TradingCommoditiesandFinancialFutures

AStep-by-StepGuidetoMasteringtheMarkets

GeorgeKleinman

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PraiseforTradingCommoditiesandFinancialFutures,ThirdEdition

“CongratulationstoGeorgeKleinmanforwritingacomprehensivefuturescompendiumthatshouldbemandatoryreadingforanyoneconsideringfuturestrading.KleinmandispelsthemyththattheindividualtraderalwayslosesagainsttheGoliathsinthemarkets.”

—MaryCashman,HeadofInternationalOperations,GlobalCommodityIntelligence“Disciplineandexecutionarethetwomostimportantanddifficultaspectsintrading.GeorgeKleinmanoffersthesolutionstotheproblems,andtheyaresuperb.Clear,crispwritingthatwillkeepyou

readingandhelpyoubecomeasuperiortrader.”

—YiannisG.Mostrous,Editor,WallStreetWinners,FinancialAdvisory“WithoutadoubtthebestbookIhavereadontheindustry!Perfectforthenovicespeculator,yetcomprehensiveenoughfortheseasonedveterantoreferbacktotimeandagain.Thetraderwhohasbeenaroundawhilewill

enjoyreadingthestories.Believeme,theyaretrue!”

—JosephM.Orlick,TheChicagoBoardofTrade

ToSherri

Contents

Introduction

1TheFourEssentialsDoyouhavewhatittakes?PatienceKnowledgeGutsHealthandrest

2HowtoBecomeaSuccessfulTrader

3ADiabolicalStory

4TheFuturesPrimerFuturesmarketsandthefuturescontractItisaseasytosell“short”astobuy“long”MarginandleverageDeliverymonthsBrokersandcommissionsTheplayersBasisriskTheshorthedgeThelonghedgeThebasisSpeculatorsversushedgersHowisthepricedetermined?OrderplacementAnothertruestory

5TheOptionsCourseAnoptionsprimer

Anoptionforwhat?AdvantagesanddisadvantagesofoptionsTypesofoptionsStrikepricesStylesofoptionsHowareoptionpricesquoted?Buy’emandsell’emAdvantagesanddisadvantagesofsellingoptionsHowoptionsworkHowareoptionpricesdetermined?Howchangesinthepriceoftheunderlyingcommoditychangeanoption’spremiumExercisingprofitableoptionsShouldyoueverexerciseanoption?Ifsellingoptionsputstheoddsinmyfavor,whynotdoit?OptionsasahedgingtoolStockindexoptionsAdvancedoptionstrategiesStraddlesandstranglesRatiosEightwinningoptiontradingrules

6TheIntermediateTradingCourse(OrJustEnoughKnowledgetoBeDangerous!)

FundamentalanalysisTechnicalanalysisWhichisbest:fundamentalortechnicalanalysis?The4futuresgroupingsFinancialfuturesEnergiesAgriculturals

MetalsContinuingyourcommoditytradingeducationContraryopiniontheorySpreads

7AlgorithmsEliminatingPeopleOpenoutcryisdeadRoguealgosExplodingvolatilitySpeedsacceleratingMeldingtheoldwiththenewPanics,manias,andbubblesExplosivecommoditydemand

8TheAdvancedTradingCourseFundamentalsversustechnicalsDoestechnicalanalysisreallywork?ThetrendisyourfriendBasicchartanalysisThetrendlineTrendchannelsSupportandresistanceBreakoutsfromconsolidationAdditionalclassicchartpatternsVolumeOpeninterestRSIStochasticsElliotwaveanalysisPointandfigurechartsJapanesecandlestickchartsSpreads—avaluableforecastingtool

HeadandshouldersGK’ssignificantnewsindicatorBreakingpar

9TheMovingAveragesPrimerBottompickersversustrendfollowersAmovingpictureThesimplemovingaverageHowmanydaysshouldyouuseinyourmovingaverage?AlternativestotheSMAExponentialandweightedmovingaveragesNaturalnumbers

10GK’sPivotIndicatorGeneratingthebuysignalGeneratingthesellsignalThepivotindicatormethodinpracticeDiversification

11AndFinallyDeterminingyourmotiveOvercomingthesixhurdlestotradingsuccessDevelopingthewinningtouchIfyoudon’tfeelright,youwon’ttraderightJesse’ssecretCommentsorquestions?

Appendix:25TradingSecretsoftheProsSecret1:Thetrendisyourfriend!Secret2:Whenamarketischeaporamarketisexpensive,thereprobablyisagoodreasonSecret3:ThebesttradesarethehardesttodoSecret4:Haveaplanbeforeyoutradeandthenworkit

Secret5:BeaggressiveSecret6:NoregretsSecret7:MoneymanagementisthekeySecret8:SuccesscomeseasierwhenyouspecializeSecret9:PatiencepaysSecret10:GutsareasimportantaspatienceandmoreimportantthanmoneySecret11:The“tape”(quotes)willtrickyouSecret12:BeskepticalSecret13:BetimecognizantSecret14:Watchthereactionto“thenews”Secret15:Nevertradewhenyou’resick,worried,ortiredSecret16:Overtrading:yourgreatestenemySecret17:Keepacoolheadduringblow-offsSecret18:NeverletagoodprofitturnintoalossSecret19:Whenindoubt,getoutSecret20:SpreadyourrisksbydiversificationSecret21:PyramidthecorrectwaySecret22:WatchforbreakoutsfromconsolidationSecret23:GowiththerelativestrengthSecret24:LimitmovesareimportantindicatorsofsupportandresistanceSecret25:Neveraveragealoss

Index

ImportantRiskDisclosures

Beforeyoutradewithrealmoney,familiarizeyourselfwiththerisks.Commodityfuturestradingisspeculativeandinvolvessubstantialrisks,and

youshouldonlyinvestriskcapital.Youcanloseasubstantialamountorallyourinvestment,andyoushould

carefullyconsiderwhethersuchtradingissuitableforyouinlightofyourfinancialcondition.Thehighdegreeofleveragethatisobtainableincommoditytradingcanwork

againstyouaswellasforyou,andtheuseofleveragecanleadtolargelossesaswellaslargegains.Ifthemarketmovesagainstyourposition,tomaintainyourposition,youmay

onshortnoticebecalleduponbyyourbrokertodepositadditionalmarginmoney.Iffundsarerequested,andyoudonotprovidethemwithintheprescribedtime,yourpositionmaybeliquidatedataloss,andyouwillbeliableforanyresultingdeficitinyouraccount.Undercertainmarketconditions,youmayfinditdifficultorimpossibletoliquidateaposition.Thiscanoccur,forexample,whenthemarketmakesa“limitmove.”Theplacementofcontingentorders,suchasa“stop-loss”or“stop-limit”order,willnotnecessarilylimityourlossestotheintendedamount.Thereisnoguaranteethattheconceptspresentedinthisbookwillgenerate

profitsoravoidlosses.Pastresultsarenotnecessarilyindicativeoffutureresults.

Acknowledgments

Mysincerethankstotheseformerpittraderswhosestoriesmadeforentertainingandinformativecontributionstothiswork:WilliamG.Salatich,Jr.,fromthecattlepit,JoeOrlickfromthecornpit,andJosephSantagataandJamesGallofromthecopperpit.ThankstomyeditorsatPearson—JimBoyd,JovanaShirley,andKittyWilson—formakingmythoughtsflowmuchbetter.Jim,thankyouforpersuadingmetodothislatestedition.IdidthebestIcould,andtheresultisthebesttodate.ThankstothepeopleatCQGwhomadethechartspossible.Thankstomybestclients,whochoosetoputupwithme,andmybelovedwife,Sherri,whohasnochoice.

AbouttheAuthor

GeorgeKleinmanisthepresidentofCommodityResourceCorp.,afuturesadvisoryandtradingfirmthatassistsindividualtradersandcorporatehedgers.Georgehasatrackrecordofsuccessinthecommodityfuturesbusinessthatspansmorethan30years.AgraduateofOhioState,withanMBAfromHofstraUniversity,George

enteredthecommoditytradingbusinesswithMerrillLynchCommoditiesin1979.WhenheleftMerrilltostarthisowntradingfirm,Georgewasamemberof”TheGoldenCircle”(thetop10commoditybrokersinternationally).From1983to1995,CommodityResourcewaslocatedonthetradingfloorof

theMinneapolisGrainExchange,whereGeorgeheldmultiplemembershipsandservedontheMGEboardofdirectors.GeorgewasalsoamemberoftheCOMEXExchangeforoveradecade.Georgehasbeenfeaturedforhistradinginnationalpublicationsandhas

lecturedatmajorfinancialconferencesregardinghistradingtechniques.Heistheauthoroffourpreviousbooksoncommoditiesandfuturestradingandisanactivetraderforclientsaswellashisownaccount.Georgehasdevelopedhisownproprietarytradingtechniques,someofwhicharehighlightedinthisedition.Hecanbereachedviaemailatgkleinman1@mac.com.In1995,GeorgeandhisfamilymovedtonorthernNevada,andhenowtrades

fromanofficeoverlookingbeautifulLakeTahoe.

Introduction

“Itisnotthestrongestofthespeciesthatsurvives,northemostintelligent.Itistheonethatisthemostadaptabletochange.”—CharlesDarwin

NewYork’soldestcommodityexchange,theNewYorkCottonExchange,wasestablishedin1870.Foroveracentury,traderspackedthecottontradingpit.Theywoulddiscussweatherandcropreports,andtheywouldmakeandlosefortunes.OnarainyFriday,October19,2012,thefloortradersincotton(aswellasincoffee,cocoa,sugar,andorangejuice)donnedtheirtradingjacketsandyelledouttheirbidsandoffersforthelasttime.Yousee,thiswasthefinaldayof“open-outcry”trading.ThefollowingMonday,forthefirsttimesince1870,everytradeinthesemarketswasmatchedbycomputers.Ifoundthispassingofanerasad.Thebeststoriesinthisbookemanatefrom

thedaysofthefloortraders.Humanstoriesmakeformoreentertainingreadingthanroguecomputeralgorithms(whichiswhyIkepttheminthisedition).Criticsofelectronictradingtellusthattheolddaysofthepitsaddedorderto

themarkets.Aprofessionalmarketmakerstandinginthepitwouldobservetheorderflowintermsofthenews,andheorshewouldtaketheothersideofexcessivespeculativeorderflow.Thismadeforamoreorderlymarketenvironment.Manyofthecomputerprogramsdon’tevenlookatthenewsbutmonitortheorderbookinmillisecondstohoponforaride.Liquidationworksinasimilarmanner,asthecomputersscrambletoexit.Stopsarehit,generatingmargincalls,causingmoreliquidationasitallfeedsonitself.Havingnoprofessionalmarketmakerleadstovacuumsandoverextendedmovesbecausefewerplayersareavailabletotaketheothersideofmomentum.Whenthevacuumisfinallyfilled,themovebackintheoppositedirectionisjustasfrenzied.IadmitI’msentimentalforthedaysofthepittraders.Idealtwiththemmost

ofmytradinglife,butwehavenochoiceotherthantomoveforwardandadapttochangeinordertosurvive.InthewordsofAynRand,“Youcanignoretherealitybutyoucannotignoretheconsequencesofanignoredreality.”Today’selectronicmarketsarelikeabattlefield.InthewordsofNapoleon

Bonaparte,“Thebattlefieldisasceneofconstantchaos.Thewinnerwillbetheonewhocontrolsthatchaos,bothhisownandtheenemy’s.”

Today,thereismorechaosthaneverbefore.Speedandvolumehavecombinedtomakethemarketsmorevolatilethanthey’veeverbeeninthepast.Thischaosiscleverlyprogrammed—notbytradersbutbyengineers.I’vealwaysbeengoodinmath,butintroductorycalculuswastheextentofmyacademicmathtraining.Today’sprogrammerscodeformulassimilartotheoneshowninFigureI.1—onlymuchmorecomplicated.(TheexampleshowninFigureI.1isarelativelysimpletradingformula,now10yearsobsolete.)

FigureI.1.A“simple”tradingformula

Aftertheformulasareconstructedandcoded,they’refedintosophisticatedtradingcomputersthatcostmillionsofdollars.ManyofthesecomputersareactuallylocatedintheExchangebuildingforaspeedadvantageproximitythatyouandIwillneverhave.Withtechnologyevolvingseeminglyatthespeedoflight,howwillweevercompetewiththesefolks?Thesimpleansweristhatwewon’t(nordoIwantto),nordowehaveto.That’snottosayadjustmentsfromthedaysofthepitsareunnecessary.Astraders,wehaveallhadtoadjustourmethodstothenewmarketrealitiesinstocksandcommodityfutures.Inthisbook,I’veusedtheKISS(“keepitsimple,stupid”)method.IknowI’mnowherenearassmartasthecomputerwizards,butinthewordsofthegreatHomerSimpson:“Stupiditygotusintothismess,andstupiditywillgetusout!”I’mnotgoingtoblametoday’sheightenedvolatilitytotallyoncomputerized

trading.Italsohastodowithcentralbanks,governmentpolicies,globaluncertainty,andinstantdisseminationofinformation.Thenewestvariable,

however,isthecomputersreplacingthepittraders.Previously,“newsdays”werevolatile,butnowweseevolatilityjustabouteveryday.Wenowreceiveinstantfills,whichisagoodthing,butintheprocess,theInternethascreatedadog-eat-dogtradingworld.Weneedtogetusedtothisbecauseit’snotgoingaway.Thegoodnewsisthatthemoreextremethemoves,thebetteritisforthetrend-followingmethodsIpresenttoyouinthefollowingpages.Inthisbook,oneofmygoalsistoprovideyouwithstrategiesdesignedtohelpyoucaptureyourshareoftheprofitpool.Asanold-timetraderoncetoldme,thekeytosuccessintradingis“Slowand

steadywinstherace.”Thisrequirescalmnessatalltimes,whichisnotalwayseasytoobtain,butasystematicapproachwillhelp.Withthatsaid,Icanalmostguaranteethatyou’llstrayfromyouroriginalplanattimesbecauseyou’rehuman.So,thepittraderhasgonethewayofthedodobird,theeight-tracktape,and

theVCR.Still,despiteallthechanges,muchhasremainedthesame.Themarketshavedramaticallychangedincertainrespects,andI’veaddressedthesechangesinthisrevisededition.Inmyfirst30yearsinthisbusiness,therewasnothingIcanrecallakinto“bangingthebeehive”(astrategyinwhichhigh-speedtraderssendafloodofordersjustpriortothereleaseofamajorreport,millisecondsbeforethedataisreleased,inanefforttotriggerhugepriceswings).Yet,themarketshaveremainedthesameintherespectthathumanbeings,withtheiremotions(particularlyfearandgreed),areultimatelybehindallthetransactions.Today,therearewhatcanbetermed“synthetic”asopposedto“real”moves.Whiletheremaybechaosinthemillisecond,inthelongerrun,thebasicfundamentalsofsupplyanddemandaffectcommoditypricesinthesamewaystheydidforhundredsofyears.Andtherearetimesthatcomputersgetstung“bangingthebeehive;”theywhackeachother.YouandIdon’thavetoparticipaterightbeforemajorreportsarereleased;wehavetheabilitytowaitforthatfatpitch,thatfastballintooursweetspot.In1951,thelegendarytraderW.D.Gannsaid,“Thetapemovesinmysterious

ways,themultitudetodeceive.”Andin1923,JesseLivermoresaid,“Itisliterallytruemillionscomeeasiertoatraderafterheknowshowtotrade,thanhundredsdidinthedaysofhisignorance.”Myprimarygoalinthisneweditionistohelpyounavigatetheshark-infested

tradingwaterstoavoidthesharks.GeorgeKleinmanLakeTahoe,Nevada

1.TheFourEssentials

“It’stoughtomakepredictions...especiallyaboutthefuture.”—YogiBerra

Afloorbrokeroncetoldmethefollowingstory,andheswearsit’strue:Inthe1960s,therewasacornspeculatorwhotradedinthepitattheChicagoBoardofTrade.Hewasknownforplunging:takingbigpositions.Earlyonesummer,heputonalargeshortcornpositionforhisownaccount.(Shortpositionsmakemoneyifpricesfallbutloseifpricesrise.)Withindays,theweatherbegantoheatupinthemidwesternUnitedStates,wherethecornisgrown.Thecorncropneededrain,andpricesbegantorise.Dayafterday,thesunshone,thetempsrose,notacloudinthesky—thecorncropwasburningup.Themarketcontinuedtorallyagainstthisguy,andheknewifthiscontinued,he’dgobroke.Lateonetradingsession,thebigtraderstartedarumorinthecornpit.Hisrumorwasthatitwasgoingtostartrainingthenextmorningsometimearound10:30a.m.Theothertraderslaughedatthisprediction.Thefollowingmorning,thesunwasshiningwithoutacloudinthesky,andthemarketopenedhigheronceagain.Then,almostmiraculously,atprecisely10:30a.m.,rainstartedpouringdownthewindowsthatsurroundedthegraintradingroom.(Theoldgrainroom,locatedonthefourthflooroftheChicagoBoardofTradeBuilding,hadtallwindowsthatlookedoutoverLaSalleStreet.)Inside,inthecornpit,asellingpanicimmediatelydeveloped,asthepittradersscrambledtosellouttheircornfutures.Tradersaroundtheworldsawpricescrashingandjoinedinthesellingfrenzy.Themarketquicklywentdownthelimit!Onthisbreak,thespeculatorcoveredhisentireshortpositionandwassavedfrombankruptcy.Howdidthefloorbrokerknowitwouldrainat10:30thatmorning?Itseemshewasowedafavorfromhisdrinkingbuddy,thechiefoftheChicagoFireDepartment.Thechiefbroughtoutthehookandladders,anddecideditwasagooddaytowashthosetallwindowsthatlookedoutonLaSalleStreet!

Soyou’rethinkingoftrading,butyoudon’tknowthechiefoftheChicago

FireDepartment?Actually,today,evenifyoudoknowhim,itwouldn’tmattermuchbecausecomputertradersfromtensofthousandsoflocationsgloballyhavereplacedthepittraders,andcomputersdon’tcareabouttheweather.So,let’sassumeyou’vejustfinishedreadingaprivatenewsletter,afirsthand

reportofhowthe“witch’staildisease”isdevastatingthecocoacropinGhana.Cocoasoundslikeamoneymaker,butyouhavenowayofknowingforsurehowtrueallthisis.Youdolikechocolate,butyoudidn’tevenknowitallstartswithabeancalledthecocoabean.(Youthoughtitcameoutofacan.)Hey,youdon’tevenknowwhereGhanais,andyou’rethinkingoftradingcocoaagainstthelikesofHersheyandNestléandwhoeverelsereallydoesknowwhat’sgoingon?Whywouldyoudothis?Tomakemoney,ofcourse!Youdoknowonething:Youcanobservethatthecocoamarketismoving

higher,andit’smovingfast.Althoughyouaren’texactlylosingmoneybydoingnothing,it’sstartingtofeelthatway.Doyouhavethegutstoact?Doyouhavethemoney?Isnowthetime?Youassumethattheshorts(thosebettingonlowercocoaprices)arebeginning

toexperiencefinancialpain.Thelongs(thosebettingonhighercocoaprices)areexperiencingtheoppositeemotions:elationandthesatisfactionthatcomesfrombeingright.Theaccountsofthelongsaregrowingbigger—moneyfromnothing.Theshortsarewatchingtheirmoneyevaporate.Let’sthinkaboutthisforamoment,becauseit’stimeforyourfirstlesson:

Eventhoughtradesarenowenteredusingcomputers,tradingisahumangame.Asaresult,emotionsaffectpriceasmuchas,orperhapsmorethan,thenews.Youwilllearnthatpricemovementsthemselvesaffectfuturepricemovements.It’sallafunctionofwhoisbeinghurtandwhoisbenefiting.It’safunctionofwhichsideofthemarketisbeing“sponsored”bythe“stronghands.”Shortsandlongsactdifferently,basedonpricemovements,andthosemovementsaffecttheiremotionsasmuchastheirpocketbooks.Yourjobasatraderistoidentifywhathappensnext.Todothat,Iwantyouto

startthinkingabouthowothersfeelbecausefeelingsaffectactions.Peoplewhoaregenerallyrighttendtodocertainthings(onbalance).Peoplewhoaregenerallywrongtendtoactdifferently.Themajorityactsacertainway,butbewarned:Themajorityisusuallywrongatmajorturningpoints(althoughtheyalsocanberightattimes).So,determinewhetherthemajorityisnowlongorshortcocoa.Theshortsare

inpain,thelongsarenot;butthenagain,thiscanchangejustasfastasthemarket’stonechanges.

Here’slessonnumbertwo:Onbalance,whentalkingaboutfuturestrading,theuninformedmajoritywilllose.Becausetheprofitableminorityactinacompletelydifferentmanner,youmustlearnwhatmakesthesepeopletickandhowtoactlikethem.Onefactiscertain:Peoplemakemarketsand,generally,peopletendtoactthewaytheydidinthepast.Withcertainstimuli,theycouldactoppositehowtheygenerallyact,butyouareplayingtheoddshere.Youneedtoidentifywhatmannerofmovethemarketisinnow.Isita“normal”move,orisitextraordinary?(Attimes,themarketactsinanextraordinarymanner,andthesecanbethebesttimestoplay.)Ifyou,asatrader,areabletoaccuratelypredictwhatthenextpatternwillbe,yourrewardswillbesubstantial.Inthisbook,Ipresentvariousmethodsdesignedtoidentifyprofitablemarket

patterns.Nomethodisfoolproof,andthebestIcandoistrytoputtheoddsinyourfavor.Mygoalistoteachyoutoapproachcommodityfuturesandoptionstradinglikeabusiness.Thisisnotacasino.Inacasino,riskisartificiallymanufacturedforrisk’ssake,andtheoddsareengineeredinfavorofthehouse.Inthecommodityfuturesandoptionsmarkets,youaredealingwithnaturalrisksassociatedwiththeproductionandconsumptionofthematerialsthatmakelifepossibleandworthwhile—food,metals,financialproducts,andenergy.Youcannotbendtheseriskstoyourwill,butyoudohavetoolstomanagethem.Unlikeinacasino,inthemarket,Ibelieveyoucanmovetheoddstoyoursideofthetable.Todothis,youmustbedisciplined.Youwillneedpatience,andyouwillneedguts.Icannotforcethesequalities

uponyou,butIcandescribehowasuccessfultraderacts.Itwillthenbeuptoyoutoacttherightway.Toprofitinthecommodityfuturesandoptionsmarkets,youwillneedasystematicapproach,awell-thought-outstrategy.Iwillpresentyouwithsomegoodideas,butit’suptoyoutoimplementthemsystematically.Afterall,astrategyisjustaconsistentapproachtotrading.

Doyouhavewhatittakes?Ifyou’vedecidedtorisksomeofyourhard-earnedcash,goforthebigbucks,andtradecommodities,youneedtoknowthatthisisazero-sumgame—thatis,foreverydollarsomeonemakes,someoneelselosesit.Someofthemoneygoestoyourcommoditybrokerintheformofcommissions,andasmallamountgoestotheExchangesfortheirfees.Then,ifyouareluckyorskillfulenoughtowin,youowethetaxmansomeofyourprofits.Whenyouloseonanyparticulartrade,mostofyourlossistransferredelectronicallytosomeoneelse’saccount(andyoustillpaythatcommission).Youwillneverseethispersonontheothersideofyourtrade,buthe(orshe)isouttheresomewhere.

Youwillbepittedagainstsomeofthebestfinancialmindsintheworld.Professionaltraders,hedgefundmanagers,commercialfirmsthatusecommodities,andothercommercialfirmsthatproducecommodities.Thentherearethoseotherindividualswithmoreexperiencethanyouhave.Canyouhopetocompete?Theansweris,emphatically,yes!ButIdidn’tsayitwouldbeeasy,didI?Youwillneedtodevelopasensibletradingplanandafeelforthemarkets.Thisbookwillhelpyou.Youmustdevelopcertainhumanqualities,too,whichnobodycangivetoyou.Morethan50yearsago,thelegendaryspeculatorW.D.Ganndiscussedthe

fourqualitiesessentialfortradingsuccess:patience,knowledge,guts,andhealthandrest.Gann’sobservationsarejustasvalidtodayastheywerehalfacenturyago,andtrustme,youmusthavethesequalitiesifyoueverhopetocompeteandwin.(Ifyoudon’thavethemnow,thendevelopthem!)

PatienceAccordingtoGann,patienceisthemostimportantoftheessentialqualitiesfortradingsuccess.Agoodtraderpossessesthepatiencetowaitfortherightopportunity.Ifyouareagoodtrader,youwillnotbeover-anxious,becauseover-anxiousnessconsumescapitaland,overtime,willtapyouout.Whenyouarefortunateenoughtocatchagoodtrade,youneedthepatiencetoholditwhenitstartstomoveyourway.Perhapstheprimaryfailingoftheamateuristocloseoutaprofitablepositiontoosoon.Inotherwords,patienceisrequiredforbothopeningandclosingaposition.Hopeandfearneedtobeeliminated.Ganntellsusifyouareinaprofitableposition,insteadoffearingthattheprofitwillturnintoaloss,youshouldhopeitbecomesmoreprofitable.Youhaveacushiontoworkwithinthiscase.Whenyouareinalosingposition,insteadofhopingitwillturnaround,youshouldfearthatitwillgetworse.Ifyouseenodefinitivechangeintrend,useyouressentialqualityofpatienceandjustwait.

KnowledgeThestakesarehigh,andthecompetitionisintense.Youneedawell-thought-outandthoroughlyresearchedtradingplanbeforeyoubegin,andyouneedtodoyourhomework.Yourplanshouldalwayshaveamechanismtocutthelossesonthebadtradesandtomaximizeprofitsaggressivelyonthegoodones.Youmustbeorganizedandremainfocusedatalltimes.Ifyourplanisagoodone,youneedtheconsistencytostickwithitduringdownperiods.Mypersonalgoalistomakemoneydaily,butthatisnotalwayspossible,soI

trynottolosetoomuchonlosingdays.Itisaconstanttrialtomaintainthe

vigilancenecessarytonottoletgoodjudgmentlapse.Ifyouareanovice,itmakessenseto“papertrade”beforeyoutradeforreal.Ifyouaretradingcurrently,youshouldkeepalogbook.Logyourtriumphsandyourfailures.Youwanttoavoidmakingthesamemistakesagain,butImustwarnyou,alltradersrepeatmistakes.Attheveryleast,learnnottomakethemistakessooften.Bykeepingarecordofwhatyoudorightandwhatyoudowrong,youcanidentifyareasofweaknessandareasofstrength.Ifyouarenottotallypreparedonanygivenday,don’ttrade.Youcan’t“wingit”inthisbusinessbecausethecompetitionwilleatyouup.Overtime,youwilldevelopwhatIcalla“trader’ssense.”Youwillknowwhenatradedoesn’tfeelright,andwhenthishappens,theprudentthingtodoistostepaside.Youcannotignorethedangersignals,andwhentheyoccur,youmustactwithouthesitation.Youmusthaveagameplanandsticktoit,buttheparadoxhereisthatyoualsoneedtobeflexible.Attimes,itisbesttodonothing,andyouneedtofighttheurgetoplayforeverypot.And,asIsaidbefore,stayfocused.Attimes,I’vebeendistractedbydaytradesandmissedthebigmovebecauseImissedthebigpicture.BythetimeIfinallysawthelight,itwastoolate.JesseLivermore,thelegendarytraderofthe1920s,oncesharedoneofhis

secrets:Heattemptedtobuyasclosetowhathetermed“thedangerpoint”ashecould,andthenheplacedhisstoploss.Inthisway,hisriskpertradewaslow.Thismakessense,buthowdoyouknowwherethat‘dangerpoint’is?Innormalmarkets,youneedtoacceptnormalprofits,butonthoserareoccasionswhenyouhavethechancetomakeawindfall,goforit.But,howcanyoutellwhenamarketisnormalasopposedtoextraordinary?Ittakesexperience,andittakesknowledge,anessentialqualityforsuccess.Knowledgetakesstudyandhardwork.Readingthisbookisagoodfirststep.

GutsCallitnerve,courage,bravado,orheart;Icallitguts,andthisonequalityisasessentialaspatienceandknowledge.Somepeoplehavetoomuchguts,andthisisn’tgoodbecausethey’retoohopefulandtendtoovertrade.Somelackthegutstoact(eithertoenterapositionwhenthetimeisrightortocutalosswhenitisn’t).Thisisacatastrophicfaultandmustbeovercome.Youneedgutstopyramidpositions,whichisnoteasy,butit’swherethebigmoneyismade.Inthisbook,Iamgoingtoteachyoutotradewithouthope,withoutfear,andwiththerightamountofguts.Iwillinstructyoutoenterpositionsontheproperbasisandthenurgeyoutorememberatalltimesthatyoucouldbewrong.Youwillneedadefensiveplantocutyourlosseswhenyouarewrong.I’vebeenastudent

intheschoolofhardknocksmanytimes,butI’veneverlostmyguts.Attimes,IknowI’vehadtoomuchandhaveovertraded,butthentherearesomepeopleIknowwhohaveaninabilitytopullthetrigger,andthatisjustasdeadly.Lookingbackonlybringsregrets,soyouneedtofacethefuturewithoptimism,knowledge,patience,andguts.

HealthandrestGann’sfourthessentialqualityfortradingsuccessishealthandrest.Ifyoudon’tfeelright,youwon’ttraderight,andthatisthetimetoremainonthesidelines.Whenyoustickwithsomethingtoolong,yourjudgmentbecomeswarped.Traderswhoarecontinuallyinthemarketwithoutrestgettoocaughtupintheday-to-dayfluctuationsandeventuallygettappedout.Atleasttwiceayear,itmakessensetocloseoutallyourtrades,getentirelyoutofthemarket,andgoonavacation.Whenyoureturn,recharged,yourtradingwillimprove.So,thatwrapsupGann’sfouressentialhumanqualitiesrequiredforsuccess.

You’llneedthem.Shortly,thisbookdelvesintospecificsthatwillhelpyoutraveltherockyroadleadingtotradingsuccess.SomeofthemostimportantlessonsI’velearnedoverthepast30yearsareinthepagestocome,andtheyshouldhelpyoumakemoney.However,ifyoudon’thavepatience,guts,knowledge,andgoodhealth,alltherulesintheworldarejustwords.So,withthatsaid,let’sgetintothemeatofthematter.I’mnottryingtobeall

thingstoallpeople,butIdobelievethisbookappeals,tonoviceandveterantradersalike.We’llbeginatthebeginning.Ifyouarenewtothisgame,you’llneedtoknowhowthegameisplayed,whattherulesare,andhowthemoneyworks.Istrivetobeascompleteaspossible,andattimes,itmightactuallyappearsimple.Ifitwerereallysosimple,however,mostpeoplewouldn’tlose,butthenatureofthefuturesmarketsistopunishthemajority.Let’sbeginourjourneytojointheminority,becauseitistheminoritywhoreaptherewards!

2.HowtoBecomeaSuccessfulTrader

“Letitbeknownthatwe’realljusttumblingdice,andtheoutcomeofthiscrapshoot’shardtosee.”—JohnMellencamp

So,youwanttomakemoneytrading?Lookseasy,butifittrulyissoeasy,thenwhydothegreatmajoritylose

money?Whatisitthattheprofitabletradersdothatmostothertradersdon’t?Believeme,thisgameoftradingisnopieceofcake.I’vestudiedsuccessful

tradersand,asaresult,refinedmypersonalapproachoverthepast30years.Mystudieshaverevealedthatsuccessfultradersthroughouthistorytendtosharecommontraits,andI’llsharethemwithyoushortly.However,I’llstartbymentioningthattherearerespectedtheorists(likeNassimTaleb,authorofFooledbyRandomness)whoarguethatchanceandluckplayamuchlargerpartintradingthanmostwilladmit.Afterall,nobodyknowswithcertaintywherethemarket’sgoing.Taleb’sbasicpremiseisthat,withalargenumberoftradersintheuniverse,

thereexiststheprobabilitythataminorityattheendofthebellcurvewilldramaticallyoutperformthemarketbasedonnothingotherthanchance.Ifyouhavethousandsofmonkeysinaroomflippingcoins,chancesaregoodthatatleastoneof‘emwillflipheads15timesinarow.WhileIunderstandthislogic,Idon’tagree.IfTalib’spremiseisuniversally

true,whyisitthen,thatthroughouthistorymarketcrasheshaveoccurredwhenthefewestnumberofpeoplehavebeenpositionedforthem?Inboommarkets,thegreatmajority(“thepublic”)makemostofthemoneyonpaper—andthat’swheretheyleaveit(onpaper),neveractuallycashingin.Whenthecrashtakesplace,themassesalwayslosemostofwhattheymade.Thisphenomenaisfarfromrandom;onlyasmallminorityeverprofitfrommarketcrashes.Inthelongerterm,commoditypricemovesofsignificancearedrivenbyreal-

worldsupply/demandfundamentals,notchance.However,evenifTalebisrightaboutrandomness,Icontendthatprofitabletradingcanstillbeachievedinachance-drivenenvironment.Considerthegameofpoker.Pokerisagameofchance,withthedistributionofthecardstotallyrandom.Yet,universitystudiesanalyzingmorethan400millionpokerhandshaveconcludedthatpokerisa

gameofskill.Manyofthesametournamentplayerstopthemoneywinninglistsyearafteryear.Themajority(thesuckers)mightmakemoneyattimes,butnotconsistently.Novicetradersareconstantlylookingforthat“holygrail,”aprogram,system,

technique,orstrategythat’saconsistentmoneymaker.Tradersusemanymethodologiesandindicatorstogetanedge(andI’llprovideyouwithsomelater).However,Iwillconcedethatmarketsarenotalwayseven-driven;attimes,they’reerraticandrandom.Sowecanruleouta“holygrail.”Whyisitthenthatinthetradinggame,asinpoker,manyofthesameplayersachievesuccessoverandoveragain?Whydothemajorityofnovicepokerplayersandthemajorityofnovicetraderslosemoney?Perhapsthewinnershavefoundawaytoovercomerandomness,luckandchance?WhileIagreethatnobodycanunerringlypredictamarket,therearecertainprocesseswinnersemploythatlosersdonot.Successfultradersareabletoworkwithchance.Insteadofsearchingforthe“holygrail,”successfultraderslookforthatfastballpitchdirectlyintotheirsweetspot.Howdotheyfindit?Unlesssomeoneistradingon“insideinformation”(somethingwehavenointerestindoing,asitwouldlandusinjail),winnersknowguaranteedoutcomesareimpossible.Instead,theirprocessesinvolvetradingdiscipline,whichinturninvolvesmoneymanagement.

Chancefavorsthewellprepared.

—LouiePasteur

Ifyou’vedecidedtotradefutures,you’vemadethedecisiontoacceptrisk.Thebasicproblemdevelopswhenthisbecomesawillingnesstohangontolosingpositionsfortoolong.Duetothenatureofmarkets,manytimeslosingpositionsrevertbackintowinners.Thedilemmaisthattheydon’talways.Mosttraders(andremembermosttradersarelosers)arefarmoreskittish

whendealingwithgains.Universitystudieshaveproventhatthegreatmajorityoftradersarewillingtotakeagreaterriskinanefforttonotlose$500thantogain$1,000.Tradinginvolvesrisktaking,butwhatIwantyoutounderstandisthattheline

betweenwinningandlosingbasicallydependsonhowyoumanagetherisk.Theverynatureofrisktakingmeansyouwillbemakingdecisionswith

incompleteinformation.Themarketplaceiscomposedofunpredictableswings.Youwillbefunctioninginthisenvironment,andwhileyou’llberightattimes,youwillalsobewrong.Thebesttradersareconstantlywrong,thisisinevitable.

Bothbadandgoodtradersgetluckyattimes,andtherewillbesituationswhena“lucky”breakbailsoutabadtrader.Basedonstatisticalrandomness,therearebadtraderswhowillbeprofitableforextendedperiods,andtheywillbelievetheyaregood.However,badtraderswillinevitablyfacecatastrophiclossesthateitherwipethemoutforgoodorrequirefundinjectionsfromcapitalsourcesnotrelatedtotrading.Inreviewingmypersonalnotesforthisbook,Iseethatovertheyears,I’ve

compiledplentyof“rules.”Rulesthatthewinnersstrivetosticktoandlosersneverconsider.Wearenotmachines;we’rehumanandwon’talwayssticktotheserules.Still,tobeasuccessfultrader,youabsolutelymustunderstandandthenapplywhatI’mabouttosharehere.Ifyou’reabeginningtrader,pleasekeepanopenmind.Ifyou’reexperiencedbuttodatenotverysuccessful,youwillneedtodropyourbadhabitsanddevelopanewconceptofwhatcanbeachievedinyourtradingaccount.Here’swhatthelosersdo(trainyourselfnottodothesethings):•Theylosemoreintheirlosingpositionsthantheymakeintheirwinningpositions.•Theygetaggressivewiththeirlosers(byaddingtothem,or“averagingdown”).•Theyhavefewfearsorreservationsbeforealosingtradebutplentyafter.•Theygettrappedbytheirownself-doubts,broughtaboutbypreviousmistakes.Theytendtooveranalyze(particularlyafterastringoflosers)tothepointthattheygettrappedintoinaction.Asaresult,theymissthebesttradeswhilewatchingfromthesidelines.Theypriceeverytrade(insteadofentering”atthemarket”),andbecauseofthis,theymisssomegoodonesbutarefilledoneverybadone.•Theyhaveagoal(andthat’sfine),butgetobsessedaboutreachingthatgoal(whichisnotgood).Thisallowsloserstogetoutofcontrol.•Theytakeonhigh-risktradesbecausetheyvisualizeonlytheprofitsandnotwhatcouldgowrong.Then,ifsomethingdoesgowrong,thestresscanputthemontilt.Somelosersarecompulsive,alwaysneedingtoplay,regardlessofwhethertheoddsfavortheirplay.•They’reopinionated,argumentative,andgreatatplacingblame(onthebroker,thefunds,thegovernment—anythingbutwhatthey’reincontrolof).

Here’swhatthewinnersdo(trainyourselftodothesethings):

•Theymakemoreintheirwinningpositionsthantheyloseintheirlosingpositions.Howdotheyaccomplishthis?By(a)holdingthewinnerslongerand(b)bybeingbold—gettingaggressivewithwinnersbysizingup.Theyhavetheability,ongooddays,toquicklymakebackthebadday’slosses.•Theytradeinthepresent,guidedbywhatthemarketisdoing(reality)andnottheirbiasofwhatthemarketshouldbedoing(hope).Andtheyaretotallyprepared,readytotakethetrades.Theyhaveaplan,andfollowit.Onceinatrade,ifthemarketisgivingthemwhattheyexpected,theyplayitout;however,ifitisn’t,theyacceptwhatthemarketispreparedtogivethem.Again,thisisrealityversushope.•Theytakeonahigh-risktradeonlyifthere’sanedgeinthattrade—afavorablerisk-to-rewardratio.Theyhavepatiencetowaitforthebestsignals,andwhensignaled,theycanactwithoutreservationsoranxiety.Theyhavetheabilitytobuyorsell“atthemarket,”knowingtheycouldmisssomeofthebesttradesbypricing.Theyrealizethat“badpricefills”canmanytimesbeasymptomoftheverybesttrades.•Becausetheyhaveaplanandthedisciplinetofollowit,theyarerelaxed,withoutstressorexcuses.HowdoIavoidstressduringtradinghours?Idomymarketanalysisbeforethemarketopensandwriteoutascriptwiththeplanofactionforvaryingcircumstances...WhileIdon’talwaystrade“atthemarket”(attimesItrytopriceanentrybetterusingalimitorder),ifIdon’tgetthetradeonfairlyquickly,Iwillnothesitatetogo“atthemarket”togetiton(evenifIhaveto“payup”).Whenthetradeiscompleted,IreviewwhatIdidrightandwhatIdidwrong.DidIgetouttoosoon(profitabletrades)ortoolate(losingtrades)?DidIsizeupcorrectlytomaximizemyprofit?DidIactinadisciplined,consistentmanner,ordidIpanicorgamble?

Whenyoutradecorrectly,you’llfindthatthegreatmajorityofyourtradingprofitsaretheresultofaverysmallpercentageofyourtrades—typicallylessthan10%.Thishighlightstheimportanceofmaximizingprofitswhenyouaresmart(orluckyenough)tocatchawinner.Howmanytimeshaveyoulookedatachartofapositionyouwereinmonthsagoandseentheproofofhowmuchyouleftonthetable?So,howdoyoumaximizeprofits?Firstofall,youneedtotakecareofyour

losses.Youhavetophysicallyplaceyourstops:Moveyourstopsfavorablywhenthemarketmovesyourway,and(unlessyouhaveaverygoodreasontogetout)letthemarkettakeyouout.Ifyou’reindoubtwheninawinningtrade

(orquiet,smallwinnerorsmallloser),it’susuallybettertostayputandjustletyourstopdotheworkforyou.Ontheotherhand,whenindoubtinalosingtrade,it’susuallybettertogetout!Thesmallpercentageofbigwinnersalsounderscorestheimportanceof

tradingbiggerwhenyou’rewinningandsmallerwhenyou’relosing.Thelosingtraderseithertakeontoomuchriskornotenough;theydon’tsizeupwhentheoddsfavortheirplay,andtheygetoutofpositivetradeswaytoosoon.Whenatradehasmetorexceededyourriskpoint,orprofitobjective,you

can’tbecomecomplacent.Bereadytostopthebleedingand/ortoturnpaperprofitsintocash.Bottomline:Winningtradersandlosingtradersareconsistentintheir

behavior—butinoppositeways.Peoplearetaughtfromchildhoodinsportsandotherendeavorstowin,butyouhavetolosetowininthetradinggame.Remember,ifyougetoutwithasmallloss,you’veputoutafire.Youcanalwaysgetbackinwhenthemarketisgoingyourway,andwithfarlessemotionandstress.Thisisn’tallyouwillneedtoknowtoachievesuccess.Youstillneedto

developatradingmethodologythatyou’recomfortablewith,whichincludesyourownrisk/rewardparametersbasedonthesizeofyouraccount,butthesearemerelytactics.Thenutsandboltsofwhatyouneedtoknowtosucceedinthetradingbusinessiscontainedinthisbook.

3.ADiabolicalStory

“Stillamanhearswhathewantstohearanddisregardstherest.”—PaulSimon,“TheBoxer”

OnabeautifulIowasummer’sdayin2012,RussellWasendorf,Sr.,thechiefexecutiveofamajorfuturesbrokeragefirm,wasfoundbyanemployee,unconsciousinhiscar.WasendorfhadriggedatubedirectlyfromhisexhaustintotheChevy’scabininanapparentsuicideattempt.Hewasrevivedandsubsequentlyconfessedtostealingover$200millionfromhiscustomers’accountsovera10-yearperiod.Hespentthemoneyonanewcorporateheadquarters,realestateinvestments(primarilyinRomania,ofallplaces),aprivatejet,andtravelandentertainmentforfamilymembersandstaff.HowdidWasendorfgetawaywiththisoversuchalongtimeperiod?

Basically,thesamewayBernieMadoffgotawaywithhisscheme.Whentheregulatorsandauditorscametoverifythefirm’scustomeraccountbalances,WasendorfhandedthemanenvelopeaddressedtothelocalU.S.Bankbranch.Theregulatorsmailedtheirauditconfirmationstothebank,buttheaddressontheenvelopewasapostofficeboxWasendorfcontrolled.Whentheauditconfirmationshowedup,Wasendorfmerelyfilledinafalsecustomeraccountbalanceandmaileditback.Itwasthateasy.Whattrippedhimupwaswhen,in2012,theregulatorschangedtheirauditprocedures.Theyfinallyjoinedthedigitalageandrequireddirectelectronicverificationfromthebank.UnlikeMFGlobalexecutiveJohnCorzine(whosaidhehadnoknowledgeofhislossofnearly$2billionincustomermoney),Wasendorf,likeMadoff,willlikelyspendhisremainingdaysbehindbars.ItseemsthatthesePonzi-likeschemesrepeatthemselvesthroughouthistory.

Whichbringsmetothisdiabolicalstory.Thesamefloorbrokerwhotoldmethetaleofthecornspeculatorandthefirechiefalsotoldmethisstory.Hesayshebelievesit’struebecause,onceuponatime(manyyearsagonow),hehiredoneofthemaincharactersashisclerk,whichishowhegottohearthestoryinthefirstplace.TheclerkhadanopportunitytojoinacollegebuddyofhisinSanDiegoand

becomeacommoditybroker.Hequicklypacked,leftChicago,andmovedtotheWestCoast.TheSanDiegoofficetheclerkjoinedproducedsomebusiness,butnothing

spectacular.Customerswouldcome,manywouldloseandleave,andnewoneswouldtaketheirplace.Oneafternoon,asthesetwocharacterswerestaringouttheirofficewindow(whichlookedoutoverthePacificOcean),theyspawnedanidea.Theydiscussedhowjustaboutalltheircustomerswouldlosemoney;infact,over80%ofthetradeswouldultimatelybeliquidatedaslosers.Withthisthoughtinmind,thetwocharactersplacedanadinthepapertohirerookiecommoditytrainees.Afterinterviewinganumberofapplicants,theyhired10“averageJoes.”Theytoldthesenewhiresthattheywouldperformthenormaldutiesofacommoditybroker,servicingcustomeraccountsandthelike,butinaddition,theyeachweregoingtobegivenarareopportunity.The10wouldeachbegivenano-strings-attached$50,000accountwiththefirmto“manage”aportfolioofcommoditytrades.Iftheycouldshowprofitableperformance,theywouldshareintheprofitsandreceiveabonus.Thetraineeswereallowedtoeachtradethe$50,000accountsastheysawfit;

therewasjustoneproceduretheyhadtofollow.Unlikewithtradesforcustomersofthefirm,iftheyweregoingtoplaceatradeintheir“managed”accounts,theorderhadtogothroughoneofthetwoprincipals(eithertheownerortheguyfromChicago).Youhavetoaskyourselfwhythesetwowouldtrust10novices—we’retalking10rawrookieshere—with$500,000oftheirmoney.Well,yousee,thiswasalljustadiabolicalschemethetwohatchedthatoneafternoon.Whatwouldhappenisthatonerookiebrokerwouldcalltobuy10cattle

contracts,anotherwouldwanttosell7soybeans,andanotherwouldbuy3copperorshort5silver.Thetwoguysbehindtheschemewouldcallthevarioustradingfloorsandsell10cattle,buy7soybeans,andsell3copperorbuy5silver.Inotherwords,theywoulddoexactlytheoppositeofwhattheir“traders”wantedthemtodo.Yousee,themoneyinthetraders’accountswasfictitious.Thefirm’smoneywas,inreality,goingtheotherway,withoppositepositions.Thenextday,fictitiouspositionsheetswouldbedistributedtothe“traders,”showingthemwhattherookiesbelievedtobetrue.Over80%ofnoviceswhotradelosemoney.Inevitably,therookiewho

“bought”thecattlecouldn’tstandthemarketmovingagainsthim,sohewouldcalloneofthetwoprincipalstoliquidatehis“losing”position.Thiswasthesignalforoneoftheprincipalstocallthefloor,buybacktheirshorts,andactuallytaketheprofits!Thenextday,thecattle“trader”wouldshowalosingtradeonhissheet—his$50,000wouldbesomethingless—butinreality,thetwowerecashingin.Thispatterncontinuedwiththeguyinthebeantrade,theguyinthecoppertrade,andsoon.

Intheveryfirstweek,onetraderactuallylosthisentire$50,000.Hewasimmediatelysummonedtotheboss’soffice.Thinkinghewasabouttobefired,beforeanythingwassaid,hestartedtocry.Hesaidhehadbeenmarriedforonlyayear,justhadtwins,andreallyneededthisjob.Hepromisedhewoulddobetterandwouldlearnfromhismistakes,andhepleadedforanotherchance.Imaginehissurprisewhentheygavehimanotherchance.Infact,theboyscouldn’twaitto“recapitalize”hisaccountwithanotherfictitious$50,000.Theyalsocouldn’twaitforhimtoleavetheofficebecausetheycouldhardlycontaintheirlaughter.Bythisfellowlosing$50,000,theyactuallymade$50,000intherealmarkets.Itwasbetterthanprintingmoney.Theschemeproceededmuchthesamewayforawhile.Onetraderwould

blowout,andthenanother.Theonlyproblemwasthatthetwobosseswerefindingitincreasinglydifficulttosupplythetraderswiththefictitiousstatementsforallthetransactions.Theycouldn’tkeepupwiththepaperworkandstartedfallingbehind.Nevertheless,theycontinuedonwiththeplanasbesttheycould—thatis,untilthesilvertrade.NowIshouldmentionthatthiswasallhappeningduringtheearly1980s,the

sametimetheHuntbrotherstriedtocornerthesilvermarket.Silverranuptoabout$50perounce,andoneday,oneofthetradersinourstorycalledtosellshortfivesilver.Ofcourse,ourboysactuallyboughtfivesilver.Thesilvermarketmovederraticallysidewaysforafewdays,andthenitstartedtoturnover.Duringthistime,thetraderwhosoldthesilverwenttoKansastovisithis

mom.Whilehewasvisiting,atornadohithistown,atreefellonthehouse,theroofcollapsed,andheendedupunconsciousinahospitalbed.Heremainedinacomafortwoweeks.Meanwhile,ourmastermindsbackinSanDiegowerewonderingwherethe

hellhewasandwhenhewasgoingtotakehis“profit”sotheycouldtaketheirloss.InNewYork,theyraisedthemarginrequirementsanddeclaredthatsilverwasforliquidationonly,andthemarketstarteditsfamouscollapse.Themastermindswentbellyup.Theguyinthecomaawakened,andthefirst

wordsoutofhismouthwere“Getmeanewspaper.”Heimmediatelyturnedtothecommoditysection,andwhenhesawhowfarsilverhadbroken,hescreamedforjoy.HequicklycalledSanDiego,anticipatingpraiseandlookingforwardtohisbigbonus.Instead,heheardtwowords:“You’refired!”

4.TheFuturesPrimer

“Thereareknownknowns;therearethingsweknowthatweknow.Thereareknownunknowns;thatistosaytherearethingsthatwenowknowwedon’tknow.Buttherearealsounknownunknowns—therearethingswedonotknowwedon’tknow.”—DonaldRumsfeld,U.S.SecretaryofDefenseintheGeorgeW.BushAdministration

Performingafewmouseclicksandtransmittinganorderisn’tallthathard.It’snotallthatdifficulttounderstandhowthemoneyworks,either.Whatisdifficultisextractingprofitsfromthemarkets(somethingwe’lltacklelater),butyouhavetostartsomewhere.Thischapterisforthosewhoneedtounderstandthebasics.Commoditiesarenotonlyessentialtolife,theyarenecessaryforqualityof

life.Everypersonontheplaneteats.Billionsofdollarsofagriculturalproductsaretradeddailyontheworld’scommodityexchanges—everythingfromsoybeanstorice,corn,wheat,beef,pork,cocoa,coffee,sugar,andorangejuice.Foodiswherethecommodityexchangesbegan.Inthemiddleofthenineteenthcentury,businessmenstartedorganizing

marketforumstofacilitatethebuyingandsellingofagriculturalcommodities.Overtime,farmersandgrainmerchantsmetincentralmarketplacestosetqualityandquantitystandardsandtoestablishrulesofbusiness.Overthecourseofonlyafewdecades,morethan1600exchangeshadsprungupatmajorrailheads,inlandwaterports,andseaports.Intheearlytwentiethcentury,ascommunicationsandtransportationbecamemoreefficient,centralizedwarehouseswereconstructedinmajorurbancenterslikeChicago.Businessbecamelessregional,morenational;manyofthesmallerExchangesdisappeared.Intoday’sglobalmarketplace,approximately30majorExchangesremain,

with90%oftheworld’sbusinessconductedonaboutahalfdozenofthem.Nearlyeverymajorcommodityvitaltocommerce,andthereforetolife,isrepresented.Billionsofdollars’worthofenergyproducts—fromheatingoiltogasolinetonaturalgas—aretradedeverybusinessday.Howcouldwelivewithoutindustrialmetals(suchascopper,aluminum,zinc,lead,palladium,nickel,andtin);preciousmetalslikegoldorplatinumandsilver(considered

bothindustrialandpreciousmetals)?Howcouldwelivewithoutwoodortextiles?It’shardtoimaginelifewithoutthem,andyetfewpeopleareawareofjusthowthepricesforthesevitalcomponentsoflifeareset.Unlike100yearsago,todaytheworld’sfuturesExchangesalsotradefinancialproductsessentialtotheglobaleconomicfunction.Fromcurrenciestointerestratefuturestostockmarketindices,moremoneychangeshandsontheworld’scommodityexchangeseverydaythanonalltheworld’sstockmarketscombined.Governmentsallowcommodityexchangestoexistsothatproducersandusers

ofcommoditiescanhedgetheirpricerisks.However,withoutspeculators,thesystemwouldnotwork.Anyonecanbeaspeculator,andcontrarytopopularbelief,Idonotbelievetheoddsneedbestackedagainstanindividual.Inthisbook,Isharewithyoutechniquesdesignedtohelpyoumakemoneytradingcommodities.Actually,youasanindividualhaveonedistinctadvantageoverthebigplayers,andthat’sflexibility.Youcanmovequickly,likeacat,somethingagiantcorporationcan’tdo.Manytimes,severalofthebigcommercialoperatorsthatutilizetheExchangeforhedgingliterallyhandyouyourprofitsonasilverplatterbecausethey’reinthemarketforadifferentreason.So,let’sstartbylookingathowfuturescontractsworkandthevariousparticipantsinthemarketplace.We’llalsolookatwhatthoseparticipantsareattemptingtoaccomplishandhowtheyinteractwitheachother.

FuturesmarketsandthefuturescontractFuturesmarkets,intheirmostbasicform,aremarketsinwhichcommodities(orfinancialproducts)tobedeliveredorpurchasedatsometimeinthefutureareboughtandsold.Afuturescontractisthebasicunitofexchangeinthefuturesmarkets.Each

contractisforasetquantityofsomecommodityorfinancialassetandcanbetradedonlyinmultiplesofthatamount.Afuturescontractisalegallybindingagreementthatprovidesforthedeliveryofvariouscommoditiesorfinancialassetsataspecifictimeperiodinthefuture.(PriortothetimeIwasinthisbusiness,Ienvisionedthepartiesactuallysigningcontracts.It’snothinglikethat.)Whenyoubuyorsellafuturescontract,youdon’tactuallysignacontract

drawnupbyalawyer.Instead,youenterintoacontractualobligationthatcanbemetinonlyoneoftwoways.Thefirstmethodisbymakingortakingdeliveryoftheactualcommodity.Thisisbyfartheexception,nottherule.Fewerthan1%ofallfuturescontractsareconcludedwithanactualdelivery.Theotherwaytomeetthisobligation,whichisthemethodyouwillbeusing,istermedoffset.

Verysimply,offsetismakingtheopposite(oroffsetting)saleorpurchaseofthesamenumberofcontractsboughtorsoldsometimepriortotheexpirationdateofthecontract.Becausefuturescontractsarestandardized,thisisaccomplishedeasily.EverycontractonaparticularExchangeforaspecificcommodityisidentical

exceptforprice.Thespecificationsaredifferentforeachcommodity,butthecontractineachmarketisthesame.Inotherwords,everyfull-sizedsoybeancontractisfor5,000bushels.Everyfull-sizedgoldcontractisfor100troyounces.(Isayfull-sizedbecausemanymarketsalsotrademinicontracts.Forexample,therearealsoactive50-,33-,and10-ouncegoldcontracts,butformostcommodities,thefull-sizedcontractsgetthebulkofthevolumeandliquidity).EachcontractlistedonanExchangecallsforaspecificgradeandquality.For

example,afull-sizedsilvercontractisfor5,000troyouncesof99.99%puresilveriningotform.Therulesstatethatthesellercannotdeliver99.95%puresilver.Therefore,thebuyersandsellersknowexactlywhattheyaretrading.Everycontractiscompletelyinterchangeable.Theonlynegotiablefeatureofafuturescontractisprice.Thesizeofacontractdeterminesitsvalue.Tocalculatehowmuchmoneyyou

couldmakeorloseonaparticularpricemovementofaspecificcommodity,youneedtoknowthefollowing:

•Contractsize•Howthepriceisquoted•Minimumpricefluctuation•Valueoftheminimumpricefluctuation

Thecontractsizeisstandardized.Theminimumunittradableisonecontract.Forexample,aNewYorkcoffeecontractisfor37,500pounds,aChicagocorncontractisfor5,000bushels,andaBritishpoundcontractcallsfordeliveryof62,500poundssterling.Thecontractsizedeterminesthevalueofamoveinprice.Youalsoneedtoknowhowpricesarequoted.Forexample,grainsarequoted

indollarsandcentsperbushel:$5.50perbushelforcorn,$9.50perbushelforwheat,andsoon.CopperisquotedincentsperpoundinNewYorkanddollarspermetrictoninLondon.Cattleandhogsarequotedincentsperpound,whereasgoldisquotedindollarsandcentspertroyounce.CurrenciesarequotedintheUnitedStatesincentsperunitofcurrency.Asyoubegintrading,youwillquicklybecomefamiliarwithhowthisworks.Yourbrokeragefirmcanfillyouinonhowpricesarequotedonanyparticularmarketwhereyoudecidetotrade.

Theminimumpricefluctuation,alsoknownasa“tick,”isafunctionofhowpricesarequotedandissetbytheExchange.Forexample,pricesofcornarequotedindollarsandcentsperbushel,butthe

minimumpricefluctuationforcornis1/4¢perbushel.So,ifthepriceofcornis$6.00/bushel,thenextpricetickcaneitherbe$6.001/4(ifup)or$5.993/4(ifdown).Pricescantrademorethanatickatatime,soinafastmarket,thepricecouldjumpfrom$5.00to$5.001/2,butitcouldnotjumpfrom$5.001/2to$5.005/8becausetheminimumpricefluctuationforcornisaquarterpenny.Therefore,thenextminimumpricetickforcornfrom$5.001/2upwouldbe$5.003/4,ordownwouldbe$5.001/4.Theminimumpricefluctuationforagoldcontractis10¢perounce,soifgoldistradingfor$1,525.50perounce,theminimumitcanmoveinpricewouldbe$1,525.60ifupor$1,525.40ifdown.Onceagain,inafastmarket,orifthebidsandoffersarewide,itmightjumpfrom$1,525.50to$1,526even,butinliquidandquietmarkets,manytimesthemarketmovesfromoneminimumtickfluctuationtothenext.Thevalueofaminimumfluctuationisthedollarsandcentsequivalentofthe

minimumpricefluctuationmultipliedbythecontractsizeofthecommodity.Forexample,thesizeofacoppercontracttradedintheUnitedStatesis25,000pounds.Theminimumpricefluctuationofacoppercontractis5/100¢perpound(or1/20¢).Bymultiplyingtheminimumpricefluctuationbythesizeofthecontract,youobtainthevalueoftheminimumpricefluctuation,whichinthiscaseis$12.50(1/20¢perpoundtimes25,000pounds).Inthecaseofthegrainsandsoybeans,aminimumpricefluctuationis1/4¢,andacontractisfor5,000bushels,sothevalueofaminimumfluctuationisalso$12.50(1/4¢perbusheltimes5,000bushels).Exceptwithgrains,minimumfluctuationsaregenerallyquotedinpoints.For

example,sugarpricesarequotedincentsandhundredthsofacentperpound.Theminimumfluctuationis1/100¢,oronepoint.Ifthepriceisquotedat251/2¢perpound,youwouldsayitistradingat2550,andifitmovesupbyaquarterofacentperpoundto253/4¢,thiswouldbeamoveof25points,to2575.Incertaincases,thevalueofaminimummovemaybemorethanapoint.In

thecopperexample,theminimummoveis1/20¢perpound.Apennymoveis100points(forexample,ifcopperpricesrisefrom$5perpoundto$5.02perpound,themarkethasmovedup200points),butbecausetheminimumfluctuationisfor1/20¢,aminimummoveis5points,or$12.50percontract.Amoveof1¢isworth$250,whichis100points.Youmustunderstandwhatthevalueofamoveisforthecommodityyouaretrading.Forexample,ifyouare

tradingsoybeans,youshouldknowthatamoveof1¢isworth$50percontract(eitherupordown),andifyoubuythreecontractsandthemarketclosesup10¢thatday,youwouldmake$1,500,or$500percontract.Ifthemarketclosesdown10¢,youwouldlosethesameamount.Althoughthisallmightseemconfusingatfirst,you’llquicklyunderstandthevalueofaminimumfluctuationandthevalueofapointatthetimeyoupayyourfirstmargincall.

ThisremindsmeofanamusingtruestoryoncetoldtomebyJoey,myfavoritecopperpitbroker,aguywhoretiredinFloridawhencopperwentelectronic.Whenthepitswereactive,ontheflooroftheCOMEX(theworld’slargestmetalsExchange,nowownedbytheCME),wherecopperistraded,thepitbrokersalwaystalkintermsofpointsinsteadofdollarvalues.Youwouldhaveheardatradersay,“Imade300pointstoday,”or“Ilost150pointsonthattrade.”Anumberofyearsago,therewasabigcommissionhousebroker(afloorbrokerwhomadehislivingfillingbuyandsellordersfromcustomerswhocallinfromoffthefloor)whowaspressuredbyhiswifetohirehisbrother-in-law.Thebrother-in-lawwasn’tallthatbright,butthebrokerfelthisbrother-in-lawcouldn’tdothatmuchdamageifhewereonthephoneasaclerk.Afterall,theclerksjustusedtotakethebuyandsellordersoverthephoneandrunthemintothepittobefilled.Well,everythingwentreasonablywellforafewweeks,andthenthefirstinevitableerroroccurred.Apparently,thebrother-in-lawtookanordertobuyfivecontracts,andhewrote“sell”ontheorderticket.Bythetimetheerrorwasdiscovered,ithadresultedinalossof370points($925)thatthecommissionhousebrokerhadtomakegood.Afterthemarketclosed,thebrokertookthebrother-in-lawasideandcarefullyspoketohim.Thebrokersaid,“Look,mistakeshappenand,fortunately,thiserrorrelativelysmall,onlyfor370points.Itcouldhavebeenmuchworse,butyouhavetobemorecareful.Wecannotaffordtohaveanymoreerrorslikethisone.”Thebrother-in-lawreplied,“Whatareyougettingsohotunderthecollarfor?SureImadeamistake,butit’sonlypoints.”Fromthatdayon,wheneveranyoneinthecopperpitmadeanerror,theguysonthefloorwouldsay,“Hey,what’syourproblem?It’sonlypoints!”

Certaincontractshaveassociateddailypricelimits,whichmeasurethemaximumamountthatthemarketcanmoveaboveorbelowthepreviousday’s

closeinasingletradingsession.EachExchangedetermineswhetheraparticularcommodityhasadailytradinglimitandforhowmuch.Thetheorybehindthelimit-moveruleistoallowmarketstocooldownduringparticularlydramatic,volatile,orviolentpricemoves.Forexample,asthistextisbeingwritten,therulesforthecorncontractstatethatthemarketcanmoveupordown40¢perbushelfromthepreviouscloseifitdidnotclose“limit”thepreviousday.(Limitmovesresultinexpandedlimits,andtherulesonlimitscanchange,soconsultExchangewebsitesforcurrentlimitspermarket,ifany.)So,ifthecornmarketclosesat$8.10perbushelonTuesday,thenonWednesday,itcantradeashighas$8.50oraslowas$7.70.Contrarytopopularbelief,themarketcantradeatthelimitprice;itjustcannottradebeyondit.Attimesofdramaticnewsorpricemovements,amarketcanmovetothelimitand“lock.”Alock-limitmovemeansthatthereisanoverabundanceofbuyers(for“locklimitup”)versussellersatthelimit-upprice,orthatthereisanoverabundanceofsellers(for“locklimitdown”)atthelimit-downprice.Forexample,supposethatinadroughtmarket,theweatherservicesare

forecastingrainoneweekend,therebycausingthemarkettotradeloweronaFriday.However,therainnevermaterializes,andonSundayevening,theforecastisbacktodrought,withrecord-hightemperaturespredictedfortheweek.Conceivably,themarketcouldopen“upthelimit”asshortsscrambletobuybackcontractspreviouslysold,andbuyerswouldbewillingto“payup”forwhatappearstobeadwindlingfuturesupplyofcorn.Let’ssaythemarketclosedonFridayat$7.50andthatitopenedat$7.90onSundayevening.Nowitcouldtradeatthatprice,oritcouldtradeevenlowerthatday.Butsuppose30,000contractsarewantedtobuyatthelimit-uppriceof$7.90,withonly3,000contractstosell.Thefirst3,000wouldtradeat$7.90,withthenext27,000inthe“pool”wantingandwaitingtobuy.Ifnoadditionalsellorderssurface,themarketwouldremainlimitupthattradingsession,withunsatisfiedbuyingdemandatthe$7.90level.However,nothingsaysthemarkethastoopenhigheronthenextsession(itcouldunexpectedlyrainMondayevening),butallotherfactorsremainingequal,thisunsatisfiedbuyinginterestwouldmostlikely“gapthemarket”higherwhenthefollowingsessionbegan.Mostmarketsthatuselimitshavewhatarecalledvariablelimits,which

meanslimitsraisedifamarketcloseslimituporlimitdownduringatradingsession.Cattleisoneofthemarketswithvariablelimits.Cottonisanother.Ifoneormorecontractmonthscloseat,forexample,the3¢(300-point)limit,thelimitisraisedto6¢thenextbusinessday.(YoucanconsultthewebsitesofthevariousExchangesforthedailyprice-limitrulesforeachmarket.)Limitmoves

arerare,buttheydooccurduringshockstoamarket.Porkbelliesusedtobenotoriousformovingmultiplelimitdaysafteranunexpectedlybullishorbearish“HogsandPigsReport.”Alas,the“bellies,”onceaspeculator’sfavorite,weredelistedin2012.

ThebeststoriesIhavecomefromthepitdays.It’sjusthardtotellahumorousstoryaboutaroguecomputeralgorithm.Sohere’sanothertruestoryofhowgutsysomeofthefloortradersattheBoardusedtobeattimes.Bill,whoonceworkedmysoybeanorders(whentheyweretradednotincontracts,butin“bushels”)toldmeaboutonesummerdaywhenthesoybeanmarketwasdownthelimit.Itwasn’tjustdownthelimit;itwas“lockeddownthelimit,”with5millionbushelsofferedtoselldownthelimitandnobuyersinsight.Itwasveryquiet.Then,outofnowhere,onelarge“local”wanderedintothepitanduttered,“Take’em.’’“Howmany?”theyasked.“Allof’em!’”Theotherbrokersinthepitliterallyfelloverthemselves,sellingtheentire5milliontothisguy.Whatcouldhebethinking?Butthen,assoonasthe5millionwerebought,andthequotemachinesaroundtheworldshowedthis,thetelephonesaroundthepitstartedtoring.Offthefloor,tradersaroundtheworldassumedthatwithsuchabigbuyeratlimitdown,somethingwasup,andtheystartedtobuy,too.Themarketimmediatelystartedtorally.Whenitmoved5¢perbusheloffthelimit-downprice,thelargelocalsteppedbackinandsoldhis5millionbushelsrightbeforeitwentbackdownthelimit.Itwasaquick$250,000profit,andittookonly20seconds!

Toreviewthusfar,beforeyoutradeinanymarket,youneedtoknow,atminimum,theExchangethemarketistradedon,thetradinghours,thecontractsize,andthedeliverymonthstraded.Youneedtoknowhowpricesarequoted,theminimumfluctuation,thedollarvalueoftheminimumfluctuation,andwhetherthereareanydailytradinglimits.Youalsoneedtoknowthetypesofordersacceptedatthatparticularmarketplace.Finally,youneedtoknowwhatthemarginrequirementisforthemarketyouaretrading,aswellaswhatcommissionyourbrokerwillbecharging.

Itisaseasytosell“short”astobuy“long”Theconceptofsellingshortisconfusingtonovices,butafteryoubegintotrade,sellingshortwillbecomesecondnature.

Everyoneknowsthatifyoubuysomethingatonepriceandsellitforahigherprice,youmakemoney.Ifyousellitatalowerpricethanwhatyoupaidforit,youlosemoney.Whenyoutradefutures,youcanbuyorsellinwhateverorderyoulike.Youcanbuyandthensell,orsellandthenbuy.Whicheveryouchoose,theideaisthatthesellingpriceshouldbehigherthanthebuyingprice.OnequestionI’veoftenheardis,“Howcanyousellwhatyoudon’town?”Well,here’show:Abuyerofafuturescontractisobligatedtotakedeliveryofaparticularcommodityor—andthisiswhathappensmostofthetime—sellbackthecontractpriortothedeliverydate.Theprocessofsellingback,whichcanbedoneanytimeduringnormalmarkethours(assumingthatthemarketisnot“lockedlimitdown”inamarketthathaslimits,whichisarareoccurrence),ineffect,wipestheslateclean.Ifyoubuyatonepriceandsellatahigherprice,youmakemoney,andviceversa.Forexample,ifyoubuysoybeansat$12perbushelandsellthemat$12.20

perbushel,yourprofitis20¢perbushel,whichisworth$1,000forasoybeancontract.(Apennymoveisaprofitorlossof$50.)Ifyoubuyacontractofbeansat$12andsellthembackat$11.80,youlose20¢,or$1,000percontract.Ifyoubuy10contractsofJulysoybeans,youcouldcancelyourobligationtotakedeliverybysellingback10contractsofJulysoybeans.Youwouldthenbeoutofthemarket,andthedifferencebetweenthepriceatwhichyouboughtandsoldwoulddetermineyourprofitorlossonthetrade.Whentradingfutures,becauseyouaretradingforfuturedelivery,itisjustas

easytosellfirstandthenbuybacklater.Sellingfirstisreferredtoasshortingorsellingshort.Tooffsetyourobligationtodeliver,allyouneedtodoistobuybackyourcontract(s)priortotheexpirationofthecontract(s).Thisprocessofbuyingbackisknownascovering.Youcan“coveryourshortposition”towipetheslateclean.Thepurposeofshortingistoprofitfromafallinprices.Ifyoubelievethepriceofaparticularcommodityisgoingdown,duetoanoversupplyorpoordemand,youwanttogoshort.Theobjectiveistocoveratalowerpricethanyousold.Inthesoybeanexample,ifyoubelievepricesat$12aretoohighandare

headingforafall,youcouldgoshortat$12.Ifpricesfallto$11.80,youmightwanttocoveryourpositionandtakethe20¢profit.Ashortsaleat$12,coveredat$11.80,isaprofitof20¢,or$1,000percontract.Ofcourse,ifpricesriseandyouhavetocoverat$12.20,youwouldhavealossontheshortsaleof20¢percontract,or$1,000.“Sellhigh,buybacklow”canbejustasprofitableas“buylow,sellhigh.”

Kevin“Mac,”whoonceleasedmyCOMEXseat,toldmethishumorous(andtrue)story.Kevintradedinthecopperpit,asdidAl,abigcommissionhousebroker.Alwasbiginmorewaysthanone,andhisweightseemedtorollercoaster,dependingonwhichdiethewasonatthetime.Dietornot,Alwasabigguy,andthiswasanadvantagethatwouldgethimnoticedinthepit.Alwasalsoacolorfulguywholikedtoplaythehorses,butathearthewasashyman.Still,youwouldn’tknowitwhenyousawhiminthepitbecausehemovednimblyandpossessedagruffvoice.He“filledpaper”foraliving,meaningheexecutedcustomerordersinthepit(aprofessionthatbecameextinctafterelectronictrading).Thishappenedinthecoppermarketof1987–1988,aparticularlywildtime.Thedayofthestockmarketcrash,themarketspikeddownward10¢perpound,ahugesingle-daymove,toacopperpriceoflessthan80¢perpound.(Interestingly,justafewmonthslater,itwasmorethan$1.40perpound.)Themarketwaswildandnoisythatday,andAlwassummonedtothephonetotakealargebuyorderfromaNewYorkclient.Alwasononeofhisdiets,andthatdayhehadforgottenhisbelt.Herushedintothepit,raisedhisarmstobidforthecopper,andhispantsfelltohisankles.Itwasawildday,butforafewseconds,noonecouldbelievetheireyes.EveryonestoppedtradingtostareatAl’sboxershorts.Alturnedredasheputhishandsovertheheartsonhisboxers.(HehadgottenthemforValentine’sDay.)ThenKevinbrokethesilence(asKevintellsit,hedidn’tstoptothink—itjustcameout),yelling,“LookatAl!He’scoveringhisshorts!”Nowthere’sastoryonlycommoditytradersfindfunny.

MarginandleverageOneofthebigattractions—andwhatmakesfuturesexciting—isleverage.Leverageistheabilitytobuyorsell$100,000ofacommoditywithonlya$5,000securitydepositsothatsmallpricechangescanresultinhugeprofitsorlosses.Leveragegivesyoutheabilitytoeithermakeakillingorgetkilled.Youneedtounderstandhowthisimportantconceptworksbeforeyoutrade,andathoroughunderstandingofthepowersandpitfallsofleverageisimperativetosoundmoneymanagementprincipals.EachcontractboughtorsoldonafuturesExchangemustbebackedbya

good-faithdeposittermedmargin.Thisisnotlikebuyingonmargininthestockmarket.Whenastockmarketinvestorbuysonmargin,sheis,ineffect,borrowinghalfofthepurchasepriceofthestockfromherbroker.Theinvestoris

chargedinterestonthebalance.Thisprovidesadegreeofleverage,butnothinglikewithcommodities.Toseehowpowerfulleveragecanbe,let’scompareafuturespurchasewitha

stockpurchaseforcash.Ifastockinvestorbuys200sharesofastocktradingat$10,hispurchasecostis$2,000.Ifthestockmovesupby10%,to$11pershare,theinvestorhasmade$200onhis$2,000investment,or10%.Marginincommoditytradingislikeagood-faithdeposit.Itisasmallpercentage,generallyintheneighborhoodof2%to10%,ofthevalueoftheunderlyingcommodityrepresentedbythecontract.MargindepositsaresetbytheExchange,andtheycanchangewithpricemovementsandmarketvolatility.Becauseyouaretradingforfuturedeliveryandnotborrowinganything,nointerestischargedonthebalance.Marginisnotapartialpaymentoradownpaymentatall,andit’snotevenconsideredacost.Ifyoumakemoneyonthetrade,uponliquidation,yourtotalmargindepositisreturned,alongwithyourprofits.Commissionsarededucted,andtheyareacost.Marginismoneydepositedinyourbrokerageaccountthatservestoguaranteetheperformanceofyoursideofthecontract.Marginisaformof“earnestmoney”depositedbyboththelongsandtheshorts,anditservestoensuretheintegrityofeveryfuturestransaction.Ineffect,marginensuresthatyouarepaidwhenyouwinandthatwhoeverisontheothersideofyourtransactionispaidifyoudon’t.Whenyouenteraposition,youhavedeposited(orwilldeposit)themargin

moneyinyouraccount,butyourbrokeragehouseisrequiredtopostthemarginwithacentralExchangearmcalledtheclearinghouse.Theclearinghouse,ineffect,managesthedailyprocessofdebitingtheaccountsofthelosersandredistributingthemoneytotheaccountsofthewinners.Nowbacktotheleverageexample.Assumethatthemarginrequirementfora

5,000-ouncesoybeancontractis$2,000.At$6perbushel,acontractisworth$30,000($6perbusheltimes5,000bushels).Ifthepriceofsoybeansrisesby10%,to$6.60,thesamecontractisworth$33,000.However,supposethatthesameinvestorputsuphis$2,000andinsteadbuysasoybeancontract.Ifthepriceofsoybeansrisesby10%,or60¢,hemakes$3,000onhiscontract.Thisis150%onmargin,not10%.It’spowerfulleverage,butit’salsoadouble-edgedsword.Ifpricesfallby10%,theinvestor’s$2,000isnowworthanegative$1,000.Whenyoutradefutures,youareresponsibleforthetotalvalueofamoveofanypositionyouhold.Inmostcases,ifamarketmovesagainstyou,youhavetimetoliquidatebeforetheaccountshowsadeficit;however,thisisnotalwaysthecase.Ifyoudon’tuseadequaterisk-controlmeasures,orifamarketmovesveryquicklyagainstyou,youraccountcouldgointoadeficit

situation,andyouareobligatedbycontracttopaythedifference.Therearetwotypesofmargin:initialmarginandmaintenancemargin.Initialmarginistheamountthatmustbeinyouraccountbeforeyouplacea

trade.Ifyoudonothaveenoughinitialmargininyouraccount,youincuramargincall.Mostbrokeragefirmsrequiretheinitialmargintobeintheaccountbeforetheyallowatradetobeplaced.Somemightissuecreditforgoodcustomers,buttheygenerallyrequirethatthemargincallbemetwithinoneortwobusinessdays.Anyfirmhastherighttorequiresame-daydepositbybankwiretransferatanytimeandmightrequestthisduringvolatilemarkets.Maintenancemarginistheamountthatmustbemaintainedinyouraccountaslongasthepositionisactive.Iftheequitybalanceinyouraccountfallsbelowthemaintenancemarginlevel,becauseofadversemarketmovements,youincuramargincallaswell.Afterthemargincallisissued,youarerequiredtomeetthecallorliquidatetheposition.Ifyoufailtomeetamargincallinatimelymanner,thebrokerhastheright(andwilluseit)toliquidatethepositionforyouautomatically.Thisisdonetoprotectthebrokerfromadditionaladversemovementsinthemarketbecauseheisresponsibleformeetingyourmargincall,evenifyou’readeadbeatanddon’t.Ifyoufailtomeetamargincall,andthepositionisultimatelyliquidatedata

lossthatleavesadeficitintheaccount,thebrokerisimmediatelyresponsibleforthedeficit,butyouarelegallyresponsible.Inotherwords,theinitialmarginisnottheextentofyourliability.Youareresponsibleforalllossesresultingfromyourtradingactivities.Ifyouareinacomaandthemarketmovesagainstyoufive,six,orsevendaysandyoudidnotgetoutbecauseyouwereunableto,ifthemarketmoveslimitagainstyouandeatsupyourmargin,youarestillresponsibleforanyandalllosses.Laterinthisbook,you’lllearnwaystomanagetherisk,butatthispoint,beawarethatwheneveryoutradefutures,yourriskisnotlimitedtotheinitialmarginoryouraccountbalance.Itcangofurtherthanthat.(Optionsworkdifferently.)Assumethatcornistradingat$6perbushel,andtheinitialmargin

requirementis$2,000.Acorncontracthasasizeof5,000bushels,soat$6perbushel,thetotalvalueofthecontractis$30,000.However,allthatisrequiredtopurchaseorsellacontractis$2,000(inthisexample,about6%).Aruleofthumbformaintenancemarginisthatitwillbeatthe75%levelofinitial.Iftheinitialis$2,000,forexample,maintenancemightbe$1,500.Ifyouhaveanaccountvalueof$20,000withnootherpositionson,youcouldbuy10contractswithoutamargincall;however,thisisnotrecommendedbecauseyouwouldbeovertrading,ortoohighlyleveraged,andarelativelyminorpricemovement

wouldmoveyouintomargincallterritory.Forillustrativepurposes,let’sassumethatyouraccountbalanceisat$20,000

andthatyoubuy10corncontracts.Yourmaintenancelevelisat$15,000.Ifthemarketstartstomoveyourwayimmediately,you’reokay.Becauseacorncontractisfor5,000bushels,a1¢moveresultsinaprofitorlosspercontractof$50.Inthisexample,the10contractsgiveyouaprofitorlossof$500perpennymove.Supposeyoubuythe10contractsat$6,andthemarketclosesthatsamedayat$6.05.Youraccountbalanceis$22,500atthecloseofbusinessthatday.Youhaveanunrealizedprofitof$2,500.Theprofitisunrealizedbecausethepositionisstillopen.Theincreaseinequityvalueof$2,500istheresultofthe5¢moveinyourfavor(5¢times$50percontracttimes10contracts).Supposethatthenextdaythepricefalls10¢,tocloseat$5.95.Youraccountvaluedecreasesby$5,000,to$17,500.Youwouldnothaveamargincallbecauseyourvaluestillwouldbeabovethemaintenancelevel.Ifonthenextdaypricesrose5¢,backto$6,yourequityvaluewouldmovebackto$20,000.Basically,thefuturesinvolvesaprocessofgeneratingacreditordebitdaily

againstyourinitialpositionuntilyoucloseitout.Ifyoumakemoneyonanyparticularday,theunrealizedcreditbalanceiscreditedimmediatelytoyouraccountanddebitedfromthepeopleontheothersideofthetransaction.(Youwillneverknowwhotheyarebecauseit’scompletelyanonymous,buttheyareoutthere.)Ifthemarketclosesagainstyourpositiononanyparticularday,thelosswouldbeimmediatelydebitedfromyouraccount.Now,let’sgetbacktotheexample.Onthefourthday,themarketdrops25¢,

tocloseat$5.75.Youraccountisdebited$12,500(25¢times$50percontracttimes10contracts).Yourequitybalanceisnowdownto$7,500,whichisbelowthemaintenancemarginlevel,soit’smargincalltime.Younowgetacommunicationfromyourbroker,whoinformsyouaboutyour$12,500margincall.Afteryourequitylevelfallsbelowthemaintenancemarginlevel,youarerequiredtobringyourbalanceuptotheinitialmarginlevel.Younowhavetwochoices:Youcaneitherliquidatethepositioninwholeorinpart,enoughtomoveyourequitybackabovetheinitialmarginlevel,oryoucanmeetthecall.Inthiscase,youcouldsellout7contracts,realizeyourlossonthose7,holdontothe3,getyourinitialmargindownto$6,000,andhopethemarketrecovers.Ifyoufeelstronglyabouttheposition,youcouldopttomeetthecall.Let’ssayyoudeposittheadditional$12,500inyouraccount.Youraccountbalancenowshows$20,000,soyouare“offcall.”Youhavedeposited$32,500intoyouraccountatthispoint,butifyoucloseoutthepositionatthecurrentpriceof$5.75,youhaveabalanceremainingof$20,000minusanytransactioncosts.Ifyourthinkingis

correct,andthecornmarketrecoversto$6,youraccountbalancewouldgrowbackto$32,500.Younowhavetherighttorequestthatthe$12,500(theamountovertheinitialmargin)besentbacktoyou,evenifyouarestillintheposition.Ifthemarketfallsagain,however,youcouldcertainlybeissuedanothermargincall.Itisimportanttoleaveacashcushionintheaccountsothatyouhavethe

abilitytorideoutnormalmarketfluctuationswithoutreceivingamargincall.Mygeneralruleofthumbistonevermarginhigherthan50%maximum.Inotherwords,ifyouraccountvalueis$25,000,Iwouldnotputonpositionsthat,atmost,wouldrequiremorethan$12,500ininitialmargin.Eachmarkethasitsownmarginrequirement,basedonthevolatilityoftheparticularmarketandalsothevolatilityofthemarketsasawhole.Greatervolatilityequalsgreaterriskandhigherrequirements.Here’sanotherimportantpointonmargins:AlthoughtheExchangesetsa

minimummarginrequirement,individualbrokeragehouseshavetherighttochargehigherthan“Exchangeminimum.”Thisprotectsthebrokeragehousefromovertraderswhotendtoplunge(tradeinexcessofprudentspeculation,eveninexcessoftheirabilitytopay),whichwouldrequirethebrokertomakegoodonhiscommitmenttotheclearinghouse.Theentirepointofthismarginingsystemisthatallpositionsare“markedto

themarket”bytheclearinghousedailyandrevaluedtothecurrentmarketprice.Profitsandlossesarepaiddaily.Onelastpointaboutmargins:TheExchangeallowsinitialmarginstobe

postedeitherincashor(intheUnitedStates)U.S.governmentobligationsoflessthan10yearstomaturityandeven,insomecases,gold.IfaninvestorwishestopostT-Billsformargin,hecandoso;theinterest(whenT-Billsarepayinginterest)passesbacktothecustomer.So,ineffect,theinitialmargincanearninterest.

DeliverymonthsEveryfuturescontracthasstandardizedmonthsthatareauthorizedbytheExchangefortrading.Forexample,wheatistradedfordeliveryinMarch,May,July,September,andDecember.IfyoubuyaMarchcontract,youneedtosellaMarchcontracttooffsetyourpositionandmeetyourcontractualobligation.IfyoubuyaMarchwheatcontract,andyousellaMaywheatcontract,youhaveoffsetnothing.Youarestill“long”Marchandnow“short”May.Somecommoditiesaretradedineverymonth,butbyconvention,somecontractmonthsaretradedmoreactivelythanothers.Forexample,goldtradesinevery

monthoftheyear,buttheactivemonthsareFebruary,April,June,August,October,andDecember.OntheLondonMetalExchange,orLME(wherealuminum,copper,zinc,nickel,lead,andtinaretraded),adifferentsystem,knownaspromptdates,isused.AttheLME,theactivecontractonanyparticulardayisthe3-month.Ifyoubuyorsellanew3-monthonsay,May10th,youareintheAugust10thcontract(assumingthatAugust10thdoesnotfallonaweekendorholiday).Then,tooffsetyourposition,youneedtoselltheAugust10thcontract.YoucandothatpriortoAugust10th,butyourbuyorsellpriceisbasedonaninterpolationofthecash(orspotcontract)to3-monthdifferentialonthedayyouliquidate.ThemarginingprocedureisdifferentfortheLMEaswell,soifyouarethinkingoftradinginthesemarkets,talktoyourcommoditybrokerabouthowitworks.Whichmonthshouldyoutrade?Thisisageneralruleofthumbonly,but

unlessyouhaveaspecificreasonfortradingaspecificmonth,tradetheactivemonth.Forexample,saythatit’sMaybutyouwanttobeshortDecembercornbecausethisisthefirstnewcropmonthand,despitetightsupplies,youthinkthere’sabigcropcomingandpredictthatthismonthwillfallfaster.Otherwise,youwouldtradetheactivemonth.Theactivemonthistheonewiththehighestopeninterest,andyoucanobtainthisinformationfromtheExchangeforanyparticularcommodityatanypointintime.Thisisbecausetheactivemonthshavethegreatestnumberofplayersand,therefore,themostliquidity.Becauseofthis,youcangetinandoutwithasmallerdegreeofslippage.Slippage,ineffect,meanshavingyourorderfilledatapriceunfavorablydifferentfromthatwhichexistedasthelasttrade.Forexample,let’ssayyouwanttobuygold,andthelastquotedpriceis

$1,801.10,butthebestbidis$1,801.10andthebestofferis$1,801.30.Itisafast-movingmarket,andyouwantin.Youbuyatthemarket,andeventhoughthelasttradeis$1,801.10,yourpricefillcomesbackat$1,801.30.These20pointsrepresent$20percontract,andthey’relikelytogointothepocketofamarketmaker.Itislegal,andaslongastherearenoloweroffersintheorderbook,itisthepriceyoupayfortheliquiditythemarketmakersprovide.Thepointis,forminimumslippage,itisbesttotradeinhigh-volume,activemarkets.Inmostcases(andthereareexceptionstothisruleaswell),itdoesn’tmake

sensetotradeinadeliverymonth.Therefore,youwanttoavoidenteringpositionsthatareclosetodeliverybecauseyou’llneedto“rollover”intothenextcontractsooner.Therulesaredifferentforeachmarket,butinmanycases,acontractentersactualdeliverythelastdayofthemonthpriortothedeliverymonth.Forexample,withMarchwheat,thefirstnoticeday—thatis,thefirst

possibledaytheshortscanmakeadelivery—isthelasttradingdayinFebruary.Whathappensifyoufailtoselloutandarestillinthecontractonfirstnoticeday?Well,thereisapossibilityyouwillgetactualdeliveryofthewheat,buttheshortsarenotrequiredtomakedeliverythefirstdayorthenext.Ashortisrequiredtomakedeliveryonlyifyouhavenotcoveredyourcontractpriortothelasttradingday.ThelasttradingdayforMarchwheatisinthethirdweekofMarch,sothedeliveryperiodlastsaboutthreeweeks.Alongcanreceivedelivery,atthediscretionoftheshorts,onanyoneofthedaysinthedeliveryperiod.Ifthecashpriceisabovethefuturesonfirstnoticeday,theshortsmaynotfinditlucrativetodeliverandwait.Ifthecashpriceisbelowthefutures,oddsincreasefordeliveries.Now,justbecausedeliveriesaremadeonanyparticulardaydoesnotmeanyouwillgetdeliveryonanyparticularday.Earlyinthedeliveryperiod,thenumberofopencontractsexceedsthedeliverablesupply.IfopeninterestintheMarchwheatis,say,100millionbushels,andthedeliverablesupplyintheelevatorslicensedfordeliveryis20millionbushels,theoddsofdeliveryarehighonlyifyoupurchasedthecontractmonthsagoinsteadofdaysago.Thisisbecausedeliveriesareassignedtotheoldestdatefirst.Theoldestlongisfirstinlinefordelivery.However,asthedeliveryperiodprogresses,theoddsforreceivingadeliveryincreaseasthenumberofoutstandingcontractsisliquidateddownwardandyourdatebecomes“fresher.”So,whathappensifyoudogetdelivery?Contrarytopopularbelief,youdo

notgetaloadofwheatdumpedonyourdoorstep—or,worseyet,aloadofhogs.Instead,youreceiveawarehousereceiptthatshowsyounowown5,000bushelsofwheatin,forexample,aToledoelevator.Becauseyouarenowinacashcontract(thedeliveryoffsetsyourfutures),you’renowrequiredtopostthefullvalueofthecontract.Yourleverageisgone.Ifyourmargindepositwas$1,400forthefutures,younowneedtoponyupanadditional$38,600ifyoureceiveddeliveryat$8perbushel.Ifyoudon’thavethemoneyinyouraccount,yourbrokerwillhavetopostthisamountonyourbehalf,andshewillchargeyouinterestonthebalance.Otherfeesincludeanadditionalcommission,insurance,andstoragecosts.Youcanpassyourdeliveryreceiptontosomeoneelse.Becauseonlytheshortscanmakedelivery(andyouarelongawarehousereceipt),youfirstneedtosellacontractshortandtheninstructyourbrokertomakeyourdeliveryonyourshortcontract.Thisisthewaytosellbackyourwarehousereceipt.Inmostcases,thereisnogoodreasontobetradinginadeliverymonthunless,ofcourse,youhaveagoodreasontodoso.Agoodreasonmightbeabeliefthatthereisnotenoughofthecommodityavailabletodeliver,whichcouldcauseashortsqueeze,apanicsituationfortheshorts.

However,beawarethatthisisgenerallyagameforsophisticatedtraders.Ofcourse,asashort,youhavenochanceofreceivingadelivery(becauseitisatyourdiscretionastowhentomakeit),butthenyourchanceofbeingsqueezedincreaseswitheachdayyouareinthecontractduringthedeliveryperiod.Ifyouareinonthelastday,andyourbrokerhasn’tforcedyouout,goodluckinmakingthedelivery.Thisisagameforthecommercials.

Manyyearsago,whenIwasatMerrillLynch,oneofthecommoditybrokershadaclientwhorefusedtoliquidatealongsugarpositionpriortothedeliveryperiod.Theclientthoughttherewasnosugarbut,alas,therewas.(Thesugarcontractiswrittensothatyoucanreceivedeliveryatanyoneof100portsaroundtheworld.)HegothissugaronabargeoffBangkok,anditcosthimplentyforMerrillLynchtofindacashoperatoranddisposeofthisdistressmerchandiseinthecashmarket.(Thecommercialsknewhehadnousefor112,000poundsofsugaronabarge.)

Onelastpoint:Mostfinancialfutures(stockindicesandcurrencies)andevensomeoftheagriculturalfutures(feedercattleandhogs)arecashsettled.Anypositionsstillopenwhenacontractexpiresareclosedatthesettlementprice.Theamountpaidorreceivediscalculatedforeveryonewhoremainedinatexpiration,basedonthiscommonprice.

BrokersandcommissionsAlthoughmarginisn’tatruecost(yougetitbackattheendofthetrade,plusanyprofitsorminusanylosses),commissionsareatruecost.Commissionsareyourbroker’sfeesforhisorherservices,andtheyrangeacrosstheboardandbybroker.Thetwomajortypesofcommissionfirmsarediscountersandfull-servicefirms.Commissions,whileimportant,shouldnotbeyouronlyconsiderationwhen

choosingabroker.Irunafull-servicefirm,andalthoughourcommissionsarecompetitiveforfullservice,theyarehigherthandiscounters.Ifyouareaself-directedtrader,arerelativelysophisticated,knowexactlywhatyouwanttodointhemarketplace,donotrequireadviceoradditionalservices,andonlyneedorderexecution,thenyoushouldcertainlygoforthecheapestrate.However,youneedtoevaluatewhatyou’rereceiving.Withsomefirms,discountcommissionsequalcheaperservice,particularlywhenyouhaveaproblem.Inaddition,youneedtoevaluatehowmuchhelpyourbrokerisprovidingyouversushowmuchhelpyourequire.Aknowledgeablefull-servicebrokerwho

providesyouwithprofitablerecommendationsisworthhighercommissionscharged.Justasimportantly,isyourbrokerhelpingyoutocontrolyourrisksproperlyonthebadtrades?Isheorshehelpingyouavoidclassicmistakessuchasovertrading?Thesearefactorsyou’llneedtoevaluatewhenyoubegin.Abrokeragerelationshipisextremelypersonal,andwhomyoutradewithcanmeanthedifferencebetweenprofitandloss.Onelastthoughtaboutcommissions.Whentalkingcommodityfutures,thefee

percontracttradedislowcomparedwithmanyothertypesofinvestments.Thefeecanbelessthanafractionofapercentagepointofthetotalcontractvalue.Itisahigherpercentagewhencomparedtothemargindeposit,butit’sstillsmall.Theothersideofthecoinisthatfuturestradersaremuchmoreactivethanmoretraditionalinvestors,andtotalcommissioncostsforanactivetradercanrunupsubstantiallyovertime.

TheplayersThetwomajorclassesofparticipantsinthefuturesandoptionsmarketsarehedgersandspeculators.Hedgerscanaccountfor5%to30%ofthevolumeandopeninterestinthe

majorfuturesmarketsanduptohalformoreinsomeofthesmallercontracts.Hedgersuseexchange-tradedcontractstooffsettheriskoffluctuatingpriceswhentheybuyorsellphysicalsuppliesofacommodity.Forexample,acopper-miningcompanymightsellcopperfuturestolockina

salepricetodayforitsfutureproduction.Inthisway,thecompanyprotectsitsprofitmarginsandrevenuestreamfromapossiblefuturedropincopperprices.Iffuturecopperpricesrise,thecompanylosesonitsfuturesposition;however,thevalueofitsphysicalmetalrises.Thecoppermineisaproducerandisjusttryingtooffset,orhedge,itspricerisk.Ahedgercanbeabuyeroraseller.Atubemanufacturerthatbuyscopperasarawmaterialintheproductionof

coppertubeusedforplumbingmightbuycopperfuturestolockinitscoppercostforfuturepurchase.Ifthepriceofcopperrises,themanufacturerhasaprofitonitshedge,whichcanbeusedtooffsetthehigherpriceofphysicalcopperitneedstopurchaseinthemarketplace.Ifcopperpricesfall,themanufacturershowsalossonthefuturessideofthetransaction,butitisabletobuythecoppercheaperinthemarketplace.Ineithercase,thecoppermineorthetubemanufacturerhastheabilitytohold

itscontractsintothedeliveryperiod.ItthenhastheoptiontomakeortakecopperdeliverythroughtheExchangeatanapprovedwarehouselicensedtodo

businessontheExchange.ThisoptionisasimportantintheoryasinpracticebecauseitiswhatallowsphysicalcommoditypricesandtheExchange-tradedcontractstocometogetherinprice.Ifthepriceofthecommodityistoohighinrelationtothefuturesprice,thenthepeopleinvolvedintheuseofaparticularcommoditybuythelow-pricedfuturescontractsandtakedelivery.Theirbuying,ineffect,pushesfuturespricesuptomeetthephysicalprice.Ifthepriceofafuturescontractistoohighinrelationtotheactualcommodity,thenproducersofthatcommoditysellthecontracttomakedeliverybecausethehigher-pricedfutures(inrelationtothephysical)justmightbetheirbestsale.Theirsellingpushesthepriceofthefuturesdowntothecashprice.Thisentireprocessisknownasconvergence.Thispotentialprocessofconvergenceiswhatmakesthesystemwork;however,inpractice,only1%to2%ofallcommoditycontractsendindelivery.Oddsarethatyou,asaspeculator,willnevergetinvolvedinadelivery,andthere’snoneedto.Infact,eventhemajorityofhedgersdonotusethemarketstoactuallymakeortakedelivery;theyusethefuturesasapricingtooltohelpstabilizetheirrevenuesandtheircosts.

Ioncehadaclient,amajormanufacturingfirmthatpublishedabiannualcatalogwithpricesithonoredduringthelifeofeachcatalog.Thisfirmusedcopperandzincinitsmanufacturingprocess,anditknewwhatitsprofitmarginwasbasedontoday’spriceofcopperandzinc.Ifitdidn’thedgeandlockinthesix-monthpriceofcopperinitially,andthepricewentupduringthetimethecatalogwasdistributed,itsentireprofitmargincouldhavebeenwipedout.Theothersideofthecoinisthatifcopperpricesfellandthepublishedpriceremainedbasedonthepublishedhigherpricesoftherawmaterials,thefirmcouldhavereapedawindfallprofit.However,thefirmwasnotinthebusinessofspeculation;itwasinthemanufacturingbusiness.Itwasmorethanwillingtoforgothechanceofawindfalltobeassuredofaprofitmarginthatallowedthemtokeeptheplantrunningandavoidlayoffs.Afewtimeseachyear,Isatdownwiththisfirmtodeterminewheretobuycopperandzincfuturestolockinapricethefirmcouldlivewithforthecomingsixmonths.Afteritknewthisprice,thefirmpublisheditscatalogwithpeaceofmind,knowingthatitsprofitmarginwassecure.Ifthepriceofcopperrose,thefirmwouldhavetopaythehigherpriceinthecashcoppermarket;however,itsfuturescontractsroseinvalueaswell,andtheprofitsfromthefuturesoffsetthehigherpricethathadtobepaidinthephysicalmarket.Ifthepriceofcopperfell,thefirmrealizedalossonitsfutures,butthiswasoffsetbythelowerpriceitenjoyedinthecashmarketwhenit

boughtcopper.

ManyoftheproductshedgedonafuturesExchangeareactuallycross-hedges.Forexample,jetfuelissimilartoheatingoil,andtheyareoftenpricedwithinafewcentsofeachother.Amajorairlinemightusetheheatingoilcontracttohedgeitsjetfuelrequirements,andatruckingcompanymightusethesamecontracttohedgeitsdieselfuelneeds.

BasisriskBasisisthedifferencebetweenthecash,orspot,priceandthefuturesprice.Everycontracttradedhasspecifications,whichmakethecontractsfungibleandstandardized.Forexample,let’slookatthecontractspecificationsforheatingoil:

TradingUnit=42,000U.S.gallons(1,000barrels).PriceQuotationinU.S.dollarsandcentspergallon.TradingMonths—Tradingisconductedin18consecutivemonths,commencingwiththenextcalendarmonth.MinimumPriceFluctuation—$0.0001(0.01¢)pergallon($4.20percontract).MaximumDailyPriceFluctuation—$0.25pergallon($10,500percontract)forallmonths.Ifanycontractistraded,bid,orofferedatthelimitforfiveminutes,tradingishaltedforfiveminutes.Whentradingresumes,thelimitisexpandedby$0.25pergallonineitherdirection.Ifanotherhaltistriggered,themarketwillcontinuetobeexpandedby$0.25pergallonineitherdirectionaftereachsuccessivefive-minutetradinghalt.Therewillbenomaximumpricefluctuationlimitsduringanyonetradingsession.LastTradingDay—Tradingterminatesatthecloseofbusinessonthelastbusinessdayofthemonthprecedingthedeliverymonth.SettlementType—Physical.Delivery—F.O.B.seller’sfacilityatNewYorkharbor,ex-shore.Allduties,entitlements,taxes,fees,andotherchargeshavepointpaid.Requirementsforseller’sshorefacility:capabilitytodeliverintobarges.Buyermayrequestdeliverybytruck,ifavailable,attheseller’sfacility,andpaysasurchargefortruckdelivery.Deliveryalsomaybecompletedbypipeline,tanker,booktransfer,orinter-orintra-facilitytransfer.Deliverymustbe

madeinaccordancewithapplicablefederal,state,andlocallicensingandtaxlaws.DeliveryPeriod—Deliveriesmaybeinitiatedonlythedayafterthefifthbusinessdayandmustbecompletedbeforethelastbusinessdayofthedeliverymonth.GradeandQualitySpecifications—ThesegenerallyconformtoindustrystandardsforfungibleNo.2heatingoil.

Whenyoureadthiscontract,youcanseethatitisstandardized,inthatallcontractscreatedarethesame.ContractspecificationsforallcommoditiestradedontheExchangeareavailablefromtheExchangewebsite.Asaspeculator,youreallyarenotconcernedwiththedeliveryspecificationsbecauseyouwillnotbeinvolvedindelivery—you’llbeoutlongbeforeitstarts.Whataboutahedger?ThisparticularcontractcallsfordeliveryofNo.2heatingoilinNewYorkharbor.Ofcourse,notallheatingoilisusedintheNewYorkarea,andpricesinothercitieswillvaryduetodifferencesintransportationcosts,storagecosts,andlocalsupply-and-demandconsiderations.AwaveofArcticairsweepingthroughEuropewouldnodoubtraisethepriceofheatingoilglobally,butthepricewouldrisefasterinRotterdamthaninNewYork.Thesedifferentialsareknownasthebasis.Thebasiscanbestableandpredictableattimes.Forexample,ifitcosts3¢pergallontotransportheatingoilfromNewYorktoBoston,thebasisinBostonmaypredictablyrunat“plus3¢pergallon,”allotherfactorsremainingequal.However,ifBostonisunderadeepfreezeandNewYorkisn’t,thebasismightmoveupto“plus4¢.”ForthemanufacturingfirmIworkedwith,thepriceofscrapcoppercould,at

times,beatthepriceofthevirginmetal(whenthereisascrapshortage).Othertimes,itcouldbeasmuchas4¢or5¢perpoundunder.Thepointisthatahedgerhaswhat’scalledbasisrisk.Basisriskisalmostalwaysfarlessthanthepricerisksinvolvedwithoutahedge.Ahedgerwhodoesnothedgeisjustlikeaspeculatorbecausesheisassumingthenaturalrisksofthemarketplace.Onceagain,Iwanttopointoutthatevenmosthedgerscloseouttheirfuturespositionslongbeforetheirfuturescontractsexpire,andthemajorityofthemdosolongbeforethedeliveryperiodevenstarts.Then,theytakeormakedeliveryofthephysicalcommoditytheyareinvolvedinthroughnormalchannelsbyusingtheirstandardsuppliers.Knowingthateachcontractisactuallykeyedintoaspecificactualgradeoftheunderlyingcommoditykeepsthevaluetruetolife.Nomatterwhattheunderlyingcommodityis,eachExchangeultimatelyguaranteesthepurchaseandsale,aswellasthedeliverygradesforqualityandquantity.ThisiswhyquotationsfromtheExchangesformostofthecommoditiestradedareused

aspricingstandardsaroundtheworld.Hedgescomeintwobasicforms:shortandlonghedges.

TheshorthedgeAshorthedgeisenteredintotoprotectthevalueofaninventory.Consideranexampleusingcrudeoil.Aninventoryof1,000barrelsofcrudeoilconstantlychangesinvaluefromwellheadtoconsumer,evenbeforeitisprocessedintogasolineorheatingoil.Ashorthedgeisusedbytheownerofacommoditytoessentiallylockinthevalueoftheinventorypriortothetransferringoftitletoabuyer.Adeclineinpricesgeneratesprofitsinthefuturesmarketontheshorthedge.Theseprofitsareoffsetbydepreciationintheinventoryvalue.Let’ssayanoilproducerisafraidofafuturepricedecline.InAugust,he

anticipateshewillsellhisAugustproductioninSeptember.Hisproductionis1,000barrelsadayfor25days.ThecashpriceinAugustis$120perbarrel,andOctoberfuturesarequotedinAugustat$120.10perbarrel.Here’swhattheproducermightdointhefuturesmarket:sell25Octoberfutures(eachcontractisfor1,000barrels,sothisrepresentshisAugustproductionof25,000barrels)at$120.10,whichlocksinavalueofhisinventoryequivalentto$3,002,500($120.10perbarreltimes25,000barrels.)Supposeheiscorrectaboutthepricefalling.AlongcomesSeptember15,andthepriceofcrudefallsinthecashmarketby$20perbarrel.Becausethefuturesmirrorthecashfairlyclosely,thefuturesalsofallinprice.Let’ssaythatthefuturesonthatdatearequotedat$100perbarrel.ThecashpriceonSeptember15isnow$100,or$20lessthanthe$120priceatproductiontime.Hesellshisproductinthecashmarkettotherefineryforatotalof$2,500,000($100times25,000),or$500,000lessthanwhathecouldhavereceivedinAugust.However,thefutureshavealsodropped,andhebuysbackhisOctoberfuturescontractsonSeptember15for$100.(Thisoffsetshisposition;hedoesnothavetomakedelivery.)Remember,hesellsfortheequivalentof$3,002,500,hebuysbackattheequivalentof$2,500,000,andthedifferenceof$502,500ishisgaininthefutures.Thefuturesgainof$502,500offsetsthecashmarketlossof$500,000,andtheoilproducerhas,ineffect,protectedthevalueofhisinventoryattheAugustprice.Whatiftheoilproduceriswrong,andthecashpricerises?Let’ssaythat

insteadoffallingto$100,thecashpricerisesto$130bySeptember15,andtheOctoberfuturesriseto$130.10.His25,000barrelsrealizehim$3,250,000inthecashmarket,or$250,000morethanhecouldhavereceivedinAugust.However,hisfuturesalsorise,byatotalvalueof$252,500($10.10times25,000).Whenhebuyshiscontractsback,herealizesafutureslossof$252,500Therefore,the

futureslossof$252,500mustbetakenintoconsiderationwiththeextracashprofitof$250,000.HestillcomesbacktoapproximatelytheAugustprice.Theshorthedgehasprotectedthevalueofhisinventoryatabout$120perbarrel,whichisthenumberhewastargeting.ANebraskafarmerwhowantstolockinthepriceofhiscornforharvesttime

inthefall,whileitisstillinthegroundduringthesummer,woulduseashorthedgeinmuchthesamewaythatthisoilproducerusesashorthedge.

ThelonghedgeAcommodityuser(buyer)entersintoalonghedgetofixacquisitioncostsandensureacertainprofitmargin.Forexample,let’ssaythataproducerofethanol(acorn-basedfueladditive)uses1millionbushelsofcorntomeettheproductionfortheirmajorcustomerduringthepeaksummerdrivingseason.ItisApril,andJulycornfuturesarequotedat$6.50perbushel.ByJuly,dependingonweather,exports,andotherunknowns,thepriceofcorncouldbemuchhigherorlower.Thisbigcustomerwishestoenterintoacontractwiththeproducerfordeliveryattoday’spriceinAugust.(Forethanol,theproducerwillmanufactureinJuly.)Theproducercanmakeaprofitattoday’sethanolpricesifthepriceofcornremainsat$6.50.Hecalculateshisgrossprofitat$6.50corntobe$50,000.Theprofitwouldbegreaterifcornpricesfell.Thebreak-evenisat$6.70corn,andifcornpricesriseabovethislevel,thiswouldactuallywipeouttheprofitmargin(assumingtoday’sethanolprices,whichalsocouldfluctuate).Tokeeptheircustomerhappyandloyalandtoensurethattheplantcontinues

torunatcapacity,theethanolproducerentersintoanagreementtodeliverethanolattoday’spricetothebigcustomerinAugust.Ratherthantaketheriskofthemarketplaceandruntheriskofpotentiallysellingtheproductionatalossinthesummerifcornpricesrise,theyforgothegambleofawindfallprofit(intheeventthatcornpricesfall)andenteralonghedgeinthefuturesmarket.Theproducerbuys1millionbushelsofJulycorninthefuturesonApril15.ThisisthedaytheyalsoentersintothecashcontractfordeliveryofethanoltothecustomernextAugust.ThepriceofJulycornonApril15is$6.50.Adroughtdevelops,andinJuly,whentheethanolproducerneedstogointothecashmarkettopurchasethe1millionbushels,thepriceofcornhasrisento$7.00inboththecashandfutures.Ithasgoneupby50¢perbushel,whichisanadditionalcosttotheproducer,overandabovetheAprilprice,of$500,000(1millionbushels,or2005,000-bushelcontractstimes50¢perbushel).However,thefutureshavealsorisenby50¢,andtheethanolproducersellsthe

Julyfuturescontractstheypurchasedfor$6.50atthethen-prevailingpriceof

$7.00.Theyrealizeafuturesgainof$500,000,exactlyoffsettingtheadditionalcashlossof$500,000.Inthisway,a$50,000grossprofitwasassuredonthetransaction.Withoutthislongcornhedgetheywouldhavelost$450,000onthecashcontractinsteadofrealizingaprofitof$50,000.Nowiftheweatherhadbeengood,anditlookedasifalargecropwere

forthcoming,pricesmighthavefallento,say,$6.20byJuly15.Theethanolproducer’scashcorncostinthiscasewouldbe$300,000less.Ifnothedged,andiftheyhadenteredintoacashcontractforethanolattheAprilprice,theycouldhaverealizedawindfallprofitof$350,000versus$50,000,allotherfactorsremainingequal.Ifhedged,theylose$300,000onthefuturestransaction(afallof30¢perbusheltimes$50/pennytimes200contracts).However,theethanolproducermakesthedecisiontoalwaysenterintoprofitablecontractswiththeirusers,andtheyknowtheywillremaininbusiness.Theyarenotinthecasinobusiness;theirbusinessisethanolproduction).Thissimpleexampledemonstratesthattheobjectivesofhedgersand

speculatorsarenotthesame.Aspeculatorisalwayslookingtomakemoneyontransactions.However,ahedgerisnotalwayslookingtoprofitonthefuturessideofthetransactions.Thehedger’sgoalsaretolockinapricethatwillassureanoverallprofitorpreventalossforhisbusiness—eithertheproductionorconsumptionofsomeproduct.Abreadbakerwhowantstolockinhisfuturewheatpurchasepriceswouldusealonghedgeinmuchthesameway.

ThebasisIntheseexamples,Ihavekeptthebasisfairlyconstant,butinreality,itcanchange.Ifashorthedger(onewhosellsfutures)experiencesawideningofthebasis(wherecashpriceshavefallentoagreaterdegreethanfutures—eithercashhasfallenfasterorrisenslowerthanfutures),abasislossmayresult.Inotherwords,theshorthedger’scashpositionlossmaybegreaterthanthegainrealizedonthefuturessideofthetransaction.Or,inarisingmarket,thegainonthecashsideofthetransactionwouldnotbeaslargeasthelossonthefuturesside.Conversely,abasisgainwouldoccurwithawideningbasisonalonghedge.

Thefutureswouldriseinpricetoagreaterdegreethanthecash.Anarrowingbasisyieldsadditionalgainsforashorthedger(thecashfallsless,orrisesmore,inrelationtothefutures)andincrementallossesforalonghedger(thecashfallsless,orrisesmore,inrelationtothefutures).Basisgainsorlossesarearisktoahedger,butthey’renotnearlyasbigariskaswhatiscalledflatpricerisk.Thepriceofheatingoilmaymove20¢pergalloninacoupledays,whereasthebasismightmove1¢eitherway.Forexample,theflatpricemovecouldbearesultof

awarmer-than–normal,winterwhereasthebasischangemaybeduetothefactitwascolderinNewHaventhanNewYorkthatparticularwinter.Aspeculatormightanalyzebasischangestohelpdeterminethestrengthorweaknessofamarket,butthisisreallymoreofahedger’sconcern.

SpeculatorsversushedgersItdoesn’tmatterwhethertheuserneedscopperorsoybeanoilortopurchaseyensixmonthshence;anymarketinwhichpricesfluctuatecreatespriceriskforcommercialparticipants,whichinturncreatestheneedforahedgingtool.Remember,hedgersarenottryingtomakeakillinginthemarket;theywishtooffsetpricerisks.Aspeculator,ontheotherhand,triestomakemoneybybuyinglowandsellinghigh(orviceversa).Aspeculatorisamarketplaceparticipantwhoisneitheraproducernoraconsumerofacommodityorfinancialinstrument.Bydefinition,hedoesnothaveorwanttheunderlyingcommodity,andthisparticipantcouldbeyouorme.Withoutspeculators,thesystemwouldnotwork;theyaddliquidity.Speculatorsoftentaketheothersideofthebidsandoffersinthemarketplaceputoutbyhedgers.Attimes,theytaketheothersideofaspeculativebidandoffer,andattimes,differenthedgersmaybeonbothsidesofatransaction.However,atradecannotbecompletedunlesssomeoneiswillingtotaketheotherside,andiftherewereonlyhedgersandnospeculators,thesystemwouldnotoperatesmoothly.Byassumingtherisksthehedgersaretryingtoavoid,thespeculatorswillmakemoneywhentheyarerightandlosewhenwrong.Intheearlierethanolexample,whenthemanufacturermadethe$500,000inthefuturesmarket,somepersonorpersonslostthatmoney.Thosepersonscouldhavebeenspeculatorsbettingthatthecropwouldbegoodandpriceswouldfall.Ontheotherhand,ifpricesdidfall,thishedger’slossmighthavebeenmadebyspeculatorswhowerebettingonlowerprices.

Howisthepricedetermined?Conspiracytheoristswouldtellyouthatpriceisdeterminedbythebigbanksortheoilcompanies.Asimplerexplanationissupplyanddemandor,inotherwords,buyersandsellers.Ifthebuyersaremoreaggressivethanthesellers,pricesgoup.Ifthesellersaremoreeager,pricesgodown.Inafreemarket,pricesaredeterminedbywhatthesellercangetfromthebuyer.Pricesaremadebywhatsomeoneiswillingtopayforagivenproduct.Youmightthinkanygivenpriceistoolowortoohigh,butatanypointintime,themarketsetstheprice,andthere’sanoldadagethatsaysthatthemarketisalwaysright.

Orderplacement

Assumethatyou’rereadytoplaceyourfirsttrade.What’stheprocedure?Verysimply,youneedenterthesymbolofcommodityyouwanttotrade,thequantity(intermsofnumbersofcontracts),themonth,andwhetheryouwanttogolongorshort.Youthenneedtodeterminehowyouwantyourordertobeexecuted.Therearevariousordertypesdependingonyourobjectivesonhowandwhenyouwanttoenterthemarket.

MarketorderAmarketorderisanordertobuyorsellattheprevailingprice.Bydefinition,whenacommodityisboughtorsold“atthemarket,”thisisanordertofillimmediatelyat“thenextbestprice,”butinreality,itisthe“nextoffer”(ifabuy)orthe“nextbid”(ifasale).I’veseenadviceinsometradingmanualsthatstatesthatyoushouldneveruseamarketorder.Thereasoninghastodowiththebid/offerspread.Inanauctionmarket,tradersmakebidsandoffers.Thebidisthepriceputout

forimmediateacceptance.Theoffer(sometimesknownasthe“askedprice”)isthepriceatwhichtheselleris“offering”forimmediatesale.Inmostcases,youbuyattheofferandsellatthebid.Youpotentiallylosethisdifference—itmaybesmall—butyoucanloseitbyplacingamarketorder.Idonotagreewiththeadvicenevertousemarketorders.Foronething,ifyou

usealimitorderataspecificprice,thereisnoguaranteethatitwillbefilled.Themarketmayhavetomoveawayfromthedirectionyouthinkthemarketismovingtogetfilled.Mostimportantly,withamarketorder,youknowyouwillbefilled.Thisisimportantinafast-movingmarketbecausethesearetheonesyoumostwanttobein.Bydefinition,youwillbefilledoneverybadtradeatalimitprice(becauseithastomoveoppositeyourbiasfirst),butyoucouldmisssomegoodtrades.Ifamarketismovingat50,55,60,65,60,70,80,tocloseat120,andyouplaceamarketordertobuyatthe60levelthefirsttimeyousee60,youmightget60—morelikely65oreven70—butyouknowyouareinatradethatisatleaststartingoutright.Ifyoulimityourpriceto55or60,youmightnevergetinthisgoodmove.Whoknows?Thenextdayitcouldopenat150.

LimitorderWhenyouplacealimitorder,youknowwhatyouwillgetintheworst-casescenario(youcouldgetbetter),buttherearestringsattached.Alimitorderpreventsyoufrompayingmorethanthelimitpriceonabuyorderorreceivelessthanthelimitpriceonasellorder.However,unlessthemarketiswillingtomeetyourterms,youwillnotgetin.Thedrawbackofalimitorderisthatthereisno

guaranteeyouwillgetin.Youcouldmisstrades.Youarenotevenassuredthatyouwillgetinifyourlimitpriceishit.Intheprecedingexample,ifyouplacealimitordertobuyat“50orbetter”andthemarkettouches50,thismaybeyourtrade,oritmaybesomeoneelse’s.Youcanbeonlyreasonablyassuredthatyouareinifthemarkettradeslowerthan50.Itisfrustratingtoplaceanordertobuyat50,seethemarkettradethereonceandfindthatyou’renotfilledjustasthemarket’scrossing75.That’snottosaythereisn’taplaceforlimitorders.Iliketousetheminquiet,back-and-forth-typemarketssoasnottogiveuptheslippageseenwithamarketorder.Ialsousethemtotakeprofitsonagoodposition.Itrytoletthemarketreachouttomylimitprice.Afterall,ifthemarketdoesn’treachmylimit,Icanalwaysreverttoamarketorder.

StopordersStoporders,orstops,areusedintwoways.Themostcommonmethodistocutalossonatradethatisnotworking(alsoknownasastoplossorder).Astopisanorderthatbecomesamarketordertobuyorsellattheprevailingpriceonlyifandafterthemarkettouchesthestopprice.Asellstopisplacedunderthemarket,abuystopabovethemarket.Forexample,saythatyoubuyJulysugarat11¢(1100).Youbuyitbecause

youranalysissuggeststhatthemarketisgoingtogohigher.However,youdonotwanttoriskmorethanapproximately50points,soyouplaceasellstop,to“sellJulySugarat1050stop.”Aslongasthemarketmoveshigher—fineandgood—yourstopwillnotbeelected.However,ifthemarkettradesdownto1050,yourstoplossautomaticallybecomesamarketordertosell.Dependingonthespeedanddirectionofthemarket,youwillbeoutatthenextbestprice.Itmostlikelywillbe1050orslightlybelow,say,1049.Inafastmarket,itcouldbelower,say1048,oritevencouldbehigher,say1051,ifthemarketupticksafterthestopishit.Astopcanalsobeusedtolockinaprofitandcutaloss.Inthesugarexample,

let’ssaythemarketstartstomoveinyourfavor,upto1150.Youmightdecidetocancelyour1050stopandmoveitupto1104,therebyassuringaworst-casebreakevenorasmalllossaftercommissions.Thisisacancel/replaceorder.Themarketcontinuestomoveup,reaching1210.Youdecidetomoveyourstopupto1150,therebyassuringaprofitonthetrade,evenifittradesbackdown.Thisis,attimes,termedatrailingstop,whichoccurswhenyoumoveyourstopwiththemarket.Abuystopisplacedabovethemarkettoliquidatealosingshortposition.Forexample,yougoshortsugarat1201andplaceyourbuystopabovethemarketat1253tolimityourloss.Youcanalwayscancelandmoveyourbuy

stoplower,incasethemarketmovesinyourfavor.Stopsalsocanbeusedtoinitiatepositions.They’reusedbymomentum

traderswhowanttoenteramarketmovinginacertaindirection.Forexample,ifatraderbelievesthatifgoldisabletotradeabovethepsychologicallysignificant$2,000mark,itwillmovehigher.Heplacesabuystopat$2,001.Ifthemarketremainsunder2000,thetraderneverentersthemarketandpotentiallyavoidsa“donothing”or,worse,alosingtrade.Ifthemarketreachesthe2001level,hewillbeinatthenextprevailingprice.Thehopeisthatthemarketkeepsmoving,to2002andonup.Oncein,thetradercanplaceasellstopat,say,1990,tolimitlossesshouldthisturnouttobeafalsesignal.Ofcourse,theriskisthatthemarketcouldrunupto2001andbackdownagain.Inthiscase,itwouldhavebeenbettertolimitthepriceatalowerlevelinsteadofusingthestoptoinitiatethetrade.However,whenusedcorrectly,thesecanbeusefulorderstoenteranew

position.Whileabuystopwouldbeusedtoinitiateanewpositionabovethemarketonmomentum(ifnotinthemarket),asellstopwouldbeusedunderthemarket.Thereadditionallyisavariationofastopordercalledastoplimit.Withastoplimitorder,ifthestoppriceistouched,atrademustbeexecutedatthelimitprice(orbetter)orhelduntilthestatedpriceisreachedagain.Theriskwiththestoplimitisthesameaswithastraightlimit.Inotherwords,ifthemarketfailstoreturntothestoplimitlevel,theorderisnotexecuted,soInormallydonotrecommenditsuse.Itcan,inafast-movingmarket,defeatthepurposeofthestop(tostopyourloss).

MarketiftouchedAlsocalledMITs,market-if-touchedordersarethemirrorimageofstops.AMITisplacedabovethemarkettoinitiateashortpositionandbelowthemarkettoinitiatealongposition.Forexample,saythatyouarelongplatinumat1405,andyouwanttotake

profitsat1420.Youcouldplacealimitordertosellat1420,butyoucannotbeassuredthatyouwillbefilledifthepricetouches1420.Themarketwouldhavetotradeabove1420tohaveareasonableassurancethatyouareout.AnMITat1420becomesamarketorderif1420istouched,whichwillensurethatyouareoutatthenextprevailingprice.MITstendtobefilledbetteronaveragethanstopsbecauseyouaremovingwiththeprevailingtrend.Inamarketthatmoves1409.50,1410,1410.50,1411,anMITat1410wouldbefilledateither1410or1410.50.Ifthenexttickafter1410were1409.50,youcertainlycouldfilledat1409.50(becausetheMITbecameamarketorder),butitismorelikelythata

buystopat1410wouldbefilledat1410.50inthisexample.AnMITcouldalsobeusedtoinitiateanewshortpositionabovethemarket.AnMITtobuyisplacedunderthemarkettoexitashortpositionorenteranewlong.Ifthemarketistradingat100,youmightplaceanMITtobuyat99,butyouwouldplaceastoptosellat99.Seethedifference?Exoticorders

So,thesearethemajortypesofordersyouwilluse.ThereareotherexoticordersI’venotfoundusefulinpractice,withtheexceptionoftheOCO(whichstandsforonecancelstheother).Itisusedonbothsidesofthemarketeithertotakeprofitsorcutlosses;onecancelstheother.Forexample,youbuysilverat37.00,youwanttotakeprofitsat37.90orcutthelossifthemarkettradesdownto36.75.YoucouldplaceoneOCOordertosellat37.90or36.75stop;onecancelstheother.Inthisway,youareassuredthatifonesideishit,theothersidewillbecanceled.Thisissignificantinvolatilemarketsandmarketsthattrade24hoursadaysinceyou’llbesleepingatsomepoint.Ifyouplacedtwoseparateorders,andthemarketfirstrunsupto37.90,takesoutyourpositionataprofit,thentradesdownto36.75,youcouldbesoldintoanewshortpositionyoudidn’twant.

AnothertruestoryThisconcludesourdiscussionofthebasics.Ifthisisyourfirstexposuretocommoditytrading,younowknowjustenoughtobedangerous.Ifyou’reanovice,hopefullythishasshedsomelightonthegame.Ifyou’vetradedawhile,thisisprobablynothingnew,butnowyoucangetontothemoreexcitingstuff.Let’sconcludethischapterwithatruestorythathappenedtoacommodity

brokerfriendofmine.Remember,itisacommonpractice(andagoodone)toplaceyourstoplossorderatthesametimeyouplaceyourtrade,andagoodbrokerwillremindyouofthis.Thereisabeliefthatthetraderswillattemptto“runthestops,”however,I’vefoundtheproperandjudicioususeofstopsisessentialtosuccessfultrading.Thebestmarketswillneverreachyourstop.Iknowthatinmypersonaltrading,astophasmanytimespreventedabadtradefromturningintodisaster.

MycommoditybrokerfriendTimtellsthestoryofElmer,afarmerclientofhisfromruralMinnesota.TimsuspectedthatElmerwasgrowingabitfeeble,butthenagain,Elmerhadbeentradingformanyyears,andhehadalwaysbeentheeccentrictype.TimrecountsthedaythatElmercalledhimpriortothemarketopen.

ElmertoTim:“Tim,amiraclehappenedtomethismorning.”TimtoElmer:“What’sthat,Elmer?”ElmertoTim:“Tim,Iwasshavingthismorning,andasIlookedinthemirror,theHolySpiritcametomeandsaid,‘Elmer,todayyoushouldbuy50Marchwheatmarketattheopen.’”ThewayTimtellsit,hedidn’thesitate,cross-examine,orstopbeforepassingGo;heimmediatelyqueried,“Elmer,didhetellyouwheretoplaceyourstop?”

5.TheOptionsCourse

“Themarketcanremainirrationallongerthanyoucanremainsolvent.”—LordKeynes

Theproponentstoutoptionsas“thebestofbothworlds;unlimitedprofitpotentialwithtotallylimitedrisk.”Soundsterrific!Whywouldanyonetradeanythingelse?Withoptionstrading,aswitheveryotherfinancialinstrument,thereare

advantages...butthereisnofreelunch.Actually,thereareprobablymorewaystolosemoneywhentradingoptionsthanwithanyotherfinancialinstrument.Thisisbecauseyougivesomethingupforthelimited-riskfeature,butincertainscenariosit’sworthittogivethissomethingup.Iknowfolkswhotradeonlyoptionsandwouldn’tthinkoftouchingfutures.Manyofthesepeopledoquitewell.Iknowotherswhohavetoldmeoptionsdon’tworkforthem;theydespisetheaddedcostsandpointoutthatmostoptionsexpireworthless.Likeanythingelseinthespeculativeworld,optionsrequiresgoodjudgment,asoundgameplan,andattimesabitofluck.Thischapterisan“Options101”courseforbeginners(andthosewhowantto

brushup).Inthefirstsection,you’lllearnthebasics:whatoptionsare,howtheywork,thejargon,andthevariouswaystoplay.Intheconcludingsection,we’lldelveintosomeofthemoreadvancedstrategies.

AnoptionsprimerWhatisanoption?Anoptiongivesabuyertheright,butnottheobligation,to

buyorsellastatedquantityofacommodity(orsomeother“asset”)ataspecifiedpriceonorbeforeaspecificdateinthefuture.Optionsareoftencomparedtoinsurance.Whenyoubuyhomeowner’s

insurance,forexample,youpayapremiumforcertainrights.Theserightsareyours,butthepolicycanlimitthepayoff.Tosomeextent,thisanalogyworksforahedger,buttherearemajordifferenceswhenspeculating.Forexample,anoptionbuyertheoreticallyhasunlimitedprofitpotential.Insurancepolicieshaveastatedlimit.Insuranceisnottransferablebetweenpartiesandisusuallyspecifictoapersonorproperty.Optionsarestandardizedandcanbesoldinthemarketplace.Actually,Exchange-tradedoptionsarequitesimple.Therearetwo

types—thecallandtheput.Thefeaturesarefairlystraightforward,andtheycanbeutilizedeffectivelyundercertainsituationsbybothspeculatorsandhedgers.Thecostofanoptioniscalledthepremium.Thepremiumisaone-timecost

andrepresentsthemaximumexposurethatthebuyerhas.Nomatterhowfarthepriceoftheunderlyingassetrisesorfalls,theoptionbuyerknowswhathismaximumriskwillbe.However,theprofitpotentialisnotfixed.Aswithfutures,potentialoptionprofitsarelimitedonlybyhowfarthemarketmovesinthestatedtimeperiod,minustheinitialcost.Optionsareavailableforjustabouteveryfuturesmarket,fromorangejuice(anoldadagesaysneversellcalloptionsduringfreezeseason)tonaturalgas,gold,copper,heatingoil,currencies...younameit.Themostliquidandactivefuturesmarkets,asyoumighthaveguessed,generallyhavethemostliquidoptionmarkets.Likefutures,optionstradeindesignatedcontractmonths.(Youneedtoknow

yourexpirationdatesbecauseinmanycasestheoptionsexpireinthemonthprecedingthefuturesmonththeycorrespondto.)Marchgrainoptions,forexample,expirethethirdFridayofFebruary.Formostofthecash-settledfuturescontracts,liketheS&P500andFeederCattle,theoptionsandfuturesexpirethesameday.Youmighthaveheardthetermtriplewitchinghour;itreferstothesimultaneousexpirationofstockindexfutures,stocksoptions,andstockfuturesoptionsonthethirdFridayofMarch,June,September,andDecember.Allthisactivitysupposedlycauseswildandcrazyfluctuations,butinmyexperience,thishasgenerallybeenanon-event.Inmanyoftheactivemarkets,optionsaretradedeverymonthoftheyear.Forexample,theJanuary,February,andMarchcurrencyoptionsallcorrespondto(andareexercisableinto)theMarchcontract.ConsulttheExchangewebsitesoryourbrokerforthespecificsonoptionmonthsandexpirationdatesbymarket.

Anoptionforwhat?Optionscanbeconvertedintotheunderlyingfuturescontractatthediscretionofthebuyer;thisiscalledtherighttoexercise.Thisiswhythesizeofeveryoptionisexactlythesameasthecontractitrepresents.Byexercisinganoption,thebuyerreceiveseitheralongorshortpositionattheoption’sstrikeprice.

Anownerofacalloptionwhochoosestoexercisereceivesalongfuturesposition.Anownerofaputoptionwhochoosestoexercisereceivesashortfuturesposition.

AdvantagesanddisadvantagesofoptionsForoptionbuyers,theprimaryadvantageisdefinitelythelimited-riskfeature.Unlikewithfutures,withoptions,themostyoucaneverloseasabuyer(notasaseller)iswhatyoupayfortheoption.Youcouldloselessbysellingoutpriortoexpiration,andyoucouldevenmakeasignificantprofittradingoptions,butyouhaveaspecificallydefinedandmaximumrisk.Additionalmargincallsarenotapossibility,andyoucanavoidsleeplessnightsbecauseyouknowtheworst-casescenariothedayyouinitiateanoptionpurchase.Thesameisnottruewithfutures.Foroptionbuyers,theprimarydisadvantageisthepremium.Thepremium

mustbepaidupfront,andthiscostmustberecoveredinpartorinwholethroughafavorablemovementinprice...orelseyoulose.Whenbuyingoptions,youcanbecorrectinyourmarketassessment,butifthemarketdoesn’tmovefarenoughinyourfavor,youstilllose.Considerthis:Ifyoubuyawheatoptiongoodforthecurrentmarketpricefor

apremiumcostof$1,000,andthemarketgoesnowhere(itstaysatthesamepriceforthelifeoftheoption),you’reout$1,000plusfees.Themarketmovednowhere,andwhoeversoldthatoptiontoyoukeepsyour$1,000.Toprofit,theoptionselleronlyneedsastagnantmarket,amoveinhis

direction,oranadversemovethatdoesnotcoverthepremiuminfull.Ifyoubuyafuturescontractandholditforthesametimeperiodinamarketthatgoesnowhere,you’reoutnothingexceptthecommissioncosts.Inthiscase,the“limited-risk”optionisdefinitelymorecostlythanthe“higher-risk”futurescontract.Ofcourse,inthissimpleexample,wedon’tknowwhattranspiredintheinterimperiod.Themarketcouldhavesoldoffwildly,resultinginamargincallorastoplossbeinghitinthefuturesandsubsequentlyrecovered.Thefuturestradercouldhavebeenknockedout,perhapsmorethanonce,whiletheoptiontrader(notsubjecttomargincalls)couldsititout.Yousee,therearenoeasyanswershere,andwe’veonlyscratchedthesurface.

TypesofoptionsCallsandputsarethetwobasicoptiontypes.Calloptionsareboughtbybullishtraders.Acalloptiongivesthebuyerthe

right,butnotanobligation,topurchasetheunderlyingassetatanagreed-uponprice(knownasthestrikeprice)withinaspecifiedtime.Putoptionsarethemirrorimageofcalls.Aputoptiongivesthebuyerthe

right,butnoobligation,toselltheunderlyingassetatanagreed-uponprice(the

strikeprice)withinaspecifiedtime.Bearishtraderswhoanticipateaweakermarketwouldbethebuyersoftheseoptions.Whatistheunderlyingasset?Itis,forExchange-tradedoptions,thecorrespondingfuturescontract.Callbuyershavetherighttoexerciseintoalongfuturesposition,andputbuyershavetherighttoexerciseintoashortfuturesoption(atthecorrespondingstrikeprice).

StrikepricesTheoptionrulesaresetbytheExchangewheretheoptionsaretraded,andbyconvention,theExchangedeterminesthestrikepricesatwhichoptionstrade.Thesepricesarelistedatsetintervals.Forexample,wheatoptionstradeatevery10¢perbushel:$7.50,$7.60,$7.70,

andsoon.(IamreferringtoExchange-tradedoptionsinthisbookbecausethesearetheoptionsavailabletothegeneralpublic.Somebrokersandinstitutionsalsoofferover-the-counter[OTC]options,whicharedealtofftheExchange.OTCoptionsarecompletelyflexible;theexactdetails,suchasdateandquantity,arefreelynegotiablebetweenthebuyerandseller.OTCoptionsarecommoninthecurrencymarkets,forexamplebutaregenerallyavailableonlytobigplayersinlotsof$1millionminimum.)Exchange-tradedoptionsarestandardized.TheExchangesetsthestrike

prices,size,specifications,expirationdate,andstyle(AmericanorEuropean).Mostimportantly,theExchangeeliminatesthecounterpartyrisk.IfanExchangemembergoesbellyup,theclearinghouseguaranteesperformance.IfthebankontheotherendofyourOTCoptionhasoneroguetradertoomany,thereisnoguaranteeyouwillbeabletocollectevenifyouareprofitable.Althoughtheriskofnonperformancebyalargemoneycenterbankormultinationalbrokeragefirmisslim,itisneverthelessarisk.OptionswrittenbyLehmanBrothersin2008neverwerepaidoffbythatoptionwriter.AnothermajoradvantageofExchange-tradedoptionsisquotations,or

transparency.ThisadvantagemayseeminsignificantbecauseyouareabletogetaquotefromthecounterpartyforyourOTCoption.However,withtheOTCs,thequotecomesdirectlyfromtheotherparty—andwhoseinterestdoyouthinkisforemostintheirmind?QuotesonExchange-tradedoptionsaredisseminatedpubliclybyathirdparty—theExchange—basedonactualtradesinanauction-likeenvironment.

StylesofoptionsTwostylesofoptionsareavailable:AmericanandEuropean.Thebasicdifferenceisintherulesofexercise.AbuyercanexerciseanAmerican-style

optionatanytimebeforeitexpires.AbuyercanexerciseaEuropean-styleoptiononlyontheexpirationdate.Allotherfactorsbeingequal,aEuropeanoptionisgenerallyslightlycheaperthananAmericanoptionbecauseitcanbeexercisedonlyontheonedateand,therefore,involveslessuncertaintyfortheseller.ThevastmajorityofExchange-tradedoptionsareAmericanstyle,andthevastmajorityofOTCoptionsareEuropeanstyle.

Howareoptionpricesquoted?Optionpricesarequotedintermsoffuturesticks.Forexample,a€122calloptionmightbequotedat99bid/102offered.Theseareticks,andbecauseatickfortheeurocontractontheChicagoMercantileExchange(CME)represents$12.50.Ifthe122Eurooptionispricedat101,itisworth$1,262.50.A790wheatcallat22¢goesfor$1,100.(Itisa5000-bushelcontract,soeachpennyisworth$50.)

Buy’emandsell’emOptionbuyers,forbothputsandcalls,payapremium.Whogetsit?Theoptionsellerreceivesthepremium.Inmanycases,optionsellers(alsocalledoptionwriters)areprofessionaltradersbecausethepublicgenerallyprefersbuyingoptions.However,anyonecanbeanoptionseller.Whywouldyouwanttobeanoptionseller?Itplacestheoddsinyourfavor.Youreceivethepremium;itiscreditedtoyouraccountandbecomesacushionagainstanadversemarketmove.Whenwouldatradernotintheoptionmarketconsidersellingoptions?

•Calloptionsareprimarilysoldbybearishtraders:Calloptionsarealsosoldbytraderswhoexpectamarkettogonowhereoverthespecifiedtimeperiod.Calloptionsarealsosold,attimes,bybullishtraderswhowishtoreceiveprotection,orcover,alongpositionorgainadditionalincomefromalongposition.•Putoptionsareprimarilysoldbybullishtraders:Ifthemarketmovesupandremainsabovethestrikepricewithinthespecifiedperiod,theputsellerkeepsthepremiumwithnopenalty.Putoptionsmayalsobesoldbytraderswhofeelthemarketisgoingnowhere.Attimes,bearishtraderswhoarelookingforprotectiontocoverashortpositionortogainincrementalincomeforashortpositionsellputs.

AdvantagesanddisadvantagesofsellingoptionsTheprimaryadvantageofsellingoptionsisthatthesellerreceivesthepremiumincomepaidbythebuyerimmediately.Allsheneedstomakemoneyiseithera

quietorstablemarket,oramarketmoveawayfromthebuyer,oramarketmoveinfavorofthebuyerthatislessthanthepremiumreceived.Inotherwords,thereisawiderrangeofpricemovementinwhichtheoptionsellerprofits.Theoddsareintheseller’sfavor,andthisiswhyprofessionalsliketosellthem.Thedisadvantageofsellingoptionsistheunlimitedrisk.Sellingoptionsisthe

mirrorimageofbuyingoptions:Becausethemarketcanmoveanunspecifiedamountawayfromthestrikeprice,theriskcannotbepredetermined.YoucanthinkofitlikeaLasVegascasino,withtheoptionsellerasthehouse.Youknowthehousehastheadvantage,butthisdoesn’tmeananyindividualonanyparticulareveningcouldn’tmakeamajorhitagainstthehouse.

HowoptionsworkLet’slookatanexampleofhowoptionswork.Saythatyou’rebullishgoldandwanttoplaythismarketusingoptions.You’reabull,soyoucanemploytwobasicstrategies:Youcaneitherbuyacalloptionorsellaputoption.However,otherdecisionsneedtobemade.It’slikeakidwhogoesintobuyhisfirstpackofcigarettes.Theclerkaskshimwhichbrandhewants.ThekidasksforMarlboro.StandardorMenthol?100sorshorts?Boxorsoftpack?Withhisheadspinning,thekidrunsoutofthestore,rationalizingthatcigarettesaren’tgoodforyouanyway.Similarly,optionscomeinavarietyofflavors.Thesimplestwaytoparticipate

istobuyacall(ifyouthinkthepricewillrise)orbuyaput(ifyou’rebearish).Supposeit’sDecember,andthepriceofgoldis$1,399perounce.YoucanbuyanApril1400callfor,say,$26perounce.Theoptionisexercisableintoastandardfuturescontract,andthisoptionhasasizeof100ounces,so$26isequaltoacostof$2,600peroption.Thisoptiongivesyoutheright,butnottheobligation,toreceiveanAprilfuturescontractatapriceof$1,400atanytimeatyourdiscretion,priortotheexpirationdate(whichinthiscaseismid-March).YoucanpaylessforanApril1420callormoreforanApril1380call.YoucanpaymoreforaJune1400callorlessforaFebruary1400call.YoucanpaymuchlessforanApril1600calloralotmoreforaFebruary1340call.Thepermutationsarejustaboutendless.Ofcourse,youcansellanyoftheseaswell.Clientswhohaveamarketopinionoftenaskme,“Whichisthebestoptionformetobuy?”Howdoyoudeterminethis?Itdependsnotonlyonyouroutlookbutalsoyouroutlookforyouroutlook.Thereareafewotherissuesyouwillneedtounderstandbeforeyoumakeyourfirstoptiontrade.

Time

Thefirstissueyouneedtounderstandbeforeyoumakeyourfirstoptiontradeistime.Youhavetodecidehowmuchtimeyouwishtopayfor.Abasicruleofthumbis—andthisshouldbenosurprise—thatthemoretimeyouwanttheoptiontohavebeforeitexpires,thehigherthepremium.Youcangofaroutintimeandreceivealotmoretimeforyourpositiontowork,butthisisgenerallyabadidea.Remember,thereisnofreelunch.Long-datedoptionsaremoreexpensive,andyoutieupmoremoneyforalongerperiodoftime.Instead,youcouldusethatmoneyforalternativetransactions.Plus,thefurtheroutyougo,thelessliquidtheoptionbecomes.Whentradingalong-datedoption,youaregenerallydealingwithamarketprofessionalwhowillquoteawidebid-to-offerspread.Ifyouwanttoliquidatetheoptionintheoptionsmarket(asopposedtoexercisingtheoption),you’llhavetodealwiththisspreadonceagain.Inotherwords,theslippageishigh,andtheseareadditionalhiddencosts.Thecheapestoptionsarethenearestoptionstime-wise.Theproblemwitha

short-datedoption—andthisisobviousaswell—isthatyouhaveamuchshortertimeforthemarkettomoveyourway.Unlikewithfutures,withoptionsthemarketnotonlyhastomoveyourway,butitneedstodosomorequickly.Thisworksattimes,butthemarketdoesn’talwaysknowyouroption’sexpirationdate.Therearenosimpleformulasthatcantellyouwhatisafairpricetopayfortimeatanyparticularpoint.Asix-monthoptionmightormightnotcosttwiceasmuchasathree-monthoption.Youaredealingwiththespreadsoftheunderlyingcommodity,whichcanchange.Manytimesthenearmonthmovesfasterthanthebackmonths,andthisisreflectedintheoption’scost.

TimedecayAllelsebeingequal,thetimevalueofanoptiondecreasesslightlyeachday(providedthatthereisstillareasonableamountoftimeleftbeforeexpiration).Therateofthisdecreasebecomesmorerapidastheoptiongetsclosertoexpiration.Thisistermedthenormaltimedecay,anditworkstothedetrimentofthebuyerandthebenefitoftheseller.Asanoptiongetsclosetoexpirationtime,thevaluebecomeslessandless.Whatmattersistherelationshipbetweenthestrikeandtheunderlyingcommodity.Thisisbecauseatexpiration,theoptioncanonlybeworthsomethingor,alternatively,nothing—andthat’sit.Remember,youmightbuyacallbecauseyouthinkaparticularcommoditywillincreaseinprice,butyoucouldshowalossevenifyouarecorrect.Thishappenswhentheextentoftheriseisinsufficienttocompensateforthetimeittakestooccur.

In,at,andoutofthemoney

Ifyoulookatanoptionpricetable,youwillseetwomajorcategories:putsandcalls.Thenyouwillseelistingsfordifferentmonthsintothefuture.Undereachmonth,youwillseeavarietyofdifferentstrikeprices.Thesearethepricesatwhichtheoptionscanbeexercised,animportantfeatureofoptionsthatmakesthemmorecomplicatedthanfutures.Let’slookatgoldasanexample.Saythatyouarebullishgoldanddecideto

purchasetheApril1400callwhenAprilgoldistradingat$1,399.Aprilgoldfuturessubsequentlyriseto$1,425perounce.Atthispoint,theoptionhasintrinsicvaluebecausethepriceoftheunderlyingasset(inthiscase,Aprilgoldfutures)isabovethestrikeprice.At$1,425perounce,the1400callhas$25ofintrinsicvalue.Thisisnowanin-the-moneycalloption—inthemoneyby$25.Becauseagoldoptionisfor100ounces,andevery$1isworth$100peroption,thevalueofthisoptionisatleast$2,500($25times$100perounce).Anotherwaytolookatthisisthattherighttobuyat$1,400,whenthecurrentpriceis$1,425mustbeworthatleast$25becauseitisalreadyprofitablebythisamount.Itcouldbeworthmoreifthereisstilltimevalue.Timevalueisthatportionofthepremiumpriceoutsideoftheintrinsicvalue.

Anoption’spriceisdependentontime,butthereareotherfactorsaswellthatdetermineanoption’svalue.Bydefinition,acalloptionis“inthemoney”whenthemarketpriceofthe

futuresisabovethestrikepriceoftheoption.Acocoa2400callisinthemoneywhenthefuturesaretradingat2458.Acalloptionisoutofthemoneywhenthefuturespriceisbelowthestrike.Thesamecallisoutofthemoneywhenthefuturesareat2361.Becauseputsarealwaysthemirrorimageofthecalls,aputoptionisinthemoneywhenthemarketpriceofthefuturesisbelowthestrikepriceoftheoption.A2400cocoaputisinthemoneyata2361futurespricebutoutofthemoneyat2458.Out-of-the-moneyoptionshavetimevalueonly.

Howareoptionpricesdetermined?Likefutures,optionsaretradedinanauction-likeenvironment.Futurestradersarelookingatwhatevertechnicalorfundamentalfactorstheyusetodeterminethevalueoftheparticularcommoditytheyaretrading,whereastheoptiontradersarealsolookingatthefutures.Itgoeswithoutsayingthattheunderlyingassetdeterminesanoption’spremiumprice.Dissectingthisabitfurther,youseethatanyparticularoption’spremiumhastwobasicparts:timevalueandintrinsicvalue.Optionsthatareoutofthemoneyhaveonlytimevalue.Thatis,theseoptionshavenovalueotherthanpotentialvalue.Forexample,intheearlierscenario,theApril1400goldcallwastradingfor

$26perounceinDecemberandwouldhavecostthebuyer$2,600.ThepriceofAprilgoldatthattimewas$1,399,sotheoptioncouldnothavebeenexercisedataprofit.NobodyinhisrightmindwouldexerciseanoptiontoreceiveAprilfuturesat$1,400whenhecouldgoimmediatelyintothemarketplaceandbuyit$1perouncecheaper.Sowhy,then,wouldanyone(inhisrightmind)pay$2,600forthisright?The

reasonisthatthisoptionhaspotential.Tobuyfutures,theriskispotentiallygreaterthan$2,600.Yes,youcouldbuyAprilfuturesat$1,399andplacea$26stop.Althoughthiswouldessentiallyprovidethesameinitialriskwithoutrequiringyoutoforkoverthe$2,600,somemajordifferencesexist.Foronething,whenyoubuyanoptionfor$2,600,youknowyourmaximumriskisguaranteed.Ifyoupurchasefutures,witha$2,600stoploss,thestopcouldbefilledbetterattimes,butitcouldbefilledworsethanyourstoplosspoint.Anotherpossibilityisthatthemarketcouldtradeinarange.Themarketcouldfall$26ormore,stopyououtofyourfutures,andtheneventuallytradebackuptoprofitablelevels.Thisunderscoresanothermainadvantageofoptionpurchases;stayingpower.Theothersideofthecoinisthecost.Ifyouranalysisisright,andyouarewillingtotaketheriskofthefutures,youareguaranteedtomakemorethanyouwouldbybuyingoptions.Ifthepriceofgoldrisesto$1,425,andyouboughtyourcontractat$1,399,youhavetheabilitytocashinwitha$2,600profitpercontract($26times$100perounce)minusfees.Youhavetherighttosellyouroptionand/orexerciseit,butyourprofithastobelessthanthe$2,600.Remember,inourexample,youpaid$2,600fortime—or$2,600forthepotentialtomakeascore.Sometimehaspassed,andsometimevaluewillhavedisappeared.Youwon’tgetbackthatfull$2,600,onlyaportionofit.Let’sreviewtheseconceptsandclearupanyconfusionthatremains.Calls

thathaveastrikepriceabovethemarket(forexample,a1400goldcallwiththemarketat$1,399)andputsthathaveastrikepricebelowthemarket(forexample,a1390putwiththemarketat$1,399)havepremiumscomposedoftimevalueonly.In-the-moneyoptions(forexample,a1400callwiththemarketpriceat$1,425ora1440putwiththemarketat$1,425)havebothtimeandintrinsicvalue.Themoreanoptionisinthemoney,themorevaluableitbecomes,sobydefinition,itbecomesmoreexpensive.Anotherwayoflookingatthisiswithasimpleformula:

TimeValue=Premium–IntrinsicValue.Timevalueincreasesforoptionswithgreatertimetoexpiration.Itmakes

sense,ofcourse,becausethemoretimeanoptionhasuntilexpiration,themorepotentialtheoptionbuyerhasforsomethingtohappen,andthatincreasesthevalueoftheoption.Theselleristakingadditionalrisk(there’smoretimeforsomethingtogoawryfromhisstandpoint),andhedemandsadditionalcompensationforthisadditionalrisk.So,in-the-moneyoptionshaveintrinsicvalueandtimevalue.Out-of-the-

moneyoptionshavetimevalueonly.You’llhearthetermatthemoneyaswell;thistermreferstoanoptionforwhichthestrikepriceisequivalenttotheunderlyingfuturesprice.Inpractice,at-the-moneysareoptionsforwhichstrikepricesareclosetothepriceofthefutures.IntheexamplewithAprilgoldat$1,399,the1400sare“atthemoney.”The1410saredefinitelyoutofthemoney,andthe1390sareinthemoney.The1340saredeepinthemoney.Whatwouldyoucallthe2,500s?Youcouldcallthemdeepoutofthemoney,orIwouldcallthesealongshot.Longshotsaregenerallycheap.Youcanbuyquiteafewout-of-the-money

optionsforrelativelylittlemoney,soifsomethingextraordinaryoccurs,youstandtomakeakilling.AgoodanalogywouldbetheMegabucksslotmachineswhereIliveinNevada.Thestate’scasinoslinkupfortheMegabucksjackpot,where$3canwin$30millionormore.Peopledowinthese,buthowmanysuchpeopledoyouknow?Thejackdoespopoutoftheboxonceeverybluemoon,however.

Ioncehadaclientwhoownedway-out-of-the-moneywheatcalls(worthlessthanapennyeach,ifIremembercorrectly)andonlythreedaystogo.Itlookedhopeless,andIfeltheshouldhavesalvagedafewpenniessohecouldatleastcovercommissions.ThensomethingcalledChernobylhappened.Wehadnevertradedanuclearaccidentbefore,andtherumorsstartedtofly.ThefirstrumorwasthattheentireSovietwheatcropwaswipedout.Wheatwentlimitupthenextdayandthedayafter.Theoptionscamebackfromthedead,andmyclienteventuallycashedouteachoptiononexpirationdayfor39¢perbushel.Inotherwords,optionsweresellingforlessthan$50eachjustdaysbeforeandblossomedto$1,950onexpirationday.Itwasagoodthinghehadtosellthatday(andthathedidn’tdecidetoexercise)becauseaftertheextentoftheradiationdamagewasdeemednotassevereasfirstfeared,wheatpricescameallthewaybackdownafewdayslater.

Youdohearrags-to-richesstoriesattimes,ascheapoptionscometolife.Ipersonallyownedsomeeuroputsthatwereessentiallyworthless,andthenthe

dayoftheSovietcoup,theyblossomedto50points,or$625.WhenYeltsinstoodonthetank,andthecoupfailedthenextday,theybecamevirtuallyworthlessagain.Sometimesyouneedtobenimble.Thepointis,deepout-of-the-moneyoptionscanhitattimes,buttheyarelongshotsandgenerallyaloser’sgame.Ipreferbothbuyingandsellingat-the-moneysinmostnormalsituations.Withdeepin-the-moneyoptions,youtieupcapitalthatotherwisecouldbeusedfordiversification.Deepout-of-the-moneysgenerallyexpireworthless.Giventhechoice,Ialsoprefertopaymorefortime.

VolatilityOkay,wehavediscussedhowanoption’svalueisdetermined—timeandtherelationshipofthestrikepricetotheunderlyingfuturesprice.Andthereisanothercomponent:volatility.Verysimply,asthevolatilityofamarketincreases,sodooptionpremiums.Thisisanimportantdeterminantinpricingoptions.Sleepymarketssupposedlyhavelowerpotentialpricemovements,andoptionbuyersbidless.However,someofmybestoptionpurchaseshavebeen“cheap”buys.Wheneveryoneisbuying,thesmartmoneyisselling.Thereasonpremiumsincreasewithhighervolatilityisverysimple:Optionsellersdemandhigherpremiumstooffsetthehigherriskstheiroptionsentailinamorevolatileenvironment.Manyoftheoptionpricingmodelsplaceagreatdealofemphasisonhistoric

volatility.Indetermining“fairvalue,”youareaskedtoinputthisnumber.Forexample,ifthemarketismovingataratethatequals20%ofthepriceannualized,thisisyourhistoricvolatility.Ihavefoundthistobeanacademicexerciseoflimitedvalue.Itisonlyaprediction,andthepastisnotnecessarilyagoodpredictorofthefuture.Myexperiencehasshowntheopposite:Quietmarketsleadtomorevolatilemarketsandviceversa.Whenvolatilityishigh,optionpricesareexpensive,andalthoughittakesguts,thisisgenerallythetimetosell.Ontheotherhand,anold-timeroncegavemesomesageadvice:“Neversellaquietmarket.”Letmesumthisupanotherway.Ingeneral,thepremiumsreflectrecentmarketconditions.Inexplosivemarkets,thepremiumsarelargerthanquietmarkets.Theriskequalsthereward;however,insomesituations,themajoritydoesnotseethechangecoming.Premiumscouldbetinyjustbeforeamajormovecomes;optionsarecheapestwhentheyarethebestbuys.Conversely,atthepinnacleofexpectation,decentopportunitiestosellarisebecausepremiumsareattheirhighest.Onelastpointaboutvolatility:Onapercentagebasis,volatilityaffectsat-and

out-of-the-moneyoptionstoagreaterextentthanin-the-moneyoptions.Here’s

thereason:In-the-moneyshavebothintrinsicandextrinsic(thatis,anythingotherthanintrinsic—mostlytime)value.Intrinsicvalueisnotaffecteddirectlybychangesinvolatility.Therefore,achangeof10%involatilitymightchangeanin-the-moneyoption’svalueby2%,whereasitwouldchangeanat-the-money’svalueby10%.Out-of-the-moneysareaffectedmostbychangesinvolatilitybecausetheycanbecomeprofitableonlywhenthemarketmovestothem.Achangeof10%involatilitycouldresultinanoption’spricemovingbyupto50%ormore.Thispercentagemoveisalsoeasiertoaccomplishforout-of-the-moneysbecausetheyarecheaper.Onefinalfactorthatdeterminesoptionpremiumsisthecostofmoney,or

interestrates.Iwon’tdwelloninterestrateshereordiscussthevariousmodelsforfairoptionpricing,becauseIhavefoundthesevariablestobemoretheoreticalthanpractical.Inmostcases,theprofessionalsonthefloorareabletoexploitminordegreesinoptionmispricing,butthisisnotwhatweareplayingforhere.Weareinthisforbiggermovesthatcanbeexploited(or,forahedger,optionsasatoolforpriceprotection).

Howchangesinthepriceoftheunderlyingcommoditychangeanoption’spremiumAllotherthingsbeingequal,thebasicruleofthumbforhowchangesinpriceoftheunderlyingcommoditychangeanoption’spremiumareasfollows:

•At-the-moneyoptionsmoveata50%rateofchange.Forexample,iftheS&Pmoves200points,anat-the-moneyoptionwillincreaseordecreasebyabout100points.•In-the-moneyoptionsmoveata50%–100%rateofchange,dependingonhowdeepinthemoneytheyare.•Out-of-the-moneyoptionsmoveat0–50%rateofchange,dependingonhowdeepoutofthemoneytheyare.

Again,thesearerulesofthumb.Ihaveseendaysinquietmarketswhenbothputsandcallslosepremium,regardlessofthemoveofthemarket.Thenagain,intimesofwildfluctuationsorgreater-than-normalexpectations,bothputsandcallscangainpremiuminthesameday.However,innormalmarkets,theserulesworkfairlywell.Anat-the-moneyoptionmovesatabouthalfthespeedofthefutures.Ifacall(andanupday)thenextlowerstrikepricemightmoveup55%ofthefuturesmove,thenexthigherstrikeupsay45%ofthefuturesmoveandsoon.Ifaput,anat-the-moneywillalsomoveathalfthespeedofthefutures,thenextlowerstrikeupsay45%(ifadownday)andthenexthigherstrikeup

somethinglike55%.Ifyoutradeoptions,youpossiblywillalsohearthetermdelta,whichiswhat

I’mreferringtoabove.Deltavaluesrangefrom0(forverydeepout-of-the-moneyoptions)to1(or100%foroptionssodeeplyinthemoneythattheymovejustliketheunderlyingfutures).At-the-moneyoptionshaveadeltavalueof50%(or.5).Callshaveapositivedelta,whereasputshaveanegativedelta.If,forexample,a400coppercalltradingfor1250points(or121/2¢)hasadeltaof.6,a1¢(or100-point)moveinthecopperpriceresultsinamoveof60pointsinthevalueofthecallto1310.Youmightalsohearthetermdeltahedging.Professionalswhospecializein

sellingoptionstothepublicstrivetomanipulatetheirpositiontoalwaysbeneutraldeltahedged.Inthisway,theylooktomaximizethebenefitsoftimedecay.Gammaisaninterestingconceptintheory—itistheextenttowhichthedelta

itselfischanginginrelationtotheunderlyingpricemove,orthechangeinvolatility—butI’vefounditofnouseinpractice.Theaveragetraderneedn’tmonitorgamma.Forthosewhowishtoachievedeltaneutralityconstantly,itissomethingtokeepaneyeon,butamoredetailedexplanationisbeyondthescopeofthisdiscussion.

ExercisingprofitableoptionsWhenyouexerciseanoption,youreceivetheunderlyingasset.Inthecaseofaputoption,youreceiveashortfuturescontract.(Theselleroroptionwriterreceivestheothersideofthetransaction,whichisthelongposition.)Forexample,let’ssayitisMarch.Youfeelthatsoybeanpricesareovervalued

andpurchaseMay$17.00putoptionswhentheMayfuturesare$17.02for30¢perbushel.Thenthefuturesfallto$16.85.Theputsreflecttheincreasedintrinsicvalue,inthiscase.Theytradeforatleast15¢,thedifferencebetweenthestrikepriceandtheintrinsicvalue,ortheamounttheoptionisinthemoney.Theputbuyercouldexerciseheroption,receiveashortfuturesat$17.00,and,ifdesired,couldcovertheshortfuturesat$16.85inthefuturesmarkettorealizethe15¢.Shemakesanautomaticprofitof15¢perbushel,or$750percontract,whichisthedifferencebetweenthepurchasepriceoftheoptionandthefuturesprofit.Ofcourse,thisexampledoesnotincludetimevalueorcommissions,oneofthebasicreasonsoptionsareoftennotexercised.Insteadofpayingthecommissiontoreceivethefuturesandanadditionalcommissionwhenyouoffsetthefutures,itismuchsimplerandeasiertoselltheoptionbackintheoptionsmarket.

Thegreatmajorityofoptiontransactionstakeplaceentirelyintheoptionsmarket.Whenyouareinthefutures(whichiswhathappenswhenyouexercise),youassumetheadditionalrisksoffutures.Youcanstilllosemorethanyourinitialinvestmentifyou’renotcareful,andyoumustpostmarginsrequiredforfutures.Infact,optionbuyersneverhavetogetinvolvedinfuturesatall.Optionpremiumsreflectthechangeinvalueoftheunderlyingfutures.Inaddition,thereisanothergoodreasonnottoexerciseoptionsinnormalmarkets.Inmostcases,youaregivingupsomeadditionalmoney,whichrepresentsanytimevalueremaining.Let’slookagainattheabovesoybeanputoptionexample.Theputvalue

alwaysincludesanycashvalue,orintrinsicvalue,whichisdeterminedbytheunderlyingfutures.Whenthemarketistradingat$16.85,the$17putis15¢inthemoneyandhas15¢inintrinsicvalue.Dependingonhowmuchtimeisleftuntilexpiration,thisputalsohassometimevalueassociatedwithit.Itmaybetradingfor30¢ormoreifalotoftimeisleftorperhaps19¢ifjustafewdaysareleft.Thisisanin-the-moneyputinthisexample.The$16.80alsohasaquotedvalue.Withmonthsleft,itcouldbe30¢ormore,orwithdaysleft,itcouldbeonlyafewpennies.Thisisanout-of-the-moneyoptionwithnointrinsicvalue.Itstotalpriceconsistsoftimevalue,orthepotentialtobecomeprofitablebasedontime,marketoutlook,andvolatility.Inconclusion,themostprofitable,leastcostly,andeasiestwaytoliquidatean

optionistoselltheoptionbackintotheoptionsmarketinsteadofexercisingit.

Shouldyoueverexerciseanoption?ThereisreallyonlyoneinstanceinwhichIwouldconsiderexercisingalongputorcall:onthelastday,withnotimevalueleft.Optionsarepricedaccordingtotheircashvalue.Thisalsohappens,attimes,todeepin-the-moneyoptionspriortoexpiration.Youmightthinkyoucouldalwayssellanoptionforatleastitscashorintrinsicvalue,butthisisnotalwaysthecase.Attheveryend,youaremostlikelydealingwithaprofessionaltrader.Thepublicisnotinterestedinsellingin-the-moneyoptionsonthelastday.Theprofessionalsrequireasweetenertotaketheothersideofyourtransactionifyouarelookingtosellanoptionlikethis,andyoumayneedtogiveupasmallpieceofthepremiumyouearnedtoliquidateintheoptionsmarketatanilliquidtime.Lookingatthesoybeanputexampleoncemore,let’ssaythemarketisat

$16.60,andyoutrytosellyour1700putfor40¢withverylittletimeremaining.Youmightnotgettheorderfilled.Youmightneedtopriceitat39¢,whichwouldguaranteethelocalamodest1¢($50percontract)profit.Hejustoffsets

thetransactioninthefuturesmarket,andthisguaranteeshimaprofit.Anotheroptionistobuythefuturesat$16.60,exercisethe1700put,andbeassignedashortfuturesat$17.00,whichoffsetswithyourlongfrom$16.60andresultsina40¢futuresprofit.Yournetprofitinthisexampleisthe40¢minusyouroriginaloptioncostminuscommissions.Youneedtoconsiderwhetherthismakesmoresensethanlettingthelocaltakethesweetener.Or,ifyoustillfeelthemarketisgoingtomoveinthedirectionofyouroption,considerexercisingaprofitableoptiononthelastday.Youdon’tneedtoevenconsiderthispriortothelastday,butonthedayofexpiration,youdo.Rememberthatwhenyouexercise,youaresubjecttothemarginingrequirementsoffutures.Inmanycases,however,foradeepin-the-moneyoption,youhavethiscoveredbythevalueoftheoption—atleasttemporarily.Agreaterconcernisthatyouarenowinfutures,somethingoptionbuyershavebeentryingtoavoid.Theriskisnolongerlimited,andanunfavorablemoveintheunderlyingfuturescannowwipeoutyourprofit,soyoushouldconsiderusingastoplosstopreventlosingwhatyoumade.

Ifsellingoptionsputstheoddsinmyfavor,whynotdoit?Professionaltraderssellmanymoreoptionsthanthepublic.Traderslikegettingtheheadstartthatselling(alsocalledoptionwriting)entails.Anyonecantaketheothersideofanoptionpurchase;however,thefieldiswideopen.Itissomethingtoconsider,butfirstthinkaboutthis:Theprimaryadvantageofbuyingoptionsistheoptionwriter’sdisadvantageWhenyousellanoption,youagreetoprovidetheoptionbuyerwitheithera

longposition(whenwritingacall)orashortposition(whenwritingaput).Youreceivethepremium,butbecausethemarketcouldmoveanunlimitedamountawayfromthestrikeprice,theassociatedriskisalsounlimited.Thegreaterthepremiumreceived,thelowertherisktotheoptionwriter.Thelowerthevolatility(notalwaysaneasythingtopredict),thelowertherisktotheoptionwriter.Asageneralrule,thelesstimethatexistsuntilexpiration,thelowertherisktotheoptionwriter.Theoptionwriterisalsosubjecttotheriskofexercise.Thisisarightspecificallygrantedtotheoptionbuyer,overwhichthesellerhasnocontrol.Whenthebuyerexercisesacalloption,heiscreditedwithalongfuturespositionatthestrikeprice;thesellerreceivestheshortsideofthetransaction(atthestrikeprice).Whenaputisexercised,thebuyeriscreditedwiththeshortandthesellerwiththelong.Abuyerexercisesanoptiononlywhenitisprofitabletodoso.Becauseprofitabilityisthemainreasonabuyerisinoptions,thereisnootherreasontoexercisetheoption.Thebuyerwouldjustwalkawayfromanunprofitableoption,eitherbylettingitexpireworthlessorby

sellingitbacktotheoptionmarketifthereistimevalueleft.Bydefinition,whenanoptionisexercisedagainsttheseller,itisunprofitabletotheseller.Theonlytimeitwouldnotbeunprofitableisifthesellersoldtheoptionintheafter-marketwhenitwasalreadyunprofitabletoapreviousseller.Theriskofexerciseandtheunlimitedpotentialriskaretherisksalloption

sellersmust,bycontract,accept.So,whytaketheserisks?Thereasonistheoptionsellerhasaheadstart;shereceivesthepremium.Thisinsulatesherrisktosomeextent,andshemakesmoneyinmoresituationsthanthebuyer.Thebuyerneedsamoveinhisfavor.Ifheholdstheoptionuntilexpirationtorealizeaprofit,thebuyerneedsnotonlyafavorablemovebutalsoamovethatexceedsthepremiumhepaid.Thesellercanmakemoneyifthereisamovefavorabletoherposition(upwhensellingputsordownwhensellingcalls).Shealsomakesmoneyinaquietorstationarymarket,whichissomethinganoptionbuyercannotdo.Finally,shecanprofitevenifthemarketmovesagainsther,aslongasitmovestoalesserdegreethanthepremiumreceived.Youwillnodoubthearwarningsagainst“naked”optionwriting.Butjusthow

riskyisittoselloptions?Well,itcanberisky—certainlymoresothanbuying—butitisactuallylesssothanfutures.It’sriskybecauseyoureceiveapremium,andinthecaseofwritingout-of-the-moneyoptions,youhavetheadditionalcushionofthegapbetweenthemarketandthestrikeprice.Furthermore,anoptionwritercanusedefensivestrategiestoprotecthimself.Thewritercanalwaysbuybackhisshortposition,justasashortfuturestradercanbuybackhers.Hecanuseastoplossintheoptionmarket,justasinfutures.Someoptionsarenotallthatliquid,andyouneedtotakethisintoaccount,butmanyofthemtradeactivelyandareasliquidastheunderlyingfuturesmarkets.Finally,theoptionwritercanbuy(inthecaseofsellingacall)orsell(foraput)afuturesagainsthisoptionifhegetsintotrouble.Inmanycases,professionalsusethisstrategytobecomemoreneutral.Forexample,assumethatyou’rebullishcorn,andyouarelookingforanup

movebutnotnecessarilyamajormove.Youcanbuyfutures,buycalls,orsellputs.ItislateSeptember,andDecembercornistradingat$7perbushel.Youcanbuythefuturesat$7,haveunlimitedupside,and(theoretically)haveunlimitedrisk.YoucanbuytheDecember700callsfor20¢perbushelorselltheDecember700putsfor20¢.Youprojectthatthemarketwillmakeamovetothe$7.20level,soyoudecidetoselltheputs.Ifthemarketclosesanywhereabove$7atexpiration,youkeeptheentirepremium,whichinthiscaseis20¢,or$1,000peroption(minustheinevitablecommission).Ifthemarketdoescloseat$7.10,youkeepthepremium(becausethe700putexpiresworthlessandis

abandonedbythebuyer).Thisisaprofit,thesameasforafuturesbuyerwhobuysat$7andsellsat$7.10.However,theputsellerrealizesthesameprofit—atacornpriceof$7atexpiration,whereasthefuturesbuyeronlybreakseven.Youcanevenbewrongandnotlose.Atexpiration,ifthemarketdropsto

$6.80,whilethefuturesbuyerissittingwitha20¢loss,theoptionsellercanstillgetoutofhisobligationintheoptionsmarketatapproximately20¢,oraboutbreakeven...thesellerwaswrongaboutthemarketgoingup,yetnolossinthiscase.Thebeautyofsellingoptionsisthatyoucanalsobewrongandstillprofit.Inthisexample,ifthemarketfallsto$6.95byexpiration,theoptioncanbecoveredat5¢,fora15¢profit.Youcanbewrongandstillmakeaprofit,whichisanimpossibilitywithfuturesoranyotherinvestmentIcanthinkof.Theoddsareintheoptionseller’sfavorbecausethemajorityofoptionsdoexpireworthlessandareneverexercised.However,thepayoffsarenotaspotentiallyhigh.Here’stherub:Themostanoptionsellercaneverreceiveisthepremium,and

neverapennymore.Therisksaregreaterthanwithbuying,andforsometraders,therisksarejusttoohighforthepotentialgain.Thisisthetrade-off.Sellershavetheoddsintheirfavor,butbuyershavethegreaterpotential.Thisisnottosaythatsellersarestuckwiththeposition.Justasinfutures,theriskscanbemanaged.Aswithashortsellerinfutures,ashortoptionsellercangetoutbycoveringherpositionintheoptionmarket.Stop-lossordersareacceptedinoptions.Shouldyouwriteoptions?Nothingiswrongwithitforthosewhounderstandtherisksandhowtomanagethem.Sometraders,however,justcannotfinditinthemselvestocutthelosses(oneofthemostimportantlessons)andshouldbuyonlyoptions—nothingelse.Youknowwhoyouare.

OptionsasahedgingtoolHedgingistheoffsettingofrisksfromotherpositions.AlthoughasaspeculatorIpersonallypreferfuturestooptions,Ibelievehedgersinmaycasesshouldconsideroptionsoverfutures.Optionstrulycanofferthebestofbothworlds.Forexample,acattlefeedershouldknowwhathisbreak-evencostis.He

knowswhathepaidforthecalf,andheknowshisfeedcosts.(Hehedgedhiscorn,ofcourse.)Heknowshisvetcostsandlabor,hehasanallowancefordeathloss,andhecantothepennycalculatehiscosttofinancetheentireoperation.Therefore,hewouldknowthathisbreak-evenis70¢perpoundforthefinishedproduct(amarket-readyanimal120dayshence).Whatthecattlefeederdoesn’tknowiswhathisultimatesellingpricewillbe

onthatdate.Afterall,heisdealingwiththeunknowntosomeextenthere.The

futures120daysoutcouldbetradingat73¢,andbysellingthefuturestoday,hecanguaranteehimselfa3¢profit.Thisisn’tallbad,exceptthatcattlefeedingisariskybusiness.Inperiodsofwindfallprofits,30¢perpoundormorecanbehad.Inotherperiods,120daysofworkandriskresultinanetloss.Ifa3¢profitcouldalwaysbelockedin,alotoftheriskanduncertaintywouldbetakenoutoftheequation,butintherealworld,it’snotalwayspossibletolockinaprofit.Thebottomline?Youneedthewindfallprofitsattimestooffsetthemarginal

profitsandlosingperiodsthatalsooccur.Futureshedgeslockoutthewindfallprofits.Ifyousellfuturesat73¢,andthepriceatfinishis80¢,youhaveafutureslossof7¢,whichoffsetsthewindfallcashgainof10¢.Thenetresultgetsyoubacktoyour3¢profit.Today,mostcattlefeedersjustaccepttheriskofthemarketplace.Theyfeedcattleandhopeforadecentpriceinfourorfivemonthstorewardthemfortheirefforts.Sometimesithappens,buttherearealsomanyformercattlefeedersoutthere.Ontheotherhand,thebig,profitablecorporatecattlefeedersuseoptions.Thisshouldtellyousomething.Here’showitmightwork.Thefeederinthiscasecouldbuya120-daylive

cattleputat,say,a73strikepricefor2¢perpound.Ineffect,heis“lockingin”a71¢sellingprice(73minus2).Ifthepricefallsto,forexample,66atexpirationwhenhiscattleareready,hewilltakea4¢bathinthecashmarket.Hisbreak-evenis70,soasaleat66isa4¢loss.However,tooffsetthisloss,hisoptionwillbeworth7¢,foranetprofitof5¢beforecommissions(recallthathepaid2¢).Addthe5backtothe66,andthefeeder,ineffect,getsbacktohis71¢intheworst-casescenario.Sothefeederisgivingup2¢ofpotentialprofitfortheabilitytoavoidcatastrophicloss.Therealbeautyofoptions,unlikefuturesandunlikeforwardcontractinginthecashmarket,isthattheupsideistotallyunlimited.Ifpricesriseto80,thefeederreapsa10¢profitinthecashmarket.Thisisreducedbythecostoftheoption,inthiscase2¢,downto8¢,buttheupsideisunlimited.Thebottomlineisthatthefeederhasatoolinwhichhecanguaranteehimselfapricefloor,aworst-casescenario,whilenotconstructingaceiling(whichiswhatheisdoingwithfutureshedges).Preciousfewopportunitiesexistforthefeedertoreapwindfallprofits,andhe

needsthemtooffsetthemediocreorworse-than-mediocreyears.Optionsareapowerfultoolthat,whenusedproperly,achievethisgoal.Thisconceptworksjustaswellinfinancialfutures.SaythataU.S.company

receivesanorderfromGermanyforequipmentnotyetbuilt,withtheU.S.companyreceivingeurosondeliveryinsixmonths.Theeuroistradingtodayat125tothedollar.Theprofitmarginisgood,butitcouldbewipedoutbyexchange-ratefluctuations.Also,awindfallgaincouldbepossibleifthe

currencymovesupinrelationtothedollarwithinthetimeperiod.Thecompanyisnotinthebusinessofcurrencyspeculation;itsbusinessisbuildingequipment.Thecommonpracticeistohedgeinthecurrencyforwardbyusingtheinterbankmarket(theelectronicmarketbetweenbanksforforeignexchangetrading).Thismightbeprudent,anditcertainlymakesmoresensetoamanufacturingbusinessthanfloatinginthewind.Optionscanbejustasprudent,andtheyoffersomethingelse,asweetener—thepossibilityofimprovingonapositionwhilelimitingtheriskforapredeterminedcost.Thecompanycanpurchaseanoption,givingittherighttoselleurosat,say,

125tothedollarinsixmonthsfor300basispoints—a125put.AstandardcontracttradedattheCMEisfor€125,000.Theminimumtickisfor$12.50percontract,soaquoteof300pointswouldcostthecompany$3,750.Iftheorderisfor€1millionworthofequipment(today’sexchangerate),thecompanymightbuyabouteightoftheseputs—asprofitinsurance,sotospeak.Iftheeurorises,thecompanylosesthepremiums,butitcanreapanadditionalcurrencyprofitthatistheoreticallyunlimited.Iftheeurofalls,thecompanysellstheputforaprofit,andthisoffsetsthecheapercurrency.Ultimately,thecompanyiswillingtopaythe$30,000,whichreducesitsbottom-lineprofittoensureaprofit.Finally,let’slookatthisfromtheotherside.Ifacompanyplacesanorderfor

merchandiseorequipmentandisrequiredtopayforitonreceiptsometimeinthefuture,thisfirmalsohasacurrencyexposure.Ariseinthevalueoftheeuro,oryen,oranyothercurrencymeanshighercosts.Afallreducesthecostofthepurchaseandaddstolineprofits.Unlessthefirm’spurchasingpeoplearegamblers,whocanendupbeingheroesorbums(andbumsdon’tkeeptheirjobs),theywillhedgethisrisk.Thetraditionalmethodistoforwardcontractintheinterbankmarketorbuyfutures.Bothmethodslockinapriceorcostofthecurrency.However,buyingcallsmightbeabetterwaytogo—establishingaceilingpriceoncostswhileallowingforwindfallprofitsifthecurrencyfallsbymorethantheoptionpriceinthetimeperiod.

StockindexoptionsHowmanytimeshaveyoubeenrightaboutthedirectionofthestockmarket,butyourstockswentnowhere?Well,youguessedit,there’sasimplewaytogambleonthestockmarketwithouthavingtobeastockpicker.AtraderwhoisbullishcanbuyS&P500(oranyoftheother)stockindexcalloptions.Abearwould,ofcourse,buytheputs.Or,whenthepremiumsarehigh,asalemightbewarranted.MuchofthevolumeintheS&Pisinstitutional,whereaportfoliomanagerusesthefuturesoroptionsforprotection,butanyindividualcanuseS&Pat-the-

moneyputsforpriceprotection.TheyallowthebuyertoselltheS&P500Index(the500biggeststocks,representingmorethan80%oftheU.S.market)attoday’smarketprice.Ifpricesrisebyexpiration,thepurchasepriceandcommissionsarelost,butnoadditionalfundsarerequired.Thisisahedge,however,andifyouloseontheput,hopefullyyourstockportfoliorose.Ifthemarketfallsbythesameamountasthepremium,you’llgetyourpurchasepriceback.Inotherwords,you’reprotectingyourportfoliofromafallofgreaterthanthepremiumpaid.Ifthemarketfallsbyagreaterpercentage,youloseonyourportfoliobutgainontheputoption.Whywouldn’tabearjustsellhisstocks?Forlong-terminvestorswaryofamarketdip,thisischeaperandeasier.Sellingalargeportfolioofstockswouldinvolvenumerousandcostlycommissions.ThecommissiononeachS&Poptiongenerallyischeaper.Plus,youneednotforgodividendincomeonyourstocksorworryaboutlong-termcapitalgainstaxes,and,ifyourstocksoutperformthemarketingeneral,youhavearelationshipgain.Ifthemarketdeclines,theinvestor/hedgercansellhisputataprofitandholdontothestocks.Ifthemarketrises,thestockswillbeworthmore,andtheputhastobeconsideredinsurancethatjustneverneededtobeused.

AdvancedoptionstrategiesThickbookshavebeenwrittenaboutoptions.Manyofthemgettoopreciseforpracticalreal-worldtrading,coveringsuchacademictopicsascomplexbutterflyspreadsandotherstrategiesthatmightlookgoodonpaperbutinpracticeI’veseldomfounduseful.Here,I’llcoversomebasicstrategiesIfeelworthyofyourconsideration.

BuyingoptionstoprotectfuturesBuyingoptionstoprotectfuturesinvolvesbuyingaputwithlongfuturesorbuyingacallwithshortfutures.Thisstrategyisalsoknownascreatingsyntheticoptionsbecauseaputcombinedwithalongfuturesissimilartoacall,andthecallinconjunctionwiththeshortfuturesissimilartoaput.Youcanmakeacasethatifyoubuyanat-the-moneycalloptionwhilesimultaneouslyholdingashortfuturesposition(syntheticput),oryoubuyaputoptionwhilesimultaneouslyholdingalongfuturesposition(syntheticcall)thattheoverallpositionwillactjustlikeaputoracall(sowhybother?).Becausethiscanbeabetterstrategysinceitgivesyouaddedflexibility.Forexample,saythatyouarefundamentallybullishthehogmarket,butyou

areconcernedthattheupcomingHogsandPigsReportcouldmovethemarketsubstantially(hopefullyinyourdirection,buttherearenoguarantees).Infact,

theHogsandPigsReport,releasedquarterlybytheUSDA,hasareputationformovingthemarket’slockedlimit,attimesconsecutivemultiplelimitdaysinarow.Lock-limitmoves(orabnormalmovesinmarketswithoutlimits)isariskeveryfuturestraderhastoaccept.IftheHogsandPigsReportisabearishsurprise,youcouldlosemanytimesyourinitialmarginbecauseyoumightnotbeabletoliquidatethefirstdayoreventhesecond.Thiscanbecomearealnightmarewhenyou’recaughtonthewrongsideofathree-daylock-limitreport,anditdoeshappen.Ofcourse,theHogsandPigsReportcouldconfirmyourfundamentalbias.If

youarenotinaposition,andthemarketstartsmovinglimitinyourintendeddirection,youmightbeunabletoenteratareasonableprice.Youcouldbuyacall,ofcourse,buthere’samoreflexibleapproach.Saythatyoubuythehogsat72andsimultaneouslypurchasea72putfora

premiumof180points,or$720.Ifthereportisbullish,youcanabandonyourputforwhateverthemarketwillofferandreapyourprofitonthefutures.Ifthereportisbearish,youareprotected,andregardlessofhowmanylimitmovesthemarketmakes,youknowyourworst-casescenario—inthiscase,a$720maximumriskplusfees.Ifworsecomestoworst,youcanexercisetheput,andyouwillbeassignedashortfuturespositionthatautomaticallyoffsetsyourlongfutures.Youalwayshavetherighttosellyour72purchasefor72—inotherwords,awashinthefutures.Youareout,atmost,thecostoftheput.Thisisthepointwhereflexibilitycomesin.Thesereportsareunpredictable,

andI’veseenmarketsopenlimitinthedirectionofthereportandclosetotallyoppositebyday’send.Themarketstradeoffthereportsinitially;however,thereportsarenotalwaysright,andthesmartmoneyusesthenewsasanopportunity.Itisalmostalwaysasignificantsignwhenamarketclosesoppositethedirectionareportindicatesitshould.Let’ssay,inthiscase,thattheconsensuswaslookingfor3%morehogs,andthereportindicatesthereare7%more—inotherwords,quitebearish.You’regladyouhadtheforesighttobuytheputbecausethenewswiresare

talkingtwo,perhapsthree,limitdaysdown.Themarketopenslimitdownat69.Theputincreasesinvaluefrom180to450attheopen.Themarketshouldtheoreticallyremainlimitdown,andiftwodaysdown,theputshouldtheoreticallytradeupto550orhigher.Youplaceasellstopontheputat320.Remember,ifthemarketrises,theputlosesvalue.Theonlywayforthestoptobehitisforarallytooccursometimeduringtheday.Ifthemarketremainsweak,yourplanistoleavetheputinplace,butifthemarketstartstorally,you’restoppedoutofyourputataprofitof140points,andyoustillownthe

longfutures.Ineffect,youarelongthefuturesinanenvironmentwherethemarketis

trading;theabnormalsituationismorenormaland,therefore,moremanageable.Youcannowplaceastoplossunderyourfutures.Ifthemarketkeepsrallying,youhaveagoodposition.TheHogsandPigsReportshavebeenproventobeinaccurate40%ofthetime,butnobodyknowsforsureuntilsixmonthsdowntheroad,whenthepigsactuallymaterialize—ornot.Inthisscenario,youhaveprotectionifthereportprovesunmanageable.Ineffect,ifitisafavorablereporttoyourposition,thisprotectionbecomesa“mistake”youarehappytomakebecausethefutureswouldrisemorethantheputwoulddeteriorate.Bottomline:Youhavealotmoreflexibilitythanjustbuyingacallorbeingnakedlongfutures.Usingoptionsinconjunctionwithfuturescangiveyoustayingpowerwhile

allowingyouthechoiceofliftingonesideoranotheratanytime.Ifyourtechnicalorfundamentalbiaschanges,youcanalwaysliftonesideandkeeptheother.Ifyoureachyourprofitobjectiveonthefutures,youcanliquidateyourfuturespositionandholdtheoption.Attimes,“dead”optionsreturnfromthedeadandearnyouadoubleprofit.Anothervariationonthisthemeinvolvesbuyingoptionstoprotectprofitsfor

apositionthathasalreadymovedyourway.Yousee,I’mabigfanofridingatrendforallit’sworth.Inabigmove,amarketalwaysseemstogofurtherthanlogicalonemightwarrant.However,attheendofamove,amarketcangetoverheated,andwhenyouknowthetopisin,itcouldbetoolate.Whenyoufeeltheendisnear,butthereisnofundamentalortechnicalreasontoliquidate,whynotjustbuyanoptiontoprotectprofits?Itcouldbemoneywellspent,andifyouaretooearly,thisisthekindofmistakeyouliketomakebecauseyouwillmakemoreonthefuturesthanyouspendontheoption.

WritingoptionsasahedgingstrategyPreviously,youlearnedhowacompanywithforeigncurrencyriskcouldpurchaseoptionstohedgethisrisk.Amoresophisticatedstrategyinvolvesthesellingofoptionstogenerateadditionalincome.Forexample,whatifacompanyneedstobuyJapaneseyenandishappywith

today’srateofexchange?Togenerateadditionalincome,themanagercouldsellat-the-moneyputoptions.Let’ssaytheyenistradingat100,andthe100putsfor60daysarepricedat200points.Bysellingtheputs,thecompany’saccountiscreditedwiththepremium—inthiscase,$2,500peroption.Ineffect,thecompanyissayingitiswillingtobuyyenfromtheoptionbuyerat100.Ifthe

valueoftheyenrises,theputsremainunexercisedatexpiration,andthecompanykeepstheentirepremium.Thisisahedge,inthatthemoneycanbeusedtooffsetthehigheryen.Iftheyenrisesbylessthan200points,thecompanyismoneyahead.Ifitrises

bymore,thecompanycanbuycallsorfutures,orforwardcontractatanappropriatespot(ifitisunwillingtoacceptadditionalriskinthemarketplace).Iftheyenfalls,thecompanysimplyhonorsitscommitmenttopurchaseyenatthehigherprice.(Itwillbeassignedlongfuturesat100,apriceitwaswillingtolivewith.)Butthecompanystillkeepsthe200pointsthateffectivelylowersthepurchasepriceto98.Thisstrategyworksbestiftheoutlookisforastable,slightlyrising,or

slightlyfallingmarket.Byreceivingthepremium,thetraditionalcostsofhedgingarenotonlyreduced,butattimestheycanbetotallypaidforplusabonus.

CoveredoptionwritingAswe’vediscussed,theadvantageandattractionofbuyingoptionsisthatyourriskislimitedandpredetermined,andtheprofitpotentialisunlimited.However,themajorityofoptionsexpireworthless,andthepremiumseventuallydisappear.Therefore,buyingoptionsisgenerallyalosingproposition.Thisisnottosaythatyoucannotmakegoodmoneyinamajorbullormajorbearmarket,butbeadvisedthatprofessionalsprimarilyselloptions(generallytothepublic).Theymighthedgethesesaleswitharatiooflongorshortfutures,butthepublicgenerallylikestopurchasepremium.Theadvantageofsellingoptionsisthatyoucancapitalizeonthetimedecayofoptions.Becausethepremiumsthatpeoplepayforoptionseventuallyrisetooptionheaven,theoptionsellergainsthesepremiums.Whilewritingoptionsisgenerallyawinningstrategy,thebigdisadvantageisthattheriskisunlimited,whiletheprofitpotentialislimitedtothepremiumsreceived.Whenoptionpremiumsarehigh,thegeneralruleofthumbisthatitisbettertoselloptionsthantobuythem.Theadvantageoffuturesistheunlimitedprofitpotential,buttheriskis

theoreticallyunlimitedalso.Youshould,therefore,userisk-managementtechniques(stops).Stopsarenotfoolproof,buttheygenerallyworkefficiently.Themainproblemswithstopsisthattheycanbefilledawayfromyourintendedrisklevelattimesandinavolatilemarketyoucanbestoppedoutonlytohavethemarketeventuallygobackyourway.Ontheotherhand,ifyoudonothavestops,youcannotpredeterminewhatyourriskis.Coveredoptionwritingcanallowyoutotakeadvantageofthedecaying

optionpremiumsjustliketheprofessionalsellers,butitislessriskyinavolatilemarket.Itbasicallyinvolvessellingcalloptionsandbuyingfuturesorsellingputsandshortingfutures.Forexample,inarecentbullsoybeanmarket,IboughttheNovemberbeansat$18.00andsoldthe1800callsfor60¢.Thisgaveme60¢indownsideprotection.Atexpiration,ifthemarketwasanywhereabove$17.40,Iwouldstillprofitonthistrade.Ifthemarketwasanywhereabove$18/bushelatexpiration,Iwouldkeepthe60¢,or$3,000grosspercoveredcontractposition—notabadprofit.ThedisadvantageofthisstrategyisthatthemostIcouldmakeoneach

transactionwas60¢,or$3,000grosspercoveredcontract.So,ifthebeansranupto$22,thecoveredpositionswouldallowonlyalimitedprofit.HereishowIovercamethisdisadvantage:Myplanwastopyramidthepositionapproximatelyevery50¢up.So,ifthemarketmovedto,say,$18.50,Iwouldlooktobuymorefuturesat$18.50andsellthe1850callsforapproximately60¢.Atthispoint,mylowerbuysaresafer.Icouldtheoreticallyridethese1800coveredwritesbackdownto$17.40,sothemarketwouldhavetofall$1.10/bushelbeforeIwasinmajortrouble.IfIhappenedtohavethe1750sonatthispoint,theywouldlookevensafer,andsoon.Now,ifthemarketappreciatesrapidlyandweaddevery50¢up,takinginan

averageof50¢eachtime,wemake$1.00(or$5,000/contract)forevery$1moveupifthemarketremainsstrong.Withacalloption,ifyoupay60¢andthemarketmovesup$1,youwillmakeonly40¢atexpiration.So,thispyramidingtechniqueisactuallyamoreprofitablestrategythanjustbuyingcallsinamajorbullmove.Andduringcorrectionstothemajoruptrend,youarebetterabletorideoutthefluctuationsthanyouwouldbewithuncoveredfutures.Inasidewaysmarket,youwouldmakemoneywiththisstrategyalso,whereasyouwouldlosewhenjustbuyingcalls.Ofcourse,withthisstrategy,thereisnopredeterminedriskifthemarketgoesdownmorethantheshortpremium,whereaswithoptionpurchases,theriskislimited.Withthecoveredposition,theriskislessthanfutures,butyou’llneedtomonitorthepositionanduseariskpointonthefutures/optioncombinationsifthemarketagainlooksweak.

OptionspreadsFuturescanbespreadinvariousways,andoptionscanbespreadinevenmore.Onlywithoptionscanyouspreadtwodifferentcontractsofthesamemonth.Optionspreadscanbeconstructedinavarietyofwaystofine-tunemarketoutlooks.AlthoughpersonallyIrarelyspreadoptions,someofthesestrategiesareverypopularandfitinnicelywithsometradingstyles.

VerticalcallspreadsWithaverticalcallspread,youhavetwooptionsofthesamemonthbutwithdifferentstrikepricesthatarespreadagainsteachother.Theverticalcallspreadisbullish,andtheverticalputspreadisbearish.Forexample,you’rebullishwheat,it’sMarch,andMaywheatistradingat$4.20.YoubuytheMay420call,pay22¢,simultaneouslyselltheMay450call,andtakein7¢.Yourcost(excludingcommissions)isthedifferencebetweenthetwopremiums—inthiscase,15¢,or$750.Thedifference(alwaysadebit)isyourmaximumrisk.Ifthemarketatexpirationclosesbelow420,youlosethe22¢andkeepthe7¢,amaximumriskof15.Yourmaximumprofitisthedifferencebetweenthestrikepricesminusthedebit.Inthiscase,450–420=30and30–15=15.Atexpiration,above450,youlosepennyforpennyonthe450whatyoumakeonthe420.So,yourmaximumprofitisatorabove450.Returning30foryour22investmentisthelower-pricedcall,butyoukeepthe7¢,foratotalof15¢.Whyspreadvertically?Inonerespect,bullspreadingcallsofferthebestof

bothworlds.Therisk,asinbuyingoptions,isstrictlylimited.Youloweryouroverallcostbybenefitingfromthetimedecayofsellingpremium.Youaresellingpremiumonthegreaterout-of-the-moneyoption,whichismorelikelytoexpireworthlessthanthelower-pricedoption.Themaindisadvantageisthattheprofitislimited,andthiseliminatesoneofthemainadvantagesofbuyingoptions.Thereisstillapremiumcost,oneofthemaindisadvantagesofbuyingoptions,andyouincurdoublecommissions.

VerticalputspreadsTheverticalputspreadisthemirrorimageofthecallspread.Forexample,saythatyouaremildlybearishinthestockmarket.ItisJuly,andtheminiSeptemberS&Pistradingat1750.YoubuytheAugust1740put(whichkeysofftheSeptembercontractandexpiresthethirdFridayinAugust)for1,800pointsandsellthe1710for450points.Yourmaximumriskis1800pointsminus450(1,350points=$675).Youloweryourmaximumriskoverjustbuyingthe1740putfor$900.Yourmaximumprofittakesplaceunder1710andisthedifferencebetweenthestrikeprices(inthiscase,30points,or$1,500minusthedebitof$675,whichis$825,excludingcommissions).Bywritingalower-pricedputagainstahigher-pricedput,youtakeonlessriskforaloweredpotentialprofit.Forcallspreads,bywritingahigher-pricedcallagainstalower-pricedcall,youdothesamething.Therearequiteafewvariations,butinpractice,ifyouuseacallthatispricedtoohighoraputpricedtoolow,youwillnotreceiveenoughpremiumstolowerthecostsufficiently.

CalendarspreadsAlsoknownastimespreads,calendarspreadstakeadvantageofthetendencyofnearbyoptionstodecayfasterthandistantoptions.Thisstrategyinvolvesthesaleofanoptioninonemonthandthesimultaneouspurchaseofanoption(usually,butnotnecessarily,thesamestrikeprice)inalatermonth.Forexample,youmightsellaSeptember2500cocoacallandbuyaDecember2500cocoacallforanetdebit.Ifthemarketremainsfairlystable,youeventuallygainthepremiuminthenearbytocheapentheultimatecostofthedistant,ortherewillbeanetgainontheentirepositionaftersometimepasses.(Youcan,ofcourse,liquidatebothsidesorjustonesideatanytime.)Oneofthepotentialpitfallsinthisstrategyisthatthespreadvaluesoftheunderlyingcommoditycanchange,perhapsfavorably,butcontrarytoexpectationsaswell.Manytimes,thenearbymonth,whichaffectstheshortsideofthespread,movesmoredramaticallybecauseofhigheropeninterestandgreaterspeculativeplay.Theriskcannotalwaysbepredeterminedtoanexactlevelliketheverticalspreads;however,thereismeritinthisstrategyifitismonitoredandusedcorrectly.

StraddlesandstranglesStraddlesandstranglesareoptionspreadsthatinvolvebothputsandcalls.Astraddleinvolvesbuyingorsellingputsandcallsatthesamestrikeprice.Duringthelifeofastraddle,itisacertaintythatoneorbothoftheoptionswillbeinthemoneyatanypointintime.Astrangleinvolvesdifferentstrikeprices,soitislesslikelythatbothorevenoneofthestranglelegswillbeinthemoneyatanypointintime.However,itiscertainlyquitepossible.Therearetwosidestoeachofthesemarketplays,solet’sexaminethefourpossibilities.

BuyingastraddleSaythatitislateSeptember,andtheDecemberT-bondsaretradingat10503.YoubuytheDecember105callandthe105put.Thecallistradingfor2fullbondpointsand1/32.Theputistradingfor1fullpointand31/32.Yourcostisthesumofbothpremiums—orinthiscase,4fullpoints,or$4,000(pluscommissions).Tobeprofitableatexpiration,bondsmustmovemorethan4points,above109orbelow101.Theadvantageofthisstrategyisthatyouknow,tothepenny,yourmaximum

riskonthetrade.Thedisadvantageisthatyoumustovercomedoublepremiumstobeprofitable.Whydothis?Theonlysituationinwhichthismakesanysenseiswhenyouanticipateavolatilemarketbutdonothaveanyideawhichdirectionthemarketwillmove.Supposethere’sabigunemploymentreportcomingout

thatwilldetermineFedpolicy.Youknowthisreportwillmovethemarket,butyouhavenoclueastohowitwillcomeoutorhowitwillbereceived.Afterthereport,youcandecidewhetheryouwanttocutthelossesonthebadoptionandletthegoodoneroll,orwhetherthemoveisdramaticenoughforthegoodonetocoverbothpremiums.Inpractice,I’vefoundthisstrategyworksonlyifyouarewillingtomanageit.Toovercomethetimedecayoftwooptions,youneedtobeveryrightovertime.Attimes,afteramoveofsignificance,itcouldmakesensetotakeaprofitonthegoodsideandhopetheotheronereturnsfromthedead,ortocutthelossontheunprofitablesideandlooktomaximizethegoodside.Therearenohard-and-fastruleshere.Ittakesmanagementandsmarts.Backtotheexample,thereportisreleased,andunemploymentisupdramatically.Becausethisindicatesaweakeningeconomy,thethoughtisthattheFedcouldlowerrates,whichmeansbullishbondprices.Next,youobservehowthemarketreactstothereport.Rememberthatitisnot

thenewsbuthowthemarketreactstothenewsthatisimportant.Inthiscase,bondpricesmoveup,rallyingmorethan21/2points,tocloseat10718.Thecallgainsabout11/4points,andtheputloses1point.Becauseofthedeltapricingofoptions,thefirstlegofthemoveistheleastprofitableforthisstrategy.Asyourprofitableoptionmovesdeeperintothemoney,itactsmoreandmorelikeafuturescontract,andthisstrategybecomesincreasinglyprofitable.Theout-of-the-moneylosescomparativelylessbecauseithaslesstolose.Ofcourse,atanytime,youhavethechoiceofsellingoutonelegofthestraddleorboth.Ifatsomepointyourindicatorstellyouthemoveisover,youmightwishtotakeprofitsonthecallandholdontotheput,hopingthemovereversestothedownside.Youcould,ifyouarelookingforamajorbullmarkettounfold,cutyourlossontheputandholdontothecall.Inthiscase,youwouldrealizealossofaboutonepoint,andyouwouldmostlikelybeoutabout$1,000orsoontherealizedsideoftheequation.Ifatexpirationthemarketfallsbackunder105,youwouldloseyourentirecallpremium,andthis“limited-risk”tradewouldcostyoumorethan$3,500perstraddle.Forthisreason,itisimportanttoprotectprofitsonthegoodsideofthespread.Youcouldplaceastoponthecallatbreakeven(forthecallside),andthisactionwouldlimityourriskontheentirepositiontoapproximatelytheputlosswhileleavingyourupsideopen.Afteryouareoutoftheput,youwouldneedamove(atexpiration)tomorethan108toshowanetprofit.Everypointmoveabovethislevelresultsina$1,000profitperpointperstraddle.Theimportantthingtorememberistousesoundjudgmentandgoodmoneymanagementwhenemployingastrategylikethis.Atexpiration,onesideofthestraddleexpiresworthless,soyou’llneedtomakethis

up.

SellingastraddleInthepreviousexample,therewassomeoneontheothersideofeitherorbothoptions.Mostlikely,thebuyerofthestraddleboughtfromtwodifferentsellers,butyoucouldbeasellerofthestraddle,too.Thisisastrategythatplacestheoddsinyourfavorbutraisestherisklevel.Inthepreviousexample,theselleroftheDecemberT-bond105straddlereceivesbothpremiums,orinthiscase,about4points.Ifthemarketdoesn’tmove,andattheexpirationdateitclosesexactlyat105,thesellergetstokeepbothpremiums.Theoddsofthisoutcomearesmall,butaslongasthemarketremainswithinarange,thesellermakessomething.Inthisexample,hehas4pointstoworkwith.Ifthemarketstayswithintherelativelywiderangeof101to109,someprofitispossible.Themarketmustmoveoutsidetherangeforthestraddlewritertolose.Theproblemwiththisstrategy,inmanycases,comesinthetimingofthemove.Ifthemarketmovesfast(ineitherdirection)andvolatilityincreases,thesellercouldgetintrouble.Justaswithanyotherlimited-profit/unlimited-riskstrategy(inthisexample,theprofitislimitedtoanabsolutemaximumof$4,000),itneedstobemanaged.Iftheunemploymentreportresultsinaho-humreaction,youmightwanttostaywiththeentireposition.Ifthereisadramaticmove,itcertainlycouldmakesensetocutthelossontheunprofitablesidebutthenlooktolockinaprofitbyusingsomeformofrisk-controlmeasure(astopcomestomind)ontheprofitableside.

BuyingastrangleAstrangleissimilartoastraddlebutwithanimportantdifference.Astrangleplayerusesdifferentstrikes,usuallyateithersideofthemarketprice.Asabuyer,yourriskislimited.Yourleverageincreasesbecauseamajormoveresultsinagreaterprofitonfundsatrisk.Let’sgobacktotheT-bondexample.Inthestraddle,youpurchasedthe105callandthe105put,withthemarkettradingabout105.Thestranglebuyermightbuy,asoneofnumerousexamples,the108callfor1pointandthe102putforjustunder1point.Therefore,yourcostisperhaps$2,000insteadof$4,000,andyourriskiscutinhalf.Youroutlookismostlikelythesameasthestraddlebuyer’s;thatis,youarelookingforasubstantialmoveinavolatilemarketbutdon’thaveaclueastodirection.Thedisadvantageisthatthemarketmustmovesubstantiallyforyoutoshowaprofit.Inthestraddleexample,atexpiration,theprofitzoneisoutside109or101.Forthisstrangle,therangehaswidenedto110ontheupside(108plusthe2pointsinpremiumpaid)and100onthedownside.However,ifbondssoarto118at

expiration,thisstrategyresultsinagrossprofitof$8,000.The102putexpiresworthless.The108callwouldbeworth$10,000.Thecostis$2,000,resultinginagrossprofitof$8,000,or400%.Inthestraddleexample,thegrossprofitwouldbe$9,000at118.The105callwouldbeworth$13,000minusthe$4,000cost,whichequals$9,000.Althoughthegrossprofitishigher,theleverageislower.Ona$4,000risk,thenetprofitis225%.Forthesamerisk,youcouldhavepurchasedtwostrangles,resultinginagrossprofitof$16,000.Don’tforget,Iamhypotheticallyassumingamajormovehere.Suchmovesdohappen,butdon’tcountonthem.

SellingastrangleSellingastrangle,whichwouldinvolvetakingtheoppositesideofthepreviousexample,isprofitablethemajorityofthetimebecausemostout-of-the-moneycallsexpireworthless—oratleasttheydonottotallyovercomethepremiumspaid.Inthiscase,youarewritingtwoout-of-the-moneyoptions,butthisdoesnotnecessarilyputtheoddsdoublyinyourfavor.Ifamajorbullorbearmovetakesplace,thestranglesellercouldfindhimselfinbigtrouble.Icannotstressenoughhowimportantitistomanagetheseoptionspreadstrategies,especiallywhenyouareastranglewriter.Therisksareless,buttheyarestillthere,andtheyareveryreal.Stranglewritinghasalowerpotentialprofitthanmanyotherplays.Inconclusion,astranglebuyerpayslessthanastraddlebuyer,butherprofit

potentialislower.Thestranglesellerhasbetteroddsofaprofit,buthisrisksarehigher.Thestrangleandstraddlesellerscandoquitewellinquiet,trading-rangetypemarkets.Thebuyerdoeswellduringmajorbullorbearmovesandparticularlywellinrunawaymoves.Yourmarketoutlookisnotasimportantusingthesestrategiesasthedegreeofthemoveis.Premiumsvarybymarketconditions,soyouneedtovaryyourstrategybasedontheseconditionsandyouroutlook.Theonerulethatalwaysholdstrueisthattherewardsarehigherwiththerisks!

RatiosRatiosinvolvebuyingorsellingagreaternumberofcallsorputsononesideofthetransactionthantheother.Theyarebasicallyacombinationofstrategiesalreadydiscussedandareusefulincertainsituations.

RatiowritesSimplystated,aratiowriteinvolvessellingagreaternumberofoptionsthantheunderlyingfuturesposition,withthemostcommonnumberbeing2.

Forexample,saythatit’sSeptember15andyoubuyDecembercottonat8055,andyousimultaneouslyselltwoDecember86callsforapremiumof130each.Youaretakingin260pointsinpremium.(Forcotton,1pointisworth$5.)Therefore,thisstrategygivesyou$1,300indownsideprotection.Thedownsideriskstillexistshere,butitislessthaninanoutrightfuturesposition.Themarketatexpirationmustmovebelow7795forthisstrategytoproducealoss(notincludingcommissions).Withthefutures,anymoveunder8055resultsinaloss.Profitsarealsohigheronanormalbullmovecomparedtoanoutrightfuturesposition.Ifthemarketonoptionexpirationdateclosesat8305,asinglefuturespositionshowsagrossprofitof250points,or$1,250.Theratiowriteshowsamuchmoreimpressiveprofitof$2,550becausethe86callsexpireworthless,andthesepremiumsarekeptinfull.Itshouldbenotedthatthisprofitisalsogreaterthannakedcallwriting.Inthisexample,thenakedcallsellerreceivesthe$1,300,notthe$2,550.Therub?Thisratiowritehasatwo-sidedrisk,whichisnotseenineither

coveredornakedwrites.Ifthemarketfallssubstantially,theriskonthefuturesisnotlimited.Ifthemarketralliessubstantially,theupsideriskisunlimitedaswell,becausethereisanextranakedcalltocontendwith.Aratiocallwriterhasaneutraltoslightlybullishoutlook.Aratioputwriter(shortDecembercottonandalsosellingtwoDecemberputs)hasaneutraltoslightlybearishoutlook.I’vestressedthisbefore,andI’lldosoagain:Thisisastrategythatcanbequiteprofitablebutmustbemanaged.Aratiowritershouldknowherbreak-evenpoint,bothaboveandbelowthemarket,andsheshouldmanagethepositionwhenitappearsthreatened.Thebestpositionsarethosethathaveawideenoughprofitrangetoallowfordefensiveactionshoulditbecomenecessary.

RatiospreadsA2:1ratiocallspreadinvolvesbuyingonelower-pricedcallandsellingtwohigher-pricedcalls.Forexample,withMaybeanstradingat$16.89,youmightbuyaMay1700callfor34¢andselltwo1750callsfor14¢each.Under$17,thereisnorealriskotherthannetcostof6¢.Infact,ifyoucanestablishthespreadatacreditinitially,thereisnodownsiderisk.Themaximumprofitoccursattheupperstrikepriceatexpiration.Ifthemarketexpiresexactlyat$17.50,youkeepthe28¢plusshowanetprofitof16¢(50minus34)onthe1700.The44¢,inthiscase,isthemaximumprofit.Theprofitpotentialisreducedabovetheupperstrikepricebecausethelossis

theoreticallyunlimitedforthenakedportionofthespread.Thegreatestriskforratiocallspreadsalwaysliesabovethemarket.Ratioputspreadshavetheir

greatestriskbelowthemarket.Ratiospreadsandratiowritesaresimilarinthattheybothinvolveuncoveredwrites,andbothhavepredeterminedprofitranges.Thedifferenceisthedownsiderisk(forratiocallspreads)orupsiderisk(forputs)issmallandinsomecasesnonexistent.Again,youwouldusethisstrategyinaneutralormildlybullishorbearishenvironment.Virtuallyunlimitedpermutationsofratiosandstrikepricescanbeused;justremembertousegoodjudgmentandmonitorthemarketinquestion.

ReverseratiospreadsAsthenameimplies,areverseratiospreadisastrategyoppositethemorecommonlyutilizedones;therefore,youdon’thearmuchaboutit.Itinvolvessellingacallorputatonestrikepriceandthenbuyingagreaternumberofcallsatahigherstrikepriceorbuyingagreaternumberofputsatalowerstrikeprice.Thisisalsocommonlycalledabackspread.Lookforbackspreadsthatyoucanestablishforacreditifpossible,andinamarketwhereyouanticipatearelativelysubstantialmoveforthebestprofits.Forexample,saythatitisFebruary,andMaysugaristradingat1112.Yousell

an1100callfor65pointsandyoubuytwo1200callsfor23pointseach.Thespreadisestablishedatacreditof19points(plus65minus[23times2]).IfMaysugarexpiresunder1100,thenallthecallswillexpireworthless,andthecreditof19pointswillbetheprofit.Whileyoudon’tputonabullbackspreadanticipatingadownmove,stillifyouaretotallywrongandthemarketfallsyoucanstillearnaslightprofit.Thisstrategyhaslimitedrisk.Themaximumlosscomesatexpirationatthepurchasedcalls.Inthiscase,at1200,the1100callsoldwillshowalossof35points(100pointsofintrinsicvalueminusthe65received),andthe1200callswillexpireworthless.Therefore,thetotalriskonthisoneis35plus46,or81points.Theriskisnevermorethanthis.Therealprofitpotentialcomeswhenthemarketmovesabove1200,withno

limitsonthemaximumprofitpotential.Ifthemarketexpiresat1300,theshortcallwillshowalossof135points.However,eachofthe1,200callswillshowaprofitof76(foraprofitof17;76times2minus135),arelativelysmallprofit,butatthislevel,theprofitpotentialisnowunlimitedshouldthemarketcontinuetomoveintheanticipateddirection.Oneshortandonelongcalloffseteachother,buttheaddedcallgainswiththefuturesmarket.At1400inthisexample,thisstrategyresultsina117pointprofit,at1500,itresultsina217profit,andsoon.Theprofitrange(withoutfees)isanywherebelow1119andanywhereabove1283,butnotinthemiddle.Verysimply,thisisabullishstrategy,onethatishedgedtoanextentbytheshortsale.Theprofitisunlimitedonamajorupside

move,andyetthereisawiderrangeofpotentiallyprofitableoutcomesbecausethetradercanalsoprofittoanextentwhentotallywrong.Aswithalltheseotherplays,thisonecanbeperformedwithputswhenbearish.Itshouldbeusedwhentheoutlookisforarelativelylargemoveinavolatilemarket.Itgenerallymakesmoresensewithmoretime,andittiesuplessmoneythanjustbuyingoptions.Thedrawbackcomeswitharelativelynormalmoveinthedirectionanticipated.Ifthemoveisnotlargeenough,alosswillresult.

EightwinningoptiontradingrulesSo,itmayappearyouroptionswhentradingoptionsareseeminglyinfinite.Howdoyousortthroughallthestrategiestofindwhatworksbest?Theseeightrulesjustmighthelpyou.

1.Avoiddeepin-the-moneyoptionsThetwokeyadvantagesofbuyingoptionsareleverageandlimitedrisk.Ifanoptionisdeepinthemoney,itcutsdownonyourleverageandaddstoyourrisk.Eventhoughtheriskisstilllimited,you’repayingmoreandthereforehavemoretolose.Youcutdownonyourleveragebecauseyouneedabiggermoveintheunderlyingassettogenerateasignificantprofit.Thewholeideaofleverageistotakeasmallamountofmoneyandownanoptiontoexerciseintoanassetworthmanytimesasmuch.Whenbuyingdeepin-the-moneyoptions,youtieupalotmoremoneythatcanbeusedforotheropportunities.Idon’tlikesellingdeepin-the-moneyoptionseither.Youtieupaconsiderableamountofcapitalthisway(sinceyouneedtomargintheposition).Thebiggestadvantagetoanoptionselleristimedecay,anddeepin-the-moneyoptionshavelesstimevalue;therefore,youhavelesstogaintheeasywayandmoreriskwiththeintrinsicvaluecomponent.Bottomline:Istayawayfromdeepin-the-moneyoptionswhenbuyingorselling.Ofcourse,whenbuyingoptions,yourobjectiveistoturnanout-of-the-money,at-the-money,orslightlyin-the-moneyoptionintoadeepin-the-moneyoption.Yourobjectivewhensellingoptionsistoavoidturningyoursaleintoadeepin-the-money.Thisisaneffectivewayforyourwallettogodeepoutofmoney!

2.Avoiddeepout-of-the-moneyoptionsTheillusionisthatdeepout-of-the-moneypurchasesgiveyoualotofleverage.Inreality,theygiveyoualotofhope,encourageovercommitments,andgenerallyofferlittleprofitopportunity.Yes,theydohitattimes—andsodoesthePowerballlottery—butthisisagameofprobabilities,andtheoddsarecertainlyagainstyouwhenbuyingdeepout-of-the-moneys.Youhavetobe

realistic.Ifthepremiumappearscheap,there’susuallyareason.Ofcourse,youcouldbuyanAugust1200soybeancallinJulywhenthebeansareat600andhopeforacropfailure.Youcouldprobablybuyalotofthembecausethey’dbecheap,maybejust$100each.But,itwouldbeunlikelyforbeanstorise$6perbushelinjustthreeweeks.Itmakessomewhatmoresensetopurchaseadeepout-of-the-moneyoptionifyouhavesufficienttime—but,thenagain,youlosesomeleveragebecauseyouarepayingforthattime.Theoddsaregreatlyinyourfavorwhenyouselldeepout-of-the-moneyoptions,buttheexpectedrewardisminusculeinrelationtotherisk.Youcouldbeprofitable99outof100timeswhensellingdeepout-of-the-moneyputoptionsonthestockmarket,butthatcrashwillinevitablycomeonsomeunexpectedeventwhenyouleastexpectit.Unlessyouwishtobe“thehouse,”theentitycapitalizedsufficientlytocoveritslotteryorslotmachinejackpot,stayawayfromdeepout-of-the-moneys.

3.Tradeslightlyout-of-the-money,at-the-money,orslightlyin-the-moneyoptionsThereasonsherearetheoppositeofthereasonsforavoidingthedeepoptions.Slightlyout-of-the-money,at-the-money,andslightlyin-the-moneyoptionshaveareasonablechanceofprovingprofitablewhenbuying;yougainfromthemaximumpossibletimedecaywhenselling;andtheyaregenerallythemostliquidofthebunch,resultinginatighterbid/askspread,whichinturnsavesontransactioncosts.Theonevariationonthisthemehastodowithsellingoptions;inthiscase,itiscertainlyfine,andevenadvantageous,tosellout-of-the-moneyoptions—withthisonecaveat:Thepremiumreceivedmustwarranttherisk.Whatpricemightthisbe?Therearenohard–and-fastrules;youjustneedtousegoodjudgment.Itisalsoadvisabletousegoodjudgmentwhencuttinglosses.Thisinvolvestakingareasonableorsmalllosswhencoveringshortoptionsthatarenotworking.Itisimportant,aswell,tocutlossesinlongoptionsthataren’tmakingyoumoney.Humannaturemakesitalltooeasytobecomecomplacentwhenbuyingoptions.I’veseentoomanypeopleplaythemoutallthewaytoexpirationwhenalltheindicationssaytheplayisn’tworking.Thisisjustanotherformofhope,andhopeisnotarecipeforsuccess.Thefactthatmostoptionsexpireworthlessshouldbeastrongcluetothebuyertoselloutpriortotheendincasesofnonperformance.Thisiseasytodo—justclickto“sell!”

4.ThereisatimeforallseasonsWhatImeanby“thereisatimeforallseasons”isthatyouneedtohaveafeelformarketconditionspriortoimplementinganyoptionstrategy.I’veknowntraderswhohaveinitialsuccesswithoneoranotherstrategyandthinkthey’ve

foundtheholygrail.Imetadoctorwhowasluckyenoughtoturn$5,000intosixfiguresduringthebullcornmarketof1996.Hisfirsttradewasalongshotthatworked—thepurchaseofdeepout-of-the-moneycallsforMarchthatturneddeeplyinthemoneybyexpiration.Hetookhisprofitsandrolledthemintoat-the-moneyMaysthatalsowentdeeplyintothemoney,thenonceagainintoJulys,andthatworked,too.Hecaughtthebestkindofmarketforthisstrategyandthenproceededtogiveallhisprofitsbackinadullperiodofflatmarkets.I’vealsoseenpeoplewin9ofout10timeswhensellingout-of-the-moneycallsorputs,onlytofallflatontheirfaceslater.Intheearly1980s,afirmcalledVolumeInvestorsbecameoneofthelargestoptionplayersinthegoldpitbycontinuallysellingpremium.Itworkedbeautifullyforyears,butittookjustoneunexpected,volatilespiketowipethemout—tothetuneof$6million.Thelesson:Knowyourmarket.Optionwritingcanbeextremelyprofitableindull,flatmarkets.Ifthetonechanges,coverfastbeforethatcatastrophicloss.Ifoptionpremiumsfeeltoolowtogiveyouanadequatecushionofincome,theyprobablyare.Thecommonwisdomisto“sellflatmarkets,”butIsuggestthisisjustthetimetostartthinkingaboutbuying.Avoidsellinginperiodsofrisingvolatility.Optionpurchaseswillstarttobecomemoreexpensive,butthentherisingvolatilitywillworkinthebuyer’sfavor.Onlywhenvolatilityreacheswildproportionsshouldyouthinkaboutselling—justmakesureyou’readequatelymarginedtotaketheheat.

5.Coveredcallwritingisadecentstrategyforabullishenvironment,andcoveredputwritingisgenerallygoodforthebearThisisoneofthefewstrategieswhereyouusefuturesandoptionstogetherandhavetheabilitytoprofitonbothlegs.Thestrategyworkswellinamodestlybullishorbearishenvironmentaswell.Itisnotriskfree,butitislessriskythantheoutrightpurchaseorsaleoffutures.Furthermore,byusingmylimitedpyramidstrategydiscussedpreviously,youhavetheflexibilitytocapitalizeonamajormovewhenusingcoveredpositions.

6.In“normal”markets,writestraddlesandstranglesSellingputsandcallsworksinmostmarketenvironments.Itisagoodstrategy,aslongasitismanagedproperly.“Normal”isatermIamunabletodefinespecifically;it’smoreofafeelingyouwilldevelopaftertradingforawhile.Inmostcases,thepremiumsreceivedwhenwritingstraddlesandstranglesgiveanadequatecushiontoweathermoststorms.However,whenthetyphoonhitsandyourmarginbalanceisdiminishing,runfortheexitdoor.

7.FindopportunitiestobackspreadBackspreadingisaseldom-usedstrategy,butithaspotentialtomakeyourich.Recallthatthisinvolvessellingacallorputatonestrikepriceandbuyingagreaternumberofcallsatahigherstrikepriceorbuyingagreaternumberofputsatalowerstrikeprice.Looktoestablishbackspreadsforacredittobenefitfromtimedecay,andonlyconsidermarketswiththepotentialtomovebig.Thisstrategyalwayshasapredeterminedandlimitedriskandisoneofthefewthatcanstillprovemildlyprofitable(keepyourequitytogether)whenyou’redeadwrong.Theprofitisunlimitedonamajorupsidemove.Itisnottheholygrail,andtherecertainlyisriskhereaswell,butIknowofoneS&Poptiontraderwhotradedbackspreadsonly.Heheldhisequitytogetherquitewellovermanyyearsandwasalwayspositionedforamajormoveineitherdirection.Duringthestockmarketcrashof1987,hisbearbackspreadsworkedsowellhewasabletoretire!

8.UseoptionstohedgeaprofitablefuturespositionIfyouareatrend-followingtrader,likeme,andyou’reluckyenoughtocatchamajormovethatisshowingmassiveunrealizedprofits,thegreatdilemmaiswhentocashin.Youknowyouinevitablywillhavetogiveupalargeportionofyourpapergainsifyouwaitforconfirmationofatrendchange.Buttopandbottompickingareveryhardthingstodo.Thereisonlyonetop,andthereisonlyonebottominmajormovesofimportance,whichcoulddevelopoverhundredsoftradingsessions.Manytimes,themostimportantlegofamajormovetakesplaceinthelast48hours.Whynotuseputoptionstolockinbull-moveprofitsandcallsforthebear-moveprofits?Commercialhedgersuseoptionsallthetime.Tradingisabusiness,andoptionscanbeaprimetooltohedgeyourprofitwhilestillallowingforadditionalprofits.Forexample,saythatyouownsoybeansinadryperiod.You’reinat$7,andthemarketisnow$9.Thereisnorainintheforecast,it’smid-July,andwithanothertwoweeksofthis,theoldrallyingcallof“beansintheteens”willagainbecomeareality.Optionsaren’tcheap,butthisisasituationinwhichIwouldbuypremiumanyway.The$9Augustputsarerunning40¢.Buythem.Thisisano-losesituation.It’scheapinsuranceat40¢:Youassureyourselfa$1.60profitpercontract—$8,000percontract—andthat’snotbad.Thisisinsuranceyouhopeyouneverneedtouse.Letthegoodtimesrolliftheforecastsprovecorrect!They’renotalwayscorrect,asI’vefoundout.

Duringthedroughtof1988,noweatherservicethatIknowofcalledtheend.Itwasalongholidayweekend,andwhenwewenthomeonFriday,itwas

morethan100degreeswith“zerochanceofmeaningfulprecipitationforatleasttwoweeks.”Soybeanswereapproaching$11,with“beansintheteens”avirtualcertainty.ItremainedhotanddrySaturdayandSunday,withnotacloudinthesky.Then,seeminglyoutofnowhereonMondayafternoon,withthemarketsclosed,theskiesopened.Itpouredrainoverawidearea,andweweregreetedwithamultiple-limit-downsituationbeginningwithourreturnTuesdayattheopen.IfIhadonlyusedputstolockinthesignificantpaperprofits,andithadturnedouttobeamistake,itwouldhavebeenthekindofmistakeIwouldhavebeenhappytomake.Plus,buyingoptionstolockinprofitsonfuturesisthebestwayIknowoftoavoidpremature“profit-taking-itis.”Thisaffectsusallatonetimeoranother.

Bottomline:Optionscanbewonderfultools.They’renotapanacea,butatonelevel,optionscanofferyouthebestofbothworlds.Bealertforwaystousethemtoyourbenefit!

6.TheIntermediateTradingCourse(OrJustEnoughKnowledgetoBeDangerous!)

“Pleasedon’tthinkthatIamshowingoffwhenIsaythatIknowthesecretofhownottolosebutwin.Ireallydoknowthesecret;itisterriblysillyandsimpleandconsistsofkeepingone’sheadthewholetime,whateverthestateofthegame,andnotgettingexcited.Thatisall,anditmakeslosingsimplyimpossible...butthatisnotthepoint:Thepointiswhether,havinggraspedthesecret,amanknowshowtomakeuseofitandisfittodoso.AmancanbeaswiseasSolomonandhaveanironcharacterandstillbecarriedaway.”—FyodorDostoyevsky,TheGambler

Abrokertookonacustomerwithwhomhewastoldtobeextremelycarefulwith.Themoneywasthoughttobefromorganizedcrime.Thecustomeropenedtheaccountwith$50,000andinitiatedalongplatinumposition.Themarketwentdown,andthecustomerboughtmore.Themarketwentdownevenmore,anditwasmargincalltime.Thebrokerwasbecomingabitnervouswiththeposition,butwhenhecalledthecustomer,thereplywas,“Sure,we’llsendyoumoremoney.Noproblem.”Whenthemargincallwentthateasy,thebrokerfeltmuchmorerelaxed.Themarketkeptgoinglower,thecustomerkeptaddingtotheposition,themargincallscontinued,andthecrimebosscontinuedtosendinthemoney.Thebrokerwastalkingwithhiscustomeronedayandconfidedthathewasnotsureplatinumwasgoingtoreboundanytimesoon.Theresponsewassimple,“Let’sgetthisstraight.Youcanhaveallthemoneyyouwant;justremember,wedon’ttakelosers!”

FundamentalanalysisTherearebasicallytwomacro-methodsyoucanusetoanalyzeandthereforetradethemarkets:fundamentalanalysisandtechnicalanalysis.Boththefundamentalistandthetechnicianaretryingtosolvethesameproblem:topredictfuturepricemovement.However,theyapproachthisproblemindifferentways.Fundamentalanalysisbasicallyisthestudyofsupplyanddemand.The

fundamentalistsaysthatthecauseandeffectofpricemovementisexplainedbysupplyanddemand.Here’sanexampleofhowfundamentalanalysismightwork:Fundamental

statisticsareavailableinmarketreports.Youmightreadnewcoppermineproductionthisyearwillbe300,000tons,manufacturingdemandisprojectedtobe400,000tons,and“above-ground”suppliesavailabletothemarketare50,000tons.Afundamentalistwouldconcludethatthesestatisticsprojectacomingsupplydeficitof50,000tons.Therefore,logicallycopperpricesmustrisetorationordiminishthisimpossiblelevelofdemand.Fundamentalanalysisappealstoourlogic.Afterall,ifBrazilissufferingthroughadroughtduringthefloweringphaseofthesoybeanplant,onecanrationallyexplainwhybeanpricesarerising.Agoodfundamentalistisabletoforecastamajorpricemovewellinadvanceofthetechnician.Somefundamentalistshavewhatamountsto“insideinformation”(whichisperfectlylegalinthefuturesmarkets).IfCargillhasascoutinAfricawhoidentifiesacocoa-killingfungusthatisdevastatingthatcrop,oddsareCargillwillactonthisinformationlongbeforeyouorIhearaboutit.Fundamentalistsareabletotradethecourageoftheirconvictionsandarenot

shakenoutaseasilyduringfalsemarketmovements.Theyarebetterableemotionallytomaximizepositionsbecausefundamentalscantakealongtimetochange.Inlate1995,withcorntradinginthemid-$2-per-bushelrange,InoticedChina(formerlythethird-largestcornexporter,andthelargestexporterinAsia)hadturnedintoacornimporter.ThiswasthefirsttimeinhistoryChinahadimportedcornfromtheUnitedStates.China’slivestockproductionhadgrowntoaratethatcouldnotkeeppacewithitsreducedcropproductionofthatyear.Inmymind,thiswasasignificantfundamental,whichwasamajorreasoncornpriceswereabletohitnewall-timerecordhighswithinasix-monthperiod.Nodoubt,fundamentalscanbepowerfulandallowatradertostaywithapositionlongerthanheotherwisemightstay.However,theyalsocanpromptatradertostaywithapositionlongerthanheshouldstay.

TechnicalanalysisOntheotherhand,atechnicianisconcernedwithmarketactiononly.Thebasicissueisnotthatfundamentalsarewhatultimatelymovesprice;thetechnicianconcedesthispoint.Thetechnicianbelievesthatitisvirtuallyimpossibleformostofustoknowallthefundamentalsthataffectpriceatanygiventime.Bythetimethenewsreachesmostofus,ithasbeendisseminatedsowidelythatithasbeendiscountedinprice.Becauseatradermakesorlosesmoneyviaprice

movements,thetechnicianbelievesthisiswhatshouldbestudied.Inotherwords,thetechnicianbelievespriceistheultimatefundamental.Inearly1997,cornhadretreatedbacktothe1995lows—inthemid-$2.50

per-bushelrange.Thepricewaslowbecausethefundamentalsweredecidedlybearish.Supplywasdramaticallyup,withanexcessofa1-billionbushelcarryoversupplyprojected,whichwaslargeforthattime.Thelivestocknumbersweresharplyreduced.Exportswerefalling,andChinahadonceagainturnedintoacornexporter.However,themarkettracedoutatechnical“bottomformation,”andcertaincommodityfundsbought.Otherfunds,seeingthepriceactionmovingup,boughtmore.OnedayinFebruary,theybought100millionbushels.Manyofthecommodityandhedgefundstradetechnically.Itseemedtheyallsawthesamepriceactionatthesametime,andtheyactedonit.The100-million-bushelpurchasepushedpriceshigher,despitethebearishfundamentals.Thehigherpricesattractedmoretechnicalbuying,andthisnewbuyinghitpricestopsabovethemarket.Undercapitalizedshortscouldnotmeetmargincallsandhadtocovertheirpositions,andthismeantmorebuying.Thecommercialfirmsweresellingintothemarket,butthefundsboughtmoreasadditionalpriceobjectiveswerehit.Inafour-dayperiod,thefundsaddedanother150millionbushelstotheirinitialpurchases.Pricessoaredby50¢perbushel,morethan20%.Farmersstartedtonoticethatpriceswererisingandbegantoholdbackontheircashcornsalesastheybecamebullishandwaitedforhigherprices.Inthiscase,atechnicalmoveactuallyresultedinthefundamentalschanging(thatis,arestrictionofsupplyduetolessfarmerselling).Eventually,themarketfellofitsownweight,butthereisnodenyingyoucouldhavemadeaniceprofitinacaselikethisbyignoringthefundamentalsandjustlisteningtothesoundsofthemarket.Inmanyways,technicalanalysiscanbesaidtoincludefundamentals.

However,thereverseisnottrue;apurefundamentalistdoesnotlookatcharts.Thebestfundamentalisttendstomakethemostmoney,butshealsotendstolosethemostwhenshemissessomething.Inthe1970s,therewasaphenomenalporkbellytraderwhohadamassedafortuneamountingtoseveralhundredmilliondollars.Whenshort-terminterestratesstartedtheirrisefrom4%to10%,thisguybegantoshortT-billfuturesunderthefundamentalbeliefthatratesatthislevelwereunsustainable.Bythetimetheyreached18%,hewasbroke.Hewasultimatelyrightinhisanalysisasrateseventuallyplummeted,butnotbeforehelostallhismoney.

Whichisbest:fundamentalortechnicalanalysis?

Correctfundamentalanalysiscanmakeyoumoney,andsocanagoodtechnicalplan.Ineithercase,agoodforecastercangobrokeifheisnotagoodtrader.Agoodtradercanmakemoneyregardlessofwhetherhecanidentifythecorrectfundamentalsortechnicaltoneofthemarket.Mybeliefisthatatradershouldbeawareoftheunderlyingfundamentals,butaprimarilytechnicalapproachcombinedwithasensiblemoneymanagementplan,producesthebestresultsovertime.Inmyexperience,thebesttradescomewhensolidfundamentals(asweseethem)agreewiththetechnicalactionofthemarketplace.My“advancedtradingcourse”inChapter8,“TheAdvancedTradingCourse,”covershowtousetechnicalindicatorsinyourtrading.However,youshouldknowwhatitisyou’retrading(althoughIknowasoybeantraderwhohadnotevenseenwhatasoybeanlookedlikeuntilafterhehadspenthisthirdsuccessfulyearinthepit).

The4futuresgroupingsWhiletherearehundredsofExchange-listedfuturescontractsglobally,andmostofthemhaveliquidoptionsmarkets,themajorfuturesmarketsbasicallycanbearrangedinfourgroupings:

•Financialfutures•Energies•Agriculturals•Metals

Financialfuturesincludethreemajorsubsets:theinterestratefutures,thestockindices,andthecurrencies.Theagriculturalmarketsincludethegrains,themeats,andthesofts.The“softs”aremarketssuchascocoa,cotton,sugar,coffee,andorangejuice.Themetalsareclassifiedaseitherindustrial(copper,aluminum,tin,lead,zinc)orprecious(gold).Somearebothpreciousandindustrial(silver,platinum).Foranyofthemarketsyouhaveaninterestintrading,IsuggestyouconsultthewebsiteoftheExchangewherethatparticularmarketistradedfordetailedfundamentaldata.Thefollowingisaquickanddirtyoverview.

FinancialfuturesFinancialfuturescanbebrokendownintothreebasics:interestrates,stockindices,andcurrencies.Manyofthefundamentalsthataffectonegroupaffecttheothers.Obviously,interestratesaffectstockpricesandcurrencyvaluations.Governmentsallowinterestratefuturestoexistsothathedgerscanneutralizeorshiftsomeoftheirpricerisks.Amortgagebankercantransferhispricerisktoa

speculator,justasacorporatecomptrollercanlockinhercostofborrowingfunds.Thebestwaytothinkofanyhedgeisasatemporarysubstituteforatransactionthatwilloccuratalatertimeinanothermarket.Whentalkingaboutinterestrates,somehedgersareinterestedinprotectingagainsthigherratesinthefuture,andsomelower.Speculatorsaretryingtoprofitfromtheinherentrisksinchangesinthecostofmoney.Ofcourse,inaglobaleconomy,ratescanbemovinginonedirectioninJapanandanotherintheUnitedKingdom.Thefundamentalsthatmoveinterestratesand,therefore,interestratefutures,arevariedanddynamic.Humanemotionisjustasimportantafundamentalascreditflows.Futureshavebeentradedoncommodityexchangesformorethan100years.

Thefirstinterestratefuturescontractwasintroducedin1975.Yieldsreflectinterestratesinvariousmoneymarketinvestments.Itgoeswithoutsayingthattheyieldonashort-terminstrumentis,inmostcases,dramaticallydifferentfromlonger-term“paper.”Youwillsoonerorlaterhearthetermyieldcurve,whichmeasurestherelationshipoftheyieldsofvarioussecuritiesagainsttheirmaturities.Theeurodollarisbasedonashort-term,90-daydebtissue.Technically,aeurodollarisdefinedasanyU.S.dollarondepositoutsidetheUnitedStates(generallydollardepositsatLondonbranchesofmajorworldbanks)that,therefore,fallsoutsidethereserverequirementsoftheFederalReserve.Actualeurodollartimedepositsaresecuritiesavailableinashort-termmaturitytimeframeforeithertakingorplacingdeposits.Inreality,thismarkethasbecomethebenchmarkforshort-terminterestratepricediscoveryforshorter-termU.S.rates.Theeurodollarpricesarequotedintermsofanindex.Theindexisbasedonthedifferencebetweentheactualeurodollaryield.Thereisnodollarsignhere,justthenumber100.Forexample,ayieldof3.00%isquotedas9700.Ifyieldsriseto3.50%,theindexfallsto9650(thedifferencebetween100and96.50).Thecontractsizeis$1million,butbecausethisisa90-dayinstrument,1basispointisworth$25percontract(.01of1%).So,ifyieldsriseby1%,thepricefallsby100basispoints,or$2,500percontract(100pointstimes$25perpoint).The10-year,5-year,and2-yearT-notefuturesandoptionsconsistentlyrankin

thetopintermsofvolume.Treasurybondsfuturesaredesignedtoreflectpricesoflonger-terminterestrates(suchasmortgagerates).Thesecontractsarebasedonasecuritywithafacevalue(paramount)of$100,000.Bondandnotepricesareamirrorimageofinterestrates.Wheninterestratesrise,bondandnotepricesfall(andviceversa).ThereareinterestratefuturesonEuropeanpaper,Japanesepaper,Canadianpaper,andonandon.Thefundamentalsthat

determineinterestratesarecentralbankmanipulation,withthecentralbankssupposedlybasingtheirdecisionsonthelevelsofunemployment,inflation,andeconomicactivity.Thereareallkindsofstatisticsthefundamentalistcananalyze,everythingfromhousingstartstobalance-of-tradefigures,carsales,andretailsales.Theproblemafundamentalisthasisthatthereisjusttoomuchinformationoutthere,andtheeconomyistoocomplextomakeconsistentlyaccuratepricepredictionsofinterestratesorstockmovements.Therearedozensofstockindextrades,theprimaryU.S.indexintermsof

futuresvolumebeingtheS&P500Index,followedbytheNASDAQandRussell.TradedontheChicagoMercantileExchange(CME),theS&P500representsthe500biggestU.S.stocks,accountingforabout80%oftotalU.S.sharestraded.Itisaweightedindexcomposedroughlyof400industrialcompanies,40utilities,20transportationcompanies,and40financialcompanies.Itis“weighted”becauseabiggercompanycarriesproportionatelygreaterweightintheindex.TheE-MiniS&Pisthemostactivelytradedcontractintermsofdollarvolumeandisoneofthedaytrader’sfavoritesbecauseitisliquidandcanbevolatile.Day-tradingmarginsaregenerallymuchsmaller,butatraderisalwaysobligatedforthedifferencebetweenentryandexit.Inotherwords,ifyoulose,youmustpaythepiperbytheendoftheday.Themajorstockmarketfundamentalsarethesameasforinterestrates,but

throwinpoliticalconsiderationsandinvestorattitudes.Let’sfaceit:Anyonething(war,aleader’sdeath,aninterest-ratehike,a

majorcompany’searnings)couldaffectthestockmarketonanyparticularday.Thestockmarketsoftheworldgenerallymovetogether;however,anyonemarketcancertainlymoveoppositethepack,basedoninternalconsiderations.Onethingseemsclear:Attitudesandeconomictrendstendtolastforawhile;therefore,themajortrendsofthestockmarkettendtolastforawhile.It’sthoseminortrendsthatcankillyouormakeyourich.Theveryfirstfinancialfuturescontractswerebasedonforeigncurrencies.It

shouldbenotedthatthespot(orforwardmarket)ismuchbiggerthanthefuturesmarket.Theforwardmarket,alsoknownastheinterbankmarket,isdominatedbycurrencydealersatmajorglobalbanks.Whilethespotmarket’svolumetowersoverthelistedExchangevolume,thisvehicleisnotavailabletotheaverageinvestor.Theaverageunitis$1million.CurrenciesalsocanbetradedatretailFOREX-typeoutlets.Theactivefuturescontractsatthistimearetheeuro,yen,Swissfranc,Britishpound,andAustralianandCanadiandollars.TheU.S.dollaristradedasanindex,andofincreasingimportancearecurrenciessuchastheBrazilian,Indian,Russian,andChinesecurrencies.ThrowintheNew

Zealanddollar,theSouthAfricanrand,andotherAsiancurrencies,andthereisacurrencymarketforjustabouteverycurrencytrader.Thepriceofacurrencyisdeterminedinthesamewayasthepriceofany

othercommodity.Currencyusershaverisks.Ifacurrencydepreciatesinvalueandamanufactureristoreceivethiscurrencyinpaymentforaproductthathewilldeliversixmonthshence,helosesmoney.Ifnothedged,hisentireprofitmargincouldbewipedout.IfthepeopleintheUnitedStatesdemandmoreJapanese-madegoods,thedemandfortheyengoesupinrelationtothedollar,andAmericanswillhavetopayhigherpricestoinduceholdersofyentosell.IfinterestratesgoupinGermanyinrelationtotheUnitedKingdom,theeurowilllookrelativelymoreattractiveasaninvestmentthantheBritishpound.Fundamentalistslookattradebalances,acountry’swealth,budgetdeficitor

surplus,interestrates,inflation,andpoliticalfactorssuchastaxrates.Inaddition,centralbankinterventiontosupport(ornotsupport)acurrencyis

definitelyamarket-movingfactor.Attimes,acountrycanmovealonetosupportitscurrency,andsometimesanorchestratedgroupeffortisunderwaytoattempttosupportsomecurrency.Thecentralbanksarehuge,butthey’renotalwayslargerthanthespeculativecommunity.Iftheultimatefundamentalsareopposedtoartificialsupport,acurrencycanstillmovecontrarytothewishesofthecentralbanks.ThiswasdemonstratedwhenGeorgeSoroswasabletobreakthebackoftheBritishpoundandsuccessfullychallengetheBankofEnglandinthelate1980s;heprofitedtothetuneof$2billion.Obviously,someofthesefactorsaresubjective,whereasothersarehardto

predictinadvance.Ultimately,capitalflowsarethemajorfundamentalthatdetermineswhatacurrencyisworth,andthesearedeterminedbytheconsensusoftheworld’straders.

EnergiesTherearetwomajorenergyexchanges.TheICEtradesanactiveBrentCrudeOil,andtheCMEtradesanactiveWTI(WestTexasIntermediate)CrudeOilcontract.WhenIfirstenteredthebusiness,apartofmytrainingprogramatMerrill

LynchwasatouroftheExchangefloor.TheNewYorkExchangeswerehousedinthesamebuilding,andaftertouringthewildandwoollyCOMEX(wherethemetalsweretraded—nowawhollyowneddivisionoftheCME),wepassedapitwithfourorfivetraders,notoneofwhomwasshoutingoutbidsoroffers.(Infact,afewofthemwerereadingthepaper.)WeweretoldthiswastheNYMEX,

the“poorman’sExchange,”alsocalledthe“PotatoExchange,”whereplatinumwasthemajorcontract.Youcouldhaveboughtaseatfor$2,000,butthenthe$100permonthduesmadethisappeartobealosingdeal.Afewyearslater,theyhadtheforesightandgoodfortunetoregistertheirNo.2HeatingOilcontractwiththeCommodityFuturesTradingCommissionandstarttradingitin1978.TheNYMEXbecameoneoftheworld’smajorExchanges,andwhentheExchangewentpublic,aseatwasworthinexcessof$3million.(Ifonlywehadknowninthose“poorman”daysandhadpickedupafewofthosecheapseats!)Crudeoilistheworld’slargestcashcommodityintermsofdollarsand

volume.(Theannualvalueexceeds$500billion.)Over20%oftheworld’sentiretradeisinoil.(Onlycurrenciesarebigger.)TheWTIisalight,sweetcrude,preferredbyrefinersduetoitslowsulfurcontent.Mostoftheworld’ssupplyissour(high-sulfur)crude,butbecausethesulfurcontentvarieswidely,thecontractbasedonWTIisoneofthetwopacesettersforworldoilpricesingeneral.BrentCrudeisalsoliquidandactive,basedontheEuropeanNorthSeavarietybutabenchmarkformuchoftheoiltradedinEuropeandAsia.Bothare1,000-barrelcontracts.Ifyouthinkyouhaveaprettygoodideawhothetopoilplayers,thetopproducers,andthetopusersare,youjustmighthavetorethinksomeofyourassumptions.Thekeycountriesinoilasofthiswritingareasfollows:

•Producers—SaudiArabia,Russia,UnitedStates,Canada,Venezuela,Iraq,Iran,China,Nigeria,Kuwait,UnitedArabEmirates,andMexico•Consumers—UnitedStates,China,Japan,Germany,India,Brazil,France,Russia,SouthKorea,UnitedKingdom,andSpain

Ofcourse,theserankingsaredynamic(constantlychanging).Whenmylastbookwenttopress,forexample,Japanwasthenumber-twoglobalconsumer,butithasbeenreplacedbyChina.TheUnitedStatesaswegotopressisfarfromenergyindependence,butthatisthegoal(andasoldergasguzzlersareretired,moreefficientcarsarehelpingtowardthatgoal).Thatsaid,therearealotofcommonmisconceptions.DidyouknowtheUnitedStatesisthe3rd-largestcrude-oilproducerintheworld?Whenasked,mostpeopledon’tplacetheUnitedStatesinthetop10.TheU.S.problemisnotthatproductionisallthatsmall.Ithaddeclinedforover20years,from1985to2005,butsincethenhasbeengrowingagain.In2012,forthefirsttimeinhistory,oilproductioninNorthDakotasurpassedthatinAlaska.Texasbyfarremainsthehighest-producingstate.TheUnitedStatesproducesmoreoilthananyothercountrygloballyexceptSaudiArabiaandRussia.TheproblemisthattheUnitedStatesgulpsthestuff,everydayburningthroughmuchmorethanitproducesdomestically.The

UnitedStatesstillconsumesfourtimesmoreoilpercapitathanthesecond-largestglobalconsumer.In2010,however,forthefirsttimeinhistory,totaloilimportsasapercentageoftotaldomesticconsumptionwashigherinChinathanintheUnitedStates.WereyousurprisedKuwaitandNigeriaarenotamongthetopsevenproducers?Iraqisthesecond-largestcountryintheworldintermsofprovenreserves(112billionbarrels).Theneweststarintermsofproduction—veryclosetoSaudiArabiabecause

ofinvestmentinimprovedtechnology—isRussia(alongwithsomeformerSovietstates).RussiaisnotanOPECmember,soOPECisfarlessimportanttodaythanitwas30yearsago.AsOPEChaslostmarketshare,it’slostitspricecontrolaswelltofree-marketforces.China’sproduction(wereyousurprisedtoseeChinainthetopseven?)has

alsobeenincreasing;however,itsconsumptionisincreasingatafarfasterrate.In1993,Chinaturnedintoanetoilimporter.Japanhasthebiggestproblembecauseithasnodomesticproductionatallandistotallydependentonimports.ChinahasthesameproblemasJapanandtheUnitedStates,becauseitisdependentonimportstofillthegap,butitsrateofconsumptionversusitsproductionisacceleratingatthefastestrateintheworld.TheramificationsoftheincreasingindustrializationandeconomicgrowthofChina,India,andBrazilwillhavethemostprofoundofalldynamicsonoilpricesinthecomingyears.RealizethatChinahasfivetimesasmanypeopleastheUnitedStates,yettoday,itusesjustone-fourthofwhatAmericauses.Whathappensasthisgapcloses?It’sclearthatwhileoilpriceswillcontinuetofluctuate,inthenextfewyears,demandwillincreaseatafasterratethannewsupply.Unlessalternativeenergysourcestakehold,thecheappricesofyearspastaregoingtoremainamemory.Formanyyears,theNYMEXheatingoilcontractwasthesecond-most-liquid

energycontract,althoughinrecentyears,ithasbeenovershadowedbynaturalgas.Itisalsoknownasthenumber-twofueloilandaccountsforabout25%oftheyieldofabarrelofcrude.Thiscontractalsoisusedbyhedgersofdieselfuelandjetfuel,bothofwhicharechemicallysimilartoheatingoil.Thecontractsizeis42,000gallons,anda1¢moveequalsaprofitorlossof$420.Futurespricesforunleadedgasolinemightappeartobetoocheapwhen

comparedtothepumpprice,buttheyarebasedonthewholesalepricefordeliveryatNewYorkHarbor.Thepriceyoupayatthepumphasallthosecostsaddedtogetittothestation,includinglocalandnationaltaxes.Unleadedgasolineisbyfarthemostimportantproduct,accountingforalmosthalfoftheyieldfromabarrelofcrude.Thecontractsizeisalso42,000gallons,witha1¢move(100points)equaltoaprofitorlossof$420percontract.

Thirtyyearsago,sevenmajoroilcompaniesowned50%oftheworld’soilreservesandproducedtwo-thirdsofitscrudeandproducts.Today,thesesamesevenownlessthan10%andproducelessthanone-thirdoftheproducts.OPECisstillafactorbutnolongerthemajorpricesetter.Themajorpricesetterisnowthemarketplace.Thefollowingfactorsareimportantandmustbeconsideredinanyfundamentalanalysisoftheenergymarkets:weather,inventoryreports,OPEC,andother“political”actions.Formanyyears,U.S.naturalgaspricesweresubjecttogovernmentprice

controls;ithasonlybeenrecentlythatthechainshavebeenbroken.Thecontract,whichstartedtradingin1990,isnowthesecond-most-activelytradedenergycontract.Ofallthenaturalgasthatisproduced,industry(includingutilities)usesabouttwo-thirds,andhomeownersuseone-fourth.An80-yearsupplyofnaturalgasisavailableunderAmericanground,anditisvirtually“free”totap,exceptforthetransportationandstoragecosts,withmiddlemanprofitsinbetween.Thecontractsizeis10,000MMBtu(millionBritishthermalunits),withpricequotedindollarsandcentsperMMBtu.Thepriceofnaturalgaswasabout$1in1992andabove$10duringthewinterof2000(whenitwasfreezingcoldinbothNorthAmericaandEurope)exchanges.Then,thepricedroppedunder$2ayearlaterandonceagainralliedover$10duringthewinterof2003.

AgriculturalsFutureswereinventedinthesixteenthcenturyfortheJapanesericetrade.Theagriculturalmarketscontinuedtodominatefuturestradingthroughoutthefirst75yearsofthetwentiethcentury.Today,agriculture,whilestillimportant,accountsforperhapsone-quarterofglobalfuturestrade.Humansandanimalsrequirefat,protein,andcarbohydratesforsurvival.

Althoughmeatisgenerallythoughtofasthepredominantproteinsource,muchoftheworld’shumanpopulationandamajorityoftheworld’slivestockpopulationsobtaintheirproteinfromsoybeans.Cornisthepredominantcarbohydratesourceusedforanimalfeed.

OilseedsSoybeanswerementionedinancientChineserecordspriorto2000B.C.TheUnitedStates,nowaccountingforunder50%oftheworld’soutput,wastheworld’slargestsoybeanproduceruntil2004.Priortothe1980s,theUnitedStatesaccountedfor80%oftheworld’soutput,butCarter’sgrainembargopromptedtheJapanese,whowerelookingforamorereliablesupplier,tofund

theBraziliansoybeanindustry.In2000theUnitedStatesplantedabout65millionacresofbeans.In2012,thatnumberwasupto80million.Theacreagekeepsgrowing,butsodoestheworld’spopulation(whichisgrowingatover80million—thesizeofaMexico—eachandeveryyear).Today,morethan50%oftheworld’ssoybeancropisgrowninSouthandCentralAmerica,primarilyinBrazilandArgentina.Chinaaccountsformostoftherestoftheworld’sproduction,butitremainsamajorimportermostyears.Calledthemiraclecrop,soybeansareusedinthousandsofapplications,primarilycrushedformeal(usedasananimalproteinfeed)andoil(forhumanconsumptionandasacookingoil).Financially,itisgenerallythemostvolatileofallthegrains,although,technically,itisnotagrainbutalegume(alsoknownasanoilseed).Thecontractsizeis5,000bushels,withpricesquotedindollarsandcentsperbushel.A1¢moveisworth$50percontract.Therichestproteinsourceofalltheoilseedsissoybeanmeal;afeedstuff

suitedforcattle,hogs,andpoultry.Onebushelofsoybeansweighsabout60poundsandyieldsabout48poundsofmeal.SixtypercentofU.S.productionisuseddomestically,andthebalanceisexported.Acontract’ssizeis100shorttons(2,000poundsperton),withpricesquotedindollarsandcentsperton.A$1moveequalsplusorminus$100percontract.Thecontractfortheothermajor“product”ofthesoybean,soybeanoil,is

sizedat60,000pounds.Onebushelofbeansproducesabout11poundsofoil.Thisisanediblevegetableoilandcompetesintheworldmarketwithotheredibleoils,suchaspalm,peanut,canola,corn,olive,andsunflower,andevenfatssuchaslard.Pricesarequotedincentsperpound,witha100-pointor1¢moveequaltoaprofitorlossof$600percontract.ThemajoroilseedgrowninCanadaiscanola.Canola,theoilofchoiceamongthehealthconscious,generallywillhavepricemovesinthesamedirectionassoybeans,althoughatadifferentspeed.Palmoilistheworld’ssecond-most-heavilyproducedvegetableoil,anditis

tradedinMalaysia.ProductionisdominatedbyMalaysiaandIndonesia.Palmoilcompetesdirectlywithsoybeanoilandcanolaoil,butitgenerallytradesatadiscountbecauseofhealthconcernsaboutsaturatedfatintropicaloils.Palmoilisattractivetocountrieswithexpanding,low-incomepopulations.

GrainsTraditionally,thehighestvolumeofthegraincontractsiscorn,themajorU.S.-growncrop.Thecontractspecificationscallforfeedcorn,notthevarietyusedforhumanconsumption.Inrecentyears,inexcessof85millionacresofcorn

havebeenplantedannuallyintheUnitedStates,producingcropsthatcanexceed13billionbushelsinagoodyearandaccountingforone-halfoftheworld’sproduction.TheUnitedStatesconsumes70%ofitscropdomestically(75%ofthisisusedtofeedanimals,and25%isusedtoproduceethanol),withthebalanceexported.Theoatmarketisgenerallyaslower-moving,morethinlytradedmarket.Oats

istheonlymajorcropthattheUnitedStatesimports,primarilyfromtheScandinaviancountries,Argentina,andCanada.Millingquality(usedinoatmealandotherformsofhumanconsumption)andfeedoatsarethetwomajorvarietiesofoats.Thecontract,whichisfor5,000bushels,tendstoactmorelikeafeedcontract,basedonthedeliveryspecificationsthatfavordeliveryoflower-qualityoats.A1¢moveperbushelequalsplusorminus$50percontract.Wheatisthe“staffoflife’”andisgrowninmorethan80countries.The

UnitedStates,Russia,theUkraine,Canada,China,Argentina,andIndiaarethemajorproducingcountries.TheChicagocontractisthehighestvolumecontractintheworld.ThedeliverablegradeisSoftRedWheat,usedforcakes,pastries,andcereals.ThiscropisgrownintheareaaroundsouthernIllinoisandMissouri.TheKansasCityandMinneapolisvarietiesaredeliverableontheChicagocontract;however,becausetheygenerallytradeatapremiumpriceandhavefreightconsiderations,thisdoesnothappenoften.However,ifChicagopricesevertradeatagreaterthan20¢premiumtoMinneapolis(thecostoffreightfromMinneapolistoChicago),ithasnotbeenunheardofforamajorgraincompanytoloadaunittrainofwheat(100railcars)andsendthattrainsouth.Thecontractsize,asitisforalltheCBTcontracts,is5,000bushels,soa1¢pricemoveequalsplusorminus$50percontract.TheKansasCityBoardofTradeiswhereHardRedWinterWheatistraded.ThisbreadwheatisthemostimportantclassofwheatgrownintheUnitedStates,accountingforhalfoftheproduction,butthevolumethereislowerthaninChicago.ThiswheatisgrownprimarilyinKansas,Oklahoma,andTexas.Itisplanted,liketheCBTwheat,inthefallandharvestedinearlysummer.Itliesdormantoverthewinter,andthat’swherethenamecomesfrom.Thecontractsizeis5,000bushels,anda1¢movealsoequals$50.TheprimarycontractofthesmallMinneapolisGrainExchangeisNorthern

HardSpringWheat.Thiswheatisahigh-protein,milling-quality-typewheatgrownprimarilyinMinnesota,NorthandSouthDakota,Montana,andCanada.Itisusedinspecialtybakeryproductssuchascroissants,Frenchrolls,andbagels.Itisplantedinlatespring(hencethename)andharvestedinlatesummer.Becauseitisahigher-proteinwheat,itgenerallytradesatapremium,

from20¢touptodollarsperbushelabovetheChicagoExchange.IhaveseenittradeatpricesbelowChicago(1996wasaverypoorwinterwheatcropandabumperspringwheatcrop)andasmuchas$12overin2008whenMinneapolistradedashighas$25/bushelonadevastatedspringwheatcrop.TheSpringWheatcontract,liketheothers,isfor5,000bushels.WhiteWheat,thefourthmajorwheatvariety,represents10%oftheU.S.crop

andisgrowninthePacificNorthwest.Itisusedincrackersandpitabread.Forthegrainsandthesoybeancomplex,fundamentalanalystssetuptables

anddebatewheretheendingstocksultimatelywillbeattheendofthecropyear.Ifitlookslikestocksaretoolow,higherpricesareneededto“rationdemand.”Ifstocksappeartoohigh,lowerpricesaretheresult,asfarmersellingoverwhelmsdemand.Thesupply-and-demandtableforsoybeans,forexample,includesthefollowing:

•Beginningstocks:Thisiswhatthegovernmentsayswillcarryoverfromthepreviousyear.•Production:Thisisthecropestimateforthecurrentyear.Duringthegrowingseason,theUSDAreleasestheweeklyCropProgressReport,whichshowstheconditionofthecrop.•Imports:BecausetheUnitedStatesisanexporter,thisisgenerallyasmallnumberfortheU.S.table.•Totalsupply:Thisisthebeginningstocksplusproductionplusimports.•Crush:Thisisthedomesticdemandbythe“crushers,”whobuyrawsoybeansandcrushthemintotheproducts,meal,andoil.•Exports,seed,andresidual:Thesearetheothersourcesofdemand.Eachyear,3%to4%ofthecropisheldbackforthenextyear’sseeduse.ExportdataisreleasedtwiceweeklybytheUSDA.ThereisaMondayreport,calledExportInspections(aftertheclose),andthereisasimilarThursdayreport,calledExportSales.Exportsalsocanbeaffectedbythestrengthorweaknessofthedollarandothermajorcurrencies.Ifthedollarfallsdramatically,itmakesthesecommoditiescheapertoforeignbuyersandhelpstostimulateexportdemand(andviceversa).•Totaldemand:Thisisthesumofthecrush,exports,seed,anda“residual”numberforotheruse.•Endingcarryoverstocks:Totalsupplyminustotaldemandequalsthecarryover,orending,stocks.Thisistheimportantnumbereveryonetalksabout.Asupply-and-demandtablecanbesetupforasinglecountryorthe

world.Thesetablestheoreticallycouldbeconstructedbeforethecropisinthe

ground.Ifproductionfallsbyjust100millionbushels(acouplebushelsperplantedacre),theendingstockscoulddroptoan“unsustainable”number.(“Pipelinesupply”isconsideredtobeendingstockssomewhereintheneighborhoodofjustover100millionbushelsforsoybeans.)Thiswouldbeperhapsafewweek’ssupply.Ontheotherhand,ifyieldsinayearincreasedbyjustafewbushelsperacrebecauseoffavorablegrowingconditions,theendingstockswouldrisetoperhaps300millionbushels(whichisacomfortablelevel).Basically,afundamentalanalystconstantlyadjuststhesenumbersbasedonweeklyexportandcrushnumbers,aswellashisdeterminationofhowthecropismaturing.Benchmarksforwherepriceshavegonebeforearebasedonvariouscarryoverlevels,buteveryyearseemstobecompletelydifferent.Thefollowingaresomeotherimportantfundamentals:•“Deliverablestocks”ofgrain:TheExchangedistributesinformationonthefollowinginaweeklyreport:thequantityandchangeofbushelsofcorn,wheat,soybeans,andoatsintheelevatorslicensedtodeliveronthefuturescontracts.Thereportisusefulindeterminingwhetherthereisthepotentialfora“squeeze,”wheretheshortsarenotabletofindthegraintodeliver.Ifallthecornisprimarilyonthefarmandverylittleisavailableforfuturesdelivery,thisisshort-termbullish(eventhoughthelonger-termfundamentalscouldbebearish).Ifthereisalargesupplydeliverableandthecommercialplayershavenoexportbusiness,thebestplaceforthemtosellmightbeafuturesdelivery(tospeculatorswhoreallydon’twantthegrain),andthisisbearish.Thesenumbersaremostusefulforanalyzingthenearestfuturesmonth.•Governmentpolicy:Governmentfarmprogramscanexpandorrestrictacreageingeneralorforaspecificcrop.Pricesupportprogramscanpullsupplyoffthemarket,and“exportenhancement”programscanstimulateexports.•Weather:Thisisthebiggestfactorwhenanalyzingfuturesupply.Nothingaffectssoybean,corn,andwheatpricestoagreaterdegreethanweather.A“weathermarket”occurswhendroughtorfloodingmovesthemarket.Thesecanbethemostemotionalofallmarkets.InthespringintheUnitedStates—and,infact,inmostoftheNorthernHemisphere—themarketwatchestheplantingprogress(forsoybeans,corn,andspringwheat).Inthesummer,themarketmonitorsthecropdevelopment,andintheautumn,

itkeepstrackoftheharvestprogress.IntheNorthAmericanwinter,themarketwatchestheplantingprogressandcropdevelopmentoftheSouthAmericancrops(duringtheirsummer).Inthespring,itwatchestheirharvestprogress.Awetharvestcancausedelaysandhurtyields.Inthewinter,themarketwatchestheweatheraffectingthedormantWinterWheat.Thewheatneedssnowcover,orelseitissusceptibleto“winterkill,”ifthetemperaturesdroptoolowwithouttheinsulatingeffectofsnow.Weatherissoimportantthatservicesforhireprovideweatheradviceandpredictions.•Seasonality:Allotherfactorsremainingequal(aboldstatement),thegrainsandoilseedsdoexhibitcertainseasonaltendencies.SoybeansandcorntendtoputinahighintheMay-to-Julyperiod,attheheightofthe“weatherscare”period,andbottomoutatharvesttimeintheOctobertoDecembertimeframe.Cottonexhibitsthesameseasonaltendency.WinterWheattendstobottomoutintheJune-to-Julyperiod(harvesttime)andpeaksinJanuarytoMarch,whensuppliesaredepletedtoanextentbutbeforethenewcropisavailable.Iamnota“seasonal”trader—withtwoexceptions.ThesearewhatIterm“superseasonals.”

TheVoicefromtheTomb(superseasonal#1)

“I’mnotafraidofdying;Ijustdon’twanttobetherewhenithappens.”

—WoodyAllen

WhenyouhavetradedaslongasIhave,youacquirealotofknowledge.Unfortunately,notallofitisuseful;however,Ibelievethismighthelpyou.Ihavediscoveredtwoseasonaltendenciesthatcouldhelpyoucaptureprofits:oneinthesoybeanmarketandtheotherinthewheatmarket.The“VoicefromtheTomb”isawheatseasonal.Between1983and1995,mytradingbusinesswaslocatedonthefloorofthe

GrainExchange,whereImetaverysuccessfulold-timetrader.Othertraderswouldaskthisman’sopinion,whichwashighlyregardedbecausehewasknownasasuccessfultrader.Hisresponseoftenwas,“Listentothe‘VoicefromtheTomb.’”Overtheyears,Ibefriendedhimandfinallygotupthenervetoaskhimwhathemeantbythisstatement.HetoldmethattheVoicefromtheTomb(VFTT)wasoneofthesecretsofhissuccess,andthelegendgoessomethinglikethis:

Yearsago,amillionairegraintraderlosthiswifeanddedicatedhislifetohisthreechildren.Butasinmanysecondgenerationsofself-madepeople,thechildrenwerelazyandthoughttheywouldinheritallhismoney.Asheaged,hebegantolookathischildrenaswasteful,andhebelievedtheytookhimforgranted.Whenhedied,heleftnothingtothechildrenandinsteadgaveallthemoneytocharity.Allhelefttheminhiswillweredatesofwhentobuyandsell.Thewillstatedthatiftheystrictlyfollowedhisadvice,theywouldhavethefortunetheyhadalwaysexpectedtoinherit.

Then,myfriendsharedtheVFTTdatesforthewheatmarket:•SellMarchwheatonJanuary10.•BuyMaywheatonFebruary22.•SellJulywheatonMay10.•BuyDecemberwheatonJuly1.•SellDecemberwheatonSeptember10.•BuyMarchwheatonNovember28.

Hetoldmethesedatesworkedforhim80%ofthetime(aremarkablepercentageforatradingprogram),butheneversharedexactlyhowheusedtheminhisowntrading.So,Iwentbackandstudiedthewheatcharts.Iresearched35years’worthofrecordsandfoundthattheVFTTwas

historicallyprofitableapproximatelyin75%ofthetrades,basedonthecriteriaIdeveloped.IusedtheVoicefromtheTombdatessimply:Originally,Iwouldbuyorsellatthecloseofeachdateandrisk15¢perbushel,or$750percontract,tomake15¢,or$750percontract.IfadatefellonaSaturday,IwouldtakethetradeontheFridayclose;ifthedatefellonaSunday,IwouldusetheMondayclose.Istartedtradingitwithrealmoneyin1999,anditworkednicelyforeightyears,upuntil2007.Theactualresultswereasfollows(numberofprofitsinsixtradesignalsannually):

•1999—Fiveoutofsix•2000—Fouroutofsix•2001—Sixoutofsix(seeFigure6.1)

Source:CQG,Inc.©2008.Allrightsreservedworldwide.

Figure6.1.2001wheatmarket(VoicefromtheTomb)

•2002—Fouroutofsix•2003—Fouroutofsix•2004—Threeoutofsix•2005—Fiveoutofsix(seeFigure6.2)

Source:CQG,Inc.”2008.Allrightsreservedworldwide.

Figure6.2.2005wheatmarket(VoicefromtheTomb)

•2006—FouroutofsixSo,duringthiseight-yearperiod,Iexperienced30profitsandonly12losses.

Andin2001,itwasperfect:sixtradesandsixprofits.Theoverallresultwasmorethan70%profitable—anicelittleprogram.In2005,itresultedinfiveprofitsandonlyoneloss,asshowninFigure6.2.ForthetimeIbegantradingwithrealmoneyuntil2007,Ihadonebreak-evenyear,sevenprofitableyears,andnolosingyears.In2007,thesystemself-destructed:Theresultswereonlytwoforsix.Whatmadethatyearworsewasthatthefirsttradewasashortsalethatcameoutthedaybeforeamajorcropreport.Thecropreportwasbullish,resultinginasharpgaphigheratthemarketopenthedayofthereportandcreatinga27¢lossonour15¢stop.Now,Ineededtwowinsjusttomakeupforthatoneloss,but,unfortunately,thenexttwotradeswerelosersaswell.ThiswasalsothefirstandonlytimesinceIhadbeentradingtheVFTTthatithadthreelosingtradesinarow.Itoldmyclientsthatsomethinghadchanged,somethingwasnotright.Aftereightyearsofawinningprogram,Iretreatedtothesidelines.Asitturnedout,twoofthethreeremainingtradesthatyearworked,butoverall,thiswastheyeartheVFTTdidn’twork.

Theninsummer2008,aclientofminewhohadbeenontheprogramforyearsandwasstillmonitoringitaskedifIhadbeenwatchingtheVFTT.Hesaidthatafterwequit,itwasworkingnicelyagain.Duringthelastthreetradesof2007andthefirstfourtradesof2008,itwasfiveforsevenandrightbackontrack.So,Itookanotherlookattheprogramthathadbeensogoodforsolong,andthisiswhatIdiscovered.RememberthebadtradeinJanuarythattookplacerightbeforeamajorcrop

report?Ifthesignalhadtakenplaceonedaylater,attheclosethedayofthecropreport,itwouldhaveworked.TheMaysignaldidn’twork,andIgaveupbeforetheJulysignal,butthatoneworkedlikeachamp.TheSeptembersignalwouldnothaveworked,butifithadtakenplaceonedaylater,itwouldhaveworked.AndtheNovembersignalworkedjustfine.Thistoldmethatthebasicseasonaltendenciesstillseemedtowork,butsomethingwasoffadayortwoforcertainsignals.ThatsomethingwasthemajorcropreportinbothJanuaryandSeptember,whichskewedtheprogram.Andguesswhat?Fordecades,thecropreporthadcomeoutonthe10thofthemonth.Butduetodatechanges,theJanuaryreporthadcomeoutadaylaterthantheusualdate,ashadtheSeptemberreport.IbelievetheVFTTworksbecauseit’sbasedonnormalseasonaltendenciesforthewheatmarket.Forexample,theJulybuysignaltakesplaceaboutthetimethewinterwheatharvestisapproximatelyhalfover.Becausemanyfarmersselltheirwheatcroprightoutofthefieldsatharvesttime,thetendencyisforpricestofallintotheharvestperiodbecausetherearegreater-than-normalsuppliesavailabletothemarketplaceatthattimeofyear.Thefuturesmarketanticipatestheendofharvestandgenerallybottoms,andthenitstartstoclimbastheharvestperiodturnsthecornerandunwinds.Whenacropreportcomesout,tradersreacttoit.Abullishreportmightbe

releasedduringanormallyweakseasonalperiodandmightspikethemarkethigher.However,inanormalyear,themarkettendstomovealongthenormalseasonalpathofleastresistanceafterthenewsisout.Basedonitsstellarpast,itwastimetorevisittheVFTTprogram,butwithonemajormodification:lookingatthetradingcalendartodeterminewhenthemonthlycropreportwillbereleased.Ifasignalisduetotakeplacethedaybeforethereport,wewaitadayandbuyorsellattheclosethedayofthereport.Mytheoryisthis:Iftheseasonalisbearishandthereportisbullish,wewillshorttheartificialspikeandthenletthebearishseasonaltakeover.Ifthereportisbearishandweendupsellinglower,thenormalseasonaltrendwillbailusoutanyway.Thisimprovementwouldhaveturneda2-and-4yearintoa4-and-2yearin2007andmaintainedthewinningstreak.Usingmynewrules,thesubsequentresultswere

asfollows:•2008—Fouroutofsix•2009—Fouroutofsix•2010—Fiveoutofsix(seeFig.6.3)

Source:CQG,Inc.©2012.Allrightsreservedworldwide.

Figure6.3.2010wheatmarket(VoicefromtheTomb)

•2011—Threeoutofsix•2012—Fouroutofsix

Onelastobservation:Thinkofmy15¢ruleasanoptimizationrule.Thetrendoftenmovesmuchfarther,andyoucanmakeconsiderablymorethanthe15¢/bushel.Sometimes,youneedtotake15to20,andothertimes,youcanmakealotmore.Forexample,considerthe2008February22signal:Thebuycameat$10,andwithzeroriskonthatsignal,themarketralliedabove$12,or200¢($10,000percontracttraded),injustthreetradingsessionsbeforethefirstsignificantcorrectionoccurred.So,youmightwanttowaitandwatchabitwhentheprofittargetismet,anduseatrailingstop.Onemethodistoraiseyourstoptoensureamodestprofitwhenthe15numberisreached,andtrytomaximizethetrade.

Bottomline:IbelievetheVFTTwillputtheoddsinyourfavor.Justwatchoutforthosecropreports.Sometradersbelievethatseasonalsexistinmanymarkets,suchasgold,butin

myexperience,I’veobservedthemsuccessfullyonlyinthegrainmarkets.Bytheway,VoicefromtheTombdatesoccurforcornaswell.But,myexperienceisthatthey’renotasaccurateasthoseforwheat,whichiswhyIdidn’tincludethemhere.However,Ihavediscoveredmyownextremelyreliableseasonalforthesoybeanmarket.Soysecret(superseasonal#2)

“Threemaykeepasecret,iftwoofthemaredead.”

—BenjaminFranklin

IwanttosharewithyouanothersuperseasonalIcallthesoysecret.Thesoysecretissimplythis:SoybeansexhibitanextremelystrongtendencytoformaseasonalpricebottomduringOctober.Thelargenumberoffarmerswhotendtoselltheircroprightoutofthefields

togeneratecashatharvesttimeresultsinsellingpressureandcreatesthisbottomingtendency.Sometimes,particularlyinhigh-pricedyears,thismarketbehaviorismorepronouncedthaninothers.Aftertheharvestsellingpressuresubsides,thesoybeanmarkettendstoexhibitapost-harvestrally,offeringaprofitabletradingopportunity.WhenIquantifiedtheprobabilitiesforasoybeanpricerisepost-harvest,I

discoveredsomethingquiteexciting:Mydatabasecovers43years,beginningwiththe1968–1969cropyear.InthespreadsheetshowninFigure6.4,Isortedthisdatabythepercentagegain(lastcolumnontheright)theJulysoybeanfuturescontractmadefromitsOctoberlowpricetotheJulycontracthighpriceforeachyear.The“Risk”columnreferstothemaximumpricebreak(incentsperbushel)forthatcropyearundertheOctoberlowprice(post-October),andthe“Gain”columnmeasures(incentsperbushel)thehighestpriceachievedaftertheOctoberlowwasregisteredforthecontract.

Figure6.4.Julysoybeans(rankedbypercentagegain,lowtohigh)

Forexample,theJuly2008soybeancontractfollowedthispattern(seeFigure6.5).ThecontractlowwasmadeonOctober7,at$9.65perbushel,andadramaticuptrendensued,withaninterimhighthefollowingMarchatjustbelow$16perbushel.(TheactualcontracthighwasreachedduringthedeliveryperiodinJuly,at$16.60perbushel.)Bottomline:Itwouldhavebeenhardnottomakeatleastsomemoneythatyearusingthesoysecret.

Source:CQG,Inc.”2012.Allrightsreservedworldwide.

Figure6.5.July2008soybeans

Now,let’sanalyzethespreadsheetdatatodevelopatradingplan.Lookingatthelastcolumnfirst,weseeonlytwoyearswithzerogain,which

meanstherewereonlytwoyearswhenthemonthofOctoberwasahigh-pricedperiodfortheJulycontract.For41ofthe43cropyears,atleastsomepricegainoccurredabovetheOctoberlow.Inotherwords,over95%ofthetime,thismarketexhibitedarallyofftheOctoberlowbeforetheJulycontractwentofftheboard.Thishastobemorethanrandomchance,wouldn’tyouthink?However,tradingisneveraseasyasjustbuyinginOctoberandsellingata

profitsometimelater;weneedtoberealistic,basedonsomerisk-to-rewardcriteria.Intherealtradingworld,I’veidentifiednineyears(1974–1975,1981–1982,1983–1984,1990–1991,2004–2005,2005–2006,2006–2007,2008–2009,and2011–2012)whenImadetheassumptionthatatraderwhoknewaboutthesoysecretstillmightnothaveprofitedsinceameasurablepricedropoccurredatsomepointfromtheOctoberlowbeforeanybiggains.Take,forexample,2011–2012(seeFigure6.6);eventhoughthemarketeventuallygainedahuge41%fromtheOctober2011low,IplacedthisyearinthelosingcategorybecausethemarketmadealowerlowinDecember.ThisDecemberlowwasfollowedbya

bigrally,soitiscertainlypossiblethatatraderactuallywouldhaveprofitedthisyearonthesoysecret.However,tobeconservative,Iplacedyearslikethisoneinthelosingcategory.

Source:CQG,Inc.”2012.Allrightsreservedworldwide.

Figure6.6.July2012soybeans—marketmadealowerlowthantheOctoberlowpriortoahugerally

Yet,evenifweplaceyearslikethisoneintheredcategory,overalltherewasanexcellentchancetomakeaniceprofitwithminimalriskbybuyinginOctober—over80%ofthetime(35ofthe43years).

Now,here’saclueonhowtoturna“red”yearintoa“black”year:InthegreatmajorityoftheyearsthatdidregisteralowerlowaftertheOctoberlow(the9yearsIplacedinthelosingcolumn,tobespecific),in7ofthose9,themarketeventuallyralliedabovetheOctoberlowprice.Theeventualgainswereanywherefrom9%toover40%.ThekeytoprofitingintheseyearsistonoteifandwhenthemarketwaseventuallyabletotradeabovetheOctoberhighprice.Forexample,inthe2012market,theOctoberhighpricewas$12.99.Oncethemarketwasabletobreakaboveandcloseabovethatlevel(lateFebruary),themarketcontinuedtorally.Inotherwords,this“breakout”levelgenerallysignaledalow-riskentrypointduringthe“red”years.

Ofcourse,everyyearisdifferent,andyouhavenoguaranteeorsurepathtoprofit.Youmightwanttostudythefundamentalsofaparticularyear(acreage,yield,carryoversupplies,andprojecteddemand),butknowledgeispower,andunderstandinghistoricaloddscanonlyimproveyouroddsforfuturesuccess.Andonelastthought:Howaboutwekeepour“marketsecret”justbetweenus?Let’snowgetbacktoouroverviewofthefundamentalsforadditional

agriculturals.

Meats

Here’sanotherreal-lifetruestory.AbuddyofminewasatCostcotheotherday,andhesawsomeguyintheparkinglot,loadingpackageuponpackageofmeatintoapickup.Mybuddythoughthewasbeingcutewhenhesaystotheguy,“Youshouldbuyacow!”Theguylookedbackathimandsaidthefollowingthreewords:“Thisispork.”

TheUnitedStatesisthelargestproducerandconsumerofbeef.Justasthechickenstartswiththeegg,thesteakstartswiththecow/calfoperation.Thisisabreedingoperationthatusesgrazingland,cows,andasmallnumberofbullstoproducecalves.Calvesspendtheirfirstsixmonthsoflifewiththeirmothers,andthentheyareweaned.Someareplacedinfeedlotsimmediately,butthemajoritypassthroughanintermediatestagecalled“backgrounding.”Backgroundersplaceweanedcattleonsummergrass,winterwheat,orsometypeofroughage.Thisphaseofthecalf’slifemightlastfrom6to10months,oruntiltheanimalreachesadesirablefeedlotweightof600to800pounds.Aftertheanimalsarereadytobeplacedinthefeedlot,theyaretermedfeedercattle.Usually,feedingcontinuesuntiltheanimalsweighfrom1,000to1,300pounds,atwhichtimetheyareslaughter-readyanimals.TheCMELiveCattlecontractconsistsof40,000poundsofslaughter-readyanimals.Thecustomerfortheseanimalsisthemeatpackerwhobuysthelivestockandsellsthemeatandotherproducts,suchashides.Pricesarequotedtwoways,eithercentsperpoundordollarsper

hundredweight(hundredpounds),whichreallyarethesamething.Almostallfeedlotcattlearesteers(castratedmales)andheifers(femaleswhohavenotcalved).Becausesomeheifersareretainedonranchestoreplacecowsthatgettooold,therearealwaysmoresteersthanheifers.Feedlotscanbeassmallas100headoraslargeas100,000.Somefeedlotsarefarmerowned,andsomeare

commercialoperations.Thecommercialoperations(cattlehotels)accountforlessthan5%ofalllotsbut80%ofallcattlemarketings.Afeedlotoperatormightbuyfeedercattleforhisownaccount,or,forafee,hemight“customfeed”forfarmersorothercattleowners.Thesefeedlot-readyanimalsmakeuptheCMEFeedercontract,whichhasasizeof50,000pounds.Thespecificationscallforapproximatelya750-poundsteer;therefore,thecontractrepresentsabout60animals.Pricesarequotedineithercentsperpoundordollarsperhundredweight.Unlikethecattlecontract,thefeedercontractiscash-settled,justlikemanyofthefinancialfutures.Itisbasedonanindex,whichthecontractwillequalonthelastday.TheindexiscompiledbytheUSDA,basedonaweightedaverageoffeedercattlecashmarketsales.Likecattle,theporkindustrycanbedividedintosegments,butthereare

importantdifferences.Thepreslaughterphaseofhogproductionisusuallycombinedintowhat’scalledthe“farrow-to-finishoperation.”Inthehogindustry,thebackgroundingphasedoesnotexist.Inotherwords,thehoggenerallystaysonthesamefarmfrombirthtofinish.(Eightypercentofallhogsareproducedthisway,and20%comefromabreeding-onlyoperationtothefarm.)Hogsaretakentomarketwhentheyweigh220to240pounds,andthistakesaboutsixmonths.Mostbeefissoldasfreshmeat;however,alargeportionofporkisprocessedfurtherandbecomesstorableasham—smoked,canned,orfrozen.Porkbelliesaretherawmaterialforbaconandcanbefreshorfrozenand

storedforuptoayear.Thehogcontractrepresents40,000poundsofcarcassandiscash-settledbasedonanindexofpricescollectedbytheUSDA.Forover50years,wealsotradedporkbellies,highlightedinthemovieTradingPlaces.Thebellycontractwasnotoriousfornumerouslimitmovesandvolatile,erraticbehavior.ItwasaspeculativefavoritewhenIstartedinthebusinessinthe1980s,butalas,duetodecliningvolume,thecontractwasde-listedin2012.

Here’satriviaquestionforyou:Howmanybelliesdoesahoghave?Theansweristwo.

Majormeatfundamentals

Accumulationorliquidation?Duringtheaccumulationphaseofthecattlecycle,ranchersarebuildingtheirherdsbyholdingbackcows.Thismethodcantemporarilycreateashortsupplyofmarket-readyanimals,butitisbearishlongerterm.Duringliquidation(forexample,intimesofdrought,whichkillsoffthegrazingpastures,orhighfeedprices),cowsaresenttomarket.Thisis

bearishfromasupplyandpricestandpointintheshortrunbutbullishlongerterm.Thistacticworksthesamewayforhogsascattle.Duringtheexpansionphase,anincreasednumberofgiltsandsows(femalebreeders)arewithheldfromslaughtertobecomepartofthebreedingherd.Duringcontraction,femalesareculledfromthebreedingherd,andthefemaleportionofthetotalslaughterrises.Afundamentalistwouldanalyzethefollowingdata:•Seasonality:Althoughitdoesnothappeneveryyear,feedercattlesalestendtopeakinthefall,withtheendofthegrazingseason.Atthesametime,calf/cowoperatorstendtoselloffunproductivecows,whichincreasesthetotalbeefsupplyanddepressesprices.HogpricestendtobethehighestinthesummermonthsbecausetheDecember-through-Februarytimeframeistraditionallyalow-birthperiod.Also,thedemandforporktendstopeakduringthesummermonths.•Cornandfeedprices:Theruleofthumbisthathighfeedpricesresultinliquidationandlowfeedpricesresultinaccumulation.Theothervariablehereisthemarketpriceofthefinishedproduct.Ifsalepricesofcattleorhogsarehigh,thenmoremoneycanbespentonfeed.In1996,whencornpricessoaredtoathenall-timerecordhighofmorethan$5perbushel,manycattlefeedersfounditmoreprofitabletoselltheirstoredcornandtaketheircattletomarket(includingbreedinganimals).Otherscouldnotaffordthehighfeedcosts,andthisaddedtotheliquidation.Pricesofcattlespikeddownwardundertheweightoftheburdensomesupply,butthisturnedouttobebullishforthelongerterm.Thisispureeconomics.Whenitisprofitabletoraiseorfeedanimals,thisiswhatproducersdo;whenitisn’t,theydon’t.•Feedercosts:Incattlefeeding,thefeeder’scostaccountsfor,inmanycases,morethanhalfofthetotalcostofproduction.Higherfeedercostsleadtolowerplacementsintofeedlots.•Weather:Toughwinterweathercanresultindeathlossandweightloss,whichcanreducesupplypermanentlyortemporarily.Attimes,whenthetemperaturesinthemajorfeedingregionsgetextremelycold,cattleeatmoreandgainless.Animalsthatweretobereadyformarketatacertaindateare“pushedback,”creatingatemporaryshortage,andthereisaglutlaterwhentheyreachmarketweight.Thisfundamentalismoreimportantforcattlethanhogsbecausethemajorityofhogsarenowfedindoors.•Consumertastes:Thiscanbeapproachedinamacrosenseandamicro

sense.Theper-capitaconsumptionofbeeforporkandhowitchangesovertimeaffectsprice;thisisamacrofundamental,andithastodowithdietaryconsiderationsandmedianews.Onamorefocusedapproach,hotsummerdaysincreasebarbecuedemand,andholidaysincreasethedemandforhams.•Exportsandincomelevels:Whenacountryachievesahigherlevelofincome,thedemandforredmeatincreases.ExportstoAsiahavebecomeamuchmoreimportantfactorinrecentyears,andunexpectednewexportbusinesscan,attimes,resultinpricespikes.Chinaisamajorsoybean(andattimescorn)importerdueinlargeparttoitslargeandexpandinghogindustry.•Thesubstitutioneffect:Beef,pork,chicken,turkey,andfisharesubstitutablecommoditiestoamajorextent.Forexample,ifthepriceofchickenplummets,salesincrease,whichtakesawaydemandfromtheothermeats.•CattleonFeedReport:ThisisanimportantandmuchanticipatedmonthlyreportreleasedbytheUSDA.Threemajorpartscomposethereport:cattleonfeed(thetotalnumbersinthefeedlots),placements(ofcattleintofeedlotsthepreviousmonth),andmarketings(outofthefeedlotsthepreviousmonth).Becauseaplacementofa700-to900-poundanimalintoalotwillbecomeamarket-readyanimalin120to160days,thisreportcangiveagoodindicationoffuturemarket-readysupplies.Marketingsoutoffeedlotscanvarybasedoneconomicconsiderationsbecausecattlefeederscanmovecattleaheadabitorfeedthemabitlongerattimes.•CattleInventoryReport:Thisisacountofthetotalnumbersofmatureanimalsaswellasthecountry’s“calfcrop.”Itisanimportantreportbutisreleasedonlytwiceayear,inJanuaryandJuly.•HogsandPigsReport:Thisisthemostimportantreportforthehogfutures.Themarketoftenmoves“limit,”sometimesfordays,afterthisreportisreleasedwhenitshowsnumbershigherorlowerthanexpectations.Itshowsthetotalnumbers(thepigcrop),thebreedingherd(numberskeptbackforbreeding),thefarrowingsandfarrowingintentions(thenumbersactuallybredandanticipatedbreedinglevels),andthemarkethogs(thoseintendedformarket).Weightclassesalsogivecluesabouttotalfuturesupply.ItshouldbenotedthatalthoughtheHogsandPigsReportmovesthemarket,itisoftenwrong.However,thisfactcannotbeverifiedforuptosixmonthsinthefuturewhentheanimalseithershowordon’t.

•DailySlaughterLevels:Thisreportgivesanindicationofhowmanyanimalsareprocessedbythepackersonadailybasis.

Sal,myfeedercattlebrokerinthepitdays,oncetoldmeastoryofasuccessfulhogtrader,whohadabrother-in-lawwhowasstrugglinginthepit.Thesuccessfulonewantedtohelphissister,whowaspromisedanewhousebyherhusband(thebrother-in-law),buthecouldneverseemtocomethrough.ThedayafteraverybullishHogsandPigsReport,thestrugglingtradersaw100longhogcontractsinhisaccount.Thinkingitwassomesortoferror(andnotinquiringwhytheywereinhisaccount),heproceededtotradeoutofthemrightaftertheopen.Aftera$7run-upinhogprices,thesuccessfulonewalkeduptohisbrother-in-lawandtoldhimtogoandbuythatnewhouseforhiswife(thesuccessfulone’ssister).Thebrother-in-lawresponded,“Withwhat?”Thesuccessfulonesaid,“Whatdoyoumeanwithwhat?Taketheprofitsonthose100longsIputinyouraccounttwoweeksago!”

SoftsThecommoditysubclasstermedthesoftshasalsobeenreferredtoasthe

breakfastcommoditiesbecauseitincludescoffee,cocoa,sugar,andorangejuice.Cotton,whilenotconsumable,isalsointhisclassbecauseit’ssoft.Andalthoughlumberishard(althoughitcanbeclassifiedasasoftwoodorahardwood)andhasnothingtodowithbreakfast,we’llplaceitinthiscategorybecausethereisnootherwhereitfits.Sugarisgrowninmorethan100countriesaroundtheworld.Mostsugaris

consumedinthecountryinwhichitwasgrownandproducedundergovernmentpricingarrangements.Thesugarthatisnotsubjecttogovernmentrestrictionsisfreelytradedamongnations,corporations,andtraders.Thisfreemarketistypically15%to25%ofworldproduction.A5%changeinproductioncanmeana25%changeinfreemarketsupply.Thetwomaintypesofsugargrownintheworldarecaneandbeet.Both

producethesametypeofrefinedproduct.Sugarcane,abamboo-likegrass,accountsforabouttwo-thirdsofworldproduction.Cuba,India,Thailand,andBrazilaretheleadingcaneproducers,whereasRussiaandtheEECarethemajorbeetproducers.ThelargestsugarexportingnationsareCuba,theEEC,Australia,Thailand,andBrazil.ThemajorimportingnationsareRussia,theEEC,theUnitedStates,China,andJapan.Acontractisfor112,000pounds,with

pricesquotedincentsperpound.A1¢moveequalsaprofitorlossof$1,120percontract.CoffeeistradedinLondon,butthemostactivecontractisintheUnited

States,whichisalsothemajorconsumingnation.Coffeeisclassifiedintotwotypes:ArabicaandRobusta.TheArabicaareasproduce60%oftheworld’soutput,withBrazilandColumbiaaccountingforone-thirdoftheworld’sexportablesupplies.TheCentralAmericancountriesofCostaRica,Mexico,Guatemala,Honduras,andElSalvadorarealsoimportantproducers,asareUganda,Indonesia,andVietnam.TheUScontractcallsfordeliveryofArabicacoffee.Robusta,withflavorsgenerallynotasmildastheArabica,isproducedinthehotareasofAfricaandAsia.TheLondoncontractisaRobustacontract.Ittakesapproximatelyfouryearsforacoffeebushtoproduceausefulcrop.Thefruitisgreenatfirst,andasitripens,itchangestoyellowandthenred.Itshouldbepickedonlywhenred,andtheworkisextremelylaborintensive.Coffeebeansdonotripensimultaneously,evenwhenonthesamebranch,sothecropneedstobehandpickedinmostcases.InNewYork,thecontractsizeis37,500pounds,orroughly100bags.A1¢moveequalsaprofitorlossof$375percontract.NotethatmostoftheCentralAmericanvarietiesaredeliverableonthecontractatpar,butifyoudeliverColombiancoffee,youreceivea2¢bonusbecauseitisconsideredapremiumproduct.Thecocoatreeisatropicalplantthatgrowsonlyinhot,rainyclimates.Asa

result,themajorproducingcountriesare(inorder)Brazil,TheIvoryCoast,Ghana,Malaysia,andNigeria.Thefruitofthecocoatreeappearsasapodonthetree’strunk,whichwhenripeiscutdownandopened,andthenthebeansareremoved.Cocoabutterisextractedfromthebeansforuseincosmeticsandpharmaceuticals,butitsprimaryuseisforthemanufactureofchocolate.Cocoaisconsumedprimarilyincountriesofrelativelyhighincome.ItwasfirstbroughttoEuropeasaluxurydrinkintheseventeenthcentury.Theleadingimportingnationsare(inorder)theUnitedStates,Germany,France,theNetherlands,andtheUnitedKingdom.Thesefivecountriesaccountforabouttwo-thirdsoftheworld’sconsumption.CocoatradesinLondon,buttheU.S.contracttradedontheInterContinentalExchange,commonlyknownastheICE;theleadingExchangeforcocoa.Thesizeofthecontractis10metrictonsofcocoabeans,withpricesquotedindollarsperton.Cottonisgrownaroundtheworldandhasbeenusedfor7,000years.Sincethe

CivilWar,cottonhasbeenthemajorcashcropoftheAmericanSouth.WhenIwrotethefirsteditionofthisbook,theUnitedStateswasthelargestworldproducer,butasofthiswriting,theUnitedStatesisthird,behindChinaand

India.OthermajorproducersincludePakistan,Brazil,Australia,Uzbekistan,andTurkey.Thecottonfiberisusedtoproducefabric,andtheseedisusedforcookingoil.Themajorconsumers(someareusersformanufacturing)ofcottonare,inorder,China,India,Pakistan,Turkey,Brazil,andtheUnitedStates.Thecontractcallsfor50,000poundsofU.S.-grownwhitecotton.A1¢moveisequaltoplusorminus$500percontract.Orangesaresecondonlytoapplesamongfruitinproduction.TheUnited

Statesusedtobeself-sufficientinproduction;however,aseriesofkillerfreezesinFloridasparkedthegrowthoftheBrazilianorangeindustry.Nowupto50%ofU.S.consumptionisimportedfromBrazil.TheNewYorkcontractisbasedonaU.S.gradeoffrozenconcentratedorangejuice.Inyearsofcropproblems(primarilyafreeze),pricescantradewellinexcessof$2perpound.Inyearsofhighproduction,theytradebelow$1.Thisisarelativelythincontract,withasizeof15,000pounds.Woodsareclassifiedashardorsoft.Softwoodsaccountfor85%oftotal

lumberconsumption.Mostharvestingoflumberisdonebythemillonlandleasedfortimberrightsbyprivatepartiesorthegovernment.Thebarkisremoved,andlogsmovetotheheadsaw.Thecontractcallsforconstruction-graderandom-lengthtwo-by-foursmanufacturedinthePacificNorthwestorCanada.Thecontractsizeis80,000boardfeet,withpricesquotedindollarsandcentsperboardfoot.A$1moveequalsplusorminus$80percontract.Likeorangejuice,thisisarelativelylow-volume,thincontract.Thefollowingaremajorfundamentalsforthesofts:•Stocks-to-usageratios:Thelevelofsugarsuppliesinrelationtodemand,thestocks-to-consumptionratio,isthemajorstatistictraderstalkaboutwhenmeasuringthedegreeof“tightness”inthemarketplace.Forsugar,aratioof20%to30%isconsideredlowandisconsistentwithhigherprices.Whenpricesspikedabove25¢perpoundin1980,thisratiowasinthemid-20s.Whentheratioroseabove40%inthemid-1980s,pricesfellaslowas3¢.Becausethefree-floatingsupplyofsugariscomparativelylow,itdoesnottakeabigmoveinthestocks-to-consumptionratiotoresultinamajorpricemove.Candysalesareimportant,asisthepriceofcorn.(High-fructosecornsyrupisacompetitorofsugar.)•Forcocoa,the“grind”isthetermusedtomeasureconsumption:Highergrindsindicaterisingdemandandviceversa.Fromtimetotime,theInternationalCocoaOrganization(ICO)forgesanagreementintendedtosupportprices.TheICOisagroupofproducingnationsthatpurchases

cocoaforitsownaccountandstoresittopushpricesupward.Whenashortagedevelops,theICOreleasesstocksontothemarket.Coffeeconsumptionisbelievedtobemoreinelastic,withamajorpriceincreaseneededtocurtaildemand.However,thesharpriseincoffeepricesin1996to1997wasmetbyacommensuratereductioninconsumption.AmericansconsumeclosetodoublewhattheGermansdrink(theyarenumbertwo),followedbytheChinese,theFrench,theJapanese,andthenthosefromtheothermajorEECcountries.Consumptiontrendsneedtobefollowedclosely.Inthelate1940s,theUnitedStatesaccountedfortwo-thirdsofworldimports,butbecauseofthegrowingpopularityofcoffeeglobally,thisnumberisdowntoone-third.•Cropyields:Weather,disease,insects,andpoliticalandeconomicconditionsintheproducingcountriesallaffectproductionrates.Forexample,thegreatfreezein1994causedcoffeepricestosurgefromlessthan$1perpoundtocloseto$3.Forcoffee,theInternationalCoffeeOrganizationprovidesusefulstatistics,suchasnumberofbagsproducedbycountry.

WhenIwasayoungbrokeratMerrillLynch,IonceheardacommoditybrokertellaclientthattherecouldbeafreezeinBrazil,whichwouldhurtthecoffeecrop.Itseemedreasonabletomebecause,atthetime,welivedinMinnesota,anditwaswellbelowfreezing.OnlylaterdidIrealizethattheNorthAmericanwinteristheSouthAmericansummer,andtherewasnowaytheyweregoingtofreezeinthesummer.

MetalsTherearetwomajorsubsetstothemetalscategory:preciousandindustrial.Althoughgoldcertainlyisusedinthejewelryindustryandelectronicsandotherindustries,itisconsideredpreciousduetoitstraditionalroleasamediumofexchange(inotherwords,money).Silverisconsideredbothpreciousandindustrial.Metalssuchascopper(sometimescalledthepoorman’sgold)areconsideredtobeintheindustrialclass.

PreciousmetalsUniqueandthereforeprecious,goldisitsownassetclass.Pricesarequotedalongsidesecuritiesinthemajorfinancialmedia,andmanybelievegoldtobeaglobalreservecurrencyaswellasacommodity.Goldisahedgeagainstasseterosionintimesofinflationandpoliticalunrest.Itwasalwayspopularasastore

ofvalueinIndia,anditisbecomingincreasingpopularasaninvestmentvehicleinChina,aswealththeregrows.In1816,GreatBritain,theworld’smajorsuperpower,backeditscurrencyexclusivelywithgold,whichinturnforcedothernationstofollowitslead.TodayGreatBritainisnotevenoneofthetop10goldholders.Themetalformallyenteredtheworld’smonetarysystemin1944,whentheBrettonWoodsagreementfixedalltheworld’spapercurrenciesinrelationtothedollar,whichwastiedtogold.Then,onAugust15,1971,PresidentNixoncanceledthedollar’sconvertibilitytogold,whichlikelyledtothehyperinflationofadecadelater.Goldnowtradesfreely,inaccordancewithsupplyanddemand.Iconsidergoldanassetclassuntoitself,withmoneyflowingintothemetalas

astoreofvalue,particularlywheninflationaryexpectationsheatuporintimesofmoneyprinting.Thisisalistoftherankingsofgoldholdersaswegotopress,startinginfirstplace:TheUnitedStates(withover8,000tons),followedbyGermany,Italy,France,China,Switzerland,Russia,Japan,theNetherlands,andIndia(about600tons).IftheInternationalMonetaryFund(IMF)wereacountry,itwouldrankthird,astheIMFholdsapproximately3,000tons.Iftheeurozonewereonecountry,itwouldrankfirst,andsomeestimatesplace“private”holdingsinIndianhouseholdswayupintherankings(perhapsatfirstplace),butthereisnoharddataonthis.Today,someoftheworld’scentralbanksaredivestingthemselvesofaportion

oftheirgoldreserves,whileothers(notablyRussia,Korea,andChina)areadding.Forover40years,beginningin1965,theworld’scentralbanksweresellinggoldinaggregate.Aswegotoprint,however,theworld’scentralbanksareincreasingtheirgoldholding(inaggregate).SouthAfricaistheworld’slargestgoldproducer,accountingformorethan25%oftheworld’sproductionand50%ofthein-groundreserves.Thenextfivemajorproducers(inorder)areRussia,theUnitedStates,Canada,Australia,andBrazil.Whenthefirsteditionofthisbookwasprintedoveradecadeago,theall-timefuturespricehighwas$1,026(reachedinJanuary1980ontheOctober1980contractwhenthespotpricehit$875).Asthiseditiongoestopress,theall-timehighfuturespricewas$1,921inSeptember2011.Ihavenodoubttherewillbeanewall-timehighpriceinthefutureascurrenciesdepreciate.Whenthegoldfuturescontractwaslistedin1976,itcame“ontheboard”lessthan$100.Themostpopularfuturescontractisa100troy-ouncecontract,andtherearealsominisin50-,33-,and10-ouncesizes.Pricesarequotedindollarsandcentsperounce,witha$1moveequalingaprofitorlossof$100onthe“big”contract.

Inthesummerof2011,mywifebookedathree-dayClassIVriverrafttripforus.Thiswasduringamajorbullmarketforgold,andthedayweleft,Iwaslonggoldformyselfandnumerousclients.IhadaprobleminthatweweretoldtherewasnoInternetorcellphonereceptionwhereweweregoing.Themarketwasextremelyvolatileatthattime.Goldwastradingatabout$1,885rightbeforeweleft,andbecauseIwouldbeunabletomonitorthemarket,Isoldoutourentireposition.Justbeforewedepartedfromthehoteltomeettheguide,Ireceivedonelastpricequote;goldhadjusttradedabove$1,900forthefirsttimeinhistory.Damn,Ithought;it’sonitswayabove$2,000.ButtherewasnothingIcoulddo,soweleftforthetrip;itwasrelaxing,andItriednottothinkaboutthemarkets.ThefirstthingIdid,however,whenweagainreachedcivilizationwaspoweruptheiPhoneforagoldquote.Itflashed$1,755(actuallyonitswaydowntothe$1,500sinthenextfewweeks).TheclientsthoughtIwasprettysmart,sellingoutjustonedaybeforethetop.Sometimesbeingluckyisasgoodasbeingsmart.

Althoughanindustrialmetal(usedintheautomotiveindustryandinchemicals,petroleumrefining,andelectronics),platinumisconsideredapreciousmetalbecauseonly80tonsofnewproductionreachtheworldannually.Ninetypercentoftheworld’sproductiontakesplaceinSouthAfricaandRussia.SouthAfricastillaccountsfor85%oftheworld’sin-groundreserves,withitstwolargestproductioncompaniessettingtheproducerprice.However,thefuturessetsthefreemarketpricewitha50-ouncecontract,whichisworth$50per$1ouncemove.Platinum(andpalladium,platinum’spoorcousin)arealsoactivelytradedonTOCOM(TokyoCommodityExchange).Until2012platinumalwaystradedatapremiumtogold,andtheplatinum/goldspreadisapopularspeculation.Silveristrulyahybridindustrial/preciousmetal.Inthe1980sand1990s,

manyoftheworld’sdedicatedsilverminescouldnotoperateprofitablybelow$8perounce,somuchoftheproductionwastheresultofaby-productofcopper,lead,andzincmining.However,inrecentyears,newdedicatedsilvermineshavebeenbroughtintoproduction.MexicoandtheUnitedStatesaretheworld’slargestproducers,followedbyPeruandCanada.FourthandfifthinproductionareAustraliaandRussia.Inrecentyears,silverconsumptionhasoutpacednewproduction,withthebalancebeingmetbyabove-groundsupplies.Thisprobablycannotoccurforeverwithouteitherdemandfalling,productionrising,orpricesrising.Themajorsilverfuturescontractissizedat5,000troyounces.Pricesarequotedindollarsandcentspertroyounce,witha1¢moveequalingaprofitorlossof$50percontract.WhentheHuntbrothersfeltthe

worldwouldrunoutofsilverandattemptedtocornerthemarketfrom1979to1980,theywereabletorunpricesashighas$50perounce,apricesilverdidnothitagainuntil31yearslater.Silverwas35¢perounceduringtheGreatDepressioninthe1930s.Herearethemajormetalsfundamentals:•Centralbanksandinflation:Watchwhatthecentralbanksaredoing.Attimes,thecentralbanksareaggressivesellers,andattimes,theyareabsentfromthemarket.Whentheyareprintingmoney,goldbydefaultrises(morecurrencyunitsincirculationrequireahighergoldpriceperounce).Keepaneyeontheglobalpoliticalclimateandhowgoldreactstoit.Intimesofinstability,goldisconsideredastoreofvalue.Waroralossofconfidenceintraditionalinvestmentscancauseashiftoffundsintogold.WatchChina,India,andothergrowingeconomies.Asincomegrowthincreasesthere,sohasgolddemand.Mostimportantly,keepaneyeoninflationandinflationaryexpectations.Inthelongrun,thepricesofgoldandallotherpreciousmetalsaresensitivetoinflation.Regardingsilver,watchthepriceofgold,butalsowatchthepricesofcopper,zinc,andlead.Becausemuchofthenewproductionofsilvercomesasaby-productofthesethreemetals,ifthepriceofthethreeisdepressedandproductioncurtailed,silveroutputwillsufferaswell.Thereverseisalsotrue.WatchIndianimports.SilverisapreciousmetalofchoiceinIndia,andastrongeconomythereincreasesdemand.•Platinum:Regardingplatinum,watchJapan.InJapan,platinumisthepreciousmetalofchoice,withmoreofitusedforjewelrythangold.AstrongeconomyinJapanisgoodforplatinumprices.Thisisanindustrialmetalandapreciousmetal,andthedemandforplatinumissomewhatdependentonthehealthoftheautomotive,electrical,dental,medical,chemical,andpetroleum.

Now,let’sbrieflydiscussindustrialmetals:•Copper:Theredmetal,copper,istradedbothinNewYorkandinLondonattheLondonMetalsExchange.TheLMEcontractisfor25metrictons,or55,000pounds;pricesarequotedindollarsandcentsperton,witha$1moveequaltoaprofitorlossof$25.TheCMEcontractisfor25,000poundsor121/2“shorttons.”Thepriceisquotedindollarsandcentsperpound,witha1¢moveequalingaprofitorlossof$250percontract.Copperisthethirdmostwidelyusedmetal,afteraluminum.ItisminedallovertheworldbutprimarilyintheUnitedStates,Chile,Mexico,Australia,

Indonesia,Zaire,andZambia.•Aluminum:TheBritishcallaluminum(andspellit)aluminium(“al-you-min-e-um.”Theyincludeanextraiandanextrasyllableintheword.WeAmericanscallitaluminum(“al-ou-min-um”).Aluminumistheworld’ssecondmostwidelyusedmetal,afteriron.TheLMElistsanactive,liquidcontract.Thecontractsizeis25metrictons,or55,000pounds.Pricesarequotedindollarsandcentsperton.IntheUnitedStates,pricesroutinelyarequotedincentsperpound.Toconvertfromdollarspermetrictontocentsperpound,youdividethepriceby2,204(thenumberofpoundsinametricton).TheLMEalsotradesascrapaluminumcontract;thealuminumalloyisa20metrictoncontract.•Zinc,nickel,andlead:Zincisusedasanalloywithcoppertomakebrass.Italsoisusedwithironorsteelinaprocesscalledgalvanizing,whichisthelargestuse.TheformerUSSRcountries,Canada,theUnitedStates,andAustraliaarethemajorproducers.TheLMElistsa25metricton(55,000pound)contract,whichisquotedincentsperpound.Mostofthenickelproductionisusedinstainlesssteel.Italsoisusedasacoatingforsuchvariedapplicationsashelicopterrotorsandturbineblades.Nickelisalsousedincoinsandrechargeablebatteries.ThemajorproducersareCanada,Russia,andAustralia.ThecontractalsoistradedontheLME,in6-tonlots,withpricesquotedindollarsandcentsperton.Themajorusesofleadincludecarbatteries,ammunition,fueltanks,andasasolderforpipes.TheUnitedStatesisthelargestproducer,followedbyCanada,Mexico,Kazakhstan,andAustralia.Becauseitisextremelytoxic,therehasbeenaconcertedeffortto“gettheleadout”ofmanyproductsinrecentyears.TheUnitedStates,Japan,Germany,andtheUnitedKingdom(thecommonlinkhereisamajorautomotiveindustry)arebigconsumers.LeadalsoislistedontheLMEin25metrictoncontractsquotedindollarsandcentsperton.•Tin:Tinismanufacturedintoacoatingforsteelcontainersusedtopreservefoodsandbeveragesandotherformsofelectroplating.Chinaisthelargestproducer,followedbyBrazil,Indonesia,Malaysia,Bolivia,andThailand.However,moretinissmeltedinMalaysiaforexportthananyothercountry.Itcanbevolatileattimes.TradedontheLMEin6-toncontracts,pricesarequotedindollarsandcentspermetricton.•Palladium:Palladiumisamemberoftheplatinumgroup,usedintheautomotive,electrical,andmedicalindustries.Russiaistheworld’slargestproducer,withSouthAfricaaclosesecond.Thetwocountriesaccountforabout93%oftheworld’ssupply.Palladiumfuturesarethinlytradedin

100-ouncecontracts.Every$1perounceofpricemovementresultsina$100profitorlosspereachcontractpurchased.

Thefollowingaremajorindustrialmetalfundamentals:•Economicactivity:Watchtheeconomiesofthemajorindustrializednationsthatcomprisetheprimedemandfundamentalsofthisgroup.Eachofthemetals,ofcourse,hasitsownfundamentals(zincandleadaregenerallyminedtogether,forexample),butindustrializeddemandisthekey.Ifthereisathreatofaneconomicslowdown,thiswillbereflectedinlowerprices.•LMEstocks:Everyday,theLMEreleasesitswidelywatchedstocksreport,whichisagoodmeasureofsupply.ItliststhestocksintheExchange-approvedwarehousesforaluminum,copper,zinc,tin,andlead.•Miningstrikes,productionproblems,andwar:Demandtraditionallysoarsfortheindustrialmetalsintimesofincreaseddefensespending.Copperhasbeencalledthe“warmetal.”•Inflation:Theindustrialmetalshave,attimes,beencalled“thepoorman’sgold,”andtheyheatupinaninflationaryenvironment.

WhenIwasanovicecommoditybrokeratMerrillLynch,mybiggestclientwasaretiredformertopexecutiveofamajorsoftwarecompany.Whenthecompanywentpublic,hisstockwasworthmorethan$15million.Inretirement,hishobbywastradingcommodities.Hetradedabitdifferentlyfrommostofus,inthathehadthefundsavailabletobackhisconvictionsuntiltheyeventuallyworked—andtheyusuallydid.Forexample,heoncestartedtoshortwheatat$3perbushel.Themarketwentagainsthim,andheaddedtotheposition,at$3.50.Headdedtohisshortpositionat$4andmoreat$4.50.Whenthecropfinallycamein,hecoveredtheentirepositionat$3—aniceprofit.Thisisnotarecommendedwaytotrade,mindyou,butitworkedforhim.Hewasastrictfundamentalistandneverlookedatcharts.In1979,whensilverfirstcrossed$8,hestartedtoshortthemarketwithamodestpositionoffivecontracts.Hewasaformermetallurgicalengineer,andhehadatheorythatabove$8,thetechnologywasavailabletoextractsilverfromtheslagheapsalongsidethemines,andthemarketwouldbefloodedwithsupply.Remember,atthispoint,wedidnotknowthattheHuntsandtheirArabpartnerswereaccumulatingsilverbullionandsilverfuturesintheirattempttocornerthemarket.At$8.50,myclientshortedanotherfiveandanotherfiveat$9.Bythetimethepricecrossed$10,hewasshort25

contracts,withanunrealizedlossofmorethan$125,000.Hewasdeterminedtokeepshorting;“whateverittakes,”hetoldme,untilhefinallybeatthisone;thiswashisstyle.Bythetimethemarketreached$12(anall-timehigh),hewasshortapproximately50contracts,withanaveragepriceof$10andanunrealizedlossof$500,000.Iwasgettingverynervousandconcerned,buthewasadamant.Allweknewatthattimewasthattherewasabrokerfromthenow-defunctContiCommodityfirmwhowouldcomeintothepit,almostdaily,purchaseahugeposition,andleavethepitfortheday.Manytimes,hisbuyingwouldputthemarketupthelimit.(Therewasa50¢-per-ouncelimitatthetime.)Whenheleftthepit,themarketwoulddriftabitandusuallyclosehigherontheday,butnotupthelimit.Istartedtohavesilvernightmares,afraidmybigclientwouldgodownwiththeship,butIdidn’treallyknowwhattotellhim.Atthetime,therewasn’tagoodfundamentalexplanationthatcouldconvincehimhewaswrong.IthenrememberedthattherewasaMerrillLynchexecutivewhowasalsoontheboardofdirectorsoftheCOMEX(metalsexchange).ThenextmorningIcalledhim,explainedIhadthisbigclientshortsilverwithabigloss,andhejustwouldn’tgetout.Istillrememberthecall:TheMerrillLynchexecutive’sresponsewentsomethinglikethis:“Look,there’sbigmoneybehindthismarket.Ifyou’reshort,GETOUT.That’sallIcantellyou—don’tcallmeagain!”Then,hehungup.About10minutespriortotheopen,withmyheartpounding,Icalledmyclientandtoldhimaboutthisconversation.ImusthavesoundeddaftasIheatedlytoldhim,“Theguysays,‘Ifyou’reshort,GETOUT,’”becausehecalmlytoldmeto“Reversethepositionattheopen.”Isaid,“Youmean,notjustbuyyour50tocover,butbuy50more?”Hesaid,“Yes.Ifwe’rewrongtobeshort,thenweshouldbelong.”NowIwasreallynervous.WhatifIconvincedmyclienttocoverandthenheboughtatthetop?Hecouldlosewellover$1million,andIcouldlosemybestclient.Still,itwastoolatetodoanythingbutputtheorderintobuy100contractsattheopen.Guesswhathappened?Themarketopenedlimitup,atanall-timehighpricesomewherearound$12.50.Then,itstartedtodriftdown.So,hecoveredhis50atalossinexcessofacoolhalf-million,andbecauseofmyphonecall,henowowned50contractsatwhatwasanall-time,record-highprice—andthemarketwasdriftingdown!Tomakealongstoryshort,themarketdriftedanother10¢orsolower,butthenreverseduptoclosethatdayupthelimitprice(soatleasthewasnotshowingalosson

thenewpositionattheclosethatday).Asitturnedout,thenext$2to$3highercamefairlyeasily,andwhenherecoupedhistotalloss,plusamodestprofit,hegotoutofthe50,inthe$15to$16range.Ofcourse,ifheheldontothe50uptothehighs,around$50,hecouldhavemademorethan$9million.Thenagain,hecouldstillhavebeenthereonthedescentbackto$5.Inanycase,disasterwasaverted.Henevertradedsilveragain,butcontinuedtotradeactively(evenfromhishospitalbed)untilthedayhepassedawayaboutthreeyearslater.

ContinuingyourcommoditytradingeducationConcludingourintroductiontothefundamentals,isthereanythingelseyouneedtoknow?Well,there’sanoldsaying,“Tomakeasmallfortuneincommodities,startwithabigone.”AndImaybegivingyoutheimpressionthattheoddsarestackedagainstyouwithallthecomputeralgorithmsandprofessionalhedgefundmanagers,butIdon’tfeelthatway.It’struethatmostpeoplelosewhentradingcommodities,butit’snotbecausetheoddsarestackedagainstthem.Everybuyerofeverylosingtradecouldhavebeenasellerandmademoneyonthatsametrade,andeverysellerofeverylosingtradecouldhavebeenabuyerandmademoneyonthattrade.Aprofitableminorityisdoingjustthat.Notoneverytrade,mindyou,butonbalance.Sowhat’sthekey?Isithowyouanalyzethemarket?Wewilldiscussvariousindicatorsandmethodologiesshortly,butthereal

determinantofsuccessorfailureisthetrader’sstateofmind,hisorherpsychology.Allwinningtradersunderstandthis.Tradingemotionally,orongutfeelings,willfail.Youneedtounderstandmasspsychologybecausethisisthereasonmarketsmoveintrends.Youalsoneedtounderstandwhenthetrendsareturningandwhythemajorityiswrongatturningpoints.Thekeytothiswholeequationissmartmoneymanagement.Ifemotionscankillyouinthemarkets,thentheoppositemustbetrue:Being

unemotionalenhancesyourprospects.Yearsago,afriendofminewhomIrespectasasuccessfultradercashedinonwhatIknewwasamajorscoreinthewheatmarket.Isawhiminthemembersdiningroom,andIsaidtohimsomethinglike,“Youmustbefeelingdamngoodhavingcashedinatthetop.”Hewasacalmsortoffellow,andhesaid,“George,whenthemarketstreatmewell,Idon’tdanceinthestreets,andwhentheydon’t,Idon’tbeatmyselfup.Alwaysrememberthesewords:Slowandsteadywinstherace.”Yearslater,Iknowwhathemeantbythis.Whatatraderneedstodoisnottothinkaboutthe

moneybutinsteadtoconcentrateontradingcorrectly.Ifyoutradeproperly,themoneywillcome.Ifyoutradeincorrectly,you’redoomed.Aloserhopestoomuch.Shehasaninabilitytogetoutofalosingtradeearly

enoughbecauseshekeepshopingthemarketwillturnbackherway.Sometimesitdoes,buttoooften,themarginclerkistheoneforcingherout.Invariably,aftershe’sforcedout,themarketcomesbackthewayshethoughtitwould,butbythen,it’stoolate.Thevolumeoftradegenerallyswellsatmajorbottomsandmajortops.Why

dosomanypeoplesellatthebottomorbuyatthetop?It’sbecausethey’reactingemotionallyinsteadofintellectually.Onesimplewaytoavoidthisistonotgetattachedtoaposition.Tradingshouldnotbeanegothing.Thereisalwaysanothermarkettomorrow.I’vewitnessedliterallythousandsoftradesfromhundredsofbrokerageclients

overtheyears.I’veseenwhatthosewhomakemoneydo,andI’veseenwhatthelosersdo.Invariably,thelosersmakethesamemistakes.Theymaymakemoneyinitially,andtheymightevenhavemorewinnersthanlosers,buttherealwaysseemtobethoselargelossesthatwipeoutwhatevergoodcamebefore.Manyyearsago,theCMEhadanadcampaigninwhichittriedtoteachthe

publichowtotrade—animpossibleundertaking.Oneofthefull-pagemagazineadspronounced,“Donotriskthywholewad.”Howprofound.Andyet,thisistheonemajormistakethemajorityofnovicetradersmake.Theybettoomuchononetradeorononemarket,whichbringsustothefirsttenetofgoodmoneymanagement:Youmustknowinadvancehowmuchyouareriskingonatrade,andunlessitisasmallpercentageofyourtotalriskcapital,don’ttakeit.Icouldgointotheoreticalprobabilityhere,butcommonsenseworksbetter.

SomeofthemostimportantadviceIcangiveyouinthisbookistoplanforslowandsteadygainsandlooktominimizethedraw-downs.Thewaytodothisistocutthelossesquicklyonthebadtrades.So,howmuchshouldthisbe?Itshouldprobablynotbemorethanatmost10%ofyourtotaltradingcapitalpertrade,andideallynomorethan2%to5%pertrade.Thinkofitthisway:Ifyourisk5%oneachtradewhenyoustarttrading,youwillneedtobewrong20timesinarowtobetotallywipedout.Youwouldneedtobeusingaverypoortradingsystemtodothis.Considerthis:Ifyouwinonjusthalfofyourtrades,butyournetprofitis10%

oftradingcapitaloneachwinningtrade,withyournetlossof5%oneachlosingtrade,you’reup50%onyourfirst20trades.Notbadforbeingrightonlyhalfofthetime.Ontheotherhand,ifyourisk25%ofyourcapitaloneachtrade,it

takesonlyfourlosingtradesinarowbeforeyou’redone.Andthat’sacertainty;thetimewillcomewhenyouhavefourlosingtradesinarow.Thekeyhereistoavoidmajordraw-downs.Plus,Ihaveacoupleofothertips.Forone,diversify.Don’tputallyoureggsinonebasket,anddon’tplaceall

yourchipsonasinglerollofthedice.Thislessenstheopportunityforanyonetradetobeyourlast.Stickwiththetradesthatareworkingandculltheonesthataren’t.Ifyoudon’thavethedisciplinetogetoutofthebadtradeswhenyouneedto,makeityourownpersonalruletoimmediatelyandphysicallyplaceastoplossorderinthemarketthemomentyouenteranytrade.Believeme,yourstopswillnotbehitontheverybesttrades.Andonceyouhaveareasonablepaperprofitonatrade,moveyourstopsothatitneverturnsintoaloss.

ContraryopiniontheoryAttimes,itpaystobecontrary.Andbecauseyoushouldavoiddoingwhatthelosersdo,whichgenerallyiswhatthemajorityisdoing,thisisagoodtimetointroducecontraryopiniontheory.Theconceptissimple:Ifallthebullshavealreadybought,therearenobullslefttobuy,andthemarketfallsbecauseofitsownweight.Ifapieceofbullishnewsfailstomovethemarketup,thisisyourclue.Whenallthebullsdecidetorunfortheexitdoor,therewillbenocushionofnewbuyerstosoftenthedecline,andthedeclinewillbeparticularlysevere.Thereverseistrueif“allthebears”havealreadysold.Contraryopinionisnotahard-and-fasttradingsystem.Thewaytouseitisto

watchcloselyforsignsofaturninthemarketplacewhenthemajorityofwhatyoureadisverybullishorverybearish.IamalwaysonalertwheneveryoneknowsthestoryorwhenthestoryisonthefrontpageoftheofTheWallStreetJournalortheFinancialTimes,orpicturesofburned-upcornareontheeveningnews.Inthesummerof1993,whenthefloodshittheMidwestandthousandsofacresofcropswereunderwater,itseemedeveryonewasbullishsoybeans(includingmyself).Theconsensuswasover90%bullish.Newsweek,whenitstillwasamajorprintmagazine,ranacoverstoryonthefloods.Thecoverhadapictureofafarmeruptohisneckinwater.Lookingback,wenowknowthatissuecameoutontheverydaythecontracthighforthenextdecadewasreachedinthegrains.

SpreadsUsingspreads(attimescalledstraddlesorswitches)isamoresophisticatedwayoftrading,anditfitswellintothegameplanofmanytraders.Iknowsometraderswhotradeonlyspreadsbecausetheyfeelspreadsarethebestwaytolimit

someoftherisksinherentinfuturesandoptions.Actually,thisisthemainpurposeofspreading:toreducerisk.Whenyouenteraspread,theobjectiveisnotnecessarilytomakemoneyona

riseorfallinthemarketinquestionbutrathertomakemoneyfromachangeintherelationshipbetweendifferentprices.Whenyouputonaspread,youbuyonecontractwhilesimultaneouslyselling

another.Youarelongandshortineithertworelatedcommoditiesortwodifferentmonthsofthesamecommodityatthesametime.Therelativechangebetweenthetwodeterminesyourprofitorloss.Thetwomajorcategoriesofspreadsareintramarketandintermarketspreads.

IntramarketspreadsIntramarketspreadsconsistofbuyingonemonthinaparticularcommodityandsimultaneouslysellingadifferentmonthinthesamecommodity.ExamplesincludebuyingJulycornandsellingDecembercorn,buyingMarchcrudeoilandsellingAprilcrudeoil,andbuyingMaycottonandsellingDecembercotton.Sinceyouaretradingtwodifferentmonthsinthesamecommodity—onelongandtheothershort—theirpricestendtomoveinthesamedirection.Sohowcanyoupossiblymakemoneyinaspread?Well,althoughspreadstendtomoveinthesamedirection,theydon’thaveto.Andevenwhenthetwomonthsmoveinthesamedirection,theygenerallytendtomoveatdifferentspeeds.Manytimes,whenyougainononesideofaspread,youloseontheother.Whatyou’relookingforisabiggergainonthewinningsidethanlossonthelosingside.Let’slookatanexample.AssumethatyouputonaspreadbetweenMarch

copperandJulycopperinDecemberofthepreviousyear.YouarebuyingtheMarchandsellingtheJuly.Whenyoubuythenearmonthandsellthedistant,itiscalledabullspread.Abearspread(shortMarchandlongJuly)isthemirrorimage.Inabullspread,youarepredictingthatthenearmontheitherwillrisefasterthanthedistantorfallslower.Eitheroutcomeisprofitable.Spreadscanbemorereliableandmorepredictablethanoutrightpositions,whichispreciselythereasonmanytraderslikethem.Spreadsarenotsurethings,buttheycanputtheoddsinyourfavor.Forexample,mostyears,theMarchcoppertendstogainontheJulybecause

ofseasonalconsiderations.Marchishistoricallyahigh-demandtimeoftheyearforcopperbecauseofinventoryrebuildingpriortothepeakbuildingseason.Supposethatwhenyou“place”thespreadinDecemberthatMarchistradingat302andJulyistradingat301.Youhaveputonthisbullspread—longtheMarchandshorttheJuly—withtheMarchtradingata100-points(1¢perpound)

premiumtotheJuly.(IftheMarchweretradingat300andtheJulyat302,youwouldsayyouwerelongtheMarchandshorttheJuly,withtheMarch200pointsdiscounttotheJuly.)Afewmonthspass,andinFebruary,copperhasriseninprice,withbothmonthsappreciating—butatdifferentspeeds.TheMarchistradingat315andtheJulyat310.Thespreadhasnowwidenedfrom100pointspremiumtheMarchto500pointspremiumtheMarch,andyousenseitistimetotakeyourprofits.Toexit,youwoulddothereversetransaction—thatis,selltheMarchandbuytheJuly.Thisoffsetsbothsidesofthespreadandeffectivelywipesyourslateclean.Let’slookattheresult.TheMarchhasrisenfrom302to315,soyouhavea13¢,or1300-pointprofit,onthissideofthespread.TheJuly(theshortside)hasrisenfrom301to310,soyouhavea9¢,or900-pointloss,onthissideofthespread.Thedifferencebetweenwhatyougainedandwhatyoulost(1300minus900)isyourprofit,whichinthiscaseis400points.Notethatyoudon’tneedtocalculatebothsidestodetermineyourprofit;thisworksoutneatlytobethespreaddifferences:500minus100is400.Because1pointincopperisworth$2.50percontract,thisisagrossprofitof$1,000perspread.Youmightbeaskingyourselfwhyyou’dwanttotradethespreadwhenyou

couldmakemoremoneybysimplybuyingtheMarchoutright.Inthiscase,Marchralliedfrom302to315,a1300-pointmove,or$3,250profitversus$1,000profit.Itallhastodowiththerisksversusthereward.Spreadsgenerallymoveslower.Yes,youcancertainlyloseinaspreadaswell,butattimesyoucangainevenwhenthemarketdoesn’tmovethewayyouplan.WhatiftheeconomyweakensandMarchcopperfalls1300points?Ifyouwerelong,youwouldlose$3,250percontract.Thespreadcouldcertainlyfall400points,butitisalsopossiblethattraderswouldturnbearishthewholemarket,andbothmonthscouldgodownthesameamount,therebyresultinginnoloss.Whenspreadtrading,youaremoreinterestedinthedifferencebetweenthemonthsthantheoutrightflatpricemovements.Theabilitytoprofitinbothupordownsituationsisoneoftheadvantagesof

spreadtrading.Also,themarginrequirementsforspreadsaregenerallymuchsmallerthanoutrightpositionsbecausetheExchangerecognizesthat,inmostcases,spreadsarelessrisky.IfyouarelongMaycornandshortSeptembercorn,andthepresidentdeclaresagrainembargo,oddsarethatbothmonthswillbedownsharply.Inotherwords,youaresomewhatinsulatedfromdramaticnewswiththeresultingpriceshockswhenspreadtrading.Inaddition,spreadstendtomoveslower,givingyoumoretimetoreact,andmanytradersbelievespreadsaremorepredictable.

IntermarketspreadsIntermarketspreadsconsistofbuyingonecommodityandsimultaneouslysellingarelatedcommodity.TwoexamplesarebuyingsilverandsellinggoldandbuyingMinneapoliswheatandsellingChicagowheat.Intheseexamples,thetwomarketsarerelated,andtheygenerallymoveinthesamedirectionbecausethesamemarketforcesaffectboth.However,theymoveatdifferentspeeds.Forexample,youmaydecidetobuyJulycornandsellJulywheat.Bothare

grains,bothcanbeusedforanimalfeed,andbothareexportcommodities.Theywilltendtomoveinthesamedirection.However,ifthefundamentalsareopposed,thetwocouldmoveinoppositedirections.Let’sassumethatitisMarchandthatyoubelievethesuppliesofcornaretightbutthatwheatsupplieswillgrowlargerasthemarketmovesclosertotheharvestintheearlysummer.Julycornisat$3.10andJulywheatisat$4.50,soyoubuythecornandsellthewheat,withcornata140discounttothewheat.(Besuretoreadtheorderwiththelong,orthebuyside,first.)Intermarketspreadscannotbeclassifiedasbullorbear,likeintramarketspreads.Supposethatafewmonthsgoby,andbothcornandwheatfallinprice—cornto$2.80andwheat,becauseofharvestsellingpressure,to$3.60.Youdecideitistimetounwindthespread.YoubuytheJulywheatandselltheJulycorn,whichoffsetsbothsidesofthespreadandwipesyourslateclean.Thelongside(thecornside)showsalossof30¢,andtheshortsideshowsaprofitof90¢.Yourgrossprofitisthedifference,60¢,andbecauseingrainsapennymoveisworth$50percontracttraded,thisisaprofitof$3,000.Notethatyouputthespreadonata140discountandtookitoffatan80discount;thedifferencebetween140and80is60.Inthiscase,youwantedthespreadtonarrow;youwantedthelower-pricedcorntogainonthehigher-pricedwheat,anditdid.Ifthecornfellby40¢andthewheatby20¢,youwouldhavelost20¢onthespread.Iftherewereweatherproblemswiththenewwheatcrop,andthespreadwidenedto190(wheatwentup40¢andcornfell10¢),youwouldhavelost50¢,or$2,500perspread.Certainspreadsareactivelyandcommonlytraded.TheExchangesgenerally

givestradersabreakonthemarginratesfortradingthecommonspreads.Forexample,althoughmarginmightbesetat$1,700tomarginawheatcontract,becauseKansasCityandMinneapolisrecognizeintermarketspreadsbetweentheirtworespectivewheatmarkets,alongMinneapoliswheatandshortKansaswheatspreadmightrequireonly$1,500total(or$750a“side,”not$3,400).Inthegrains,thenewcrop/oldcropspreadsarepopularamongtraderswho

trytodeterminehowtherelationshipwillchangebetweenonecropthathasalreadybeenharvestedandanotherthatiseitherinthegroundoryettobe

planted.Herearesomecommonexamples:•LongMayorJulycorn/shortDecembercorn•LongMayorJulysoybeans/shortNovembersoybeans•LongMayorJulysoybeanmealoroil/shortDecembersoybeanmealoroil•LongMayorJulyoats/shortDecemberoats•LongMarchorMaywheat/shortJulyorDecemberwheat

Popularintermarketgrainspreadsincludethese:•Longorshortwheatversuscorn•Longorshortcornversusoats•Longorshortsoybeansversuscornorwheat

Soybeanprocessorsusethesoybeancrushtolockinprofitmargins,whenavailable.Thisinvolvesthepurchaseofsoybeans(therawmaterial)andthesimultaneoussaleoftheproducts:soybeanmealandsoybeanoil.Thereversecrushinvolvesthepurchaseoftheproductsandthesaleofbeans.Thenewcrop/oldcropJulycottonversusDecemberispopularandcanbe

volatile.Inthemeats,thehogsversuscattle,cattleversusfeedercattlearethemost

popular.Sometradersliketotradethecattlecrush,whichinvolvesapurchaseofcornandfeedercattle(thetworawingredients)versusthesaleoflivecattle(thefinishedproduct).Byfarthemostpopularenergyspreadisthepurchaseorsaleofheatingoil

versustheunleadedgasolinebecausetraderstrytotakeadvantageoftheseasonaltendenciesofthesetwoproductstomovetowardorawayfromeachother.TheCrackSpreadisthesimultaneouspurchaseandsaleofthecrudeoilcontractversustheproducts,gasolineandheatingoil.Inthemetals,thegold/silverratiospreadiscalculatedbydividingthepriceof

goldbythepriceofsilver.Itrepresentsthenumberofouncesofsilverrequiredtoequalthepriceof1ounceofgold.In1980,whengoldwas$850andsilver$50,theratiowas17;however,in1996,withgoldat$350andsilverat$5,theratiowas70.I’mnotsurethereisanaverageoracorrectnumberhere,butrecentlytheratiohastradedbetween30and70,withtheaverageforthepastcenturyat32.5.Thepurchaseorsaleofplatinumversusthepurchaseorsaleofgoldisanotherpopularmetalspread,withamarginbreakforbuyingoneandsellingtheother.ApopularinterestratespreadistheNOB(TreasurynotesversusTreasury

bonds),orthespreadbetweentheU.S.TreasuriesandtheBund(GermanGovernmentBonds),ortheEurodollarversustheNotespread(therelationshipbetweenshort-termandlonger-termrates).Limited-riskspreadsincludecarryingchargespreads.Carryingchargesarethe

coststoholdacommodityfromonemonthtothenextandincludestoragecostsandinterest.Forexample,ifitcosts3¢permonthtoholdwheat,andtheJuly/Septemberwheatspreadistradingat8¢premiumtotheSeptember,bydefinitiontheriskonthisone,islow.Unlessinterestratesrisedramatically,thelikelihoodthatSeptemberwouldrisemuchmoreaboveJulyisminimal.However,ifabullmarketdevelopsinwheatduetolimitednearbysupplies,thereisnolimitastohowfarJulycouldriseaboveSeptember.Thesearespreadstowatchfor.Limited-riskcarryingchargespreadscanbefoundonlyinstorablecommodities.Ontheotherhand,thereisnolimittohowspreadscanvaryineitherdirectionforperishablecommoditiessuchaslivecattle.Andyes,youcan“legoff”aspread(meaningyoucanliquidateonesideand

leavetheotherintact),butitisgenerallynotagoodidea.Younormallyenterthespreadbecauseitisalower-risktransaction.Novicetraders,whenaspreadisn’tworking,havebeenknowntotakeofftheprofitableleg,leavingtheunprofitableon,inhopesthatitwillcomebackandprofitscanberealizedonbothsides.Forsomeunexplainedreason,thisusuallydoesn’twork.(Itwouldbebetter,inmostcases,totakeofftheunprofitablesidebecausethisisthesidethatisn’tworking.)Nomatterwhichsideyoutakeoff,however,ifyouexitonesideofaspread,youimmediatelyincurtheriskofanoutrighttransaction.Youcanthinkofthislikesplittingsixesinblackjack,becauseyoudon’tlikea12againstadealer’sace.Althoughitmightworkattimes,inthemajorityofsituations,you’rejustaskingfortrouble.(Incidentally,whenyoulegoffaspread,youimmediatelyloseyourmarginadvantage,andyouraccountischargedfullmarginfortheremainingoutrightposition.)Notethatspreadscantradewiththefrontmonthhigherthanthebackandvice

versa.Youcanusethisfactasavaluableforecastingtool:Generally,marketslikethisarebullish.I’llendthisparticulardiscussionofspreadswithacaveat:Becausethemarginsaregenerallymuchloweronspreads,thereisanaturaltendencytoovertradeorputontoomany.Justbecausespreadsarelimitedriskdoesnotmeanthereisn’trisk;onoccasion,spreadscanactuallyentailgreaterriskthanoutrightpositions.Anumberofyearsago,afriendofminehadthelongJuly/shortDecembercottonspread.Oneafternoon,afterthemarket’sclose,achangeinagovernmentpolicywasannounced.AlthoughI’veforgottenthespecifics,IrememberthatthenextdaythemarketopenedlimitdownintheJuly

andlimitupintheDecember—theresultbeingthatmyfriendwashittothemaxonbothsides!

Finally,here’sanothertruestoryfromthepitdaysoftheChicagoMercantileExchange.OnemorningbeforeamajorUSDACattleReport,alargetraderinthecattlepitbought100contractsatsteadymoneyonthedaytoinitiateanewlongposition.Severalsmallertradersinthepitalsobought,figuringthisguyknewsomethingandthattheycould“coattail”him.Then,thefirstwaveofsellinghitthepit.Themarketmoved50pointslowerontheday.Insteadofpanicking,thelargelocalboughtmore.Sodidthecoattailers.Then,thesecondwaveofsellinghitthepit.At100pointslower,thebigguyboughtmore.Sodidthe“coattailers”—butatthispoint,theircoattailswerefeelingabittight.Then,thethirdwaveofsellinghitthepit.Themarketwentlimitdown,atthattime1.5¢perpoundunderthepreviousday’sclose.Iftherehadbeenmoresellersthanbuyers,themarketcouldhaveendedtheday“locklimit”down,withtradersconceivablybeinglockedintoapositionuntilthenextday.Still,thebigguyboughtevenmore.Thistime,however,thecoattailersranforexits;theyjustcouldn’ttakeitanymore.Justastheysoldout,theyheardthebigguysay,“Nowwe’vegot’emrightwherewewant’em.”Onlyonecoattailerhadthegutstohangon.Asitturnedout,thatthirdwaveofsellingwasthelastwaveofselling,andthemarketendedupclosinghigherontheday!Perhapsthisiswherethefollowingold-timetrader’sexpressioncomesfrom:“Iboughtthefirstbreak;Iboughtthesecondbreak;Iwasthethirdbreak.”

7.AlgorithmsEliminatingPeople

“Relax,”saidthenightman,“Weareprogrammedtoreceive.Youcancheckoutanytimeyoulike,Butyoucanneverleave!”—TheEagles,“HotelCalifornia,”1976

AnelectrictensionfillstheairasLouisWinthorpeIIIandBillyRayValentinemuscletheirwaythroughthecrowdoftradersliningtheNewYorkBoardofTrade’sorangejuicetradingpit.Thetradersaresweatingfromheatgeneratedbymorethan100tightlypackedbodies,nervouswiththeanticipationofwhat’stocome.Theclerks,manningthephonessurroundingthepit,areonhighalert.Thecropreportwillbereleasedinfiveminutes.Whenthosenumbersarereleased,themarketwillmovebigtime,creating(anddestroying)fortunesintheprocess.WinthorpeandValentinearenowstandingshouldertoshoulderwithothertradersandeyeingtheirarchnemesis,ClarenceBeeks.Beeksbelieveshealreadyknowstheactualcropreportnumbers,sinceheillegallyobtainedanadvancecopyofthereportinhisquesttocornertheorangejuicemarketonbehalfoftheinfamousDukeBrothers.However,ourheroeslearnedofBeeks’splan,theymanagedtostealtherealcropreportbackfromBeeks...andsecretlydeliveredhimafakeversion.The“real”cropreportwillshowarecord-largeorangeharvest,resultinginhugesuppliesthatwillultimatelymovethetraderstoyell,“SELL!”Beeksbelievesthenumbersinhisfalsereportandislookingfortheorangecropproductiontobesharplylower.Heisplanningto“BUY!”inhisquesttocornertheorangejuicemarketfortheDukes.Commoditiescanbevolatileonanyday,butparticularlysooncropreportday.Theopeningbellrings,andthedecibellevelexplodes.(Inthe1980s,allthetradesinOJweremadeinthepitbythe“open-outcry”process,inwhichthetradersyellouttheirbidsandoffers.)Beeksstartshittingalloffers,screaming,“Buy,buy,buy!”Mostofthetradersinthepitaresheeplooking

tohoponfortheride.SeeingBeeksbiddingthemarketup,theybelieveheknowssomethingandjoininhisbuyingfrenzy.Therumorshavestartedtofly:“TheDukeBrothers(withBeeksastheiragent)arelookingtocornerthemarket!”FCOJpricesarenowonatear,risingashighas$1.45perpound.Untilnow,WinthorpeandValentinehavebeenlyingintheweeds.Withperfecttiming,theybegintoscream,“Sell,sell,sell!”—rightatthetopofthemarket.Thetruecropreportnumbersarethenrevealed.Themarketbeginstocrash,andattheoptimallowpointof29¢perpound,ourboysreversecourseandstartscreaming“Buy,buy,buy!”Theyarenowcoveringtheirshortsales.Themajorityofthesesalesweremadewellabove$1perpound,andtheyarecoveringfrom25¢to46¢andnettingmillions.TheDukes,whoboughtnearthetop,areleftholdingthebag.

Theclassic1983comedyTradingPlacesisoneofmyall-timefavorites.WinthorpeisbeautifullyportrayedbyDanAykroydasarichcommoditybrokerturnedhomeless,withValentineplayedbythecomicgeniusEddieMurphyasahomelessmantransformedintoarichcommoditybroker.Manypeoplebelievethatthestorywasinspiredbythesilvermarket’sincredibleriseandultimatefallin1980,whentheHuntbrothersofTexastriedunsuccessfullytocornerthatmarket.SilverpricescrashedinMarchofthatyear,whenthebrotherswereunabletomeettheirlast$100millionmargincall.WhatreallymadeTradingPlacesexcitingwasthetradingpititself,filmedin

theactualpitattheNewYorkBoardofTrade(NYBOT),whererealtradersplayedthemselvesinthemovie.Theclimacticscene(inmostviewers’minds)isthechaoticbuyingfrenzythattookplaceinthepit(althoughsomemaleviewersmightarguethattheclimacticscenewaswhenJamieLeeCurtistookoffhersweater).Inanycase,themoviewouldnothavebeenasvisuallyexcitingornearlyassuspensefulwithoutthetradingpit.It’shardtoimagineanyexcitementifourheroeswerejustclickingamouseinfrontofacomputerscreen.TradingPlacesisnowmorethan30yearsold.TheNYBOT,wherecotton,

coffee,cocoa,sugar,andorangejuiceweretraded,wasestablishedin1870.OnarainyFriday,October19,2012,thefloortradersincotton,coffee,cocoa,sugar,andorangejuicedonnedtheirtradingjacketsandyelledouttheirbidsandoffersforthelasttime.Yousee,thiswasthefinaldayof“open-outcry”trading.Open-outcrytrading,thebackboneoftheExchangeformorethan100years,waspermanentlysilenced.Itwasprogress,butthepitclosingput1,000tradersandsupportstaffoutofwork.OneveteranpittradertoldaNewYorkPostreporter,

“Mostofthesepeoplereallydon’tknowhowtodoanythingelse,andnowwewillallhavetofindourplaceintheworld.”However,otherthanthesefolks,theclosinghadlittletonoeffectonthedealingsinthesekeyglobalcommodities.Ordidit?

OpenoutcryisdeadWhenIwrotetheIntroductiontomybookTheNewCommodityTradingGuide:BreakthroughStrategiesforCapturingMarketProfitsin2008,Idiscussedtheupsideofreplacingthepittraderwithcomputers.Therewasnoneedfortraderstoleavetheirhomesinthemorning.Noneedtomaintainadowntownfacilitywiththeassociatedhighrentsandutilitycosts.Noneedtohirerunners,phoneclerks,andtradingclerks.Andaboveall,noneedforthepittrader.Iusedtopayagoodpittraderanextra$2to$5percontract(abovenormalclearingfees)toexecutemytrades,andIwasgladtodoso.Iftheguywaslouderorbiggerorquickerthanmycompetitor’sfloorbroker,Iwouldoftengetthebetterprice.So,thecostsavingsofcomputerizedtradingisobvious,butitalsobringsthebenefitofalevelplayingfield.ErnestHemingwayoncesaid,“Thebestwaytofindoutifyoucantrustsomebodyistotrustthem.”Intheolddays,youreallyhadtotrustyourpitbroker.Yearsago,IwasusingafloorbrokerintheNewYorksilverpittoexecutemy

tradesthere.Allwasgoingwelluntiloneday,whenIplacedanordertobuy50silvercontractsatapricethatshouldhavebeeneasilyfilled.Afterafewminuteshadelapsed,themarketsurgedhigher,nettingmeatidyprofit...atleastthat’swhatIthought.Ihadbeenwaitingforthepitbroker’sphoneclerktocallmebackwiththefill.Hehadn’tcalledyet,soIcalledthefloor.ThebrokergotonthephoneanddeniedIhadeverplacedtheorder.Iaskedtolistentothetaperecordingofthetransaction,butithadbeenmysteriouslyerased.Tothisday,Ihavelittledoubtthathefilledtheorderandpocketedmyprofitforhimself.Myonlyrecoursewastoneverusethisguyagain,andsubsequentlyIdidfindapitbrokerIcouldtrust.Thiskindofproblemdoesn’toccurwithelectronictradingbecausethecomputercan’tlie.Andthereareotherbenefits.Youcanplaceordersfaster—asfastasamouse

click.Duringafast-movingmarketintheoldendays,itwasentirelypossibletomissapricebythetimetherunnerdeliveredtheordertothepitbroker.Evenwithusingamarketorder(requiredtobefilledatthenextavailableprice)duringawildpitsession,wemightnothaveknownforhourswhatpricewewerefilledat.Inerraticmarketconditions,agoodfillwasoftentheluckofthedraw.Todaythesedoubtsaregone;fillsreturntothetraderinstantaneously.Thecomputer

canalsomanagemultipleordersandpricefillsmoreefficientlythanahuman.Clearingfirmslikecomputerizedtradingaswellbecausecreditandriskmanagementareautomated.Thecomputercancutoffanout-of-controltraderbeforethetrader’saccountmovesintoanunsecureddebitposition.Reducedcostandspeed,enhancedinformationmanagement,theexpansionof

marketsgloballywith24-hourtrading...isn’ttechnologyterrific?Otherthanthelossofafewjobsandtheromanticismofthebygoneeraofthepits,arethereanydownsides?Overtime,atleasttome,thedownsideshavebecomemoreevident.ThelegendarytraderLivermoreoncesaidsomethingtotheeffectthat

technologymightchange,butthemarketsneverwillbecausemarketsaremadebyhumanbeings,andhumannaturedoesn’tchange.Traderstodaystillmakethesamemistakestradersmade50or100yearsago.Marketswillcontinuetotrendupandtrenddown.“Thetrendisyourfriend”isabasicthemeofsomeofmyotherbooks.This

truismhasnotchangedandremainsaprimarythemeforsuccessfultradinginthisbook.Icanciteliterallythousandsofexamplesofmarketsthathavetrendedlongandfarand,intheprocess,madesomepeoplerichandwipedoutmanyothers.Youmighthaveheardaboutthepoorsoulwholosthisfarm.Icanalmostguaranteethatguywasbull-headedandfoughttheprevailingtrendofthemarketuntilhefinallyranoutofmoney.Inthe1920s,forexample,theNewHavenrailroadwasthepremierblue-chip

stockofthedayandsoldashighas$279pershare.Inthosedays,youcouldtradestockson5%margin,aswetradefuturestoday.WhenNewHavensold50pointsoffthetop,itmusthavelookedcheapatthetime.Howmanytraderswouldhavehadthegutstosellitshortwhenitcrossedbelow179,100pointsfromthetop?Betteryet,whowouldhavehadtheguts,orthevision,tosellthisinvestment-gradesecurityshortat79,or200pointsfromthetop?Itmusthavelookedextremelycheapat79because,remember,thiswastheAppleofitsday.Yetthetrendwasdown,andafterthecrashof1929,ittradedaslowas12.Intheyear2000,afriendofmineboughta“newtechnology”stockatthe

offeringpriceof$66.Headdedtohispositionat$150ashare,againat$200,andthenagainat$300.Isuggestedheusestopstolockinhisprofit,buthe“knew”thiscompanywasonlygoingup(hisdaughterworkedthere),andhetoldmeitwouldultimatelytradeat$1,000.ItdidkeepgoingupbeyondwhatIimagineditevercould,andheaddedtohispositionat$450and$500.Itactuallytradedashighas$600.Today,ithasbeendelisted,goingofftheboardat$0.He

lostmuchmorethanhisoriginalinvestmentbecausehewastradingonmargin.RememberEnron?Thiswasa“blue-chip”energycompanyandthelargest

contributortothe2000Bushpresidentialcampaign.Atthattime,thestockwastradingat$90ashare.Today,itnolongerexists.Ifyoustillownthestock,youcanuseyourcertificateaswallpaper.Thetrendisyourfriend;donotfightit.ElectronictradingwillnoteliminatetrendsoreliminatefutureEnronsorsilvercrashes.Thekeystosuccessfultradingarestill,andalwayswillbe,successfullyidentifyingthetrendsandpracticinggoodmoneymanagement,combinedwiththeessentialqualitiesofpatienceanddiscipline.WhileIhavelongsubscribedtoLivermore’sbeliefthatmarketsdonotchange

becausehumannaturedoesnotchange,eliminatingpeoplefromthemiddleoftheequationhasmadesomedifferenceinpricemovements.

RoguealgosKnightCapitalisafirmthatspecializesinexecutingtrades.OnaWednesdaymorninginAugust2012,thefirmwastestinganewelectronictradingalgorithm,andsomehowina45-minuteperiod,thefirmmanagedtolose$440million.Thiswasnotcausedbyaroguetrader,orevenhumaninteraction.Itwasblamedona“badalgorithm”inthecomputersoftware.Ifnotforacashinfusionbycertaincustomers,thefirmwouldhavebecomeinsolvent.Thisdisasterwasalldonebythecomputer,at40tradesperstockpersecondoverhundredsofstocks.Buyingtoohigh,sellingtoolow,andattractingothercomputerstotaketheotherside,movingthemarketsandcausingchaos.Tradesoccurredat“abnormal”prices,bothaboveandbelowtheprevailingmarket;onKnight’sappeal,theExchangeletthegreatmajorityofthetradesstand.Somebodymadethe$440million,butmanyotherinnocenttraderswerecaughtinthiswebaswell.Ifyouhadastopworkingtocutaloss,itmighthavebeenhit.Ifyouhadalimitordertobuyorsell“away”fromthemarket,itcouldhavebeenfilledthatmorning.Bottomline:Thecomputerscancreateweirdmarketactions,andattimestheyevendothisbydesigninnormaltrading.Somefirmsprogramtheiralgorithmstocreatewildswings,tosetoffstopsandmovemarketstopointsthey’veengineeredtoprofit.It’sallmarketactionandmayhavenothingtodowithnewsorfundamentalsofsupplyanddemand.Itseemsthateveryday,Iseemarketactionsthatneverwouldhaveoccurredwhenthetradesweredoneinthepits.Astraders,wehaveallhadtoadjusttothesenewmarketrealitiesinstocks

andcommodityfutures,andyouwillneedtoadjustyourmethodsaswell.

Explodingvolatility

Oneconsequenceofeliminatingpeopleisvolatility.Speedandvolumehavecombinedtomakethemarketsmorevolatilethantheyhavegenerallybeeninthepast.Volatilitycanleadtotraderanxiety;however,ananxioustraderwillnotbeasuccessfultrader.Succeedingintradingtodayrequirestheabilitytocopewithexplodingvolatility.Areyouoldenoughtorememberthegoodolddayswhengasolinewasless

than$1agallon?ConsiderFigure7.1.

Source:CQG,Inc.©2008.Allrightsreservedworldwide.

Figure7.1.1990soil

Thisisadailychartoftheoilmarketforthe1994–1995tradingperiod.Eachverticallinerepresentsonefulldayoftrading.Youarelookingatnearlyonefullyearofoilfuturestrading.Thechartappearstoillustrateavolatilemarketwithbigupsanddownsthroughoutthisperiod.However,italldependsonhowthechartisscaled.Thepricerangeduringthis10-monthperiodwasanextremehighof$19.07

perbarrelinAugustandanextremelowof$17inDecember.Thisisa$2.07-per-barrelrangefromhightolowwithinthisentireperiod.Thesizeofoneoilfuturescontractis1,000barrels;therefore,every$1-per-barrelmoveequals$1,000profitorlosspercontracttraded.Duringthis12-monthperiod,wesawapproximatelya$2,000-per-contractrangeinpricemovementbetweenthetwo

extremes—notanatypicalyearforthatperiod.Today,theoilcontractsizeisexactlythesame;however,volatilityhas

exploded.ConsidertherecentexampleshowninFigure7.2.

Source:CQG,Inc.©2008.Allrightsreservedworldwide.

Figure7.2.Today’soil

InFigure7.2,you’relookingata30-minutechartoftheoilmarketthatcoversonlytwodaysinAugust2008.Eachverticallinerepresentsjust30minutesoftrading(versusonedayperlineinFigure7.1).Duringthefirsthighlightedone-hourperiod(two30-minutebars),thepricerangedfrom$122.30perbarrelto$126.03perbarrel,andinjustoneadditional30-minuteperiod(from8:30A.M.to9:30A.M.CST),oilranupanadditional$2.57.Withinjustthis11/2-hourperiod,therangewas$6.30,or$6,300percontracttraded.Inonly90minutesthisday,thepricerangewastripletherangeoftheentire1994–1995tradingyear.Thenextday,asimilardollarmoveinexactlytheoppositedirectionoccurred.Thisisnotatypicalforthecurrentmarketenvironment.Infact,oilnowmovesthesameamountinanaveragedaythatitmovedinanaverageyearbefore1990.Whythisdramaticriseinvolatility?Screentradingisthemajorculprit;

however,reasonsotherthanelectronictradingaretoblame,too.Commoditydemandhasmultipliedinrecentyearsduetothedramaticindustrialrevolution

inanumberofcountries,notablyChinaandIndia.Thisdemandincrease(withadoseofinflation)hasresultedinhigherprices.Higherpricesleadtolargerrangesforthesamepercentagemoves.For$19oil,a10%moveequals$1.90,butfor$90oil,a10%moveequals$9.So,thisispartofit,butitdoesn’tfullyexplainthevelocityandferocityoftoday’smarketmovements(letalonethevolatility).

SpeedsacceleratingAreyouoldenoughtorememberthedayswhenyouheardasongontheradioandwantedtobuythealbum?Theprocessinvolvedphysicallygoingtotherecordstore,findingwhatyouwerelookingfor,andreturninghometoplayit.Thisprocesstooktime.Nowyoucanfindanddownloadmusicinseconds.ThemainreasonfortheincreasedspeedofmarketmovementsistheInternet,adirectresultofthedramaticshiftduringthepastfewyearsawayfromnearly100%pittradingtoprettymuch100%electronictrading.Untilrecently,thisisthewayIwouldplaceanorderinthecommodity

markets:Iwouldpickupthephoneanddialatradingfloor.Hopefully,theclerkwouldpickupthephonecallinatimelymanner,butinafast-movingmarket,sometimesitwouldringforwhatfeltlikeforever,andthiscouldbemaddening.Whentheclerkdidpickupthecall,Iwouldreadmyorder,andtheclerkwouldwriteitonanorderticketandthentime-stamptheticket.Goodprocedurerequiredtheclerktoreadbackmyordertomeforconfirmationandconsistencybeforeshesentitoff.Theclerkwouldthenpassmyordertoarunner(hopefullytherunnerwasnearthephoneclerkandnotouthavingacigarette),whothenphysicallywalkedittomybrokerinthetradingpit(or,attimes,thebroker’sclerk,adjacenttohiminthepit).Thepitbrokerwouldcuetheorder,andwhenthemarketapproachedmyprice,thepitbrokerwouldyelloutthebuyorsellintothetradingpit,lookingforanoffsettingtradeviatheopen-outcryprocess.Aftertheorderwasfilled,theprocesswouldreversefromrunnertoclerk,withmoretimestamps,andeventuallyitwouldbephonedbacktome.Thisalltooktime.Fromtoday’spointofview,itisamazingthatweoperatedthisway—andinmostcasesefficiently.Nowwithelectronictrading,ordersaredisseminatedandreceivedinstantly.

Ordersofallsizesfromaroundtheglobearenowenteredinstantly,eliminatingthisentirehuman-basedprocess.Thisvolatilityenablesmanyopportunities,butitalsogeometricallyincreases

theriskscomparedtotheolddays.So,howdoesahumantradercopewiththisriseinvolatility?Theanswerisyoumusthaveaplan.

Today,atraderneedstocompresshistimeparametersandusecomputingpowerovershortertimespans.Aplanwillnoteliminatethevolatilityandspeedoftoday’smarkets,butitwillhelpyoucompete.

MeldingtheoldwiththenewOneobjectiveofthisbookistomeldthenecessaryadjustmentsforthecurrentmarketenvironmentwhilemaintainingthosetimelessmethodologiesthathaveworkedinthepastandwillcontinuetoworkinthefuturebecauseofhumannature.Fearandgreedultimatelymovemarkets.Andnomatterwhatmachinesweutilize,thesehumantraitswillnevergoaway.Speedcanbeourfriendorourenemy.Thereishardwareavailabletodaythatcanmaketradesinextremelytiny

fractionsofasecond.ThetruthisthatyouandIarenotgoingtocompetewiththat,nordoweneedto.Maybewedonotwantto.RememberthatKnightCapitalwasrichenoughtoaffordthatdegreeofcomputingpower.Whatweneedtodoisfocusonmethodologiesthatcanworkforus.Weneed

todeveloptradingmethodologiesthatutilizehumantraitsforsuccess.Oneoftheobjectivesofthisbookistohelpguideyouthroughthesewaters.AsthelegendarytraderW.D.Gannoncesaid,“Mostpeopleareintoobiga

hurrytogetrich,andasaresulttheygobroke.”Thishasn’tchanged.In1841,CharlesMackaypennedMemoirsofExtraordinaryPopular

DelusionsandtheMadnessofCrowds,inwhichhewrote:“Men,ithasbeensaid,thinkinherds;itwillbeseenthattheygomadinherds,whiletheyonlyrecovertheirsensesslowly,andonebyone.”Thishasn’tchanged.Thepittradermayhave“gonethewayofthedodo,”becominganextinct

species.(Theyweregoodtoeatandeasytocatch.)However,humannaturehasn’tchanged.Itisinterestingtonotethechangeinhowthemainstreamviewscommodities.

Duringmostofmytradingcareer,whichspansmorethan30years,futurestradingwasviewedasacasino.Now,manyfinancialplannerstreatcommoditiesasanassetclass,andtheyallocateaportionoftheirportfoliostocommodities,alongsidetraditionalstocksandbonds.Whilethecommoditymarketsmayactdifferentlynowthantheyusedto,manytime-testedmethodsdostillwork.Afewyearsafterthe1929stockmarketcrash,thegreattraderand

philanthropistBernardBaruchwroteaforewordtoareprintofCharlesMackay’sclassic.Asthetitleindicates,Mackay’sbookchroniclesvariousinvestmentmaniasfromthe1500sthroughthe1800s.FromthetulipcrazetotheMississippi

andSouthSeabubbles,thebasicunderlyingpremiseisthatmanias(economicandotherwise)areaconditionofthehumanspecies.Theywillcomeandgoovertimebutneverdisappear.ThereprintededitionofPopularDelusionsthatIownwaspublishedinOctober1932,rightinthethickoftheGreatDepression.Inthisquotefromtheforeword,Baruchreferstothatmostrecentmaniahetermedthe“1929marketmadnessinAmerica:”“Ihaveoftenthoughtthatif,inthelamentableeraofthe‘NewEconomics,’culminatingin1929,eveninthepresenceofdizzilyspiralingprices,wehadallcontinuouslyrepeated,‘twoandtwostillmakefour,’muchoftheevilmighthavebeenaverted.”Thoseverywordscouldbeusedtoday;justsubstitutethedatesandthemarketyouwanttoinsert.

Panics,manias,andbubblesThe1929panicandeventualrecoveryfromtheGreatDepressionthatfollowedwerenotfirstsforAmerica.Crashesandmarketpanicshadpreviouslyoccurredin1837,1857,1861,1873,1893,and1901.The1857panicwasprecededbytheCaliforniaGoldRush.The1873panicwasprecededbyaspeculativelyinducedbubbleinrailroadstocks,justasthepanicof2008wasprecededbyaspeculativeboominhousingpricesthatcreatedthesubprimemortgagedebacle.Still,morehasbeenwrittenaboutthe1929crashthananyothercrashinhistorybecausemorepeopleinthenewlymintedmiddleandupperclasseswereaffected,andalsobecausefewpeoplesawitcoming.Peopleheldawidespreadbeliefatthattimeinthe“neweconomics;”aperiodofpermanentprosperityhadarrived.Certainly,the1920swasanunprecedentedperiodofprosperity,withnewwealthcreatedfromtheautomobileindustryandtheaccompanyingboominroadbuildingandtravel.Aplethoraofnewtechnologiesandnewhouseholdelectronicappliances,suchastheradio,wereborn.Totopitalloff,the1920ssawthecreationandwidespreaduseofinstallmentcreditproducts.Perhapsthiswasoneofthemainunsungunderlyingcausesofthecrash.Lookingatmodernhistory,wecanpointtothedot-commaniaofthelate1990s.Maybegoldwillbethenextbubble;andwhilewecan’tknowwhetheritwillbethenextbubble,wecancountonthefactthatbubbleswillcontinuetogrowandpop.Obscuremaniaspopupnearlyeveryyearbutfailtoreachthemainstreammediabecausetheyaffectonlyafewwhoaredirectlyinvolved.Onesharedtraitofallmaniasisthatthemajorityofplayersneverseethe

crashcoming.Ifyoureadthefinancialpressfrom1929to1931,allduringtheperiodthemarketwasfalling,respectedanalystscontinuallyconsidereditacorrectionthatwouldsoonbeover.Whenstocksfinallydidhitbottomin1933,

morethan80%ofallvaluehadbeenlost.Willthisbehowthecurrentcommodityboomends?Theanswertothisquestionis,yes,itcertainlywillendbadlybecausealleconomicbubbleseventuallyburst.Theonlyquestionis“When?”Itwilltakeplaceafteranybullmarketmoveinaparticularcommoditymarketmorphsintoamania.Thiswillbethetimewhenthegeneralpublicistotallyimmersedinthestoryoftheday.It’snever“differentthistime:”Italwaysendsthesameway—badlyforthegeneralpublic.So,whenanalyzinganymarketmoveforatop,askyourselfwhetherthe

marketyou’relookingatiscurrentlyspiraling.Doesitlooksimilartoaflagpolereachinguptothesky(whichthelawsofphysicstelluscannotlastindefinitely),orhasitrecentlybeencleansedandpurgedviaahealthycorrection?Inthemiddleofamove,someoftheair(thebuying)thatwaspumpedinflowsoutbeforenewairispumpedin.Oneofmygoalsforthisbookistoteachyouhowtorecognizetheearlysignsofanewbullrunandalsohowtorecognizetheendoftherun.Itdoesn’tmatterifthemovewascreatedbycomputersorhumanbeings.Theresultwillbethesame.Onetypeoftopistheblow-offtop,aformationthatoccursattheendofa

sustainedbullmarketrun.Howcanyoutellifamarketisinablow-offtop?Closetotheendofthemove,duringthetopformation,themarketsurgeshigher,withonlyshallowcorrections.Comparedtothenorm,volumesarehuge.Technicalindicators,suchastheRelativeStrengthIndex[RSI],runuptoextremelyhigh(overbought)readings,butalthoughthesereadingsappeartobeinunsustainableterritory,themarketcontinuesmovinghigherthananyonebelievedpossible.Thenyou’llhearoutlandishpricepredictionsinthemainstreammedia,alongwithtalkofshortagesinthisorthat.ThetalkwillbethattheworldisgoingtorunoutofXcommodity.Inmanycases,thelast48hoursofamajormovecanbethemostfeverishandthereforethemostlucrativeforthebulls.Thisfinalsurgethatformstheactualblow-offisthemostpainfulforthebears.Theircapitulation(shortcovering)createsthefinalhighprices.NobodyIknowofisabletopicktheexacttopinasituationsuchasthis.However,inmarketsthatshowthesesigns,ifyouhavebeenfortunateenoughtobeonforsomeoftheride,it’stimetobevigilantbecausetheendisnear.Thetoppricewillcomewhennobodyislookingandgenerallywhenthenewsisasbullishasitcanget.Mostpeoplewillseethefirstbreakfromthetoppriceasanormalcorrection,

justatemporarybreakwithinabullthatisnowhereclosetobeingoveryet.Themarketmighthaveasecondaryrallyafterthefirstbreak,butthenitwillbeunabletoregisternewhighs.Withoutmostoftheplayersrealizingit’s

happening,theairwillbeletoutofthebubble.Thenoneday,whoosh!Bullishnewsmightcontinueduringmuchofthemovebackdown.Thebullturnsintoabear,thedeclineaccelerates,andultimatelythere’sbloodinthestreets.Thisisthetimewhenthenewswillturnverybearish,therewillbeamultiyearsurplusofthisorthat,anditwillappearthatthebearhassettledinforthelongpull.Inreality,asonlythesmartmoneywillseeduringbloodinthestreets,thebearislosingthegameandwillsoonbereplacedbyayoungbull.

ExplosivecommoditydemandAtthiswriting,themacroforcesofglobalcommoditydemandappeartoremaininforce.Theballoonisinflating,notdeflating.Sure,therehavebeen,andwillcontinuetobe,plentyofhealthycorrectionsalongtheway,butatthistime,considerthesemerelytemporarytops.Weknowexplosivedemandgrowthexistsinthedevelopingworld,andthere

isnoeasywaytoturnthistrainaround.Morethan1billionconsumersaremovinguptoahigherlevelofconsumption,demandingthecomfortstheWesthasenjoyedsincetheIndustrialRevolutionthatbeganintheearly1900s.Formanydecades,1billionofEarth’shumaninhabitantshaveconsumedtwo-thirdsofEarth’sdevelopedresources.Theother6billionhavegottenbyontheremainingone-third.Now,ledbyChinaandIndia,thedevelopingworldiseatingbetterandlivingbetter,andthisrequiresmassivecommodityconsumption.Thesepeoplearetransitioningfrombeingmainlyproducerstoacombinationofproducersandconsumers.Fromamacrosense,thisplacesupwardpressureoncommodityprices.Sure,therewillbecrashesandbustsalongtheroad,butthisisanoverallmacrotrendthatlikelywillcontinuethroughoutourlifetimes.Morepeopledrivemorecarsandconsumemoreproteinandmoreelectric

power.Thisyear,morethan5millionnewcarswillbeproducedeverymonth—morethan60millionfortheyear.Heating,lighting,airconditioning,andappliancesrequirepowerplants.Newbuildings,roads,ships,ports,trains,trucks,andbuses...thelistgoeson.Energyneeds,foodrequirements,textiles,coppertobuildnewelectricalgrids,cornandsoybeanmealtofeedgrowingpopulationsofpigs,chicken,andcattle.Soybeans,cotton,rice,sugar,andcornforfoodandfuel,withmorefertilizerneededtogrowthesecrops.Thisyear,therewillbemorethan100millionnewbirthsbeforethemonthof

October.Netofdeaths,theglobalpopulationisgrowingatmorethan80millionpeopleannually.ThisistheequivalentofaddingoneMexicototheworldeveryyear.Theareasoftheworldwiththegreatestpopulationpercentageincreases

aremovingtowardtheconsumptionpatternsofthedevelopedworld.Andwhileallthisistakingplace,thedevelopedworldcontinuestoconsume.Andit’snotjustIndiaandChinathatareplayersinthisindustrialrevolution.OtherrapidlyemergingAsiannations,EasternEuropeans,andSouthAmericans(withBrazilattheforefront)arecreatingmassivenewconsumermiddleclasses.NorthandSouthAmericanfarmershaveexperiencedgreatgrowingweather

forthemajorityofthepast100years.Thisbenefit,combinedwithimprovementsinagriculture,hasresultedinabundantcropsmostyears.Youhavetogoback800yearstofindaperiodofsuchfavorableweatherforsuchalongtime,anditisnotgoingtocontinuelikethis.AstheU.S.droughtof2012hasdemonstrated,withonecropfailureanywherearoundtheworld,pricesofcornorsoybeanscaneasilytriple.WithanotherMexicobeingaddedtotheworld’spopulationeachyear,thedemandsideoftheequationwillnotsolvethisproblem.Whentheworldagainexperiencesayearofbadweather(whethertoomuchrainortoolittle,temperaturestoohotortoocold),foodpricesaresettosurgeagain.Despitethecomputerstakingoverthevolume,allthesefactorsunderscorethe

reasonmanyinvestorsneedtodiversifyandbecomecommoditytraders—atleastwithaportionoftheirportfolio.Butthequestionstillremains:“Howcanwebestcompetewiththecomputers?”GeorgeSorosoncewrote,“Themostimportantfundamentaliscreditflows,”

or,moresimply,money.Moneyflowsmovemarkets,andthisisthemostimportantdeterminantofpriceaction.Mypremiseisthatyouneedtocorrectlyanalyzeonlythisonefundamental—whichdirectionthemoneyisflowing—tobesuccessful.Howdowedothis?Myanswertothisquestionlieswithtechnicalanalysis,whichthebalanceofthisbookfocuseson.But,nomatterhowyoudecidetotrade,rememberthatcommoditiesare

necessaryforlifeandcomfort,andasaresultwillbetradedaslongasthehumanraceexists.Everyeconomyhasexperiencedlongperiodsofnegativegrowthwhencommoditypriceshavebeendepressed.Thenthebullcyclesoccur.Minicycles,suchasthecommoditydecadeofthe1970s,havelastedabout10years.However,long-termchartsbeginninginthe1700stellusthatmajorbullcyclesincommoditiesgenerallylastdecades.America,andbycontagionmuchoftherestoftheglobe,willcertainly

continuetohavetheirshareoffuturefinancialcrises.In2008,whenthemajorinvestmentbanksBearStearnsandLehmanBrothers,bothinbusinessforover100years,disappeared,andtheU.S.governmentbailedoutFannieMae,AIG,

andGeneralMotors,countlesspaperassetsplummetedinvalue.Yetcommoditypricesremainedrelativelystrongbecausetheyarenecessarytosustainandenhancelife.Ianticipatethatcommoditieswillcontinuetobeahotassetclassforyearstocomebecausetheworldhasenteredaperiodoftighteningcommoditysupplieswithincreasingdemand.Theplanet’sresourcesarelimited,andcommoditiescanplayaroleinyourasset-allocationdecisions.However,therewillbedowntrendsaswell,sojustrealizethatbearcyclescanbeasprofitableastheircounterpart,andtheycanmovemuchfaster.Bottomline:Followthemoneyflows.

8.TheAdvancedTradingCourse

“Howdoweknowwhenirrationalexuberancehasundulyescalatedassetvalues?”—AlanGreenspan,1996

FundamentalsversustechnicalsIfyouworkforaglobalcommoditytradingfirmlikeCargillorGlencoreandhaveaccesstoaccurate,timely(andexpensive)fundamentalintelligence,theoddsareit’sbetterinformationthantherestofusaregetting.It’sNestlé’sbusiness,forexample,toknowtheconditionofthecocoacropinGhanaorBrazil.Althoughyoumightreadsomebrokeragehousereportthatdiscussesthe“witch’staildisease”anditspotentialtodevastatethecrop,NestléhastheirmanrightthereinGhana,withanotherinBrazilwalkingthefields.NestléandHersheybothhavebetterintelligenceforjusthowgoodorbadthecropsarethanyou’lleverhave(andtheyhavenoreasonorobligationtosharethisinformation).Supposethecocoacropisdeteriorating.Aconfidentialcommuniquéissentto

Switzerland,andthefolksinchargeofcocoapurchasingforNestlégetbusy.OneaspectoftheirjobistohedgebybuyingcocoafuturesinLondonandNewYork.Protectingagainstfuturepriceriskiswhathedgingisallabout.TheNestlétraderswill,asquietlyastheycan,accumulatenewcropcocoafutureslongbeforeyouknowwhatthey’reupto...butthere’sacatch.Nobodyisabletoaccumulatealargeposition,eitheronthelongorshortside,withoutleaving“footprintsinthesand.”Large,significant,“informed”volumeisreportedaccordingtoExchangerulesandinevitablywillmoveprice.Thisiswhattechnicalanalysisisallabout—analyzingcurrentpriceactiontoprojectfuturepriceaction.So,ifyouandIareunabletocompeteonthefundamentals,perhapsatechnicalapproachiswarranted?

Doestechnicalanalysisreallywork?Mymorethan30yearsofexperienceprovesthattechnicalanalysisworks.Solidtechnicalanalysisis,inmyopinion,atoolthatcangiveanindividualtraderadecentchanceagainsttheprofessionals.Youmightnothavetheresearchcapabilitiesofthecommercialsortheexecutionadvantagesofthemillisecondcomputerquants.Howeverwithtechnicalanalysisonyourside,youhavethe

luxuryofnothavingyourtradingsizeaffectprice.Youhaveadifferentperspective,andyoudon’thavetobesubjecttofalsetrendmovements—“noise”thattakesplaceonthescreenwhenthecomputersare“spoofing”or“beatingthebeehive.”Andyou’renotstucktradingjustonemarket(whichmightormightnotbemoving).Youcansitback,relax,andanalyzeyourchartsinthecomfortofyourhomeoroffice.Puretechniciansbelievethatthemostimportantfactornecessarytothe

marketsispriceaction.Theydonotlookatcropsize,exportdata,moneysupply,oremploymentnumbers.Theydon’tcareifit’sraininginBraziloriftheheadoftheEuropeanCentralBankjustmadeaspeechsayinghe’sinfavorofraisinginterestrates.Techniciansbasicallycareaboutpriceaction.Thisisnottosaythattechniciansdon’tbelievethatfundamentalsmovethe

market.Theyconcedethisfact.AtechnicianmightknowthatsoybeanpricesarerisingbecausedroughtisdevastatingtheBraziliancrop.Healsowilltellyouthatpricewillsignalwhenthediminishedsupplyhasfinallybeenrationedbydiminisheddemand,andthiscouldhappenlongbeforethedroughthasbroken.Thetechnicianbelievesthatallthepertinentfundamentalinformation,

perhapsthousandsofbitsofdataimpossibleforanymortaltoassimilate,isreflectedinpriceaction.Inessence,thepriceactionreflectstheconsensusofthemarketplayersfarbetterthanthemainstreamfundamentalinformationavailabletothepublictrader.Somepurefundamentalistsdismisstechniciansasmerely“chartists,”

insinuatingthattechnicalanalysisisvoodoo.Theypointoutthat“everysunkenshipcarriedachart.”Ishouldpointout,however,thatchartsareanintegralpartofmostsciences,fromengineeringtomedicine.Therearefourreasonsthattechnicalanalysismakessense:1.“Footprintsinthesand”:Thesmartmoney(whoaregenerallythebigplayers)cannothide.Theymightbebetterinformed,buttheirbuyingorsellinghastoshowupinprice,volume,andopeninterest.

2.Themarketdiscountsallfundamentalsinprice.3.Historydoesrepeat,andifyoudon’tlearnfromit,youareboundtofail.4.Marketsdomoveintrends,andthesetrendsaremorelikelytocontinuethannot.Itisthegoaloftechnicianstodeterminethetrend.

WhileIfeelamixoffundamentalandtechnicalanalysismakesthemostsense,aprimarilytechnicalapproachismoreimportantforyouandme.Iknowofmanysuccessfultradersandfunds,peoplewhoconsistentlytakemoneyoutof

themarkets,whoarepurelytechnical.

ThetrendisyourfriendThisrhymemightsoundlikeanoversimplification,butdon’tunderestimateit.Whentalkingaboutsuccessfultrading,thesefivewordsaresomeofthemostprofoundaround.Asuccessfultraderoncetoldme,“Ifyoucancorrectlydeterminethetrendofamarket,youwillmakemoney.”Althoughthismightsoundlikeasimpleconcept,it’snoteasytoaccomplishintherealworld.Thereasonyou’llmakemoneywhenyoucorrectlyidentifythetrendisthattheoddsfavoryourpositionasyoushouldshowaprofitinshortorder.Evenifyourtimingisinitiallyoff,ifyouhavecorrectlyidentifiedthemajortrend,manytimesthetrendwillbailyouout.Ontheotherhand,whenyouattempttopicktopsorbottoms,youmustbeextremelynimbleinbookinganyavailableprofitsbecausethey’llbefleetingwhenthetrendreassertsitself.Myexperiencehasbeenthatcontra-trendprofitstendtoquicklyevaporate.Justasit’smucheasiertoswimwiththecurrentthanagainstit,andit’seasier

towalkwiththewindthanagainstit,it’sgenerallyeasiertotradewiththetrendthanagainstit.Thetrickishowtodeterminetheprevailingtrendanddetermineitearlyenoughtoreapthebenefit.It’saparadoxthatthetrendisalwayspointingupattheverytopanddownat

theverybottom,andpeoplewhoaresomehowabletopicktopsandbottomscertainlymakethemostmoney.IprofessthatI’munabletodothis(Ipersonallyknowofnoonewhocandoitconsistently),butthegoodnewsisthatyoudon’tneedtocaptureafullmovetomakemoney;aportionofamovewilldojustfine.Inthelongrun,fundamentalsdetermineprice.However,asLordKeynessaid,

“Inthelongrun,we’realldead.”MyprimarygoalintradingistodeterminethetruetrendsofthemarketsItrade.Mypremiseisthatifyouareabletoaccuratelydetermineatrend,youwill(overtime)makemoney,andyoucandeterminethetrendusingtechnicals.

BasicchartanalysisApricechartisyourroadmap,yourprimarytradingtool.Chartscomeindifferentflavors,frompointandfiguretoJapanesecandlestickandthemostpopular,thebarchart.Mostofyouarenodoubtfamiliarwithbarcharts.Althoughthey’refairly

easytoconstruct,theyarenotalwaysthateasytoanalyzeformaximumprofitability.Abarchartcanbeinanytimeframeatraderprefers.Adaytrader

mightuseafive-minutetimeframe,whereasthelong-term“positiontrader”mightlookataweeklytimeframe.Allthechartsareconstructedbasicallythesameway.Forexample,onadaily

barchart,eachdayisplottedasaverticalline(orbar),withtherangeoftheday’stradingrepresentedbythelengthofthebar.Inotherwords,thetoppointofthebaristheday’shigh,andthelowpointistheday’slow.Onastandardbarchart,thehorizontalaxismeasurestime,andtheverticalaxismeasuresprice.Asmallhorizontal“tickmark”(or“flag”)isplottedoneachdailybar“waving”totherighttoindicatetheclosingprice.Somebarchartsalsoreflecttheopenviaasmallhorizontalflag(orticmark)plottedoneachdailybarwavingtotheleft.Inthischapter,Ipresentthemostsignificantchartpatterns.InChapter9,“The

MovingAveragesPrimer,”IdiscussaspecifictechnicalapproachIuseinthemarkets.Thefollowingpagesshouldgiveyouagoodbasisforadditionalstudy,butIdonotmeantoimplythatthepricepatternsdiscussedarethegospel—farfromit.Everyoneofthesepricepatternswillprovideyouwithfalsesignalsattimes.Inaway,however,thiscanbebeneficial,becauseevenfalsesignalsareusefulsignals,ifyouknowwhattolookforandhowtoreact.

ThetrendlineThetrendlineisperhapsthemostpopularofallcharttools.Rememberthatifyoucandeterminethetrendofthemarket,you’llmakemoney.Thisiswhatthetrendlineisdesignedtodo:determinethetrendofthemarketandkeepyouwiththetrenduntilitchanges.Trendlinesbasicallyareoneoftwotypes:theuptrendlineandthedown

trendline.Inanuptrend,themarkettendstomakehigherlowsandhigherhighs.Adowntrendischaracterizedbylowerhighsandlowerlows.Youcanprovetoyourselfthatmarketsmoveintrendsbysimplylookingatchartsanddoingan“eyeball.”Notehowthemovesofsignificancearecharacterizedbyaseriesofhigherhighs/higherlowsorlowerhighs/lowerlows.Certainly,hindsightis20/20.Itisnotalwayseasytoknowjustwhatatrendis

inthethickofthebattleor,ifyoucanaccuratelydeterminethecurrenttrend,justhowlongitwilllast.Thisiswherethetrendlinescomein.Atrendlineisdrawnonthechartyouareanalyzingalongthetopsorbottoms

ofthepricebarsinthedirectionofthesignificanttrend.Inabull,orrisingmarket,thetrendlineisdrawnbyconnectingastraightlinethatconnectshigherlows.Atleasttwopointsarenecessary,butIrecommendaminimumofthreetoaddvalidity.(SeeFigure8.1.)Inabear,orfallingmarket,thelineconnectstwo

(butpreferablythreeormore)highs.

Figure8.1.Classictrendlines

Theruleofthumbisthatthemorepointsyouhaveconnected,themore“valid”thetrendline.Buthere’stherub:Themore“valid”thetrendline,bydefinition,themorepricedatayouhavetouse,and,therefore,theolderthetrendandthecloseritistoitsinevitableconclusion.Abrokentrendline(thatis,priceactionmovingbelowanuptrendlineoraboveadowntrendline)isadangersignalthatthetrendhasreversed(seeFigure8.2).Thisishowtechniciansusetrendlines.Whenanuptrendlineisbroken,longsshouldbeliquidatedandnewshortsestablished.Shortsshoulddotheoppositewhenadowntrendlineisbroken.Manytradersplacestopsjustunderanuptrendlineorjustaboveadowntrendlinetoexitpositions.Ifatrendisofsignificantduration,atrailingstopcanbeused,wheretheriskisreducedgraduallydailyasthestoplossismovedinthedirectionoftheprevailingtrend.Inthisway,thefirstriskisthegreatestrisk.Theobjectiveisfirsttoachieveabreakeven,andthenifeverythinggoesaccordingtoplan,amodestprofitislockedin.Overtime,additionalprofitsarelockedinuntilthetrendlineisfinallybroken.Thebestandmostreliabletrendlinesareolderand,therefore,bydefinition,longer.

Figure8.2.Classicuptrendlineandtrendlinebreak

Theproblemwithusingtrendlinesisthat,inpractice,marketsarenotalways

allthatorderly.Astraightlineassumessomesortofsymmetricalseriesofhigherlowsandhighs,orthereverse.Intherealworld,marketscanactthiswayforatime,butbecauseofhumannatureorcomputerprograms,therewillbesharpandmeaninglessreversalsintrend,whichinthelongrungeneratefalsetrendlinereversalsignals.Falsetrendlinereversalsignalsaremorelikelytooccurwhenatrendlineistoosteep.Steepertrendlinesaregenerallythoseofshorterlength;therefore,theyareshorterindurationand,bydefinition,mostlikelytobeviolated.(SeeFigures8.3and8.4.)

Figure8.3.Classicdowntrendline

Figure8.4.Redrawntrendlinesafteratrendline“break”

Whenatrendlineisbroken,itcertainlycanbeusedasadangersignal.Butwhatdoyoudoifthemarketinshortorderresumesbackinthedirectionofthemajorprecedingtrend?Youcanconstructanewtrendlinebyusingthenewsignificantloworhigh.TechnicalAnalysisofStockTrendsbyEdwardsandMagee,firstpublishedin1948,isoftenreferredtoasthe“bibleoftechnicalanalysis.”Thebasicpremiseofthisbookisthatpricesofstocksandcommoditiesmoveinrepeatingandidentifiablepatterns,theresultoftheebbandflowofsupplyanddemand.Althoughsomeoftheconceptspresentedinthebookatthattimewerenew,manyhadbeenaroundsincetheturnofthecentury.Althoughmarketsmighthavechangeddramaticallysincethe1940s,humannaturehasnot;therefore,manyofthepatternspresentedbythesetwogroundbreakersremainvalidtoday.

Note:IsourcedallthechartsinthischapterusingrealmarketdataonaCQG,Inc.,platform.Allrightsreservedworldwide.

Whentrendlinesarebrokenrepeatedlyandnewtrendlinesareredrawn,thecharttendstolooklikeafan(asinFigure8.4).Aseriesoftrendlines,allstartingoutatthesamepoint,movesinparallel.Thisfaneffecteitherindicatesthatthe

majortrendisstillintact(albeitlesssteep)orthemajortrendisactuallychanging.Goodinterpretationandanalyticaltoolscomeintoplayatthispoint;sometradershaveasixthsensewhenthisoccurs.Othersneedtorelyonacompletelymechanicalapproach.Bottomline:Itisbestnottobecometooreliantonanyonetechnicaltool.Trendlinesarehelpful,butIdonotseeyoumakingmoneyusingthemalone.Notallmarketstrendwell,andnomarkettrendsallthetime,whichiswhentrendlineswillnotworkatall.Nevertheless,trendlinescanindicatethebasictendencyofatrendingmarketandalsocantellyouwhenthetrendhasexhausteditself.However,bycombiningtrendlineswithotherchartpatternsplussomeofthemorepowerfultoolslikemovingaverages(coveredshortly),you’llincreaseyouroddsforawinningcombination.

TrendchannelsPricesinaclassictrendcommonlytendtotraderoughlywithinachannel.Achannelisidentifiedbyconstructingalineparalleltothemajortrendline.Ifamarketistrendinghigherandanuptrendlinehasbeenconstructed,thetoplineofthechannelisdrawnbyconnectingprogressivehighs.Inadowntrend,aparalleltothedowntrendlineisdrawn,connectingprogressivelowsandachannelisborn(seeFigure8.5).Aslongasthemarketremainswithinthechannelforthemostpart,themarketisbehavingnormallyduringatrending-typeperiod.Nimbletraderslooktobuyonthetrendlineandselltowardtheupperchannelline(assumingthatthey’reinanuptrend).Activetradersmightalsolooktoreverseatthechannellines,butthisgenerallyisnotrecommended,becausetheywouldbefightingthetrend.

Figure8.5.Trendchannel

Marketswilleventuallytradeoutsidetheboundsofthechannel.Thiscanbeasignificantcluetosubsequentmarketaction.Thegeneralruleofthumbisthatwhenamarkettradesabovetheupperchannelline(inanuptrend)orbelowthelowerchannelline(inadowntrend),oddsarethatthemarketisenteringanacceleratedphaseinthedirectionofthemajortrend.Inotherwords,asignificantchangeinthenormalsupplyanddemandbalancehastakenplace.Withbonafidebreakoutsofchannels,themarkettendstomovefaster,withpriceactionbecomingmoredramatic.Stopscanbetightened,positionscanbepyramided,andyour“antennashouldbeup”foranysignsofasubsequenttrendreversal.Theacceleratedphaseofanymarketcanbethemostprofitableandmostexcitingtimetoplay,butitalsocanbetheshortest.Don’tfightit;gowithitbutremainalert.Ifactingright,afterithasbrokenout,themarketshouldnotfallbackintothechannelbecausethiswouldbetheplacetoexitandreevaluate.

SupportandresistanceSupportandresistancelevelsarepricepointsthatcanclearlyindicateatwhatpricelevelsthedemandorthesupplyforaparticularcommodityrests.Thinkofthemasfloorsandceilings.Simplyput,supportisasignificantareainwhich

buyinginterestdevelops,hasdeveloped,orisexpectedtodevelopbasedonpasthistory.Supportbecomesevidentonapricechart,asthemarket“bouncesoffsupport”or“holdssupport.”Forexample,ifcottontradesupto9900(99¢/pound)andthenbreaksdownto

9500,bouncesbackupto9700andthenbreaksbackdownto9490,andfinallybouncesupto10000(onedollar/pound),andthenbreaksbackto9510,whereitagainstartstomoveinanupwarddirection,traderswouldsay,“Supportisaround9500.”Supportisanareainwhichthebuyinginterest,whetheritbecommercialcottonusers,fundbuyers,orbargainhunters(itactuallydoesn’tmatterwho)haveeitherplacedrestingbuyordersorstepuptobuyatthemarket.Italsomightbeanareainwhichabigshort,orperhapsmultipleshorts,looktocovertheirpositionstotakeprofitsorexitalosingposition.Don’tgetallcaughtuponwhythepriceholdsatthislevel;thisisalevelwherebuyingcomesoutofthewoodwork,andasaresult,itistermedasupportlevel.Supportlevelscanbeplainlyseenbylookingatpricechartsandappearwhere

buyinginteresthasshownuppreviously.Therefore,theexpectationisthatbuyinginterestwillbethereagainifthemarkettradesthereagain.Ifthemarketdoesn’tholdonareturnrun(asintheprecedingexample,withcottonbreakingdownto9400thefourthtime),thisistermed“breakingsupport”andisabearishsign.Traderswhopreviouslyhadsupportedthemarketataround9500areeithergone(orallthesignificantshortshavecovered),oriftheywerenewlongs,theyareweakerthistimethanthenewsellers.Themirrorimageofsupport,theceiling,iscalledresistance.Thisisalevel

wherethemarkethasahardtimemovinghigherorwhereamarkethastroublegettingaboveacertainpoint.Ifcottonralliesto10000,thentailsoffto9700andbackupto9995,anditdoesthismorethanonce,thisisthelevel(atleasttemporarily)ofresistance.Inotherwords,resistanceisanareainwhichthesellinginterestisgreaterthanthedemand.Supportandresistancelevelscanbedrawngraphicallybyusingahorizontal

lineonabar,chartconnectingthefloorpoints,inthecaseofsupport,andceilingpoints,inthecaseofresistance.Theseareimportantlevelsthatindicatetheareasyouwouldexpectamarkettoholdortofail.Aswithtrendlinepoints,tradersarecognizantofwheresupportandresistancelevelsare.Asaresult,theycanbecomeaself-fulfillingprophecy,atleastintheshortrun.Ifamarketcontinuestofailatacertainresistancelevel,thesellersbecomeboldereverytimethatpriceisreached,andthebuyersassumethatthisistheplacetoexit.Formanyyears,cornpriceswereunabletotradeabove$4.Thiswas

consideredaceilingpriceinyearsofbigdemandandinyearsofdrought.In1996,whenChinaforthefirsttimeturnedfromacornexporterintoamajorimporter,cornpricesbrokethe$4“glassceiling”(anddidn’tlookbackuntiltheyhit$5.50).Extendedperiodsofsupportandresistancebothholdingsimultaneouslycan

leadtooneofthemostpowerful(oneofmytwofavorite)ofallchartpatterns,the“breakoutfromconsolidation.”YoucanseethisinFigure8.6,andwe’llspendabitmoretimeonthisone.

Figure8.6.Supportandresistanceexamples

BreakoutsfromconsolidationThinkofamarketbouncingoff“support”asbeingsimilartoaballbouncingoffthefloor.Ifthefloorisadeckfourstoriesofftheground,theballwillbounceaslongitremainsonthedeck.But,ifitsubsequentlyfallsoffthedeck,itdropslower.Alternatively,“resistance”issimilartoaceiling,butifaglassceilingissmashed,thebirdsarefreetoflyhigher.Supportandresistancelevelsareveryimportanttotraders.Whenamarketis

inarelativelyflatrange(holdingatsupportandfailingatresistance),it’scalledconsolidation.Consolidationisaninabilitybyeitherthebullsorthebearstowin

thebattle.Whenthemarketholdsatsomelevel,rallies,andthenagainretreatstothatsamelevel,itthenappearscheap.Bullsthatmissedthefirstrallyfeelasiftheyhaveasecondchanceat“cheap”levelsandstepuptotheplate.Theshorts,especiallythosewhoarescalpingandsellingathigherlevels,seethemarketstarttobounce,andthey’reinducedtocovertheirshortsbeforetheirpaperprofitsdisappear.Thisadditionalbuying(shortcovering)addsfueltothebullmove.Thereverseoccurswhenthemarketralliestothelevelofpreviousfailure—theresistancepoint.Someofthelongswhopreviouslypurchasedatsupportmightfeelthatthemarketislookingexpensiveandcashin.Bears,whomissedsellingthelastrally,willconsiderthisa“secondchance”andstartselling.Themarketstartsitsretreat,andotherlongs(whodonotwanttoseetheirpaperprofitsdisappear)sellout,addingfueltothebearfire.Weknowthatifamarketfailsataresistancelevelonnumerousoccasionsandoverasignificantperiodoftime,andthenproceedstotradeabovethatlevel,thisisasignthatthebearshavelostthebattle.Thebuyinginterestwasfinallystrongenoughtooverwhelmthesellinginterest,andthedefensiveceilingbuiltbythebearshasbeenshattered.(Theoppositeishappeningifasupportlevelisbroken.)Insimplerterms,abreakaboveresistanceorbelowsupportindicatesthatamajorshiftisprobablytakingplaceinthesupplyanddemandfundamentalsofthemarketinquestion.Figure8.7showswhatabreakoutlookslike.

Figure8.7.Breakoutfromconsolidation

TakealookatFigure8.8,whichshowsthe1988oatschart.Thismonsteroatsrallydrovepricestoall-timehighsthatwerenotexceededforthefollowing20years.Lookatthelengthandbeautyoftheconsolidationthatprecededthisbullmove.

Figure8.8.July1988oatsbreakout

Ihaveasoftspotinmyheartforthis1988oatsmove.Thisisatruestory:

Ihadawealthyclientwhowasstubbornandgutsy,andwhowouldnotgetoutofhisMarch1988oatscontractbecausehebelievedoatsweretoocheap.Heowned2millionbushels(thelimitanindividualcouldbuyatthattime),andItoldhimthatifhedidn’tgetout,hewouldgetdelivery.IlikedtheoatmarketbutsuggestedthatherollhisMarchcontractsintoJuly.No,hetoldmehewouldtakethedelivery,eventhoughwhendeliverytakesplaceatraderisrequiredtoputupthefullvalueofthecontractandisnolongeronmargin.Sohetookdeliveryofthe2millionbushelsatapproximately$1.60perbushelinMarch.Hewiredthe$3,200,000intohisaccount.Fromthatdayon,myjobwastolookforabuyertoselltheoatsinthecashmarket,butneitherofthebigplayers(GeneralMillsnorQuakerOats)seemedinterested.

Themarketcontinuedtotradeintheconsolidationrangeforafewmonths,andthenitgothotanddry.(That’swhatcausedthebreakoutfromthelongconsolidationyouseeinFigure8.8.)Thedroughtof1988ishistorynow,butletmetellyoutheresulttothemarket.TheoatcropintheDakotaswasdevastated,andthefuturespricetradeduptoapproximately$4perbushel.OnJune28,theall-timerecord-highdayforoats,Igotacallfromoneofthelargeprocessors.Heaskedifthedeliveryoatswerestillforsale.Itoldhimyes,andhepromptlyoffered$4perbushelfortheentire2million.Icalledmyclient,whotoldmetorejectthe$4bidbutofferthewholelotat$4.40,“takeitorleaveit.”WhenIcalledtheprocessorback,heimmediatelysaid“Sold!”Myclientsold2millionbushelsofcashoats40¢perbushelhigherthanthefuturespriceandattheall-timerecordpricetothatdate.Theclientclearedacool$5million.Monthslater,whenIaskedthegrainmanwhyhewassoquicktobuytheoatsatarecord-highprice(remember,theseareoatshedidn’twantat$1.60)of$4.40(whichwasobviouslytoohigh,basedonthefuturesprice),hetoldmethis:“Ihadthechoiceofclosingdownthemillandputting200peopleoutofworkbecauseIdidn’thaveanyoatstomakeoatmealorpaying‘toomuch’andbumpingthepriceofaboxofcerealby10¢.Whatwouldyouhavedone?”

Bottomline:Thesepatternsarepowerful,buttheyarealsofairlyuncommon.Andtheycanoccurinvaryingtimeframes.Let’slookatafewotherexamples.ThewheatexampleinFigure8.9illustratesapotentiallyfalsebreakout(whichlaterprovedtrue)andhowbreakoutsfromconsolidationscanoccurduringatrendmove,notjustatthebeginning.Ihavefoundthatapotentiallyfalsebreakout,whichlaterprovestrueviaasuccessfulsecondattempt,usuallyturnsouttobeanexcellentsignal.

Figure8.9.Wheatfalseandtruebreakouts

Certainly,thesepatternscansignifybreakoutstothebearsideaswellasthebullside,asthecattleexampleinFigure8.10illustrates.

Figure8.10.Cattledownsidebreakout

Thepreviouschartsarealldailycharts(soonebarequalsoneday’strading).Intoday’selectronicage,breakoutscanoccurinanytimeperiod,andtradersneedtobeready.TakealookatFigure8.11,whichshowsabreakoutonafive-minutechart(whereonebaronthischartequalsfiveminutesoftrading).

Figure8.11.Copper(five-minutechart)

Figure8.11illustratesasleepyCincodeMayo,withLondonclosedduetoaholiday,theNewYorkcoppermarketwasinatightconsolidationbetween$3.83and$3.86.Thebreakoutaboveconsolidationoccurredat7:10A.M.abovethe$3.86level.Within20minutes(four5-minutebarsonthechart),themarkettradedashighas$4.27,representingamoveof41¢,or$10,250percontract.Themarginforonecontractatthetimewas$7,763,sothiswaswellovera100%returninlessthanahalf-hour.Don’teventrytocalculatewhattheannualizedreturnwouldlooklike;itwouldbearidiculousnumber.Tenminuteslater,themarketwasbackbelow$4.Thenews?Therewasnone.Stopswerehitallthewayup,andthemarketeventuallyendedbackwhereitstartedbythenextday.Amoveofthismagnitudewouldnothaveoccurredinthisshortofatimeperiodduringthepitdaysbecauseprofessionalpittraderswouldhavesteppedintoblunttherallyatanearlierstage.Still,thetime-honoredbreakoutfromconsolidationsignaledthewaytogoonthisone.Althoughthisstuffisgood,andIbelieveitworks,youdidn’tthinkthiswould

beallthateasy,now,didyou?WhenIfirstdiscoveredtechnicalanalysis,Istudiedtheprofitableexamplesinthebooksandthoughtthistradinggigwouldbeapieceofcake.Unfortunately,aswithalloflife,itdoesn’tworkallthetime.Imusttellyouthatfalsebreakoutsfromconsolidationhaveoccurredandwillcontinuetooccur.Manytradersarewellawareofhowpowerfulatoolthesepatternscanbe.Asaresult,theylookforthesebreakouts.Manytechnicianswillplacestopsjustundersupporttolimitlossesorestablishnewshortpositions.“Beatingthebeehive”isonestrategydesignedbythecomputernerdstotriggerthesestops.It’snotsinister;thecomputeralgorithmsmakeaneducatedguessonwherethestopsreside.Forexample,ifamarkethasheldnumeroustimesat95anditapproachesthatlevelagain,what’stostopaprofessionalcomputerizedtraderfromofferingthemarketdownto94.90?Theobjectiveistouncoverthesellstops.Asellstopisarestingordertosellatsomepredeterminedlevel.Ifthestopsareactually“resting”at94.90(numerousordersrepresentinghundredsoftradersfromvariousunrelatedfirms),thesellingcommences.Sometimes,thisactioncanfeedonitself.Thesellstopsinplaceat94.90

immediatelybegintowork.Therestingorderstobuyat94.90arefilled,sothemarketisofferedlower(94.80,94.70,94.60),buteveryoneseemstobeselling,andit’sallonstops.Thescalperslovethis,especiallyinaquietorthinmarket.Theywillcomebackinandbidat94.50and94.40,forexample,andcovertheirshortsataquickandtidyprofit.Becausenofundamentalsubstancecausedthispriceaction,themarketquicklybouncesbackabove95againastheshortsarecovered,andcommercialtradersandbargainhuntersstepin.Foraspeculator,gettingcaughtinafalsebreakoutisfrustrating.Seeingyourstophitandknockyououtofagoodposition,onlytowatchthemarketquicklyreverseinthedirectionyouthoughitwasgoinginthefirstplacewillsteamyou.Ifyoutradelongenough,thiswillhappentoyou,sokeepyourcool.Placeyourstopscarefully,whereyoudon’tthinkeveryoneelse’sstopsare.

SixrulesfortradingbreakoutsfromconsolidationBreakoutsfromconsolidationaresuchpowerfulindicatorsofpotentialtrendchangesthatyoushouldneverbecomecomplacentwhentheyoccurjustbecausefalsebreakoutsexist.Herearemysixrulesfortradingbreakoutsfromconsolidation:

1.Thelongerittakestoformaconsolidation,themoresignificantthebreakoutandthebiggertheexpectedmovetofollow.Abreakoutonadailychartismorepowerfulthanabreakoutona30-minutechart,andabreakoutonaweeklychartisevenmorepowerful.Abreakoutfrom

consolidationonayearlychartisthemostpowerful,signifyingsomemajorfundamentalchangeinthesupply-and-demandbalanceofthatmarket.

2.Afterabreakoutoccurs,themarketcanretracebacktothebreakoutlevel,butitreallyshouldn’ttradebackintotheconsolidationzone.Ifitdoes,theoddsofafalsebreakoutincrease.

3.Thebreakoutshouldremainabovethebreakoutlevelforasignificantamountoftime.Afteritmovesabovetheresistanceorbelowthesupport,youshouldn’tbeinmuchtroubleifyouwentwiththebreakout.Ifprofitsarenotforthcominginareasonableamountoftime,bewary.Aquickfailureisasymptomofafalsebreakout.

4.Watchthevolumeonthebreakoutsinceatruebreakoutisgenerallyassociatedwithasharpriseinvolume.Sometimesthishigh-volumelevelmightprecedethebreakoutbyadayortwo;however,falsebreakoutsareusuallyassociatedwithmodestvolume.

5.Whentradingabreakoutusingstops,neverplaceyourstopsjustbelowsupportorjustaboveresistance.Alltheamateursdothis,andtheybecomebaitforrunningthestops.It’sgenerallybettertotakeabitmorerisk(whatIterma“buffer”)andplaceyourstopataslightlygreaterdistance.

6.Abasicruleofthumb,whichtrulydoeswork(usesomejudgmenthere),isthatwhenamarketbreaksoutfromconsolidation,itwillmoveroughlythedistanceupordownequaltothehorizontaldistanceoftheconsolidationphase.Itermthisphenomenon“thecount.”Thelongertheconsolidation,thebiggerthecount.Todeterminethecount,measurethehorizontaldistanceoftheconsolidationandthenmeasureupwardfromtheresistancebreakoutordownwardfromthesupportbreakouttogetanideaofthepriceobjectiveforthecomingmove.(SeeFigure8.12.)

Figure8.12.Thecount

AdditionalclassicchartpatternsChartpatternsbasicallyfallintotwogroups:

•Thosesignalingareversalintrend•Thosesignalingacontinuationintheprevailingtrend

Reversalpatternsincludetheheadandshoulders,doubletopsandbottoms,roundingtopsandbottoms,andreversaldays.Continuationpatternsincludeflagsandpennants.Certainpatternsarehybridsthatcansignaleitherorboth;gapsandtrianglesforexample.Thefollowingsectionsexplaintheclassicpatterns,whichIhavefoundremainvalidtoday.

DoubletopsandbottomsDoubletopsandbottomsarereversalpatterns,manytimesassociatedwithmajortopsandbottoms.Doubletopsoccurwhenpricesrallyfromanareaclosetoaprevioushigh,butthenthemarketfails,withaninabilitytocontinuedecisivelyintonewhighterritory.I’mtryingtobecarefulinmychoiceofwordsbecausemanynovicetradersbelieveadoubletopisvalidonlyifamarketfailsundertheprevioustop.I’vefound,inpractice,thatmanytimesdoubletopsareformed

whenamarketjustnicksorevenattimesmovesslightlyabovetheprevioushighandthenfails.ThinkofdoubletopsastheletterM,withtherightmastattimesabitlowerorabithigherthantheleft.Doublebottomsarethemirrorimageofthetops.Thinkofthemastheletter

W.Themarketmakesamajorbottom,rallies,fails,andholdsslightlyaboveorslightlybelowthepreviousbottom,andthenitreverses.(SeeFigure8.13.)

Figure8.13.Doubletopanddoublebottom

Theoneproblemwithdoubletopsandbottomsisthattheydon’talwaysoccuratthetoporthebottom.Youhavetobecarefulbecause,manytimes,you’llseetheseinthemiddleofmoves(whichobviouslydoesn’thelpinidentifyingatoporabottom).AsI’vestatedbefore,thereisnoholygrail.Allyoucanhopetodoisplacetheoddsinyourfavor,usinggoodmoneymanagementtocutthelossesonthetradesthatdon’tgoaccordingtoplan.Toavoidfalsesignals,itisimportanttowaituntilthepatterniscompleted.Thisremovessomeoftheprofitpotentialbutalsoimprovesyourodds.Makesureyoulookfordoublebottomsandtopsonlyafteramajortoporbottomismadeandthenwaitforthemarkettotestthelow/highandthenrally/breaksignificantly,whichincreasesitsvalidity.Howmuchis“significant”?Unfortunately,Ican’tgiveyouanumber,butafteryouhavebeendoingthisawhile,andafterstudyinghundredsofcharts,you’ll

getafeelforthisinvariousmarketsituations.

RoundingtopsandbottomsRoundingbottomsaresometimesreferredtoassaucerbottoms.Althoughyou’llrarelycomeacrossthese,theyarereliablereversal-typepatterns.Figure8.14showsaroundingbottom.

Figure8.14.Roundingbottom

Theseusuallytakequiteabitoftimetoformproperly,andagain,it’simportanttowaitforthepatterntobecompleted.Falseroundingtopsorbottoms,whentheyoccur(evidencedbyahigherhighorlowerlow),oftenprecedethefinaltoporbottom.

Flags,rectangles,andpennantsFlags,rectangles,andpennantsarethreerelativelycommoncontinuationpatterns.Theygenerallyoccurinthefirstthird,middle,orsecondthirdofmajormovesandcanbegoodformationstopyramidfromusingfairlytightstops.Rectangles,attimescalled“boxes,”areformationswherethemarketpauses

andproceedstotradeinatightrange.Arectangleislikeaconsolidationbutmuchsmallerinlength.Unlikeaconsolidation,arectangleoccursafteramove

isunderway—notatatoporbottom.Itisgenerallyapricemovementthatiscontainedbetweentwohorizontallines,asshowninFigure8.15.

Figure8.15.Rectangles

Theupperlineoftherectangleistheresistanceline,andthelowerlineisthesupportline.Theplanisnottoanticipatebutrathertogowiththeflow.Inanuptrend,buyonthebreakofresistance,andinadowntrend,goshortonthebreakofsupport.Rectanglesbasicallyrepresentpausesinthemajortrend;themarketremainsfundamentallybullishorbearish,butithastofirstundergoa“healthy”roundofrepositioningorprofittakingbeforeresumptionofthemove.Volumegenerallydriesupduringthisbox-likeformationandincreasesonthebreakout.Justlikeinthenecklineoftheheadandshoulders(explainedshortly),manytimesthemarketreturnstothebreakoutlevelafterittakesplace.Rectanglesprovideanexcellenttimetopyramidawinningposition.Ilooktoaddtoprofitablepositionsafterthebreakout,movingmystoponthetotalpositiontoaboveorbelowtheoppositeboundaryofthebox.Onedrawbackofrectanglesisthattheyarecontinuationpatterns,whichat

timescanrevertintoreversalpatterns.Onceagain,bewarned:Keepanopenmindandbenimble.Aflagisbasicallyarectanglewhoseboundariesslantupwardordownward.

Theboundariesareparallel,likearectangle(seeFigure8.16).The“flag”is,again,apauseduetoprofittakingbytheweakhands,areststopbeforethetrainonceagainrollsoutofthestation.

Figure8.16.Flagandpennant

Thegeneralruleisthattheslantofaflagwillrunoppositethedirectionofthemajorpricetrend,butthisisn’talwaysthecase.Actually,contrarytopopularbelief,I’vefoundthatmanypowerfulmovesoutofflagcongestionscomefromthoseslantinginthedirectionofthemajortrend.Pennantsworkjustlikeflagsandrectangles.Thebasicdifferenceisthatthe

boundariesarenotparallel.ThisdifferenceisillustratedinFigure8.16.Allthesecontinuationpatternsworkbestwhentheyaretight,fast,neat,and

formedonrelativelylightvolume.Bewaryofflags,pennants,ortrianglesthatdon’tmeetyourexpectationsquickly.TakealookatFigure8.17,whichshowsthedroughtcornmarketof2012,amarketwheretechnicalanalysishelpedmeimmenselyincapturingafairshareofthismove.

Figure8.17.Cornmove

TrianglesTrianglesarecongestionpatternsthatcansignaleithercontinuationorreversal.Theycomeinthreedistinctvarieties:symmetricaltriangles,ascendingtriangles,anddescendingtriangles.Asymmetricaltrianglehasanupperlinethatslopesdownward(itlookslikea

downtrendline)andalowerlinethatslopesupward(itlookslikeanuptrendline).Theselinesconvergeatapoint.Withallcongestionpatterns,thereisawargoingonbetweenthebullsandthebears.Withinatriangle,thesidesarematchedfairlyevenly,withneithersidewinning.(SeeFigure8.18.)However,atsomepoint,astimegoesforward,onesidewillwin.Themarketwillbreakoutofthetriangle,andthisisthetimetoactbecausethebreakoutsignifiesthedirectionofthenextmajormove.

Figure8.18.Symmetricaltriangle

Thegeneralruleisthatthemostvalidsignalswillcomewhenthemarketbreaksoutpriortoreachingtheend,termedtheapex.Thebestbreakoutsgenerallyoccurapproximatelytwo-thirdsofthewayalongofthelengthofthetriangle.Also,aswithmostoftheotherpatterns,volumeshouldincreaseonthebreakout.Youknowyou’recaughtinafalsemove,a“trap,”whenthemarkettradesbackintothetriangleafterthebreakout,andallbetsareoffwhenitmovesovertotheotherside.Ascendingtrianglesanddescendingtrianglesareliketheirsymmetrical

brethren,excepttheyworktowardabreakoutinthedirectionoftheirrespectivenames.Theascendingvarietyhasaflatupperboundarywitharisinglowerboundarythatcanbedefinedbyanuptrendline.Thebullsareabletosupportthemarketatsuccessivelyhigherlows,whilethebearsaremakingastandattheupperresistancelevel,withtheresultmorelikelytobeabreakouttotheupside.Thisisgenerallyacontinuationpattern,mostlikelytobeseenduringamajoruptrend.Thedescendingvarietyisthemirrorimage,withalowerhorizontalsupportlineandsuccessivelylowerhighsthatcanbeconnectedbyadowntrendline.ExamplesshowninFigure8.19.

Figure8.19.Ascending(parta)anddescending(partb)triangles

Volumecharacteristicsmatchtheotherpatterns;manytimes,volumewilljumponthebreakout.Thebiggerthetriangle,thebiggerthemovetofollowislikelytobe.

GapsAgapoccurswhenacommodityopensatapricehigherthanthehighofthepreviousdayorlowerthanthelowofthepreviousday.Bydefinition,thegapremainsintactifit’snot“filled”duringthetradingsession.Inotherwords,ona“gapupday,”themarketnevertradedlowenoughtoequalorexceedthehighofthepreviousdayonthedownside.Ona“gapdownday,”themarketwasneverabletotradehighenoughtoequalorexceedthelowofthepreviousdayontheupside.Gapscanbeidentifiedfairlyeasilyonadailybarchart.Thetrickistodeterminewhichofthefour—common,breakaway,measuring,orexhaustion—youarelookingat.

1.Commongaps:Themajorityofgapsaremorelikelytobefilledsoonerthanlater.Mostdailygapsarefilledduringthesametradingsession,andofthosethataren’t,moreoftenthannot,theyarefilledwithinadayortwo.Becausethesearethemostcommonvariety,theyareknownascommongaps.Theymightoccur,forexample,asaresultofagovernmentreport,butthenewsusuallyisnotstrongenoughtochangethemajortrend,andthegapisfilledquickly.Commongapsareseenquiteofteninthin,orlow-volume,marketsandarerarelysignificant.Thetrickistobeabletodifferentiatethecommonvarietyfromtheotherthree.Theotherthreevarietiesareimportanttechnicaltoolsthathavepowerfulforecastingabilities.

2.Breakawaygaps:Abreakawaygapdevelopsatabeginningofanewmove.Anupsidebreakawaygapoccurswhenpricesjumpupfromabottom,oftenfromsomesortofcongestionarea.Adownsidebreakawaygapoccurswhenpricesjumpdownfromatop,alsomanytimesfromsomesortofconsolidation.Abreakawaygapissignificantbecauseitsignalsachangeinthesupplyanddemandbalanceofthemarketinquestion.Thepressuretopushamarkettothenextlevelissogreatthatthemarketliterallyhastoleapfrogtothisnewlevel,effectivelytrappingmanymarketparticipantsonthewrongside.Itisthosetrappedonthewrongsidewhowilleventuallyaddfueltothisnewfireastheyliquidate.Theshortstrappedundertheupsidebreakawaygapareallholdingpositionsatalossandwilleventuallyneedtofindaplacetocover.Someofthemwillhopeforabreaktocover,butitwon’tcome.Alternatively,numerouslongswill

betrappedabovethedownsidebreakawaygap,andatsomepoint,theywillbesellingout.Theinevitableresultismoredownsidepressure.Howcanyoutellabreakawayfromacommongap?Commongapsarefilledfairlyquickly.Breakawaygapsarenotfilledforalongtime,sometimesneverforthelifeofacontract.Theysignifythestartofanewandmajortrendmove.Manytimestheyformoutofaconsolidationorduringblow-offhighsorlows.Thebreakawaydayisaccompaniedbygreater-than-normalvolume,usuallyatleast50%greaterthantheaveragevolumeoftheprecedingtwoweeks.Thesearesignificantandpowerfultoolsthatyoushouldbealertforconstantly.Particularly,watchforthemwhenamarketappearstobe“cheap”or“expensive.”Themarketcouldbebasingforamajorbottomorclimaxingforamajortop.

3.Measuringgaps:Ameasuringgapisfoundatapproximatelythemidpointofapowerfultrendmove.Suchagapformsoneday,oftenonnews,butunlikewithacommongap,themarketcontinuesonitswaywithoutfillingthegap.Onceagain,volumeisusuallylarge.Measuringgapsservetotrapmanyplayerswhoareonthewrongsideevenmoredeeplyinthemuck,andthesetradersprovidesomeofthefuelforthenextlegupordown.Theinterestingthingaboutthesegapsisthattheytendtooccurwhenamoveisjustabouthalfover.Ifthebreakawaycameat100andthemeasuringisat140,youcanprojectthatthismovewillruntoabout180.Themeasurementruleiscertainlynotwritteninstone.Attimes,therewillbemorethanonemeasuring-typegapinpowerfulmoves,perhapsoneat33%ofthemoveandanotherwhenthemoveisabout60%to67%.However,the50%ruleisusuallyprettyclose,soitcanhelpyoudetermineapproximatelywhereyouareinthemove.Exhaustiongapscandothis,too.(SeeFigure8.20.)

Figure8.20.Breakawayandmeasuringgaps

4.Exhaustiongaps:Anexhaustiongapformsneartheendofamove.Inamajoruptrend,themarketgapsuptonewhighs,generallyonbullishnews.Inamajordowntrend,themarketgapsdowntonewlows,perhapsonnewbearishnews,sometimesbasedonfinalpanicliquidation.Inbothcases,manytimesthesegapsfollowwide-rangingorlimit-typemoves.Inmarketsthatstillhavelimits,theexhaustiondaymighteventradeatthelimitatsomepointinthedirectionofthemajortrend.Unlikewiththeothergaps,however,thisisthebeginningoftheend.Themarkethasrunoutofsteam,eventhoughmostoftheparticipantsdonotrealizeitonthatday.Onewaytoexplainthisisthatonthedayofanupsideexhaustiongap,thelastoftheweakshortshavethrowninthetowelandarecoveringtheirpositions.Thelastofthe“uniformed”longsareenteringthepartybelievingthismarketstillhasalongwaytogo.However,thenewsisalwaysthemostbullishatthetop,andthemarketissatiated.Highpricesarestartingtorationdemand,andsupplyisbeginningtocomeoutofthewoodwork.Withadownsideexhaustiongap,thelastoftheunder-

marginedlongshavegivenup.Manytimes,panickyconditionsprevailastheredinkflows.This,too,isthebeginningoftheendbecauselowpriceshavebeguntostimulatedemand.Howcanyoudeterminewhetheragapisoftheexhaustionvariety?Unlikewithbreakawayormeasuringgaps,anexhaustiongapwillbefilledfairlyquickly.Morecommonly,themarketwillchurnforthreetofivedays,butitwillgenerallybefilledfairlyquickly—sometimesthenextday.Manytimes,thehighoftheexhaustiontopdaywillnotbeexceeded,orwithadownside,therewillbenolowerlows.Volumewillbehigh,butitwasprobablyhighinthedaysprecedingtheexhaustionday,too.Likebreakawaygaps,exhaustiongapsarepowerfulindicators.Keepyourexhaustiongapantennaupwhenamarketbecomeswild-eyedafteralongrunuporpanicstrickenafteralongrundown.Remember,itisalwaysdarkestbeforethedawnandbrightestjustbeforethesunstartstorecede.

Finally,nodiscussionofgapsiscompletewithoutmentioningtheislandformation.Islandscanbeformedinpartbyeitherexhaustionorbreakawaygaps.Anislandbottomisformedbyagapdown,priceactionatabasinglevel,andthenabreakawaygapup.Anislandtopisformedbyacontinuationorexhaustiongapup,somepriceactionatnewhighs,andthenabreakawaytypegapdown(orviceversa).Islandsareeasytospotbecausetheylooklikeislandsinthesky(orthesea).Theyarerare,butpowerful,andyou’llknowonewhenyouseeit!Figure8.21isadailycocoachartillustratingexamplesofeachvariety,alloccurringwithinatwomonthtimeperiod.

Figure8.21.Gaps

FiverulesfortradinggapsThefollowingarefiveusefulrulesforsuccessfulgaptrading:

1.Themajorityofgapsarecommonandwillbefilled.Donotlookforsignificantgapsatnonsignificanttimes.Ifamarketgapsonminornews,lowvolume,orwhatdoesn’tappeartobeamajortoporbottom,assumethatitwillbefilled.Scalperscanfadethesecommongapsandlooktotakeprofitswhenthey’refilled.Ifagapisnotfilledfairlyquickly(withintwotoseventradingdays),begintotreatitasasignificantgap(eitherabreakaway,measuring,orexhaustiongap—dependingonwherethemarketisinitscycle).

2.Whenamarketisformingalongbase,placeabuystopabovethebasetocatchabreakaway-typemove.Manytimes,breakawaygapsoccurwhenthey’releastexpected;attimes,theyoccuronnonews.I’veobservedonbreakaway-updaysthatthelowsaregenerallyregisteredrightattheopen.Ifyouarestoppedintoanewlongpositioninthisway,placeyoursellstopatthelowend(thefill)ofthegap.Ifitisanygood,itshouldnotbefilled,andyoushouldbeinclosetothelowsformaximumpotentialprofitability.

3.Measuringgapsofferanexcellentopportunitytopyramidaposition.If

youspotameasuringgapandarealreadyinonabaseposition,itistimetodoubleupandmoveyourstoplossontheentirepositiontothefillofthemeasuringgap.Youraveragepriceisbetterthanthemarket,andyourriskonthenew“add”isminor.Whentheywork,youhavealotofprofitpotentialremainingonthenew,largerposition.

4.Neveranticipateexhaustiongaps—waitforthemtobefilledtotakeanewposition.Exhaustiongapsoccurinthefinalstagesofamajormove.Thisphaseisalmostalwaysvolatile,anditisextremelydifficulttopickatoporbottom.Itisonlyaftertheexhaustiongapisfilledthatyoucandefinewhatyourriskisandthatittrulywasanexhaustion.Ihaveseenoccasionswhenthebullishsentimentissofrothythatitformsanexhaustionbutstillcanworkhigherfordaysorweeksbeforeit’sfilled.

5.Whenyouseeasignificantgap(abreakaway,measuring,orexhaustiongap),act!Thisisnotthetimetohesitate;itisthetimetoactaggressively.Justdoit!Ifyouwait,you’llbeleftholdingthebag.Significantgapsgenerallyoffergoodrewardtoriskbecauseyoucandefinefairlycloselywhatyourriskshouldbe.

VolumeI’vementionedvolumerepeatedlyinthischapterbecausewhenitisgreaterthanaverage,itaddsevidencetoothertechnicalsignals.Theonerecurringthemeyoumighthavenoticedisthatsignificantdaysgenerallyareassociatedwithgreater-than-averagevolume.Gapdays,breakoutsfromconsolidation,andsupportorresistancepenetrationsaremanytimesassociatedwithgreater-than-normalvolume.Toknowwhatgreaterthannormalis,youneedtoknowwhataveragevolumeisforthemarketyou’retrading.Allmarketsaredifferent,andyouneedtoknowwhattheaverageis.Aruleofthumbisthatasignificantvolumedayisatleast50%higherthanthe30-dayaverage.I’veidentifiedthreemajorvolumerules:1.Inamajoruptrend,volumewilltendtoberelativelyhigheronralliesandlowerondeclinesortradingranges(consolidations).

2.Inamajordowntrend,volumewilltendtoberelativelyhigherondeclinesandloweronralliesortradingranges(consolidations).

3.Volumewilltendtoexpanddramaticallyatmajortopsandbottoms.Majorbottomscanbecharacterizedbyclimax-typeselling.Blow-offtopswillbeassociatedwithclimaticvolume,too.

OpeninterestOpeninterest(OI)analysisisapowerfultradingtoolthatfuturestradersuse.(Stocktradersdonothaveaccesstothistool.)OIissimplythenumberofcontractsoutstanding—thetotalnumberheldbybuyersor(notand)soldshortbysellersonanygivenday.TheOInumbergivesyouthetotalnumberoflongsandthetotalnumberofshortsbecause,unlikeinstocks,infutures,theshortinterestisalwaysequaltothelonginterest.Eachlongiswillingtoeitheracceptdeliveryofaparticularcommodityoroffsetacontract(s)sometimebeforetheexpirationdate.Eachshortiswillingtoeithermakedeliveryoroffsetacontract(s)beforetheexpirationdate.Withthisinmind,youcanplainlyseethatOIisameasurementofthewillingnessoflongsandshortstomaintaintheiropposingpositionsinthemarketplace.Itisaquantitativemeasurementofthisdifferenceofopinion.OInumbersgoupordownbasedonhowmanynewtradersareenteringthe

marketandhowmanyoldtradersareleaving.OIgoesupbyonewhenonenewbuyerandonenewsellerenterthemarket.Thisactcreatesonenewcontract.OIgoesdownbyonewhenatraderwhoislongclosesoutonecontractwithsomeonewhoisalreadyshort.Becausethiscontractisnowclosedout,itdisappearsfromtheOIstatistics.Ifanewbuyerbuysfromanoldbuyer(whoissellingout),totalOIremainsunchanged.Ifanewsellerbuysback,orcoversfromanewsellerenteringthemarket,OIalsodoesnotchange.Theoldbearhadtobuytocover,withtheothersideofthistransactionbeingasellbythenewbear.Let’slookatanexample.IfheatingoilhasatotalOIof50,000contracts,and

thenextdayitrisesto50,100,thismeans100newcontractswerecreatedby100newbuyersand100newsellers—orperhaps10newnetbuyersandsellersof10contractseach,orwhateverittakesnettocreatethenew100.Duringthatday,manypeopleclosedoutandmanyentered,andthenetresultwasthecreationofnewOI.Themarkethas50,100contracts’worthofshortsand50,100contracts’worthoflongsattheendoftheday.Theoretically,oneshortwhohad100newcontractssold(probablythesmartmoney)couldhavetakentheopposingsideof100otherswhoeachboughtone(themajority,probablythedumbmoney),buttheshortandlonginterestarealwaysthesameonanyparticularday.TheexchangesreleaseOIfiguresdaily,buttheyarealwaysfortheprevious

day,sotheyareadayold.YoucanchartOIonapricechart,andthedirectionitischangingcantellyousomeinterestingthings.OIstatisticsareavaluabletoolthatyoucanusetopredictpricetrendsand

reversals.ThesizeoftheOIreflectstheintensityofparticipants’willingnesstoholdpositions.Wheneverpricesmove,someonewinsandsomeoneloses—azero-sumgame.ThisisimportanttorememberbecausewhenyouthinkabouttheramificationsofchangesinOI,youmustthinkaboutitinthecontextofwhichwaythemarketismovingatthetime.AnincreaseinOIshowsawillingnessonthepartoftheparticipantstoenlargetheircommitments.Let’ssaythemarketismovinglowerandOIisincreasing.Youcanassumethatsomeofthehurtlongshavelefttheparty,buttheyarebeingreplacedbynewlongs,andmanyexistinglongsarestillthere.Iftheywereliquidatingenmasse,OIwoulddrop.Likewise,iftheshortholderswereprimarilytakingprofitsandleavingtheparty,OIwouldalsodrop.However,becausetheOIisincreasingandthepriceisdropping,youcanassumethatthebullsarelosingmoney,butmanymustbehanginginthereortheyarerecruitingbuddiesatanincreasingrate.WhataretheramificationsofanOIdecline?Itisasignthatthelosersareinaliquidationphase(itdoesn’tmatterwhichwaythemarketismoving),thewinnersarecashingin,andnewplayersarenotenteringinsufficientnumberstoreplacethem.

SixrulesfortradingOIThefollowingsectionsdescribesixprofitrulesforanalyzingOI.

1.IfpricesareinanuptrendandOIisrising,thisisabullishsignInthissituation,thebullsareincharge.Theyareaddingtopositionsandmakingthemoney,thusbecomingmorepowerful.Shortsarealsobeingstoppedout,butnewsellersaretakingtheirplace.Asthemarketcontinuestorise,thelongsgetstronger,andtheshortsgetweaker.(SeeFigure8.22.)

Figure8.22.BullmarketOI

2.IfpricesareinadowntrendandOIisrising,thisisabearishsignThebearsareinchargeinthiscase.Theyareaddingtotheirpositions,andtheyaretheonesmakingmoney.Weakerlongsarepossiblybeingstoppedout,howevernewbuyersaretakingtheirplace.Asthemarketcontinuestofall,theshortsgetstronger,andthelongsgetweaker.Anotherwaytolookatthefirsttworulesisthat,aslongastheOIisincreasinginamajortrend,itwillhavethefinancingitneedstodrawuponandprosper.

3.IfpricesareinanuptrendandOIisfalling,thisisabearishsignTheoldlongs—thesmartmoney(Icallthem“smartmoney”becausetheyhavebeenrighttothispoint)—aretakingprofitsandliquidating.Theyarereplacedbysomenewbuyerswhowillnotbeasstrongonbalance,butthedecliningOIisanindicationthattheweakshortsarealsobailing.Theywillbereplacedtosomeextentbynewshortswhoarestrongerthantheoldshortswere.

4.IfpricesareinadowntrendandOIisfalling,thisisabullishsign—themirrorimageofrule3Thesmartmoney,theshorts,arecoveringorliquidating.Theywillbereplaced

toadegreebynewshortswhoarenotasstrongastheywere,butthedecliningOIindicatesthattheweakenedlongsarelargelythrowinginthetowel.Theywillbereplacedbyfreshlongswhowerenotasweakenedbythelowerprices.AnotherwaytolookatRules3and4isthatwhenthepooloflosersisdepleted,thepartywillbeover.

5.IfpricesareinacongestionrangeandOIisrising,thisisabearishsignThissituationisabearishsignbecausethepublicgenerallyplaysthelongside.RisingOIinatradingrangeaffairassumesthatthecommercialsandprofessionalsaretakingtheshortside,andtheuniformedpublicwillmostlikelyloseoutintheend.

6.IfpricesareinacongestionrangeandOIisfalling,thisisabullishsignThissituationisabullishsignbecausetheprofessionals,whoaremorelikelytobeshort,arecovering.Theweakhandsarethrowinginthetowel.

RSIOscillatorsareagroupoftechnicalindicatorsthatarepopularwithtradersasoverboughtoroversoldindicators.Themostcommonlyusedoscillatoristherelativestrengthindex(RSI).RSIwasdevelopedoriginallybyWellesWilderinthelate1970s.Whenyouhearthewordsoversoldandoverbought,here’swhatthey’retalkingabout:Marketsdonotgostraightuporstraightdownforeverwithoutcorrectivemoves.Therecomesapointwherethemarketisreadytoturn,eithertemporarilyorforgood.Overboughtbasicallymeansthemarketistoohighintherespectthatit’srunningoutofbuyers;ineffect,it’sabouttofallofitsownweight.Oversoldistheantonym:Themarketistoolow,runningoutofsellers(atleastforthecurrenttimeperiod),andreadyforabounce.Oversoldisnotascientifictermandisbandiedaboutsomewhatarbitrarily.TheRSIattemptstoquantifythedegreeofoversoldoroverbought.TodeterminetheRSI,atraderselectsthenumberofdays;nineisthestandard,

ordefault,inmostprograms.Tocalculatethenine-dayRSI,youneedtoaveragethechangeofthepreviousnineupdaysanddividethisnumberbytheaverageofthechangeofthepreviousninedowndays.TheRSIrangesfromjustabove0tojustunder100,butitisextremelyraretoseeanumberclosetoeitheroftheseextremes.TheRSIspendsmostofitstimefluctuatingbetween25and75.Atextremes,itmovesunder25orover75.Thesearethestandardoversold(lessthan25)andoverbought(greaterthan75)areas.HowdoyouusetheRSI?Whenthisnumbergetstoosmallortoolarge,itis

timetoputyourantennaup.Themarketcouldbegettingclosetoareversalpoint.SometradersattempttobuywhentheRSIwandersintooversoldrangeandsellintheoverboughtrange.Myopinionisthatifyouattempttodothis,youbetterhavedeeppockets.Attimes(rangeboundmarkets),thiscanbeanexcellentwaytopicktopsandbottoms.However,inthemajormovesandatextremes(themostprofitabletimeforthetrendfollower),theRSIcanremainintheextremerangesforlongperiodsoftimeandforquiteafewpoints.(And,hey,it’s“only”points,right?)ThisisthemajordrawbackoftheRSI:Itworksinnormalmarkets,butwhenthemarketisintheblow-offorpanicstage,itcanremaininoverboughtoroversoldterritoryforanextendedperiodandbecomequitecostly.Still,IdobelievetheRSIisausefultool,butonlywhenusedinconjunction

withotherindicators.Youneedtoknowwhattypeofmarketyouarein(trading-rangeortrending,youngormature).Ifyoucandeterminethis,theRSIcanhelpyouidentifythepointinthelifecycleofthemarket.TheRSItendstogethighinthematurestagesofabullmarketandlowinthematurestagesofabear,butthereisnomagicnumberthatsignalsthebottom.Infact,I’vefounditisagoodpracticetowatchfortheRSItoturnupafteritfallsunder25tosignalabottomandviceversaforthebull.Yet,eventhistactictendstoleadtonumerousfalseandmoney-losingsignalsbecausetheRSIisacoincidentindicator.Itmoveswithprice.AminorupswinghastoturntheRSIup.ThebestwayinmyopiniontousetheRSIistolookfordivergences.These

occurwhentheRSIdoesn’tmakeanewloworanewhighcoincidentallywiththemarket.Forexample,supposethatcoffeeralliesfrom128to158;theRSIregistersahighforthemoveof83at158(soitisinoverboughtterritory).Themarketthenfallsbackto152,anormalcorrection,andtheRSIfallsbackto71.Subsequently,thecoffeemarketcontinuesitsbullishwaysandreachesanewhighof161.Upuntilthispoint,theRSIhasmovedwithprice.Eachday,coffeeregisteredanewclosinghighforthemove,andsodidtheRSI.However,onthisoccasion,theRSImoveduptoonly79,alowerhigh.Themarketmadeanewhigh;theRSImadealowerhigh.(SeeFigures8.23and8.24.)

Figure8.23.RSIdivergence

Figure8.24.RSIdivergence

Thisisclassicdivergence,andI’vefoundthatthebestsignalscomefromRSIdivergence.Theverybestsignalscomefromtripledivergence,inwhichthemarketmakesathirdhigherhighorthirdlowerlow,whiletheRSImakesathirdlowerhighorathirdhigherlow.I’vealsoseenquadrupledivergenceandevenmoredivergences.ThiscanbeanotherdilemmawhenusingRSI.Doubledivergencecanbeseenmanytimesjustbeforeaturningpoint,butinthemostpowerfulmoves(theonesyoureallywanttobeon),thereisnothingtosaythemarketcannotkeepgoinginthedirectionofthemajortrend.Thisissomethingtolookatdaily,becauseitcangiveyousomeusefulinformation,butIwoulduseRSIasaconfirmingindicatoronly,notasastand-alonetradingmethod.

StochasticsStochasticsareanotherpopularoscillator.WhileGeorgeLaneisgenerallycreditedasthedeveloperofstochastics,someintheindustrycontendthatRalphDystantwasactuallythecreatorofthiswidelyfollowedindicator.ThestochasticsformulaisabitmorecomplexthantheRSIandisreadilyavailableforthosewhowanttoseethemathematics.Iwon’tdiscussithere(youcanletthecomputerfigureitoutforyou,likemostothertradersdo),butIwilltalkaboutthebasicsofhowtointerpretstochasticsdata.Thestochasticsformulameasureshowthecloseimpactsthetrend.Hereisthe

theory:Inbullmarkets,thecloseismorelikelytooccurneartheday’shigh,andinbearmarkets,thecloseismorelikelytooccurneartheday’slows.Thewaythemarketclosesdetermineshowthestochastictrends.Inessence,stochasticsareameasurementofhowthemostcurrentcloserelatestowherepriceshavebeenduringtheperiodunderstudy.Stochasticsconsistoftwolines:the%K,whichismoresensitive,andthe%D,

whichisslowermoving.AswiththeRSI,thetradercanchoosethenumberofdaysfortheformula.Shorterterms(5daysispopular)aresensitiveandactquicklybutleadtomanymorewhipsaws.Longerterms(14dayiswidelyused)identifylonger-termmovesandeliminatesomeofthewhipsawsoftheshortervariety.Ifyouplantoworkwithstochastics,thecomputerwillplotthe“fast”andthe“slow”versions.Theslowversionislikelyabetterwaytogobecauseitissmoothedtoeliminatemanyofthewhipsawandfalsesignalsoftheformer.Thestochastic’svaluesrangebetween0and100,justliketheRSI’s.Overboughtisgenerallyconsideredtobeavalueinexcessof80,andoversoldislessthan20.TheycanbeusedasintheRSI,buttheytendtogivebettersignalswhentheydivergefromprice(aswiththeRSI).Divergencecanprecedethemarket.

Bullishdivergenceiswhenpriceshitnewlows,butthestochasticmakesahigherlowthanitspreviouslow.Bearishdivergenceiswhenpriceshitanewhigh,butthestochasticmakesalowerhigh.Bothoftheseoccurrencescangivestrongindicationsofmarkettopsandbottoms.Tradersalsolookforthestochasticlinestocrosstoexitanexistingpositionorenteranewone.(SeeFigure8.25.)Thebestsignalscomewhendivergenceispresent,andthenthe%Klinecrossesthe%Dlinethatconfirmsthedivergence.

Figure8.25.Stochastics

ElliotwaveanalysisRalphElliotwasanaccountantwhodevelopedhistheoryonmarketcyclesin1939.Basically,Elliotbelievedthatthereisa“naturalorder”tothemarketsandthattheytravelinpredictablecycles.Hebelievedthatthemarketralliesinfivewaveswheninanuptrendandfallsinthree-wavecorrectivemoves.Wheninadowntrend,themaintrendisfivewavesdown,withthree-wavecorrectiveupmoves.Thisfive-wavepatternismadeupofthreeodd-numberedwaves—1,3,and5—whichareconnectedbytwocorrectivewaves—2and4.Eachmajorodd-numberedwavecanbesubdividedintofivewaves,andcorrectivewavescanbebrokenintothreeparts(theABCcorrection).(SeeFigure8.26.)

Figure8.26.Elliotwave

Attimes,Ihavelookedatlonger-termchartsofmajortrendsandbeenabletoseeexactlywhatElliotwastalkingabout.Othertimes,itjusthasn’thappened.ThemainproblemIpersonallyhavehadwithElliotwaveanalysisisthatIfinditdifficulttodeterminewhatwavethemarketisinduringtheheatofthebattle.IfyoudelvedeeplyintoElliotwaveanalysis,you’llfindnumerousrulesthatexplainawayeverywiggleonthecharts.Therearesubsetsofsubsetsofwaves,andwhenanElliotwavetheoristmissesthecount,hereviseshisanalysistosaywave3wasactuallynotwave3,butasubwave4ofmajorwave2,andthisisthereasonforanABCcorrection,whichhedidn’texpect.I’mnottryingtobecriticalhere,becauseIdobelievethereisvaliditytoElliot’swork,butIpersonallyhavehadtroubleusingit.Everytradermustusewhatworksforhim.Twotraderscanhaveentirelydifferentapproaches,andbothcanstillmakemoney.

PointandfigurechartsThepointandfigure(P&F)isanothertypeofpricecharting;theuniquethingaboutP&Fisthatitignorestime.Timeisirrelevant;onlypricematters.XsandOsindicatepricesignals.AP&FchartistusesXstoillustraterisingpricesandOsforfallingprices.Aslongasthepriceisrising,Xsareadded.Oscomeintoplaywhentheyaredropping.ThedecisiontostartanewcolumnofXsorOsisbasedonthemarketmakingapricechangeofacertainamountdesignatedbythetechnician.Thiswouldbeabox.Thetechnicianalsomustdesignate(inadditiontothesizeofeachbox)whatdeterminesareversal.Forexample,apopularreversalsizeisthreeboxes.So,ifyouuseascaleof

10pointsforcattle,areversalsizewouldbe30points.Thevaluesfortheboxandreversalarearbitrary,dependingonhowsensitivethetraderwantstheP&Fcharttobe.Thelargertheboxsizeandreversalvalues,thelesssensitivethechartisand

viceversa.A1¢boxforwheatisobviouslymoresensitivethana10¢box.Ifthechartistoosensitiveandtheboxestoosmall,youincreasethechancesofbeingwhipsawedbyinsignificantfluctuations.Iftheboxesaretoolarge,youmissoutonsignificantportionsofsomemovesandtaketoomuchrisk.Figure8.27illustratesatypicalP&Fchart.

Figure8.27.TypicalP&F

AlthoughIpersonallydonotuseP&Fcharts,Iknewanumberofsuccessfulfloortraderswhodid.ThisiswhyIwanttoatleastmentiontheminthisbook,soaseriousstudentwhowantstopursuetheP&Fcanresearchfurther.

JapanesecandlestickchartsCandlestickchartsarethethirdmajorchartingmethodavailableonmostchartingprograms.TheJapaneseusedcandlestickchartsbeforechartingeverbecamepopularintheWest(ricefutureswereactiveinJapanasearlyasthe1700s),andtheyaretheearliestformoftechnicalanalysis.WhereasbarchartsusebarsandpointandfigurechartsuseXsandOs,candlestickchartsuserowsofcandleswithwicksoneitherend.Thebodyofeachcandleisthedistancebetweentheopeningandclosingprices.Iftheclosingpriceishigherthantheopen,thebodyisleftemptyorwhite(oritcouldbeonecolor,likeblue).Iftheclosingpriceislowerthantheopen,thebodyisfilledinwithblack(oranothercolor,likered).Theupperwickrepresentsthehigh,andthelowerwickrepresentsthelow.Thewicksarenotasimportantasthebody.Inotherwords,candlestickchartistsarenotasinterestedintheday’shighorlowastheyareintherelationshipbetweentheopenandtheclose.Iamnotanexperton

candlestickcharts;entirebookshavebeenwrittenonthevariouspatternsforthosewhowanttodelvedeeper.WhileI’vedecidedthatcandlewickchartsdonotfitmypersonalstyle,a

numberofinterestingpatternsappeartohavesomevalidity.Theyhavecolorfulnames,too.Candlestickchartistsreferto“hangingmen,”“tweezerstops,”and“darkcloudcovers.”Inmystudies,theengulfingpatternsappeartoworkmoreoftenthannot.Theyseemtobeabletoidentifytopsandbottomsbetterthanstandardreversalpatterns.Theengulfinglinecanbeseenatmajortopsandbottoms,andtherealsocanbecontinuationpatternsseeninthemidstofamajortrend.Inmanycases,theydosignaltheendofacorrectionwithinamajortrend.Thebullishengulfinglineconsistsofawhite(orcoloredin,attimesempty)

bodythattotallyengulfs,orcovers,thepreviousday’sbody.Inotherwords,thehighofthebodyishigherthanthehighofthepreviousbody,andthelowisbelowthepreviouslow.Thewhitebodyisformedbyalowopeningmetbystrongbuying,whichpushespricetocloseabovethepreviouscandle.Thisisabullishindicatorthatisseenoftenatmajorbottoms.Bearishengulfinglinesarethemirrorimageseenattops—alongblack(orcoloredin,attimesempty)candlethattotallyengulfs,orcovers,thepreviousday’scandle.Thisisoftenseenatablow-offtop.Itisapowerfulsignalforcandlestickpeople.(SeeFigure8.28.)

Figure8.28.Typicalcandlestickpattern

Spreads—avaluableforecastingtoolI’vefoundthatbymonitoringthespreadactioninmanyoftheactivelytradedphysicalcommodities,atradercangetvaluablecluesabouthowbullishorbearishamarketis.Spreadsalsocanbeusedtopredictthemarketpathofleastresistance.Typically,commodityfuturesmarketsarein“carryingcharge”or“normal”configurations.(InLondon,theywouldsaythemarketisincontango.)Thisiswhenthedistantmonthssellatahigherprice(orpremium)totheclosermonths.Here’satypicalexampleofwhata“normal”coppermarketmightlooklike:

Becauseitcostsmoneytostorecopperfromonemonthtothenext(storagecosts,insurance,andinterest),thisisreflectedintheconfigurationoffuturesprices.However,attimes,marketstakeontheoppositeconfiguration,inwhichthenearmonthistradingatapremiumtothedistants,asillustrated:

Thisconfigurationiscalledaninvertedmarket.(InLondon,it’scalledbackwardation.)Whatcausesamarkettoinvert?Inmostcases,aninvertedmarketistheproductofaperceivedorrealnear-termshortageofthecommodityinquestion.Thiscanbecausedbyweather.Forexample,coldweathertendstopushthenearbynaturalgasoverthebackorcouldevenpushthenearbycattlecontractsabovethebacksbecausecattledonotgainweightefficientlyincoldweatherandcouldconceivablybe“pushedback”—notreadyformarketina

timelymanner.Inversioncouldbecausedbyaminingstrike,agovernmentprogram,bignear-termexportdemand,oraclassicshortsqueeze—actually,anynumberofthings.Theimportantpointhereisthatthespreadscangiveyouimportantcluesaboutthestrengthorweaknesswithinamarket.Here’smygeneralruleofthumb:Whenthebullspreadsareworking(thenear

monthsaregainingonthebackmonths),thisisabullishsign.Whenthebearspreadsareworking(thenearmonthsarelosingtothebackmonths),thisisabearishsign.Aswitheveryrule,thereareexceptions.Forexample,NovemberbeansmightbegainingonJulybeansinJune,becausethenewcrop,whichwillbeharvestedinthefall,isburningupduetodrought;however,thereareadequatenear-termsupplies.Asarule,however,thisworks.I’musuallyskepticalifI’mshortamarketandthebullspreadsareworking—somethingiswrong.Here’sanotherpowerfultradingtip:Watchforspreadstocross“evenmoney.”

I’venoticedthatwhenspreads“crosszero,”moretimesthannot,thisindicatesasignificantindicatorofachangeinthesupply-and-demandbalanceofthecommoditybeingstudied.Myadviceistogowiththeflow.Ifthespreadinquestioncrosseszerototheupside,playthebullspreads(longnearby,shortthedeferred)orplaythemarketfromthelongside.Ifthemarketcrosseszerotothedownside,playthebearspreads(shortthenearby,longthedeferreds),orplaythemarketfromtheshortside.Forexample,considerthespreadbetweenMay2003sugarandMarch2004sugar,showninFigure8.29.Notethatthisactiontookplaceduringmid-2002intoearly2003(the2004contractislistedtwoyearspriortoitsexpiration).

Figure8.29.Sugarspread

ThisspreadcrossedthezerolineinAugust2002,whichturnedouttobejustafewweeksbeforeamajorbullrunbeganinthesugarmarket.Thepriceatthattimewas574.Themarketonthatdayreallydidnot“showitshand”;whatImeanbythisistherewerenorealindicationsofthemajormovethatwastofollow.Still,thespread(bythemereactofinverting)turnedouttobeanexcellentleadingindicatorofamajorbullrun.Thisparticularbullspreadcontinuedtoworknicely,peakingonJanuary29at

132pointsMayovertheMarch.Onthatdate,Maysugarclosedat822,sothemarkethadmoved248points,equivalenttoaprofitof$2,777percontracttraded.Thespreaditselfhadrallied132pointsabovethezeromark,foraspreadprofitof$1,478perspreadtraded.Consideringthatthespreadmarginsaregenerallymuchlower—inthecaseofsugar,onlyone-thirdthesizeofanoutrightcontract—tradingthreespreadsforeveryonecontractwouldhaveyieldedanadditional50%profit.Ofcourse,onthatdate,therewasnowaytoknowthatthiswasthehighestthisspreadwouldrun;however,whenthespreadstartedtoturnsouth,ourantennashouldhavebeenraised.Myexperiencehas

beenthatmoretimesthannot,spreadsleadpriceaction—spreadscanbeapowerfulindicator.NotethatafterthespreadpeakedonJanuary29,thesugarmarketcontinuedtorise,andthecontracthighwasregisteredFebruary20,at884.Onthatdate,despitetheMaycontractmakinganewhigh,thespreadwasalreadyfading,tradingat115,orequalto17pointsbelowitspeak.OnMarch10,thedaythespreadbrokebelowits50-dayexponentialmovingaverage,Maysugarwastradingat801.Certainly,therewereothercluesthatthebullhadrunitscourse.Forexample,

openinterestwasrisingnicelyduringthebullrun,butitpeakedonFebruary13,afullweekbeforethepricepeaked.Thepricerisingandopeninterestfadingwiththebullspreadsdecliningweretwopowerfulsignalsthattogethercouldhavebeenusedtopredicttheendofthisbullrun.TheicingonthecakewasavolumespikeonFebruary19,onedaybeforethetop.Onthatday,volumehitcloseto74,000contracts,theonlytimethatyearitwasabove70,000.High-volumedayscancomeatturningpoints,andhistorically,sugarvolumetendstoexpandjustpriortoandcoincidentallywiththebeginningofabullmove.Thisdayturnedouttobethethird-highestvolumedayinsugar’shistorytothedate.TheprevioushighestwereJanuary5,1999,andFebruary24,1998.Bothoftheseregisteredover80,000,andbothcameatmajortops,withthemarkettradingabove9¢perpound.(SeeFigure8.30.)

Figure8.30.Sugarmultipleindicators

Incidentally,withgreaterspeculativeparticipationtoday,I’venotedthatvolumerecordscontinuetobebroken.(Today,100,000+contractdaysinsugararecommon,with200,000+spikedays.)

HeadandshouldersNexttothebreakoutfromconsolidation,theclassicchartpatterntheheadandshoulders(H&S)ismyotherfavorite.EdwardsandMageemadetheH&Spatternfamousintheir1948bookTechnicalAnalysisofStockTrends,anditstillremainsavalidandusefulindicatortoday.TheH&Sisareversalpatternthatsignalsachangeintheprevailingmajor

trend.We’lltakeupsomeinkreviewingthisconceptherebecause,inmyexperience,itremainsoneofthemostreliable.(Ialsowilladdmyowntwiststoidentifyingandanalyzingthispattern.)WhenyouseeanH&Spattern,it’stimetoeitherexitandtakeyourprofits,

cutyourlosses,orestablishanewpositioninthenewdirection.Aninteresting

characteristicoftheH&Sisthatitnotonlytellsyouamarketismakingatoporbottom,butitalsotellsyouhowfartheensuingmovewilltravel.TheH&Sdoesnotactuallypickthetoporthebottom,butitgivesyouthesignafterthetoporbottomisinplace.Becauseapictureisworth1,000words,let’sstartwithatwochartsthat

illustratetheH&Spattern(seeFigures8.31and8.32).

Figure8.31.SugarH&Stop

Figure8.32.GoldH&Stop

Thehead(H)isapricepeak;anotherpeaklowerthantheheadtotheleftistheleftshoulder(LS),andanotherpeaklowerthantheheadtotherightistherightshoulder(RS).Thelineconnectingthelowsofthedeclinesfromtheshouldersandtheheadiscalledtheneckline(NL).InaclassicH&S,thenecklineisoftenhorizontal(similartoasupportline).However,itcanalsobeupwardsloping(asinFigures8.31and8.32),similartoanuptrendline,ordownwardsloping,similartoadowntrendline.Thisiswhereyouranalyticalskillscomeintoplay.ManyofthebestH&Spatternsaremutants,whichresembletheoriginalbutinaskewedway.YoucanspotanH&Sdevelopingwhentheleftshoulderandtheheadarein

placeandthemarketstartstorallyfromtheneckline.Ifitfailsatalowerhighthanthemajorhigh,therightshoulderisinformation.AclassicH&Softenhasarightshoulderoftheapproximatesamesizeanddurationastheleft.However,itcanbelowerorhigher,longerorshorter,butitspeakwillultimatelyenduplowerthanthehead.Thepatternisnotcompleteuntiltherightshoulderiscompletedandthedeclinefromtherightshoulder’speakbreaksundertheneckline.Whenthathappens,atopispresumed.Itistimetoexitlongsandgoshort.Aftertheinitialbreakoutbelowtheneckline,themarketoftenralliesbackuptoapproximatelytheneckline,givingthetraderanexcellentlow-riskshorting

opportunity.H&Spatternscanalsosometimesprovidefalsesignals.SuspectafalsesignalifthemarketisabletorallybackabovethepeakofRS(thisistheplacetoinitiallysetyourriskpoint).ThiswillnotoccurwiththebestH&Ssignals;mostwillnotrallybeyondNL.Ifthemarkettradesabovethepeakoftherightshoulder,youcansafelyassumethatallbetsareoffandthisoneisn’t“right.”There’sabonusthatcomeswiththeH&S:Italsoprovidesatargetthatis

generallyreliableandmoreprecisethanmosttechnicaltechniques.Ifyoumeasurefromthetopoftheheadtothenecklineandbringthismeasurementdownfromtheneckline,youhaveatargetforaminimumobjective,wherepriceswillsubsequentlyendup.Themarketcancertainlymovefartherthanthiscountfortheobjective,butitgivesyouaminimumobjectivethatcouldpreventyoufromexitingprematurely.H&Spatternsoccurinalltimeframes,andyoucanoftenfindtheminthe

short-termminiS&Pchart.Withasmallerpattern,youusuallyneedtoshootforasmallerobjective.Figure8.33illustratesashort-termcomplexH&Spatternona45-minutechart(whereeachbarrepresents45minutesofmarketactivity)thatItradedsuccessfullyfromtheshortside.

Figure8.33.CocoaH&S

Watchvolumetoconfirmthepattern.VolumeoftenwilltendtospikeattheheadandusuallyishigherthanaverageatthebreakoftheNL.AnH&Soccursatmajorbottomsaswellandlookslikethemirrorimageof

onethatformsatthetop.Sometraderscalltheseinvertedheadandshouldersorreverseheadandshoulders.Inthisvariety,theheadisatthelowestpoint,withtwohighershoulders,oneoneachside.Otherthanthefactthatthesearethemirrorimageofthetops,youtradethemthesameway.ThegoldH&SbottomshowninFigure8.34isofthesimple,classicvariety;thesoybeanismorecomplex.NotehowtheextendedandcomplexbottomingpatternillustratedinFigure8.35signaledthestartofamajormovethatgreatlyexceededtheminimumobjective.

Figure8.34.GoldH&Sbottom

Figure8.35.SoybeanH&Sbottom(invertedcomplex)

10rulesfortradingH&SHerearetenrulesforsuccessfullytradingusingH&Spatterns:

1.Neveranticipate.WhenIfirstdiscoveredH&Spatterns,Ihadagreattrade,butthenitseemedIstartedfindingthemeverywhere.Iwouldstarttosellafterarightshoulderandaheaddeveloped,onlytolosemoney.IwouldseecompleteH&Spatternsdevelopandtakeactionbeforepenetrationoftheneckline,onlytohavemyheadhandedtome.AsYogiBerrasaid,“Itain’tovertillit’sover.”Waituntilthepatterniscompletedbeforeyoutradeit.

2.ThebiggertheH&Spatternandthelongerittakestodevelop,thebiggerthesubsequentresultingmove.

3.Thecountisaminimummeasurement.Oddsactuallyfavorthemovecarryingmuchfurther.However,awarninghere:Aswithallotherchartpatterns,youarenotdealingwithacertaintyhere.Ifyourcountsaysthemarketwillfall400points,anditfalls380andstartstoreverse,itwouldbeashametoletallyourprofitsevaporateoveralousy20points.

4.Afterthemarketbreakstheneckline,watchforthereturnmovebacktotheneckline.Thisoccursinatleasthalfofallvalidcasesandoffersaplace

toenterwithaclosestop.5.Watchtheslopeoftheneckline.Downward-slopingnecklinesforH&Stopsincreasetheoddsforamorepowerfulbearmovetofollow.Upward-slopingnecklinesforinvertedH&Sbottomsincreasetheoddsforamorepowerfulbullmovetofollow.

6.Bevolumeaware.Themostreliablenecklinebreakoutsareaccompaniedwithhigher-than-averagevolumes.IhavesometimesseenthehighestdailyvolumedaysoftheyearassociatedwithH&Spatterns.

7.Watchfortheheadtoalsoforman“island”(seeFigure8.36).Thiscombinestwoverypowerfulpatternsandgeometricallyincreasesthevalidityofthesignal.

Figure8.36.IslandH&Stop

8.Whenthepatterniscomplete,itshouldactcorrectly.Thesepatternsarefairlyreliableanddonotoftendeviatefromtheirtruepurpose,unless,ofcourse,theyarefalse.Howcanyoutellifapatternisfalse?Onegoodindicationisthatyourmarginaccountwillstarttoshowaloss.Don’tfreezewhenit’snotactingproperly;whenindoubt,getout.Besuspiciousifthepatternoccursonlowvolume.Rememberthatthemarketcanretracetotheneckline(thisisnormalandagoodplacetoposition),butifthe

patternisgood,theretracementreallyshouldn’tgomuchfurther.9.Ifit’safalsesignal,looktoreverseyourcourse.I’vefoundthataclassicH&Sfailureoftenoffersanexcellentopportunitytogetbackinsyncwiththemajortrend.Ifthemarketagaintradesabovetherightshoulder’stop(orbelowtherightshoulder’sbottomforareverseH&S),oddsfavor,ataminimum,onelastthrusttoanewhighornewlow.Iwouldbuythemarketatthispoint,withtheobjectiveofanewhigh,riskingtoundertheneckline.ForaninvertedH&Sfailure,sellthemarketunderthelowoftherightshoulder,withaminimumobjectiveofanewlow,riskingtoabovetheneckline.

10.Afterafalsesignalisconfirmed,watchthemarketactioncloselyassoonasanewhighorlowisregistered.I’venoticedthatanH&Sfailurethatturnsoutnottobethefinalhighorlow,ultimatelyleadstoanewcontracthighorlowinshortorder.TheH&Swastellinguswewereclosetothemajortoporbottom,butthebullsorbearswereabletomountonelasthurrah.Ifthemarketisunabletoshowmuchfollow-throughafterthisclimatictoporbottom(followinganH&Sthatdidn’twork),bereadytotakeactionbecauseamajortoporbottomisnowinplace.

GK’ssignificantnewsindicator

“Firstthedoctortoldmethegoodnews:Iwasgoingtohaveadiseasenamedafterme.”—SteveMartin

Aslongasmarketshaveexisted,savvytradershavepaidattentiontothemarket’sreactiontosignificant(potentiallymarket-moving)news.Thiswastrueinthedaysofthetickertapeandisstilltrueintoday’selectronicage.Significantnewsshould,bydefinition,resultinasignificantmarketreaction.

Butitdoesn’talwayshappen,andmanytimesthereactionisoppositeofwhat’scommonlyexpected.Inthissection,Ipresentmy“significantnewsindicator”(SNI).TheSNIwillhelpyoutradethemarket’sreactiontonews.It’sasmuchatradingphilosophyasanindicator,butbecausewe’reabletoapplyspecificrulestonewsreactions,theSNIcanbeasusefulasanymathematicalindicator.Tointroducetheconcept,considerthisstatement:Whatmattersisnotthe

newsbuthowthemarketreactstothenews.Certainly,thenewssetsthepublicperception,butyoumustbealertfordivergencesbetweenthenewsandmarketaction.It’sexpectationversusreality.Lookforthedivergencebetweenwhat’s

happeningandwhatpeoplethinkissupposedtohappen.Whenthebigturncomes,thegeneralpublicwillalwaysbelookingthewrongway.

SixrulesfortradingnewsThefollowingaresixnewsrules:

1.Ifbadnewsisannouncedandthemarketstartstoselloffinlargevolume,it’sagoodbetthatthemarket’sgoinglower.

2.Ifthemarketfailstoreacttogoodnews,ithasprobablyalreadybeendiscountedintheprice.

3.Movesofimportanceinvariablytendtobeginbeforeanynewsjustifiestheinitialpricemove.Whenthemoveisunderway,theemergingfundamentalswillslowlycometolight.Abigrally(decline)onnonewsisusuallyverybullish(bearish).

4.Itisgenerallynotagoodpracticetobuyafterverybullishnewsorsellafteranextremelybearishreportbecausebothgoodandbadnewscanalreadybediscountedintheprice.

5.Alwaysconsiderwhetherthetrendisdownorupwhenthenewsismadeknownbecauseawell-establishedtrendwillgenerallycontinue,regardlessofthenews.Asanexample,IremembergettingcaughtintheemotionofaverybullishcornreportinJanuary1994.Lookingback,thisnewswastheverytop.Anopposite(verybearish)reportthefollowingyearturnedouttobethespringboardforoneofthebiggestcornbullmarketsinhistoryandledmetodeveloptheSNI.

6.Whenunexpectednewsoccurs(newsthatthemarkethasnothadtimetopreparefor)andthemarketopensinawiderangeor“gaps”lowerorhigher,selloutyourlongsorcoveryourshortsandwait.Watchthemarketfor30minutestoanhour.Ifthemarketopenedsharplylowerwithheavysellingandwasnotabletotrademuchlowerthanthat,it’sintosupportandyoucanbuyitwithatightriskpoint.Watchthemarketcloselyatthispointandnotethetoneoftherally.Ifit’ssmallandthemarketisabletoagainfallunderthelevelsmadewhenthebadnewscameout(orriseabovethelevelsmadewhenthegoodnewscameout),it’ssafetoassumethemarketisgoinglower(higher).

Irecallthebigbullcoffeemoveof1994.Oneday,themarketwastradinginthemid-80¢level.IwaslongwhenunexpectednewshitthewiresaboutthesurprisegovernmentreleaseofmassiveBrazilianstockpilesofcoffee.These

stocksweresupposedtobeheldinreserveandoffthemarket,butBrazilneededforeignexchangeatthetimeandchangeditspolicy.Themarketgappedlowerattheopenandproceededtotradedown400points,stoppingmeoutintheprocess.Itremainedweakforadayorso,butassoonasthemarketwasabletocrossabovethemid-80¢levelagain(thepriceregisteredbeforetheunexpectedbadnewshit),itbasicallywentstraightup.Thiswasthetimetoreenter.Itwasuptoabout$1.40beforethefirstfreezehit.Thefullmovewasn’toveruntilcoffeepriceshitcloseto$2.75,andthemonsterbullrunbeganwhenthemarket,onnonews,crossedthelevelmadebeforethereleaseofthebadnews.

Inthesummerof1999,theBritishCentralBankannouncedthatitwasgoingtoauctionoffhalfofitsgoldreserves,callinggolda“barbaricrelic.”Thepricewas$250perounce,andalthoughthisnewswasbearish(floodinganalreadyweakmarketwithmassiveadditionalsupply),thiswasamajorbottom.Withthistypeofmarketactioninmind,itwasthebearishcropreportof1995

thatledtometodeveloptheSNI(althoughIdidnotformallyputanametoitatthetime).WeweremovingfromMinnesotatoLakeTahoeanddrivingalongInterstate80onthedayofthereport—August11,1995.IhadalargelongpositioninDecembercornforclientsandmyself.Atthattime,thecropwaslookinggood,andnobodyknewtheweatherwouldturnunfavorablelatethatsummer,creatingashortcrop.Imusthavehadmyreasonsforbeinglong,butmyhopesweredashedwhenthecropreportwasreleasedbeforethemarketopenthatday.Iremembercallingmyassistantfromtheroadwhenhetoldme“limitdown.”Thecropreportwassobearishinreportinganincreasedsizeoftheupcomingcropthattheearlycallswereforthemarkettoopendownthe(then)10¢-per-bushellimit.Andnotonlylimitdown,buttheearlybanterwasthatthemarketwouldopenlimitdownand“lock,”meaningwecouldbestuckinourpositionwithonlyofferstoselllimitdownandnobidsatthatprice.IwasuncomfortableasIsweatedoutthehourandahalfbeforethemarket’sopen,tryingtodecidehowI’dworkoutofthismessfromtheroad.Iaskedmyassistanttocallmerightbeforethemarketopenedandgivemeablow-by-blow.Themarketdidopensharplylower—7¢lower,tobeexact,butnotlimitdown,

tooursurprise.Themarketgaveme,andanyoneelsewhowaslong,achancetogetoutandsaveourskinsbeforealimit-downmove.But,insteadoftradinglowerfromthe7¢loweropen,myassistanttoldmecornwasbeginningtotradeupfromtheopen.Itfeltasifacloudwaslifted,andmynervousnessdisappeared.Itoldhimtoplaceastoponourentirepositionjustbelowthe

openingpriceof270.SeeFigure8.37.

Figure8.37.December1995corn

Icontinuallycheckedinthatday,butthestopwasneverhit.Whenthemarketwastradinghigherfortheday,IinstinctivelyknewIwassafe.That270lowregisteredthatdaybecauseofthebearishnewswasamajorlowthatwasneverchallengedagaintherestofthatyear.Itactuallyturnedouttobeasignificantlowthatheldupforyears,anditwasthespringboardforoneofthebiggestbullmovesinhistory.Bythenextyear,duetocropproblemsintheUnitedStatesandglobally(ChinaturnedfromthelargestcornexporterinAsiaintoanimporter),cornpriceshaddoubled.TheSNIisafairlysimple,butpowerful,concept:TheSNIisthepriceat

whichamarketistradingjustbeforethereleaseofasignificantmarketnewsevent.Thenewsisgenerallyapreplannedevent;however,itcanalsobeunexpected.

FourrulesfortradingSNIHere’showtosuccessfullyusetheSNIinyourtrading:

1.Ifthenewsisconsideredbullish,theSNIisyourmajorsupportnumberand,ifactingproperly,themarketshouldremainaboveit.Ifthemarketisactingproperlyafterabullishevent,youcanenteralongpositionwitha

stopjustbelowtheSNI.2.Afterabullishnewsevent,amovebelowtheSNIgeneratesanautomaticsellsignal,andyoucanimmediatelyenterashortsalewithatightstopjustabovetheSNI.

3.Ifthenewsisconsideredbearish,theSNIisyourmajorresistancenumber,andthemarketshouldremainbelowitifactingproperly.Ifthemarketisactingproperlyafterabearishevent,youcanenterashortpositionwithastopjustabovetheSNI.

4.Afterabearishnewsevent,amoveabovetheSNIgeneratesanautomaticbuysignal,andyoucanimmediatelyenteralongpositionwithatightstopjustbelowtheSNI.

Inotherwords,whentheSNIiscrossed,ittellsatraderwhentoenterandwheretoplaceaprotectivestop.However,itdoesn’ttellatraderwhentoexitaprofitableposition.(Othertechnicalindicatorsoratrailingstopshouldbeusedforthat.)It’simportanttoknowwhatthemarketisexpectingbeforethereleaseofa

newseventsothatyoucanaccuratelyjudgewhetherthemarketisactingproperly.Forexample,ifacropreportistobereleasedandthemarketisexpectinganincreaseinsoybeanacreageof2millionacres,anincreaseof1millionisbullishnews.Youwouldneedtoknowtheaverage“guesstimate,”orexpectation,beforethereleasetoaccuratelyevaluatethereportandthemarket’sreactiontoit.I’veinstinctivelyorknowinglyusedtheSNIaftereverycropreportformany

yearsnow.Isimplyevaluatethemarket’sreactionversusexpectation.Forexample,theOctober2006cropreportwasconsideredbullishcorn.The

marketwasanticipatingarecord-large(bearish)corncropestimateofmorethan11billionbushelsontheUSDAreport;however,thecropsizewasreducedby2%andwaswellunderthisfigure.Themarketclosedthedaybeforethereportat284(thiswastheSNI)andopenedlimitupat304thedaythereportwasreleased.(SeeFigure8.38.)

Figure8.38.December2006corn

Themarketwasnotabletoremainlimitupthatdayandgaveampleopportunitytoenteranewlongposition,basedonourfirstrule.Thesellstopshouldhavebeenplacedatjustunder284,theclosingpricebeforethereport’srelease.Fortheremainderofthatyear,countlessopportunitiesarosefortraderstotakeadecentprofitenteringafterthebullishnewswaswellknowntothemarketplace.Notethisactionalsocreatedameasuringgap.Incontrast,thatsamereportwasconsideredverybearishforsoybeans.The

marketwaslookingforanunchangedsoybeancropestimate;however,theUSDAreportindicatedthatthecropsizewasmorethan3billionbushelsforthefirsttimeever.Thiswasup3%fromtheSeptemberreportandwasrecordlarge.TheJanuary2007soybeanfuturesclosedthedaybeforethereport’sreleaseat

577;however,themarketopenedhigher,at588,afterthe“bearish”number.TheSNIwastherefore577,andahigheropenwasanimmediateandautomaticbuysignalaccordingtoourfourthrule,withaninitialsellstopjustbelow577.ThemarketcontinuedtoclimbuntiltheendofNovember.Eventhoughthenumberwasconsidered“bearish,”theChineseturnedouttobemajorbuyersofsoybeansfortheremainderoftheyear,pushingpricesmuchhigher(althoughatradercouldnothaveknownthatatthetimeofthereport).However,themarketcertainlyknewthis,leavingcountless‘footprintsinthesand’.(SeeFigure8.39.)

Alsonote,onthedayofthe“bearish”report,you’llalsoseeabeautifulbreakoutfromaconsolidation.Thenewsdidn’tmatterasmuchashowthemarketreactedtothisnews.

Figure8.39.January2007soybeans

TheSNIworksnotonlywithcropreportsbutalsowithfinancialreportsandothernewsevents,bothexpectedandsurprise.EveryWednesday,theoilinventoryreportisreleasedat10:30A.M.EST.This

numbertypicallymovestheoilmarket,sometimessharply.Thisisanexampleofatypicalreactiontoabullishsupplynumber:OnthisreportdaythefirstweekinJune,justbeforethereleaseofthenumber,thenearbyoilfuturesweretradingat12230.Themarketwaslookingforaslightdrawdowninweeklyoilstocks,buttheactualnumberwasa5-million-barreldrawdown—bullish.Themarketimmediatelytradedhigherand,withinaminute,wastradingabove12300.Themarketexhibitedabullishreactiontothenewsandwasactingproperly.(SeeFigure8.40.)

Figure8.40.June5oil

Afterthemarketmovedquicklyhigher,manytraderswouldhaveshiedaway,believingthenewswasalreadyoutanddiscounted.However,thiswasanopportunitybasedonourfirstrule.Thechartlookedgood,themarketwasactingcorrectly,andyoucouldenteralongpositionwithastopjustbelowthe12230SNI(thepricejustpriortothereleaseofthenews).Afterall,ifthemarketisanygooditshouldn’tbeabletotradebelowthepointjustbeforethereleaseofthebullishnews.Subsequently,themarketranabove12400,corrected,madeahigherlowatapproximately12300(atwhichtimethestopcouldberaisedtojustbelowthishigherlow),andatrailingstopcouldhavebeused.Duringthefollowing48hours,thisparticularmoveranupto13900—over$13/barrel,or$13,000percontract,beforethefirstsignificantcorrectiontookplace.Twoweekslater,another“bullish”inventoryreportwasreleasedwitha

higher-than-anticipateddrawdown.Justbeforetherelease,themarketwastradingat13700.ThatwastheSNI.Themarketimmediatelytradedhigher(inotherwords,actedproperly),upto13836.However,withinanhourafterthenumberwasreleased,themarketreversedandquicklymovedbelowthe13700SNI(seeFigure8.41).Unliketwoweeksearlier,ithadbeenabletotradebelowthepointbeforethereleaseofthebullishnews.Thisisbearishaction,accordingtooursecondrule.Atradercouldhavegoneshortonastopjustbelowthis

13700numberand,iffilled,placeabuystopjustabove.

Figure8.41.June18bullishinventoryreport

Withinthefollowing24hours,theopportunityarosetomakeupto$5,000-per-contractprofitontheshortside,witheffectivelyzeroriskafterentry.NotethattheSNIdoesn’ttelluswhentoexitaprofitableposition.Itsignalsanentrypoint.Youcanplaceyourstopclosetoyourentrypoint,butsomealternativemethodisrequiredtosignalyourexit.Youcanutilizeatrailingstop.Inthisexample,wesawareversalbaratthelowswithaminiH&Sbottomingpatternthatsignaledthebottom.Thefollowingweek,thenumberwasbearish,withalarger-than-expected

stockbuild.Justbeforethereleaseofthenumber,theoilmarketwastradingat13570.(SeeFigure8.42.)

Figure8.42.June25bearishinventoryreport

Afterthereleaseofthenumbers,themarketwasinitiallyactingproperly(bearishly),andanimbletradercouldhavegoneshortbyutilizingatrailingstop.Themarketsubsequentlybottomedbelow13200.Butthefollowingday,itwasabletotradeabovethe“bearish”number,andthiswasabullishsign.Hopefully,ifshort,aprofitwas“lockedin”viatheuseofatrailingstop.However,ifstillshort,theminutethemarketcrossedabovethe13570level,allshortsshouldbeimmediatelycovered,andnewlongscouldbeenteredwithatightstop.Themarketwasnowtradingabovethelevelofthebearishnews,andthisisabullishdevelopmentaccordingtoourfourthrule.Eventhoughthisoccurredadaylater,itwasstillwithinafairlyshorttimeperiod.Thisiswhyit’simportanttonotethepriceleveljustbeforethereleaseofsignificantnews(theSNI).SNIsareimportantnumbersandoftenwillactasmajorsupportorresistancefordays,evenweeksintothefuture.TheSNIworksequallywellforfinancialnewsevents.Forexample,inJuly

2008,itwasanticipatedthattheEuropeanCentralBankwouldraiseinterestratesbyaquarter-point,butitactuallyraisedratesbyahalf-point.Justbeforetheannouncement,theeurowastradingat15815.Justaftertheannouncement,itactedproperlybytradinghigher,reaching15853withinanhour.However,thatsameday,themarketcrossedbelowthe15815level,thepricejustbeforethe

announcement.Asellstopcouldhavebeenusedatjustbelowthisnumber(forexample,15810),basedonoursecondrule.Inwhatturnedouttobeazero-risktrade,themarketcollapsed200points,or$2,500percontract,andnevertradedmuchhigher.(SeeFigure8.43.)

Figure8.43.July3,2008,euro30-minutechart

Icouldfillthebookwithexamplessimilartothese;theyoccurjustabouteveryday.Whenyouknowanimportantreport(acropreport,anunemploymentreport,aFedannouncement,aninventoryreport,orastockearningsreport)willbereleased,notewherethemarketistradingjustbeforetherelease.ThislevelwillbeyourSNI,andyoucanuseittosuccessfullytradeagainst,usuallysettinguptradingopportunitieswithhighpotentialrewardinrelationtotherisk.It’sallbasedonthesimplepremisethatiskeytosuccessfultrading:Whatmattersisnotthenewsbuthowthemarketreactstothenews.

Breakingpar

“Perfectnumbers,likeperfectmen,areveryrare.”

—ReneDescartes

Ingolf,pardenotesanidealscoreforthebestgolfers,butthegenerallyaccepted

definitionofparismerely“average”or“ordinary.”Therefore,“abovepar”hascometomeananabove-averageorextraordinaryevent.Inthefinancialmarkets,trading“abovepar”—abovethepsychologically

significantnumber100—isconsideredanimportantmarketmilestone.Ifthepriceofabondistradingabove100(forexample,at106),it’strading“abovepar”and“atapremium.”Thisisasignofstrength.Ifthesamebondfallsandsubsequentlytradesdownto94,itwouldbetrading“atadiscount”or“underpar.”Althoughthenumber100shouldhavenogreatersignificancethananyotherinteger,intherealworld,I’vediscoveredthatcrossingabove100(thebreakingofpar)issignificantfromatradingstandpoint.Forexample,itwasaglobalnewseventwhencrudeoilfirsthit$100perbarrel.Youcanapplythissameruletoanybigroundnumber,suchas500or900;however,thosebeginningwitha1andendingintwoormorezeros(100,1,000,and10,000)areconsideredthepatriarchs.TheloudestcheersevertoringoutfromtheflooroftheNewYorkStock

ExchangeresoundedonNovember14,1972,whentheDowJonesIndustrialAveragecrossedthe1000markforthefirsttime.ThiswasthemostimportantpsychologicalbarrierfortheDowtothatdate.Fortheprevioussixyears,ithadtriedandfailedtobreakabove“Dow1000.”Afewyearsafter1972,theDowbrokebackbelow1000andjustkeptdropping.Duringthebrutalbearmarketof1974,ittradedaslowas577.IttookeightyearsfortheDowtocrossabove1000again,butonceitwasagainabletoin1982,ithasremainedaboveeversince.Amarketbreakingaboveapsychologicallysignificantnumbercreatesa

tradingopportunity.Ihaven’tstatisticallyquantifiedthis,butaftermakingthousandsoftradesoverawidevarietyofmarkets,myexperiencehasbeenthatthemarketwillcontinuetomovehigherbyanother15%minimum,upto30%,and,inmanycases,bymuchmore.Soifamarketcrossesabove100,oddsfavoramovetoatleast115,andlikely130,beforefallingback.Andtotakethattoanotherlevel,ifthepriceofastockorcommoditycrossesabove300,anticipateamovetoatleast345andlikely390.OnApril1,2004,thepriceofoneshareoftheChicagoMercantileExchange

(CME)firstcrossed100,closingthatsessionat$100.50pershare.Afterthefirstcrossof100,theCMEquicklyranto130andthen148beforethefirstmeaningfulcorrection.Itsubsequentlyhastradedashighas700,andbackdownto400,butitneveragaintradedbelowparuntilthestocksplit.ThismagicalruleofbreakingparandcontinuingupwardisonethatI’velong

observedandtradedsuccessfullyformanyyears,butit’snotmydiscovery.IfirstpaidattentiontothisconceptafterreadingReminiscencesofaStockOperator,thesemi-autobiographicalaccountofJesseLivermorewrittennearly100yearsago.Livermorewrites:“Ithasbeenmyexperiencethatwheneverastockcrosses100or200or300forthefirsttime,itnearlyalwayskeepsgoingupfor30to50points,andafter300fasterthanafter100or200.Itisanoldtradingprinciple.”Atonepointinthatbook(myabsolutetopmust-readforeverytrader),

Livermorediscussedhowhewaitedsixweekswithouttradingfortheperfectopportunitytorebuildatradingstake:

Ireallybegantowaverandsweatbloodwhenthestockgotupto90.Whenitgotto98Isaidtomyself,“Bethlehemisgoingthrough100,andwhenitdoestheroofisgoingtoblowcleanoff!”Itellyou,Isaw100onthetapewhenthetickerwasonlyprinting98.SoIsaidtomyself,“Ican’twaituntilitgetsthrough100.Ihavetogetitnow.Itisasgoodasgonethroughpar.”...Iputinanordertobuy500sharesofBethlehemSteel.Themarketwasthen98.Igot500sharesat98to99.Afterthatsheshotrightupandclosedthatnightat115.Ibought500sharesmore.ThenextdayBethlehemSteelwasat145andIhadmystake.ButIearnedit.ThosesixweeksofwaitingfortherightmomentwerethemoststrenuousandwearingsixweeksIeverputin.

Thisruleholdsequallytrueforcommodities.Forexample,whensugarfirstcrossedabove1,000onthemonthlychart(10¢perpoundequals1,000onthetape)inAugust2005,itdidn’tstopthere.Itquicklyranabove1100,thenabove1200,andthenaboveeveryXX00untilthemovewasfinallyoverwiththeFebruary2006peakatapriceof1973.(SeeFigure8.44.)

Figure8.44.2005monthlysugar

AparcasestudyInlate2007,thesoybeanmarketwasinabulltrend.Thecarryoversuppliesfor2008wereprojectedtobeverytight,andIwaswatchingtheJuly–November2008soybeanspreadforapossiblecrossabove100.Julysoybeansrepresentthecurrentcrop(thecropthatwasharvestedthe

previousautumn),andNovembersoybeansrepresentthe“new”crop(thecropthatwillbeharvestedthefollowingyear).Soybeansareplantedinthespringandharvestedinthefall.Whentradingfutures,wearecertainlydealingwiththeunknowntoanextent,andweknewverylittleinlate2007abouttheNovember2008beansbecausethiscontractrepresentedacropthatwasnotyetplanted.Preliminaryestimateswereavailableontheacreagefarmerswouldplantinthespring,buttheseplantingintentionswouldcertainlychangebasedonthepriceofsoybeansversuscompetingcrops.Weknewnothingaboutweather,potentialyields,demand,andsoon.AnyonebuyingorshortingNovemberbeanswascertainlybettingontheunknown.Weknewmoreaboutthe“old”Julycropbecausethiscropwasalreadyharvested.Theoldcroppricehadbeenfluctuating,andwouldcontinuetofluctuate,basedondemand(forexports,biofuels,livestockfeed,andthehundredsofothersoyuses)plusdifferingopinionsand

futurechangesintheofficialsupplynumbers.Julycomesneartheendofthecropyear,andtheultimatepriceofJulysoybeansinJulyisdependentonending-crop-yearsuppliesbeingtightorplentifulatthistimebeforethenewcropbecomingavailable.Thisspreadhistoricallyisvolatilebecausewearedealingwithtwocompletelydifferentcropyears.Althoughtheoverallsoybeanmarketmightbebullishorbearish,andallthemonthsmightmovehigherorlowertogether,thedifferentcropyearsalmostalwaysmoveatdifferentspeedsandsometimesinoppositedirections.Thiswasabullishsoybeanmarket,andtheoldcrop(July)hadbeengaining

onthenewcrop(November)throughout2007.Atonepointduringthesummer,thespreadwasat“evenmoney”(withtheJulypriceequaltotheNovemberprice),andbyThanksgiving,itwasapproachingpar,or100.Atthattime,theJulysoybeansweretradingnearly$1/bushel(100¢abovetheNovembercontract).Fromexperience,Ibelieved,asLivermorehadtaughtus,thatabreakaboveparwouldopenupanewandpotentiallyprofitabletradingopportunity.Thequestionwas,howtoplayit?Asyoureadthiscasestudy,rememberthatitispertinenttoallmarkets,notjusttheJuly–Novembersoybeanspread.IwanttogiveyouafeelforhowIapproachapotentialtrade,andthisisdesignedtoprovideyouwithatemplateforanalyzingandhopefullysuccessfullytradinganymarketthatcrossespar.Thefirststepwasbackgroundanalysis,tofindandthenanalyzewhatIcall

analogyearsofthisspread.Forexample,wecananalyzeallyearsthespreadbrokeparwhilerememberingthatnotwomarketsactidentically.Iknewthatthisspreadhadbeenaboveparinthepast,butnotveryoften.Itis

ahighlyunusualeventfortheJulycontracttobetrading$1perbushelabovetheNovembercontract.Forthespreadtobetradingata$1differenceorhighermeanssomethingquiteunusualistakingplacebeyondthenormalsupply-and-demandbalancebetweentwoconsecutivecropyears.Usinghistoricaldata,IcouldfindonlysixpreviousyearswhentheJuly

contracttradedatorabove100morethanthefollowingNovembercontract:1973,1984,1989,1994,1997,and2004.Ithenexaminedtheseanalogyearstoseehowthespreadactedonabreakof

100.Forexample,lookatFigure8.45,achartoftheJuly–November2004spread.

Figure8.45.July–November2004soybeanspread

Afterthespreadcrossed100,itneverlookedback.Ifyouenteredthespreadonthefirstcrossof100(orevenonthefirstcloseabove100)andriskedtoaclosebelow,youwouldneverhavebeenintrouble.Theminimumprofitobjectiveofa15%to30%move(or115to130),asoutlinedinthe“profitobjectivezone,”waseasilyattained.Infact,thespreadtradedabove200thatyear.AfterIwasarmedwiththishistoricalknowledge,Iwasreadytotradethe

2007spreadbecauseweknewwhattolookforwhenitwastradingproperly.Thatyear,thespreadfirstbrokeandclosedabove100onNovember29,withthecloseata103premiumfortheJulycontract—abuysignal.However,thenextday,itbrokeandclosedunderparat96,indicatingthatthiswasafalsesignal.Theproperactionatthistimewastotakethelossofapproximately5¢.(SeeFigure8.46.)

Figure8.46.July–November2008soybeanspread

ThespreadremainedbelowparuntilDecember10,whenitonceagaincrossedandclosedabove—anewbuysignal.Thecorrectplaywastoreenter,andthistimetheprofitobjectivezonewasquicklyandeasilyreachedand,ultimately,exceeded.However,notethattheprofitshouldhavebeenlockedinatthefirstsignofatrendreversal.Ifitwasn’tturnedintorealcash,theprofiteventuallyevaporatedbecausethespreadcollapsedafteritcrossedbackunder100inJanuary.Actually,thistheoryworksbothways.Youcanplayacrossunder100justaseffectivelyasacrossabove:Justreversetherulesandalwayspayattentiontomoneymanagement.Livermore’stimelessobservationthatbreakingparoftenresultsinaquickand

significantfollow-throughisapowerfulconcept.I’vegivenyoualottoworkwithinthischapter.Checkoutthepatternsand

methodsandusetheonesthatsuityourpersonalityandrisktolerance.InChapter9,you’llgetanin-depthlookatwhatIconsideroneofthemostvaluabletechnicaltoolsandamethodologyIusedailyinmyowntrading.

9.TheMovingAveragesPrimer

“Thefutureislikeacorridorintowhichwecanseeonlybythelightcomingfrombehind.”—EdwardWeyer,Jr.

Ifaholygrailexistsfortrading,I’venotfoundit.OneofthemostimportantlessonsIcanteachyouisthis:Nosinglepattern,system,method,orindicatorworksinallmarketconditions.Thebestyoucanhopeforistofindatoolthatwillplacetheoddsinyourfavor.Ifyourwinningpercentageisfavorable,andifyouraveragewinsarebiggerthanyouraveragelosses,you’llmakemoney.Thegoodnewsisthatexcellenttechnicaltoolsareavailablethat,whenusedproperly,canputtheoddsinyourfavor.WediscussedmanyoftheminChapter8,“TheAdvancedTradingCourse,”andI’vededicatedthischaptertowhatIcall“themostvaluabletechnicaltool”(TMVTT).Asmentionedpreviously,anold-timeroncetoldme,“Ifyoucancorrectly

identifythetrend,youwillmakemoney.”Howprofound.Anditmakessensebecauseifyoucancorrectlyidentifythetrend,themarketwilllikelymoveyourway.Evenifyourtimingisinitiallyoff,thetrendoftenwillbailyouout.Onesetoftechnicaltoolshasvalidityfortrenddetermination,andIhavepersonallyfoundthemTMVTT:movingaverages.I’veusedthemsuccessfullyinmyowntradinginavarietyofways.Thischapterdiscussesthebasics:whattheyare,howtheywork,andhowtousethemproperlyinyourowntrading.

BottompickersversustrendfollowersAminorityoftechnicaltradersareabletopicktopsandbottomswithaccuracy,andindicators(suchastheRSI)andvariouspatterns(suchascandlestick“engulfinglines”)aredesignedtohelpdothat.Nodoubtatraderwhocanpicktopsandbottomswithadegreeofsuccesswillmakethemostmoney;however,I’vefoundthatthisisverydifficulttodo.Anyonewhotradeslongenoughwillbeluckytocatchamajortoporbottom.Icanrememberveryfewtrades,overthousandsinmycareer,whenI’vebeenluckyenoughtocatchtopsand/orbottoms.I’mnottalkingaboutadailyhighorlow,butamajortoporbottom.I’mtalkingaboutthecontracthighorlowonthehistoricalcharts.Catchingoneoftheseisaveryluckyandanalmostimpossiblethingtodobecauseinhundredsoftradingdayseveryyear,there’sonlyonemajorannualtopandonly

onemajorannualbottom.Evenminortopsandbottoms(dailyorweeklyhighsandlows)aredifficulttocatchbecausethey’retheexception,nottherule.Anoldtradingadagegoessomethinglikethis:“Bottompickersgettheir

handsslapped.”AsthelegendarytraderW.D.Gannhastaughtus,nomatterhowcheaporhowexpensiveamarketmightappear,it’snevertoocheaptosellortoohightobuy.Asaresult,Ihavefounditmucheasier,andultimatelymoreprofitable,totakeaportionoutofthemiddleofamove.Thisiswhatmovingaveragesaredesignedtodo.Movingaveragesaretrend-followingtools.Thismeanstheydonotanticipatethemarketbutratherlagit.Theyaredesignedtohelpusdeterminewhatthecurrenttrendisandwhenthetrendhasturned;however,theycantellusthesethingsonlyafteratrendisinplace.Bydefinition,thisisafterthemoveisalreadyunderway.Therefore,it’simpossibletopicktopsandbottomsusingmovingaverages.However,don’tworryaboutmissingthetoporthebottom.Toomanytradersfeelthatiftheyhaven’tpickedatoporbottom,it’stoolatetotakeatrade.Thisisoneoftheprimaryreasonsthatthemajorityoftradersnevermakeanymoney.Goldmighthavefallen$200perounceandalreadymadeitslow,butafteritrallies$30offthebottom,itdoesn’tlookthatcheaptomostpeopleanymore.Thisisbecausemostpeoplehaveshort-termmemories,andrecenthistoryisthehistoryrememberedfirst.Theprevious$170downwasatremendousshortsale;anyonelookingatachartcouldhavedeterminedthat.Lookingback(andhindsightisalways20/20),though,sowhatifyoumissedthefirst$30ofthatmove?Orwhatifyouweretryingtohangontoalongpositionfortheprevious$100down?Inthatcase,Ibetyouwishedyouhadleftthattop$30onthetable.Theprimaryjobofatraderistoidentifyamajortrend,andifyoucandothis

withanydegreeofaccuracy,youwillmakemoney.So,myadviceisnottoworryaboutmissingthefirstpartofanymove.Thenextpartscanbeveryprofitable,andhistoryhasshownthat,inmostcases,thatlastpartisthemostprofitable.Youshouldalsorememberthatscoresoflegendarytraders,includingRichardDennisandPaulTudorJones,usetrend-followingtechniques,andtheyhavetakenhundredsofmillionsofdollarsoutofthefuturesmarkets.Movingaveragesmethodologieshavebeenaroundformorethanacentury.

RichardDonchianisthemodern“fatherofmovingaverages.”Donchianwaswiththe(now-defunct)Shearsoninthelate1970s.Hedevelopedspecificmovingaveragestradingtechniques,andformorethan20years,hesuccessfullymanagedmoneyusingthem.Theywereusefulthenandarejustasusefulnow.Thisisbecausethemarketsstilltrend,andasyouknowalready,ifyoucanaccuratelyidentifythetrendofthemarket,youwillmakemoney.

AmovingpictureAnyonepriceissimilartoasnapshotintime:Itcannottelluswhatthetrendis.Ittellsussomething,buthardlythewholestory.Whenyoutake10photographsinrapidsuccession,however,youcangetabetterpictureofthewholestory.Ifthestoryisthemarket,yougetabetterpictureofthetruetrendbylookingatthelast10pricesinsteadoflookingatjust1.Whenyouputtogetheraseriesof20blocksof10photoseach,youhaveavideothatwillbeinfinitelymoreinformativethan1or2photos.Thisvideoisanalogoustoamovingaveragelinethatyoucanoverlayonapricechart.Byobservingthedirectionthislineismovingandthestrength(orvelocity)ofthemove,youcangetasenseofwhichfactionisstrongeratthetime—thebullsorthebears.Ifthebullsarestrongerthanthebears,themovingaveragelinewillappeartomoveup,andthecurrentpricewilltradeabovethemovingaverageandviceversa.ThetoughquestionwhenusingTMVTTishowmanypricesgivethebestfeelforthetrend.Ifyouusetoomany,theolddatacantendtoputthetruetrendoutoffocus.Ifyouusetoofew,youcannotreallytellwhatyou’relookingat.Rememberthatwhenyouutilizeanytrend-followingmethod,you’renot

tryingtoforecastwhenamarketmovewillstartorend.Instead,youareusingatotallytechnicalapproachthatreliesonaspecifictypeofindicatortotellyouwhatthetrendis.Then,bytakingamarketpositioninsyncwiththistrend,youattempttoplacetheoddsinyourfavor.Youwouldalsoliketohavethisindicatoralertyou,withsomedegreeofreliability,whenthetrendhaschangedbeforeyougivebacktoobigachunkofyourpaperprofitsorbeforeanyunrealizedlossesbecometooserious.Movingaveragescanindicatewhenatrendchanges.Moreimportantly,they

keepyouonthe“meat”ofamajortrend,andthisiswherethebigmoneyismade.Still,nothingworthwhileisevereasy.Intrendlessmarkets,movingaveragestechniqueswillgeneratefalsesignals,andsomeperiodswillhavestringsofsmallerlosses.Sometimesstringsofsmallerlossescanadduptobiggerlosses.Beforewarnedthatdrawdownperiodswilloccur,andyoumustbeadequatelycapitalizedtoridethemout.Finally,whenusingmovingaverages,itisextremelyimportanttoneverloseyourwinningqualitiesofpatienceanddiscipline—particularlywhenthebadstringsoccur.Thisisakeytosuccess.Movingaveragescomeinvarioussizes.Theyrangefromsimple,toweighted,

tosmoothed,toexponential.Traderscanusethemaloneorincombinationsascrossovers.Theyusetheminoscillatorsasmovingaverageconvergenceanddivergenceandinbands.Thebasicunderlyingassumptionisthatmarketsmove

inatrendingfashionmoreoftenthantheydon’t.Whendemandforaparticularcommodityorafinancialassetisstrongerthansupply,prices(and,therefore,themarket)willmoveinanuptrend.Whensupplyisoverwhelmingdemandatanyparticularpointintime,themarketwilltrenddownward.Forexample,it’seasyforyoutotellmethedirectionofthemajortrendsof

themarketsinFigure9.1andFigure9.2.

Figure9.1.Uptrend

Figure9.2.Downtrend

It’seasytodeterminetrendsafterthefactbylookingatachart.However,it’snoteasytodeterminethetrendsinthethickofthebattle.Andthenews(thefundamentals)willnothelpyoubecausethenewsisoftentimesbullishatthetopandbearishatthebottom.Plus,marketsdonotalwaystrendupordown;theycanalsomovesideways.Anerraticupordownperiod,atrendlessmarket,temporarilywreakshavocwithanytrend-followingsystem.Youneedtouseyourdisciplineandpatiencetopersevereinsuchperiods.ThegoodnewsisthatIhavefoundthatmarketsareinuptrendsordowntrendsforlongertimeperiodsthantheyareinsidewaystrends.Thisiswhymovingaveragesmethodologiescanputtheoddsinyourfavor.

ThesimplemovingaverageThesimplestmovingaverageissimpletoconstruct—andit’scalled(surprise!)thesimplemovingaverage(SMA).AtradercanselectanynumberofdaysorperiodsandthenusetheSMA

formula:SMA=(P1+P2+P3+...+PN)/N

wherePisthepriceofthecommoditybeingaveraged,andNisthenumberofdays(orperiods)inthemovingaverage.ThevalueofanSMAisdeterminedbythevaluesthatarebeingaveragedand

thetimeperiod.Forexample,a10-daySMAshowstheaveragepriceforthepast10days,a20-daySMAshowstheaveragepriceforthepast20days,andsoon.Thetimeperioddependsonthetrader’stimehorizon—itcanbeyears,months,weeks,days,minutes,oreventicks.Youcancalculatemovingaveragesbasedonopens,closes,highs,lows,andeventheaverageoftheday’sranges.Irecommendusingtheclose,orsettlementprice,foreachdayorinterval.Ondailycharts,it’sthemostimportantpriceofthedaysinceit’sthepriceusedtocalculatemargincalls.Ifthemarketclosesonthehigh,orinthehighrange,mostoftheshortplayers(unlesstheyshortedrightatthehigh[s])willhavefundstransferredoutoftheiraccountsandplacedintothelong’saccounts.Thisactionmakestheshortsabitweakerandthelongsabitstronger(atleastforthenextday).Thesamelogicworksonshorter-termintervals.Evenonafive-minutechart,ifacloseisonthehighofthebarthismeansthateveryshortduringthefive-minuteintervalisonthelosingsideofthat5minutepricerange...atleastintheshortrun.Let’sconstructa5-daySMAofsugar,basedonthedailyclosingprices.

Assumethattheclosesduringthepast5dayswere2105,2110,2115,2120,and2125.The5-daySMAis2115.Ifthemarketclosesat2155onthe6thday,itwillcausethe5-daySMAtoriseto2125,theaverageofthepast5daysdividedby5:

5SMAday1=(2105+2110+2115+2120+2125)/5=21155SMAday2=(2110+2115+2120+2125+2155)/5=2125

Intheformula,youalwaysdroptheoldestclosingpriceandaddthemostrecentclosingprice.Inthisexample,whenusingthe5-daySMA,youalwaysdropthe6th-oldestday.Witha10-daySMA,youdropthe11th-oldestday,andsoon.ThetrenddirectionisdeterminedbythedirectiontheSMAismovingandbycomparingtoday’ssettlementpricewiththemovingaverage.Inthissimpleexample,thetrendisupbecausethecloseonthemostrecentday—we’llcallthisday2(2155)—ishigherthantheSMA(2125).Onday1(thepreviousday),theclosewas2125,andtheSMAwas2115,sothetrendisup.Evenwiththislimiteddata,theoddsmightsuggestthatweshouldplayfromthelongside.Onday2,theclosewas2155,andtheSMAwas2125,sothetrendisup,andwestaylong.Whentheclosingpriceturnsdownandundertheaverage,asellsignalisgenerated.Youcanconnecteachday’svalueonacharttoproducealine.Youcanchart

thislineandoverlayitontoapricecharttogeneratetradingsignals.Asimpletradingprogramwouldlooklikethis:Aslongasthelineonanyparticulardayisundertheclosingprice,thetraderwouldstaylongbecausetheSMAhasdeterminedthatthetrendisup.Afterthelinecrossesovertheclosingprice,thetraderwouldgoshortbecausethetrendhasturneddown.Ifthepositionislongandthelinecrossesovertheclosingprice,thetraderwouldreversethepositionbysellingdoublethenumberofcontractsowned.Theproblemwiththissimpletradingprogramisifyoudothiseverytimethelinecrossesprice(especiallywhenusingshorter-termaverages),youcaneasilyget“whipsawed”(bouncedbackandforth,withsmalllossesandcommissionseatingyouup).Amarketcantradeinawildrange,movingupanddownwildlyinthesamesession,butasIhavementionedbefore,Ibelievethattheclosingpriceisthemostsignificant.Incidentally,aphysicalwhipsawisasawwithahandleatbothends—thekind

thatwasusedintheolddaysbytwologgerstocutdowntrees.Todaythebestplacetofindawhipsawisinanantiqueshop,butyoucanpicturetwoguysoneithersideofalogsawingbackandforth.Awhipsaw,movingbackandforthinalternatingmotionwillhelpcutalog,butitrelentlesslyconsumescapitalwhentrading.AsasimplerulewhentradingusingdailySMAs,Irecommendignoring

intradaymovements(whichoftenmerelycreate“noise”)andwaitingfortheclosetopenetratetheSMAtogenerateasignal.Insomemarkets,itisbettertowaitfora“two-dayclose”(twoconsecutivedaysofpenetratingthemovingaverageattheclose)tosignalachangeintrendandachangeinposition.However,aproblemofwaitingforthecloseisthatyoutakeonadditionalrisksinceinwide-rangingday,thepriceattheclosecouldbefaraboveorbelowthemovingaverage.Forexample,ifyouwaitedfortheS&PcloseonBlackMonday1987(thedaytheDowclosed500pointslowerthanBlackFriday),youwereindeepwater.Thisiswhygoodmoney-managementsensesaystoadditionallyuseanultimate“down-and-outpoint”foranyposition—aphysicalstoploss.Youshoulddothiswhenusinganytechnicalsystem(orfundamentalsystem,forthatmatter).Placeyourstoptocreateanapproximatemaximumpercentagelossforthoseabnormalmoves.Abnormalmoves,althoughrare,dooccur,andyouwanttoalwaysavoidthatcatastrophicloss—theonesobigthatitrendersyouunabletocontinuetrading.Optionstrategiescanalsohelphereattimes.Youcanuseputstoprotectlongpositionsandcallstoprotectshortpositions.However,mostmarketsarenormal.Innormalmarkets,ageneralruleofthumbforourfirstsimpletradingsystemisthis:Ontheclose,ifthemarketpricehasfallenbelowthemovingaverageline,asellsignalisgenerated.Ontheclose,ifthemarket

pricehasrisenabovethemovingaverageline,abuysignalisgenerated.I’vefoundthatmostdays,whenamarketclosesatanextremeofaday’spricerange(whichoftencreatesthesignal),itwillfollowthroughinthedirectionoftheclosethefollowingday.Sometimes,theviolationofthemovingaveragecouldbeaclosecall.Onthosedays,Iwouldopttowaitonemoredayinsteadofriskingafalsesignal.However,youneedtoknowonadailybasisexactlywheretheaverageyouarefollowingwillbecomingintothecloseandusea“stopcloseonly”ordertoenteranewpositionorexitanexistingone.Alternatively,youcanplaceamarketorderjustbeforetheclose.

Howmanydaysshouldyouuseinyourmovingaverage?Thelengthofthemovingaveragegreatlyimpactstradingactivityand,therefore,profitability.Sometradersuse5-daymovingaverages,some10-day,othersuse20-day;I’veseenfundsuse50-or100-day,andsoon.Thelengthisyourdecision,dependingonthetypeoftraderyouare,butlengthdirectlydeterminesthesensitivityofanymovingaverage.Thelengthdetermineshowmuchtimeamovingaveragehastorespondtoachangeinprice.Itisamatterof“lagtime.”Thisisasimplebutimportantconcept:Shortermovingaveragesaremoresensitivethanlongermovingaverages.A5-daymovingaverageismoresensitivethana10-daymovingaverage,andbotharemoresensitivethana20-daymovingaverage.Themoresensitiveamovingaverageis,thesmallerthelosswillbeonareversalsignal;however,therewillbeahigherlikelihoodofawhipsaw(afalsereversalsignalcausingatradertoreverseatradetoosoon).Afalsesignaloccurswhenaminormovement,whichultimatelydoesnotchangethemajortrend,isenoughtopushthemovingaverageintheoppositedirectionofthesettlementprice,resultinginafalsepositionchange.Itisfalsesimplybecausethetraderwillsubsequentlyneedtoreverseonceagainwhenthemajortrendreassertsitself.It’simportanttouseamovingaveragethatislongenoughsothatitisnot

overlysensitive.However,ifthemovingaverageistoolong,thetraderwilltendtotaketoobigaloss(orgiveuptoobigaportionofunrealizedpaperprofits)beforeevenbeingawareofatrendchange.Alongermovingaveragewillkeepyouinatradelonger,therebymaximizingpaperprofits,butitcaneatintorealizedprofitsbecauseitmovestooslowly.Liketheporridgeinthestoryofthethreebears,themovingaveragecannotbetoohotortoocold;itneedstobe“justright.”ThemostpopularquestionI’maskedhastodowithwhatisthe“right”movingaveragetouse.“Justright”isnotalwayseasytodetermineandwillchangewithmarketconditions.Voluminousstudieshavebeendonetodetermine

whichlengthisrightforwhichspecificmarket,butIbelievethattheseareuselessbecausemarketconditionschangeforallmarkets.ThesilvermarketoftheHunteraisnotthesameasthesilvermarketoftoday.Soybeansinadroughtmarketactfardifferentlythaninanormal-weathermarket.

AlternativestotheSMAYoucanthinkofanyonepriceasasnapshotintime.Ittellsyousomethingaboutprice,butithardlytellsthewholestory.Tenphotosinrapidsuccessionprovideyouwithabetterpictureofthestory,and20blocksof10photoseachpaintsanevenbetterpicture.Ifyouarelookingatamoviecomposedof200snapshots,thelast20willmostlikelytellyoumoreaboutwhat’sprobablycomingnextthanthefirst20.Thisisakintoexponentialandweightedmovingaverages.Theyplacemoreweightonthenewestprices,andthiscanbemorevalidthantheolderpriceswhendeterminingthetrend.

ExponentialandweightedmovingaveragesTheexponentialmovingaverage(EMA)andweightedmovingaverage(WMA)assignagreaterweighttomorerecenteventsthantoeventsfurtherinthepast.TheWMAincreasestheimportanceofthemostrecentpricebyafactorequaltotheperiodused.Forexample,witha5-dayweightedaverage,thefifthdayisgivenafactorfivetimesgreaterthanthefirst.Tocalculatea5-dayweightedaverage,multiplyday5(themostcurrentday)by5,day4by4,day3by3,day2by2,andthefirst,oroldest,dayby1,andthendivideby15.TheEMAalsoweightsrecenteventsmorethandistantevents,butitsmoothsouttheaverageforamoreconsistentresult.Thesmoothingfactor(SF)isdeterminedbydividing2intothemovingaverageplus1oftheSMAyouwanttoweightandsmooth.Forexample,ifyouwanttosmootha5-daySMA,youdivide2by6.Theresult,.33,isthesmoothingfactor.Fora10-daySMA,theSFis2dividedby11=.18.Fora20-daySMA,theSFis2dividedby21=.096.TheSFisafixedweightappliedtothecurrentprice,withthebalanceappliedtothemostrecentmovingaveragevalueitself.Thecomputerwillfigureitallforyou,buttomakeitclearer,let’slookataspecificexample.Let’scalculatea5-daySMAanda5-dayEMAforwheat.Remember,weneedatleast5daysofdatatoproduceourstartingpointfortheSMA.Supposethattheclosing(settlement)pricesfor11consecutivedaysofwheatpricesareasfollows:

Inhindsight,wecaneasilyseefromthisdatathatbecausethemarketwentupby41,thetrendwasupduringthis11-dayperiod.However,hindsightisalways20/20,andit’snotalwayseasytoknowjustwhatthetrendactuallyiswhilewe’reinthethickofthebattle.Thisiswheremovingaveragescanhelp.TheSMAiscalculatedasfollows:

Ifyouusedthe5-daySMAtogeneratebuyorsellsignals,startingonday5,youwouldhavebeenabuyerattheclosingpriceof463(becausethepricewas

abovetheSMA).Youwouldhaveremainedlongondays6,7,and8.Butonday9,thepricefellbelowtheSMA,andyouwouldhavesoldandreversed(goneshort)attheclosingpriceof464.Theresultwouldhaveproducedamarginaltrade.Now,you’reshortat464andwouldhavetoreverseagainonday10at476,fora12¢loss.Thisisaclassicwhipsaw.Yougotjerkedoutofwhatwasagoodtradeinadefiniteuptrendwhenonelow-ballprice(theoldest)isdroppedoutoftheequation.Now,let’slookathowthe5-dayEMAperformedduringthesametime

period.Tocalculatethesmoothingfactorforthe5-dayEMA,youdivide2by6.Sixisusedbecauseitis1morethan5.2/6=.33.Youmultiplythissmoothingfactorof.33bytoday’spriceandaddthisto1minusthesmoothingfactor,whichis.67,timestheEMA:

TheresultsshowthatthepriceremainedabovetheEMAduringtheentireperiod,evenday9.Therefore,there’snowhipsaw.Thetraderwouldremainlongfrom446andstillbelongonday11,at481.Yes,youcanstillgetwhipsawedusingtheEMAinachoppymarket,butI’vefoundthatmanytimes,WMAsandEMAsaresuperiormovingaverages,withfewerwhipsaws.Manytradersareusingmovingaveragessystemswithapercentageband

(suchastheBollingerbands)thatusesanexponentiallysmoothedmovingaverageplusabandabovethisEMAandminusabandbelowtheEMAbythe

samepercentage.Asignaloccurswhenevertheclosingpricebreaksoutsidetheband.Exitoccurswhenthepricerecrossesintotheband.Sometradersprefertotradewithinthebands,whichismoreliketopandbottompicking.Theysellatthetopbandandbuyatthebottom.Theriskpointissetatsomepercentageoutsidetheband.Ibelievethismethodhassomevalidity,butbecauseIpersonallyfinditdifficulttopicktopsandbottoms(I’matrendfollower),Ileavethistothosewhoareinclinedtoattempttopandbottompicking.Also,althoughit’snicetounderstandhowthemovingaverageisderived,

don’tstressaboutthecalculations.AlmostallthetradingsoftwareprogramsonthemarkettodayautomaticallycalculatetheSMA,WMA,andEMA.Ifyouhaveaccesstoreal-timequotes,thesoftwarecalculatestheseaveragesinrealtime,basedonthelasttick,thelastbar,theaverageofabar,orthecloseofabar.Movingaveragesarenotapanacea,butifusedsystematicallyand

consistently,theywillkeepatraderontherightsideofthebigmoves.Theyareatotallytechnicalapproach(becausetheyrelyonpriceonly),anditdoesn’tmatterwhichmarketyouusethemon.Theyworkwellinbullandbearmarketsandinboththestockandcommoditymarkets;however,they’llwhipsawatraderinasidewaysortrendlessmarket.However,thisisn’tasbigofadisadvantageasitmightappearatfirstbecausemyexperiencehasshownthatmarketswillspendmoretimeintrendingmodesthanintrendlessmodes.Still,attimes,periodswithchoppy,whipsaw-typemarketshavelastedmanyweeks.Sometimes,aseasonedtradercansensethatamarketistrendless(thetimetosteptothesidelines),butnotalways.Andifnotproperlycapitalizedordisciplinedduringtheseperiods,atradercanbewipedoutor,attheveryleast,becomedemoralizedandabandonamovingaverageprogram.Usuallythetraderwillquitjustbeforethebigmovestarts.Rememberthatyouneedtocatchthebigmoveswhenusingamovingaveragesystem,oryouwon’twin.

NaturalnumbersInmybookTheNewCommodityTradingGuide:BreakthroughStrategiesforCapturingMarketProfits,Iintroduceatradingmethodologythatusesmovingaverages—my“naturalnumbermethod“—thatIcontinuetousewithsuccess.Basically,byusingalonger-termmovingaverage(inthecaseofthenaturalnumbermethod,a180-periodweightedmovingaverage)superimposedonashorter-termchart(generally15to30minutes),Iseetheoddsofbeingontherightsideoftheprevailingtrendincreasing.Asmentionedbefore,ifweboughteverytimeamarkettradedaboveamovingaverageandsoldeverytimeittradedbackbelow,wewouldbeinandoutofthemarkettoooftenduringchoppy

periods,leadingtowhipsawactivity.So,Istartedtowonderwhethernaturalnumberscouldtakesomeoftherandomnessoutoftheprocess.Naturalnumbersareroundnumbers.Whenyouroundanumber,you“bumpit

up”or“bumpitdown”toanearbycleanernumber.Mydefinitionofa“masternaturalnumber”isanumberthatendsintwoormorezeros.Theclassicmasternaturalnumberispar(Livermore’sfavorite),or100,withothermasternaturalnumbersbeing200,300,andsoforth.However,anynumberthatendsinoneormorezeros—meaningamultipleof10—iswhatItermanaturalnumber.Humansgenerallyviewnaturalnumbersassignificant.Ifyourcarodometeris

rollingoverto10,000or100,000,don’tyouwanttoseeithappen?Ifyouhavekidsinthecarandtheodometerhits49,999,you’llprobablymakeanannouncementtoyourpassengerssothattheycanseetherolloverto50,000,right?Businessesandindividualsgotoextraefforttogetaphonenumbersuchas555-7000orapostofficeboxlike3000becauseroundnumbersaretypicallyeasytoremember.Recallhowpeoplearoundtheglobecelebratedthenewmillenniumatthebeginningoftheyear2000?Eventhoughtheeventwouldn’treallyoccuruntiltheendofthatyear(thebeginningof2001),therolloverto2000wasareallybigdeal;Idon’trememberNewYear’s2001ashavingthesamepizzazz.Intheuniverseofnumbers,naturalnumbersarerarerthantheircommon

siblingsandthereforeholdaspecialsignificanceforpeople.Peoplemakemarkets,andanystudentofthemarketshasprobablyobservedthatvolumesgenerallyincreaseatnaturalnumbers.Anumberofyearsago,Ihypothesizedthatnaturalnumberswouldactassignificantsupportorresistancepoints.Afterextensivetesting,Ideterminedthatnaturalnumberspossessedstatisticallygreateroddsofbeingimportantsupportandresistancelevelsthanrandomnumbers.IthenusedthatinformationtodevelopthetradingmethodologythatIoutlinedinanotherbook.(Forafullexplanationofmynaturalnumbermethod,seeTheNewCommodityTradingGuide.)ThepointIwanttomakehereisthatmovingaveragesremain,inmyopinion,TMVTT,andusingtheminconjunctionwithnaturalnumbersisonemeansofavertingasignificantpercentageofwhipsaws,andthisleadstoasmootherprofitcurve.InChapter10,“GK’sPivotIndicator,”Iintroduceasimplertechnicaltrading

methodologyIpersonallyuse—oneI’venotdisclosedpreviously—andthatyoumightalsowishtoconsider.

10.GK’sPivotIndicator

“Ihavethe‘thing’workedout—thetrickorthesurprise;thepivotalfact.ThenIjuststartsomewhereandletthestoryworkitselfout.”—LeeChild,Author,JackReacher

Whenitcomestomakingmoneytradingcommodities,there’snoholygrail—nosinglemethodologythat’scorrect.Therearenumerouspathstoprofitability,andplentymoreleadtoloss.You’llneedtoidentifyamethodthatfitsyourpersonality.Youmightfeelmorecomfortableusingalonger-termtimehorizon,butthispathhashigherriskswiththehigherrewards.Youmightbeshort-termorientedandconsiderdaytradingwithzero“overnight”riskbutloweraveragerewards.WhatIpresentinthischapterisafairlysimplesetupandtriggerthatIbelievewillenhanceyourtradingperformance.It’snotthetotalanswer(rereadtheriskdisclaimerinthebeginningofthisbooksinceitapplies),andthismethodrequiresmonitoringandactivemanagement.Itcanbeutilizedforlongerand/orshortertermhorizons.Iuseit,andperhapsitcouldhelpyoutoo.Icallthismy”pivotindicator,”andifyouhaveaninterestinusingitinyour

trading,Isuggestthatyoufirst“papertrade”it.Reviewvariousmarketscenariosandhypotheticallytestitonvariouschartsuntilyou’retotallycomfortablewithhowitworks—thegood,thebad,andtheugly.Personally,Iuseitinconjunctionwithotherindicators,suchasvolume,mynaturalnumbermethod,andchartpatterns.Asmentionedpreviously,myprimarygoalistodeterminethetrendsofthe

marketsItrade.Ibelieveifyouareabletoaccuratelydeterminethetrendofanymarket,thenyouwill,overtime,makemoney.Justasit’seasiertopaddledownstreamthanup,andittakeslessefforttowalkwiththewindthanintoit,it’sgenerallymoreprofitabletotradewithatrendthanagainstit.ThebesttoolI’vefoundfordeterminingatrendwithadegreeofaccuracyisthemovingaverage.Mypivotindicatorusesasimplemovingaveragewithabufferandatrigger.Itgivesyouanentrypointintoatradeandariskpoint.Itdoesnotprovideyouwithaprofitobjective;thatistheprimarycomponentyou’llneedtodetermine.However,ifatradeisworking,wheretotaketheprofitisthekindofproblemyouwanttohave.

IsourcedallthechartsinthischapterusingrealmarketdataonaCQG,Inc.,

platform;allrightsreservedworldwide.

GeneratingthebuysignalTheprocessofgeneratingthebuysignalbeginswithcalculatingthe10-daysimplemovingaverage(SMA).TheSMAiscalculatedbasedonthesettlement(closingprice).Calculateitandthendrawitonadailychart.Whythe10-daySMA?It’sadynamicnumberI’vefoundusefulovera

diversifiedportfolioofuncorrelatedmarkets.Othersimilarperiodswillworkjustaswell,butforthismethodology,averyshortterm(suchas5day)istoosensitive,andalongerterm(50dayorgreater)lagstoomuch.So,hereIusethe10-daySMAforthepurposeofsettinguptradesinthedirectionofthemajortrend.Enteringanewpivottradefromthelongsiderequiresthreesteps:1.Setupbar2.Bufferedentryprice3.Triggeredentry

1.SetupbarWatchthedailybarchartforadaythemarketclosesabovethe10-daySMA.Ifthemarketclosesabovetheaverage,thatday’smarketactivitycreatesthesetupbar.Adaythatthemarketmerelytradesabovethe10-daySMAdoesnotqualify

asasetupbardaybecausethemarketcouldsubsequentlytradebackunderthe10-daySMAlinethatdaypriortothebar’sclose.Atruesetupiscreatedonlyonadailycloseabovetheline.

2.BufferedentrypriceOncewe’vedeterminedoursetupbar,thenextstepistocalculateourmarketentryprice.Ourentryforabuywillbetriggeredbyasubsequentmarketmoveabovethehighofthesetupbar.Inotherwords,entrywilltakeplaceonlyona“momentummove”(thatis,themarkethastosubsequentlytradeabovethehighofthesetupday).Myexperienceisthatbufferingtheentrypriceworksbetterthanjustenteringonaverysmallmoveabovethehighofthesetupbar.Inotherwords,entrydoesnottakeplaceonamoveofjustatickortwoabovethehighpricesincethisincreasestheoddsforafalsesignal.Todeterminethebufferedentryprice,youtakethehighpriceofthesetupbar,

multiplyitby.05%,andaddthattothehighprice.Theresultingnumberisthebufferedorderentryprice.

3.TriggeredentryIfthebufferedentrypriceishit(viathe‘buystop’weenteredabovethemarketatthebufferedorderentryprice),youarenowintothemarketonthelongsideatyourtriggeredentryprice.Thenextstepistoimmediatelyplaceyourriskpoint,orsellstop.Yourinitialstopisatick(ortwo)underthelowofthepreviousday.Atthemarket’scloseonyourentryday,thestopcanbeadjusted(raised)tojustatick(ortwo)underthelowoftheentryday.Forexample,inthesoybeanchartshowninFigure10.1,thehighofthesetup

bardaywas$14.52.$14.52×.05=7.26¢.1452+7.26=1459.26.Sincethesoybeancontracthasaminimumticksizeofaquarterpenny,theclosestbufferedorderentrypriceis$14.59anda1/4(or14592).Notethatthemarketremainedabovethe10-daySMA,withthebufferedorderentrypricehitthethirddayafterthesetupbarday.(Ifthemarkethadsubsequentlyclosedunderthe10-daySMAwithouttriggeringthebufferedorderentry,thispotentialbuysignalsetupwouldhavebeennegated.Actually,inthecaseofacloseunderthe10-daySMA,anewsetupbarwithapotentialsellsignalwouldbesetup.)However,thebuywastriggered.Sotodeterminetheriskpoint,notethatthepreviousday’slowwas$14.31;therefore,thesellstopwouldinitiallybeplacedjustunderthatpricebyatickortwo,at$14.301/2(or14304).Inthisexample,thelowoftheentrydaywas$14.35,soaftertheclose,thestopcouldhavebeenadjustedupwardbyabout4¢.Notethatthemarketcontinuedtomoveupto$16.80afterthebuysignal,forapotential$2.21profit—orover$11,000profitpotentialpercontracttraded.(Eachpennymoveina5,000-bushelsoybeanscontractisequivalenttoa$50profitorlossper1¢move.)Whiletheoddsofanyonetraderpickingthetopisslimtononexistent,youcanseethatinthistradetherewasanexcellentopportunitytorealizeaprofitpointalongthewaywithouttakingunduerisk.(Laterinthisdiscussion,we’llreviewvariousmethodstodetermineaprofitableexitpoint.)

Figure10.1.Pivotalbuysignal

GeneratingthesellsignalTheprocessofgeneratingthesellsignalbeginsthesamewayasgeneratingthebuysignal—bycalculatingthe10-daySMA.TheSMAiscalculatedbasedonthesettlement(closingprice).Whendetermined,drawitonadailychart.Enteringanewpivottradefromtheshortsiderequiresthreesteps:1.Setupbar2.Bufferedentryprice3.Triggeredentry

1.SetupbarWatchthedailybarchartforadaythemarketclosesbelowthe10-daySMA.Ifthemarketclosesbelowtheaverage,thatday’smarketactivitycreatesthesetupbar.Noteadaythatthemarketmerelytradesbelowthe10-daySMAdoesnotqualifyasasetupbardaybecausethemarketcouldsubsequentlytradebackabovethe10-daySMAlinethatdaypriortothebar’sclose.Atruesetupbariscreatedonlyonadailyclosebelowtheline.

2.BufferedentrypriceOnceyou’vedeterminedyoursetupbar,thenextstepistocalculateyourmarketentryprice.Yourentryforasalewillbetriggeredbyasubsequentmarketmovebelowthelowofthesetupbar.Inotherwords,entrywilltakeplaceonlyona“momentummove”(thatis,themarkethastosubsequentlytradebelowthelowofthesetupday).Myexperienceisthatbufferingtheentrypriceworksbetterthanjustenteringonasmallmovebelowthelowofthesetupbar.Inotherwords,entrydoesnottakeplaceonamoveofjustatickortwobelowthelowpricesincethisincreasestheoddsforafalsesignal.Todeterminethebufferedentryprice,youtakethelowpriceofthesetupbar,

multiplyby.05%,andsubtractfromthelowprice.Thisnumberisyourbufferedorderentryprice.

3.TriggeredentryIfyourbufferedentrypriceishit(viathe“sellstop”weenteredbelowthemarketatthebufferedorderentryprice),youarenowintothemarketontheshortsideatyourtriggeredentryprice.Thenextstepistoimmediatelyplaceyourriskpoint,ourbuystop.Yourinitialstopisatickortwoabovethehighofthepreviousday.Atthemarket’scloseonyourentryday,thestopcanbeadjusted(lowered)tojustatickortwoabovethehighoftheentryday.Forexample,inthecoffeemarketchartshowninFigure10.2,thelowpriceof

thesetupbardaywas$1.35/pound.$1.35×.05=.0675¢.Inmarketterms,13500–68=13432.Sincethecoffeecontracthasaminimumticksizeofa.05,yourclosestbufferedorderentrypriceis(inmarketterms)13430(or$1.3430/pound).Notethatinthisexample,thebufferedorderentrypricewashitthedayimmediatelyfollowingthesetupbarday.(Ifthemarkethadsubsequentlyclosedabovethe10-daySMAwithouttriggeringthebufferedorderentry,thissellsignalsetupwouldhavebeennegated.Actually,inthecaseofacloseabovethe10-daySMA,anewsetupbarwithapotentialbuysignalwouldbesetup.)However,thesellwastriggered.So,todeterminetheriskpoint,notethatthepreviousday’shighwas13940;therefore,yourstopwouldinitiallybeplacedjustabovethatpricebyatickortwo,at13950.Inthisexample,thehighoftheentrydaywas13685,soaftertheclose,thestopcouldhavebeenadjusteddownwardbyabout2.5¢(or250points).Notethatthemarketcontinuedtomovelower,tojustunder$1.20/pound(12000),forapotentialprofitof14¢,orover$5,000potentialpercontracttraded(becauseeachpennymove(a100pointmove)ina37,500-poundcoffeecontractisequivalenttoa$375profitorloss).Whiletheoddsofanyonetraderpickingthebottomisslimtononexistent,you

canseethattherewasthepotentialtopickupaniceprofitsomewherealongthewaywithouttakingunduerisk.

Figure10.2.Pivotalsellsignal

ThepivotindicatormethodinpracticeMyexperienceusingthepivotindicatorprocessisthatitworksinaggregate,regardlessofmarketortimeframe.Itcertainlydoesnotworkoneverysignal,butithasbuilt-inriskcontrol.Theriskpertradeislimitedtojustabovethehighorbelowthelowofthepreviousday,soyoucandeterminethepotentialrisktoafairlyclosedegree.Thebeautyisthatduringamajormove,theprofitsareallowedtorun.Icouldshowyou“cherry-picked”movesthatranlongandhard,withawesomeprofitpotential.However,let’slookatwhatIwouldconsideratypicalperiodbylookingatasix-monthperiodforasoybeancontractIpickedatrandom(seeFigure10.3).

Figure10.3.Typicalsignals

InFigure10.3,thesetupsareindicatedwithanS,andifthebufferedentrypricewastriggeredforabuyorsellsignal,thisisindicatedwithaT.Duringthisfairlytypicalsix-monthperiod,notethatthereare17setupsbutonly12triggeredentries.Therearetworeasonsasetupdoesnotleadtoanentry.Thefirstisthatthemarketjustgrazedthesetuphighorlowandthebufferkeptyououtoftrouble.Theotheristhatthereisnofollow-throughafterasetupandthereforenosignal.Ifyoumagnifyatypicalsignal,itwilllookasshowninFigure10.4.Infact,asetupthatisnottriggeredwouldleadtowhatIcalla“reversepivot.”

Figure10.4.Areversepivot

Areversepivotoccurswhenasetupthatisnottriggeredleadstoaconfirmedsignalintheoppositetrenddirection.Myexperiencehasbeenthatreversepivotsmoreoftenthannotleadtopowerfulsignalswithabove-averagereward-to-riskratios.LookbackatFigure10.3.Ofthe12signals,thereare7buysignalsand5sell

signals.Sincewecansee,inretrospect,thatthemarketwasinanuptrendforagreaterpercentageofthetime,thisiswhatwewouldhaveexpected.Ofthe12signals,5werefalse,mostlikelyleadingtothestoplossbeinghit.Theaverageriskwasapproximately20¢($1,000forasoybeancontract).Thepotentialprofitonthe7profitablesignalsaveraged$1.05($5,025forasoybeancontract).Thepotentialrewardtoriskwasabout5to1.Inpractice,itisimpossibletopicktopsand/orbottoms,andthereforeitisfairlyimpossibletoreapthemaximumpotentialprofit.However,youcanseethatthepivotindicatormethodcangeneratesignalsthatprovideyouwiththatpotential.Recallthatifyouarecorrectonatrend,youshouldmakemoney.Ifyourmajorproblemisthetimingofwhentocashinonaprofitabletrade,thatisthekindofproblemyouwanttohave,isitnot?So,whenthepivotindicatormethodhasidentifiedaprofitabletrade,thereare

somemethodsyoucanemploytodeterminewhentotakeaprofit.Thekeyliesinlettingthemarkettellyouthebesttimetoexit.LetmesharewithyouacoupleoftechniquesI’vefounduseful.ThefirstinvolvesusingtheconceptspresentedinChapter8,“TheAdvancedTradingCourse,”specificallyusingtime-testedchartpatterns.Forexample,thebottominFigure10.5wasformedwithahead-and-shoulders(H&S)bottom.Thepivotindicatormethodforthissignaltriggeredabuyjustabovetheneckline.YoucertainlycouldusetheH&Smeasuringruletodetermineaminimumprofitobjectiveandtheneitheraccepttheprofitoruseatighttrailingstoptoassuresomeprofitandmaximizethesignal.

Figure10.5.Profitobjectiveusingchartpatterns

AnothermethodI’vefoundusefulistofullyutilizewhatIrefertoinChapter9,“TheMovingAveragesPrimer,”as“themostvaluabletechnicaltool”(TMVTT):movingaverages.Todothis,yousimplywaitforacloseunderthe10-daySMA(technicallyasetupbarinthereversedirection)toexit.ThiswouldkeepyouonthemeatoftheuptrendduringoneoftheprofitablesignalsfromthesoybeanchartinFigure10.3,foragrossprofitof$5,850percontract,asindicatedinFigure10.6.

Figure10.6.ProfitobjectiveusingSMA

AnotherusefulpivotindicatormethodtoolisoneItermthe“pivotbounce.”TheSMAisapowerfultoolthatprovidesastrongindicationofsupportand/orresistanceinthemarketplace.Inreviewingyourcharts,notehowoften,inaconfirmeduptrendordowntrend,themarketwilltouchtheSMAandbounce.Often,themarketwilltradeclosetotheSMA,withouttouching,orwillgentlytradejustunder(inanuptrend)orjustabove(inadowntrend)and“bounce,”closingaboveorbelowtheSMAinthedirectionofthemajortrend.AnexampleofthisphenomenonisillustratedinFigure10.7.Whenyouseethistypeofmarketaction,withaconfirmedcloseinthedirectionofthemajortrend,itoftensetsupalow-riskopportunitytopyramidatradethat’sworking.Theriskpointwouldbejustbelowthepivotbounceday(orjustaboveit,inadowntrend).

Figure10.7.Pivotbouncepyramid

Inaddition,thereisnorulethatconstrictsyoutoonlytradethisonadailytimeframe.Ifyouareashort-termtrader,thepivotindicatormethodworksjustaswellonashorter-termtimeframe.AnillustrationofthisisFigure10.8,whichshowsacornchartasa30-minutebarchart(witheachverticallinerepresenting30minutesoftrade,comparedtoafullday,asinthepriorcharts).

Figure10.8.Shorter-termtradingusingthepivotindicatormethod

Notethatthesetupbar,bufferedentryprice,andtriggeredentryworkexactlythesame,withthedifferencebeingthatashortertimeframetypicallyresultsinreducedrisk(andreducedprofit)pertradesignal.Justusethetimeframethatsuitsyourpersonality.

DiversificationWhentradingusingmypivotindicatormethod,Irecommenddiversifyingintoaminimumofthreeunrelatedmarkets.Thesemarketsshouldbeliquidtoallowforstoporderswithminimalslippage.Althoughthisruleisnotwritteninstone,andIalsobelievethatyoucanmakemoneyusingthismethodologytradingjustoneortwomarkets,thisgenerallyrequiresgreaterpatience,particularlyifyoustartatthewrongtime.Theideaisthatthegreaterthediversification,thegreaterthechanceofcatchingamajormovesomewhere.Atanypointintime,onemarketmightbeinamajoruptrendandonemightbeinamajordowntrend,withathirdtrendless.Thepivotindicatormethodworksbecausethemajormoveswillbeprofitableenoughtooffsettheinevitablesmallerlossesinherentinthosechoppymarketsituations.Theoddsofcatchingmajormovesincreasewiththenumberofmarketstraded.Onecaveat:Theyshouldbeunrelated

markets.AlthoughtheSwissfrancandtheeurocanmoveinoppositedirectionsat

times,theygenerallymoveinthesamedirection(albeitatdifferentspeeds)inrelationtothedollar.Soybeansandsoybeanoilcanmoveinoppositedirections(andtheysometimeshave,intheshortrun),butbecausetheyarerelatedproducts,theygenerallymoveinthesamedirection(albeitatdifferentspeeds).Inpickingtheoptimalmarketstotrade,Ipersonallylikethosethat

traditionallyhavethetendencyformoredramaticmoves(insteadoftheslowermovers)becausethemorevolatilemarketswillhavemoveslargeenoughtoovercometheinevitabletrendlessperiodswhenyouconsidertheinherentcostsofcommissionsandslippage.Forexample,Igenerallyprefercorntooatsbecauseofcorn’sgreatervolatility.Ilikemarketswithgoodvolumeandmajorcommercialparticipation(forexample,thegrainsandtheenergies).Thecommercialinterestsandhedgefundshavedeeperpocketsandtendtosupporttheirpositionslonger.Considertradingonecurrencybecausecurrencieshaveatendencytotrendnicely.Anyofthemajorcurrencies(theeuro,theBritishpound,theAustralianorCanadiandollar,andtheJapaneseyen)workswell.Ialsoprefertotradeagrain,andIpersonallyprefersoybeans(technicallynotagrain,butanoilseed)andcornbecausetheybothtendtotrendnicelyandpossesssufficientvolatility.Finally,Irecommendthatyouconsiderroundingoffyourportfoliowithametal(mypersonalpreferenceisgold)andafinancial,suchasastockindexoraninterest-rateproduct.Thepivotindicatormethodisdynamic,anditworksovertimeifused

systematicallyonavarietyofunrelatedmarketsoranysinglemarket.However,myexperiencehasbeenthatthinmarkets,suchaslumberandorangejuice,placetheoddsagainstusatthestartbecausethefillsareoftendisappointing.Attimes,stopswilljustbehit,andsometimestheywilljustbemissed.I’ve

foundthatthese“justs”(justgettingstopped,justmissingaprofit)appeartoevenoutovertime.It’sallafunctionofthe“marketgods”andisnotwithinourcontrol.

11.AndFinally

“ThisisthefifthbookI’vewritten,whichisn’tbadforaguywho’sonlyreadtwo.”—GeorgeBurns

So,you’vestayedwiththistothefinalchapter.I’vesharedalotwithyou,andyounowfeelreadytogo.However,statisticsonwinnersandloserstellusthatthemajorityaremissingtheessentialelementsforsuccess.Peopleoftenthinktheyhavethekeystosuccessbeforetheybegintrading.Afterall,theresearchisfundamentallysoundorthetradingsystemlookstobeasurewinner(onpaper).Themajorityoftradersembarkontheirjourneyconfidently,sowhydosomanyfail?Tradingisexciting,butitisalsoextremelydifficult.Inthisfinalchapter,my

goalistosteeryoutofocusonyourinnerselfandtheabilitytoconcentratetotallyonthetaskathand.Thischapterisatreatiseondiscipline,oneoftheessentialqualitiesforsuccess.This,inturn,relatestomoneymanagement,acriticalsubsetofdiscipline.Icouldhavealternativelytitledthischapter“ThePsychologyofTrading”or“TradingConsistently,”butitallreallyboilsdowntoonething:yourstateofmind.Forasuccessfultrader,thementalgameisasimportantasalltheothertradingrulescombined!AsDannyOzark,formerPhilliesmanager,oncesaid,“Halfthisgameisninetypercentmental.”

DeterminingyourmotiveInthefirstchapterofthisbook,wediscussedwhatittakestobecomeasuccessfultrader.Haveyoupersonallyanalyzedyourtruemotives?Iknowyouwanttomakemoney.Wealldo.Butyourmotivesshouldgowellbeyondthat.Hedgersusethemarketsforbusinessreasons—tomanagetherisksinherentin

thecommodityorfinancialmarketsassociatedwiththeirbusinesses.Speculatorsshouldbeinitforthesamereason—toenhancebottom-lineprofitability.Still,manyfolksaretradingforanotherreason:thethrill,theexcitement,andtheadrenalinerush.Thesepeople,andIthinkthenumbersaresignificant,arelookingforthesamerushasahorsebetteroracrapshooter.Althoughit’snotimpossibletomakemoneyasaVegasgambler,andsomedo,mostdon’t.So,yourquestiontoyourselfshouldbe“Whataremyrealmotives?”Onlyyoucananswerthisquestion,butifyourrealmotiveisaction,andifyourequireinstant

gratification,youwillfail.Yourstateofmindwillpromptyoutotradewithoutregardtoconditions,andtheconditionsmustfavoryouractions,oryouwillfail.So,whatshouldyourmotivesbe?Nottojustmakemoney—that’snot

enough.Youmostlikelyareacompetitiveperson,onewhoenjoysplayinggamesandsolvingpuzzles.Youshouldstrivetoactinadisciplined,consistent,andunemotionalmanner.Inthiswayyouwilltradewhentheconditionsfavoryourtrade.Thisisnotaguaranteeofprofitability,butatleastwillplaceyouontherighttrack.

OvercomingthesixhurdlestotradingsuccessPriortoeachtrade,youneedawell-thought-outplanforthattrade.Theplanwillincludeexpectationsforapositiveoutcome,butitneedstohaveabuilt-incontingencyforanunexpected(unprofitable)outcome.Youneedtoactinaconfidentandunhesitatingmanner.Yourplanmustovercomethesixhurdlestosuccessfultrading:1.Tradingforthethrillofit2.Tradingforrevenge3.Lackingmoneymanagement4.Lackingawell-definedtradingplan5.Beingunabletopullthetrigger6.Beingunabletoadmityou’rewrongThefollowingsectionsdiscusswaystoovercomethesehurdles.

1.ConditionyourselftobeunemotionalOnceyoudetermineyourtruemotivesfortrading,youwillbebetterabletopositivelyconditionyourstateofmind.Ifyouaretradingforthethrillofthegame,youmighttradewhentheconditionsfavoryourmethods,butyouwillalsotradewhentheydon’t.Whenyoutradeemotionally,youovertradebecausethatisaninevitableoutcomeofthrilltrading.Youoverstayyourwelcomeontradesthataren’tgoingyourway,andthisinvitesdisaster.Itmightworkforatime,buttherewillcomeanothertimewhenthrilltradingwillwipeyouout.Thentherearepeoplewhotradefortheadrenalinerushbutaresubconsciouslyuncomfortablewithrisk.Ifyouareoneofthesepeople,youtendtoundertradeorplaceyourstopstooclose,andthisisn’tarecipeforsuccesseither.Ifyoucannotconditionyourselftoassumetheriskofaleveragedmarket,placeyourhard-earnedmoneyinTreasurybills(orgoldcoins)andgohome.

2.AvoidrevengetradingHasthiseverhappenedtoyou?Youwerestoppedoutforaloss,abiggerlossthanyouhadoriginallyanticipated.Perhapsitwasabadfillbeyondyourstopduetosomeunexpectednews.It’searlyinthetradingday,andyoufeelyoucanmakeitback.Plus,youjustcannotgohometodaywithalargeloss.Themarketowesyouyourmoneyback,itwillpayyouback,anditwilldoittoday!Haveyoueverhadthisfeeling?Ihave,andletmetellyouthatwhenI’moutforrevenge,9timesoutof10itleadstoabiggerloss.Thereasonisthatthere’sanunstablestateofmind.Tradingangryinevitablyleadstobaddecisions.Whenyougetthisfeeling,forceyourselftotakeastepbackandrelax.Walkawayfromthescreen,maybedosomepushupsorotherexercise.Themarketwillbetheretomorrow,andtherearealwaysopportunities.Thisisn’tthetimetocompoundaproblem;it’sthetimeforyouressentialqualityofpatiencetotakeover.Toomanypeopleletalossaffecttheirpsychologyonthenexttrade.I’mnot

sayingitisalwayseasytobeunemotional;emotionisahumantrait.But,youmustconditionyourselftoremainincontrol,andifyoufeelyouareoutforrevenge,forceyourselftostepasideforatime.

3.PreserveyourcapitalWhenyouhavelittletonomoneymanagementprograminplace,itisimpossibletopreserveyourstake.Unlessyouconditionyourselftoriskonlyasmallpercentageofyouraccountonanyonetrade,thatonetradethatlooksperfectwillinevitablycomealong,andyou’lltradeittooheavily.Afterall,thetrade“lookssoright,”“everythingisfallingintoplace,”andbeforeyouknowit,you’redippingintothetillonceagain.Letmeshareasecretwithyou:Theyalllooksoright.Iwouldn’tenteratrade

unlessitlookedgood,butthereisnowaytoknowinadvancewhichtradeisgoingtobethebigwinner.Ifyouknewthis,thenthesewouldbetheonlyonesyou’dtake.I’vefoundthatmostyearsonlyafewtradesmakemyyear,anditisusuallynotthetradesIthoughtwouldbethebigwinners.IfIhadnomoneymanagementplaninplace,Iwouldbelonggonebeforeevercapturingthosemajormoves.Youmustpreserveyourcapital,andthismeanstakingsmallandconsistenthitsonthemanyinevitablelosers.Thegoalistostillbeinthegamewhenthosemega-tradesfinallydomaterialize.

4.EnsurethatyourtradingplaniswelldefinedNobodyentersapositionexpectingaloss;however,eventhetoptradersexperiencenumerouslosses.Ifthebestlose,whywouldyoubeanydifferent?A

well-definedplandefinessuccessandfailureboth.Askyourself,“Whyareyoubuyinggold?”Iftheanswerissomethinglike“Becauseitjustbrokeabovethe10-daymovingaverage”or“Becauseinflationisheatingup,andinthelongrungoldissensitivetoinflation,”youhavenotdefinedyourplan.Youhavereasonsyouenteredbutnoclearexitstrategy.Youaretradingonhope,andthisisnotarecipeforsuccess.Youmustdefineyourlosspointbeforeyouenteratrade,andifyouarenot

preparedmentallytolose,you’llneverwin.Itisessentialtorealizethatyou’lllosecountlessbattlesinthetradingwar,orthewarwillneverbewon.Youshouldhaveaprofitgoal.Profitgoalscanbeflexible,butstoplosspointsshouldn’tbe.Youcanhavecontingencyplanswhenyourprofitobjectiveisreached.Theplanmightbenothingmorethansomethinglikethis:“Iamrisking$500percontractonthistrade;mytechnicalprofitobjectiveis$1,200.Ifthemarketmoves$500myway,Iwillmovemystopuptoanapproximatebreakeven.Ifitmoves$900myway,Iwillmovethestopuptoapproximatelya$400profit.Ifitreachesmytechnicalobjective,Iwillwatchcloselyforsignsoffailure.Ifthemarketshowsthesesigns,Iwillsellatthemarket.However,ifitmovesthrough,Iwilltightenmystoptojustunderthepreviouslow.”Thisplanmightormightnotwork,butatleastitisaplan,andwithoutaplan,you’reultimatelydoomedtofailure.

5.Actwithouthesitation(ifyouhaveagoodreasontodoso)Whatifyouareindecisive?ConsiderthisquotefromLeeIacocca,whenhewasbringingChryslerbackfromthedeadintheearly1980s:“Sowhatdowedo?Anything.Something.Solongaswejustdon’tsitthere.Ifwescrewitup,startover.Trysomethingelse.Ifwewaituntilwe’vesatisfiedalltheuncertainties,itmaybetoolate.”Anddon’tforgetJohnSteinbeck:“Thebestlaidplansofmiceandmen...”

Whenyoupapertrade,youalwaystakethelossortheprofit.Intheheatofthebattle,itisnotaseasytopullthetrigger.Toomanytimes,evengoodtradersdonottakethelosswhentheplannedriskpointisreached.Itishumannaturenottobeabletoadmityouarewrong,anditisseductivetowaitjustabitlongerortakejustabitmorerisk,hopingthemarketwillturnbackyourway.Inthegreatmajorityofcases,thiswillonlyexacerbatethepain.Howdoyouovercomethisshortcoming?Verysimple:Placeaphysicalstoplossorderthemomentyouenterthetrade,andthenjustletthe“marketgods”determineyourfate.Youwon’tbestoppedoutofthebesttrades.Takingprofitswhenthetimepresentsitself,althoughnotascritical,canbejustasimportant.Ialwayshaveamental

profitobjectiveinmind.It’snotsobadtowatchthemarketwhenitreachestheprofitobjectivebecausethebestmarketsmanytimesexceedyourminimumprofitobjective.However,ifthemarketappearstohesitateasyounearthegoalline,cashin.Justdoitbecause,manytimes,themarketwillnotgiveyouasecondchance.AndwheneverIamunsure,IjustmovemystopverytightandmakesureIlockinagoodportionoftheprofit.Themajorityoftimes,Igiveupsomething,butsometimesI’mabletosqueezeoutquiteabitmore.Stopsarevaluabletoolsthatgiveyouanedge—sousethem!

6.ConditionYourselftoBeHumbleHavinganegoisnotatraitofasuccessfultrader.WithapologiestoVinceLombardi,Imustsaythatwinningisnoteverything,anditcertainlyisnottheonlything.IoncehadaclientwithanS&Pday-tradingsystem,onewhomademoneyonfouroutoffivetrades.Theproblemwasthatthefifthlosingtrademorethanoffsetthefourwinners.Yet,untilheranoutofmoney,hekepttradingitforsmallprofitsbecauseitfeltgood.I’vehadnumerousclientstrytopicktopsandbottoms,butthisisanalmostimpossibletaskbecauseeverymajormovehasjustonetopandjustonebottom.Whocareswhetheranyoneparticulartrademakesmoney,orwhetheryouhavemorewinnersthanlosers?Thenameofthisgameisnothowmanywinnersyouhavebutmakingmoneyatthefinish.Theultimatetriumphisconsistentlyhavingwinningmonths.Andinawinningmonth,myexperiencehasbeenthatyoumostlikelyhaveacceptedlosersthroughoutthatmonth.Mostpeoplehavetroubleadmittingtheyarewrong,whichiswhytheylosemoneyinfuturestrading.Inmyowncase,overtheyears,mybiggestlosseshavecomeinthosemarketsinwhichIhavehadastrongopinion.Ihaveattimesfoughtthemarket,takingtoomuchrisk,andvoidingmymoneymanagementprincipals.Attimes,Ihavebeenforcedoutofamarketjustbeforetheturninmyfavor.Inotherwords,inthisinstances,Imayhavebeenrightinmyopinion,butmytiminghasbeenoff.(Amarginclerk,however,doesn’tcareifyouareultimatelyright.)Othertimes,somenewnewsIwasunawareofwouldsurfacetodemonstratewhyIwaswrongandthemarketwasright.Itisbettertoletthemarkettellyouwhatitissayingthantotrytodictate,becausethereisnodoubtwho’sgoingtowinthatargument.Mostpeopletakeprofitstoosoonbecausetakingprofitsispsychologically

pleasant.Ialwayshaveprofitobjectivesformytrades,butthey’renotwritteninstone.Afterall,thereisonlyonetopineverybullandonlyonebottomineverybear.IamnotarrogantenoughtoassumethatIamtheonewhocanpickthosetopsandbottoms.Canyou?Abetterplanistoseehowthemarketactswhenitdoesreachyourprofitgoal.Manytimesitgoesmuchfurther,soifthemarket

wantstokeepgoing,whynotletit?Forgetaboutbeingrightonanyparticulartradeandfocusonmakingmoney!

DevelopingthewinningtouchYousee,thetraitsthatleadtosuccessintradingaredifferentfromthoseyouhavelearnedduringyourlifetime—thosethatleadtosuccessineverydaylife.You’vebeentaughtthatperseverancewillultimatelyleadtotriumph,butintradingyouneedtoloserepeatedlytowin.Ittakesconditioningtotrainyourmindtoactinamannercontrarytowhatworksoutsidetrading.Inlife,itisgenerallyarecipefordisastertoactimpulsively;itisbettertositbackandreflectonyoursituation.Intrading,however,youmustconditionyourselftoact,perhapsnotimpulsively,butquicklywithouthesitationandunemotionallytocutaloss(ortakeaprofit).Afteryouconditionyourstateofmind,youhavecontroloveryourtradingemotions.Youhavegreaterconfidencewhentakinglossesandenteringnewpositionsbecauseyouknowyourtradingplanwillprosperovertime.Conditiondiscipline,oneoftheessentialqualitiesfortradingsuccess.Knowyouaregoingtohavelosingstreaks.Ifyourseriesoflosingtradesisaresultofalackofplanning,andthemarginclerkforcesyououtofthemarket,it’sdifficulttobounceback.Youloseconfidenceinyourabilitytorecoup.Ontheotherhand,ifyouknowyoufollowedyourdisciplinedprogramofcuttinglossesaccordingtoawell-definedplan,youcan’tbedevastatedbecauseyoufollowedyourplanandknowthatovertimeitwillworkforyou.Howcanyoutradeincontrol,relaxed,unemotionally,andwithconfidence?

Thesimpleansweristodevelopaconsistentmoneymanagementstrategywithapositiveoutcome.Timeandtimeagain,I’veheardfromwinningtradersthatamediocresystemwithgoodmoneymanagementtriumphsoverasuperiorsystemwithpoormoneymanagement.Moneymanagementisthevitalelementrequiredforsuccess,yetfewtradersconcentrateonit.So,what’sthebestmoneymanagementstrategy?Ithinkabeginningtraderis

lookingfortheholygrail,butasyouknow,I’venotfoundit.Inmyowntrading,Istrivetoriskamaximumof5%(inmostcasesmuchless)ofavailableequityonanyonetrade.However,Irealizethatslippageandextraordinaryeventscouldpotentiallyraisethatnumberforanyoneparticularlosingtrade.Ifyoukeepyourlosspertradeto5%maximum,ittakes20losingtradesinarowtogetwipedout.Withareasonabletradingprogram,theriskoftotalruinundertheseparametersissmall.Ofcourse,youmuststicktotheparametersyoucreate,andthisiswhereconditioningcomesintoplay.AfterI’vedefinedmynormalrisk,Ialsodefinemynormalreward.I

personallyamshootingforatleastatwo-to-onereward-to-riskratio,andinmostcasesbetterthanthat.Ofcourse,manytradesresultinasmallerprofit,orsmallerloss,andbecauseItrytoneverletadecentprofitturnintoaloss,Iseemtohavemanyscratchtrades(smallprofit,smallloss,breakeven).Let’sanalyzetheramificationsofthissimplesystem.Supposethatyouhada

verysmalltradingaccountof$10,000.(Withtheleverageinherentinthefutures,youshouldstartwithmore,butlet’susethisnumbertokeepitsimpleandassumethatyou’retradinglessvolatilemarkets.)Youcouldhavesevenlosingtradesat$500eachandthreewinningtradesat$1,500each(three-to-one),andyouwouldstillbeawinner:

7×($500)+3×$1,500=$1,000Thinkaboutthis:Youarewrong70%ofthetimeandstillcomeoutawinner!

Thisisthebeautyofagoodmoneymanagementprogram.Sure,therewillbetimeswhenyouprojectalossof$500,abadcropreportisreleased,andthatlossturnsinto$750.However,myexperiencehasbeenthattheseextraordinaryeventsseemtoevenoutovertime.Atsomepointdowntheroad,therewillbeafavorableunemploymentreport,themarketwillgapinyourfavor,andyouwillreapanadditional$300percontractprofitoverandaboveyouroriginalobjective.Let’stermthisthe“EvenSteveneffect.”(Idon’tknowwhythegoodandthebadevenout;itisoneofthemysteriesofnature.)Finally,youmustcontinuallyadjustyourpositionsize,basedonmarket

volatility.Asmallaccountshouldconcentrateonlessvolatilemarkets,sotheriskcanbeadjustedtosuittheaccountsize.Aquickandsimplewaytoevaluatevolatilityistoobtainalistofmarginrequirementsbymarket.Theclearingfirmhas,toamajorextent,determinedthevolatilitylevelsforyoubecausemarginrequirementsareadjustedbasedonvolatility.Althoughtherearealwaysexceptionsduetomarketinefficiencies,mygeneralruleisthattheinitialmarginforonepositionshouldnotexceed15%ofyourtotalexcessequityavailablefortrading.Ifyouhavea$100,000cashaccountandthemarginforsoybeansis$1,250,asuggestedmaximumpositionsizewouldbe12contracts.Butiftheprojectedriskinthiscaseis$500percontract,youwouldberisking$6,000with12contracts,whichis6%oftotalequity.Therefore,youshouldparedownyourpositionsizebyafewcontractsifyouwanttostickwithinthe5%rule.Iftheperceivedriskasdeterminedbyyoursystemis$750percontract,thenonlysixcontractsshouldbetradedforthisposition.Ifyoualwaysadjustyourpositionsizetovolatility,theneveninthebadtimes,youwillhavecapitallefttostayinthegame.Thenameofthegameistoavoidcatastrophicriskofruin.

Ifyoudon’tfeelright,youwon’ttraderightRodneyDangerfieldoncecomplained,“It’sbeenaroughday.Igotupthismorning,putonashirt,andabuttonfelloff.Ipickedupmybriefcase,andthehandlecameoff.I’mafraidtogotothebathroom.”Ifthisisthewayyourdaystartsout,don’ttrade.Youmustfollowawell-thought-outmoneymanagementplan,butanother

importantfactorisyourstateofmindandyourhealth.Hundredsofthousands—perhapsmillions—oftraderswhohavealoser’sstate

ofmindarepotentiallyontheothersideofyourtrade.Theymightnotrealizeit,buttheiractionsinthemarketplaceattesttothisfact.Thiswilltiltthemarketsyourwayifyoucanmodifyyourbehaviortoactinapositivemanner.Ifyoudothiscorrectly,tradingwillbeenjoyableandnotfraughtwiththeanxietysomanyface.Researchyourtradingplan,developgoodmoneymanagementtechniques,conditionyourmindforsuccess,onlytradewhenyoufeelhealthy,andyouwillsucceed!

Jesse’ssecretI’vetriedtospareyouthemarketaxiomsthatsoundterrificintheorybutreallydon’thelpyoumuchinpractice.(“Buylowandsellhigh,”forexample.)Thereis,however,onesecrettomakingthebigmoneythatI’vesavedforlast.Itissimplythis:Maximizethebigmove.Thisprincipletakesalongtimetolearn,andmanytradersnevergetit.Thetruthisthatyouwon’thavemanytradesthatturnintobigmovers.Thebigmoversarerare.Forme,it’sjustoneortwotradesthatmakeabigyear.Capitalizingononlytwoorthreemajortradingcampaignscouldmeanalifetimeofdifferenceforyou!WhenIfirststartedontheflooroftheGrainExchange,I’dseethisone

member,arelativelyyoungmanatthetime,who’dshowupeverysooften.He’dappearmaybeonceaweek,jokewithsomeofthetraders,checkthemarkets,andattimesplaceafeworders.He’ddisappearforweeksormonthsattimes.Overtime,Igottoknowhimbetterandlearnedhelivedahappylife.Thereasonwewouldn’tseehimformonthswasbecausetravelwashispassion,andhecouldwellaffordtopursuehispassion.Hewasindependentlywealthy,anditwasn’tinheritedmoney;hecamefrommodestmeans.Hisstorycenteredonthe“Russiangrainsteal”marketsof1973–1974.Hewasworkingforalivingbackthenandtradingontheside.Idon’tknowexactlyhowmuchmoneyhefinallytookoutofthemarkets,butjudgingbyhislifestyle,Ibelieveitwassubstantial.Hestartedwithamodestsumandmadehisbigmoneyinthesoybeanmarket.

Hewasfortunatetobeontherightsideofoneofthebiggestsoybeanmovesinhistory.Hewassmartenoughtohaveavision,hadthegutstopyramidhisposition,andwasdisciplinedenoughtostandfirmuntilthemarkettoldhimthemovewasover.(Thiswasamarketwheresoybeansranfromlessthan$4perbusheltonearly$13).Bottomline:Inlessthantwoyears,thismanwasabletochangehislifedramaticallyforthebetter.Whathedidisrare,almostimpossible,butheislivingproofthatitispossible.Thinkabouthowtoughitmusthavebeentodowhathedid,toconstantly

avoidthetemptationtocashinonwhatmusthavebeenhugepaperprofitsduringthemove.Humannaturewouldhaveurgedhimto“booktheprofit”everytimethemarketralliedtonewhighs.Afterall,youcanalways“getbackin”andreestablishapositiononthenextcorrection,right?Takingprofitsispleasurablebehaviorandtheeasiestroadtofollow.Afterabigrun,whenthecorrectiondoesmaterialize,atradercanpathimselfonthebackforcashingout.Profitabilityisenhancedeverytimeyoubookaprofitandarethenabletobuybackcheaper.Afterall,there’sanothermarketaxiomthatsoundsgreatintheory:“Younevergobroketakingaprofit.”Thetruthis,younevergetrichthatway,either.Themajorglitchin“taking

profits”hastodowiththecorrections.Althoughthecorrectionswillcome,theydon’talwaysoccuronscheduleorfromthelevelwhereyoudecidedtoexit.Thisman,unlikemost,hadthedisciplinetoforgo“normal”profitsandholdoutfor“life-changing”profits.Howdidhedothis?Ibelievehehadavision.Hehadtobelievepricescoulddowhatotherscouldneverenvision.Atthattime,howcouldanyonehaveenvisioned”beansintheteens?”Avisionisthekey,butthismanalsomusthavehadthepatiencetohangin

thereuntilthetrendabsolutelychangeddirection.Thisisn’teasytodo,andit’snotalwayseasytosee.Hehadtohavethecouragetohangonduringviciousshakeouts.(Takealookatachartofthesoybeansmarketatthattime;likealltheothermajormoves,thisonehadsharpanddeepshakeoutsevenwhilethemajortrendcontinuednorth.)Hemusthavehadthegutstopyramidhispositionformaximumprofitability,andthisisn’tallthateasy.Ittakes“smartguts.”Ifhehadbeentootimid,henevercouldhaveachievedlife-changingprofitability.Ifhehadbeentoobold,hewouldhaveovertradedandbecomeundermargined,unabletoholdhisposition.JesseLivermore,thelegendarytraderofthe1920s,madeandlostmega-

fortunescountlesstimesoverhistradingcareer.Thiswasamanwhomademorethan$15millioninthecrashof1929,amega-fortuneatthetime.Unfortunately,healsomusthavepossessedafatalflaw,becausehesomehowlosthismulti-

fortunes.Jessewasacompulsivegambler,andattheendofhislife,hediedpenniless.Hewasfounddeadintheearly1940swithaself-inflictedbulletwoundthroughhishead.Apparently,hedidnotfollowhisownadviceinhiswritings.Hecautionedtraderstoalwayslockawayforretirement,unavailablefortrading,halfofanybigprofit.Yearsbeforehisdeath,LivermoretoldusinReminiscencesofaStockOperator(asemi-autobiographicalaccountofhistradingcareerupto1923),thatheactuallydidthis(puthalfhisprofitsinanirrevocabletrustforhiswifeandson).Iguesshemusthavetakenoutthekeyandturneditataweakmoment.Still,hehadtheamazingabilitytotakemillionsoutofthemarkets,startingwithrelativelymodestsums.Thiswasn’taone-timefluke,either;hemademillionsnumeroustimesthroughouthiscareer.Thehighpointwashishugeshortpositionin1929,whichhecoveredatthelowsonthedayofthefamouscrash.WhatwasJesse’ssecrettomakethebigmoney?Heshareditinthebook.In

today’sworld,wehavecomputerizedtradingandfinancialfutures,butthebasicsoftradingandwinninghaven’tchanged,andhumannaturehasn’tchanged.Inthe1920s,stocksweretradedlikecommoditiesaretoday:highlyleveragedonsmallmargin.Earlyinhiscareer,Jessesufferedfromthesamemaladymostofushave.Unlikemost,however,hewasabletounlockthesecret.InReminiscences,JesserelatesthetaleofoldMr.Partridge:

YoufindveryfewwhocantruthfullysaythatWallStreetdoesn’towethemmoney.Well,therewasoneoldchapwhowasn’tliketheothers.Tobeginwith,hewasamucholderman.Henevervolunteeredadviceandneverbraggedofhiswinnings....TimeandagainIheardhimsay,“Well,thisisabullmarket,youknow!”asthoughheweregivingyouapricelesstalisman...and,ofcourse,Ididn’tgethismeaning....“ButIcouldn’tthinkofsellingthatstock,”Mr.Partridgewouldsay.“Whynot?”Iwouldask.“Whythisisabullmarket.Mydearboy,ifIsoldthatstocknow,Iwouldlosemyposition,andthenwherewouldIbe?AndwhenyouareasoldasIam,andyouhavebeenthroughasmanyboomsandpanicsasIhave,you’llknowthattoloseyourpositionissomethingnobodycanafford—notevenJohnD.Rockefeller.Ihopethatstockreactsandthatyouwillbeabletorepurchaseyourlineatasubstantialconcession,sir.ButImyselfcanonlytradeinaccordancewiththeexperienceofmanyyears.Ipaidahighpriceforit,andIdon’tfeellikethrowingawayanothertuitionfee.”

Jessethengoesontosay:

ThemoreIlearned,themoreIrealizedhowwisethatoldchapwas.Hehadevidentlysufferedfromthesamedefectinhisyoungdaysandknewhisownweakness.IthinkitwasalongstepforwardinmytradingeducationwhenIrealizedatlastthatwhenoldMr.Partridgekeptontellingtheothercustomers,“Wellyouknowthisisabullmarket,”hereallymeanttotellthemthatthebigmoneyisnotintheindividualfluctuations,butinthemainmovements—thatisnotinreadingthetape,butinsizinguptheentiremarketanditstrend.

AfterspendingmanyyearsinWallStreetandaftermakingandlosingmillionsofdollars,Iwanttotellyouthis:Itwasnevermythinkingthatmadethebigmoneyforme.Itwasalwaysmysitting.Gotthat?Mysittingtight!Youalwaysfindlotsofearlybullsinbullmarketsandearlybearsinbearmarkets.Ihaveknownmanymenwhowererightatexactlytherighttimeandbeganbuyingorsellingwhenpriceswereattheverylevelthatshouldshowthegreatestprofit.Andtheirexperienceinvariablymatchedmine—thatis,theymadenorealmoneyoutofit.Menwhocanbebothrightandsittightareuncommon.Ifounditoneofthehardestthingstolearn.Butitisonlyafteraspeculatorhasfirmlygraspedthisthathecanmakebigmoney.

Itisliterallytruethatmillionscomeeasiertoatraderafterheknowshowtotradethanhundredsdidinthedaysofhisignorance.

(ReprintedfromEdwinLefevre,ReminiscencesofaStockOperator,Traders’LibraryPublications1993,bypermissionofJohnWiley&Sons,Inc.)

I’vehadcertainclientsmakebigscoresinthemarkets,butit’srare.I’vebeenfortunateenoughtodothesameattimes,butnotasoftenasIshouldhave.WhenIgobackandlookatmybrokerstatements,Iseethesamepatternformy“‘best-of-the-best”trades.Apositionenteredintogenerallybeforeitwasthepopularplay.Apositionheldforagreaterperiodoftimethanmostofmytrades,heldthroughmajorshakeoutsorsharpshortcoveringrallies.Apositionpyramided(butnotalwaysthelargestpositions).Substantialmoneycanbemadewithafairlymodestposition,ifthetimingisrightandheldforagoodportionofamove.Toachievesuccess,youhavetoresistyourhumanweaknesses.Humannature

promptsustotakeprematureprofitsbecauseit’spleasurable.Themajormoves,theonesyouwanttomaximize,arethehardesttohold.Yourtechnicaltoolscan

helphere.Movingaverageswillhelptokeepyouonthetrend;actually,anytoolthathelpsyoudeterminethetrendandmaximizeprofitswhilecuttinglossesinasystematicmannerisbetterthanthinkingtoomuch.Technicaltoolscanprovideyouwiththedisciplinetostaywithmovesyouotherwisewouldcashinonprematurely.Thebigmovesarealwaysavailable,butmostofusneverseetheforestforthetrees.Lookingatrecentcharts,againIseenumerousmarketsthathavetrendedfor

bigmoves.Majormovestakeplaceeveryyearandinbothdirections,butmostofusseethesemovesonlyinhindsight.What’sexcitingisthattheycontinuetodevelop,andthereisprobablyonestartingsoonthatcouldprovideyouwithsuccessbeyondyourwildestdreams.You’llneeddiscipline,guts,andcourage,andyou’llneedtotaketheroadlesstraveled.It’snoteasy,buttheopportunitiesarethere.

Commentsorquestions?Iinviteyoutoemailmeatgkleinman1@mac.comwithquestionsorcommentsasI’minterestedinhearingaboutyourexperiences.Ihopeyou’llbeabletousetheconceptspresentedinthisbooktoyour

benefit,andofcourse,Iwishyouanenormouslysuccessfultradingexperience.Goodluckandgoodtrading!

Appendix.25TradingSecretsofthePros

“Historydoesn’trepeatitself,butitdoesrhyme.”—MarkTwain

WhenI’vedonewellinthemarkets,ithasusuallybeenbecauseIactedinacertainmanner.WhenI’vedonepoorly,itusuallyhasbeenbecauseIdidn’t.The“secrets”presentedherearepartiallyfromexperience(the“schoolofhardknocks”)butalsooriginallygleanedfromreadingthemasters.Twomastersofthepastcometomindfirst—JesseLivermoreandW.D.Gann.Theirheydaywasthe1920s;however,forme,theybothstilllivethroughtheirwritings.Atradercanlearnmorefromtheirfailuresthantheirtriumphs.Thesamemistakesmade50and100yearsagocontinuetobemadebytraderseveryday.Technologymightchange,buthumannatureneverdoes.Ithankthesetwomen.Manyofthe“secrets”discussedhere,althoughwritteninmywords,comefromthem.Ifyoudisregardwhat’spresentedhere,youlikelywillbecomelostinthe

financialdesert,dyingofthirst.(Perhapsthat’sabitstrong,buttrustme,thisisgoodstuff!)

Secret1:Thetrendisyourfriend!Don’tbuckthetrend.Thewaytomakethereallybigmoneyistodeterminethemajortrendandthenfollowit.Ifthemarketwillnotgoyourway,youmustgoitsway.Whenyouareinabearmarketandthemajortrendisdown,theplanshouldbetowaitforralliesandsellshort,nottrytopickthebottom.Inamajorbearmarket,youcanmissthebottomseveraltimesonthewaydownandenduplosingallyourmoney.Thesameapplies(inreverse)duringamajorbullmarket.Alwaysgowiththetide—neverbuckit.Letmerepeatthis,becauseitisimportant:Itiseasiertowalkwiththewindthanagainstit,itiseasiertoswimwiththetidethanagainstit,andthebigmoneyismadebygoingwiththetrend,notagainstit.AsLivermoretoldus,inamajorbearmarket,itissafertosellwhenthe

marketisdown50pointsfromthetopthanwhenitisdownjust10.Thereasonis,atdown50,allsupportisgone,andthosewhoboughtthebreakshavelostallhope,aredemoralized,and,inaleveragedmarket,areatthepointwheretheyalltrytoexitthesamesmalldooratthesametime.Theresult,attimes,canbeanunexpectedavalanche.Icangiveyoumanyexamplesofmarketsthathave

trendedlongandfar,madesomepeoplerich,andwipedoutmanyothers.Youmighthaveheardaboutthepoorsoulwholosthisfarm.Icanalmostguaranteethatguywasbull-headedandfoughtthetrenduntilhefinallyranoutofmoney.Howdoyoustickwiththetrendandnotfightit?Itisn’tallthateasy.That’s

whymostpeopledon’tmakemoneyinfutures.Youneedtohaveastrongwill.Whenyoucandeterminethetrendofthemarket,don’tchangeyourminduntilthetapeshowsthechange.Inanymajormovetherewill,ofcourse,becorrectivemovesagainstthetrend.Somenewswilldevelopthatwillcauseasharpcorrection,butitwillbefollowedbyamoverightbackinthedirectionofthemajortrend.Ifyoulistentothisnews,youwillbetemptedtoliquidateprematurely.Avoidthetemptationandlistentonoone—listenonlytothemarket.Onewaytodothisistoneversetafixedpriceinyourmindasaprofitobjective.Themajorityofpeopledothis,andthere’snogoodreasonforit—it’sabadhabitbasedonhope.Donotsetafixedtimetoliquidateeither.Thisisthewaytheamateursdoit.Theybuysilverat$35becausetheirbrokertoldthemit’sgoingto$50.Well,itgetsto$39.97,turnsandheadssouthagain,andthey’restillholding,lookingfor$50,watchingandwaitingastheirunrealizedprofitsmelt.I’veseenit,andthisisjustplainbull-headedness.I’veseentheopposite,too.Themarketclosesat$35.95,looksstrong,andis

fundamentallyandtechnicallysound.Theamateurhashisgood-until-canceledordersittingtosellat$36,becausethisishisprice.Themarketgapsupandfillshimat$36.15,andhisbrokerispleasedtoreporthesoldbetteratthisprice.However,thisisaformoftoppicking,andwhoissmarterthanthemarket?Themarketprobablygappedupabove$36becausethebuyinginterestwasabletooverwhelmthesellers.I’veseenmanycaseslikethisone,inwhichtheopenwassharplyhigherbutstillturnedouttobethelowoftheday.Inotherwords,itwasthekindofmarketthatneverlookedbackuntilithit$50.Thisisallaversionofbuckingthetrend—somethingIdonotrecommend.Conditionsdochange,andyoumustlearntochangeyourmindwhentheydo.Awisemanchangeshismind;afoolneverdoes.Justbesurethatifyouchangeyourposition,itisbasedonsoundreasoning.

Secret2:Whenamarketischeaporamarketisexpensive,thereprobablyisagoodreasonThissecretgoeshandinhandwith“thetrendisyourfriend.”Livermoretoldusthathealwaysmademoneysellingshortlow-pricedmarkets,whicharethepublic’sfavoriteandinwhichalargelonginteresthaddeveloped.Alternatively,hecashedinonexpensivemarketswheneveryonewasbailingoutbecausethe

publicthoughtthemarketwashighenoughforahealthyreaction.Thepublicwassellingsoybeansshortat$6perbushelin1973becausethiswasanall-timehighandintoresistance.Whocouldhaveguessedthatsoybeansweren’tevenhalfwaytowhatwouldbenewrecordhighs—closeto$13?Alwaysrememberthatitisnotthepricethat’simportant,it’sthemarketaction.

Secret3:ThebesttradesarethehardesttodoYouneedtohaveguts,andyouneedtobeaggressiveonentry.Youneedtoquicklycutyourlosseswhenthemarketisnotactingright.Thenewsalwayssoundsthemostbullishatthetopandappearstobethemosthopelessatthebottom.Thisiswhythetechnicaltoneofthemarketissoimportant.Ifthenewsisgoodbutthemarkethasstoppedgoingup,askyourselfwhyandthenheedthecall.Bottomscanbethemostconfusing.Theaccumulationphase,wherethesmartmoneyisaccumulatingaposition,canbemarkedbyreactions,crosscurrents,shakeouts,andfalsereversals.Afterthebottomisinplace,manytraderslookforthenextbreaktobeabuyer.Afterall,themarkethasbeensoweaksolongthattheoddsfavoratleastonemorebreak,right?Butitnevercomes.Thesmartmoneywon’tletit.Thesmartmoney’sobjectiveafterthebottomisinplaceistomovethemarketuptothenextlevel.Thebesttimetobuycanfeelveryuncomfortable.However,thetrainhasalreadyleftthestation,andyouneedtohavethecouragetohoponfortheride.

Secret4:HaveaplanbeforeyoutradeandthenworkitIfyouhaveaplanandfollowit,youwillhavetheabilitytoavoidtheemotionalismthatistheenemyofanytrader.Youmusttrytostaycalmduringtheheatofasessionandremainfocused.Todothis,youhavetobetotallyorganizedpriortotheopeningbell.Yourdailymission,shouldyoudecidetoacceptit,istomakemoneyeachdayor,barringthat,atleastnottolosemuch.Innormalmarkets,youshouldtakenormalprofits.Inunusualmarkets(thatoccurrarely),youneedtoshootforabnormalprofits.Thisisoneofthekeystosuccess.Thenextisthatyoumustalwayslimitlossesontradesthatarenotgoingaccordingtoplan!Thistakeswillpowerandisasessentialaqualityashavingplentyofmoney.Infact,it’smoreimportantthanhavinglotsofmoney.Moneyisnottoholdonwith;that’sforthesheep,andyoudon’twanttobesheared.Ifbigrisksarerequired,don’ttakethattrade.Waitforanopportunitywhereyoucanplaceatighterstop.Livermore’smethodoftradingwastolookforopportunitieswherehecouldenterclosetohisriskpoint.Inthatway,hisriskpertradewassmallinrelationtotheprofitpotential.

Ifyoudonothavethewillpowertotakethelosswhenyourriskpointishitduringthetradingsession,thenyouabsolutelymustusestoplossorderstomaintainyourdiscipline.Simplyplaceyourstopatthesametimeyouplacethetrade.Youprobablyhaveheardstoriesaboutthetradersorthecomputers“runningthestops,”butIassureyouthatinthegoodtrades,themajorityofthetimeyouwillnotbestoppedout.Youwillbestoppedoutofthebadones,andthat’sagoodthing.Personally,Ihaveatradingplanlaidoutthenightbefore.Igenerallyknow

whatIwilldoifthemarketactsthewayIanticipateitshouldand,justasimportantly,whatI’lldoifitdoesn’t.Itisaguide,ofcourse,notwritteninstone,anditisflexible.However,ifamarketisnotacting“right”accordingtomyplan,Iknowitistimetotakeaction—eithertotaketheprofitifavailable,orcutthelossifnot.Generally,I’vefoundthatwhenItrytofudgetheplan,Igetmyheadhandedtome.Thisdoesn’talwayshappen(andthisiswhyit’shardtofollowplansmanytimes),butithappensenoughtoknowthat,intheheatofthebattle,theplanissmarterthanIam.

Secret5:BeaggressiveBeaggressivewhentakingprofitsorcuttinglosses(ifthere’sagoodreasontodoso).Agoodtraderactswithouthesitation.Whensomethingisnotright,sheliquidatesearlytosavecashandworry.Neverthinktoomuch.Justdoit!Anddon’tlimityourprice—goatthemarket!Manytimes,amarketgivesyouoneoptimalopportunitytoactandthat’sit—sogowithit.AsGannsaid,“Thewaytobenefitthroughintuitionistoactimmediately.”

Secret6:NoregretsWhenyouliquidateatradebasedonsoundreasoning,neverregretyourdecision.Justgoon,andifitwasamistaketogetout,allyoucandoislearnfromit.Weallmakemistakes.Don’tbeatyourselfup,oryouwillloseyourperspectiveandbecometoocautiousinthefuture.

Secret7:MoneymanagementisthekeyYoudonotnecessarilyneedtohaveahighwin-to-lossratio,butyouraveragewinmustbehigherthanyouraveragelossifyouwanttosucceed.Todothis,theremustbe(atleastsome)“bighits.”Youhavetomaximizesometrades.Youneedthesebigwinstooffsetthenumerous(andhopefullysmall)lossesthatareinevitable.I’vefoundthatbeingabletocutlossesearly,byevenasmallincrementalamountpertrade,like$100,canmakeamajordifferencetothe

bottomline.Thistakesdecisiveness,sobedecisiveifthetradeisnotactingright.Waitingforafewmoreticksisgenerallynotarecipeforsuccess.Andonemorepointhere:Itisgenerallybadpracticetocancelorextendastoplossorder.Myexperiencehasbeenthatthemajorityoftimescancelingastopisthewrongthingtodo.It’sokaytocancelaprofit-takingorderattimes,butthesooneralossisstopped,thebetter.Whenyougetoutofabadpositionquicklyandwithaminimumoftrauma,notonlyisyourcapitalbasemaintainedbutyourjudgmentimproves.Withoutawell-definedriskpoint,there’snojudgment.Thetermforthatishope,andyoushouldnevertradeonhopealone.

Secret8:SuccesscomeseasierwhenyouspecializeEverymarkethasitsownpersonality.Somemarketstendtomaketopsandbottomswithafastrunupandreverse(calledaninvertedVtop,ortheopposite,aVbottom).Somehaveroundingtopsandbottoms,somedoubletopsandbottoms,andsometopandbottomwithalongconsolidation.Youcanreadamarketbetterwhenyoubecomefamiliarwithitsidiosyncrasies.Familiaritycomesfromconcentrationandexperience.Ifamarketdoesnotfitwithyournature,findanotherone.Whencertainmarketsdon’tseemtoworkforyou,leavethemaloneandstickwiththeonesthatfavoryou.Thereareplentyofmarketsareoutthere.

Secret9:PatiencepaysAsGannoncesaid,“Peopleareintoobigahurrytogetrich,andasaresult,theygobroke.”Don’ttrytogetrichinafewmonths.Don’ttrytocatchallthefluctuations.Marketmovementsofimportancerequireweeksorevenmonthstogetready.Afewdays(orlonger)afterabigmovegetsunderway,there’sgenerallyplentyoftimetobuyorsell.Attimes,amanorwomanwithnerve,knowledge,andabitofluckcanturnasmallamountofmoneyintoafortune.However,thiscannotbedonecontinually.Theverybesttradescomealongonlyrarely.Youneedthepatiencetowaitfortherighttrades.Whentheycome,youneedthepatiencenottobeoveranxiousandgetintoosoonorovertrade.Whenyoudogetinandthemarketstartstomoveyourway,youmusthavethepatiencetoholdontightuntilthere’ssufficientcauseforclosingoutthetrade.Rememberthateveryact,eitheropeningorclosingatrade,musthaveasoundbasis.Nevertradeforthethrillofit.Ifyoucannotseeadefinitetrade,useyouressentialqualityofpatienceandwait!Afteryouareoutofthemarketwithabigprofit,youdon’tneedtobeintoo

bigahurrytogetbackin.Thebestopportunitiesmightbejustaroundthecorner,

butthey’renotthereeveryday.Youneedthepatiencetowait.Bigaccountbalancesleadtothetemptationtoplayforless-than-desirabletrades.Ifyoumadeagoodprofit,thenlookatitthisway:Youcannowaffordtowaitafewweeksormonthsforthenextbigmove.

Secret10:GutsareasimportantaspatienceandmoreimportantthanmoneySometradersaretoobold,andasaresult,theyovertrade.Othershavetroublepullingthetrigger,andthisisaweaknessthatmustbecorrected.Youmusttrainyourselftotradeinsuchawaythatthereisnohopeandnofear.Whenyouenterorexitaposition,doitdecisivelyandwithoutemotion.Youneedthegutstopresshardwhenyouareright.Andgutsareparticularlyimportantafteratoughlosingstreak.I’vewitnessedtraderswhostillhadmoneyleftaftersufferingastringoflosses,andwhenthebestopportunityoftheyearcamealong(onetheyidentified),theydidn’thavethegutstoact.Incaseslikethis,gutsaremorevaluablethanmoney.

Secret11:The“tape”(quotes)willtrickyouGannoncesaidthatit’simpossibleforamanwhostandsover“theticker”everydaytoidentifyabigmovebeforeitstarts.Thetapewillfoolyoueverydaywhileaccumulationistakingplace(andittakestimetoaccumulateordistributealargeposition).Gannactuallyfeltthatthetape(todaywecallitthequotescreen)wastheretofooltraders.“Thetapemovesinmysteriousways,themultitudetodeceive”isthewayheputit.Pricescanlooktheweakestorstrongestatthestrongestorweakesttimes.Watchingquotesalldaycausesyoutochangeyourmindconstantly.Tradetoooften,andthisincreasesyourpercentageofbeingwrong.Ifyougetinwrong,thequotestendtokeepyouinwronglongerthanyoushouldbebecauseeverytickyourwayrenewsyourhopes.Ifyougetinrightandyouwatchthescreentooclosely,therewillcomeaminormoveagainstyouthatwillshakeyouout.Thismove,inthelongrun,meansnothing,andasaresult,youwillloseagoodposition.

Secret12:BeskepticalAnotherwaytoputthisisthatitpaystobeacontrarian.Tobesuccessful,youneedtobeastudentofhumannatureanddotheoppositeofthegeneralpublic.Sellonyourfirstcluesofweakness;don’twaituntileveryoneisbailingout.Ifyou’redaytradingtheS&P,thisrulecouldapplytomovesof15minutes.Ifyou’reswingtrading,thisrulecouldapplytoamovelasting3days.Itcertainly

appliestomoveslastingweeksormonths.Andbewaryoftips.Thetip-givermightbewellintentioned,buttipsinvariablyinfluenceyouinthewrongdirection.Rememberthatthemarketdoesn’tbeatyou—youbeatyourself.Followingtipsandnotthemarketisjustanothersignofhumanweakness.

Secret13:BetimecognizantIt’simportanttoknowhowmuchtimeamovehastakentogetwhereitis.Thelongeramarketmovesinonedirection,thegreaterthevelocityofthebuyingorsellinginthefinalstageofthemove.Inmanycases,themostsignificantportionofamajormovetakesplaceinthefinal48hours,andyou’llwanttobethereforthat!Whilewe’reonthesubjectoftime,watchthevolumeafteramarkethasmade

along-termmove.Volumetendstorunhigherthannormalattheendofamovebecausethisisthe“distributionzone,”wherethesmartmoneyisunloadingtheirpositiontoapublicwhoisfrenziedbythenews.Actually,it’simportanttoknowwhat“zone”themarketisin.Marketphases

tendtoactinasimilarmanner.Manytimes,atthebottom,amarketcanrallyonsmallvolume.Thisindicatesthattherereallyisn’tmuchforsaleattheprice.Thebottomcanfollowaperiodofpanickyconditions,pessimism,andapathy.Eventhepriorbullsstarttosoundmorecautious,andsayitcouldgetworsebeforeitgetsbetter.Itseemsnobodyisinterestedinbuying.Thisisthetimetowatchyourmovingaveragesclosely.Iftheyflashabuysignal,thenimmediatelycovershortsandstarttobuy.Topsaretheoppositeofbottoms.Itseemsnobodynoticesthatthemarketissaturated,yetthemarketmightstopgoingup.Afterthefirstbreakfromthetop,manytimestherewillbealow-volume“failuretestofthehigh.”Whenthemarketfailsatalowerhigh,ifyouarenotoutalready,thiscouldbeyourlastbestchancetoliquidate.Asageneralrule,thebigmoneyismadeinthelaststageofabullmarket,

whenpricesarefeverishlyactive.Thebigprofitsontheshortsidearemadeinthelaststageofabearmarket,wheneveryonewantstosell,anditseemsnoonewantstobeabuyer.AsGanntoldus,“Itisalwaysdarkestbeforethedawnandbrightestatnoon

justbeforethesunstartstorecede.”

Secret14:Watchthereactionto“thenews”Remember,it’snotthenewsbuthowthemarketreactstothenewsthat’simportant.Certainlyit’sthenewsthatsetsthepublicperception,butyoumustbe

alertfordivergencesbetweenthenewsandmarketaction.Itallhastodowithexpectationversusreality.Lookforthedivergencebetweenwhat’shappeningandwhatpeoplethinkissupposedtohappen.Whenthebigturncomes,thegeneralpublicwillalwaysbelookingthewrongway.UseGK’sSignificantNewsIndicator(discussedinChapter8,“TheAdvancedTradingCourse”),andbeawareofthefollowingwaystoanalyzereactionstonews(orevenalackofnews):

•Ifbadnewsisannouncedandthemarketstartstoselloffinlargevolume,it’sagoodbetthemarket’sgoinglower.•Ifthemarketdoesn’treactmuchtogoodnews,it’sprobablybeendiscounted.•Movesofimportanceinvariablytendtobeginbeforethereisnewstojustifytheinitialpricemove.Whenthemoveisunderway,theemergingfundamentalsslowlycometolight.Abigrally(decline)on“nonews”isalmostalwaysbullish(bearish).•Itisgenerallynotgoodpracticetobuyafteralotofbullishnewsorsellafteranextremelybearishreportbecausebothgoodandbadnewsareoftenalreadydiscountedinprice.Ofcourse,youshouldalwaysconsiderwhetherthetrendisdownorupwhenthenewsismadeknown.Awell-establishedtrendgenerallycontinues,regardlessofthenews.Considerthis“breakingnews”from2003:“March18:BAGHDAD(AP)—Iraq’sleadershiponTuesdayrejectedtheU.S.ultimatumthatSaddamHusseinandhissonsleaveIraqorfacewar,andtheUnitedNationspulleditsweaponsinspectionstaffoutofthecountryasbattleappearedinevitable.”Today,fewrememberthatonthatday,worldoilpricescollapsedby10%(beforetheIraqwarhadevenstarted)becausethemarkethadalreadydiscountedtheworstoutcome.•Whenunexpectednewsoccurs(newsthatthemarkethasnothadtimetopreparefor),andthemarketopensinawiderange,orgapslowerorhigher,selloutyourlongsorcoveryourshortsandwait.Watchthemarketfor30minutestoanhour.Ifthemarketopenedsharplylowerwithheavysellingandwasnotabletotrademuchlowerthanthat,it’sintosupportandcanbeboughtatthemarketwithatightriskpoint.Watchthemarketcloselyatthispoint.Notethetoneoftherally.Ifit’ssmallandthemarketisabletoagainfallunderthelevelsmadewhenthebadnewscameout(orabovethegood),itissafetoassumethatthemarketisgoinglower(higher).

Secret15:Nevertradewhenyou’resick,worried,ortiredGoodhealthisessentialtosuccess.Ifyoudon’tfeelwell,closeoutyourpositionsandstartoveragainwhenyoudo.Restisequallyessentialtosuccess.Itisagoodideatocloseoutallyourtradesperiodically,getentirelyoutofthemarket,andgoonvacation.Themarketwillstillbetherewhenyoureturn;trustme.I’veheardfromsomeofthemostsuccessfultradersthattheytradetheirbestrightafteravacation.Ifyousticktosomethingtoolongwithoutrest,yourjudgmentbecomeswarped.Traderswhoarecontinuallyinthemarketdayinanddayoutlosetheirperspectiveandultimatelylose.

Secret16:Overtrading:yourgreatestenemyGanncalledovertradingthe“greatestevil.”Hethoughtitwasthecauseofmorelossesthananythingelse,andwhoamItodisagreewithoneofthemasters?Theaveragenovicetraderreallydoesn’thaveaclueabouthowmuchmoneyisneededtobesuccessful,andheinvariablybuys(orshorts)morethanprudencedictates.Hemightberightinhisbasicanalysis,butbecausehetakestoobigaposition,he’sforcedtoliquidatewhenthemarginclerkcalls.Whenhe’sliquidating,soaretheothernovices,andthat’swhenthesmartmoneymovesin.

Secret17:Keepacoolheadduringblow-offsMarketstendtotopoutinthesameway.Whenclosetotheendofamajormove,marketscanturnwild.Volumeishuge,activityisfeverishanderratic,andtheimaginationofmosttradersblossoms.Ifyou’vehadthevisiontoridethetrendtothispoint,yourpaydayhascome;however,inextrememarkets,menandwomenofreasonloseallsenseofproportion.Theystarttobelievethepropagandathattheworldwillliterallyrunoutofthisorthat,butitneverhappens.TheHuntsransilverfrom$5anouncetomorethan$50.Theyfeltitwouldgoupforever,buttheyforgotthatatsomeprice,Grandma’ssilvercandlestickscomeoutofthecupboardandintothesmelter.Therichestmenintheworld(atthattime)lostallsenseofreasonandproportionandlost$2billionintheprocess.Thehistoryoftheworldhasshownthattherehasneverbeenatimewhentherewasagreatdemandforanythingthatasupplyinexcessofdemanddidn’tdevelop.Extrememarketsarenotthetimetopyramid—theysignifythebeginningof

theend.Allgoodthingscometoanend,andyourmissionistojumpbeforethebigbump.Atsomepoint,“theherd”willwanttoexitbythesamedooratthesametime—andyouwanttomakesureyou’vealreadylefttheroom.When

everyonewantstosellandallbuyingsupportdisappears,profitscanrunintolossesfast.Inthestockmarketcrashof1987,profitsmadeinthefirst10monthsoftheyearwerewipedoutin2days,andthiswasrepeatedinthedot-commaniainearly2000andonceagainduringthefinancialcollapseof2008.Howdoyouturnyourpaperprofitsintocashduringarunawaymarket?In

blow-offmarkets,thecorrectionsaregenerallyshortandsweet.Themarketisfeverish,andeveryoneisbullish.(Thebearshavealreadythrowninthetowel.)Thepublicisbuyingmadly.Weeksmightgobywithoutamajorcorrection.You’llhearoffortunesbeingmade,andifyouarefortunateenoughtobeonthemove,yourpaperprofitswillgrowgeometrically.Theendmightbenear,butinfact,nobodycanseetheforestforthetrees.Onlyabout10%ofthosewithbigpaperprofitsevercashinnearthetop.Here’saruleIfollow:Inthistypeofmarket,itdoesnotpaytotakealoss

amountingtomorethantwoconsecutivedays’fluctuations.Ifthemarketgoesagainstyoumorethantwodays,it’slikelytogomore.Plus,bealertforadaywhenthemarketopensoffdramatically,withoutnewstoaccountforthebreak.Itmightrallyweakly,butwhentherallyfails,thisisyoursignoftheend.Themarkethasreachedthesaturationpoint,whereit’srunoutofbuyers;supplyhasfinallyoverwhelmeddemand.Also,watchforafailuretestofthehigh.Manytimes,afterthefirstbreak,themarkethasasecondaryrallythatfailsunderthehigh.Ifyoufailedtogetoutonthefirstbreak,thiscouldbeyourlastgoodchance.

Secret18:NeverletagoodprofitturnintoalossIfyouhaveadecentprofitinanypositionandyouareabsolutelysureitisgoingtogrowlarger,attheveryleast,placeaphysicalstopwhere(intheworstcase)you’llbreakeven.Ifthemarketisanygood,yourstopwon’tbehit.Shouldthemarketcontinuetomovefavorably,keepmovingyourstoptolockinatleastsomeprofit.Theobjectiveisalwaystoprotectyourprincipalineverywaypossible,andwhenyouarefortunateenoughtostartaccumulatingpaperprofits,lockthemin.

Secret19:Whenindoubt,getoutIfthemarketisnotactingrightaccordingtoyourplan,getout!Ifthemarkethasnotstartedtomoveinyourfavorwithinareasonableamountoftime,getout!Yourjudgmentdeterioratesthelongeryouhangontoalosingposition,andatextremes,youwilldothewrongthing.Oneoftheoldtimersoncesaidsomethinglikethis,“Iamprudentenoughnottostandinthemiddleofthe

railroadtrackswhileItrytodecideiftheheadlightIthinkIseeisafreighttrainoranillusion.”

Secret20:SpreadyourrisksbydiversificationDistributeyourriskamongavarietyoftradesandmarkets.Onewaytoachievethisistodivideyourcapitalandneverriskmorethanamaximumof5%onanyonetrade.Onegoodprofitoftentotallyerasesfourorfivesmalllosers.Ontheotherhand,ifyoutakebiglossesandsmallprofits,youhavenochanceofsuccess.Ialsosuggestconcentratingonactive,liquidmarkets—thosethatallowyoutoenterandexitwhenyouwanttowithaminimumofslippage.

Secret21:PyramidthecorrectwayBigmoneyismadebypyramidingagoodpositioninatrendingmarket.Youhaveanexcellentopportunitytouseleveragewithyourunrealizedprofitstocreatealargerpositionthanwouldotherwisebepossible.Pyramidingtakesbothcourageandself-control.The“weakhands”seldommakethebigmoney,primarilybecausetheydonothavethegutstopyramidandmaximizetheopportunitiesthey’rerightabout(ortheydonothavethesmartstodoitright).Thereisarightwaytopyramid,andthere’sawrongwaytopyramid.Themasterssuggestthatyounever“reversepyramid”(thatis,addagreater

numberofcontractsthanyourinitialpositionwhilethemarketmovesyourway).Yourfirstriskshouldbeyourgreatestrisk.Itisgenerallybettertodecreasethesizeofyourpositionthroughouttheride,notincreaseit.Inthisway,youhavetheopportunitytoincreaseyourprofitabilitywithoutdramaticallyincreasingyourrisk.Let’slookatahypotheticalexample.Ifyoustartoutwithapurchaseof10

cocoacontractsat1300,thecorrectwaytoaddtothispositionis5contractsat1350,3at1400,2at1450,and1everyadditional50pointsupindefinitelyuntilthemoveisover.Youwouldfollowthispositionupwithatrailingstoploss.Inthisway,yourlasttradeortwoshowsaloss,butalltheothersshowbigprofits.Thepointhereisthatbypyramidingwiththelargerpositionunderneathforlongsoraboveforshorts,youraveragepriceisalwaysbetterthanthemarket.Whentradingthisway,acorrectionismorelikelytoshowbottom-lineprofitability.Twoadditional(anduseful)pyramidingrules:•Nevertrytopyramidafteralongadvanceordecline.Theoddsareagainstyou.Ididthisinsoybeansduringthefloodsof1993.Istartedtobeabuyer

atjusttherighttimeandclosetothelows,butIgottoobullishatthetop,addedtoomanycontracts,andnevermadeanymoneyoutofthatone.Thetimetobeginapyramidiswhenthetrendfirstturnsupordownafteralongmove.Yourtechnicalindicatorscanhelpyouhere.•Itisalwayssafertopyramidafteramarketmovesoutofaccumulationordistribution—inotherwords,abreakoutfromconsolidation(seethenextsecret).Themoretimethatpassespriortothebreakout,thegreaterthemoveyoucanexpect.

Secret22:WatchforbreakoutsfromconsolidationI’vealreadydiscussedthisindepth,butit’spowerfulandcannotbeoveremphasized.Youneedtoknowwhatkindofmarketyouarein.Inaconsolidatingmarket,youcanmakemoneybyscalpingsmallmovesbackandforth.However,youwon’tmakebigmoneyinthiskindofmarket,andyounevershouldattempttopyramidinthiskindofmarket.Bigprofitsaremadeintherunsbetweenaccumulationanddistribution.I’vefoundthatyoucanmakemoremoneybywaitinguntilacommodityplainlydeclaresitstrendthanbygettinginbeforethemovestarts.Toomanytradersarefixatedonpickingthetoporbottom,andasaresult,theymissthebigpicture.Whatdifferencedoesitmakeifyoubuy10,20,or30ticksoffthelows,aslongasyoumakemoney?Gettheideaofpriceoutofyourheadandconcentrateonmarketaction.Justforgetaboutpickingtopsandbottoms,waitforthebreakout.Thelongertheconsolidation,thebetter.Whenamarkethasremainedina

narrowrangeforalongtime,abreakoutoutofthatrangebecomesmoresignificant.Themarketistellingyouthatamajorshiftinthesupplyanddemandfundamentalsistakingplace.Ifithastakenalongtimetoform,thereismorefuelavailableforthecomingmove,andthisisthebesttypeofmarkettoplaytothehilt!

Secret23:GowiththerelativestrengthI’mnotreferringtotheRSI(relativestrengthindex)here.WhatImeanisthatitisimportantthatyoufollowthetrendofeachmarketandalwaysbuythestrongoneandselltheweakone.Thisisespeciallyimportantforrelatedmarkets.Silverandgoldarebothpreciousmetalsandgenerallymoveinthesamedirection;however,theymoveatdifferentspeeds.Inearly1987,silverstartedtorun,andinashorttime,itranupalmost$6perounce,representingprofitsofcloseto$30,000percontract.Wehadclientswhodidnotwantto“chasethemarket”aftersilvermadeitsfirst$1run-up,buttheyhadnohesitationbuying

gold.Itwas,afterall,“cheap”inrelationtosilverandwouldhavetocatchupeventually,right?Golddidrunup,about$60perounce,or$6,000percontract.Nottoobad,butyouwouldhavemadefivetimesmorebybuyingthestrongoneinsteadoftheweakone.Movesofthisnaturedon’tcomealongveryoften.Ifhogsaregoingupandcattleareheadingdown,youshouldsellthecattleif

yourtrendindicatorstellyoutodoso.Itdoesn’tmatterthatthey’rebothmeatproducts;themarketsaretellingyoufewerpeopleareeatingbeef—atleastnow.WhenIfirststartedinthebusiness,Irememberatimewhenbellies(delistedin2012),whichusuallytradedata10¢to20¢premiumtothehogs,weretradingatthesamepriceashogs.EveryoneatMerrillLynchsaidthiswasaslam-dunk—youjusthadtomakemoneyspreadingbelliesandhogs.(Buythebelliesandsellthehogs.)Thismadeperfectsense.Thelogicwassound:Howcouldafinishedproducteversellforlessthantherawmaterial?Weallpiledonthisone,andyouprobablycanguesswhathappened.Thebelliescontinuedtoheadsouthandthehogsnorthuntilthebelliesweresellingata$5discounttothehogs.Thiswasalossof$2,000perspreadatthetimeina“no-risk”trade(and,ofcourse,weovertradedthisonebecauseit“couldn’tlose”).Thepointisthatyouneedtojudgeamarketbyitsownsigns;alwayssellthe

weakoneandbuythestrongone.

Secret24:LimitmovesareimportantindicatorsofsupportandresistanceWhenamarketisbidlimituporofferedlimitdown(forthosemarketsthatstillhavelimits,suchascattleorcorn),thisisalevelwhereyoucouldbeunabletobuyorsell.Thereismoredemandatthelimit-uppricethanavailablesupplyorviceversa.Themarket“should”continueinthedirectionofthelimitmove.Oncorrections,itshouldfindsupportabovethelimit-upprice(orbelow,ifalimit-downmove).Watchforthis.Ifamarketagaintradesunderthelimitbidpriceorabovethelimitoffered,gowiththeflow.Thesearetradesthatpossessreasonablerisk,becausetheyindicatetheprevioussupportorresistanceisnowabsent.Ifanyonecannowbuyamarketwhereitpreviouslywasunabletobebought(orsellwhereyoupreviouslycouldn’t)thisisamajorsignofweaknessorstrength.Here’soneexamplefrommymemory:Thedaybeforethehighpricewashit

inthebigbullcornmarketof1996,atraderwasunabletobuycorn.Itwasnotonlylimitbid,butthereweremorethan30millionbushelswanted,withnosellersatthelimitprice.Afewdayslater,themarketcrossedunderthelimitbidprice,andanyonecouldbuyasmuchashewanted.Afteritcrossedthatprice,

themarketneversawthelightofday.Itstartedonabeartrend,onethatlastedforsixmonthsanddidn’tenduntilpriceswere$1.50perbushellower.

Secret25:NeveraveragealossWe’llconcludewiththisonebecauseitissocritical.I’vetalkedtostockinvestorswho’vehadgreatsuccessaveragingdown.Whenastocktheylikedgotcheaper,theyboughtmore.Whenthelonger-termtrendturnedbackup,theymadeoutlikebandits.Aleveragedmarketisdifferent,however.Averagingalossmightworkfourtimesoutoffive,butthatfifthtimewillwipeyouout.It’saverybadhabittogetinto.Lookatitthisway:Ifyoumakeatradeanditstartstogoagainstyou,then

you’rewrong—atleasttemporarily.Whybuyorsellmoretoaveragetheloss?Whenit’sgettingworsedaybyday,whypotentiallycompoundtheproblem?Stopthelossearly,beforeitiseternallytoolarge;don’tmakeitworse.Gannthoughtthatifyoucouldavoidthreeweaknesses—overtrading,failing

toplaceastoploss,andwhathecalledthe“fatal”mistake,averagingaloss—thenyouwouldbeasuccess.Excellentadvice.

Index

Aaccumulation,97advantagesofoptions,47-49agriculturalproducts,21agriculturals,78,83-102AIG,126algorithms,117-118effectof,118volatility,119-125

aluminum,31,105analysischarts,129

breakoutsfromconsolidation,137,140-144H&Spatterns,170,175Japanesecandlestick,166P&F,165patterns,144-149,154-155resistance/supportlevels,136-137trendchannels,134-135trendlines,130,134volume,156

Elliotwave,163-164fundamental,76-77OI,156-159options,49

advantages/disadvantages,47changesinprice,55converting,46exercising,55,57hedging,59-61overviewof,45-46,49

prices,51-53quotes,48ratios,69-70rules,71-74selling,57-59stockindexes,61strategies,61-66strikeprice,48styles,48time,50timedecay,50types,47volatility,54

RSI,159-160SNI,177-186spreadsasforecastingtools,167-170stochastic,162technical,76-77,128tradingsuccess

aggression,232averaginglosses,240breakouts,238discipline,233diversification,237doubt,237emotions,236goodhealth,236intuition,231limitmoves,239moneymanagement,232overtrading,236patience,233plans,231-232prices,230profits,237

pyramiding,237-238quotes,233reactiontonews,235regrets,232RSI,239skepticism,234specialization,232time,234trends,229-230

trends,129apex,149Arabicacoffee,100Argentinagrains,84oilseeds,83

askedprice,41.Seealsooffersassociateddailypricelimits,25atthemoney,53Australia,softs,100averageslosses,240moving

alternativestoSMAs,199EMA,200-202lengthoftime,199overviewof,193,195SMA,197WMA,200-202

Bbackgrounding,96backspreads,70,73bailouts,government,126bakeryproducts,85.Seealsograinsbanks,metals,104

Barusch,Bernard,122basisgains/losses,futures,39basisrisk,futures,36-37beans,83.Seealsoagriculturalsbearspreads,110BearStearns,126beef,21.Seealsomeatsbeginningstocks,85bids,41.Seealsopricesbonds,treasury,79boommarkets,11bottompickers,193boxes,146Braziloil,82oilseeds,83softs,100technicalanalysis,128

breakawaygaps,152breakfastcommodities,99breakingabovepsychologicallysignificantnumbers,187breakouts,238breakoutsfromconsolidation,137-144BrentCrudeOil,80,83BrettonWoodsagreement,102brokers,futures,34bubbles,123-124bufferedentryprices,207,209bullspreads,110Bush,GeorgeW.,118bustmarkets,11buyingalgorithms,117-118

effectof,118volatility,119-125

chartanalysis,129breakoutsfromconsolidation,137-144patterns,144-155resistance/supportlevels,136-137trendchannels,134-135trendlines,130,134volume,156

covering,27Elliotwaveanalysis,163-164futures

contracts,22orderplacements,41-43

H&Spatterns,170,175intermarketspreads,111-114intramarketspreads,110-111Japanesecandlestickcharts,166OIanalysis,156-159options,49

advantages/disadvantages,47changesinprice,55converting,46exercising,55-57hedging,59,61overviewof,45-46,49prices,51-53quotes,48ratios,69-70rules,71-74selling,57-59stockindexes,61strategies,61-66strikeprice,48styles,48time,50timedecay,50

types,47volatility,54

P&Fcharts,165pivotindicators,206RSI,159-160stochastic,162technicalanalysis,128trends,129

Ccalendarspreads,66CaliforniaGoldRush,123callsmargins,29options,46-47,49verticalcallspreads,65

Canadagrains,84metals,104oilseeds,84

cancel/replaceorders,42canola,84capital,preserving,221capitulation,124cashsettlements,33cattle,feeder,96.SeealsomeatsCattleonFeedReport,98-99CattleInventoryReport,99centralbanks,metals,104channels,trends,134-135charts,129breakoutsfromconsolidation,137,140-144H&Spatterns,170,175Japanesecandlestick,166P&F,165

patterns,144-149,154-155resistance/supportlevels,136-137trendchannels,134-135trendlines,130,134volume,156

ChicagoBoardofTrade,5ChicagoMercantileExchange.SeeCMEchicken,96.SeealsomeatsChinagrains,84metals,102,104oil,82oilseeds,83softs,100

clearingfees,117closingprices,SMAs,198CME(ChicagoMercantileExchange),48financialfutures,79LiveCattlecontracts,96

cocoa,21,99ICO,101

coffee,21,99-100COMEX,24sellingshort,27

commissions,futures,34commoditiesbreakfast,99continuingeducation,107-109demand,124,126futures.Seefuturesleverage,28-31options,45.Seealsooptionsorderplacement,41-43overviewof,21

commongaps,152

consolidation,146breakoutsfrom,137,140-144,238

consumertastes,meats,98consumption,oil,82contango,167continuationpatterns,146continuingeducation,107,109contractsfutures

basisgains/losses,39basisrisk,36-37brokers/commissions,34deliverymonths,31-33hedgers/speculators,34-36,40longhedges,38-39margins,28-31orderplacement,41-43pricedeterminants,40sellingshort,27shorthedges,37-38

markets,22-26OIanalysis,156-159

contraryopiniontheory,109copper,31,104sellingshort,27trades,24

corn,21,84.Seealsograinsmargins,30prices,98sizeoffuturescontracts,23

Corzine,John,17costsfeeder,98ofoptions,46

cotton,99

coveredoptionwriting,64covering,27crashes,11,123-124cropyields,102crossovers,movingaverages,195crushers,85Cuba,softs,100currencies,financialfutures,78-80cycles,Elliotwaveanalysis,163-164

Ddailypricelimits,25DailySlaughterLevelsreport,99dangerpoints,8dates,prompt,31decay,time,50deliverablestocksofgrain,86deliveryfutures,22,31-33sellingshort,27

demand,commodities,124-126.Seealsosupplyanddemanddeterminants,prices,40developmentofmethodologies,15oftrader’ssense,8

disadvantagesoptions,47selling,49

discipline,7,12tradingsuccess,233

diversification,237pivotindicators,216-217

doubletops/bottomspatterns,144doubt,237downtrends,197.Seealsotrends

Dystant,Ralph,162

Eeconomicactivity,metals,106education,continuing,107-109effectivenessoftechnicalanalysis,128electronictrading,117-118effectof,118volatility,119-125

Elliot,Ralph,163Elliotwaveanalysis,163-164EMA(exponentialmovingaverage),200-202emotions,220,236tradingsuccess,232

endingcarryoverstocks,86energies,78,80-83Enron,118errors,futures,24EuropeanCentralBank,technicalanalysis,128exchangesenergies,83futures,contracts/markets,22-26

exercisingoptions,55-57exhaustiongaps,154exoticorders,43expirationofcontracts,sellingshort,27exponentialmovingaverage.SeeEMAExportInspections,86ExportSales,86exportsgrains,86meats,98

FFannieMae,126

feedprices,98feedercattle,96.Seealsomeatsfeedercosts,98financialfutures,78-80flagpatterns,146flows,money,125fluctuations,24FooledbyRandomness,11forecastingtools,spreads,167-170foreigncurrencies,financialfutures,80formulas,stochastics,162France,metals,102full-sizedfuturescontracts,22fundamentalanalysis,76-77,128charts,129

breakoutsfromconsolidation,137,140-144patterns,144-149,154-155resistance/supportlevels,136-137trendchannels,134-135trendlines,130,134volume,156

trends,129futures,21basisgains/losses,39basisrisk,36-37brokers/commissions,34contracts,22-26

deliverymonths,31-33margins,28-31

deliverymonths,31-33financialfutures,78-80groups

agriculturals,83-102energies,80-83metals,102-107

hedgers/speculators,34-36,40leverage,28-31longhedges,38-39markets,22-26orderplacement,41-43pricedeterminants,40sellingshort,26-28short,selling,26-28shorthedges,37-38

Ggains,basis,39Gann,W.D.,7-8,122,233,240gaps,152-155gasoline,82.SeealsooilGeneralMotors,126generatingbuysignals,206sellsignals,208-209

Germany,metals,102goals,8gold,23.SeealsometalsCaliforniaGoldRush,123

Governmentsbailouts,126policies,grains,86

grades,futurecontracts,23grains,intermarketspreads,111.SeealsoagriculturalsGreatBritain,metals,102GreatDepression,123groupsagriculturalfutures,83-102energyfutures,80-83financialfutures,78-80metalfutures,102-107

HH&S(headandshoulders)patterns,170,175health,9,236hedgingfutures,34-36,40longhedges,38-39options,59-61,74shorthedges,37-38

hesitationavoiding,222tradingsuccess,232

history,resistance/supportlevels,136hogs,97.SeealsomeatsHogsandPigsReport,99humility,222

IICE(InterContinentalExchange),100ICO(InternationalCocoaOrganization),101IMF(InternationalMonetaryFund),102imports,grains,85in-the-moneyavoiding,71options,51

indexesRSI,124,159-160,239stocks,options,61

Indiagrains,84metals,102-104oil,82softs,100

indicators,12analysis,159.Seealsoanalysis

charts,129breakoutsfromconsolidation,137,140-144H&Spatterns,170,175Japanesecandlestick,166P&F,165patterns,144-149,154-155resistance/supportlevels,136-137trendchannels,134-135trendlines,130,134volume,156

movingaveragesalternativestoSMAs,199EMA,200-202lengthoftime,199overviewof,193,195SMA,197WMA,200-202

pivot,205,210-215buysignals,206diversification,216-217sellsignals,208-209

RSI,159.SeealsoRSISIN,235SNI,177-186stochastics,162

inflation,metals,104-106initialmargins,29-31insurance,options,45.SeealsooptionsInterContinentalExchange.SeeICEinterestrates,financialfutures,78-80intermarketspreads,111-112,114InternationalCocoaOrganization.SeeICOInternationalCoffeeOrganization,102InternationalMonetaryFund.SeeIMFintramarketspreads,110-111intrinsicvalue,options,51

intuition,tradingsuccess,231inventorylonghedges,38-39shorthedges,37-38

Iraq,oil,82Italy,metals,102

J–K–LJapancandlestickcharts,166metals,102oil,82softs,100

knowledge,8-9Kuwait,oil,82Lane,George,162lead,31,104-105LehmanBrothers,126lengthoftime,movingaverages,199leverage,28-31limitsmoves,239orders,41variable,26

liquidation,97deliverymonths,33margincalls,29

Livermore,Jesse,8,187,226LME(LondonMetalExchange),31overviewof,104stocks,106

longhedges,futures,38-39longpositions,OIanalysis,156-159losses,7,18-19acceptanceofrisk,12

averaging,240basis,39management,14margins,29

MMackay,Charles,122macrotrends,124Madoff,Bernie,17maintenancemargins,29managementlosses,14money,12,221tradingsuccess,232

manias,123-124margins,28-31initial,29longhedges,38-39maintenance,29profitsrequirements,26

market-if-touched(MIT)orders,43marketsanalysis.Seeanalysiscrashes,123-124fundamentalanalysis,76-77futures

agriculturals,83-102energies,80-83financialfutures,78-80groups,78metals,102-107

orders,41performance

aggression,232

averaginglosses,240breakouts,238discipline,233diversification,237doubt,237emotions,236goodhealth,236intuition,231limitmoves,239moneymanagement,232overtrading,236patience,233plans,231-232prices,230profits,237pyramiding,237-238quotes,233reactiontonews,235regrets,232RSI,239skepticism,234specialization,232time,234trends,229-230

patterns,7predictions,11technicalanalysis,76-77weather,87

measuringgaps,153meats,96-98.SeealsoagriculturalsMemoirsofExtraordinaryPopularDelusionsandtheMadnessofCrowds,122MerrillLynch,33metals,78,102-107methodologies,12developmentof,15

futurescontracts,22naturalnumbers,203updating,122

MFGlobal,17millionBritishthermalunits.SeeMMBtuminifuturescontracts,23minimumfluctuations,24minimummoves,24miningstrikes,106MinneapolisGrainExchange,85MIT(market-if-touched)orders,43MMBtu(millionBritishthermalunits),83moneyflows,125management,12,221tradingsuccess,232

months,delivery(futures),31-33motives,determining,219movements,prices,6moves,minimum,24movingaveragesalternativestoSMAs,199EMA,200-202lengthoftime,199overviewof,193,195SMA,197WMA,200-202

NNASDAQ,financialfutures,79naturalnumbers,203nerve,9Netherlands,metals,102NewCommodityTradingGuide,The:BreakthroughStrategiesforCapturingMarketProfits,117,203-204

NewHavenrailroad,118NewYorkBoardofTrade(NYBOT),116news,SNI,177-186nickel,31,105Nigeria,oil,82Nixon,RichardM.,102normaltimedecay,51NorthernHardSpringWheat,85noticedays,32novicetraders,losses,18-19NYBOT(NewYorkBoardofTrade),116

Ooats,84.Seealsograinsobservations,6OCO(onecancelstheother),43offers,41.Seealsopricesoffsets,22deliverymonths,31

OI(openinterest)analysis,156-159oil,82.Seealsoenergiesoilseeds,83.Seealsoagriculturalsonecancelstheother.SeeOCOOPEC(OrganizationofPetroleumExportingCountries),82openinterest.SeeOIopinions,109optionsadvantages/disadvantages,47buying,49changesinprice,55converting,46exercising,55-57hedging,59-61overviewof,45-46,49prices,51-53

quotes,48ratios,69-70rules,71-74selling,49,57,59stockindexes,61strategies,61-66strikeprice,48styles,48time,50timedecay,50types,47volatility,54

orangejuice,21,99ordersexotic,43limit,41placement,futures,41-34market,41MIT,43stop,42

oscillatorsRSI,159.SeealsoRSIstochastics,162

OTC(over-the-counter)options,48out-of-the-moneyavoiding,71options,51

over-the-counter.SeeOTCovertraders,31overtrading,236

PP&F(pointandfigure)charts,165palladium,103,105palmoil,84panics,5,123-124

papertrades,pivotindicators,205,210-215buysignals,206diversification,216-217sellsignals,208-209

patience,7-8tradingsuccess,233

patternscharts,144-149,154-155

continuation,146doubletops/bottoms,144gaps,152-155roundingtops/bottoms,146triangle,149

markets,7pennantpatterns,146performance,220-228aggression,232averaginglosses,240breakouts,238discipline,233diversification,237doubt,237emotions,236goodhealth,236intuition,231limitmoves,239moneymanagement,232overtrading,236patience,233plans,231-232prices,230profits,237pyramiding,237-238quotes,233reactiontonews,235

regrets,232RSI,239skepticism,234specialization,232time,234trends,229-230

personalgoals,8Peru,metals,104pittraders,117,122pivotindicators,205,210-215buying,206diversification,216-217selling,208-209

placementoforders,futures,41-43planstrading,221tradingsuccess,231-232

platinum,103-104plunge,31pointandfigure.SeeP&FchartsPonzischemes,17pork,21.Seealsomeatspreciousmetals,102.Seealsometalspredictionsmarkets,11OIanalysis,157.Seealsoanalysisspreads,167,169-170

premiums,51-53changesin,55options,46volatility,54

preservingcapital,221pricesbufferedentry,207,209corn,98

currencies,80dailylimits,25determinants,40fluctuations,24futurescontracts,23movements,6OIanalysis,157options,45,51-53.Seealsooptions

changesin,55volatility,54

P&Fcharts,165resistance/supportlevels,136sellingshort,26-28settlement

alternativestoSMAs,199SMAs,197

strikepriceoptions,48tradingsuccess,230triggeredentry,207

productiongrains,85metals,106

profits,237margins,longhedges,38-39strategies,11-15

promptdates,31protein,oilseeds,84.Seealsooilseedsputoptions,46-49verticalputspreads,65

pyramiding,237-238pivotbounce,215

Q–Rqualityoffuturescontracts,23quantities,futurecontracts,22

quotesfuturescontracts,23options,48tradingsuccess,233

ratios,69spreads,70stocks-to-usage,101

reactiontonews,tradingsuccess,235rectanglepatterns,146RelativeStrengthIndex(RSI),124ReminiscencesofaStockOperator,187,226,228requirementsmargins,31markets,26

resistance,239levels,136

rest,healthand,9revengetrading,221reverseratiospreads,70rewards,risk,31rice,21righttoexercise(options),46risk,7acceptanceof,12basis,futures,36-37diversification,237lossstrategies,14options,46,49rewards,31spreads,110.Seealsospreads

Rockefeller,JohnD.,227roundingtops/bottomspatterns,146RSI(RelativeStrengthIndex),124,159-160,239rules,13breakoutsfromconsolidation,trading,143-144

dailypricelimits,25gaps,trading,155H&Spatterns,trading,175OI,trading,158-159options,71-74SMAs,198SNI,trading,177,180

Russiagrains,84metals,102-103oil,82

SS&P500Index,financialfutures,79SaudiArabia,oil,82screensquotes,233trading,121

seasonality,87,97sellingalgorithms,117-118

effectof,118volatility,119-125

chartanalysis,129breakoutsfromconsolidation,137,140-144patterns,144-149,154-155resistance/supportlevels,136-137trendchannels,134-135trendlines,130,134volume,156

Elliotwaveanalysis,163-164futurescontracts,22H&Spatterns,170,175intermarketspreads,111-114intramarketspreads,110-111

Japanesecandlestickcharts,166OIanalysis,156-159options,49,57,59

advantages/disadvantages,47-49changesinprices,55converting,46exercising,55-57hedging,59-61overviewof,45-46,49prices,51-53quotes,48ratios,69-70rules,71-74stockindexes,61strategies,61-66strikeprice,48styles,48time,50timedecay,50types,47volatility,54

P&Fcharts,165pivotindicators,208-209RSI,159-160short,26-28stochastics,162technicalanalysis,effectivenessof,128trends,129

sessions,variablelimits,26settlementpricesalternativestoSMAs,199SMAs,197

settlements,cash,33setupbars,206,208SF(smoothingfactor),200

short,selling,26-28deliverymonths,33

shorthedges,futures,37-38shortpositions,5-6OIanalysis,156-159

signalsbuy,206sell,208-209

significantnewsindicator.SeeSNIsilver,23.Seealsometalssimplemovingaverage.SeeSMASIN,235sizeoffuturescontracts,23skepticism,tradingsuccess,234skills,7healthandrest,9knowledge,8-9motives,determining,219nerve,9patience,8success

aggression,232averaginglosses,240breakouts,238discipline,233diversification,237doubt,237emotions,236goodhealth,236intuition,231limitmoves,239moneymanagement,232overtrading,236patience,233plans,231-232

prices,230profits,237pyramiding,237-238quotes,233reactiontonews,235regrets,232RSI,239skepticism,234specialization,232time,234trends,229-230

slippage,32SMA(simplemovingaverage),197alternativesto,199buysignals,206sellsignals,208-209

smoothingfactor(SF),200SNI(significantnewsindicator),177-186SoftRedWheat,84softs,99.SeealsoagriculturalsSoros,George,80,125SouthAfrica,metals,103soybeans,21.Seealsoagriculturalsspecialization,tradingsuccess,232specifications,futurescontracts,36-37speculators,futures,34-36,40speedacceleration,121methodologies,updating,122

spreads,110asforecastingtools,167-170calendar,66intermarket,111-112,114intramarket,110-111options,65

ratios,70vertical

calls,65puts,65

SpringWheatcontracts,85statistics,fundamental,76stochastics,162stocksbeginning,85endingcarryover,86indexes

financialfutures,78-80options,61

LME,106stocks-to-usageratios,101stoporders,42straddles,73.Seealsospreadsbuying,66-67selling,67

strangles,73buying,68selling,68

strategies,7futures,21

basisgains/losses,39basisrisk,36-37brokers/commissions,34deliverymonths,31-33hedgers/speculators,34-36,40leverage,28-31longhedges,38-39markets,22-26orderplacement,41-43pricedeterminants,40sellingshort,26-28

shorthedges,37-38options,61,63-66success,11-15trading

plans,221success,231-232

strikeprices,options,48strikes,mining,106stylesofoptions,48substitutioneffect,98successskillsfor

healthandrest,9knowledge,8-9nerve,9patience,8

strategies,11-15trading,220-228

aggression,232averaginglosses,240breakouts,238discipline,233diversification,237doubt,237emotions,236goodhealth,236intuition,231limitmoves,239moneymanagement,232overtrading,236patience,233plans,231-232prices,230profits,237pyramiding,237-238

quotes,233reactiontonews,235regrets,232RSI,239skepticism,234specialization,232time,234trends,229-230

sugar,21,99-100supplyanddemandfundamentalanalysis,76-77grains,85resistance/supplylevels,136

support,239levels,136

switches,110.SeealsospreadsSwitzerland,metals,102

TTaleb,Nassim,11technicalanalysis,76-77effectivenessof,128

TechnicalAnalysisofStockTrends,131,170Thailand,softs,100theoriescontraryopinion,109Elliotwaveanalysis,163-164

timealgorithms,effectonvolatility,120decay,options,50methodologies,updating,122movingaverages,199options,50tradingsuccess,234value,51

tin,31,105TOCOM(TokyoCommodityExchange),103toolscharts,129

breakoutsfromconsolidation,137,140-144patterns,144-149,154-155resistance/supportlevels,136-137trendchannels,134-135trendlines,130,134volume,156

Elliotwaveanalysis,163-164forecasting,spreadsas,167-170H&Spatterns,170,175Japanesecandlestickcharts,166movingaverages

alternativestoSMAs,199EMA,200-202lengthoftime,199overviewof,193-195SMA,197WMA,200-202

OIanalysis,156-159P&Fcharts,165RSI,159-160stochastics,162technicalanalysis,effectivenessof,128trends,129

totaldemand,grains,86totalsupply,grains,85trader’ssense,8traders,losses,18-19tradingalgorithms,117-118

effectof,118volatility,119-125

chartanalysis,129breakoutsfromconsolidation,137,140-144patterns,144-149,154-155resistance/supportlevels,136-137trendchannels,134-135trendlines,130,134volume,156

copper,24currencies,80Elliotwaveanalysis,163-164fundamentalanalysis,76-77futures,21

basisgains/losses,39basisrisk,36-37brokers/commissions,34deliverymonths,31-33hedgers/speculators,34-36,40leverage,28-31longhedges,38-39markets,22-26orderplacement,41-43pricedeterminants,40sellingshort,26-28shorthedges,37-38

H&Spatterns,170,175Japanesecandlestickcharts,166losses,7OIanalysis,156-159options,49,71-74P&Fcharts,165pivotindicators,205-215

buysignals,206diversification,216-217sellsignals,208-209

plans,221

revenge,221RSI,159-160stochastics,162success,220-228

aggression,232averaginglosses,240breakouts,238discipline,233diversification,237doubt,237emotions,236goodhealth,236intuition,231limitmoves,239moneymanagement,232overtrading,236patience,233plans,231-232prices,230profits,237pyramiding,237-238quotes,233reactiontonews,235regrets,232RSI,239skepticism,234specialization,232time,234trends,229-230

technicalanalysis,76-77,128trends,129variablelimits,26

tradingdiscipline,12trailingstops,42treasurybonds,futures,79

trendlines,130,134trends,118,129channels,134-135Elliotwaveanalysis,163-164followers,193macro,124movingaverages,195OIanalysis,157tradingsuccess,229-230

trianglepatterns,149triggeredentryprices,207,209triplewitchinghour,46troyounces,23trust,117typesofmargins,29ofoptions,47ofspreads,110

U–VU.S.Bank,17Ukraine,grains,84UnitedStatesgrains,84meats,96metals,102oil,82oilseeds,83softs,100

units,futurescontracts,23updatingmethodologies,122

valuesfluctuations,24longhedges,38-39

shorthedges,37-38technicalanalysis,128time,51

variablelimits,26vegetableoil,84verticalcallspreads,65verticalputspreads,65VoicefromtheTomb,88-92volatilityalgorithms,119-125options,54riskrewards,31

volume,156

W–X–Y–Zwars,effectonmetalsmarkets,106Wasendorf,Russell,Sr.,17weathergrains,86meats,98

weightedmovingaverage.SeeWMAwheat,21.Seealsograinswhipsaws,202WhiteWheat,85Wilder,Welles,159WMA(weightedmovingaverage),200-202writing,options,57-59coveredoptionwriting,64rations,69

WTI(WestTexasIntermediate)CrudeOilcontract,81

yields,crops,102

zinc,31,104-105

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