drives the market for speculators; thatdichotomy is fear and greed. Speculators are torn between the two.One drives the markets to exuberant highs; the other bursts thebubble, trashing the markets. When you begin to study pricecharts, you will see repeated examples of prices hitting highs onlyto immediately reverse to test the lows and visa versa. More important, you will see many instances where a market will oscillatewithin a range, moving up and down, over and over again, as themood swings of the participants ebb and flow between confidenceand insecurity. These periods of ambiguity are gold mines for scaletraders, as will be explained in detail.Before we get into all that, let me define the basic concept offutures trading. When you buy or sell a commodity or a futurescontract, exactly what are you buying or selling? A futures contractis a fungible contract. For example, you buy or sell one crude oilcontract. By entering this contract, you agree to accept delivery of(buy side) or to deliver (sell side) 1000 barrels (42,000 gallons) ofcrude oil of a specific grade (quality) at a specific location or terminal on or by a specific date at a specific price. If you do not offset
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your futures position, you are truly expected to take (long) or make(short) delivery.Naturally, it is rare for individual traders to take or makedelivery of the physical commodity. (Most financial futures settlein cash.) Those traders, short when a contract expires, deliver tothose who are still long. If a short plans on delivering, the shortfiles a notice of intent to deliver. A long would notify the clearinghouse of his or her intent to accept delivery. The clearinghousematches up the shorts that want to deliver with the longs that wantto accept a delivery. There are usually more longs than shorts. Toavoid delivery, most traders simply offset their positions by buyingor selling equal and opposite positions on the same futuresexchange in the same contract month. If for some reason a longdoes not offset a position in time, the trader may be assigned adelivery notice. Additionally, when a trader receives a notice ofdelivery, he or she must deposit enough cash to pay 100 percent ofthe contract. If a livestock contract is involved, the trader is alsoassessed yard and feed fees.The trader who does not want to accept delivery in this situation can retender the contract. Retendering is the process of reoffering the contract to the open market. There is no guarantee as towhat price the trader will be paid for the contract. This is a risk ofretendering. The trader will also be assessed two additional commissions for handling the transactions. It is a rare occurrence, but itcan happen if a scale trader hesitates too long in rolling over expiring futures positions, which is the subject of Chapter 8.This brings another important aspect of the futures contract:expiration. Unlike securities, which you can hold indefinitely or atleast as long as the corporation is in business, futures have specificexpiration dates. When a contract expires, it is known as “going offthe board.” As one contract expires in a particular commodity,another one begins. For example, the corn contracts expire or aredelivered in March, May, July, September, and December. As onegoes off the board, another one begins, with at least three contractstrading at any one time. Other futures contracts, like crude oil, provide for delivery every month. My point is simply that you cannothold a futures position indefinitely.The contract nearest to expiration is called the nearby and isusually the most active. The farther the contract is away in timefrom delivery or expiration, the less liquid it is, as a general rule.
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Liquidity is a measurement of how many contracts are being traded per trading session. Scale traders need a certain amount of liquidity to open positions. Additionally, scale traders need a certainamount of time for the scale they are trading to develop. As you willlearn in Chapter 7, the contract month you decide to trade inwill depend on the liquidity, the number of months to expiration,and the price differential (carrying cost) between contract months.Liquidity in the futures markets has a lot to do with the roleplayed by the clearinghouse. When you buy or sell a futures contract, you are not entering in a contract with another individual orgroup of individuals in the case of multiple contracts. You are creating a financial obligation to the clearinghouse. The clearinghouseis the buyer or seller of all contracts. In securities parlance, it is thecontra party. Therefore, when you buy or sell a futures contract, it isthe clearinghouse that matches all the trades at the end of each day.You do not have to find a buyer when you want to sell or a sellerwhen you want to buy. The clearinghouse is also responsible forlicensing delivery terminals.Since your financial obligation is to the clearinghouse, it setsthe amount of money you must ante up to hold a position. This, ofcourse, is called margin money. Most clearinghouses are corporations owned by the exchanges they serve, and each exchange has amargin committee. You must trade through an FCM (futures commission merchant), who has a financial obligation to stand behindyour trading activity. In other words, the clearinghouse sets a minimum margin requirement for each contract, which is usuallyaccepted by the exchange’s margin committee. But your FCM andits IB (introducing broker) have the right to increase the exchangeminimum at their discretion.The amount of the margin can be adjusted at any time toreflect market conditions. The more volatile the market, the higherthe margin tends to become. Margins on futures contacts are considered low by most standards, which generally encourages liquidity. You might be required to deposit only 5 percent of the valueof a contract. This creates enormous leverage, which can be a boonor a bust. I will provide some examples and more details in a laterchapter.For a scale trader, it is important to know who the players arein the futures game. Each has a specific role that can be very beneficial to the trader.
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The players you generally hear most about are the speculators. Speculators come in two stripes—the professional and theamateur. If the pro trades on the floor of the exchange, he or she isusually a scalper. Scalpers seek SIPs (small incremental profits).They hold positions for very short periods of time (seconds or minutes) and rarely take positions home overnight. In the securitiesbusiness, they would be the equivalent of day traders. In the pits,they perform two important functions. First, they are the pricepolice. Whenever there is an imbalance in price, they jump on it,attempting to take advantage of the disparity.Second, they provide liquidity when it is most desired by thescale trader. There are certain times when the market as a whole isuncertain as to what the price of a commodity should be orwhether a price trend should continue or reverse. At these times,prices oscillate up and down. These incidents often occur at areasof price support or resistance. It is at these times that scalpersbecome extremely active, providing liquidity. You will be taught ina later chapter how to take advantage of these opportunities toenhance your returns. Scalpers in the pits are also referred to aslocals, simply because most of them are of local origin, unlike floortraders hired by larger firms, who are often recruited from otherlocales.The second type of professional trader either trades for his orher own account or for others. The best way to get inside the mindof these traders is to read Jack Schwager’s books Market Wizardsand New Market Wizards. Both books are a series of in-depth interviews with several of the world’s foremost futures traders. None ofthem is a scale trader, but reading the books will give you a uniqueinsight into how these people think and trade. Knowing this, youwill eventually be able to feel when these pros are entering marketsand why markets move the way they do. Price patterns are nomore than a reflection of the emotions of everyone trading at thatpoint in time and space, and the market wizards are often the leaders of the pack.Some wizards trade for investors. They become CTAs (commodity trading advisors) and trade very large pools of money.Other professionals trade for large trading firms and institutions,like pension funds. A few CTAs provide professionally managedscale trading programs. Trading large amounts of money, oftentens of millions of dollars, magnifies the impact of the pros.
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The amateur speculators also fall into two categories—fullor part-time. They can be further divided by the time frames theytrade. The full-timers tend to be nerds in the sense that they eitherhave a computerized, technical trading system that they developed themselves or acquire a proprietary system, such as TradedStation by Omega Research. The trading systems this group usesmay be of any time frame. The part-timers tend to be in the gameseeking large, quick profits, but they are not, as a rule, seriousstudents of the markets. Often heavily influenced by their commodity brokers, many of them are in reality gamblers. Their timehorizon tends to be short term. Again, both add liquidity at justthe right times, which is extremely important as you will see whenI discuss strategies.The market segment of most importance to the scale trader isthe commercials. These are businesses that actually use the commodities represented by the futures contracts being traded. Theyuse the futures markets to manage risk and control the flow of theunderlying entities they need in order to produce the products theymake, sell, or own. As mentioned earlier, silver is used to make filmand electrical devices. Grain merchants, livestock producers (beef,chicken, turkey, pork, etc.), bakers, and cereal manufacturers musthave corn and wheat at reasonable prices and when it is needed tomeet customers’ demands. Refineries cracking crude oil into heating oil and gasoline cannot leave price and supply to chance.Importers, exporters, banks, and even countries have a need totrade currency futures. Major stockholders, such as pension andmutual funds, banks, securities brokerage firms, and retirementplans, all hedge the risk of price fluctuation by trading stock indexfutures contracts.All these commercials have a strong financial use for whatthey trade, and most of them are large and well financed. They arestaffed with well-trained professionals using the best trading toolsmoney can buy, even to the point of having satellites photographthe key growing areas around the world. The futures contracts theybuy are said to be “held in strong hands” compared with speculators who are nowhere near as flush and only seek a quick turnaround using their intuition more than anything else. For all thesereasons, the commercials have the wherewithal to take more heat(adverse price pressure) than the amateur does. More important,
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these professional players are longer-term traders, as are scaletraders. Therefore, you will learn how to find out what commercials and larger traders are doing and input their activity into yourtrading.Since many of the commercials use the underlying entity intheir business, they are true hedgers. Once hedged, they hold theirpositions unless something extraordinary occurs. This is anothersign of their strong hands and the conviction of their commitmentto a specific contract. As you will learn, the commercials can tellyou when the light at the end of the supply-demand tunnel is lit.You do not always find this steadfastness in the farmerhedgers mentioned in the Introduction. My personal experiencewith farmer-hedgers was not gratifying. They often started as legitimate hedgers, selling on the futures market when corn pricessoared on a summer rally. But when the rally ended and pricesretreated, they often wanted to offset their short positions and takeprofits. That made their long, physical position growing in theirfields naked. Now they were speculators. Their hope was, ofcourse, for another rally, giving them a chance to hedge again. Thisdoes not always happen. The problem, and something you willhave to address yourself, is staying true to your trading strategy.The scale trader who gets lured away from scale trading intospeculation will eventually regret that decision. But sometimes it isvery tempting. For example, you have created a scale and you havefive or six long positions. The market rockets north. The scale trader is supposed to methodically exit each position at a stated price,which was specified in the scale. But with such a bull market raging and six long positions on his or her hands, it is tempting to holdthose positions for the maximum profit.More often than not, you will be whipsawed. This is whenprices move in one direction and you attempt to react to that move.About the time you do, the trend reverses itself, producing a severeloss in your adjusted positions. If you are going to scale trade, thenscale trade. If you are going to speculate, then speculate. Never tryto do both at the same time, particularly in the same account. I willshow you how to set this up later, if you have the inclination.The last player you should become familiar with is the broker. I describe later in detail what scale traders need from brokersand how to select them, but right now I want to make sure you
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understand their point of view. Brokers are primarily salesmen.Like all salesmen, some are helpful and interested in the success oftheir clients, and others are simply hyping trades for commissions.The brokers who will take scale trading accounts tend to beabove average. Scale traders do not churn their accounts as speculators do. Often scales develop slowly. The broker is expected tokeep track of a large number of orders and potential orders. Severalmarkets must be monitored, and the scale trading customersdemand large amounts of fundamental and technical information.Many brokers find scale trading too much work for them.The brokers who seek out scale trading business are the onesthat believe that scale trading is one of the strategies that providestheir customers a better-than-average chance of being successful.They look for longer-term relationships with their customers andhave taken the time to learn how scale trading works. Joe Broker,whom you bump into on the World Wide Web or on a cold salescall, will not have a clue.The selection of a broker and his or her brokerage firm is oneof your most important decisions. You will learn all you need toknow shortly to make that decision successfully.Anyone who trades the market must have a strategy or a system. Yours is laid out in this book, but let’s look for a moment athow others do it so you will be able to recognize what is happening as price trends fluctuate.In theory, futures trading is simple. Buy low; sell high. Sellhigh; buy low (see Figure 1-1). The only fly in the soup is figuringout what is high and what is low, and doing this in advance of thenext market move. Over the centuries, an enormous amount oftime, energy, and money has been expended to answer this question. Judging by the fact that most futures trades lose money, it hasnot been solved.There are two main disciplines used to project future pricesand trends—fundamental and technical analysis. You will betaught to use both in your scale trading. But now it is time toreview briefly the key elements of both.Fundamental analysis is the study of all the underlying factorsthat can possibly influence the supply-demand equation. Forexample, fundamental technicians build models of the supply anddemand chain. First, they define all the elements. Then they gather
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FIGURE
13
1-1
Just Buy Low and Sell High or Sell High and Buy Back Low
Sell @ $4.00/unit
Buy @ $2.00/unit
Sell @ $4.00/unit
Buy Back @ $2.00/unit
Futures trading is often described as simply buying low and selling highor selling high and buying back low. In practice, determining when acommodity is about to trend higher or lower early enough to takeadvantage of that trend has proved somewhat elusive for mostspeculators.
all the data and compare total supply and total demand to determine how much will be left over at the end of the year. This is calledthe carryover.A calendar year is rarely used. A fiscal year that closely resembles the supply-demand cycle replaces it. For example, for a fieldcrop like corn, supply comes from harvesting the crop. Therefore,the U. S. Department of Agriculture (USDA) sets the crop year fromOctober 1 through September 30 of the following year. Althoughsome corn in southern states is harvested before October 1, themain crop coming out of the Midwest usually begins harvest on orabout October 1.Once carryover is known, it is compared with historical pricelevels at similar carryover ranges. The analysts then forecast the nextyear’s production to determine demand and carryover for the nextcrop year. Using this equation and comparing how prices behaved inthe past under similar circumstances, they project the coming year’sprice ranges. It does not take a market wizard to realize that a lot can
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happen to modify either supply or demand over an extended periodof time. Nevertheless, fundamental analysis tends to be very usefulfor projecting long-term trends, patterns, and cycles.Technical analysis is the study of all the underlying statisticsgenerated from the trading on the various futures contracts. It isused by most traders as a trade-timing tool. If fundamental analysisis the “what” of where prices are going next, technical analysis is the“when.” Since most futures traders are short-term traders and timing is critical to them, most use some sort of technical analysis.On the other hand, most long-term traders use fundamentalanalysis. Leading among them are the grain merchants and commercial users. It is for this reason that you, as a scale trader, willpay particularly close attention to them. But you will also use technical analysis for timing and to be alerted to other trading patternsyou can use to your advantage.Besides the timing factor, futures traders use technical analysisbecause it provides precise signals. Do not confuse precise with accurate. When foretelling the future, there are no fail-safe techniques.Experienced commodity traders rely on technical analysis towarn them when they are wrong or when a trade is going sour.They follow the axiom: “Cut your losers short; let your winnersrun!” Technical analysis is good at this, and fundamental analysisis not. For example, if a trader gets into a trade, technical analysiswill indicate where to exit the trade if it is failing. There may be akey trend line or a price support level, and if either one of these isviolated, the trader should exit the trade. On the other hand, if yourfundamental analysis tells you copper is a good buy at 48 cents, itmust be a great buy at 30 cents. But if you are down 12 cents or$3000 (25,000 lb.  $0.12), you may not be ready to open anotherlong position, unless, of course, you are a scale trader, which I’ll getinto in Chapter 3.My point is that there are only five possible outcomes to atrade. You can make a big profit, make a modest profit, break even,or take a small loss or a large loss (see Figure 1-2). Technical analysis is great at eliminating one of these results—the large loss. Thetheory then states that if you limit your trading exposure to onlythe other four possibilities, you will be a net winner. This doeswork for the most disciplined of traders. My experience has beenthat all too many traders hold small losers until they become
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FIGURE
15
1-2
The Possible Results of a Trade
Large ProfitSmall ProfitBreakevenSmall LossLarge Loss
There are only five possible outcomes for any trade: (1) a large profit,(2) a small profit, (3) breakeven, (4) a small loss, or (5) a large loss. A tradercan substantially improve his or her chances of success by totally avoidinglarge losses. Technical analysis, used with discipline, can virtuallyeradicate large losses as a possible outcome.
account busters, and this is one of the primary reasons most futurestraders are net losers. You will be happy to know scale tradingeliminates this negative behavioral pattern. Still, I am not sayingyou cannot lose in scale trading.The most widely used tool of the technician is the futures pricechart. There are basically three types of charts: line, point and figure, and bar. The one most used and the one used in scale trading isthe bar chart; it is the only one we need to deal with in this text.To understand how to use charts, you must make a fewassumptions. First, you must accept the concept that the market isefficient, meaning it immediately reflects all the news, facts, rumors,and developments impacting prices on a real-time basis. The trueblue technician does not have to look anywhere but to the charts toknow everything there is to know about the price of a futures contract. Charts of course cannot distinguish between incorrect newsand correct news, any more than the floor trader can. But it reallydoes not matter, since either has the power to move the markets.Second, you must think of the charts more as a barometer thana thermometer. Rather than just telling you the temperature of a
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market, the charts tell you that upward or downward pressure ischanging and that the prices you see indicate the future, ratherthan the present. This means the market anticipates where pricesshould be at some time in the future, as opposed to the cash markets, which tell you what they are at the moment. For the scaletrader, the charts are prognosticating changes in the supplydemand equation.Finally, prices tend to trend, and the longer the trend, the morereliable it is. These are important assumptions for the scale trader.As you will see in Chapters 3 and 4, you will be looking for longterm trends and will be expecting them to continue for a periodof time. Eventually, they will reverse, providing you profit opportunities at manageable risk levels.The reason markets trend is simple. They trend up because ofgreed and down because of fear. Fear and greed rule the futuresmarket. You, as a scale trader, play into these two emotions withoutindulging in them. Along with fear and greed is the natural propensity of individuals to function as a herd when facing the unknown.Let me elaborate. One trader buys silver because he thinks it isgoing higher. Others in the pit follow because they do not know anybetter. The more it goes up, the more buyers there are. Everyone inthe pit wants to make a fortune buying silver low and selling ithigh. Greed creates an uptrend. At some point, a few traders getnervous. Silver is getting expensive. The commercial users quit buying. Speculators halt their buying. Selling begins. The nervous getscared. Fear drives the market lower. Markets tend to fall faster thanthey climb because fear is a stronger motivator than even greed.At some price point, silver is really cheap. The commercialssee profit opportunities and begin to buy again. They have a realuse for silver. They can make it into jewelry, electrical components,and photographic film and sell those products at a profit. They donot give a damn what the futures traders think or how scared theyare. The market reverses and the scale traders take their profits.When you study the charts, the length of the trend and othersignals are important. Trends or trading ranges that are a year ormore old are more important than those that are only days, weeks,or months old. The reason is simply that the longer ones enjoymore of a consensus from all the market participants. If wheat hasbeen trading lower for the past two years, the wheat traders must
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have found a reason for that; maybe bountiful harvests worldwidedue to excellent weather have kept the carryover from year to yearhigh. Supply is higher than demand is strong.Inflation can play into this scenario as well with the physicalcommodities, which are the ones I recommend for scale trading.Scale traders look at the last 10 years of price activity in their selection of scale trading candidates. They buy as prices descend and sellas they recover. Over a 10-year period, inflation usually increasesthe base price of physical commodities, taking some of the risk ofthem setting new all-time lows. In other words, inflation shouldmitigate some of the risk of scale trading. But this is not a given.Now let’s take a close look at a futures price bar chart (seeFigure 1-3). The vertical axis measures price, and the horizontalmeasures time. Only trading days are represented. Weekends andexchange holidays are omitted. A single bar, hence the name, represents a specific period of time. It could be a day, a week, or a
FIGURE
1-3
Basic Commodity Price Bar Chart
Commodity XYZ
High
Price
TradingRange
OpenCloseLow
Open InterestVolume
TimeBar charts are the most basic tool of most technicians. The vertical axisrepresents price; horizontal, time. Volume and open interest are locatedbelow the bar portion of the chart. Charts can be for any length of time,from minutes to decades. Scale traders begin studying charts of at least10-year duration looking for scale trading candidates.
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month, or it could be just a portion of the trading session, such asan intraday chart generating a bar every minute or every five minutes. The high point of the bar marks the high price for the period.Conversely, the lowest point of the bar denotes the low. The lengthof the bar is the trading range. A tick extending to the right of thebar marks the close. Some charts have a tick on the left as well,denoting the opening price.Below the bar-chart portion of the overall chart is a series ofvertical lines. There is one for each period of time, representing thetrading volume for that period. Above the volume is a line designating open interest. Scales measuring the volume and open interest are on the right of the chart. The importance and use of thisinformation to the scale trader is discussed later.Technical analysts study the charts looking for recurring patterns. They believe that certain patterns predict future movement ofprice. Some chart patterns are so familiar to so many traders thatthey become self-fulfilling prophecies. Others are more esoteric andless reliable. There are literally hundreds of patterns and formations, more than can be dealt with in this text. But the ones you needto know as a scale trader are covered in Chapter 10. If you wish topursue this study, you will find some recommended texts inAppendix 2.Before we leave the subject of futures trading, you need toknow a little about placing orders. Each exchange has its own rulesregarding types of orders allowed and when they are permitted.Here is a brief overview of the possibilities:Market Orders—This order will get filled the fastest, butyou have no control over the pricing. You relinquish yourauthority to buy or sell to the floor broker after specifyingwhich contract and how many contracts you wish to buyor sell.• Limit Order—This order specifies the medium price youwill accept. Buy limit orders are placed above the marketand tell the floor broker you will accept only a certainprice, e.g., “Buy five November corn contracts at $4.57 orbetter.” Sell limit orders are placed below the market andspecify your minimum price, e.g., “Sell 10 Decembercopper contracts at 55 or better.” Or better on a buy order•
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means at the designated price or less than the limit price;on a sell, it means at the limit price or higher.• Stop Orders—These orders become market orders when aspecific price is hit, e.g., “Buy three June crude oil contractsat 33 stop.” When June crude hits 33, that order becomes amarket order and can be filled at any price.• Market-if-Touched (MIT)—These orders are similar to stoporders. They are activated when the price specified istouched and become market orders at that time.• Stop Limit Orders—These orders combine the stop and thelimit order. When the stop price is hit, they become a limitorder, e.g., “Sell June gold, stop 410, limit 405 or better.”• Time Limit Orders—Here you are putting time limits onwhen the order can be executed. Some of those limits are:Kill or Fill (fill immediately or kill the order); Market onOpen/Close (each exchange has a designated time, suchas the first or last 15 minutes of trading, during which thistype of order must be filled); Good Till Canceled (GTCorders stay in the market until filled or canceled); or OneCancels Other (the second order cancels the first).• The priority for filling the different types of orders ismarket orders, stop orders, limit orders, and time or pricelimit orders.It behooves you to take the time to understand how thefutures markets work and who the players are. As a scale trader,you must learn to take what the market gives you. It is almost apassive role compared with that of the more aggressive speculators. It is not unlike the commercials, who know what they wantfrom the market and patiently wait for it to give it to them. Allthings come to the patient.
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The Derivative Markets—Options-on-Futures
O
ptions-on-futures are vital to a hedged scale trading strategy.You must master this subject; it is your insurance policy. In thischapter, I will teach you the science and the art of options trading.The science part of the equation is having an understanding of howoptions work for and against you, specifically time decay, volatility,liquidity, and the rules of trading.The art of trading is harder to share. It is the intuition thatcomes from years of trading and following the market. Nevertheless, I will attempt to get you inside the minds of the major players so you know how the pros look at options, compared with theway the general public does. Once you know how they think, youwill be able to act, as opposed to react, to the market. This allowsyou to make more prudent selections of options. When you do that,you will buy better, cheaper options that will provide more protection to your futures positions.An understanding of options requires you to memorize thefollowing 20 words:Long call  Right to buyLong put  Right to sellShort call  Obligation to sellShort put  Obligation to buyThat is it. Memorize those 20