
$15,750.00
$12,600.00
$9,800.00
$7,350.00
$5,250.00
$3,500.00
$2,100.00
$1,050.00
$350.00
$0.00
Totalof Losses
8
$44,250.00
$38,850.00
$33,800.00
$29,100.00
$24,750.00
$20,750.00
$17,100.00
$13,800.00
$10,850.00
$8,250.00
$6,000.00
$4,100.00
$2,550.00
$1,350.00
$500.00
Drawdown
9
8:58 AM
11
Buy Price
Number
3
Down 7, Up 7 Cents
7/2/01
10
2
1
Corn Scale
TA B L E
IPRO-F_11/13_ch04_McCaffertyPage 63
IPRO-F_11/13_ch04_McCafferty
64
7/2/01
8:58 AM
Page 64
CHAPTER 4
What can unexpectedly increase supply? High prices? Favorableweather? Government incentives? You must ask yourself thesame questions about demand. How will that change for the better or worse?This is uncertainty. The market does not know what to expect.Uncertainty breeds indecision, and indecision erodes confidence.Lack of confidence encourages herd psychology. The market getschoppier and choppier. The average daily price move widens.The opposite can happen just as easily. In this situation, themarket has a high level of confidence that the supply side is morethan sufficient for whatever commodity is being scale traded.Prices are moving slowly lower; the buyers are evaporating. Onlycommercial users of the commodity are buying hand-to-mouth,since they must keep their production facilities stocked.When the market recovers, you can see demand momentumpick up as more and more buyers enter the market. This wouldspur the speculators to jump on the bandwagon, driving priceseven higher. In either case, there is confidence as opposed to chaos.Understanding the personality of the market at the time you arecreating a scale is critical.Certainty or uncertainty—that is the question. The answer isyour first clue on how to structure your scale and how much protection you think you will need. If your answer is certainty, yourscale must be tight because the average daily price move will besmaller. If you do not use a tight scale, you will not build an inventory of long futures contracts. For example, if the daily price moveis less than 3 cents per bushel in the case of corn and your scale callsfor adding a new position every 10 cents down, it could take a whileto get a scale going. Remember, the average daily price move is notomnidirectional. It will be 3 cents up one day and 3 down the next.Further, it is an average—up 4 one day and down 2 the next for anaverage of 3, and a million variations of that refrain.As a commodity moves toward the starting point of a scale,you begin to watch the market even more closely. You studyvolatility charts, which calculate the velocity of the average dailymovement, and begin to track the 20-day moving average (this isan important indicator, explained in Chapter 7). The price trendwill be down. If it weren’t, the commodity would not be cominginto scale trading range.
IPRO-F_11/13_ch04_McCafferty
7/2/01
8:58 AM
Understanding Hedged Scale Trading
Page 65
65
All these indicators provide insights into when to begin ascale and what interval to use between limit orders. Most important is the volatility level. If there is a high level of uncertainty, yourun the risk of entering a scale and being faced with a few or evena series of limit-down days. These are trading sessions duringwhich the commodity being traded opens at or below its dailytrading limit (see Appendix 1 for specifications) or quickly reachesits daily limit, halting trading. As a scale trader, you may have oneor more orders in the market. These orders will be filled. Immediately the price drops, and you are faced with a margin call. Otherorders may be caught in the market and will be filled when tradingresumes. At that time these positions will have a margin call. Oryou might have one or two positions on by the time the limit day(s)occurs. Again, you would be facing large margin calls. I have seenhogs limited down six straight trading sessions in a row, causingmajor margin calls.Let me give you a quick example, which is based on a real situation. Several clients were in a live cattle scale. If I remember correctly, they had from four to six long positions in inventory andanother four or five limit orders in place. At that time, some negative news hit the market. I think the USDA adjusted the cattle-onfeed numbers substantially to the high side, putting the supplydemand equation out of whack. The market crashed, limitingdown for three days straight. The five limit orders already in themarket were filled, even though there was little trading. In otherwords, some locals took out all the long limit orders in the hopperas shorts when prices plunged, despite all our efforts to cancelthem (the pits are a private trading club at times). The guys scalingthe cattle now had nine long positions. The limit move for live cattle is $600 per day. That amounted to $5400 a day. Additionally,four of the positions had been opened before the limit move started, so the margin on them was higher. One of these clients wastrading five lots (five contracts at a time). His daily loss on the threelimit-down days was $27,000.My point is that the margin calls were heavy over that threeday period of time, ranging from $10,000 to $50,000. As per theaccount agreement of most brokerage houses, margin calls must bemet within 24 hours. The shock of this violent move caused two ofthe traders to exit the market with major losses once trading resumed.
IPRO-F_11/13_ch04_McCafferty
66
7/2/01
8:58 AM
Page 66
CHAPTER 4
They could not meet their calls. Even when you close your positions and your account, you are legally liable for any debit left inthe account.The sad part of this story is the market recovered almost asswiftly as it fell. The traders who had prepared for the possibility ofsuch a situation made substantial profits. Futures markets overreactto news and negative (or positive) information. Once an overreaction occurs in one direction, the market often overreacts in the other.The herd stampedes north as a direct response to a bolt of lightningcoming out of the south, only to stampede south when a second onestreaks across the northern sky.Handling margin calls is not easy on the brokers, not to mention the clients. It sincerely bothered us to see good clients lose substantial sums because they were not prepared or did not have deepenough pockets to withstand these limit moves. You will see thesereactions and overreactions time and again. They are the modusoperandi of most open outcry markets, even electronic ones likeNASDAQ and Globex. This specific event motivated us to beginexperimenting with various option strategies to somehow managethis kind of risk for our clients.The moral is as follows: As you are sizing up a market, thinkabout the worst-case scenario and plan a defensive strategy. Thismeans selecting the proper scale for the type of market and someoptions to cover at least your initial positions. The lower prices go,the less risk, because you are closer to the bottom. By trading commodities with real, intrinsic value, there is always a point at whichthey get too inexpensive for a commercial user of the commodityto resist.You should not open a scale and then think about adding afew options to manage the risk that can arise if the market you aretrading becomes more volatile. You can do this, but it usuallyworks better if you develop a plan with your broker before youenter a scale. Remember, when a market gets volatile, the price ofoptions accelerates, making your insurance expensive. You do notwant to be trying to buy puts in a limit-down market. The key element in the Black-Scholes equation that calculates the fair value ofan option is volatility.Let’s take another look at the corn market. I will continue, forthe moment, to use the corn market. It is an easy one to understand,
IPRO-F_11/13_ch04_McCafferty
7/2/01
8:58 AM
Page 67
Understanding Hedged Scale Trading
67
and investors new to futures will not have to worry about learningthe contract specifications for a number of commodities. It shouldbe less confusing this way, and the strategies detailed can be usedfor any commodity. Appendix 1 includes the contract specificationfor the commodities I recommend for scale trading. To refresh yourmemory, the key facts on corn are:Contract SizeOne-Cent Move EqualsLimit-Down Day Equals
5000 bushels$50.00$0.12 or $600 per contract
In this discussion, I describe three levels of risk taking. Aswith any investment strategy, there is no absolute right or wrongchoice. The more risk, the more gain. The less risk, the more comfort. You must decide for yourself what is the right way toapproach the markets. As always, much of the decision dependson what you are willing to risk and how you tolerate risk. Yourdecision may also depend on how confident you are in your fundamental analysis of the market in which you plan to scale trade.Is there light at the end of the supply-demand tunnel? The traditional scale trader accepts the entire risk, which is the extremeother side of the risk tolerance range.
THE JIC-TRADERThe first level is what I call the “just-in-case” scale trader, or theJIC-trader. This type of trader is one risk level below the traditionalist described in Chapter 3. He or she firmly believes in scale trading and is after the maximum profit.The JIC strategy entails buying an occasional put option asinsurance. A put gives the trader the right, but not the obligation,to take a short position in the futures market. Therefore, if the JICtrader opens a scale by buying a long futures contract, that tradercan hedge that futures contract with the put. The put gains valueas commodity prices go lower. This gain offsets the losses the JICtrader will experience from the long futures contract as the longposition loses value.If a put that is at-the-money or in-the-money or has a strikeprice that is very close to the price of the futures position is bought,the JIC-trader is fully hedged. The option will have a delta of 1 and
IPRO-F_11/13_ch04_McCafferty
68
7/2/01
8:58 AM
Page 68
CHAPTER 4
move penny for penny with the futures contract to the down side.But a put that is at-the-money is usually expensive insurance,because it is in greater demand. As with any insurance decision,the JIC-trader must decide how much of a deductible to take. Thisis done by buying an out-of-the-money option. These options onlyhave time value and no intrinsic value. Most futures markets, likeother securities markets, give little value to time.Some savvy scale traders, who plan their scales well in advanceof the price point at which they are going to enter a scale, buy theirinsurance first while it is still inexpensive. For example, they plan onbeginning a scale when the commodity reaches the lower 25 percentof its 10-year trading range. They begin buying put options when thecommodity hits the lower 30 percent. This way they can keep aheadof the option market and buy cheap, deep-out-of-the-money options.In our example, we have corn trading between $2.00 and $4.00over the past 10 years, or a $2.00 price range. The lower 25 percentis $2.50 and the lower 30 percent is approximately $2.67. Strikeprices are generally a dime apart, so there would be strikes at $2.70,$2.60, $2.50, and $2.40 for the puts needed to cover the first longposition at $2.50. When the futures price is at $2.70 moving to $2.60,it would be a good time to buy a $2.40 strike price put.Next is the selection of the contract month. Corn contracts aredeliverable in March, May, July, September, and December. If it isApril or early May and the scale is planned for the September contact, my first choice of an option would be the December $2.40 put.Remember options expire before futures. By using the Decemberoptions, there is some slippage if the scale is started late and it isdecided to scale the December contracts rather than the Septemberones. Scale trading works, but not necessarily on a tight schedule.The beauty of it is that it will cut you some slack.The December $2.40 put is my first choice, but what if it looksexpensive. For some reason, it looks like the market is willing topay a little for time, which it isn’t as a rule. I would then compareit with the $2.40 September put. How do you compare them? Ifyou do not have a software package to price options, your brokerwill. It is a function of all of the real-time price quotation servicesserving the futures industry (CQG, CSI, DTN, Futures Source,etc.), which are in front of every broker. Compare fair marketvalue and deltas. Your broker’s software should also indicate
IPRO-F_11/13_ch04_McCafferty
7/2/01
8:58 AM
Understanding Hedged Scale Trading
Page 69
69
which is overbought or oversold. Then make your decision, as wasdiscussed in Chapter 2.The real concern of the JIC-trader (or of anyone trading thelong side) is a series of limit-down days. The loss could be $600 percontract per day for corn. Further, there could be a series of dayswhen the commodity limits down and the scale trader has multiplepositions at risk. The margin calls pile up. What is the worst-casescenario? How far could corn fall? The famous commodity trader,William D. Gann, might say ”to zero,“ but that is probably too pessimistic for a physical commodity with intrinsic value. A more realistic answer would be the $1.50 area. My rationale is that corn hasnot traded on the Chicago Board of Trade for any period of time at$1.50 for over 20 years. Don’t confuse the price of corn at a local elevator near your home with the price on the exchanges. During thepast decade, it has bounced off of $1.50 only twice, and it immediately recovered. Let’s call the low $1.52 as we work through thisexample.If $1.52 is the potential bottom, how much risk will the JICtrader take? A quick glance at Table 4-1 gives you an idea of what losses could be sustained. The traditionalist, trading a single contract,faces a maximum drawdown of approximately $50,000, includingcommissions. Let’s say the JIC-trader opts to buy one put when itis about a strike price out-of-the-market for every third futuresposition established. This would amount to five options. A reasonable price for an option would not be more than a nickel each, if themarket were not extremely volatile. The more volatile the marketand the closer the option’s strike is to the current market value ofthe underlying futures contract, the more expensive the insurance.The JIC-trader would have five put options, four of which wouldbe in-the-money and would have various amounts of intrinsicvalue when corn hits $1.52.Once a bottom has been established or the JIC-trader decidesthe risk of limit-down days has passed—in other words, the market volatility has subsided, and it is clear the market is bottoming—the puts are sold, and the profits are used to supplement the fundsused to meet the margin that was needed to hold the long futurespositions.Using puts this way is not intended to mitigate all risk.The strategically placed puts are to protect against limit moves. The
IPRO-F_11/13_ch04_McCafferty
7/2/01
70
8:58 AM
Page 70
CHAPTER 4
JIC-trader plans several scale trades, looks at the price action andvolatility, and then decides when and how many puts to buy. If themarket is orderly, the trader may be lulled into skipping insurance.But just like a tsunami, a series of limit-down days can hit fast, hard,and unexpectedly. Options can take the sting out of this kind of event,especially in the early stages of a scale.
THE C-TRADERThe next level of trader, the conservative or C-trader, seeks todefine the risk as exactly as humanly possible. To do this, a put isbought for each long futures position opened at a strike pricebelow the current market value and as close to the CMV as possible. The amount of the risk depends on the strike price of options,and the cost of the insurance depends on when they are acquired.Let’s say the C-trader wants the risk limited to a nickel, or$250 a contract. Therefore, 15 puts would be bought at a strike pricethat is 5 cents below the CMV, or as close to that as possible, tomatch each futures position. In this example, if corn hits a near alltime low at $1.52, the C-trader would have 15 futures contracts and15 puts.In reality, even the most conservative trader would probablystop buying protection after the price of corn hit some level. If youlook at the long-term charts, the risk that corn will make a new contract low or an all-time low diminishes substantially some timeafter it trades below $2 per bushel. Most traders would stop buying options somewhere between $2 and $1.80, depending on howit was trading and the overall outlook of the supply-demand equation at the time.Needless to say, there is a point when insurance is not costeffective, as with a 15-year-old car with over 200,000 miles. Theactual clue as to when to cease buying protection is when you spotthe commercial buyers returning permanently to the long side, asyou will learn in Chapter 10.The insurance (i.e., premium used to buy the puts) would be$3750 (5000 Bu.  $0.05  15), if the puts were bought at an average of a nickel each, which is probably on the high side. On top ofthis would be 30 commissions to buy and sell (offset) the 15options. Let’s say they would cost $25 (if you are doing this kind
IPRO-F_11/13_ch04_McCafferty
7/2/01
8:58 AM
Understanding Hedged Scale Trading
Page 71
71
of volume, most brokers will give you a break on commissions)each times 30, or $375. The total would be $4125, which would beadded to the drawdown (see Column 6 of Table 4-1). Keep inmind that 14 of the 15 puts would be in-the-money and could besold at a profit. At this price level, I doubt if even the most“nervous Nellie” trader would be too worried about furtherdeclines. Once corn hit $1.70 or $1.60, you can bet I would be selling some of the older puts with the most intrinsic value to covermy drawdown.
THE UC-TRADERThe ultraconservative or UC-trader wants the insurance protectionof the puts FREE! That’s right, the UC-trader’s strategy includesselling covered calls above the CMV of the futures price (i.e., outof-the-money calls) to pay for the cost of the puts purchased. Thesecalls could be sold at the price at which the trader plans to close thepositions based on the scale selected. The trader holds the longfutures positions and the short calls until the futures are calledaway when the owner of the calls exercises them or they expire. Ifthis is done right, the UC-trader can even make a little money onthe spreads between what the calls sell for and what the protectiveputs cost.For each futures position opened on the corn scale beginningat $2.50, the UC-trader buys a $2.40 put to cover the downside risk.If this put costs a nickel, the UC-trader sells a call, perhaps at $2.55or $2.60, to pay for the put. Calls tend to be more valuable thanputs, since most traders favor the long side of the market‘s increasing demand. With a little luck, the UC-trader would get 7 cents forthe call and net a 2-cent profit.The exit price in the scale for the first position opened is $2.57.Strike prices are at even intervals, usually a dime or a nickel apart.Therefore the trader decides, based on the best-priced option ($2.60vs. $2.70) and the outlook for the commodity at the time, whichstrike price makes the most sense. Conceivably, the call could besold for more than a nickel, netting the trader a small profit on thedeal to help pay the commissions. Again, if you are opening threepositions each time you trade (a futures and two options), youshould be able to negotiate a good commission rate.
IPRO-F_11/13_ch04_McCafferty
72
7/2/01
8:58 AM
Page 72
CHAPTER 4
What if the market goes up instead of down? If it goes highenough, the owners of the calls will start thinking about exercisingthem. This is a very important issue. The UC-trader must unwindthe entire position at one time. Do not leg out of this type of trade.Leg out means to close each part at different times, perhaps the putfirst because it is losing value quickly, then the call, followed by thefutures. Instead, the trader might try selling off the options, calls,and puts, and hold the futures since they are gaining value.Nine out of ten times, if you leg out, you’ll get caught in awhipsaw trade. That’s when you take one action to adjust to a market trend change, only to see the market go against you. For example, you could sell your options protection, the puts, just as cornlimits down for a few days. You still have the long futures positionwithout any cover. This advice also applies if you have to roll overa position like this one; close out all related legs at the same timeand reset the entire position. In this case, the put is on for protection. Leave it on until the short call is called away, meaning youwould deliver your long position to satisfy the owner’s demand.Then dump the put to salvage any time value still left in it.Now we have discussed three styles of scale trading usingoptions. Which one you use depends on your psychological makeup, financial situation, and the market conditions prevailing whenyou open a scale. No matter which method you choose, be ready toacquire some insurance when warranted.
IPRO-F_11/13_ch05_McCafferty
7/2/01
CHAPTER
8:59 AM
Page 73
5
The Criterion for theSelection of ScalableCommodities
A
sound understanding of the impact of supply and demand oncommodities is much more complex than most scale traders realizebecause there are multiple sets of rules governing supply anddemand. If you do not master these concepts, you can never hopeto be a successful scale trader. This is because, as a scale trader, youenter markets as they are declining. You must avoid commoditiesthat have little or no hope of recovering from the downtrend overa reasonable period of time. A reasonable period is three to sixmonths.Let’s begin by discussing the key rules governing supply anddemand (see Figures 5-1, 5-2, and 5-3) in the marketplace. Theseappear to be simple at first, but they get very complicated in ahurry. Additionally, obtaining reliable facts—and all the facts—tomake accurate projections is perplexing.The most basic laws of supply and demand are:1. When demand increases, prices increase.2. When demand decreases, prices decrease.3. When supply decreases, prices increase.4. When supply increases, prices decrease.But when the price of a commodity increases too much, users havea tendency to buy less. If the price of a commodity doubles ortriples in a short period of time, we try to figure out how to dowithout it; we find ways of reducing our dependency or begin73
Copyright 2001 The McGraw-Hill Companies, Inc. Click Here for Terms of Use.
IPRO-F_11/13_ch05_McCafferty
7/2/01
8:59 AM
Page 74
CHAPTER 5
74
FIGURE
5-1
Demand Rules
6050
Prices
4030201001
2
3
4
5
Unchecked Demand DrivesPrices Higher
FIGURE
5-2
Supply Rules
6050
Prices
4030201001
2
3
4
Unchecked Demand DrivesPrices Higher
5
IPRO-F_11/13_ch05_McCafferty
7/2/01
8:59 AM
Page 75
The Criterion for the Selection of Scalable Commodities
FIGURE
75
5-3
Price Equilibrium
Supply vs. Demand
60504030201001
2
3
4
5
Price Stability Occurs at theIntersection of Supplyand Demand
searching for a replacement. When something becomes extremelyplentiful, we look for new uses.If this was all there was to it, scale trading would be a lot morepopular than it is today. A better understanding of supply anddemand may be achieved if we put ourselves in the role of an inventory manager. A professional inventory manager must evaluate allthe factors influencing the decision to purchase a commodity. Thisis a key point; you must begin to think like an inventory managerwhose annual bonus is based on buying a commodity at the lowestaverage price. You are the buyer for a large commercial user whomust have the commodity in question to stay in business. You aregoing to buy no matter what, but the better buying decisions youmake, the more you are rewarded. Additionally, you have virtuallyunlimited resources at your disposal and worldwide contacts.A friend of mine, Milo Hamilton, was in that situation. He wasthe chief trader for a large food company that required enormousamounts of rice, sugar, and cocoa. The amount of information andresources he had access to was astounding (satellite photos, computer projections, USDA officials, analysts, experts, growers,processors, coop leaders, top brokers, consultants, field operatives);in addition, he traded a futures account well into the eight-digit
IPRO-F_11/13_ch05_McCafferty
76
7/2/01
8:59 AM
Page 76
CHAPTER 5
category. Whenever a serious problem occurred in the world regarding his key commodities, you would see Milo right there on thescene making a personal assessment.Because of that and the power and prestige of his employer,there was no one within the industry, the government bureaucracies, or the trading community that he could not meet or contact. Isit any wonder that with capabilities and backing like that we, asscale traders, must pay particular attention to commercial users?Milo’s current Web site is www.nopotatoes.com. He is still promoting rice over the other white vegetable.Let’s say you are a big-time buyer, responsible for locking upwheat for a national bakery, like Wonder Bread. The price of wheatis dropping as harvest begins. It is entering the lower one-quarterof its 10-year trading range. What do you do? Do you buy all youcan store now and lock up all of next year’s needs on the futuresmarket? Or do you buy what you need now and wait to see whereprices will go after harvest? This is supply-demand managementin its most basic form.The professional inventory manager tends to buy from handto-mouth as prices fall. Whenever he sees signs of strength, hebacks off and waits for weakness. If he thinks a bottom is in place,he locks up as much as his needs demand, often using futures toreduce cash outlays. As the futures contracts expire, he acceptsphysical delivery of the commodity and moves the commodity tohis firm’s storage facilities.As a scale trader, you need to go through the same mentalexercise as an inventory manager. Let’s say the price of wheat isapproaching an entry point to begin a scale and your analysis indicates it will continue to trend lower and then begin moving higherin the next four to six months following its seasonal pattern. It is setup perfectly to start a scale right away.If, on the other hand, the data suggest that wheat prices aregoing lower or will most likely stay flat straight through to nextharvest, you should look for another commodity to scale trade. Thereason, as alluded to earlier, lies in the costs associated with havingto roll positions into more distant contract months. You do notwant to tie up trading capital indefinitely if the price of the commodity does not have the potential to rally sufficiently to take youout of your scale in a reasonable period of time.
IPRO-F_11/13_ch05_McCafferty
7/2/01
8:59 AM
Page 77
The Criterion for the Selection of Scalable Commodities
77
What would cause the price of a commodity such as corn tostay depressed for an entire year? There are several answers. First,corn is a commodity, meaning that it is easy to replicate. When theprice gets attractive, say $3.00 or $3.50 per bushel, any farmer whohas decent land will grow some. Supplies will increase, and the pricewill eventually fall. Supplies of corn, unlike orange juice, coffee, andcocoa, can be substantially increased within a single growingseason.Corn, beans, wheat, and most other crops are global commodities. Farmers in South America, South Africa, and Australia willincrease their corn or soybean acreage when world prices of thesecommodities become attractive. And the growing season in theSouthern Hemisphere is the opposite of that in the United States.When U.S. farmers are planning their soybean acreage in January,harvest is beginning in Brazil and Argentina. The South Americanbean harvest depresses prices during the first quarter of the year.What once was a no-brainer scale (i.e., buy beans at harvest and scaleout in January or February), no longer works. You must be attuned tothese changing seasonal patterns. In this country, supply is increasedor decreased as farmers switch acreage from soybeans to corn andback again, depending on which crop offers the most profit potentialat the beginning of each crop year. But you must keep in mind thatU.S. farmers always prefer to grow corn. It wins all ties.Another key supply and demand concept you need to understand is the elasticity of demand and, therefore, of price. Initially, itexpresses a qualitative relationship between various commodities,which becomes quantitative when exercised. Wheat, for example,can be substituted for corn as cattle feed. If there is an oversupplyof wheat in a given year and corn is scarce, cattle feeders may beinclined to feed wheat to their cattle rather than the