1If you go to a casino and look at the roulette wheel, you will find that there are 38squares on the wheel, 18 red, 18 black, one “0” square, and one “00” square. If thewheel stops on “0” or “00,” the casino automatically wins the bet. If you bet red(black), then you have 18 out of 38 chances of winning, and 20 out of 38 chancesof losing, i.e., 18 black (red) plus a “0” and “00.” So the odds are against you onevery spin of the wheel. Roulette bets are not fair bets because the odds of winning or losing are not equal. A fair bet is one where the odds are 50/50 each time.1.
An excellent reference to the concepts discussed here and throughout this chapter is Teweles &Jones, 1987. The Futures Game, New York: McGraw Hill. Also, any basic statistics book onprobability will be helpful.
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A fair bet doesn’t mean you win. It only means that you start out with an evenchance of winning each time. A bad bet does not mean you always lose or thatyou can’t win. It only means you start out with higher odds of losing than of winning, e.g., 49–51. In trading futures, successful traders figure out how to get theodds in their favor before they enter a position.Knowing something about probabilities also will help you establish the appropriate level of capital you need in order to trade successfully.A couple of things about probability numbers that you should keep in mind:First, probability calculations don’t mean anything unless they are based on a verylarge number of repeated experiences or trials where conditions are the same. Second,in any long series of a repeated activity, there will be periods where “runs” willoccur. In other words, the roulette wheel may stop on red five or six times in a row.What’s especially important to remember about runs is that with each successive trial that continues the run, the probability that the next trial will continueit decreases. Hence, if you develop a trading system based on estimated probabilities that a particular trading strategy will be successful 60 percent of the time,and you find that it has given you six or seven successive profitable trading signals, then you probably should not be leveraging your profits or increasing yourposition on the next trading signal. The chances are increasing, as that run continues,that the next signal in your trading system will be a loser.
Mathematical ExpectationThe mathematical expectation of an event is equal to the sum of the amount ofmoney you can win times the probability that you will win, minus the sum of thepossible amounts you could lose times the probability of losing. For example, ifyou have a 50 percent chance of winning $500 and a 50 percent chance of losing$1,000, your mathematical expectation is a –$250. If you have an 80 percent of winning $500 and a 20 percent of losing $1,000, your mathematical expectation is a+$200 (see Table 6.1).Table 6.1 Payoff or Mathematical ExpectationSum ofProbablilites ofPossible Payoffs × Each Payoff= Mathematical Expected Valuee.g.,50 percent Chance of Winning $500 = +$25050 percent Chance of Losing 1,000 = –500–25080 percent Chance of Winning 500 = +40020 percent Chance of Losing 1,000 = –200+20051
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Often I have heard (and read) that traders should only enter a trade whenthey expect to make twice as much as they expect to lose, e.g., make $200, lose$100. While setting explicit profit and loss parameters is laudable, it may not besmart because taken alone that advice is incomplete. To make it complete, tradersmust assign expected probabilities that they will achieve the $200 gain and the$100 loss. If they have a 30 percent chance of making the $200 and a 70 percentchance of losing the $100, their mathematical expectation is a –$10. This is a badtrade. If the reverse is true, their mathematical expectation (.70 × $200 –.30 ×$100) is a +$110, suggesting it is a better trade.The point is that you have to consider both dollars and probabilities. Youcannot ignore probabilities in setting your trading plan and policy, but simplyknowing probabilities is not sufficient. You also need to know and apply the concept of mathematical expectation, which looks at both sides—the dollars to begained or lost and the expected probabilities associated with each event.
Risk of RuinA trading plan that starts with a positive mathematical expectation but is executed with too little capital creates a high probability that overall the trader will loseall of his money. If you start too small, you will lose it all. If you over-reach (trademore aggressively than your capital and the probabilities allow), you will lose itall. If you fail to realize that eventually you will have a string of losses and tradeaccordingly, taking small risks, you will lose it all. The probability of runs of losses or gains increases as time passes.The concept of risk of ruin refers to a probability calculation that a series oflosses will be devastating.Studying the risk of ruin calculation provides insights into:➥ How much capital you need.➥ How and when to leverage or de-leverage your capital commitment.➥ How and when to leverage profits.The formula for calculating the probability of ruin is complex but easilyunderstood:N
 1 – Trade Advantage  = Probability of Ruin 1 + Trade Advantage Where:The trade advantage equals the difference between the probability that thistrade (trading method, technique, or decision rule) will be profitable in the long runand the probability it will be unprofitable. (See later section of this chapter for52
The Trading Plan
determining the trade advantage.) So if the probability of a profit is 60 percent, andthe probability of a loss is 40 percent, the trade advantage is 20 percent. N equalsthe percent of your total capital you are willing to make or lose on this trade beforeyou would exit from it; your stop-out point in dollars. Suppose you had $20,000total capital in your account and that on any single trade you would not risk morethan 10 percent, or $2,000.Then this factor would be
$2, 000= 10%$20, 000
To illustrate, suppose you had done a lot of research on several of the technical trading rules discussed in Chapters 9, 10, and 11, and you had discovered thatover a large number of trials, whenever a rising pennant chart formation coincided with an RSI of 75 or more, a short position was profitable 60 percent of the time.Your trade advantage would be .20 (i.e., .60 – .40 = .20). And if N = 10, your riskof ruin is: 1 – .20  1 + .20 
10
.80 = 1.20 
10
= .017 of Risk of Ruin
In this example, there is a very low probability of losing all your capital.Let’s presume you are willing to risk $5,000 per trade with the same tradingsystem. In that case,$5, 000= 4%$20, 0004
4
 1 – .20  =  .80  = .25 4 = .1975 of Risk of Ruin( ) 1 + .20  1.20 Essentially, this is a 20 percent chance of ruin, which is too high. Reduce yourrisk.Assume your trade advantage drops to 5 percent with N = 4.4
4
 1 – .05  =  .95  = .90 4 = .656 of Risk of Ruin( ) 1 + .05  1.05 This risk is totally out of the realm of reason.This exercise clearly demonstrates something good traders learn quickly:Take small risks. Don’t expose large amounts of capital to risk of loss on any single trade. Trade to survive. It is easy to make money trading commodities. It is hardto keep it.53
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The above examples assumed that the account was kept at $20,000. Supposethough that the account actually grows to $30,000 because 60 percent of the tradesreally are winners. If you keep risking only $2,000 units the probability of ruin drops.With $30,000 you can withstand a run of 15 consecutive losses—$2, 000= 15.$30, 0001 – 20 The probability of ruin here drops to  1 + 20 
15
= .00228. Not very high.
If you decided to leverage your profits and start risking $5,000 per tradeyour probability of losing all of your profits would jump to very high levels. Youcould withstand only two successive losing trades.The risk of ruin increases dramatically as more available capital is exposedon each trade. Risk of ruin is highest at the start of trading. Suppose you have$20,000 and commit $4,000 to each trade. If you lose on the first two trades, youhave only 60 percent of your capital left and probably need to reduce the size ofyour trading commitment. If you lose on four of your first five trades you are invery serious trouble, and the time it will take you to get back to even may be long.You will need a string of winners or a winner that provides an immediate and astronomical return on your money. The probabilities of either occurring can be calculated, but you will find they are very small.Sequential losses are not the only concern. In the example above, if you havea pattern of two wins and three losses repeated four times you are broke.
Adding to PositionsIf you double your position each time you double your money, the risk of ruinincreases. Conversely, if you trade at the same scale as your profits accumulate,the risk of ruin decreases. So to have probabilities work with you, scale up yourpositions but at a decreasing rate.
How Much Capital Do You Need?There is no absolute number. Clearly you need enough to meet initial margins andmargin calls up to your maximum base loss point. That question can be answeredonly in the context of how large a trade advantage you insist on in your plan andwhat percent of your capital you will risk on each trade. If you use common sense,do your homework to get the best estimate possible of your trade advantage, andthen risk small amounts of money, you can have a profitable trading experience starting with as little as $20,000.54
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Once you have determined the amount of money available for trading, youshould think seriously about your philosophy of trading. By the mere fact that you havedecided to trade futures, you have also decided to accept relatively high-risk investments. Nevertheless, as pointed out earlier, there are varying degrees of risk in trading commodity futures. You can trade conservatively by reducing your leverage, byjudicious selection of the commodities you trade, and by your method of trading. Forexample, trading a normally less volatile commodity such as wheat, a storage commodity, may be less risky than trading a perishable commodity, such as pork belliesor cattle; following a “spreading” method of trading in storable commodities is normally less risky than taking a net position in a commodity. Spreading refers to theassumption of long and short positions on the same business day in the same or related commodities for the same account. See Chapter 19 for more about spreads.In summary, before you start trading do some careful studying of your trading methods. Examine and research their effectiveness over the long run. Assignsome level of expected probability to them and then calculate your risk of ruin.
Hypothetical Is Not the Same as RealityTesting of trading methods, rules, and techniques on past data is of great value.However, hypothetical trading or simulated trading seldom turns out to be reflective of reality.Seldom does the future course of a market exactly mirror the past. The market participants are often different in one time period than in another. Emotionallyand psychologically, people act differently when faced with making decisions withreal money than they did when it was hypothetical.The lesson to be learned:1. Don’t place too high a confidence level in your probability calculations.2. Back-testing a trading system and then testing it by paper trading on livedata (or out of sample) is most important to determine your probable tradeadvantage. But after you start trading, keep a reality check on your system to see if it provides you the trade advantage you expected. If youexpected to get 60 percent winning trades, then keep a tally to see if youdo. Calculate in advance the probability that you will have X number oflosses out of your first 10 trades.
PART II—INITIATING POSITIONSThe most exciting part of a trading plan is entering positions—deciding what commodities to trade, establishing the criteria for being long or short, deciding how longyou should wait for your expected market move to occur, etc.55
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Deciding What to TradeThis choice depends very much on your interests, background, and knowledge.Pick the futures that are most familiar and the easiest for you to follow. The list fromwhich to select is rich and varied—stock indexes (like the S&P or Major MarketIndex), bonds and Eurodollars, corn, wheat, hogs, cattle, gold, silver, etc., plus alot of foreign stock indices and financial futures.Once you have picked the commodity(ies), the real work of market analysisjust begins. Before you are ready to enter a trade, you should dig deeply into themarket information. Get “inside” the market. This means you must know the typesand sources of information that are important in making judgments.Some traders base their trading decisions primarily on the “fundamentals” ofthe market. That is, they evaluate possible future price movements on the basis ofsuch things as a commodity’s estimated production, carryover from previous years,and estimated future demand, utilizing the wealth of information and data available from government and many other sources. (See Chapter 9 on “ForecastingPrices” and the section, “What to Look For and Where to Find It.”) Fundamentaltraders often tend to be long-term traders. That is, they trade relatively infrequently,and they tend to hold positions, once established, for long periods of time. Suchtraders need larger amounts of capital to withstand margin calls. These types oftraders have to be very patient and willing to wait for fundamental factors to worktheir way through the production/consumption cycles.Some traders take the “technical” approach, using price charts to predict futureprice movements on the theory that familiar price patterns tend to repeat again and again.Technical traders come in all stripes and colors. Some are long-term traders,some short-term, some very short-term traders, like day traders. If you are not onthe floor of an exchange and don’t have immediate access to quotes, don’t try tobe a day trader. In fact, a beginner is probably well-advised to aim at being anintermediate- to long-term trader; i.e., select commodities that trend, utilize yourresearch tools to identify potentially emerging long-term price trends, establish avery small position using only a small proportion of your capital, and be patient,but watchful, to see if the trend emerges.Some blend the two approaches and take a position only when their interpretation of both the fundamental and technical factors are in agreement withrespect to market direction and timing.Still others depend heavily on the advice of a broker or advisor in whomthey have confidence.Regardless of the approach taken, to make the decision-making process moreobjective and to add discipline to the approach, develop a checklist of key technical and fundamental factors, and evaluate each set of factors in light of their probable impact on price. For example, are the general supply/demand or economic statistics basically bullish, bearish, or neutral? What do the technical market factorsindicate? How does the current price level compare with historical price levels? You56
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can then assign weights to each assessment and ultimately end up with a basicindicator of whether your analysis supports a long position, a short position, or aneutral stand-aside position (see Part II of the trading plan).
Developing the Expected Trade AdvantageOnce you have a good general understanding of the expected direction of pricemovement, you need to assess the extent of the price movement and the probability that it will occur. In other words, you need to establish the expected trade advantage. This is a very subjective process and has to be discerned from past priceaction, and the expectation that past interactions of the fundamental/technical factors affecting the market will be repeated.Although this is a difficult step, it is a most important one. It forces you tothink hard about how confident you are that your expectations of price movementswill be met, and it provides a more definitive way of determining whether this isa worthwhile trade.By combining all of the information about technical/fundamental factors andthe expectations about price movements, you should get a clear indication of whetherthe weight of the analysis suggests a long, short, or neutral market position.
Calculating the Trade Advantage and Expected Value of a TradeOne of the most valuable things you can do in planning is to assign probabilitiesthat your target prices and either gains or losses will be achieved. As noted earlier, the mere process of assigning such probabilities causes you, the decision-maker,to consider the strength of your faith in prognostications. It forces you to thinkabout whether your chances of achieving a gain or suffering a loss are 90 percent?60 percent? 40 percent? etc.This process of calculating probabilities has to be based on past experience(yours or someone else’s) and the testing of your decision criteria on a historicaldata series.This essentially means you need access to several things: a data base, a computer, software, and/or a set of price charts.You need the data base of past prices so you can check out past price activity and patterns and so you can test your decision rules.You need the computer and software if you are interested in doing any substantive data analysis. The calculations of most technical indicators are so complex,time-consuming, and fraught with potential mistakes that attempting the task byhand is generally a discouraging exercise.You need the charts, if you decide not to utilize the computer. Of course, youcan use the computer to develop and build the charts and do the other calculations,too. (See Chapter 11 for more on criteria for selecting data bases and software.)57
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Let’s suppose you get access to the computer, software, and data base. Let’sassume also that you decide (a) to conduct your study based on five years of pastdata (a good time period to work with); and (b) to test the following moving average rule:➥ Buy if the nine-day moving average crosses above the 18-day movingaverage.➥ Sell if the nine-day moving average crosses to below the 18-day movingaverage.You conduct the study and find the following:# of Trades# of Profitable Trades# of Losing TradesAverage Profit on Profitable TradesAverage Loss on Losing Trades
1006040$1,000$ 700
If this is a reliable sample of how you expect this trading rule to behave inthe future then your trade advantage is .20 (i.e., .60 – .40).The mathematical expectation associated with this rule is:60 percent × $1,000 = $60040 percent × $ 700 = –$280+$320 Mathematical ExpectationIf you expect that the future will unfold like the past and have confidence thatyour trade advantage is really .20, then you can calculate the risk of ruin associated with this trading rule.Let’s suppose, though, that you consider the trade advantage too low. So youdecide to add another rule to your trading model.Assume you apply the same rule as above plus the following condition:➥ Execute the Sell order only if the 14-day Relative Strength Index is above.70.➥ Execute the Buy order only if the 14-day Relative Strength Index is below.30.Let’s further suppose your results turn out as follows:# of Trades# of Profitable Trades# of Losing TradesAverage Profit on Profitable TradesAverage Loss on Losing Trades
504010$1,200$ 90058
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Again if this sample is a reliable indicator of the future performance, then youshould expect (a) your trade advantage to be .80–.20=.60:.40= .80.50
.10= .20.50
and (b) your mathematical expectation for this model to be:80 × $1,200 = $96020 × $ 900 = $180+$780 Mathematical ExpectationThis model gives you a much improved chance of making money in the longrun. Of course, if you decide that this model is so superior to the first that you canrisk more money per trade on it, you may actually increase your risk of ruin!Remember, eventually you will get a string of successive losing trades and you needto husband your capital to survive those periods so you will be able to participatewhen the string of profitable trades appears.It is important to consider commissions in the calculations. A $45 commission and a potential profit or loss of $100 before commissions is really a potentialprofit of $55 ($100 – $45 commission) and a potential loss of $145 ($100 + $45commission).The expected potential profit must be compared to the expected potentialloss on each trade, and each trader should decide on a general rule of thumb he canuse as a guideline for decision-making. Some traders prefer to have a mathematical expectation of potential profit to potential loss of at least 3 to 1, after commissions, before they enter a trade. Others prefer a higher ratio. No matter whatratio you select as a guide to your decision to enter the market, you should have aprofit objective and a loss limit in mind when you take a position.Now you should be ready to implement your plan. The above procedureshould have yielded sufficient information to provide a sound basis for your decision. It is important to remember that the objective of the plan is sound decisionmaking. A good decision may indeed be a decision not to trade, to stand aside untilthe market trend becomes clearer or until the probabilities of a successful tradeimprove.An important factor here is patience. Pick your trades carefully. Do not rushin out of fear of losing an opportunity. Another one will be along shortly. Be prepared to recognize it.The number of different commodities to be traded, the size of the initial position and the conditions under which one should add a position are, as noted above,also important elements of any plan. For the inexperienced, it is better to tradeconservatively in only one or two different commodities with an ample cushion ofcash in your account and to add to positions proportionately on strength ratherthan weakness. A good general policy for the beginner is to add to a position only59
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when one has a profit on the original units, and never carry more than three openunits in any one commodity. The financial graveyards are full of inexperiencedpeople who took a plunge and overtraded.
PART III—EXITING A TRADE—LIQUIDATION STRATEGYNo plan is complete unless it also considers a way out of the market or a plan fordetermining when and under what conditions you will liquidate the position (seePart III of the planning form).This means you have to consider how long you intend to hold your position.Some traders feel that if they do not reach their objective within a few weeks, theyshould liquidate and stand aside until they get a more definite feel for the markettrend. Most speculative traders avoid carrying a position into the delivery month.This stems partly from fear of getting delivery if they are long in the market andpartly from a desire to avoid the increase of margin and increased volatility frequently experienced during delivery months. A plan must include target pricesreflecting the points at which you will be satisfied with the profit or will cut thelosses and liquidate the position. It is important that you be realistic in setting theseprices. Don’t get greedy, and don’t rely on hopes and dreams.To add discipline and for protection, it is a good idea to mark your targetprice objectives with a “stop order” at the same time the original order is entered.A stop order is simply a standing order to buy or sell that commodity “at themarket” when a certain price is reached. As a market order, it is executed at the bestpossible price after the specified price is reached. For example, if you bought 5,000bushels of March corn at $2.30 and you wanted to protect yourself against anundue loss—should prices decline instead of rising as you expect—you could giveyour broker an order to “sell March corn at $2.28 STOP.” If the price of March cornfutures did decline to $2.28, your order would automatically be executed at the bestpossible price, which, in a very active and moving market, might be slightly higher or lower than $2.28. Then, your position is closed.For most commodities, the stop order is given to your broker like any otherorder. The broker transmits it to the floor of the exchange where that commodityis traded, and it is held on the books of the floor trader representing your broker’sfirm. When the market price reaches the price you specified in your stop order, itbecomes a market order and is handled as such.Stop orders can be used to close out your position when you have reachedyour profit objective, to initiate a new position, or to close out a position that hasgone against you. Stop orders add discipline to your trading. They help you stickto your original objectives. The proper use of stop orders and the points at whichthey should be placed is a subject to which all traders should give careful thoughtbefore they enter the market.60
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In summary, when setting stops, there are two major criteria to consider:1. The amount you are willing to lose. You cannot avoid a decision on thisbecause the market will force it if you do not decide.2. The volatility—both historical and expected. If volatility is high and youset the stops too close to the market price, there is a high probability youwill have a lot of small losses. If you set it too far away, you have a lowprobability of it being executed, but the losses will be large.The art of setting stops is matching price volatility to your willingness tolose a certain sum of money. This means you must monitor volatility and adjustyour stop frequently to reflect changes in volatility. Remember a change in volatility affects your mathematical expectations on a trade. An excellent alternative isto buy options as a stop mechanism. In the long run, you may find it the mostprobability-efficient manner of protecting against ruinous losses.
PART IV—REVIEW OF RESULTSAfter you liquidate the position, review and analyze the results. Find out what you didright and what you did wrong. This may be the most important thing you do. Youwon’t progress to become a skillful trader unless you analyze why the results turnedout the way they did. Learn from your mistakes as well as from the things you did right.It also should be noted that all aspects of a plan are intertwined. Making asmall change in one part of the plan may affect the rest of it in a major way. Plansshould be internally consistent.To aid you in developing a plan, included at the end of this chapter are somesample forms for (a) determining your financial suitability for trading, (b) determining the amount of money you have available for trading, and (c) planning yourstrategy. After you finish the rest of the book, come back to this chapter, developa plan using the forms provided, and then, in conjunction with the practice trading exercise in Appendix 1, try it out.
A WORD ABOUT DIVERSIFICATIONDiversification of risks is one of the most basic and important means of controlling total risk.Beginning traders may find it very hard to diversify their futures tradingrisks, simply because they start with a very small amount of money—not enoughto trade several different markets or to use several different trading systems, models, or rules for entering and exiting positions.61
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There are several ways to diversify risks. You could trade several differentunrelated commodities. You could trade the same commodity but use several unrelated trading rules or models for determining your position. You can commit yourcapital in two or three tiers—a certain amount for long-term trades, called a “coretrend position,” and a smaller amount for a variable short-term trend position.A key word in the above paragraph is “unrelated.” It is not diversification totrade two or three different commodities whose price movements are highly correlated, or to rely on trading signals from two or three different trading systems orrules that are highly correlated. If they are highly correlated, they really are not “different.” You’re really doubling your risk, not reducing it.So one place to start controlling your risk is in the selection of commodityfutures you will trade. Pick two or three of them that have very low correlationsin their price movements, or two different trading plans.
SEASONALITY AND TRADING PLANSAs noted earlier, nearly all markets have a seasonal or cyclical aspect to them. Youshould factor that into your trading plan for entry and exit of positions. Seasonal patterns tend to emerge in any market as it responds to regularly recurring fundamental forces such as weather, elections, commercial schedules, governmental funding, etc. The seasonal approach to trading is designed to anticipate, enter, andcapture, historically recurring trends as they emerge. For example, winter arrivesevery year and the expected arrival, as well as the actual arrival, of cold weather creates responses among commercial interests and speculators in a market. Heating oildistributors build inventory to meet the anticipated demand of homeowners andbusinesses. When winter actually arrives, consumers and the trading public oftenprovide a flurry of buying and, as sales occur, inventories draw down during the coldseason. As spring arrives, sellers lower prices to reduce inventories further, andbuyers delay new purchases in anticipation of warm weather. The result is a patternof price movement reflecting a certain seasonality.For the trader, the relevant issue is identifying windows of opportunity wherein well-defined seasonal tendencies for tops, bottoms, and trends emerge and playout. These tendencies provide guidance for entry and exit. The exchanges, as wellas a number of authors, such as Jake Bernstein, have studied the seasonality infutures prices quite extensively over the last few years. The beginner and the experienced trader could both benefit from careful study of seasonal tendencies. Forexample, studies done by Knight-Ridder analysts on the heating oil market haveyielded the following general seasonal tendencies:First, both fuel oil and heating oil futures tend to make their seasonal bottomsin July during hot weather. Second, the seasonal tops tend to occur in the cashmarket during January, the coldest month. Third, the seasonal top in futures tends62
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to occur by mid-November. Note: Futures tend to peak before the heavy seasonaldemand of the cash product begins.
SUMMARYTo summarize, the steps in your trade plan should be as follows:1. Prepare a personal balance sheet.2. Determine how much of your net worth and of your cash you can affordto lose.3. Establish the commodity(ies) futures of interest.4. Conduct your trade selection research by identifying and testing variousrules for entering and exiting long and short positions.5. Establish the maximum amount of money in dollars and in percentagesthat you will risk on any single trade or trading methodology (i.e., N inthe risk of ruin calculation).6. Establish the trade advantage associated with #5 above.7. Determine your risk of ruin.8. Determine the mathematical expectation associated with #5 above.9. Establish the stop loss (or gains) point(s) for automatically exiting thetrade in whole or in part. This step needs to include:➥ a date or time period for realizing the expected profit;➥ a dollar amount; and➥ a method or plan for adjusting the stop as the market volatility changes.10. Establish a procedure or rule for adding to positions as profits accumulate.11. Review your experience. What did you learn?
A FINAL WARNINGThere are no sure-fire methods for always making profitable trades. The best youcan do is plan and prepare. Get the probabilities in your favor. Prob