.Your brokerage service may provide charts when you open andtrade an account. Either way, your next step is to study the weeklycharts of any of the commodities that are getting into scale tradingrange. At this point, you also want to study daily volume, 21-daystandard deviation of the close, daily trading range, the averagedaily price move, and other measures of volatility your broker canprovide (see Table 9-1). What you are trying to do is get a feel for justhow volatile the commodity is to determine your hedging strategyand the size of the price interval of the scale you will create.If the volatility is very low, you might protect only the firstfew positions with puts. If the volatility is high, you might decideto be even more defensive.Knowing the volatility helps you plan your scales. If the average daily move is 2 (cents, dollars, etc.) per unit (bushel, pound,hundredweight, barrel, etc.), you can use this as a guide in developing your scale. Should it be equal to the daily move or twice it?Matching your scale with the average daily price move also setsyou up to take oscillating profits. In the beginning, you have to relyon the experience of your broker, or you can visit the chat room onthe World Wide Web devoted to scale trading (see Appendix 2),until you develop enough experience of your own. When in doubt,play defensively.Unfortunately, I cannot give you exact scales in this bookbecause they must be modified to reflect the current price volatility.In general, the size of the interval should amount to at least a $300profit when taken, but should not exceed $500. For corn, this wouldbe 6 to 10 cents per bushel.While you are studying the charts, you are doing your supplydemand homework. How much supply is in the pipeline? Wouldyou expect to be in the scale for weeks, months, or more? You needto know this for two reasons. First, which contract month will youscale? If it is January, do you enter the June, September, orDecember contracts? Remember, with true commodities, the moredistant months should have higher prices due to the carrying costs.This means the exit price of the last contract will be higher. If it istoo high and you have to roll a few remaining contracts, you mightdecide to close them at a loss.
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Seasonal patterns may come into play in your decision. Manycommodities have reliable seasonal price patterns. All things beingeven, corn is cheaper in the fall at harvest when it is plentiful. Atmidseason, much of last year’s production has been used. The newcrop has not been “made” yet. Weather scares, primarily drought,can cause bullish price rallies, while rain brings out the bears. If, forinstance, the carryover from the previous year is not overwhelmingly large, you would expect a summer rally or two and severaloscillating profits. The least bit of bad weather news will sendprices higher. Under these conditions, if corn is in a range to scaletrade, you would probably use the May or September contracts.Keep in mind that if the supply side is very tight, corn would beout of scale trading range.In this scenario, you would expect a short scale in which youonly put on three, four, or five positions. You might want to tradeheavy, which means multiple contracts per position and keep theinterval between positions small, say 2 cents versus a nickel. Theseare the adjustments you make based on the circumstances. Themore confidence you have, the less insurance you may need.My point is you must look at the situation from every possible perspective. Always keep in mind that you are attempting toforesee the future, and only hindsight is 20-20. You could have theU.S. corn crop pegged to a bushel, but Australia or South Africamay have a bumper year and dump the excess on the world market, taking buyers away from U.S. farmers.By now, you probably have come to the conclusion that yourselection of a broker is a key decision. Besides all the typical requirements (honesty, intelligence, understanding of futures and optionstrading), it is imperative for your broker to be trained in scale trading. Here is a quickie list of things your broker needs to know.1. How to offset your positions. This is done through what isusually referred to as a special offset. Normally,commodity trades are offset on a FIFO (first in, first out)basis. With scale trading, you need LIFO (last in, first out).The last trade you put on is at the bottom of your scale,and it should be closed out first, as soon as your targetprice is hit. If you look back at Table 4-1, you would notwant the first trade, the one at $2.50, closed when cornhits $1.57 for a $4650 loss ($0.93  5,000 bu), would you?
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2. How and when to place your orders in the market. The brokershould use limit orders. You want your trades filled onlyat or better than the price on your predetermined scale. Ifyour scale is a long one, your broker may not be able toput all your orders in at one time. Orders that are too farout-of-the-money or the trading range may not beaccepted by certain exchanges. Your broker needs toknow the trading rules of the exchanges.3. How to track your orders. Scales can go on for months. Yourbroker will need a good tracking system to make sure allyour buys, sells, and special offsets are executed in atimely fashion. This can be a problem when there is highvolatility in a specific market.4. How to do fundamental analysis. Always hook up with abroker who has access to sound, in-depth fundamentalanalysis. This may rule out some small regional brokeragefirms, unless they are correspondents of a major wirehouse. Only the major firms have the resources toaccumulate and analyze fundamental information on aglobal basis. Every trader needs help getting all thematerial facts.5. How to do technical analysis. This is usually not a problem.The technical analysis you need is not out of the ordinary.Nevertheless, it is an advantage if you can get charts andtechnical advice from a competent broker. Good wirehouses also provide excellent technical research reports.Always ask to see a sample of what is available.6. How scale trading works. Can the broker calculate a scale?Handle special offsets without screwing up your account?Alert you to upcoming scale opportunities? Subscribe toany of the scale trading newsletters and visit the scaletrading chat rooms on a regular basis? Most important,does the broker want your business? Not all brokers do.The reason is that scale traders are not active traders,especially when compared with day trading or swingtrading clients. Serious scale traders put on sets ofpositions and wait for the markets to come to them, ratherthan dizzily chasing every market that has any volatility.Not every broker wants this type of business. Be sure to
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learn enough about the broker to be convinced he or sheunderstands the needs of scale traders and really wantsyour business.Between you and your broker you should be building up adetailed file on each commodity that is moving into a scale tradingprice level. Part of that file should contain specific scales you areconsidering.Creating a scale is rather simple. Originally we did it by handor on a spreadsheet program, such as Microsoft Excel. Now there aremore sophisticated programs available from brokerage firms or forsale, which create scales and even track them. You might want tocheck out www.devinedesign.net/STM/. It offers The Scale TradeManager software, which calculates scales two ways—rollover sellprices, preloaded to accommodate 41 agricultural and industrialcommodities. There is a 30-day free trial, and it is reasonably priced.It is worth testing, just to get the feel for creating scales.Personally, I like to create at least three scales for each scaleopportunity under consideration. The first shows the maximumdrawdown imaginable. Table 4-1 is an example of corn plummetingto all-time lows in the $1.50 area. I refer to it as the bear trap scale. Ifworse comes to worst, how far could the commodity fall and howmuch money would be needed in the account to withstand thedrawdown? Table 4-1 indicates that approximately $50,000.00would be needed. That should be the worst-case scenario.To that figure I add another 50 percent if only one scale isbeing traded. That brings the account size to $75,000.00. Thereserve funds are there in case the worst-case scenario is optimistic, if some contacts have to be rolled to a more distant month,and to keep you from panicking when either one of the other twooccurs. If up to three scales are being traded, I reduce the errorpercentage to 25 percent per scale. If five or more scales are inplace, the percentage drops to 10 percent per scale. My rationalization is that the more diversified your scale trading portfolio, theless likely several of the scales will experience major drawdownsat the same time and you will have the funds available in youraccount to handle the unexpected. The error or reserve amountapplies to each scale. For example, if you are trading six scales andeach requires $100,000.00 in equity, you should have no less than$660,000.00 in the account.
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The second scale describes what I really expect to happen. Irefer to it as the rational scale. In the case of the corn scale we havebeen discussing (Table 4-1), I’d be estimating the low would bein the $1.80 per bushel area, rather than the $1.50 area. Thatmakes the maximum estimated drawdown $20,750.00. With the50 percent cushion, it amounts to $31,125.00. This should bemuch more realistic. Nevertheless, the account should be fundedwith $75,000.00 if it is the only scale. Plan for the worst and you’llnever be disappointed.The final scale I call the ideal scale. If everything goes perfectly, what would happen? How can I tweak the rational scale tosqueeze out another 20 to 50 percent profit? One technique is todecrease the increment of the scale as it approaches the anticipatedbottom. For example, we really think the bottom for corn will bearound $1.80 per bushel and the scale started at $2.50 using a 7-centincrement. Once corn penetrates $2.00, we change the scale to 3cent intervals. Or as corn descends to $1.80, we double the numberof contracts purchased. The idea is that we have less risk becausecorn is nearing its bottom. If we are doing 1-lots, we start buying 2lots. If we are very aggressive, we may do both.The decision is based on how actively corn is trading at thislevel. If there is some volatility, it may make sense to reduce thescale in anticipation of capturing more oscillating profits. Wewould have a better chance at 3-cent than at 7-cent intervals. Onthe other hand, if corn is continuing to move lower, but slower, wemight go with doubling the size of our buys. Here the rationale isthat volatility has not changed significantly, but we are approaching a bottom.Before making any decision to adjust your scale, check thefundamentals. You must be able to see the light at the end of thesupply-demand tunnel before getting too aggressive. If you do not,you will make an uncomfortable situation more uncomfortable.The advice of an experienced broker can come in handy whenthese decisions are made. Also, if you become more aggressive, youmust add additional funds to the account to cover the additionalpositions that will be acquired.Prudence also dictates that you diversify your portfolio bysector as well as by commodity. This simply means that if you aretrading three commodities, they should not all be grains. Superior
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weather in the growing season that increases the supply of corn,thus extending a scale forcing you to roll over positions, will havethe same impact on soybeans and wheat. Cheap grain may causehog, cattle, and poultry producers to increase production, floodingthe market with inexpensive meat. Always try to keep balance anddiversity in your portfolio.The next big decision is which contract month to scale trade.With futures contracts, you have from 4 to 12 contracts to choose fromper year. For example, corn has contracts expiring in March (H), May(K), July (N), September (U), and December (Z). The letter behindeach month is the symbol designation. For example, the symbol forcorn is C, therefore the symbol for December corn would be CZ. Inthe case of the commodities in the petroleum complex, they trade allmonths (F, G, H, J, K, M, N, Q, U, V, X, and Z) (see Appendix 1).The decision is also based on liquidity, the premium the distantcontracts are carrying, and price forecasting. You will be buyingpositions in a “distant” contract, one that will be expiring two,three, four, or even five months hence. The most heavily traded contracts are normally the nearby ones, those about to expire due to thepressures of shorts delivering to longs. You need to select a contractmonth that has enough time for your forecast—meaning the commodity will trend lower, bottom, and recover—to materialize. Howlong will this take? How bright is the light at the end of the tunnel?At the same time, you need trading volume or liquidity so you canget orders filled efficiently. And if for some reason you decide toabandon the scale, you want to get out quickly. You do not want totrade where there is no activity.The next consideration is premium. How much is built intothe distant contracts? Earlier it was stated that the carrying cost fora grain runs around 2 cents per month to cover storage, insurance,and loss (called shrinkage). If it is January 1, the price of corn delivered in March should be about 6 cents higher. For September corn,the premium might be 18 cents. January is priced at $2.00 perbushel and at September is $2.18. This implies that the price is thesame, because it will cost the owner of the corn 18 cents to hold itfrom January to September.But what does it mean if corn for delivery in September (thisyear) is $2.00 per bushel and March (next year) delivery corn is$2.25? It means buyers are willing to pay 11 cents above the carrying
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charges for seven months to take delivery of corn in March. Thiswould play out if the prospects for harvest in September–Octoberwere soft and the commercial users expected the inventory in thespring to be getting tight. This would obviously indicate a scaletrade to avoid if you were just starting a new scale, since the marketis getting stronger rather than weaker. On the other hand if you werealready in the scale, it would signal the light at the end of the tunnel.This means much of the premium between contracts dependson supply-demand factors, which become the price forecast. The premium is reflected in what buyers and sellers, speculators, and usersare willing to pay or sell the commodity for in three, six, or ninemonths. If supply is high, the premium will be lower than the actualcarrying costs. If there is a real or perceived shortage on the horizon,the premium will be higher. Demand influences pricing conversely:high demand becomes high premiums, whereas low demand begetslow premiums. The commercial users (e.g., our friend the inventorymanager) must keep a keen eye on supply and demand, and they willlet you know what they think based on how they bid prices up anddown. Know the carrying costs so you know how much of the premium between contract months consists of hard costs and how muchcan be attributed to supply-demand factors.Your selection of which month to begin a scale depends on allthese factors. You need some liquidity, but not too much. You needthe premium to be flat or modest and the price trend to be weak tolower when beginning scales. Avoid getting too far out. If you areconsidering a contract that is six or nine months out, it puts enormous pressure on your fundamental analysis. So much can happenover that period of time. It is rare that anyone can forecast accurately for more than a quarter. Additionally, you will have yourfunds tied up for an extended period of time, which means youdeserve a greater return.Now that does not mean you won’t be caught in a scale tradesome time in your career that lasts as long as a year. It happens. Butit is not the desirable situation. Something obviously will havegone awry.The exchange you trade on is another important decision.With one exception, always use the one with the most liquidity.The exception is the MidAmerica Commodity Exchange, knownas the MidAm. It was founded in Chicago in 1868 and is the
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home of the “mini” futures contracts. Although the corn contracton the Chicago Board of Trade (CBOT) is 5000 bushels, it is only1000 on the MidAm. The margin requirements are equally small:$500 on the CBOT and $100 on the MidAm (see Appendix 1).Because of the reduced size of everything on the MidAm, itmakes an excellent trading ground for commodity traders. If youused the same corn scale described earlier that required $75,000total equity, you could duplicate it on the MidAm using only$35,000.The MidAm works the same as all other commodityexchanges do, except for the smaller contracts. Price movement onthe MidAm shadows the CBOT. But it does not have the liquidityof the CBOT in the grain pits. From time to time, you may see anorder identical to yours getting filled on the CBOT at your price,but you do not get yours filled on the MidAm. This can be frustrating. In my estimation, you can use MidAm, particularly whenyou are in the learning mode. At some point you will graduate tothe Big Boards. I recommend only the grains in the MidAm.What about electronic brokerage services and their low commission rates? The convenience and low commissions are attractive. The problem you need to deal with is special offsets. Will theyaccommodate them? Some brokerage firms that offer both electronic and brokers-assisted trading will allow you to enter orderselectronically and offset them via a broker. Placing orders electronically puts the entire burden on you to place your orders in themarket in a timely fashion. As mentioned earlier, there are timesyou cannot place all the orders for a scale in the market at one time.If some of the orders are too far out-of-the-money, you have toplace them when the market catches up. If you have the time, aprice quotation system, and a good ticker system, you can do it.Then there is the research and advice you may need from timeto time from a commodity broker experienced in scale trading. Thiscan make a difference in selecting trades and entering them in atimely manner when something unexpected occurs. That unexpected event can be rolling over contracts to more distant months,which is the subject of the next chapter.
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Roll Me Over
R
ollovers are an infrequent fact of life for scale traders, no moreunusual than a regular golfer being caught occasionally in a shower.They are uncomfortable but not account-threatening. Be patient.Simply work your way through them. Do not develop a phobiaregarding them.A rollover occurs when a scale trader is forced to sell andrebuy some or all of his or her positions because the contractsowned are expiring and the price of the commodity is still belowthe predetermined sell or offset prices. The expiring contractsmust be replaced with new ones in a more distant contract month.For example, a crude oil scale begins in mid-April scale tradingthe June contracts. Purchases are made at 20, 19, 18, and 17 (seeTable 8-1). The scale calls for exiting these positions at 18, 19, 20,and 21. Each position is expected to generate $500 in profits for atotal of $2000 over a month or so. But when the last trading dayarrives for these June contracts, the commodity is trading at 191⁄2,only the two positions #4 at 17 and #3 at 18 have been sold for thespecified profit. The other two, #2 and #1 bought at 19 and 20,respectively, are still open. The trader must sell these two and buynew September contracts, which normally would be at a higherprice due to carrying charges.What has occurred is that the price of the commodity beingscaled has not recovered sufficiently to allow the trader to exit all
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TA B L E
8-1
Short RolloverTrade #1234
Entry Price
Exit Price
Profit per Contract
20191817
21201918
$500.00$500.00$500.00$500.00
of his or her positions, either at a breakeven price or at the predetermined profit. You would consider closing these positions at breakeven only if your analysis indicates that the supply-demand situationhad drastically changed, meaning it would be foolhardy to continueor that a more opportune scale had become available and you neededyour capital.What would change your decision to continue a scale? First,an error, a miscalculation, or new developments necessitate a majorrevision in the initial analysis of the supply-demand equation. Let’ssay you have been scale trading crude oil for the past month andhave four positions in place. OPEC announces a cutback in production, and the other non-OPEC countries cannot, for whateverreason, increase production. This is the type of news you have beenexpecting to drive prices higher and take you profitably out of thescale. Unfortunately, this does not happen. One of the OPECnations goes rogue and floods the market with cheap crude. Pricesremain flat, and you are trapped in a scale not knowing what willhappen. There is no light at the end of the tunnel. Simultaneously,soybeans hit your target price to begin a scale. Two positions havebeen offset in the crude scale, and two oscillating profits have beentaken. For these reasons, you opt to bail out of crude and more intobeans. All you are down is your commissions. If you have a fewputs on, the profit from them covers the transaction costs.This is not the traditional way to scale trade. Traditionalistswill teach you to stay in and keep feeding the kitty. Sooner or later,the commodity is bound to get to a level you can exit with yourprofits. They will tell you to wait for the other OPEC nations to beatup on the rogue, getting it back in sync with the rest of them.
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Traditionalists will also tell you that you cannot lose money scaletrading. Theoretically, what they say may be true, but I have seentoo many good traders run out of money or patience before thecommodity turned around. I recommend you use your brains andnot your bucks to bend the market to your will.The rollover scenario is one of the two key events that canbring the scale traders to their knees psychologically. Masteringthis aspect of trading will make the scale trading experience moreprofitable and enjoyable. For the record, the other situation that canbreak a trader is the unexpected series of limit-down trading daysdiscussed previously. That is why I also recommend the use ofoptions. Understanding rollovers and using options are the twothings that can make scale trading a sane and enjoyable way tomake money from the futures market.Getting back to rollover situations, don’t fight them; there isnothing you can do about the direction of the market. The rolloveris telling you that your supply-demand analysis is not exactly ontarget or you might have entered the scale too early. All you needdo is sell the positions you have and replace them with some others in more distant contract months. Sell the June and buySeptember, for example.Before you do this, you need to calculate the new sell price(s).If you wish, you can add on the cost of the extra commissionsrequired to sell and repurchase these contracts. In our crude oilexample, you have sold two long crude contracts and have twoopen positions left in inventory as the June crude contract goes offthe board. One of the remaining positions was purchased at $19.00(#2) and the other at $20.00 (#1). These two holdovers are sold at$19.50 for a profit of $0.50 and loss a $0.50 respectively, a breakevensituation. You buy two replacement positions at the same time inthe September contract, which are $1 higher, $20.50. Your commissions and fees for selling two expiring contracts and buying tworeplacement contracts cost you, say, $100, or $25 per contract or$0.025 per barrel ($25 divided by 1000 barrels) in this example.Your profit objective is still $1 point per barrel per contract on thetwo new positions. This totals up to $21.60 ($20.50  $1 profit $0.10 in commissions). For a short scale, this is all there is to it.The tough question that needs to be answered is, Will crude beselling in the 21–22 range by the time the September contract expires?
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I do not subscribe to the roll, roll, roll me over philosophy of the traditionalists. My recommendation is to evaluate the rollover as if youwere entering into a completely new scale. What do the fundamentals say about the prospects for crude from the rollover date to theexpiration of the September contract? Is it realistic to believe thatcrude will hit 22? If not, what about 21? What opportunity will belost? The answers to these questions tell you whether to roll or not.Occasionally, you are caught deep into a scale. You have 10, 15,or 20 or more positions on and the commodity is trading at $2.00,$3.00, or $5.00 or more below the price point at which you enteredthe scale. This means you have several positions that have a longway to go before they are even near breakeven. You have been meeting margin calls for the past three months. As the contracts you arein reach expiration, you are looking at rolling 20 losing positions—that’s 40 commissions (one per contract to close and one per contract to open the new position)—and the market is below your lastposition. It is for situations like this that I recommend you calculatethe worst-case scenario and then add 50 percent more to your equity before beginning a scale. You will also appreciate the gains youhave on your options at this time. Nevertheless, it is painful. But ifyou persevere, you will come out of this black hole smelling like amillion bucks. If you are trading the “real” commodities recommended in this book, they will eventually reach a point whereinventory managers around the world cannot resist them, and buying will once again take you profitably out of the scale. But, attimes, you must prepare for the worst and have the staying powerto hang tough.When you are dealing with rolling over several positions, say 5,10, 15, 20, or more, it helps to create a rollover table to keep everything straight (see Table 8-2). Here is the scenario. You are scale trading silver. You begin when it penetrates the lower third of its 10-yeartrading range. Your scale is to buy each time it drops 6 cents and sellfor a 6-cent profit, or a 6-down, 6-up scale. You are trading on theCOMEX Division of the New York Mercantile Exchange. The silvercontract is for 5000 troy ounces of pure (.999 fineness) silver. A 6-centmove equates to $300 up or down. The contract months are January,March, May, July, September, and December.Fundamentals look good. Prices are declining, but supplies,while adequate, are not out of line. Demand is steady and expected
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to strengthen in the months ahead. The chart indicates that the 20day moving average broke $5.00, which signifies the lower third ofthe 10-year trading range. You commence your scale by buying onecontract at $5.00. Silver continues to move lower. You add positionsat $4.94, $4.88, $4.82, $4.76, $4.70, $4.64, $4.58, $4.52, and $4.46.Your next buy, at $4.40, is not hit. Silver bottoms at $4.41 and beginsto move higher. You offset trades 10, 9, 8, and 7 for a gross profit of$1200. Additionally, you have taken four oscillating profits, but I’veomitted them to simplify the example.At this point, the December contracts you are trading areabout to expire, forcing you to close them out. You look at youralternative and decide to roll into May, which is selling for a 30-centpremium over the December contract. You sell all the Decembercontracts at $4.72 (Table 8-2, Column 6) and buy May at $5.02(Table 8-2, Column 11). You lose money on five of these transactions and make 2 cents on one (Table 8-2, Column 7) and must addthese losses to your new sell prices (Table 8-2, Column 12).Additionally, you must pay a premium for the new contracts, makea 6 cents ($300) per contract profit, and pay two commissions ($25each) for selling the old and buying the new (Table 8-2, Columns 8,9, and 10, respectively). Combining all these figures provides thenew price (Table 8-2, Column 12) you must sell each contract for toreach your budgeted profit of $300 per contract.To determine how realistic it is for silver to trade at $5.96 orhigher, you draw a line at this level on your long-term chart. Fromthis exercise, you decide, given the current supply-demand ratio, itis not unrealistic.