Chapter 4-1 The Do’s and Don’ts
To be successful in futures trading, detachment and objectivity are two crucial attributes. As a futures trader, you must be faithless and irreverent. You do not worship silver and gold nor regard lead as base or sugar as sweet. You have passionate conviction in no market and believe in no “sure thing.” You have no predilection for either the long or the short side of a market. And any market view that you may assume today is based on a tentative estimate of likelihood, subject to change tomorrow or on the very next “tick” in the market price.
Our second set of decision rules is concerned with the problem of detecting potentially profitable situations and deciding when to initiate and close out positions. As futures market analysts and price forecasters, we must discover which markets are interesting, where they may be heading, and when.
The ultimate decision to buy or sell is a complex amalgam of fundamental and technical factors:
- Fundamental analysis: oriented, above all, to determining when a market is undervalued or overvalued, based on economic factors related to supply and demand.
- Technical analysis: geared to seeking clues-in the action of the market itself-to its probable future course and to the likely extent of a projected price move. It is a most important tool in recognizing key turning points (reversals) in price trends.
Sound fundamental analysis is a key to profitable position taking, although positions initiated on the basis of fundamental analysis should be undertaken with one eye on the technical picture. For example, if copper appears fundamentally strong, one should carefully watch the technical situation within that market for a chart buy signal. It is most important that the many tools of fundamental and technical analysis be combined into a practical, reliable trading technique.
Acknowledging the importance of fundamental analysis, major technical indicators that run counter to fundamentally oriented conclusions should be seriously heeded. Experience has shown that significant fundamental market changes frequently remain obscure until after the market price has already discounted the change. Stubbornly maintaining a position based on a fundamental analysis, in the face of adverse technical indicators (and an adverse price trend), constitutes a quick method of running up substantial trading losses. In short, do not ignore the technical action of the market, no matter how fundamentally oriented a trader you may be. Whenever possible, it is helpful to buy or sell in line with an observable seasonal pattern. For example, if soybean meal prices have advanced during the fall and early winter for eight of the past ten years, and if there is reason to believe this pattern may be repeated, then one has a supporting argument for purchases indicated by technical analysis. It is suggested, however, that the “seasonal” itself not be viewed as a completely independent basis for trading.
Whenever forward contracts trade at substantial premiums over nearbys, then such premiums may appear to offer an extra incentive to sell. Whenever forward contracts are at sizable discounts under nearbys, then such discounts may appear to constitute an extra incentive to initiate purchases. However, premiums or discounts are not in themselves
sufficient justification for trading. The logic of purchase or sale must be justified on additional grounds, particularly on technical considerations.
Remember that support and resistance levels are often useful guides to buying and selling points. Support may exist at a particular price level either for technical reasons (i.e., because a heavy volume of trading occurred at a particular level at some significant time in the past), or for fundamental reasons (i.e., a prescribed government support or sales level). In the same way, resistance may be anticipated at a particular price level for fundamental or technical reasons. Let us now relate technical analysis to trading technique in specific terms. In so doing, we shall divide the approach to technical analysis into two significant areas: identification and tactics.
- Identify both the major and the minor price trends.
- Identify the major and minor support and resistance levels,
- Identify the trend channel, if there is one.
- Identify both the short, and the long-term, price objectives based on the following:
- support and resistance levels
- pattern count or conventional and Fibonacci chart projections
- 40-50 percent retracement and other chart patterns
- long-term (continuation) chart analysis
- Do not initiate or hold a position that is counter to both the major and the minor trends. There are no exceptions. The violation of this elementary maxim probably constitutes the largest cause of speculative trading losses.
- Limit the risk on every position. Do not permit a good profit (50 percent of margin requirements) to turn into a loss; liquidate the position just ahead of the break-even point. If you have closed out prematurely, you can always reenter the market.
- On profitable positions, liquidate 40-60 percent of the position at the indicated price objective, and protect the balance of the position with stops (either chart or “money” stops).
- Have all orders scaled and entered in advance.
- Do not initiate or liquidate a position because of impatience or boredom.
- As the equity in an account increases, do not commensurately increase the size of the position. Diversify into other markets and take advantage of other trading techniques (i.e. spreads or options).
- A major problem in trading involves the correct timing of trades. The solution lies in being more accurate in initiating positions so that your percentage of correctly timed trades is greater.
- Seek to establish positions that are in the direction of both the major and the minor trends. If the major trend is sideways and the major price objective has been substantially attained, trade with the minor trend. (In a major sideways trend, initiate a position on a minor trend signal, with close stop protection.)
- The major trend invariably persists longer than anticipated. If you miss the first reversal from a major trend, you will often get a second chance to catch the new trend (particularly in an upside breakout from a major bottom area). Do not chase a market.
- A market will rarely penetrate an important overhead resistance level on the first attempt. Even if it does go through, it may pull back at least to the breakout point. Seek to sell on this rally if the other technical indicators support the sale.
- In a major downtrend, sell on a minor rally into overhead resistance, or on a 40-50 percent retracement of the last down-leg. In a major uptrend, buy on a minor reaction into support, or on a 40-50 percent retracement of the last up-leg.
- The minor trend rarely lasts more than seven trading days. Seek to buy bullish flag patterns in a major uptrend and to sell bearish flag patterns in a major downtrend, especially if the flag is five or more days old. Be especially cautious if buying an up-flag in an uptrend, especially if near the top of the uptrend channel and/or near the major upside objective-seek to unload some longs on this type of rally.
- A major move frequently runs three “legs” (Elliott Wave Theory). Start looking for a major top formation on the third major up-leg of a bull trend; look for a major bottom; formation on the third major down-leg of a bear trend.
- Important crop and statistical reports will usually be supportive of the existing major price trend (an important report is likely to continue the major market trend rather than reverse it). Accordingly, when trading with the minor trend, against the major trend, lighten up or go fiat before such a report.
- As a general proposition, avoid averaging a position when previous trades are held at losses, except if the other technical indicators strongly support the added position, and efficient stop-loss protection is maintained for the entire position.
In connection with the above trading identification and tactics approach, it may be useful to introduce. Although this trading form obviously cannot ensure successful trading results, it can materially assist the trader in objectively viewing and analyzing the technical condition of a market and in timing his trades. When used in conjunction with sound trading principles it should substantially improve overall trading results.
The “Don’ts” of Trading
Thus far, our counsel has stressed the “dos” of commodity trading. It may be prudent, in parting, to emphasize the “don’ts,” even at the risk of some redundancy.
- Above all, do not allow your losses to run, in the hope that tomorrow you will be right. There should be no tomorrow beyond your pre-assigned risk limit.
- Do not hide losses by spreading. If the position has soured, the prudent tactic is to get out. Enter spreads on their own merits only.
- Do not trade without a plan, which should encompass profit objectives as well as loss limits.
- Do not neglect either the fundamental or the technical side of the market.
- Do not overlook those seasonal patterns that have had a high frequency of success in recent years.
- Do not allow a few successful trades to build overconfidence and undermine meticulous care with respect to profit/loss ratios and likelihood estimates.
- Do not solicit or accept “tips” from brokers or other traders. Be ready to learn from all qualified sources, however, including a broker with solid research material.
- Do not permit widely held bullishness or bearishness to dominate your view. Give credence to the contrary opinion doctrine, which says: “Watch out when the overwhelming majority sees things one way.”
- Do not maintain a position when the trend of the market has reversed adversely.
As futures traders, one commitment is central. That commitment is to a rational strategy is one whose key objective is to limit one’s losses in some predetermined manner and, with equal foresight and decisiveness, to allow profits to run. This involves the necessity of preventing a good profit from turning into a loss. Success in futures trading is not easy, but it is perhaps more attainable for those who have maximally absorbed, and will practice, the tactics and techniques surveyed herein.