puts, and hold the futures since they are gaining value. Nine out of ten times, if you leg out, you’ll get caught in a whipsaw trade. That’s when you take one action to adjust to a market trend change, only to see the market go against you. For example, you could sell your options protection, the puts, just as corn limits down for a few days. You still have the long futures position without any cover. This advice also applies if you have to roll over a position like this one; close out all related legs at the same time and reset the entire position. In this case, the put is on for protection. Leave it on until the short call is called away, meaning you would deliver your long position to satisfy the owner’s demand. Then dump the put to salvage any time value still left in it. Now we have discussed three styles of scale trading using options. Which one you use depends on your psychological makeup, financial situation, and the market conditions prevailing when you open a scale. No matter which method you choose, be ready to acquire some insurance when warranted.

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5

The Criterion for the Selection of Scalable Commodities

A

sound understanding of the impact of supply and demand on commodities is much more complex than most scale traders realize because there are multiple sets of rules governing supply and demand. If you do not master these concepts, you can never hope to be a successful scale trader. This is because, as a scale trader, you enter markets as they are declining. You must avoid commodities that have little or no hope of recovering from the downtrend over a reasonable period of time. A reasonable period is three to six months. Let’s begin by discussing the key rules governing supply and demand (see Figures 5-1, 5-2, and 5-3) in the marketplace. These appear to be simple at first, but they get very complicated in a hurry. Additionally, obtaining reliable facts—and all the facts—to make accurate projections is perplexing. The most basic laws of supply and demand are: 1. 2. 3. 4.

When demand increases, prices increase. When demand decreases, prices decrease. When supply decreases, prices increase. When supply increases, prices decrease.

But when the price of a commodity increases too much, users have a tendency to buy less. If the price of a commodity doubles or triples in a short period of time, we try to figure out how to do without it; we find ways of reducing our dependency or begin 73

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FIGURE

5-1

Demand Rules

60 50

Prices

40 30 20 10 0 1

2

3

4

5

Unchecked Demand Drives Prices Higher

FIGURE

5-2

Supply Rules

60 50

Prices

40 30 20 10 0 1

2

3

4

Unchecked Demand Drives Prices Higher

5

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5-3

Price Equilibrium

Supply vs. Demand

60 50 40 30 20 10 0 1

2

3

4

5

Price Stability Occurs at the Intersection of Supply and Demand

searching for a replacement. When something becomes extremely plentiful, we look for new uses. If this was all there was to it, scale trading would be a lot more popular than it is today. A better understanding of supply and demand may be achieved if we put ourselves in the role of an inventory manager. A professional inventory manager must evaluate all the factors influencing the decision to purchase a commodity. This is a key point; you must begin to think like an inventory manager whose annual bonus is based on buying a commodity at the lowest average price. You are the buyer for a large commercial user who must have the commodity in question to stay in business. You are going to buy no matter what, but the better buying decisions you make, the more you are rewarded. Additionally, you have virtually unlimited resources at your disposal and worldwide contacts. A friend of mine, Milo Hamilton, was in that situation. He was the chief trader for a large food company that required enormous amounts of rice, sugar, and cocoa. The amount of information and resources he had access to was astounding (satellite photos, computer projections, USDA officials, analysts, experts, growers, processors, coop leaders, top brokers, consultants, field operatives); in addition, he traded a futures account well into the eight-digit

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category. Whenever a serious problem occurred in the world regarding his key commodities, you would see Milo right there on the scene making a personal assessment. Because of that and the power and prestige of his employer, there was no one within the industry, the government bureaucracies, or the trading community that he could not meet or contact. Is it any wonder that with capabilities and backing like that we, as scale traders, must pay particular attention to commercial users? Milo’s current Web site is www.nopotatoes.com. He is still promoting rice over the other white vegetable. Let’s say you are a big-time buyer, responsible for locking up wheat for a national bakery, like Wonder Bread. The price of wheat is dropping as harvest begins. It is entering the lower one-quarter of its 10-year trading range. What do you do? Do you buy all you can store now and lock up all of next year’s needs on the futures market? Or do you buy what you need now and wait to see where prices will go after harvest? This is supply-demand management in its most basic form. The professional inventory manager tends to buy from handto-mouth as prices fall. Whenever he sees signs of strength, he backs off and waits for weakness. If he thinks a bottom is in place, he locks up as much as his needs demand, often using futures to reduce cash outlays. As the futures contracts expire, he accepts physical delivery of the commodity and moves the commodity to his firm’s storage facilities. As a scale trader, you need to go through the same mental exercise as an inventory manager. Let’s say the price of wheat is approaching an entry point to begin a scale and your analysis indicates it will continue to trend lower and then begin moving higher in the next four to six months following its seasonal pattern. It is set up perfectly to start a scale right away. If, on the other hand, the data suggest that wheat prices are going lower or will most likely stay flat straight through to next harvest, you should look for another commodity to scale trade. The reason, as alluded to earlier, lies in the costs associated with having to roll positions into more distant contract months. You do not want to tie up trading capital indefinitely if the price of the commodity does not have the potential to rally sufficiently to take you out of your scale in a reasonable period of time.

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What would cause the price of a commodity such as corn to stay depressed for an entire year? There are several answers. First, corn is a commodity, meaning that it is easy to replicate. When the price gets attractive, say $3.00 or $3.50 per bushel, any farmer who has decent land will grow some. Supplies will increase, and the price will eventually fall. Supplies of corn, unlike orange juice, coffee, and cocoa, can be substantially increased within a single growing season. Corn, beans, wheat, and most other crops are global commodities. Farmers in South America, South Africa, and Australia will increase their corn or soybean acreage when world prices of these commodities become attractive. And the growing season in the Southern Hemisphere is the opposite of that in the United States. When U.S. farmers are planning their soybean acreage in January, harvest is beginning in Brazil and Argentina. The South American bean harvest depresses prices during the first quarter of the year. What once was a no-brainer scale (i.e., buy beans at harvest and scale out in January or February), no longer works. You must be attuned to these changing seasonal patterns. In this country, supply is increased or decreased as farmers switch acreage from soybeans to corn and back again, depending on which crop offers the most profit potential at the beginning of each crop year. But you must keep in mind that U.S. farmers always prefer to grow corn. It wins all ties. Another key supply and demand concept you need to understand is the elasticity of demand and, therefore, of price. Initially, it expresses a qualitative relationship between various commodities, which becomes quantitative when exercised. Wheat, for example, can be substituted for corn as cattle feed. If there is an oversupply of wheat in a given year and corn is scarce, cattle feeders may be inclined to feed wheat to their cattle rather than the more expensive corn—thus de facto increasing supply of corn and the demand for wheat. There are some inelastic commodities, meaning that decreases in supply or increases in demand do not influence price. Basic foods are an example. People will pay whatever they have to keep from starving. Corn, being fed to cattle, isn’t one of them, since other commodities can be substituted as feed or the cattle can be liquidated. Or if the cost of beef becomes too high because the price of corn is off the charts, consumers will substitute chicken or switch to cheaper cuts of

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beef. But when people are forced to make a choice between eating or not eating, they will always pay whatever the market demands. A nation’s, or a people’s, culture can also impact the supplydemand equation. For example, an ethnic group that has lived on corn tortillas for centuries will have problems adapting readily to wheat bread, particularly leavened bread made with bleached wheat. It will demand corn meal and let the wheat go begging if it can. Then there is chocolate. It is a commodity whose price is as inelastic as the item itself is addictive. Chocoholics will pay any price for a fix. Crude oil and gasoline prices can go to what seem to be unreasonable heights, and the demand rarely falters. Supplies of crude oil and the products made from it can also get out of control, offering excellent scale trading opportunities. Table salt and tobacco are also in this category, but there are no futures markets in them. Returning to our inventory manager and the overseas farmers, the supply-demand calculation must include free worldwide stocks, as well as domestic ones. And obtaining an accurate fix on world supply-demand situations brings politics into the equation. Sometimes international politics helps the scale trader; sometimes it does not. For example, when scale trading cocoa, it often helps. The Ivory Coast is one of the major producers of cocoa. If the price of cocoa gets “too cheap,” the government will stop selling cocoa on the open market. Brazil has also done this with coffee, and the oil cartel has attempted the same with crude oil. Sometimes this has worked, but other times the cartel’s unity broke down. The moral is that politicians are not consistent and you must keep some price protection in place. The U.S. government has intervened in agricultural production since Revolutionary times. Knowledge of the farm programs and subsidies is very important. USDA (U.S. Department of Agriculture) has been known to take farmland out of production or provide cash payments to farmers for not producing certain crops. We used to say, if you wanted to double farm income, give each farmer a second mailbox. My point is that the U.S. government and governments around the world subsidize and protect their farmers with tariffs and legislation. Knowing the impact of these programs is key to analyzing the supply and demand situation before entering a scale.

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There are outstanding opportunities for the scale trader with good international intelligence, which is available over the Internet and from some other services I’ll discuss later. Political intervention can stop and reverse the price trend of a commodity, thus providing a perfect scale trading opportunity. But political activity is not always benign. In the days of the Cold War, Russia played havoc with our futures markets, as mentioned previously. Mother Russia would release false information about the quality and quantity of her farm production, while trading our futures markets from Switzerland. The objective was to go long corn, wheat, and soybeans at the lows, and then take delivery of the long contracts at expiration to supplement her failing collective agricultural experiments. It was so pronounced one year, it became known as the Great Grain Robbery. This led to satellite observation of the world’s major agricultural landmasses. The Russians are not the only ones that played fast and free with supply and demand figures. Each year, USDA surveys farmers as to their planting intentions. How many acres of corn are they going to plant? Wheat? Soybeans? These surveys are regional and cover all the major crops produced, including livestock. The first survey goes out in January, and results appear a month or so later. Coincidentally, farmers are selling grain stored on their farm about this time, since most farm mortgages are due in March and it is also the time to buy seed, fertilizer, and fuel for planting. Now, if you had 100,000 or so bushels of corn or beans to take to market about this time, how would you answer USDA’s questionnaire? If you were about to sell some corn, would you tell the government you were cutting back on corn acres this year or that you were going to plant from fence row to fence row? If enough farmers reported they were cutting back, it would reduce the projected supply figures and drive corn prices higher on the futures exchanges when the results of the survey were released. The gains in the futures market would be promptly reflected in the cash market. It is not uncommon, if the results of these studies are not what the futures market expects to see, that the commodity in question limits up or down for days. To be kind, farmers have been known to think positively, at least from their perspective, when answering USDA’s surveys. My point is this: individuals, cartels, industry groups, and even nations all have vested interests and

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hidden agendas regarding supply and demand figures. Always be skeptical. There are also many totally unpredictable factors that can wreak havoc with predictions of the supply and demand situation. All agricultural commodities, from frozen orange juice to wheat, are influenced by weather. Some tremendous advances have been made in forecasting, but we are still a long way off when it comes to long-range accuracy—over an entire growing season, for example. And nothing impacts the supply of any crop more than timely rains throughout the growing season. Floods, droughts, and other disasters can send prices soaring. Or just the rumor of an interruption of supply can result in limit moves on the futures markets. There will be times when weather hurts your futures positions. Extremely favorable growing seasons will produce abundant crops, which, in turn, may prolong your scale, forcing you to roll positions into a more distant and expensive contract. For scale traders, some of these natural disasters are not as threatening, particularly the ones that reduce supply. In these situations, you will be long in the futures market. The price goes in your favor. Nevertheless, there will come a time when you are just starting a scale and the price of the commodity you are scaling limits up, closing your scale after only one or two buys. When this happens, pick up your chips and look for a new scale. Do not switch strategies and become an active commodity speculator. Successful scale traders are known for their discipline. News is another totally uncontrollable factor that can have a substantial impact on supply and demand, especially in the short term. It can be news of an actual change in the supply or demand side of the equation or just some news that moves the market. The unexpected move can be either to your advantage or to your disadvantage. News often takes the form of a rumor that is later proven false. Again, this is the reason for the totally disciplined approach of scale trading and the use of options as price insurance. The brighter side of unexpected news is that it can often provide the opportunity to take some oscillating profits. For example, a rumor sweeps the trading floor. Prices run up 10 or 20 cents taking you out of two positions in your scale, generating two

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oscillating profits. You place new limit orders to replace the closed positions at the original prices of the scale that you are trading. Just as quickly as you were taken out of the scale, you are back in when the rumor proves false. You will come to love news stories like these. There is another condition that must be present for a commodity to be a good candidate for scale trading—competition. The rules governing supply are most efficient when there is intense, widespread competition. Economists have coined the term perfect competition to describe a market structure in which there are a very large number of small producers and an equally large number of buyers. This is the ideal scale trading environment. The supply side is not materially changed if a group of producers goes out of business or substantially increases or decreases production. Nor is the demand side stunted if one user switches to a substitute commodity or goes out of business. The concept also implies easy entry and exit from the market. This explains why higher-than-expected profits draw new blood into the market and why heavy losses drive others out. This expansion and contraction is what creates perfect markets to scale. For example, if a producer is prohibited from entering a market because of extremely high costs or it takes a considerable amount of time before the commodity in question can be brought to market (grown, mined, reproduced, etc.), new producers will not enter the competition unless a long-term demand situation exists. Often monopolistic suppliers dominate these types of industries. (Take Dole and the pineapple business as an example.) This also explains why the futures contract for shrimp on the Minneapolis Exchange never became popular when Red Lobster refused to participate. Big Red has the suppliers, the major fishing fleets, under contract and does not need a futures contract. Good scale trading commodities always have a strong commercial contingency supporting them in the cash and futures markets. There are some commodities that have characteristics of both the perfect and the monopolistic competition market structure. These fall into the category of oligopoly market structures. Frozen orange juice comes to mind. It is difficult to enter or exit, because a large grove of bearing trees is required to be an efficient producer.

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Most producers are large and few in number. The fact that the fresh juice is frozen and held in inventory creates an artificial supply situation. The uneven impact of weather, freezes specifically, accounts for the commodity’s price volatility, making it a possible scale candidate. Coffee and cocoa are similar in that it takes considerable resources and time to enter these markets. But it is the political interference sighted earlier that makes these two commodities attractive scale trading candidates. Plus the demand base is so large, varied, and reliable; what would we do without our morning coffee and afternoon candy bar? On the flip side of this coin, if too many of the producers cannot exit a market easily, they continue to produce and that keeps prices low. When hog production moved off the family farm to corporate producers, the high overhead of these farrow-to-finish facilities forced the large facilities to keep turning out pork regardless of the price. They cannot ration supplies easily, and the scale trader can have a problem closing out a scale. The existence of frozen stocks in warehouses exacerbates the problem Another prominent example is OPEC. If it had ironclad discipline, crude oil would be an outstanding scale trading candidate. You would enter a scale and ride the market down. OPEC would cut off the tap at some point, and prices would rise, closing out your scale. But since OPEC members cheat on their quotas and not all major oil-producing countries are members of OPEC, scale traders cannot always close their scales and are occasionally forced to keep rolling positions into the future. Eventually they are hopelessly in positions that they can never exit at a profit. That is the problem you may face in markets when producers cannot exit quickly and easily—just another reason to have a put option or two in your back pocket. Time is of serious concern for the scale trader. For example, the supply of feed grains, as was mentioned, can be increased or decreased from growing season to growing season. The word season should be read as seasons, meaning some commodities like wheat are being harvested 12 months a year somewhere in the world. Meat production varies by species. Whereas it takes two years to increase live cattle numbers, hogs take half that time. Some commodities just cannot react quickly. Olive trees take 12 years to

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mature, and coconuts as much as 15 to 20 years; both compete with soybean oil in the eatable oil market. Crude oil supplies, on the other hand, can be boosted promptly by pumping more from existing wells. Even so, it can take six to nine months to get a usable product (gasoline and heating oil) to where it can be utilized, presupposing oil refinery capacity is not maxed out. Further, finding new sources and getting them into production can take years and is expensive and highly risky. Demand can be equally fickle. Cancer and mad cow disease scares cooled the demand for red meat in some countries, for example. But alarms like these often dissipate as quickly as they appear. Others tend to be more long-term but futile. Take our love-hate relationship with gasoline. There is not an environmentalist on earth who would not want to do away with it. On the other hand, we all want the freedom to travel by car at will. Even fashion can play a part in the supply and demand tugof-war. Demand for cotton took a tumble when synthetic fabrics became popular. You would not have wanted to be scale trading cotton when that happened. Fast-moving changes in technology can impact demand as well; for example, the adoption of fiber optics impacted copper demand. The introduction of the catalytic converter drove platinum prices into the stratosphere. So far, we have discussed only fundamental analysis of the commodities you plan to scale trade. The reason is that fundamental analysis is the key to success, and it reveals the long-term trend. It can tell you if, and approximately when, a market is expected to reverse and head north. If you do not think you can see light at the end of the supply-demand tunnel, do not enter any scale. Wait for clarity—not perfect clarity, but you must have a good feel for how long the commodity you are trading will be in the cellar. As we have seen, fundamental analysis deals primarily with economic data. This will become more apparent in the next chapter when we build some economic models. There is another type of price analysis called technical analysis. It is based almost exclusively on analyzing price data and patterns. Most futures traders rely heavily on this type of analysis. As scale traders, we use technical analysis as well, but not quite as much. The reason is that once we decide on a commodity to trade and develop a scale, we tend to stick with it to the end,

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barring jolting fundamental changes. Active futures traders and speculators take a completely different approach. As I mentioned earlier, they are more like fly fishermen, constantly casting their line into the market with the hope of a strike. If they don’t get a hit, they try again. The scale trader, on the other hand, plans meticulously and adheres to the plan. The primary planning tool is fundamental analysis. There must be some assurance as to when the commodity being scale traded will bottom and begin to move back into its normal trading range. If the speculator is a fly fisherman, the scale trader trolls the bottom for his or her catch.

TECHNICAL ANALYSIS Despite the heavy reliance on fundamental analysis, there are some technical trading tools of substantial value. The technician will tell you that every change in the supply-demand equation is immediately reflected in the price action of the commodity being analyzed. One must therefore know something about technical analysis to be alerted to fundamental changes that do not become immediately apparent for a variety of reasons. As mentioned previously, fundamental information tends to trickle into the market. By the time it is apparent to most market participants, prices have already been impacted. Knowing the basics of technical analysis is a vigilant way of looking for changes taking place in the fundamentals. Once you can define and quantify the fundamental change, you are prepared to make adjustments in your scale trading program. The most widely used technical analysis tool is price chart analysis (refer to Chapter 1, Figure 1-3). Scale traders track price charts to determine which commodities are in or about to enter the lower one-third to one-quarter of their 10-year trading range. Therefore, you need access to some long-term, continuous charts. These are available either on the Internet or from a subscription service. Some sources are noted in Appendix 2. Continuous charts, by the way, are charts in which the prices of several contracts are laced together, giving you a long-term perspective. As one contract expires, another one is linked to it. You will often see gaps in the prices, since the closing contract may

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be trading higher or lower than the new contract that is being added. Don’t let this throw you. Physical commodities tend to be influenced by inflation. The cost of production (equipment, labor, inputs) generally increases over time. So must the price of the product to encourage the producer to continue to produce. This, in turn, makes the commodity more valuable. It is for this reason that using the lower quarter of the 10-year trading range is a “safe” assumption of a price point to enter a scale. The word safe is in quotation marks. This is to denote that when one invests in anything that is going to happen some time in the future, nothing is totally safe. Also, there will be periods when prices decline even as inflation and other factors increase. Plus there are times when inflation is dormant. These periods often see the intervention of the government in the way of price support programs and supplements to keep production of essential commodities going. When you see this happening, avoid scale trading the commodities affected; there is no light at the end of the supply-demand equation. Technical analysis may provide the first clue that something is amiss. Nevertheless, the scale traders believe that over a 10-year period inflation, even at low rates, moves prices higher—particularly from all-time lows. Therefore, it is a good, calculated risk to begin a scale in this price range. All that said, there is nothing stopping a commodity from setting all-time new lows, and that is the reason scale traders carry some reserves in their trading account and buy insurance in the form of options. Another key element of technical analysis involves an understanding of liquidity. The commodities you should be considering to scale trade must be actively traded by speculators, so we will be able to enter and exit trades at will. Oats is an example of a commodity that has all the characteristics of a good scale trading candidate but often lacks the liquidity to trade. Trading volume is displayed as a bar along the bottom of most commodity price charts. Technical analysis is an excellent tool for selecting entry points or determining when to actually begin a scale. Use it to avoid beginning a scale too soon. If you open a scale at a price that is too high, you can have a costly problem as you wait and wait for the commodity prices to return to the level required for you to

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completely close out your last position. The first position opened is the last you closed. For example, you are scaling a commodity that has had a trading range from a high of $4.00 to a low of $1.50 per unit (bushel, barrel, hundredweight, ton, bale, etc.) over the past decade. The contract size is 5000 units. The scale you decide to trade has you buying each nickel down and selling for a nickel up. Your profit objective is $250.00 per contract before transaction (commissions and fees) costs. You anticipate the maximum low to be $1.00. Theoretically, the scale should begin when the commodity price hits $2.12 1⁄2, which is the beginning of the lower one-quarter of the 10-year trading range (see Table 5-1). To avoid beginning a scale too soon, never enter the first position until the price of the commodity closes below the 20-day moving average. A moving average is calculated by adding the prices for the most recent days together and dividing by the number of TA B L E

5-1

Profit-Taking Table

Buy Price 1. 2. 3. 4. 5. 6. 7. 8. 9.

$2.121⁄2 $2.071⁄2 $2.051⁄2 $2.001⁄2 $1.951⁄2 $1.901⁄2 $1.851⁄2 $1.801⁄2 $1.751⁄2

10. 11. 12. 13. 14. 15. 16.

$1.70 ⁄2 $1.651⁄2 $1.601⁄2 $1.551⁄2 $1.501⁄2 $1.451⁄2 $1.401⁄2 1

Profit Contract Sell Price

Cumulative ($0.05  5000)

Gross Profit

$2.171⁄2 $2.121⁄2 $2.071⁄2 $2.051⁄2 $2.001⁄2 $1.951⁄2 $1.901⁄2 $1.851⁄2

$250.00 $250.00 $250.00 $250.00 $250.00 $250.00 $250.00 $250.00

$250.00 $500.00 $750.00 $1000.00 $1250.00 $1500.00 $1750.00 $2000.00

$1.801⁄2 $1.751⁄2 $1.701⁄2 $1.651⁄2 $1.601⁄2 $1.551⁄2 $1.501⁄2 $1.451⁄2

$250.00 $250.00 $250.00 $250.00 $250.00 $250.00 $250.00 $250.00

$2250.00 $2500.00 $2750.00 $3000.00 $3250.00 $3500.00 $3750.00 $4000.00

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days in the sequence. In this case, a 20-DMA (day moving average) is the sum of the prices over the last 20 days, divided by 20. Each day, the oldest price is dropped and the current one added. In most cases, the closing price is the number used. Nowadays, virtually all computerized charting packages calculate and plot moving averages of any length and update them automatically. With any type of analysis, it is always a good idea to look for other data that corroborates an indicator that you are using to make a decision. In this case, study the daily chart pattern to see if a trend line has been broken. You would be looking for a shortterm trend line, perhaps over the past five days. Or you can draw channel lines; these are parallel trend lines. In this case, you are looking for a down-trending channel. Therefore, the top channel line would be drawn connecting the lower highs of the past few days. The bottom channel line would connect the lower lows over the same period. A down-trending channel confirms the signal given by the 20-DMA. Technical signals can often be self-fulfilling prophecies. When commodity traders spot the downtrend and the declining moving average, the specs are ready to short that commodity. This is what you are looking for—technical confirmation of fundamental information. The negative technical signals drive prices lower. You can often have several of your positions filled in quick succession, because herd psychology drives the market lower. Do not let this bother you. In many cases, this is an overreaction. Traders often resemble lemmings—they all go over the cliff into the sea just because the first one did. When they feel they have overreacted too much, they will reverse and overreact in the other direction. Enjoy the oscillating profits. As a downtrend progresses, the prices will get extremely attractive to our friend the inventory manager, and he will begin to buy. This slows down the move south, creating some more oscillating profits and gives everyone a chance to reassess the situation. At this point, prices may go higher or lower, but as a scale trader you are in for the long haul. This is just an example of how technical analysis helps a scale trader. I will be talking later about how technical analysis can help you get higher returns by increasing the number of oscillating profits you can execute.

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Last of all, do not forget what was said about volatility and how it impacts price. Later, I will tie all these technical concepts together into coherent trading strategies to increase your returns. Once you begin a scale, you normally continue it until you are taken out of it by rising prices. It is critical to know how to maximize your efforts. Now let’s discuss specific commodities and groups of commodities to determine which are suitable for scale trading.

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Selecting the Perfect Commodities to Scale Trade

Reviewing the most important characteristics of scale trading candidates may be the best way to begin this discussion. In my estimation, the single most important attribute is the presence of some form of what was described in the last chapter as perfect competition. This simply means that no single entity completely controls the supply and/or demand for the commodity you plan to scale trade. The ideal, which occurs rarely, is a marketplace with thousands and thousands of producers and just as many users. It is also extremely important that institutional and commercial users, who have the resources to buy, store, and use the commodity whenever the price is right, are plentiful. Professional inventory managers are often the kingpins of price discovery. Perfect competitive markets are wonderful to trade. They swing from overbought conditions to oversold and back again, like the pendulum of a grandfather clock. When the conditions are right, a scale trader can be in and out of three or four scales a year. As we all come to expect, rarely do you find anything perfect— in life or in the futures markets. A lot of the other factors, particularly greed and fear, come into play, disrupting smoothly functioning markets. Nevertheless, this characteristic, or at least a reasonable facsimile thereof, is the one factor you should always look for when researching scale trading candidates.

89

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The next thing I look for is a strong and reliable supply of information. Knowledge is golden when your primary analytic tool is fundamental analysis. There is no other way of evaluating supply and demand over the long term. Unfortunately, this is also one of the scale trading’s greatest weaknesses. First, there is usually too much information. You will find thousands of pages on the Internet on any commodity. The data can fill every hard drive you own; still, some key facts will be missing. All this will become more evident when you begin to study specific groups of commodities. The overabundance of information, combined with some missing links, is a fact of price forecasting you must accept. The beauty of scale trading is that you can be successful without having every single bit of information. Scale trading is more like throwing hand grenades or horseshoes; you can score big by just being near the target. The scale trader enters a market when it is in the lower quadrant of its long-term trading range and stays in it until it returns to its “normal” trading range. You are trolling, not fly-casting. You put your hook in the water and keep it there until you catch your limit. This is a lot different from having to predict the exact moment a commodity price is going to change its trend, as the speculator must. Always concentrate on the most important information you will need to know: about how long will it be before the commodity bottoms and begins moving to its normal trading range? You do not need an exact date, just a good estimate. You can be off by months and still be extremely successful. My third favorite characteristic is that the commodity can be produced and used globally. This factor relates back to the first one, perfect competition. The worldwide aspect often means more competition. The fact that farmers in South America began competing with North American farmers for the soybean market added liquidity and volatility to that market. You see this as well in the crude oil market when the North Sea and Venezuelan producers do their best to spoil OPEC’s plans. Elasticity is critical. The price of a commodity must give and take as the supply-demand equation is recalculated. There is also what is known as semielasticity in some commodities (e.g., crude oil). Prices

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can go to “outrageous” levels, and there is still a market. But sooner or later a limit is reached, and developing countries, the main users, look for alternative sources—synthetics, substitutes, and, if all else fails, conservation. Then, when things are back to normal, they punish the offenders, even to the point of invading them. Politics is trickier both to evaluate and to predict. Nevertheless, political actions create volatility, meaning opportunity for the commodity trader. Most of the time, the political decisions help the scale trader. Governments are protective of their farmers, in general. They buy large amounts of food when their people are starving or there is an overabundance (reducing supply) to keep their people fed or their farmers in business when tough times hit. Being fickle, politics can hurt as well. Some South American countries will undercut the price of soybeans on the world market to dump inventory, while at the same time subsidizing their farmers to produce more. The same goes for many EEC markets. This occurs when member countries need foreign currency at any price. It has a negative impact because it drives down the price of commodities being scaled, which may cause you to extend your bean scale. Worst of all, these moves are totally unannounced, because the country making them acts secretly in order to surprise the market in hopes of locking in a better price. Again, just another reason to have a few well-placed options as insurance. The last condition goes without saying, i.e., the uncontrollable factors. Largest among them is weather. When it is too favorable for long periods of time, you might not be able to see the light at the end of the supply-demand tunnel if you are scaling an agricultural commodity. Or a drought scare could stop you from starting a scale by blowing prices out of the lower quarter or third of the 10year trading range. Unfortunately, there is nothing that can be done about weather, except to buy some insurance. News also falls into this general category of uncontrollable events. But keep in mind that news almost always generates only a short-term impact. More often than not, news will create some volatility, which is another important criterion. Volatility produces oscillating profits. In every scale, we look for one or two oscillating profit opportunities every week or so, especially in the first month or two of a scale. This occurs because the buyers (inventory managers) do not know if the commodity is really heading south. They test the

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downtrend until they are confident it is for real. Remember that they have been buying the commodity for quite a while at a higher price, so it now looks like a bargain to them. Once they are convinced it is going lower, they buy only from hand-to-mouth, to the extent that they need the commodity for production of their products. And don’t ever overlook liquidity. A sufficient number of contracts must be bought and sold each trading session to get all buy and sell orders filled expeditiously. As you will see, there are some seemingly promising scale trading commodities that you should avoid just because they do not have enough liquidity. For this reason, I also recommend you trade only on the U.S. commodity exchanges. That is where the world trades; that is where you will find the liquidity and volatility you need.

THE GRAINS I will begin with the grains because, of all the commodities, they come closest to fulfilling all seven of the criteria for a perfect scale trading candidate. (Once again, for the record, nothing is perfect in the world of futures trading.) The grains are also the commodities familiar to most of us. There is nothing esoteric or complicated about them. You simply plant, harvest, store, and distribute them. When I speak of the grains, I am specifically referring to corn, oats, rice, soybeans, soybean meal, soybean oil, and wheat. Worldwide, there are many other grains (e.g., azuki beans, barley, canola, flaxseed, field peas, rapeseed and meal, red beans, sunflower seed and meal) traded on futures exchanges. I have deliberately omitted them because they are not traded on an exchange in the United States. This is not a patriotic issue. Only the U.S. exchanges have the liquidity needed to trade comfortably. Second, only these exchanges afford you the regulatory protection of the National Futures Association (NFA), which will be explained in Chapter 11.

Corn, Beans, and Wheat I begin with corn, keeping in mind that most of what is said about corn also applies to soybeans and wheat. Soybean meal, bean oil, oats, and rice are discussed separately.

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There are approximately 200,000 commercial farmers in the United States, and a good percentage of them grow corn and beans. Many grow wheat on their poorer land in the Midwest. Wheat is the primary crop on Western farms due to the reduced amount of moisture needed to grow it as compared with corn and beans. This qualifies them for the first criterion of having enough competition on the producer’s side. On the user side, there are hundreds of thousand of on-farm cattle and hog producers that use most of their corn and bean production themselves. Only the production they do not use for feed hits the open market. Additionally, corn is sought by commercial meat producers, i.e., producers of cattle, hogs, turkeys, chickens, etc. Then there are corn sweetener and gasahol manufacturers. Exporters play a big role most years, since the United States is the world’s largest exporter. On average for corn, domestic feed consumes 60 percent of the crop, while exports takes 20 percent and industrial use is 20 percent. These are enough major players to qualify corn as a “perfect market.” Wheat, being primarily a food grain as opposed to a feed grain, is exported or sold to commercial users, i.e., major baking and cereal manufacturers. Most of it, of course, runs through a series of middlemen from grain elevators to wheat brokers, which gives it a healthy commercial contingent. Wheat, in the United States, is unique in that there are two seasons: winter wheat is harvested midsummer, and spring wheat is harvested in early fall. It is further classified as durum and common. The subcategories of common are hard red and soft white. Approximately 60 percent of the U.S. crop is exported, accounting for much of the buy side activity. Abundant information is the next key issue. There is no shortage here of good information. On the contrary, too much information is the norm. To understand what you are looking for, let us review the supply-demand equation for the grains. Beginning Stocks  Production  Imports  Total Supplies Feed, Seed, Residual  Food  Export  Total Usage or Demand Total Supplies  Total Demand  Ending Stocks or Carryover

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For corn and beans, the import figure is not significant since we produce so much. Occasionally, importation of wheat can be controversial. We quarrel with our Canadian neighbors about their dumping of wheat on our market, and we need, from time to time, special varieties for special products. A key element of wheat production has become the protein content. The higher, the more demand for the wheat. Therefore, quality and type can be an issue on the demand side. The residual between the total supply and the total usage for a given marketing year (for corn it is from October 1 to September 30 of the following year or harvest to harvest) is often reported as a percentage of the total used. This gives the scale trader an idea of how abundant or scarce the commodity is, which can be translated into, “Is there light at the end of the grain supply-demand tunnel?” The primary source of supply-demand information for agricultural products is the U.S. Department of Agriculture (USDA). It calculates, as the world moves from harvest to harvest, the number of days’ supply of the key grains that are available. When the world gets down under a 100-day supply and there are still months to go before the next harvest or if there are production problems, the supply situation becomes news. Remember, the world is harvesting corn, beans, and wheat all year long, but most of the world’s free stocks are produced in the United States. Most of the rest of the world consumes what it produces, except in years when there are bumper crops. A scale trader needs to be able to spot these years and avoid trading grains in them. Look to the USDA to issue monthly an estimate of the supplydemand table (Table 6-1) in the World Supply and Demand (WASDE) Report. This report, one of 300 the USDA generates, is available on the World Wide Web (www). It is usually issued midmonth and includes demand estimates for most U.S. field crops and crop conditions in foreign countries. It is your bible, as a scale trader of grains, and has a big impact on futures prices. See Appendix 2 for more details on USDA reports and its Web site. You will also want to track USDA’s Crop Progress Reports, which provide weekly updates of crop conditions throughout the growing season. This is your early warning of increases or decreases on the supply side of the equation.

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6-1

USDA Supply-Demand Table World and U.S. Supply and Use for Grains* Million Metric Tons

Commodity Total grains‡ 1998–99 1999–00 (est.) 2000–01(proj.) June July Wheat 1998–99 1999–00 (est.) 2000–01(proj.) June July Coarse grains § 1998–99 1999–00 (est.) 2000–01(proj.) June July Rice, milled 1998–99 1999–00 (est.) 2000–01(proj.) June July

Output

World Total Trade † Supply

Total Use

Ending Stocks

1,872.76 1,864.43

2,204.73 2,221.16

256.20 266.65

1,848.00 1,878.25

356.73 342.91

1,868.86 1,868.76

2,207.93 2,211.67

267.23 265.49

1,889.38 1,882.67

318.38 328.99

588.58 585.67

727.31 723.43

121.85 127.63

589.54 596.78

137.76 126.65

575.81 581.25

701.69 707.90

126.93 126.95

595.44 593.84

106.25 114.06

890.21 875.99

1,028.59 1,034.81

107.47 115.74

869.77 881.60

158.82 153.21

892.73 888.27

1,043.72 1,041.48

115.10 113.52

890.93 887.36

152.79 154.12

393.98 402.78

448.83 462.92

26.89 23.28

388.69 399.87

60.14 63.05

400.31 399.23

462.51 462.28

25.20 25.02

403.00 401.48

59.51 60.81

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TA B L E

6-1 (Continued)

World and U.S. Supply and Use for Grains* Million Metric Tons

Commodity Total grains ‡ 1998–99 1999–00 (est.) 2000–01(proj.) June July Wheat 1998–99 1999–00(est.) 2000–01(proj.) June July Course grains § 51.37 1999–00(est.) 2000–01(proj.) June July Rice, milled 1998–99 1999–00(est.) 2000–01(proj.) June July

Output

United States Total Trade † Supply

Total Use

Ending Stocks

346.71 332.67

411.61 416.18

86.99 87.13

246.80 250.55

77.81 78.49

337.43 344.91

418.87 429.21

90.23 91.46

253.13 250.07

75.51 87.68

69.33 62.66

91.79 90.96

28.36 29.67

37.69 35.44

25.74 25.86

60.20 61.03

87.89 89.61

30.62 29.94

35.25 33.91

22.03 25.76

1998–99

271.47

312.69

55.95

205.37

263.38

317.54

54.66

211.43

51.45

270.93 277.77

323.11 331.96

56.84 58.74

214.11 212.40

52.16 60.82

5.91 6.64

7.12 7.67

2.68 2.81

3.75 3.68

0.69 1.19

6.31 6.10

7.87 7.64

2.77 2.77

3.77 3.77

1.32 1.10

* Aggregate of local markets years. † Based on export estimate. See individual commodity tables for treatment of export/import imbalances. ‡ Wheat, course grains, and milled rice. § Corn, sorghum, barley, oats, rye, millet, and mixed grains (for U.S. excludes millet and mixed grains). Source: United States Department of Agricultural, 7/17/00 This is an example of a USDA Supply-Demand Table. You should learn to read these tables and follow them for the commodities you are scale trading. You will find substantial amounts of analysis and comments on these reports on chat rooms, in newsletters, and from your brokerage firm. You will understand and be using them very quickly. They provide the insights you need to determine when the market is about to turn in your favor. The USDA provides these reports on all major and many minor commodities.

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One minor difference between corn and beans is that producers hold back some of their bean production to use as seed for the next year. This is taken into account in the supply figures. With most other field crops, the seeds are grown separately, as hybrids. You must also pay attention to any grains destined for human consumption that become contaminated by genetically altered corn. This can change the supply-side numbers. Futures trading is all about getting the news first. There are several fine consulting services that attempt to anticipate what will be in the USDA reports so traders can be prepared. Sparks Companies, Inc. (www.sparksco.com) is an example. It actually sends field scouts into the major producing areas of the world (foreign countries, such as South America for soybeans, as well as the United States) to count plant population per acre and report on field and crop conditions as the growing season progresses. How can a scale trader use this information? If, for example, you have not covered your futures positions with puts or enough positions with options, by reading a service such as Sparks you may be able to add protection before the USDA report is announced and the market overreacts. This situation can occur when you are just beginning a scale; perhaps you are starting one too soon or at a price at the high side of the scale. You are alerted to some very good news about production (saturating rains in an area short on rainfall so far that season), which might cause the commodity you are beginning to scale to limit down for a day or two. You can either exit the position or buy some cheap puts or sell a few calls. That is how you use these services. But consider an extreme approach like this only during extreme circumstances; it is not standard hedged scale trading practice. On the demand side, one of the most important reports issued weekly is the USDA’s Export Inspections. It details the total tonnage shipped to foreign countries. You use it to access how strong or weak demand is and compare it to the Monthly World Supply and Demand Report. Is demand stronger or weaker than projections? Don’t forget, the United States is the world’s most important exporter of grains. A good export year can clean out a scale in double-quick time. Naturally, the export market satisfies the requirement that the commodity is global on the demand side. On the supply side, almost every country in the world grows some wheat. As far as

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soybeans are concerned, they are certainly grown widely. That is true for corn also, but it goes under some other names—maize for example. Additionally, there are hundreds of varieties of grains grown worldwide that are basic substitutes for corn and soybeans. Price elasticity is the next requirement. Will the price of grains stretch and contract in response to the supply-demand situation? Once you study some 10-year charts and see corn prices ranging from approximately $2.00 to $5.50 per bushel, soybeans from $4.50 to $13.00 per bushel, and wheat from $2.50 to $7.00, I think you will be convinced that there is some elasticity in these markets. And, as was mentioned, the substitution factor is always present if one of these commodities gets too expensive. This brings us to some of the uncontrollable factors—first, weather and politics. Weather, when you are talking grains, primarily means water. It takes 5000 gallons of water to produce a bushel of corn. That amounts to 18 to 24 inches of rain during the growing season to grow 100 to 175 bushels per acre of corn. Beans need less and, of course, wheat is the choice of dry land farming. Besides rain, there is hail and wind to worry about; either can knock down a crop. Further, farmers worry about too much rain at planting or harvesting, which can keep them out of the fields and reduce the harvest. If that were not enough, there are insects and diseases. As a general rule, foul weather is not the worry of the scale trader. It will help you close a scale by raising prices to hit your exit points. In addition, false rumors of weather problems can run prices up for short rallies, generating oscillating profit opportunities. It is unexpectedly good weather you need to prepare for by insuring your positions with options. Consistently outstanding weather may prolong a scale, causing you to roll over positions into more distant contracts or close some out at a loss. But a little fickle weather that generates oscillating profits is a blessing. You will be happy to know that just about every summer there are drought scares throughout the corn belt. Information about weather is another one of the services available from USDA and the key growing states. USDA works with all the other government services to gather and interpret data on the impact of weather on crop production. You will be impressed with the satellite photographs available free on the Internet. The second uncontrollable element impacting price trends of grains is politics. The major agricultural policies of Congress are

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well publicized in advance. They have to do with protecting the farm, specifically the family farm, and ensuring cheap food for the U.S. population—both are good politics. These policies usually help the scale trader exit scales by driving low prices higher. Another area of concern is unexpected, emotional reactions from foreign governments in retaliation for something our government did in another area. We might restrict immigration from a certain country, which, in turn, cancels its soybean purchases and buys from Brazil instead, throwing the bean pit into chaos and triggering two or three limit-down days. The United States is not immunized against this behavior, as anyone who remembers Jimmy Carter’s grain embargo (January 4, 1980) will attest. When these situations occur, you had better be practicing safe scale trading by having some price protection in place. The last two standards are technical in nature—volatility and liquidity. One feeds on the other. If you have a lot of price activity, it attracts traders, which increases liquidity. If you have a lot of liquidity, it creates volatility. There are several ways to measure volatility. The most common is standard deviation from the mean or middle (average) price. This can be illustrated with bell curves (see Figure 6-1). The wider the curve, the more volatile the price activity of the commodity. This is because the price points are more scattered and it takes a larger area to cover one standard deviation from the mean, or 68.3 percent of all occurrences. Other ways of measuring volatility are the daily trading range and the average daily movement of the commodity futures contract. Naturally, the higher these moves are, the more volatile the commodity. You can find volatility measurements on various Web sites on the Internet. Another excellent source is Futures magazine (see Table 9-1, Volatility Table). In its annual sourcebook, you will see ratings of all the major commodities, giving you both volatility and liquidity figures. For example, the daily volume for corn, soybeans, and wheat generally exceeds 65,000, 50,000, and 25,000, respectively. These commodities also have very acceptable volatility ratings, not too high and certainly not low.

Oats The commodities in the grain group that are questionable are oats and rice. I like the way oats trades and have seen some experienced

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FIGURE

6-1

Volatility Curves

Low

Medium

High The closer price points are, the lower the volatility. High-volatility markets are characterized by wide or flat curves, since the data points are spread out.

scale traders do well with oats. Nevertheless, I disqualify oats, especially for the novice scale trader, because of lack of liquidity. The average daily number of contracts changing hands usually is around 1500, not much compared with corn, beans, and wheat. Also, there is not nearly the same number of oat farmers as for corn, beans, and wheat. Nor are oats distributed globally on a wide enough scale to qualify. Once you get a few scales under your belt, you may want to track oats for a while. There are times when liquidity is at acceptable levels. Take care to be particularly attentive to the more distant contracts, the ones you would be trading.

Rice Rice also lacks liquidity, with approximately 500 or 600 contracts traded daily. The producers are primarily large corporate farmers in California or major cooperatives composed of individual farmers in the South. Little of the crop from a worldwide perspective

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is grown for the U.S. market, but most all of the U.S. crop is exported. Our exports usually represent the majority of the free stocks, since most producing countries consume their own production. If I were your broker, I would recommend avoiding oats and rice until you have learned to trade thin markets. This is a special skill most suited for speculators. Thin markets are easy to enter and hard to exit. As a scale trader, you would be buying a contract that has several months left to expiration. These are particularly thin. You could conceivably get a decent fill using a limit order on an entry position. When it was time to close trades or roll positions, the contract would probably be the expiring contract month, normally the most active. This means you could probably do the trades necessary. But what concerns me is once you started a scale, could you get all or enough of your opening limit orders filled or would you have liquidity problems? Second, how would these markets behave? Thin markets have a tendency to be very volatile. Prices can swing up or down by 5 percent, 10 percent, or even 25 percent on little or no volume. You could get an oscillating trade on one of these spikes but not be able to replace that regular scale position. In other words, you could get a scale started and be left hanging because of inactivity in a distant contract. Also, you would most assuredly have even more liquidity problems with options on these commodities.

Soy Meal and Oil Let’s talk a little about bean meal and oil. These are byproducts of crushing beans. Meal is cattle feed, and oil has a million uses, eatable oil being one of the primary ones. It also has thousands of industrial uses. Part of your work, if you are scale trading beans, is to track supply-demand for meal and oil. It is obvious that demand for either meal (caused by increasing livestock numbers) or oil (shortages of competing oils—palm, sunflower, coconut, etc.) will drive up the price of soybeans. The reverse, low demand for meal or oil, diminishes the demand and price of beans. It gets more complicated when demand for meal is high and low for oil, or the opposite. Part of your fundamental analysis of the soybean market is to track the crush spread. You will want to have a feel for how profitable

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it is to crush soybeans into oil and meal. If it is not profitable, you may want to consider scaling meal or oil. If it is, it will show you the light at the end of the soybean supply-demand tunnel if you are in a bean or meal scale. Here is how it works. The standard weight of a bushel of beans is 60 pounds. When crushed, it produces 48 pounds of meal and 11 pounds of oil. One pound is lost in processing. Since beans are quoted in cents per bushel and meal in dollars per ton and oil in cents per pound, it takes a little work to compare the value of each component in the crush. To convert meal, you divide the 48 pounds of meal yielded by 2000 pounds, a ton. This generates a conversion factor of 0.24. Multiply this by the price of meal to get cents—or dollars and cents—per bushel. For example, let’s say meal is at $180.00 per ton. You get $4.32 per bushel ($180.00  0.024). Oil is a snap. If 11 pounds of oil are contained in the bushel of beans, multiply this by the price of oil. When oil is $0.20 per pound, it would equate to $2.20 ($0.20  11). Once all the components are in dollars and cents per bushel, you calculate the gross processing margin (GPM), which is the difference between the combined sale value of the byproducts (meal and oil) and the cost of the beans. The soybean processors, who are the soybean inventory managers, decide how aggressively to process beans depending on how wide or narrow the GPM is. As far as technicals are concerned, volatility and liquidity are good for both meal and oil. Additionally, these commodities are satisfactory from a standpoint of the other criterion. They are scale trading candidates. Figure 6-2 shows my preferences as far as scaled trading the agricultural commodities.

THE FOOD AND FIBER GROUP This group includes coffee, cocoa, sugar, frozen orange juice, cotton, and lumber. There are some others (e.g., milk, butter, cheddar cheese, white shrimp, black tiger shrimp), but they lack volume, which means you should not scale trade them. Coffee Coffee is a good scale trading play, even though it does not meet all the criteria. It is not a perfect market on the production side of the

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103

6-2

The Grain Complex Corn Soybeans Wheat Oats Rice Soybean Meal Soybean Oil

supply-demand equation. Coffee is grown on large plantations, usually owned by small groups of growers. It takes four years before coffee trees produce “cherries,” which become coffee beans. On the demand side of the equation, coffee is more of a perfect market, but most of the beans are funneled through a few brokers. In some cases, the government of the country in which the beans are produced manages the inventory. This can be a positive for the scale trader because, as with cocoa, the government of the producing country will hold product off the market when prices are unacceptably low; thus the scale trader can completely close his or her scale. These interventions can also give you a few oscillating profit opportunities. Being a major crop, coffee is watched carefully from the first budding of the trees to harvest. You will have no problem finding information. The only problem is that most coffee is grown outside the United States, Hawaii being the exception, so the government of the producing country may attempt to occasionally muddy the waters. The major producing areas are in Africa, which produces the robusta variety, and South America, known for its Arabica. The latter is the most highly prized by coffee drinkers. Since the whole world drinks coffee, it is a global commodity on both sides of the supply-demand equation. Coffee prices, particularly at retail, are inelastic. The price can go to the moon and still find buyers. But the scale trader is not worried about that end of the pricing scale. The only problem is that

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coffee can stay high for long periods of time and not offer any scaling opportunities. The scale trader is usually more concerned about political events. Since the main growing regions are in the underdeveloped countries of Africa and South and Central America, production or other problems that prevent product getting to market can interrupt the normal supply chain. Usually these delays are not longlasting, but they are followed by large amounts of product hitting the market. This, in turn, impacts price. With a little luck, you will also have some oscillating profit opportunities. There is also the possibility that one of these undeveloped countries will dump product on the market to obtain foreign currency in a financial emergency, thus trapping you in a scale. Another political consideration is the International Coffee Agreement, which sets annual production quotas for countries that belong to it. Seventy-five countries, including the United States, are members. The purpose is to stabilize the price. Organizations like these are usually a boon to scale traders. From a technical standpoint, futures contracts on coffee at the CSCE (Coffee, Sugar, and Cotton Exchange) Division of the New York Board of Trade rate satisfactory for volume. Daily volume is normally 10,000 or more contracts. Volatility is also high. It regularly scores in the top 10 in Futures magazine’s “Movers and Shakers” list, which is published in its annual sourcebook (Table 9-1). Sugar and frozen concentrated orange juice (FCOJ) are usually in the volatility top 10 as well. Weather, as with any crop commodity, is critical. Coffee needs substantial amounts of rain during the growing season, up to 40 inches. Arabica is more sensitive, while robusta is hardier. Satellite weather maps, available on the Internet, will keep you informed, but you must be attentive. Cocoa From a scale trader’s perspective, cocoa is similar to coffee. It does not have a perfect market. Price and supply are inelastic. Production takes place in Africa primarily, while some is produced in South America. Undeveloped governments control supply; demand is global and inelastic. Daily volume on the exchange is

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usually over 5000 contracts, and volatility is strong. It has been historically a great scale trading play. International commissions, composed of producer and user states, attempt to manage the supply-demand balance for both coffee and cocoa. These organizations can be the scale trader’s best friend; they can turn on the light at the end of the supply-demand tunnel. If you scale these commodities, become familiar with them. For coffee, it is the International Coffee Organization (www.ico.org), which is composed of 24 exporting and 14 importing countries. The International Cocoa Organization, with its 18 exporting and 22 importing member states, is the counterpart of the ICO. Both are affiliated with International Monetary Fund (www.imf.org), which has substantial influence on supply-demand balances among undeveloped countries. If you trade any commodities that originate in undeveloped countries, you would do well to check the news on the IMF’s site occasionally. Sugar When I speak of futures trading in sugar, I am specifically referring to World Sugar No. 11 traded on the New York Board of Trade (NYBOT). It is the contract with sufficient daily volume, over 25,000 contracts each trading session, to be scale traded. There are some other contracts on sugar, but they lack volume. Sugar is somewhat trickier to scale trade than coffee or cocoa. It has a history of shooting up to unrealistic highs and wallowing at lows for extended periods of time. It is the latter behavior that the scale trader must avoid. This can result in costly contract rollovers. It is a semiperfect market. There are large planters, particularly in cane sugar. For sugar beets, the production is more democratic. The cane sugar is harvested all year long, whereas sugar beet production is seasonal. This can prove difficult to track, yet the amount of information about supply and demand is plentiful. Production is global. The main producing countries are Brazil, Cuba, India, and Australia. Production is split 60-40 between sugar cane and beets. Cane is a perennial, although it does have to be replanted periodically, and production is easy to predict. Sugar beet acreage varies annually and will adjust to demand.

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Demand is also a relatively dependable prognostication because producing countries tend to use most of their own production. Only 15 percent of the crop hits the open market. Additionally, there are few substitutes. The exception is highfructose corn syrup, which is popular only in well-developed countries, where most of the world’s population does not reside. Sugar is a good scale trading candidate, but be sure you have a feel for when the light at the end of the supply-demand tunnel is going to come on before starting a scale. Weather is usually the key and is as unpredictable as it is necessary. Frozen Concentrated Orange Juice (FCOJ) In my estimation, this is a questionable scale trading candidate. The reason is that the supply side of the supply-demand equation dominates. FCOJ can be stored indefinitely, making warehouse stocks a critical factor. You will find the same problem with pork bellies. If you are in a FCOJ scale and warehouse stocks are plentiful, it takes a weather catastrophe to take you out of your scale. Now, weather and insects can do that, but it is not something you want to depend on. The weather problem must be in Florida, the major producing location, to make a major impact. But there is still production in California, Texas, and Arizona. The biggest supply threat outside the United States is Brazil, and it is substantial. I prefer commodities that have a more even balance between supply and demand and do not depend so much on uncontrollable factors, such as weather or news. Finally, daily volume, which runs around 3000 contracts, is on the light side. Cotton Cotton fits most of the criteria we are looking for to scale trade. It is produced by thousands of farmers in over 75 countries. The buyers are somewhat more consolidated, but there is a strong core of cotton brokers and merchants. I say it is a near-perfect market, certainly global. Information is plentiful from USDA and cotton industry groups. Price is elastic, since there are man-made substitutes. The four keys that govern price are weather, domestic and foreign gov-

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ernment programs, fashion, and carryover (inventories). Volatility is in the upper half of the major commodities, and volume is acceptable at approximately 10,000 contracts per trading session. The only weevil in the boll is type. There are several types depending on color, length of fiber, and “mike.” Mike is short for micronaire. It is a measure of airflow through cotton. Immature or overly mature cottons have lower values than perfectly mature cotton. In other words, it is a measure of quality. If you are scaling cotton using the futures contract on the New York Cotton Exchange, the contract calls for 100 bales (50,000 ponds) of low-middling, 11⁄16 inch premium mike. When you see a news story discussing the scarcity of cotton, you need to know the type of cotton or its use. Lumber Lumber, as a commodity, does not fit very many of the criteria I have set. It is not a perfect market. Nor is it global or liquid. It is volatile and there is plenty written about it. The main use, of course, is for building and furniture. Paper is also a concern on the demand side. Prices are elastic on the supply side, but not so much on the demand side. If home building is strong, prices for lumber become almost immaterial as the costs are passed on to the home buyers. Politics, in the sense of environmentalists versus loggers, is a factor. The uncontrollable and unexpected include major forest fires, diseases, insects, and prolonged droughts. Mostly, it is the daily trading volume, which can be as low as 1000 contracts, that forces me to give it only one thumb up as a scale trading candidate. Yet when you peruse the 10-year price chart, you will notice some very attractive swings from overbought to oversold conditions that would have made excellent scale trades. My advice would be not to start with lumber, but consider it when it looks particularly attractive and you have gained some experience trading thin markets. For a recap of food and fiber, refer to Figure 6-3.

THE MEAT COMPLEX Now we will take a look at live cattle, feeder cattle, lean hogs, and pork bellies as possible scale trading candidates. First, let me cross

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FIGURE

6-3

Food and Fiber Coffee Cocoa Sugar FCOJ Cotton Lumber

off pork bellies from the list. My reason is excess volatility; it is too erratic for my taste. When I first got into this business, I was warned: “Never trade pork bellies, unless you work for Heinholt Commodities.” This company is heavily committed to this market and seems to have an edge when it comes to pork belly trading. I don’t know what it is—experience, reliable information, or anything else—but I personally have not seen anyone successfully scale trade pork bellies, let alone trade them. As I said in the Introduction, never trade without an edge. I believe that and do not recommend scaling pork bellies. Live and Feeder Cattle Initially, one would think live cattle would be a very simple futures contract to scale trade because of the time it takes, approximately 21⁄2 years, to bring a steer to market. You use the pipeline method of fundamental analysis with livestock to determine supply and demand. The number of animals in each stage of the entire cycle are counted—the number of cows pregnant (9-month gestation period), calves born, weaned at 300–500 pounds, put on pasture or shipped to a feedlot, and, finally, sent to slaughter. This is the supply side. All manner of reports, private and public (USDA’s Cattle on Feed Report), monitor the numbers and movement. The fact that it takes a good deal of time to make any meaningful adjustment

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would make it seem easy for a scale trader to predict when the light at the end of the supply-demand tunnel is getting brighter. There used to be a very well-defined seven-year cycle, moving from oversupply to undersupply. Unfortunately, this is not the case anymore. Although there are thousands of small feedlots on farms, the cattle business is not a perfect market. Large, corporate meat packers buy most of the feeders. It is at this point in the process that the perfect market terminates. The fact that the packing plants are high-overhead facilities, with contracts to supply major grocery chains, means that they must process meat when the margins are high or low. The system pushes product onto the market with the expectation that adjustments in the retail price will smooth out the supply-demand kinks. It is only when the retail customer balks at high prices that the system backs up. Also food chains can feature cheap meat to attract customers and still make their profit margins on other items. Now this is not necessarily a problem for the scale trader, because the high end of the price chart is not where you will be buying and selling. The problem is that any indigestion within the supply-demand track will cause severe hiccups in the futures market. In other words, the elements of the meat complex—cattle, feeders, hogs, and pork bellies—are known for having more than their share of limit-up or limit-down trading sessions. If you own a position and a limit move against you occurs, you must have—or you will be forced to add—sufficient margin money to hold your positions. Unfortunately, you cannot close the position to relieve yourself of the financial obligation, since no trading takes place. It is for this reason I recommend strongly to trade with options whenever you scale trade in the meat complex. Your options will help compensate for the losses sustained in your futures positions at the beginning of a scale. On the demand side, meat for human consumption is the primary use. There is a certain amount of inelasticity in pricing, but there is a price point beyond which consumers look for substitutes (chicken, pork, fish, etc.) or switch to cheaper cuts (hamburger vs. T-bone). The meat complex is not a global market in that, while there is some importing and exporting, it is not a major element of the supply-demand equation. Countries tend to import breeding

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animals and develop their own meat industry, rather than import the finished product. Box beef may be the exception. Unfortunately, the box beef may be inbound for Australia, increasing supply and extending scales. Carryover, meat in freezer plants, needs to be monitored closely. This is particularly true for pork bellies (bacon) and another reason not to scale them. As for the feeder cattle futures contract, it is too thinly traded for me. Leave it for the speculators to enjoy. Hogs The production cycle of hogs is substantially shorter than that of cattle. The gestation period is four months, and it takes only six more months to deliver a 220-pound hog to market. Another big difference is the centralization of the hog industry. The small hog framers, known as “inners” and “outers,” are long gone. These were farmers who bought some feeder pigs when hog prices were high, fed them out on pasture with their own corn, and cashed in on the uptrend. They have been replaced with highly efficient farrow-to-finish operations. This has diminished the perfect market and increased volatility in the futures market, as mentioned in the cattle section. Again, be wary of limit-up and limit-down trading sessions in this market. The fundamental analytic approach is the pipeline method. What is the number of farrowings? How plentiful are feeder pigs? How many gilts will be held back for breeding? How many market hogs are in the pipeline and at what weights? What is in cold storage? As a scale trader of hogs, you will become an avid reader of USDA’s Hogs and Pigs Report, which is issued quarterly—March, June, September, and December. You must also have a commodity broker that has sources that can anticipate or project the pipeline numbers before the USDA reports. I give one thumb up to scale trading cattle and hogs, two if you use options, and no thumbs up for pork bellies and feeder cattle (see Figure 6-4).

THE PETROLEUM COMPLEX This complex is made up of crude oil, its byproducts (heating oil and gasoline), and natural gas.

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6-4

The Meat Complex Live Cattle Hogs Pork Bellies Feeder Cattle

Crude Oil and Its Byproducts A perfect market? Not with the likes of Exxon-Mobil, Dutch Petroleum, OPEC, and nationalization of production by several prominent nations. On the other hand, information regarding supply and demand is as plentiful as the commodity is global. The price is even elastic, and weather is not a factor, at least on the supply side. On the demand side, cold weather can drive prices of heating oil and natural gas higher. Good summer weather increases demand for gasoline. And the futures market is both liquid (crude 150,000 contracts a day, heating oil and unleaded gasoline 35,000, natural gas 70,000) and volatile. Politics is the most disturbing factor. It can range from an increase in import-export duties to war. As we all know, OPEC quarrels among its own member countries as much as it brawls with the rest of the world. There is just too much money at stake and too much world dependency on this commodity. As with soybeans and the crush spread, it is important to track the crack spread when scaling petroleum. The crack spread is the difference in price between crude oil and the combined prices of the byproducts of cracking—heating oil and gasoline. It is a good method for getting a handle on demand. Is crude oil and its byproducts a good scaling commodity? Yes. My greatest concern is major political upheaval. But when this occurs, it will most likely drive prices higher and take you out of your scale. On the other hand, crude oil prices can remain low for extended periods of time, like sugar. You must have some idea or reasonable assurance that there is an oil lamp burning at the end of the supply-demand tunnel before beginning a scale.

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Natural Gas The natural gas industry has come a long, long way since its early development stages at the turn of the twentieth century. In the United States, it has gone through four distinct phases: 1. 2. 3. 4.

Development, 1910–1950 Regulation, 1950–1970 Market inefficiency, late 1970s to 1980s The present time, an era of adjustment, restructuring, and deregulation

The industry is just now learning how to deal with competition and how to regulate itself. These historic changes account for the price volatility we currently see in the futures market. I am not sure I would call it a perfect market due to its history of regulation, but there are approximately 8000 independent and 24 major producers on the supply side. The gas is then transported through 160 pipelines to 1500 local gas utilities, via 260 marketers. On the demand side, there is a crowd: 53,000,000 residential users, 4,500,000 commercial users, 40,000 industrial and 500 electric utilities. But the competition is localized because few communities are serviced by more than one pipeline or utility. Expensive infrastructure reduces competition. Here are the key forces impacting supply and demand. The first is weather. Above (air conditioning) or below (heating) normal temperatures reduce supply and increase demand. Lack of reliable, timely information impacts both supply and demand, causing explosive price movement in the spot and futures markets. Stock levels, pipeline capacity, and operational problems hamper delivery and reduce supplies. Strong economic conditions result in increased demand. Due to its history as a heavily regulated industry, there is no shortage of information available on the supply-demand situation. Check out www.eia.doe.gov as an example. DOE is the Department of Energy. Additionally, just about every pipeline company, utility, local distributing company, or marketer (gas broker) has something to say on its Web site. There is even a chat room (www.strategiestactics.com), not to mention many consumer groups. Some natural gas is imported, mainly from Canada, but I would not call it a global market. Gas is used worldwide and there

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is some import-export business, but moving natural gas has its restrictions. Now that many regulations have been rolled back, there is quite a bit of elasticity in pricing. Nevertheless, politics will always be a part of this market. If prices get too high for constituents, what will politicians do? Volume of the Henry Hub Natural Gas contract on the New York Mercantile Exchange (NYMEX) runs around 70,000 contracts daily, which is more than sufficient. As mentioned earlier, price volatility is not a problem. Natural gas is a good candidate. Other Energy Contracts There are several other energy-related futures contracts that are possibilities, such as propane or electricity, but I do not recommend them. In general, they lack the trading volume needed to trade comfortably (see Figure 6-5).

THE METAL COMPLEX Let’s talk a little about the futures contracts in silver, copper, gold, palladium, platinum, and aluminum. Of these, I recommend only silver, copper, gold, and platinum. Although I have seen some clients have success in scaling palladium, I still think it and aluminum are too thinly traded, especially for traders new to the concept of scale trading. Platinum is also thinly traded, but it has FIGURE

6-5

Crude Oil and Byproducts Crude Oil Heating Oil Gasoline Natural Gas Propane Electricity

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performed rather well as a scale trading candidate. It is one commodity I reserve for the experienced practitioner. When a futures market has low volume, you often find the options are also extremely thinly traded as well, doubling your risk factor. Silver Since silver today is mined as a byproduct of the mining of base metals, such as copper, zinc, and lead, the supply side cannot be said to be a perfect market. The companies that do the mining are major conglomerates and are few in number. Additionally, there are hundreds of thousands of hoarders throughout the world that dump silver when it reaches an attractive price. Owners of silver objects and silverware can also be counted on to part with these items when the market calls. This behavior can put a top on the market, at least the spot market, and prolong bear markets. The mines continue to produce the silver, since it is a byproduct, as long as there is demand for the main product. This can create an oversupply situation that takes months, even years, to work out. The majority of demand comes from the electrical and photographic industries. Jewelry manufacturers are also big buyers. This side of the supply-demand equation is a more “perfect” market. Information about silver and its price does not go begging. You can find all you want to know from commodity brokers and coin merchants and collectors, jewelry industry as well as mining and government sources. There is no doubt it is a global market and the price is elastic. Since it is considered by some as a hedge against inflation, there is always plenty of political activity involving silver prices. Price volatility is satisfactory for scale trading, as is the volume of COMEX silver at approximately 16,000 contracts a day. It has my vote as a scale trading candidate. Copper Copper is similar to silver. It is mined by large companies and used by thousands of manufacturers and home builders. Effective reclamation programs augment the supply side. Additionally, it scores positive for most of the criteria we are using to evaluate scale trading candidates. Again, trade the COMEX contract to get the benefit of the 10,000 to 15,000 contracts traded daily.

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Gold This is not a perfect market. The supply side is difficult to evaluate for two reasons. First, most gold is produced in South Africa and Russia. Neither can be depended upon to bring gold to the market in an orderly fashion. They will hold back at times and then dump gold for foreign currencies at other times. The second problem is hoarders. They can be central banks, OPEC, and hundreds of thousands of individuals. Demand is equally difficult to gauge because 60 percent of gold is used for jewelry, which is a fickle fashion market. On the other hand, information is plentiful, but price tends to be inelastic. There are substitutes, such as platinum. It certainly is global, and politics often plays a role in its movement and pricing. Traditionally prices have been volatile, but the last few years it has been in a steady downtrend from $400 to $300 an ounce. The volume on COMEX has always been strong. I consider it a scale trading candidate, but I would want to have a good reason why the light at the end of the supply-demand tunnel is going to turn on before I started a scale. Of the metals, I’d recommend scaling half of them (see Figure 6-6).

THE COMMODITY INDEX There is one index you should definitely track and possibly even scale trade. This is not for the beginner. You need deep pockets whenever you trade an index, especially when you scale trade one. FIGURE

6-6

The Metals Silver Gold Palladium Platinum Aluminum Copper

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Also keep in mind that there is not a daily trading limit, which means the Goldman Sachs Commodity Index (GSCI) can plunge or soar any number of points in a given trading session. The only thing that can stop it is the bell, but each of the components of the index has daily limits You should track it and the CRB (Commodity Research Bureau) Index to get an overview of the price trend in commodities, but refrain from trading the CRB Index due to its weak trading volume. Knowing the overall trend can sometimes make a difference when you are deciding if it is the right time to start a scale. The GSCI contains most of the commodities I have recommended as scale trading candidates. It includes 6 energy products, 9 metals, and 11 agricultural commodities. The index is weighted based on the average quantity produced over the last five years. Therefore, it responds to world economic growth. Due to its composition and weighting, the various components tend to compensate each other. When the world economy is dominated by underdeveloped countries, the agricultural and petroleum-based commodities drive the index. Conversely, the metals move the index when industrial nations are expanding. For this reason, it does not have the volatility of other commodities. I rank it as a marginal scale trading candidate.

THE FINANCIAL AND CURRENCY FUTURES I do not consider any of what are commonly known as financial futures (bonds, interest rates, stock indexes, foreign currencies, etc.) to be legitimate scale trading opportunities. They are not pure commodities. They do not have commercial users (inventory manFIGURE

6-7

Noncommodity Candidates Goldman Sachs Commodity Index Commodity Research Bureau Index Financial Markets Foreign and Domestic Markets

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agers) buying them to use in production. Commodities are influenced by inflation. So when you enter a scale using the lower 25 percent of the 10-year trading range, you should get some help from 10 years of inflation to get you safely out of your scale. Commodities are used up and must be reproduced. This takes time, and production problems can occur. It is not like printing a couple of trillion dollars’ worth of a currency or bonds. Financial futures are not commodities, and only real commodities should be scale traded in my opinion. For this reason, the financials get two thumbs-down (see Figure 6–7).

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Mechanics of Scale Trading

You now have a good list of scale trading candidates. The very next thing you need to do is acquire a set of long-term price charts for each commodity on the list. Commodity price charts are available on the World Wide Web through price quotation services, through special trading programs, or as Omega Research, and through subscription services that send you updated charts weekly. When you decide to get serious about trading commodities, subscribe to a good price-charting software package. If you decide to use only end-of-day prices as opposed to real-time prices, you can find some very reasonably priced services. As a scale trader, you may not need real-time quotes. Real-time means tick by tick, observing every change in price as it happens. Delayed quotes are less expensive since fees to the exchanges do not have to be paid. Delayed means you receive them 15 minutes after they actually happen. End-of-day quotes are even less expensive. Which do you need? That depends somewhat on what your broker and his or her firm provide its customers. Some of the electronic services provide real-time quotes on demand, but you have to constantly refresh them. Other services include streaming quotes or quotes on their Web sites. If you deal with a live broker, you can call in for quotes. As a scale trader, you can usually get by with a system that delivers quotes on demand, because trading is somewhat automatic

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once a scale begins. But for planning scales and selecting entry points, I think you need access to a price-quotation platform that allows you to generate charts, draw lines denoting key support and resistance areas, and plot some moving averages. This can be done with end-of-day price data, unless you get into some of the more advanced strategies. To get started, you can find Web sites that provide price charts by using a good search engine, such as Google (www.google.com), and searching for “commodity price charts.” Hundreds of possibilities are available. Find a service you like and print out the monthly charts for each commodity you want to consider. Monthly charts will give you the long-term perspective, over a decade or more. Charts can be generated for virtually any time frame from minutes, to days, to weeks, to months. Next, draw parallel lines on the chart marking the highest and the lowest price. When you have access to a computerized charting program, it makes this exercise much easier and faster. For example, let’s say the high for a given commodity is $10.00 and the low is $4.00 per unit over the last 10 years. That gives you a $6.00 price range from low to high. Dividing $6.00 by 4 gives you $1.50. Adding $1.50 to the low designates $5.50 as the beginning of the price level that is the lower 25 percent of the 10year trading range. Draw two parallel lines vertically on the chart at the $10 and the $4 marks. Then draw a third parallel line at the $5.50 price level. Also draw a line at 33 percent above the low, which would be the $6 price point. Do this for each commodity that was given a two thumbs-up rating in Chapter 6. You can store these charts in a three-ring binder or post them on a bulletin board. You need to check these charts on a regular basis and update them at least weekly to monitor which commodities are in or moving into the lower 33 percent to 25 percent of their 10-year trading range. Natural