more expensive corn—thus de facto increasing supply of corn and the demandfor wheat.There are some inelastic commodities, meaning that decreasesin supply or increases in demand do not influence price. Basic foodsare an example. People will pay whatever they have to keep fromstarving. Corn, being fed to cattle, isn’t one of them, since other commodities can be substituted as feed or the cattle can be liquidated. Orif the cost of beef becomes too high because the price of corn is off thecharts, consumers will substitute chicken or switch to cheaper cuts of
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beef. But when people are forced to make a choice between eating ornot eating, they will always pay whatever the market demands.A nation’s, or a people’s, culture can also impact the supplydemand equation. For example, an ethnic group that has lived oncorn tortillas for centuries will have problems adapting readily towheat bread, particularly leavened bread made with bleachedwheat. It will demand corn meal and let the wheat go begging ifit can.Then there is chocolate. It is a commodity whose price is asinelastic as the item itself is addictive. Chocoholics will pay any pricefor a fix. Crude oil and gasoline prices can go to what seem to beunreasonable heights, and the demand rarely falters. Supplies ofcrude oil and the products made from it can also get out of control,offering excellent scale trading opportunities. Table salt and tobaccoare also in this category, but there are no futures markets in them.Returning to our inventory manager and the overseas farmers, the supply-demand calculation must include free worldwidestocks, as well as domestic ones. And obtaining an accurate fix onworld supply-demand situations brings politics into the equation.Sometimes international politics helps the scale trader; sometimes it does not. For example, when scale trading cocoa, it oftenhelps. The Ivory Coast is one of the major producers of cocoa. If theprice of cocoa gets “too cheap,” the government will stop sellingcocoa on the open market. Brazil has also done this with coffee, andthe oil cartel has attempted the same with crude oil. Sometimes thishas worked, but other times the cartel’s unity broke down. Themoral is that politicians are not consistent and you must keep someprice protection in place.The U.S. government has intervened in agricultural production since Revolutionary times. Knowledge of the farm programsand subsidies is very important. USDA (U.S. Department of Agriculture) has been known to take farmland out of production or provide cash payments to farmers for not producing certain crops. Weused to say, if you wanted to double farm income, give each farmera second mailbox. My point is that the U.S. government and governments around the world subsidize and protect their farmerswith tariffs and legislation. Knowing the impact of these programsis key to analyzing the supply and demand situation before entering a scale.
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There are outstanding opportunities for the scale trader withgood international intelligence, which is available over the Internetand from some other services I’ll discuss later. Political intervention can stop and reverse the price trend of a commodity, thus providing a perfect scale trading opportunity.But political activity is not always benign. In the days of theCold War, Russia played havoc with our futures markets, as mentioned previously. Mother Russia would release false informationabout the quality and quantity of her farm production, while trading our futures markets from Switzerland. The objective was to golong corn, wheat, and soybeans at the lows, and then take deliveryof the long contracts at expiration to supplement her failing collective agricultural experiments. It was so pronounced one year, itbecame known as the Great Grain Robbery. This led to satelliteobservation of the world’s major agricultural landmasses.The Russians are not the only ones that played fast and freewith supply and demand figures. Each year, USDA surveys farmersas to their planting intentions. How many acres of corn are theygoing to plant? Wheat? Soybeans? These surveys are regional andcover all the major crops produced, including livestock.The first survey goes out in January, and results appear amonth or so later. Coincidentally, farmers are selling grain storedon their farm about this time, since most farm mortgages are duein March and it is also the time to buy seed, fertilizer, and fuel forplanting. Now, if you had 100,000 or so bushels of corn or beans totake to market about this time, how would you answer USDA’squestionnaire? If you were about to sell some corn, would you tellthe government you were cutting back on corn acres this year orthat you were going to plant from fence row to fence row? Ifenough farmers reported they were cutting back, it would reducethe projected supply figures and drive corn prices higher on thefutures exchanges when the results of the survey were released.The gains in the futures market would be promptly reflected in thecash market. It is not uncommon, if the results of these studies arenot what the futures market expects to see, that the commodity inquestion limits up or down for days. To be kind, farmers have beenknown to think positively, at least from their perspective, whenanswering USDA’s surveys. My point is this: individuals, cartels,industry groups, and even nations all have vested interests and
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hidden agendas regarding supply and demand figures. Always beskeptical.There are also many totally unpredictable factors that canwreak havoc with predictions of the supply and demand situation.All agricultural commodities, from frozen orange juice to wheat,are influenced by weather. Some tremendous advances have beenmade in forecasting, but we are still a long way off when it comesto long-range accuracy—over an entire growing season, for example. And nothing impacts the supply of any crop more than timelyrains throughout the growing season.Floods, droughts, and other disasters can send prices soaring.Or just the rumor of an interruption of supply can result in limitmoves on the futures markets. There will be times when weatherhurts your futures positions. Extremely favorable growing seasonswill produce abundant crops, which, in turn, may prolong yourscale, forcing you to roll positions into a more distant and expensive contract.For scale traders, some of these natural disasters are not asthreatening, particularly the ones that reduce supply. In these situations, you will be long in the futures market. The price goes in yourfavor. Nevertheless, there will come a time when you are just starting a scale and the price of the commodity you are scaling limits up,closing your scale after only one or two buys. When this happens,pick up your chips and look for a new scale. Do not switch strategies and become an active commodity speculator. Successful scaletraders are known for their discipline.News is another totally uncontrollable factor that can havea substantial impact on supply and demand, especially in theshort term. It can be news of an actual change in the supply ordemand side of the equation or just some news that moves themarket. The unexpected move can be either to your advantage orto your disadvantage. News often takes the form of a rumor thatis later proven false. Again, this is the reason for the totally disciplined approach of scale trading and the use of options as priceinsurance.The brighter side of unexpected news is that it can often provide the opportunity to take some oscillating profits. For example, a rumor sweeps the trading floor. Prices run up 10 or 20 centstaking you out of two positions in your scale, generating two
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oscillating profits. You place new limit orders to replace theclosed positions at the original prices of the scale that you aretrading. Just as quickly as you were taken out of the scale, you areback in when the rumor proves false. You will come to love newsstories like these.There is another condition that must be present for a commodity to be a good candidate for scale trading—competition. Therules governing supply are most efficient when there is intense,widespread competition.Economists have coined the term perfect competition todescribe a market structure in which there are a very large numberof small producers and an equally large number of buyers. This isthe ideal scale trading environment. The supply side is not materially changed if a group of producers goes out of business or substantially increases or decreases production. Nor is the demandside stunted if one user switches to a substitute commodity or goesout of business.The concept also implies easy entry and exit from the market.This explains why higher-than-expected profits draw new bloodinto the market and why heavy losses drive others out. This expansion and contraction is what creates perfect markets to scale.For example, if a producer is prohibited from entering a market because of extremely high costs or it takes a considerableamount of time before the commodity in question can be broughtto market (grown, mined, reproduced, etc.), new producers willnot enter the competition unless a long-term demand situationexists. Often monopolistic suppliers dominate these types of industries. (Take Dole and the pineapple business as an example.) Thisalso explains why the futures contract for shrimp on theMinneapolis Exchange never became popular when Red Lobsterrefused to participate. Big Red has the suppliers, the major fishingfleets, under contract and does not need a futures contract. Goodscale trading commodities always have a strong commercial contingency supporting them in the cash and futures markets.There are some commodities that have characteristics of boththe perfect and the monopolistic competition market structure.These fall into the category of oligopoly market structures. Frozenorange juice comes to mind. It is difficult to enter or exit, because alarge grove of bearing trees is required to be an efficient producer.
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Most producers are large and few in number. The fact that the freshjuice is frozen and held in inventory creates an artificial supply situation. The uneven impact of weather, freezes specifically,accounts for the commodity’s price volatility, making it a possiblescale candidate.Coffee and cocoa are similar in that it takes considerableresources and time to enter these markets. But it is the politicalinterference sighted earlier that makes these two commoditiesattractive scale trading candidates. Plus the demand base is solarge, varied, and reliable; what would we do without our morningcoffee and afternoon candy bar?On the flip side of this coin, if too many of the producers cannot exit a market easily, they continue to produce and that keepsprices low. When hog production moved off the family farm to corporate producers, the high overhead of these farrow-to-finish facilities forced the large facilities to keep turning out pork regardless ofthe price. They cannot ration supplies easily, and the scale tradercan have a problem closing out a scale. The existence of frozenstocks in warehouses exacerbates the problemAnother prominent example is OPEC. If it had ironclad discipline, crude oil would be an outstanding scale trading candidate.You would enter a scale and ride the market down. OPEC wouldcut off the tap at some point, and prices would rise, closing outyour scale. But since OPEC members cheat on their quotas and notall major oil-producing countries are members of OPEC, scaletraders cannot always close their scales and are occasionally forcedto keep rolling positions into the future. Eventually they are hopelessly in positions that they can never exit at a profit. That is theproblem you may face in markets when producers cannot exitquickly and easily—just another reason to have a put option or twoin your back pocket.Time is of serious concern for the scale trader. For example,the supply of feed grains, as was mentioned, can be increased ordecreased from growing season to growing season. The word season should be read as seasons, meaning some commodities likewheat are being harvested 12 months a year somewhere in theworld. Meat production varies by species. Whereas it takes twoyears to increase live cattle numbers, hogs take half that time. Somecommodities just cannot react quickly. Olive trees take 12 years to
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mature, and coconuts as much as 15 to 20 years; both compete withsoybean oil in the eatable oil market. Crude oil supplies, on theother hand, can be boosted promptly by pumping more from existing wells. Even so, it can take six to nine months to get a usableproduct (gasoline and heating oil) to where it can be utilized, presupposing oil refinery capacity is not maxed out. Further, findingnew sources and getting them into production can take years andis expensive and highly risky.Demand can be equally fickle. Cancer and mad cow diseasescares cooled the demand for red meat in some countries, for example. But alarms like these often dissipate as quickly as they appear.Others tend to be more long-term but futile. Take our love-haterelationship with gasoline. There is not an environmentalist onearth who would not want to do away with it. On the other hand,we all want the freedom to travel by car at will.Even fashion can play a part in the supply and demand tugof-war. Demand for cotton took a tumble when synthetic fabricsbecame popular. You would not have wanted to be scale tradingcotton when that happened. Fast-moving changes in technologycan impact demand as well; for example, the adoption of fiberoptics impacted copper demand. The introduction of the catalyticconverter drove platinum prices into the stratosphere.So far, we have discussed only fundamental analysis of thecommodities you plan to scale trade. The reason is that fundamental analysis is the key to success, and it reveals the long-term trend.It can tell you if, and approximately when, a market is expected toreverse and head north. If you do not think you can see light at theend of the supply-demand tunnel, do not enter any scale. Wait forclarity—not perfect clarity, but you must have a good feel for howlong the commodity you are trading will be in the cellar.As we have seen, fundamental analysis deals primarily witheconomic data. This will become more apparent in the next chapterwhen we build some economic models. There is another type ofprice analysis called technical analysis. It is based almost exclusively on analyzing price data and patterns. Most futures tradersrely heavily on this type of analysis.As scale traders, we use technical analysis as well, but notquite as much. The reason is that once we decide on a commodityto trade and develop a scale, we tend to stick with it to the end,
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barring jolting fundamental changes. Active futures traders andspeculators take a completely different approach. As I mentionedearlier, they are more like fly fishermen, constantly casting theirline into the market with the hope of a strike. If they don’t get ahit, they try again.The scale trader, on the other hand, plans meticulously andadheres to the plan. The primary planning tool is fundamentalanalysis. There must be some assurance as to when the commoditybeing scale traded will bottom and begin to move back into its normal trading range. If the speculator is a fly fisherman, the scaletrader trolls the bottom for his or her catch.
TECHNICAL ANALYSISDespite the heavy reliance on fundamental analysis, there aresome technical trading tools of substantial value. The technicianwill tell you that every change in the supply-demand equation isimmediately reflected in the price action of the commodity beinganalyzed. One must therefore know something about technicalanalysis to be alerted to fundamental changes that do not becomeimmediately apparent for a variety of reasons. As mentioned previously, fundamental information tends to trickle into the market.By the time it is apparent to most market participants, prices havealready been impacted. Knowing the basics of technical analysis isa vigilant way of looking for changes taking place in the fundamentals. Once you can define and quantify the fundamentalchange, you are prepared to make adjustments in your scale trading program.The most widely used technical analysis tool is price chartanalysis (refer to Chapter 1, Figure 1-3). Scale traders track pricecharts to determine which commodities are in or about to enterthe lower one-third to one-quarter of their 10-year tradingrange. Therefore, you need access to some long-term, continuous charts. These are available either on the Internet or from asubscription service. Some sources are noted in Appendix 2.Continuous charts, by the way, are charts in which the prices ofseveral contracts are laced together, giving you a long-term perspective. As one contract expires, another one is linked to it. Youwill often see gaps in the prices, since the closing contract may
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be trading higher or lower than the new contract that is beingadded. Don’t let this throw you.Physical commodities tend to be influenced by inflation. Thecost of production (equipment, labor, inputs) generally increasesover time. So must the price of the product to encourage the producer to continue to produce. This, in turn, makes the commoditymore valuable. It is for this reason that using the lower quarter of the10-year trading range is a “safe” assumption of a price point to entera scale. The word safe is in quotation marks. This is to denote thatwhen one invests in anything that is going to happen some time inthe future, nothing is totally safe.Also, there will be periods when prices decline even as inflation and other factors increase. Plus there are times when inflationis dormant. These periods often see the intervention of the government in the way of price support programs and supplements tokeep production of essential commodities going. When you seethis happening, avoid scale trading the commodities affected; thereis no light at the end of the supply-demand equation. Technicalanalysis may provide the first clue that something is amiss.Nevertheless, the scale traders believe that over a 10-year period inflation, even at low rates, moves prices higher—particularlyfrom all-time lows. Therefore, it is a good, calculated risk to begina scale in this price range. All that said, there is nothing stopping acommodity from setting all-time new lows, and that is the reasonscale traders carry some reserves in their trading account and buyinsurance in the form of options.Another key element of technical analysis involves an understanding of liquidity. The commodities you should be considering to scale trade must be actively traded by speculators, so wewill be able to enter and exit trades at will. Oats is an exampleof a commodity that has all the characteristics of a good scaletrading candidate but often lacks the liquidity to trade. Tradingvolume is displayed as a bar along the bottom of most commodity price charts.Technical analysis is an excellent tool for selecting entrypoints or determining when to actually begin a scale. Use it toavoid beginning a scale too soon. If you open a scale at a price thatis too high, you can have a costly problem as you wait and wait forthe commodity prices to return to the level required for you to
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completely close out your last position. The first position opened isthe last you closed.For example, you are scaling a commodity that has had a trading range from a high of $4.00 to a low of $1.50 per unit (bushel,barrel, hundredweight, ton, bale, etc.) over the past decade. Thecontract size is 5000 units. The scale you decide to trade has youbuying each nickel down and selling for a nickel up. Your profitobjective is $250.00 per contract before transaction (commissionsand fees) costs. You anticipate the maximum low to be $1.00.Theoretically, the scale should begin when the commodity pricehits $2.12 1⁄2, which is the beginning of the lower one-quarter of the10-year trading range (see Table 5-1).To avoid beginning a scale too soon, never enter the first position until the price of the commodity closes below the 20-day moving average. A moving average is calculated by adding the pricesfor the most recent days together and dividing by the number ofTA B L E
5-1
Profit-Taking Table
Buy Price1. $2.121⁄22. $2.071⁄23. $2.051⁄24. $2.001⁄25. $1.951⁄26. $1.901⁄27. $1.851⁄28. $1.801⁄29. $1.751⁄210. $1.70 ⁄211. $1.651⁄212. $1.601⁄213. $1.551⁄214. $1.501⁄215. $1.451⁄216. $1.401⁄21
Profit ContractSell Price
Cumulative($0.05  5000)
Gross Profit
$2.171⁄2$2.121⁄2$2.071⁄2$2.051⁄2$2.001⁄2$1.951⁄2$1.901⁄2$1.851⁄2
$250.00$250.00$250.00$250.00$250.00$250.00$250.00$250.00
$250.00$500.00$750.00$1000.00$1250.00$1500.00$1750.00$2000.00
$1.801⁄2$1.751⁄2$1.701⁄2$1.651⁄2$1.601⁄2$1.551⁄2$1.501⁄2$1.451⁄2
$250.00$250.00$250.00$250.00$250.00$250.00$250.00$250.00
$2250.00$2500.00$2750.00$3000.00$3250.00$3500.00$3750.00$4000.00
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days in the sequence. In this case, a 20-DMA (day moving average)is the sum of the prices over the last 20 days, divided by 20. Eachday, the oldest price is dropped and the current one added. In mostcases, the closing price is the number used. Nowadays, virtually allcomputerized charting packages calculate and plot moving averages of any length and update them automatically.With any type of analysis, it is always a good idea to look forother data that corroborates an indicator that you are using tomake a decision. In this case, study the daily chart pattern to see ifa trend line has been broken. You would be looking for a shortterm trend line, perhaps over the past five days. Or you can drawchannel lines; these are parallel trend lines. In this case, you arelooking for a down-trending channel. Therefore, the top channelline would be drawn connecting the lower highs of the past fewdays. The bottom channel line would connect the lower lows overthe same period. A down-trending channel confirms the signalgiven by the 20-DMA.Technical signals can often be self-fulfilling prophecies. Whencommodity traders spot the downtrend and the declining movingaverage, the specs are ready to short that commodity. This is whatyou are looking for—technical confirmation of fundamentalinformation.The negative technical signals drive prices lower. You canoften have several of your positions filled in quick succession,because herd psychology drives the market lower. Do not let thisbother you. In many cases, this is an overreaction. Traders oftenresemble lemmings—they all go over the cliff into the sea justbecause the first one did. When they feel they have overreacted toomuch, they will reverse and overreact in the other direction. Enjoythe oscillating profits.As a downtrend progresses, the prices will get extremelyattractive to our friend the inventory manager, and he will begin tobuy. This slows down the move south, creating some more oscillating profits and gives everyone a chance to reassess the situation.At this point, prices may go higher or lower, but as a scale traderyou are in for the long haul. This is just an example of how technical analysis helps a scale trader. I will be talking later about howtechnical analysis can help you get higher returns by increasing thenumber of oscillating profits you can execute.
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Last of all, do not forget what was said about volatility andhow it impacts price. Later, I will tie all these technical conceptstogether into coherent trading strategies to increase your returns.Once you begin a scale, you normally continue it until you are takenout of it by rising prices. It is critical to know how to maximize yourefforts. Now let’s discuss specific commodities and groups of commodities to determine which are suitable for scale trading.
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Selecting the PerfectCommodities toScale Trade
Reviewing the most important characteristics of scale tradingcandidates may be the best way to begin this discussion. In my estimation, the single most important attribute is the presence of someform of what was described in the last chapter as perfect competition. This simply means that no single entity completely controlsthe supply and/or demand for the commodity you plan to scaletrade. The ideal, which occurs rarely, is a marketplace with thousands and thousands of producers and just as many users. It is alsoextremely important that institutional and commercial users, whohave the resources to buy, store, and use the commodity wheneverthe price is right, are plentiful. Professional inventory managers areoften the kingpins of price discovery.Perfect competitive markets are wonderful to trade. Theyswing from overbought conditions to oversold and back again, likethe pendulum of a grandfather clock. When the conditions areright, a scale trader can be in and out of three or four scales a year.As we all come to expect, rarely do you find anything perfect—in life or in the futures markets. A lot of the other factors, particularly greed and fear, come into play, disrupting smoothlyfunctioning markets. Nevertheless, this characteristic, or at least areasonable facsimile thereof, is the one factor you should alwayslook for when researching scale trading candidates.
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The next thing I look for is a strong and reliable supply ofinformation. Knowledge is golden when your primary analytictool is fundamental analysis. There is no other way of evaluatingsupply and demand over the long term.Unfortunately, this is also one of the scale trading’s greatestweaknesses. First, there is usually too much information. You willfind thousands of pages on the Internet on any commodity. Thedata can fill every hard drive you own; still, some key facts will bemissing. All this will become more evident when you begin tostudy specific groups of commodities.The overabundance of information, combined with somemissing links, is a fact of price forecasting you must accept. Thebeauty of scale trading is that you can be successful without having every single bit of information. Scale trading is more likethrowing hand grenades or horseshoes; you can score big by justbeing near the target.The scale trader enters a market when it is in the lower quadrant of its long-term trading range and stays in it until it returns toits “normal” trading range. You are trolling, not fly-casting. Youput your hook in the water and keep it there until you catch yourlimit. This is a lot different from having to predict the exactmoment a commodity price is going to change its trend, as thespeculator must.Always concentrate on the most important information youwill need to know: about how long will it be before the commodity bottoms and begins moving to its normal trading range? Youdo not need an exact date, just a good estimate. You can be off bymonths and still be extremely successful.My third favorite characteristic is that the commodity can beproduced and used globally. This factor relates back to the first one,perfect competition. The worldwide aspect often means more competition. The fact that farmers in South America began competingwith North American farmers for the soybean market added liquidity and volatility to that market. You see this as well in the crudeoil market when the North Sea and Venezuelan producers do theirbest to spoil OPEC’s plans.Elasticity is critical. The price of a commodity must give and takeas the supply-demand equation is recalculated. There is also what isknown as semielasticity in some commodities (e.g., crude oil). Prices
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can go to “outrageous” levels, and there is still a market. But sooner orlater a limit is reached, and developing countries, the main users, lookfor alternative sources—synthetics, substitutes, and, if all else fails,conservation. Then, when things are back to normal, they punish theoffenders, even to the point of invading them.Politics is trickier both to evaluate and to predict.Nevertheless, political actions create volatility, meaning opportunity for the commodity trader. Most of the time, the political decisions help the scale trader. Governments are protective of theirfarmers, in general. They buy large amounts of food when theirpeople are starving or there is an overabundance (reducing supply)to keep their people fed or their farmers in business when toughtimes hit. Being fickle, politics can hurt as well. Some SouthAmerican countries will undercut the price of soybeans on theworld market to dump inventory, while at the same time subsidizing their farmers to produce more. The same goes for many EECmarkets. This occurs when member countries need foreign currency at any price. It has a negative impact because it drives down theprice of commodities being scaled, which may cause you to extendyour bean scale. Worst of all, these moves are totally unannounced,because the country making them acts secretly in order to surprisethe market in hopes of locking in a better price. Again, just another reason to have a few well-placed options as insurance.The last condition goes without saying, i.e., the uncontrollablefactors. Largest among them is weather. When it is too favorablefor long periods of time, you might not be able to see the