.Trader #3 buys one contract.Trader #4 sells one contract.Tally:Open interest  2Volume  2Two contracts were traded and two were held overnight.Trader #5 buys one contract.Trader #1 sells one contract to offset existing position.Tally:Open interest  2Volume  1Open interest stays same as previous day at 2, while one contractwas transferred, making volume 1.Trader #6 buys one contract.Trader #7 sells one contract.Trader #2 buys one contract to offset.Trader #3 sells one contract to offset.Trader #5 sells one contract to offset.Trader #4 buys one contract to offset.Tally:Open interest  1Volume  3Three contracts changed hands, but only one was held overnight.
Understanding how volume and open interest work togetherprovides insight into how to trade in your ancillary account. Yourancillary account is traded exactly the same as your primary scale
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trading account with one exception. You reserve the right in yourancillary account to liquidate positions before the limit price of thescale is reached. In your primary account, you would normally waitfor the market to take you out of all trades. The ancillary account isproactive. If you are in an oscillating trade in your ancillary accountthat calls for a 5-cent profit and you see it won’t be accomplished, youcan close that position at any profit or at breakeven. In your primaryaccount, you would hold the position until the profit objective wasreached. The following interpretations of volume and open interestshould assist you in proactively trading your ancillary account.Open Interest
Volume
Price
UpDown
UpDown
UpDown
Up
Down
Up
Up
Down
Down
Up
Up
Down
Down
Down
Up
InterpretationExtremely bullish. Prices will go higher.Slightly bullish. Weak conviction, priceslower.Mildly bullish. Strong conviction, weakvolume and prices.Mildly bearish. Strong conviction, butlow volume.Extremely bearish. Strong conviction,weak market.Slightly bearish. Weak conviction, weakmarket.
Knowing how strong the conviction of traders is, based ontheir taking positions home overnight, gives a great insight intohow long to hold positions in an ancillary account. Remember, thetraders can be holding long or short. If you are in a position and themarket tells you it is weak, you should bail out of it. This is especially true if you do not have options protection in place.A government report I strongly recommend you study eachweek is the Commitments of Traders Report. It is made availableby the Commodity Futures Trading Commission (CFTC) onFridays at 3:30 P.M. EST (www.cftc.gov). The Commitments ofTraders (COT) Report provides a breakdown of each Tuesday’sopen interest for all markets with 20 or more traders holding positions equal to or larger than reporting levels established by theCFTC. Reportable levels are usually in the neighborhood of 100contracts on the same side (long or short) of the market (see Table10-1). In other words, these are very large positions. A second
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10-1
CFTC Reporting Positions Levels—Selected CommoditiesWheatCornSoybeansBean OilCottonCocoaCoffeeCopperGoldSilverCrude Oil, SweetHeating OilGasolineNatural Gas
500,000 bu750,000 bu500,000 bu175 Contracts5000 Bales100 Contracts50 Contracts100 Contracts200 Contracts150 Contracts300 Contracts250 Contracts150 Contracts100 Contracts
Reporting firms (clearing, FCMs, etc.) file daily reports with the CFTCshowing the positions of traders holding positions greater than thereporting levels. The aggregate of all reportable positions usually represents 70 or 90 percent of the total open interest in any given market.Scale traders must stay aware of the positions of commercial and largetraders to maintain a feel for the balance between supply and demand.
report that includes options contracts, Commitments of Traders inOptions and Futures, is available every other Monday at 3:30 P.M.EST. This second report is of interest to traders but is not as important to scale traders.The importance of the COT is that it tells you the positions ofthe traders with strong hands. Earlier, I mentioned speculators asbeing traders with weak hands. These are traders, usually individuals, who hold positions for short periods of time. They changetheir opinions often and easily reverse the direction they are trading, or they are quick to liquidate their holdings. They normally donot have the inclination or the financial wherewithal to holdfutures contracts long term.Strong hands are entities, mostly corporations, with deeppockets. They are often true hedgers (owning both the underlyingentity and futures contracts). Additionally, they have a real need forthe entity. Major users of the underlying entities (commodities)—
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manufacturers of silver tableware, gasoline, cereal, candy, etc.—musthave a certain amount of control over the price and delivery of thecommodities essential to their businesses, which they get throughthe use of futures contracts. These institutions cannot risk not havingthe commodity or having the price get out of control. Due to theirfinancial strength and the fact that they have a real need for the commodities, these corporations are considered to have strong hands.They will hold onto futures positions longer than just about anyindividual speculator. The Hunt family may be the exception; at leastit was for a while.The COT is available in a long and a short form. The shortform shows open interest by reportable and nonreportable positions. Nonreportable positions are determined by subtracting thereportable positions from the total of all positions. The COT showsthe numbers of contracts, long, short, or spread (accounts withequal number of contracts long and short) by noncommercial, commercial, nonreportable, and total positions. You also see changesfrom previous reports, percentage of open interest for each category,and the number of traders in each group.By studying the changes in the COT, you can obtain an excellent insight into when the light will switch on at the end of thesupply-demand tunnel. When a bottom begins to develop, youwill see the number of large traders increase on the long side of themarket. You will pay particular attention to the commercial categories because these are the ones who have a real use for the commodity. They are also the ones with the best fundamentalinformation. If they are going long and staying long, you can sleeppeacefully knowing that a bottom is near.You will also want to refer to the COT when you think thecommodity you are scaling is approaching a red zone. The changesin percentage of commercials taking positions home, meaningopen interest, will rise. That’s a reliable clue that price congestionand oscillating profits are in the offing.One last technical tool you need to keep in mind when you areattempting to anticipate red zones is the seasonal price trends ofcommodity prices. They are most obvious in agricultural commodities because they are expendable and must be reproduced. Atharvest, supply is high. As the crop year progresses, supplies disappear. Prices hit lows when supplies are abundant, and highs
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occur whenever there is fear of shortages. Take soybeans as anexample. Seventy percent of all seasonal tops occur between Apriland July, whereas 80 percent of bean bottoms occur betweenAugust and November.Most of the other physical commodities also have reliable seasonal patterns. Demand for gasoline is highest in summer, lowestin winter. Heating oil is just the opposite. Silver and copperdemand increases with housing starts in the spring. My point issimply to study the seasonal price charts that are available whenyou are searching possible red zone occurrences.There are dozens and dozens of other technical analytic tools,such as cycles, Gann numbers, Elliot Wave Theory, Williams’s %R,and Wilders’s RSI. I strongly recommend you keep your analysis assimple as scale trading is. It is the combination of simplicity anddiscipline that wins, not cute sleight-of-hand analysis!
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Getting Ready toScale Trade
T
he very first step you must take before opening a scale tradingaccount is evaluating yourself from a psychological point of view:Are you the type of person who can be a successful scale trader?Most scale traders come from the ranks of stock traders. Thinkabout what type of stock jockey you are. I classify serious tradersinto four categories:Day traders—High volume (50–100 trades a day), highturnover (hold trades for minutes or hours, neverovernight). These are typical alpha males. Little research,mostly instincts.• Swing traders—Medium volume (5–20 trades a day),frequent turnover (hold positions one to four days, neverover weekends). Very aggressive. Some research, but notin-depth. Like set plays such as earnings, splits, etc.• Intermediate-term traders—Aggressive, but thoughtful.Research-oriented, but still traders. Like to plan and holdpositions from a few weeks to several months. Strongconvictions, but able to revise trading plan when necessary.Trade leap options. Have patience to wait for play todevelop and mature.• Long-term investors—Passive/aggressive. Strongresearchers. Work as hard on composition of portfolio ason individual issues held. Hold for one to five years, oreven longer, but evaluate portfolio and individual stocksregularly.•
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I am dismissing out-of-hand both the casual trader whoplays tips and the investor who buries money in mutual funds, anIRA, or a 401K. The key word is serious trader, not an investor orsomeone who lacks a passion for trading and is not an active participant.The serious stock trader who would be best suited for scale trading is the intermediate-term trader. Scale traders must enjoy doingresearch. They must be patient and have strong convictions once theyhave committed to a scale. If you think you would panic facing oneor a series of limit-down days, scale trading is not for you.If you expect to generate 100 or 200 percent per year, as youmight have during the heyday of the tech stocks and dot coms, youwill be disappointed. You should have expectations of banking 40or 50 percent or something in that vicinity on an annual basis. Inreturn, you will have the confidence of knowing that if you havedone your research, the commodity you invested in will make a bottom and recover from the low with gusto. You must believe with allyour heart that what goes down must come up. More important,you must often be willing to patiently wait for that to happen.There will be times when you are in a scale and it seems thatnothing less than a worldwide disaster will bring your scale backinto the black. Although this happens rarely, it is something youmust psychologically prepare for if you choose to become a seriousscale trader. You’ll feel like those of us who traded the DJIA back inthe 1970s, waiting for it to close above 1000 on November 14, 1972.It was a long, painful wait, but well worth it.One of the skills you will need to manage the downside ofscale trading is sound money management. Adjust your trading tomatch your pocketbook. If your funds are limited, start trading theMidAm mini contracts. Enter scales a little late, and only trade oneswhere the light at the end of the supply-demand tunnel is alreadybeginning to glow. Be sure to have a sound financial structurebeneath you before even considering scale trading.On the other hand, it costs nothing but time to prepare to scaletrade by building your commodity sector binders or files. Get somelong-term charts. Draw lines indicating the high, the low, the lowerone-third and one-fourth of the 10-year trading range and the 15year average turning point. Then create some scales and start papertrading. Pick a commodity that is already below the 25 percent lowmark and plug in trades. Get access to daily commodity price
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charts and take oscillating profits when they occur. You can alsolook back on historical charts for red zones to see if you wouldhave already earned a few oscillating profits and where new redzones may be expected.My point is to get a feel for what it is like to scale trade. Doyou like it? Are you willing to do the research it takes to makegood scale selections? Try the chat room that specializes in scaletrading—is it interesting to you?Surf the Web using www.google.com. Search for “scale trading,” and browse through the hundreds of sites available. Do youfit into this world? Do you want to learn how to generate a decentreturn on your money with a modicum of risk? Will you be satisfied with the excitement level? It is a lot like combat—periods ofendless boredom followed by short periods of adrenaline rushes.As you paper trade, start collecting information. Do you knowyour rights and responsibilities as a commodity trader? How dothey differ from trading stocks (see Figure 11-1)? What are youroptions as far as trading is concerned? How do the new electronictrading systems fit into the scale trading picture? Once you get afeel for scale trading, write a rough draft of a trading plan.One of the biggest issues you may have to become accustomed to is leverage. Regulation T governs borrowings in the stockmarket. “T” stands for Treasury, meaning the Federal Reserve. Itsets the level traders and investors can borrow from their broker.Currently it is at 50 percent, but the Fed has the authority fromCongress to change that at any time.In the futures market, the leverage is much higher. It dependson the price of the commodity, rather than a set percentage. A margin committee at the clearing firms and at each exchange sets margins. If the maintenance margin for corn is set at $500 per contractand corn is at $3.00 per bushel, the percentage is 31⁄3 percent($500/5000 bu x $3). At $2.00 per bushel, it is 5 percent, or 20:1. Thisis the beauty and risk of commodity trading in a nutshell. Higherleverage means greater profits when you are right and greaterlosses when you are wrong. You must be comfortable with thisaxiom to open a commodity trading account.Once you decide to begin scale trading, you still have todecide whether you will open an individual trading account or oneof the several types of managed accounts that are available. Let’sbegin by quickly reviewing the paperwork you will be asked to
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11-1
Broker/Dealer(Net Capital $5,000 to $100,000 Minimum)
Registered Representative or Stock Broker
Introducing Broker(Net Capital $25,000 Minimum)
Associated Person or Commodity Broker
Broker/Dealer(Net Capital $250,000 Minimum)
Floor Brokers
Funds
Specialists
Clearinghouses
Custody of Customer
Clearing Agencies
Futures Exchanges
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Futures Commission Merchant
Securities Exchanges
National Futures Association (1982)
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(Net Capital $250,000 Minimum)
Securities and Exchange Commission (1933)National Association of Securities Dealers (1939)
Commodity Futures Trading Commission Act (1975)
The Securities Act (1933)The Securities Exchange Act (1934)
The Commodity Exchange Act (1922)
Securities
The Commodity Futures Trading Commission Act (1974)
Futures
Futures versus Securities
FIGURE
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complete. As you are paper trading, contact a few brokerage firmsand have them send you their new account package for review.Look for the areas I mention in the following list so you will havea thorough understanding of your rights and obligations and arecomfortable with them.The most important of these documents included in a basic setof commodity account papers are the following:1. Acknowledgment of Receipt of Risk Disclosure Statement. Bysigning this, you acknowledge that you understandeverything that could possibility go wrong in yourtrading account and that you accept these risks. Keyamong the risks are that you could lose more than youroriginal investment; at times, market conditions may besuch that you cannot liquidate a losing trade (limit-up orlimit-down days), placing protective stop loss orders willnot necessarily control losses, spreads may not be lessrisky than straight long or short positions; and the highdegree of leverage in this investment can work againstyou, as well as for you.2. Disclosure Statement for Non-Cash Margin. Cash in youraccount is held in a segregated account, which would bereturned to you in the unlikely event of a bankruptcy ofthe brokerage firm. But with noncash margin, commonlyheld in T-bills in street name, you would receive only aprorated share after a bankruptcy. The bankruptcy courtwould recognize you as a general creditor for the amountyou hold in noncash margin. On the brighter side, nocustomer has ever lost money to date because of thebankruptcy of a futures brokerage firm.3. Futures Account Client Agreement. This details your rightsand responsibilities as a client. Chief among them is tomaintain the proper amount of margin money in youraccount to cover the contracts being traded. If you fallshort, you receive a margin call. If that is not metpromptly, the Futures Commission Merchant (FCM),which is the equivalent of a clearing firm in the securitiesindustries, or the Introducing Broker (IB), or theequivalent of a broker-dealer with whom you opened the
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account can close out your positions. This could happenat an inopportune time.4. Personal and Financial Information. You must provide anoverview of your personal and financial situation so thatthe broker, his or her firm, the IB, and the FCM candetermine whether you are suited to trade futures. TheCommodities Futures Trading Commission (CRTC)obligates them to do this, as the Securities ExchangeCommission (SEC) does with stock investors.5. Consent to Check Credit. You authorize having your creditreviewed.6. Authorization to Transfer Funds. This allows theFCM/clearing member to move money from one of youraccounts, say a stock account, to another, say the futures,if needed. If you have more than one account and if thefirm is both a BD and IB, it can handle both securitiesand futures. Not all firms can do this. Transfers takeplace only within the accounts you have at one firm.Firms do not have the right to go to other accounts atother firms to transfer money.7. Consent to Cross Trades. This simply means that thebroker, IB, and FCM may be on opposite sides of tradesyou are carrying. You may be long, while the firm orsomeone working for the firm is short.8. Arbitration Agreement. This binds you to arbitration bythe National Futures Association (NFA) in case of adispute and you give up the right to sue. NFAregistrants, like brokers and Commodity TradingAdvisors (CTAs), are always bound by NFA arbitration.This clause may be optional.9. Joint Account Agreement. You acknowledge you areaware, if you open an account jointly with someone else,that your joint tenant can bind you to trades that you canbe held liable for. It also specifies whether the account isheld as a joint tenancy or as tenants in common.10. Commodity Option Agreement. This is an acknowledgment,similar to futures risk disclosures, that you understandand accept all the risks of options-on-futures trading.
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Most FCMs require this, even of those who do not planto trade options.11. W-9. A W-9 is needed for U.S. citizens so the FCM will knowwhat income tax account to charge profits or losses to at theend of the year. Otherwise, 20 percent of gains must bewithheld when payouts are made to the owner of theaccount.12. Special Account Forms. If the account will be opened inthe name of a corporation, a corporate resolution wouldbe required. Commercial hedgers and partnerships callfor additional forms. Your broker normally supplies anyadditional forms required.All this paperwork is needed to open your account, but more isneeded to give trading discretion to a third party. As mentioned earlier, a power of attorney (POA) must be executed. Most people use alimited power of attorney, allowing the trader only the right to enterand exit trades. A standard POA form is available from most brokerage firms. A full POA would allow the designated person to transferfunds and positions, as well as trade for you. Be careful what you sign.If you will be trading via a Commodity Trading Advisor(CTA), you will receive a copy of the CTA’s current disclosure document. You must sign a form acknowledging you received one.This form is called a Disclosure Document Confirmation (DDC).CTAs are professional traders, some of whom specialize in scaletrading. You would need to sign a limited POA to permit the CTAto trade on your behalf. You may want to contact one, via theInternet, and have him or her send you the paperwork to review.What about giving trading discretion to your son who is notregistered with the NFA or your broker who is? Part 2 of the DDCstates that you were not provided a disclosure document (“disdoc”) and leaves space for an explanation. Your son, being a directrelative, is exempt. So is your broker, if taking discretion (DRT) inyour account is incidental to his or her brokerage services and it isdone for your convenience, not his or hers. Some CTAs are alsoexempt from the “dis-doc” requirement. These CTAs have fewerthan 15 clients over a 12-month period, manage small amounts ofmoney, and do not hold themselves out to the public (sales, PR,advertising, etc.) as CTAs. In certain circumstances, one or more ofthe exchanges may ask for a release of some sort.
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There is also what is called time and price discretion. You cangive your broker discretion to place trades for you, but you mustdecide which side (long or short) you want to be on, which commodity, and the number of contracts. You instruct your broker totrade based on a certain price or time. For example, a scale traderwho will be unavailable a certain day might tell his broker toreplace a contract, if it is closed via an oscillating profit, at theprice in the scale. This can be done without any additional paperwork.If your CTA is a registered professional, you additionally haveto sign his or her paperwork, which is contained in a disclosuredocument. Basically, you acknowledge that you understand all therisks, fee structure, material facts about him or her, the trading system, and how your account will be traded. You’ll also be asked tosign an agreement to allow the CTA’s fees to be paid directly fromyour brokerage account. Remember, the CTA and the broker whointroduces you to the CTA may not be at the same firm and bothwill be receiving commissions.That wraps up the paperwork on an individual account. Thekey issue of the risk and reward is usually greatest with this typeof arrangement. Your CTA or broker (with trading discretion) cantrade your account into debit. That’s when more money is lostthan is in the account and you would be responsible for thatdebt.There are a few middlemen you may come in contact withsuch as Commodity Pool Operators (CPOs), who sponsor and promote trading funds. Savvy investors negotiate the incentive, management, and brokerage fees until the CTA or the CPO yells uncle!
INTERNET ONLINE TRADING SYSTEMThe advantage of using an online trading system is cost. Trades arecheaper because you are not interfacing with a broker. Placingtrades to open a scale is simple, except you must be careful not toplace trades that are out of range. The system may not take them,and you may not know they were rejected. Always check andrecheck open positions and confirmations.The second big problem is offsetting trades. The computersystems used to clear trades are set up for FIFO (first trade in isoffset by first fill, or first in first out). With scale trading, you want
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LIFO (last in first out). You want your last buy to match up withyour next sell.Some brokerage firms that offer both computerized orderentry and broker-assisted trades will accommodate entering thetrades electronically and exiting them via a broker. But you need tonegotiate this service in advance. It can be worth the trouble, if youare going to closely watch your trades and are experienced enoughto handle any unexpected situation. Otherwise, at least for the firstfew scales, use a broker-assisted (traditional) system.If you have problems with your broker or CTA, the primaryregulators are the NFA and the CFTC. Once trading begins, it isunder the jurisdiction of the NFA and CFTC. This is the generalrule and not a legal opinion of any sort.As an investor, you have recourse to all of the following regulators or self-regulating organizations (SROs), depending on thetype of investment you make:Securities and Exchange Commission (SEC)• Commodity Futures Trading Commission (CFTC)• National Association of Securities Dealers (NASD)• National Futures Association (NFA)• State Security Commission• State courts• Federal courts•
The route you take depends on how serious your complaint is andthe advice you get from your attorney. The SEC is listed because amanaged program could be a security. A public commodity fund,for example, may be under the jurisdiction of the SEC.For simple disputes about trades or commissions, thefutures industry regulators have well-established procedures.For example, if you had an unresolved problem in your futuresaccount, you could call the NFA’s toll-free number for advice andinformation about specific regulations covering the situation. Itwould offer to put you in touch with a trained mediator andsend you a copy of its booklet A Guide to Arbitrating CustomerDisputes. The mediator listens to your side of the story and contacts the brokers, CTA, or brokerage firm(s) involved for theirinput. An attempt would be made to resolve the issue to everyone’s satisfaction.
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If the results of mediation are unsatisfactory, you can compelthe broker and his or her firm to binding arbitration with the NFA.This would be before a panel, and you could specify that somemembers be public, not affiliated with the futures industry. Theobjective of arbitration is to obtain swift, fair, and inexpensive resolution of a simple dispute. It is considered inexpensive because alawyer is not required and the rules of evidence are not strict, asthey would be at a trial. Additionally, arbitration can take place byphone, so travel costs are avoided. This can be important if you arenot near a major financial center.A second avenue of recourse with futures disputes is theCFTC. It also has a booklet on the subject entitled Questions andAnswers About How You Can Resolve a Commodity Market–RelatedDispute. It explains the CFTC’s three reparation procedures, whichareVoluntary• Summary• Formal•
The voluntary procedure is used for claims under $10,000.00.Judgment officers appointed by the CFTC administer it. Both parties have an opportunity to uncover facts (“discovery”) and present their arguments in writing. There is no oral hearing. Decisionsare final, and no appeal is permitted. A nonrefundable $25.00 fee isrequired.The summary procedure is similar to the voluntary, but itallows for both a limited oral presentation and a written presentation, which takes place in Washington, D.C. Further, you canappeal the decision to the CFTC and to a court of law if you are stillnot satisfied. It handles complaints of $10,000.00 or less andrequires a $50.00 nonrefundable filing fee.The formal procedure is designed to handle major complaintsover $10,000.00. A courtlike hearing is conducted in 1 of 20 locationsthroughout the United States before an administrative judge. Anattorney can represent you if you wish. Appeals to the CFTC and thecourts are possible. A $200.00 nonrefundable fee is required to file.Besides the NFA and the CFTC, you can take a complaint tothe American Arbitration Association or file a civil suit. If youthink your broker or his or her firm has committed a criminal
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offense, you can contact the Federal Bureau of Investigation (FBI)or, if the U.S. mail was involved, the Chief Postal Inspector of theU. S. Postal Service.For help deciding your most effective alternative, you need tosit down and discuss it with your attorney. In my opinion, yourmost effective protection results from systematically conductingdue diligence research when selecting a CTA, a trading program,and a broker. Act with reason—do not get caught up in an emotional response to the CTA’s track record or a broker’s claims.The most beneficial negotiations are done, in my opinion,between customer and client. Once it goes beyond this stage, thecosts and complications often outweigh the results.