Chapter 3-5 Commodity Trading Techniques
In our excursion into the mysterious and sometimes misunderstood economic realm of futures trading, we have sought to provide practical guidelines for those who venture to trade in this often traumatic area. It seems useful and appropriate, as we approach the final lap of our journey, to discuss those decision rules that may help a trader join the winning minority.
Trading rules are essentially of two kinds:
- Budget concepts, designed to carefully control one’s risk taking and properly guard one’s capital.
- Trading concepts, designed to determine what position to take, in which markets, and when.
“Budget”, in the sense used here, concerns the basic problem of allocating and protecting capital. How much available capital should be earmarked for futures trading in general and what portion to each specific market? How can one prevent spilling too much down the seemingly bottomless hole of persistent error? How to be sure of maximizing those favorable returns that come our way?
In this area of capital planning and management, there are certain principal elements to keep in mind:
- One’s capital should be properly divided among uses that vary in degree of likely risk and rewards. A complete strategy of personal finance necessarily involves a choice, or rather, a weighted participation in real estate, bonds, stocks, commodities, art, and other assets. As a prospective trader, you ought to determine in advance what portion of your capital you are prepared to allocate to the “high-risk money game” of futures trading. This portion should be low enough to preclude your emotional or material ruin even if the pre-assigned capital is entirely depleted. The ultimate means of limiting losses-if your capital is infringed by a previously stipulated amount–is to merely stop trading. Or, as one old-time sage remarked, “When a market position becomes too large, sell down to a sleeping level.”
- It is suggested that the capital you have allocated to futures trading be divided into two portions, one for actual trading, comprising not more than 50 to 60 percent of the total trading capital, and the balance to be held in reserve. The portion devoted to trading should be diversified into at least six different markets, to help ensure a relatively broad mix of investments.
For each commodity trade you are considering, there are two sets of odds that should be considered ahead of time:
- The apparent profit/loss ratio-that is, the ratio of gain you are targeting relative to the loss-limit you plan to enforce.
- The likelihood of success-your estimate of the odds that the market will attain your profit objective before it reaches your loss limit.
It is sensible to favor those trading possibilities in which both odds seem exceptionally high. As a rule of thumb, consider only those trades in which you envision a profit at least three times greater than your loss limit, and also in which your estimate of the potential for success is markedly greater than 50:50. The higher your “confidence index” based on value analysis and technical measurements of potential, the more you can logically risk.
The moment you initiate a trade, decide as fully as possible what your course of action will be if the market does or does not conform to your expectations. Your plan should include a predetermined point at which you will stop your losses by liquidating an adverse position. You should also predetermine an acceptable target price at which to accept partial profits, or to protect those paper profits against a market reversal. This price objective is, of course, subject to continuous review and revision.
- Your objective in employing speculative capital is to achieve a higher annual rate of return on this capital than on lower-risk investments. Accordingly, you must be concerned not only with profit objectives but also with anticipated “time rates of gain” that is, the speed with which a return on capital is realized. This brings up the need to concentrate on markets in which action seems somewhat imminent. It also argues in favor of closely watching those technical indicators which might suggest when a move is starting.
- For the same reason (and exclusive of tax considerations), you should be willing to accept a more modest profit in a few days or weeks than might be considered satisfactory in six months or a year. In short, the time factor should be considered in determining each trade and deciding on price targets.
- Keep value in mind as an important, although not exclusive, consideration. There is an imperfect tendency, in the very long run, for a market to reflect cost of production or some other refined measure of inherent worth. Remember, however, that in the brief time it takes for your highly leveraged commodity position to achieve a substantial profit or loss, a commodity may trade far above, or below, its true value.
Accordingly, any impulse to buy scale-down “below value” or to sell scale-up, when the price is “too high,” must be carefully controlled within the framework of budget principles for conserving capital.
A tactic that can be employed advantageously when a market has begun to seem fundamentally attractive is to divide the assigned capital in each particular market into three portions. Buy the first increment when there is reason to believe that the price is untenably low, if possible, near an indicated floor, or support level. Buy the second unit when acceptable technical indicators have signaled a trend reversal from down to up. And, finally, buy the third unit when profits have begun to be manifest on all previously purchased contracts. (Of course, the same logic-and a corresponding one-two-three selling program-may be appropriate when a market appears overpriced and near some definable upper limit, and when the technical analysis agrees with the fundamental conclusion.) On occasions, a bullish or bearish spread looms as an attractive alternative to an outright long or short position. In general, a spread is preferred when it seems likely to reduce the risk inherent in an outright net position without comparably reducing the profit potential of that position.