You also believe that as it continues to climb,there will be some fine oscillating opportunities.Just in case, you figure your breakeven on the last two contracts. There is no doubt that silver will trade in the $6.00 rangeagain: it is just a question of when. If I have made 30 to 40 percenton my money when the last two contracts are at breakeven, I mightjust close out the scale. Remember, to traditionalists this would beconsidered utter blasphemy On those occasions when you are notthat committed, financially and psychologically, to a scale, youmust determine if the problem is long or short term. If it is shortterm, roll, if long term, bail.One of the keys to your analysis is the price premium betweenthe nearby contracts and the more distant ones. Remember, we said
IPRO-F_11/13_ch08_McCafferty
7/2/01
9:03 AM
Page 134
CHAPTER 8
134
TA B L E
8-2
Silver RolloverColumn 1Trade #
Column 2Buy Price
Column 3Filled?
Column 4Sell Price
123456789101112
$5.00$4.94$4.88$4.82$4.76$4.70$4.64$4.58$4.52$4.46$4.40$4.34
YesYesYesYesYesYesYesYesYesYesNoNo
$5.06$5.00$4.94$4.88$4.82$4.76$4.70$4.64$4.58$4.52
Column 5Filled?
Column 6Sell Price
$4.72$4.72$4.72$4.72$4.72$4.72YesYesYesYes
the difference is theoretically the carrying costs. How much does itcost to hold the commodity for a month? Storage? Insurance? Loss,shrinkage, or deterioration? Is transportation an element? Is processing capacity available (refineries, mills, etc.)? How many months doyou expect to hold the commodity?You can easily find these costs on the World Wide Web. Foragricultural commodities, there are annual updates on USDA andvarious state extension services Web sites. For other commodities,look to industry association Web sites or search the sites of prominent commodity trading firms. Try talking to other traders on theInternet (scalenet@egroups.com). This is something a good brokerwill have immediately available. For every major commodity traded, there are dozens of studies on the projected premium for holding a contract for periods of time.Also, keep in mind how the commodity is produced.Agricultural commodities are grown, while petroleum is pumpedfrom the ground. If the world runs low of free stocks of corn, itmust wait until the next harvest. On the other hand, if the world islow on crude oil, high prices will inspire oil-producing nations to
IPRO-F_11/13_ch08_McCafferty
7/2/01
9:03 AM
Page 135
Roll Me Over
135
Column 7Profit/Loss
Column 8NewContractPremuim
Column 9ProfitTarget
Column 10Commission
Column 11NewBuyPrice
Column 12NewSellPrice
$0.28$0.22$0.16$0.10$0.04$0.02
$0.58$0.58$0.58$0.58$0.58$0.58
$0.06$0.06$0.06$0.06$0.06$0.06
$0.02$0.02$0.02$0.02$0.02$0.02
$5.02$5.02$5.02$5.02$5.02$5.02
$5.96$5.90$5.84$5.48$5.72$5.66
immediately increase production, or the U.S. federal governmentcould even release some reserves into the system. Even so, it takesa month or two to get the crude in a form it can be used to quelldemand, even if refinery capacity exists. In other words, the lengthof the response time is a crucial factor in your planning.The seriousness of the situation is reflected in the size of thepremium between the nearby and the distant contracts. Let’s say weare looking at one of the grains, soybeans, for example. The normalcarrying cost spread between contracts is 2 cents a month, and annually there are seven contracts expiring in January, March, May, July,August, September, and November. Therefore, if the January contract is trading at $5.00, the March should be $5.04. That makes May$5.08; July $5.12; August $5.14; September $5.16; and November$5.20. This is known as backwardation. Theoretically, that is how itshould be in a perfect world. But this orderly progression does nottake supply and demand into consideration. That is why you rarelysee only carrying costs reflected in the various contracts.At the beginning of a scale, you have to decide which contract month to trade. If it is January, do you enter the May, July,
IPRO-F_11/13_ch08_McCafferty
136
7/2/01
9:03 AM
Page 136
CHAPTER 8
September, or December contracts? Remember, with true commodities, the more distant months should be priced higher due tothe carrying costs. This means the exit price of the last contract willbe higher the farther out you go. If it is too high, you might have toroll your last few contracts or close them at losses.Seasonal patterns may come into play in your decision. Manycommodities have reliable seasonal price patterns. As mentionedearlier, grains are normally cheaper in the fall at harvest when theyare plentiful. At midseason, much of the previous year’s production has been used. The new crops are not in the bins yet. Foulweather, primarily drought, produces bullish price rallies; rainfloods the market with bears. With only marginal carryover fromthe previous year, you would expect a summer rally or two, generating several oscillating profits. Under these conditions, if the grainyou are trading is in a range to scale trade, you would probably usethe September contract to take you through the turbulent summer.Keep in mind that if the supply side gets seriously tight, the commodity would be out of scale trading range.In this scenario, you would expect a short scale in which youput on only three, four, or five positions. You might want to usemultiple contracts per position and keep the interval between positions small. These are the adjustments you make based on the circumstances. The more confidence you have, the less insurance youmay need.My point is you must look at the situation from every possible perspective. Always keep in mind you are attempting to seeover a very high mountain. It is what you cannot see that can causeyou problems. There are some things that no one can forecast.That’s the beauty of the life of a trader. You must embrace it.Now, apply all the information available to this scale tradingexample. You entered a soybean scale in January at $5.20 perbushel using the May contract. Your subsequent purchases arepriced at $5.10 and $5.00. You have resting offsetting limit orders tosell these positions at $5.10, $5.20, and $5.30, respectively. By lateMay, the May contract for soybeans is trading at $5.00 per bushel,as are the July, August, September, and November contracts. Whathappened to the carrying costs? Why is the market inverted withthe nearby more expensive than the distant contracts? What couldhave happened?
IPRO-F_11/13_ch08_McCafferty
Roll Me Over
7/2/01
9:03 AM
Page 137
137
At the beginning of the year, supplies of soybeans were tight.This influenced many farmers to switch from corn to beans. Thatand good weather patterns promoted excellent prospects for abountiful soybean harvest, increasing supply and relieving thepressure on demand. And the rest of the world is having a goodproduction year as well. Always keep in mind, the futures marketstrade on the expectation of what is going to happen, not on what ishappening. There is no premium on the distant contract becausethere is no longer a perceived supply problem.For a scale trader, this is not the end of the world. You wouldclose your positions at $5.20, $5.10, and $5.00, replacing them withNovember contracts, giving you three at $5.00. Your plan is to continue to scale down as prices go lower. Rolling your first three positions results in a loss of 20 cents per bushel (20 cents  5000 bu $1000) on your first position, 10 cents ($500) on the second one, andbreakeven on the third. If these positions were covered by put optionsoffset in a timely fashion, you might be able to cover some of the loss.Now you must reevaluate the situation. You could continuethe scale by rolling into the November contract, picking up sixadditional months, during which anything can happen, such asweather problems. The better the crop looks, the lower the pricegoes. On the other side of the coin, rain at harvest or problemswith planting in South America could take you out of your scalein a hurry. If the cost of the extra commissions for rolling thetrades is a problem, you can add this cost onto your profit target,or you could increase the number of contracts you are tradingsince you are now in at a lower price level.Believe it or not, this can often be a very positive situation.The reason is that the lack of premium between the nearby monthsand the distant ones indicates that supply-demand over this periodof time is at equilibrium. Experience teaches every futures traderthat an even balance between supply and demand is as fleeting asone’s first love. This means you will more than likely have ampleopportunities to catch a substantial number of oscillating profits asbulls and bears play tug-of-war with the soybean crop. TheChicago grain pits are known the world over for their summervolatility. It is said that if someone walking by the exchange spitson the window of the CBOT in July, corn and beans lose a nickelbecause the floor traders think it is raining.
IPRO-F_11/13_ch08_McCafferty
138
7/2/01
9:03 AM
Page 138
CHAPTER 8
These profit opportunities could well be worth more than thescale itself. Enjoy the confusion caused by price volatility over thesummer. When you get an oscillator, you do not have to replace it.At the very worst, you may have to roll again into a March or aMay contract, when you will be taken out by the seasonal rally,normally in the first quarter of each year. Again, you can add ontoyour profit targets to recoup losses due to repeated rollovers.What can cause the nearby contract, in a normal carryingcharge market, to be higher than the distant months? First, this iswhat is known as an inverted market or a contango. You wouldnever normally open a scale in one because it is telling you that thenearby contracts are more valuable than the distant ones. Suppliesfor delivery are tight or demand is exceptionally high at themoment but is expected to loosen up later in the year. For example, the nearby contract is about to expire, but something has disrupted the delivery of the commodity to the warehouses. It couldbe a rail strike, very large export demand, or an early freeze on thewaterways halting barge traffic. Anyway, the shorts have to deliverto the longs, but they can’t get the commodity. This would substantially increase the demand for the nearby to use for delivery.When these situations occur, they are historically short-term aberrations, which rarely impact the scale traders.If for some reason you find yourself in a scale in an invertedmarket and you have to roll some positions, it should not be a problem. You will be selling higher-priced contracts at a loss and replacing them with lower-priced ones. This rarely happens because thetight supply situation that causes an inverted market would normally take you out of the scale before you had to roll. It could occurif your intelligence or analysis is off base and you entered the wrongcontract month, rather than waiting for this unusual situation topass. Rolling out of it should not be a challenge; just put yourselfout ahead of the big oncoming crop (supply) as far as you can without buying positions that are too expensive. If prices are flat, buythe farthest-out contract available.After you roll some positions, the decision whether to replaceoptions depends on where and how volatile the market is. If, forexample, the market has retreated a substantial amount setting anew 52-week low, you probably are beyond the need for insurance.On the other hand, if you are forced to roll early in a scale and you
IPRO-F_11/13_ch08_McCafferty
Roll Me Over
7/2/01
9:03 AM
Page 139
139
are still confident in your analysis, you should probably replace theoptions. This is especially true if the new contract month is twomonths or more into the future.I hope these examples have relieved some of your anxietiesregarding rollovers. They must be taken seriously, but they are byno means fatal. Believe me, they are rare occurrences.
This page intentionally left blank.
IPRO-F_11/13_ch09_McCafferty
7/2/01
CHAPTER
9:04 AM
Page 141
9
Starting a Scale TradingBusiness
Treat your trading as a business. Prepare with the same fervoryou would if you were opening a brand-new enterprise,scaletrading.com.Your first assignment is to gather all the information you needto develop a business plan. Top on your list of questions is, Whatbusiness are you in? In this case, Which commodity(or commodities) will you be scaling? I suggest you begin by researching at leastthree sectors, such as the grains, metals, and food and fiber. Thesesectors offer several scale trading candidates, and plenty of fundamental information is available. If you find no candidates amongthese groups, move on to the others recommended in Chapter 6.As mentioned in Chapter 7, step one is pulling long-termcharts of all the commodities in these sectors. Try www.futures.trading.com for charts powered by Omega Research. Also check out theWeb site, www.omega.com, as a possible research source. Threehole punch the charts and put them in a loose-leaf binder. Create abinder or file for each sector under consideration. In these bindersyou will gather all the facts and documentation needed to trade andtrack your scale trading portfolio. In time, your binders will be thestorehouse of your experience and an incredible reference document. A key part will be your scale trader’s journal, which we willdiscuss shortly.
141
Copyright 2001 The McGraw-Hill Companies, Inc. Click Here for Terms of Use.
IPRO-F_11/13_ch09_McCafferty
142
7/2/01
9:04 AM
Page 142
CHAPTER 9
An excellent source to begin your research is the CommodityReference Guide, published by Hartfield Management, Inc., ofChicago. It is an annual, available each December for the upcomingyear. It contains an enormous amount of historical data that you willfind most useful. For example, on each calendar day is noted keyevents (reports to be released that day, last trading day for each commodity or option, final notice day). There is a section on each commodity with seasonal charts, key fundamental factors impacting thesupply-demand equation for the new year, long-term charts (5-, 10-,and 20-year), supply-demand figures for the last decade or more,world planting and harvesting calendars, a variety of usage reportsand spread ratios (Monthly Bean/Corn Ratio, Monthly CashSoybean Meal/Corn Spread, Weekly Corn Prices vs. CommercialTrader Net Position and vs. Large Trader Net Positions). Photocopythe section on the commodities you are tracking and insert the pagesinto your binder. Use it to avoid overlooking a key factor in youranalysis. Always review the calendar of upcoming reports a monthor so in advance, so you are not blindsided by an important report.Hartfield Management, Inc., also publishes The HightowerReport, which is an excellent source of fundamental and technicalresearch. It will update the annual reference guide throughout theyear. To this material, add anything you garner from Futures magazine’s sourcebook, such as average 21-day standard deviation tolatest close, average daily trading range, average daily move, andthe noise index (see Table 9-1).Use the noise index in Futures magazine as one source forevaluating volatility. It is calculated by dividing the remainder ofthe average true range and the average daily move by the averagetrue range. The higher the noise index, the larger the part of thedaily trading range is spent outside the close-to-close range of theprevious day. It is an indicator that the commodity has difficultyfinding a closing price at the end of each trading session, whichequates to volatility. To the scale trader, it is an alert that the commodity in question may offer more than an average number ofoscillating profits. In other words, it is one more piece of the puzzle to finding good scale trading candidates.Don’t forget the Economic Research Service of the U.S.Department of Agriculture (USDA) if you plan to a scale any agriculturally related commodity. Be sure to have a list of all the
IPRO-F_11/13_ch09_McCafferty
7/2/01
9:04 AM
Page 143
Starting a Scale Trading Business
143
T A B L E 9-1
Volatility TableMovers & Shakers
CocoaPork belliesSugarCoffeeSoybean oilLean hogsOrange juiceRough riceLumberWheatCrude oilHeating oilSoybeansCornCottonSilverCopperOatsSoybean mealPalladiumGoldS&P 500DJIAPlatinumJapanese yenSwiss francMexican pesoD-markT-bondLive cattleCRB indexFeeder cattleDollar indexMunicipal bondsBritish poundT-notesCanadian dollarT-billsEurodollar
Average 21-daystd. dev./latest close
Averagedaily truerange
Averagedailymove
Noiseindex
4.94%4.52%4.50%3.65%3.48%3.30%3.27%3.02%2.99%2.99%2.87%2.87%2.62%2.59%2.59%2.54%2.52%2.46%2.41%2.30%1.97%1.79%1.72%1.62%1.28%1.25%1.20%1.16%1.14%1.13%1.09%1.07%0.80%0.79%0.78%0.76%0.63%0.07%0.06%
30.60262.36420.22674.12600.40411.43322.57120.14427.54966.02390.56020.01399.36303.88151.096110.39341.51312.33153.14527.00833.372522.5987166.33045.92140.00910.00610.00100.00540.91170.78701.65480.81860.70080.69130.00990.60320.00370.04520.0461
16.46291.37470.11932.34740.21640.77561.42900.08254.31393.29240.32550.00815.18592.18150.59335.57640.81381.25541.75094.29321.827512.462290.44783.18430.00560.00340.00050.00250.48530.41391.01990.43740.35710.38180.00590.30800.00190.02510.0208
46.20%41.85%47.39%43.11%46.46%45.89%44.42%42.81%42.86%45.34%41.90%41.78%44.61%43.80%45.87%46.35%46.22%46.15%44.33%38.74%45.81%44.85%45.62%46.22%38.20%44.62%55.02%53.70%46.77%47.41%38.37%46.57%49.05%44.77%39.93%48.94%47.40%44.49%54.88%
Source: Futures magazine’s 2000 sourcebook, January 1, 2000, page 79.
IPRO-F_11/13_ch09_McCafferty
7/2/01
9:04 AM
Page 144
CHAPTER 9
144
reports (supply, demand, production, market analysis, import,export, crop progress, pipeline status, farmers intentions, weather,etc.) available and their approximate release date. If USDA doesnot cover the commodity you plan to trade—copper or petroleum,for example—the information you need is available from anindustry group (see Table 9-2).Another outstanding source can be your brokerage firm.When I was at Securities Corporation of Iowa, it was a corresponding firm with Prudential Securities, where the head offutures research was Jack Schwager. The fundamental and technical reports Prudential produced on all the major commodities weresome of the best I ever used. These lengthy reports are updatedmonthly, with special reports and alerts issued throughout themonth when necessary.On the charts in your binder, draw parallel lines indicating theall-time high and low. Calculate the range between the two anddraw two more lines indicating the lower 25 and 33 percent of therange. Draw a fifth line at the low turning point for the past 15years. This last figure is a calculation of Angelo Namrevo and canbe found on Paul McKnight’s Buffalo Trading Group, Inc.’s Web site(“10-year Commodity Price Range Table,” www.buffalo.pair.com).This is a Web site you may want to spend some time visiting, sinceMr. McKnight is a CTA (commodity trading advisor) offering managed programs in scale trade. I’ll get into a discussion of managedprograms in Chapter 11.Review all the charts. Which commodities are approachingthe lower one-third of their 10-year trading range? Let’s say younotice that corn is approaching its 33 percent line. Using the numbers from Mr. McKnight’s Web site at the time of writing, we havethe following data:Commodity
High
Low
Range
25%
33%
Turning Point
Corn
$5.54
$1.42
$4.12
$2.43
$2.79
$1.95
As volatile as corn is, it will set new highs and, occasionally,new lows. As with all the data in this book, or any book, alwaysseek out the most current data when doing research. You can dothis quickly and easily on the World Wide Web. For reference, hereare the contract specifications for corn.
IPRO-F_11/13_ch09_McCafferty
7/2/01
9:04 AM
Page 145
Starting a Scale Trading Business
TA B L E
9-2
Sources of Industry Group Information
The Grain Complexwww.usda.govwww.sparksco.comwww.agribiz.comwww.agweb.comwww.cargill.comThe Food and Fiber Complexwww.imf.orgwww.icco.orgwww.ico.orgwww.fas.usda.gov/cottonwww.cottontrading.com/market/supplydemand.htmlwww.farmwide.comThe Meat Complexwww.beef.orgwww.ag.auburn.org (pork)www.ams.usda.org (pork overview)www.globalbuyer.orgThe Energy Complexwww.eia.doe.gov (Department of Energy)The Metals Complexwww.amm.com (International Metals News)www.cpmgroup.com/goldresearch.htmlwww.silverinstitute.org/demandwww.copper.orgThe Commodity IndexesGoldman Sachs Commodity Index www.gs.com/gsciCommodity Research Bureau (CRB) Index www.crbindex.comThis is a small sampling of the information available to you on the World Wide Web regardingthe supply-demand situation for the commodities you plan to scale trade. Use these sites onlyas the beginning of your research.
145
IPRO-F_11/13_ch09_McCafferty
7/2/01
9:04 AM
Page 146
CHAPTER 9
146
Corn Contract SpecificationsSymbol:Exchange:Trading Hours:Unit:Tick Size:Contract Months:Last Trading Day:
CChicago Board of Trade9:30 A.M. to 1:15 P.M. CST (open outcry, Globex after hours)5000 bu1⁄4 cent/bu or $12.50December (Z), March (H), May (K), July (N), September (U)Close of business, seventh trading day prior to the end of thedelivery month
Our next step is to create budgets and profit-loss projections.You must make sure that you have sufficient funding to stay in thescales during the equity drawdown period and that returns are sufficient to make the effort worthwhile. The primary element of budgeting, as far as scale trading is concerned, is the scale itself.What should you expect for a return on equity? Most scaletraders look for 15 to 20 percent from the basic scale, meaning fromthe entry point (the first buy) of the scale to the low, and then backup to the point where the scale is closed (the last sell). I have beenstudying futures markets for 20 years, and it is extraordinary to seea commodity plunge to make a low and then proceed to climb rightback up to where it started. Markets stair-step down and up.Our friend, the inventory manager, along with a crowd ofspeculators, has no idea at what price the low will be put in. It is agame of blindman’s bluff. A commodity will show some weaknessand drop a nickel or dime per unit. Some buyers support it for awhile. But if not enough buyers join them, the supporters lose faith.Or perhaps a negative news story hits the trading pits. Events likethese drive commodity prices lower. If you were an inventory manager and felt that buying the commodity a quarter higher was agood deal, you would really believe it was a great deal when itdropped another quarter. Perhaps an inventory manager who hasbeen buying hand-to-mouth as the commodity moves lower needsmore of the commodity; this buying can cause a minor rally. Thecommodity’s price rallies, but the rally fails after a week or so.Prices move lower again—up and down, down and up. On theway down you will see a series of lower lows and lower highs, ora downtrend. On the way up, you see higher highs and higherlows, or an uptrend. This is how markets have always performed.
IPRO-F_11/13_ch09_McCafferty
7/2/01
Starting a Scale Trading Business
9:04 AM
Page 147
147
It is this customary, but erratic, behavior that has led scaletraders to believe they will enjoy many oscillating profit opportunities on the way down and the way up. You will get enough ofthem during normal market conditions to double the return youexpect from the basic scale and to bring the gross return to the 30to 40 percent range. Keep in mind, you will need approximately 10percent of the gross profits to pay for commissions, leaving you anet return of approximately 20 to 30 percent. You should havesome additional return from your options as well.During good years, scale traders can successfully open andclose three or four scales, thus maximizing the use of their capital.The return is not as flashy as some commodity brokers boast aboutgetting from more aggressive forms of futures speculation, but it ismuch steadier and more reliable in my opinion and based on myexperience. If you end a year with just two scales completed, youshould be looking at 40 percent or more in net return.Now let’s build a couple of scales to get a feel for the economics of scale trading. I used the 10-year trading range from theBuffalo Trading Web site as the starting point. Remember this bookis static and the market is always in flux, which means you mustalways obtain current information when creating scales.Nevertheless, these examples should give you sufficient understanding to assist you in your decision-making process.Building the scales is a simple exercise on a spreadsheet program, such as Microsoft Excel. There are also commercial programsavailable that make it even easier. It is also not unusual for brokerage firms, Crown Futures for example, to provide Excel overlays totheir customers. Now, take a few minutes to become familiar withTables 9-3, 9-4, and 9-5.Each has five columns. The first column numbers the trades inthe scale, which can become important when matching up positions if a rollover occurs (#1 becomes #1R, for example). Column 2lists the prices at which the commodity is purchased. Column 3contains the margin. (I use the maintenance margin when budgeting.) Column 4 is the loss on each trade at the price level designatedin the second column. And Column 5 totals the losses on each tradeand the amount of money required to hold all the positions.Before I go any further, I should discuss margin briefly. Marginis an amount of money traders are required to deposit with their
IPRO-F_11/13_ch09_McCafferty
7/2/01
9:04 AM
Page 148
CHAPTER 9
148
T A B L E 9-3
Corn Scales: 33% 10-yr. RangeScale: 4 cents down; 8 up1TradeCount
2Buy Price
3MaintenanceMargin
4TradingLosses
5Cumulative