light atthe end of the supply-demand tunnel if you are scaling an agricultural commodity. Or a drought scare could stop you from startinga scale by blowing prices out of the lower quarter or third of the 10year trading range. Unfortunately, there is nothing that can be doneabout weather, except to buy some insurance.News also falls into this general category of uncontrollableevents. But keep in mind that news almost always generates only ashort-term impact. More often than not, news will create somevolatility, which is another important criterion. Volatility producesoscillating profits. In every scale, we look for one or two oscillatingprofit opportunities every week or so, especially in the first month ortwo of a scale. This occurs because the buyers (inventory managers)do not know if the commodity is really heading south. They test the
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downtrend until they are confident it is for real. Remember that theyhave been buying the commodity for quite a while at a higher price,so it now looks like a bargain to them. Once they are convinced it isgoing lower, they buy only from hand-to-mouth, to the extent thatthey need the commodity for production of their products.And don’t ever overlook liquidity. A sufficient number of contracts must be bought and sold each trading session to get all buyand sell orders filled expeditiously. As you will see, there are someseemingly promising scale trading commodities that you shouldavoid just because they do not have enough liquidity. For this reason, I also recommend you trade only on the U.S. commodityexchanges. That is where the world trades; that is where you willfind the liquidity and volatility you need.
THE GRAINSI will begin with the grains because, of all the commodities, theycome closest to fulfilling all seven of the criteria for a perfect scaletrading candidate. (Once again, for the record, nothing is perfect inthe world of futures trading.) The grains are also the commoditiesfamiliar to most of us. There is nothing esoteric or complicatedabout them. You simply plant, harvest, store, and distribute them.When I speak of the grains, I am specifically referring to corn, oats,rice, soybeans, soybean meal, soybean oil, and wheat.Worldwide, there are many other grains (e.g., azuki beans,barley, canola, flaxseed, field peas, rapeseed and meal, red beans,sunflower seed and meal) traded on futures exchanges. I havedeliberately omitted them because they are not traded on anexchange in the United States. This is not a patriotic issue. Only theU.S. exchanges have the liquidity needed to trade comfortably.Second, only these exchanges afford you the regulatory protectionof the National Futures Association (NFA), which will be explainedin Chapter 11.
Corn, Beans, and WheatI begin with corn, keeping in mind that most of what is said aboutcorn also applies to soybeans and wheat. Soybean meal, bean oil,oats, and rice are discussed separately.
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There are approximately 200,000 commercial farmers in theUnited States, and a good percentage of them grow corn and beans.Many grow wheat on their poorer land in the Midwest. Wheat isthe primary crop on Western farms due to the reduced amount ofmoisture needed to grow it as compared with corn and beans. Thisqualifies them for the first criterion of having enough competitionon the producer’s side.On the user side, there are hundreds of thousand of on-farmcattle and hog producers that use most of their corn and bean production themselves. Only the production they do not use for feedhits the open market. Additionally, corn is sought by commercialmeat producers, i.e., producers of cattle, hogs, turkeys, chickens,etc. Then there are corn sweetener and gasahol manufacturers.Exporters play a big role most years, since the United States is theworld’s largest exporter. On average for corn, domestic feed consumes 60 percent of the crop, while exports takes 20 percent andindustrial use is 20 percent. These are enough major players toqualify corn as a “perfect market.”Wheat, being primarily a food grain as opposed to a feedgrain, is exported or sold to commercial users, i.e., major bakingand cereal manufacturers. Most of it, of course, runs through aseries of middlemen from grain elevators to wheat brokers, whichgives it a healthy commercial contingent. Wheat, in the UnitedStates, is unique in that there are two seasons: winter wheat isharvested midsummer, and spring wheat is harvested in earlyfall. It is further classified as durum and common. The subcategories of common are hard red and soft white. Approximately 60percent of the U.S. crop is exported, accounting for much of thebuy side activity.Abundant information is the next key issue. There is no shortage here of good information. On the contrary, too much information is the norm. To understand what you are looking for, let usreview the supply-demand equation for the grains.Beginning Stocks  Production  Imports  Total SuppliesFeed, Seed, Residual  Food  Export  Total Usage orDemandTotal Supplies  Total Demand  Ending Stocks orCarryover
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For corn and beans, the import figure is not significant sincewe produce so much. Occasionally, importation of wheat can becontroversial. We quarrel with our Canadian neighbors about theirdumping of wheat on our market, and we need, from time to time,special varieties for special products. A key element of wheat production has become the protein content. The higher, the moredemand for the wheat. Therefore, quality and type can be an issueon the demand side.The residual between the total supply and the total usage fora given marketing year (for corn it is from October 1 to September30 of the following year or harvest to harvest) is often reported asa percentage of the total used. This gives the scale trader an idea ofhow abundant or scarce the commodity is, which can be translatedinto, “Is there light at the end of the grain supply-demand tunnel?”The primary source of supply-demand information for agricultural products is the U.S. Department of Agriculture (USDA). It calculates, as the world moves from harvest to harvest, the number ofdays’ supply of the key grains that are available. When the worldgets down under a 100-day supply and there are still months to gobefore the next harvest or if there are production problems, thesupply situation becomes news. Remember, the world is harvesting corn, beans, and wheat all year long, but most of the world’sfree stocks are produced in the United States. Most of the rest of theworld consumes what it produces, except in years when there arebumper crops. A scale trader needs to be able to spot these yearsand avoid trading grains in them.Look to the USDA to issue monthly an estimate of the supplydemand table (Table 6-1) in the World Supply and Demand(WASDE) Report. This report, one of 300 the USDA generates, isavailable on the World Wide Web (www). It is usually issued midmonth and includes demand estimates for most U.S. field cropsand crop conditions in foreign countries. It is your bible, as a scaletrader of grains, and has a big impact on futures prices. SeeAppendix 2 for more details on USDA reports and its Web site.You will also want to track USDA’s Crop Progress Reports,which provide weekly updates of crop conditions throughout thegrowing season. This is your early warning of increases or decreases on the supply side of the equation.
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6-1
USDA Supply-Demand TableWorld and U.S. Supply and Use for Grains*Million Metric Tons
CommodityTotal grains‡1998–991999–00 (est.)2000–01(proj.)JuneJulyWheat1998–991999–00 (est.)2000–01(proj.)JuneJulyCoarse grains §1998–991999–00 (est.)2000–01(proj.)JuneJulyRice, milled1998–991999–00 (est.)2000–01(proj.)JuneJuly
Output
WorldTotalTrade †Supply
1,872.761,864.43
2,204.732,221.16
256.20266.65
1,848.001,878.25
356.73342.91
1,868.861,868.76
2,207.932,211.67
267.23265.49
1,889.381,882.67
318.38328.99
588.58585.67
727.31723.43
121.85127.63
589.54596.78
137.76126.65
575.81581.25
701.69707.90
126.93126.95
595.44593.84
106.25114.06
890.21875.99
1,028.591,034.81
107.47115.74
869.77881.60
158.82153.21
892.73888.27
1,043.721,041.48
115.10113.52
890.93887.36
152.79154.12
393.98402.78
448.83462.92
26.8923.28
388.69399.87
60.1463.05
400.31399.23
462.51462.28
25.2025.02
403.00401.48
59.5160.81
TotalUse
EndingStocks
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TA B L E
6-1 (Continued)
World and U.S. Supply and Use for Grains*Million Metric Tons
CommodityTotal grains ‡1998–991999–00 (est.)2000–01(proj.)JuneJulyWheat1998–991999–00(est.)2000–01(proj.)JuneJulyCourse grains §51.371999–00(est.)2000–01(proj.)JuneJulyRice, milled1998–991999–00(est.)2000–01(proj.)JuneJuly
Output
United StatesTotalTrade †Supply
TotalUse
EndingStocks
346.71332.67
411.61416.18
86.9987.13
246.80250.55
77.8178.49
337.43344.91
418.87429.21
90.2391.46
253.13250.07
75.5187.68
69.3362.66
91.7990.96
28.3629.67
37.6935.44
25.7425.86
60.2061.03
87.8989.61
30.6229.94
35.2533.91
22.0325.76
1998–99
271.47
312.69
55.95
205.37
263.38
317.54
54.66
211.43
51.45
270.93277.77
323.11331.96
56.8458.74
214.11212.40
52.1660.82
5.916.64
7.127.67
2.682.81
3.753.68
0.691.19
6.316.10
7.877.64
2.772.77
3.773.77
1.321.10
* Aggregate of local markets years. † Based on export estimate. See individual commodity tables for treatment ofexport/import imbalances. ‡ Wheat, course grains, and milled rice. § Corn, sorghum, barley, oats, rye, millet, and mixedgrains (for U.S. excludes millet and mixed grains).Source: United States Department of Agricultural, 7/17/00This is an example of a USDA Supply-Demand Table. You should learn to read these tables and follow them for thecommodities you are scale trading. You will find substantial amounts of analysis and comments on these reports onchat rooms, in newsletters, and from your brokerage firm. You will understand and be using them very quickly. Theyprovide the insights you need to determine when the market is about to turn in your favor. The USDA provides thesereports on all major and many minor commodities.
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One minor difference between corn and beans is that producers hold back some of their bean production to use as seed for thenext year. This is taken into account in the supply figures. Withmost other field crops, the seeds are grown separately, as hybrids.You must also pay attention to any grains destined for human consumption that become contaminated by genetically altered corn.This can change the supply-side numbers.Futures trading is all about getting the news first. There areseveral fine consulting services that attempt to anticipate what willbe in the USDA reports so traders can be prepared. SparksCompanies, Inc. (www.sparksco.com) is an example. It actuallysends field scouts into the major producing areas of the world (foreign countries, such as South America for soybeans, as well as theUnited States) to count plant population per acre and report onfield and crop conditions as the growing season progresses.How can a scale trader use this information? If, for example, youhave not covered your futures positions with puts or enough positions with options, by reading a service such as Sparks you may beable to add protection before the USDA report is announced and themarket overreacts. This situation can occur when you are just beginning a scale; perhaps you are starting one too soon or at a price at thehigh side of the scale. You are alerted to some very good news aboutproduction (saturating rains in an area short on rainfall so far that season), which might cause the commodity you are beginning to scale tolimit down for a day or two. You can either exit the position or buysome cheap puts or sell a few calls. That is how you use these services. But consider an extreme approach like this only during extremecircumstances; it is not standard hedged scale trading practice.On the demand side, one of the most important reportsissued weekly is the USDA’s Export Inspections. It details the totaltonnage shipped to foreign countries. You use it to access howstrong or weak demand is and compare it to the Monthly WorldSupply and Demand Report. Is demand stronger or weaker thanprojections? Don’t forget, the United States is the world’s mostimportant exporter of grains. A good export year can clean out ascale in double-quick time.Naturally, the export market satisfies the requirement that thecommodity is global on the demand side. On the supply side,almost every country in the world grows some wheat. As far as
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soybeans are concerned, they are certainly grown widely. That istrue for corn also, but it goes under some other names—maize forexample. Additionally, there are hundreds of varieties of grainsgrown worldwide that are basic substitutes for corn and soybeans.Price elasticity is the next requirement. Will the price of grainsstretch and contract in response to the supply-demand situation?Once you study some 10-year charts and see corn prices rangingfrom approximately $2.00 to $5.50 per bushel, soybeans from $4.50to $13.00 per bushel, and wheat from $2.50 to $7.00, I think you willbe convinced that there is some elasticity in these markets. And, aswas mentioned, the substitution factor is always present if one ofthese commodities gets too expensive.This brings us to some of the uncontrollable factors—first,weather and politics. Weather, when you are talking grains, primarily means water. It takes 5000 gallons of water to produce a bushel ofcorn. That amounts to 18 to 24 inches of rain during the growing season to grow 100 to 175 bushels per acre of corn. Beans need less and,of course, wheat is the choice of dry land farming. Besides rain, thereis hail and wind to worry about; either can knock down a crop.Further, farmers worry about too much rain at planting or harvesting, which can keep them out of the fields and reduce the harvest. Ifthat were not enough, there are insects and diseases.As a general rule, foul weather is not the worry of the scaletrader. It will help you close a scale by raising prices to hit your exitpoints. In addition, false rumors of weather problems can run pricesup for short rallies, generating oscillating profit opportunities.It is unexpectedly good weather you need to prepare for byinsuring your positions with options. Consistently outstandingweather may prolong a scale, causing you to roll over positions intomore distant contracts or close some out at a loss. But a little fickleweather that generates oscillating profits is a blessing. You will behappy to know that just about every summer there are droughtscares throughout the corn belt.Information about weather is another one of the services available from USDA and the key growing states. USDA works with allthe other government services to gather and interpret data on theimpact of weather on crop production. You will be impressed withthe satellite photographs available free on the Internet.The second uncontrollable element impacting price trends ofgrains is politics. The major agricultural policies of Congress are
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well publicized in advance. They have to do with protecting thefarm, specifically the family farm, and ensuring cheap food for theU.S. population—both are good politics. These policies usuallyhelp the scale trader exit scales by driving low prices higher.Another area of concern is unexpected, emotional reactionsfrom foreign governments in retaliation for something our government did in another area. We might restrict immigration from a certain country, which, in turn, cancels its soybean purchases andbuys from Brazil instead, throwing the bean pit into chaos and triggering two or three limit-down days. The United States is notimmunized against this behavior, as anyone who remembersJimmy Carter’s grain embargo (January 4, 1980) will attest. Whenthese situations occur, you had better be practicing safe scale trading by having some price protection in place.The last two standards are technical in nature—volatility andliquidity. One feeds on the other. If you have a lot of price activity,it attracts traders, which increases liquidity. If you have a lot of liquidity, it creates volatility.There are several ways to measure volatility. The most common is standard deviation from the mean or middle (average)price. This can be illustrated with bell curves (see Figure 6-1). Thewider the curve, the more volatile the price activity of the commodity. This is because the price points are more scattered and ittakes a larger area to cover one standard deviation from the mean,or 68.3 percent of all occurrences. Other ways of measuring volatility are the daily trading range and the average daily movement ofthe commodity futures contract. Naturally, the higher these movesare, the more volatile the commodity.You can find volatility measurements on various Web sites onthe Internet. Another excellent source is Futures magazine (see Table9-1, Volatility Table). In its annual sourcebook, you will see ratings ofall the major commodities, giving you both volatility and liquidityfigures. For example, the daily volume for corn, soybeans, and wheatgenerally exceeds 65,000, 50,000, and 25,000, respectively. These commodities also have very acceptable volatility ratings, not too high andcertainly not low.
OatsThe commodities in the grain group that are questionable are oatsand rice. I like the way oats trades and have seen some experienced
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FIGURE
6-1
Volatility Curves
Low
Medium
HighThe closer price points are, the lower the volatility. High-volatility markets arecharacterized by wide or flat curves, since the data points are spread out.
scale traders do well with oats. Nevertheless, I disqualify oats,especially for the novice scale trader, because of lack of liquidity.The average daily number of contracts changing hands usually isaround 1500, not much compared with corn, beans, and wheat.Also, there is not nearly the same number of oat farmers as forcorn, beans, and wheat. Nor are oats distributed globally on a wideenough scale to qualify.Once you get a few scales under your belt, you may want totrack oats for a while. There are times when liquidity is at acceptable levels. Take care to be particularly attentive to the more distantcontracts, the ones you would be trading.
RiceRice also lacks liquidity, with approximately 500 or 600 contractstraded daily. The producers are primarily large corporate farmersin California or major cooperatives composed of individual farmers in the South. Little of the crop from a worldwide perspective
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is grown for the U.S. market, but most all of the U.S. crop isexported. Our exports usually represent the majority of the freestocks, since most producing countries consume their own production.If I were your broker, I would recommend avoiding oats andrice until you have learned to trade thin markets. This is a specialskill most suited for speculators. Thin markets are easy to enter andhard to exit. As a scale trader, you would be buying a contract thathas several months left to expiration. These are particularly thin.You could conceivably get a decent fill using a limit order on anentry position. When it was time to close trades or roll positions, thecontract would probably be the expiring contract month, normallythe most active.This means you could probably do the trades necessary. Butwhat concerns me is once you started a scale, could you get all orenough of your opening limit orders filled or would you have liquidity problems? Second, how would these markets behave? Thinmarkets have a tendency to be very volatile. Prices can swing up ordown by 5 percent, 10 percent, or even 25 percent on little or no volume. You could get an oscillating trade on one of these spikes but notbe able to replace that regular scale position. In other words, youcould get a scale started and be left hanging because of inactivity ina distant contract. Also, you would most assuredly have even moreliquidity problems with options on these commodities.
Soy Meal and OilLet’s talk a little about bean meal and oil. These are byproducts ofcrushing beans. Meal is cattle feed, and oil has a million uses, eatableoil being one of the primary ones. It also has thousands of industrial uses. Part of your work, if you are scale trading beans, is to tracksupply-demand for meal and oil. It is obvious that demand for eithermeal (caused by increasing livestock numbers) or oil (shortages ofcompeting oils—palm, sunflower, coconut, etc.) will drive up theprice of soybeans. The reverse, low demand for meal or oil, diminishes the demand and price of beans. It gets more complicated whendemand for meal is high and low for oil, or the opposite.Part of your fundamental analysis of the soybean market is totrack the crush spread. You will want to have a feel for how profitable
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it is to crush soybeans into oil and meal. If it is not profitable, you maywant to consider scaling meal or oil. If it is, it will show you the lightat the end of the soybean supply-demand tunnel if you are in a beanor meal scale. Here is how it works.The standard weight of a bushel of beans is 60 pounds. Whencrushed, it produces 48 pounds of meal and 11 pounds of oil. Onepound is lost in processing. Since beans are quoted in cents perbushel and meal in dollars per ton and oil in cents per pound, it takesa little work to compare the value of each component in the crush.To convert meal, you divide the 48 pounds of meal yielded by2000 pounds, a ton. This generates a conversion factor of 0.24.Multiply this by the price of meal to get cents—or dollars andcents—per bushel. For example, let’s say meal is at $180.00 per ton.You get $4.32 per bushel ($180.00  0.024).Oil is a snap. If 11 pounds of oil are contained in the bushel ofbeans, multiply this by the price of oil. When oil is $0.20 per pound,it would equate to $2.20 ($0.20  11).Once all the components are in dollars and cents per bushel,you calculate the gross processing margin (GPM), which is the difference between the combined sale value of the byproducts (mealand oil) and the cost of the beans. The soybean processors, who arethe soybean inventory managers, decide how aggressively toprocess beans depending on how wide or narrow the GPM is.As far as technicals are concerned, volatility and liquidity aregood for both meal and oil. Additionally, these commodities aresatisfactory from a standpoint of the other criterion. They are scaletrading candidates. Figure 6-2 shows my preferences as far asscaled trading the agricultural commodities.
THE FOOD AND FIBER GROUPThis group includes coffee, cocoa, sugar, frozen orange juice, cotton, and lumber. There are some others (e.g., milk, butter, cheddarcheese, white shrimp, black tiger shrimp), but they lack volume,which means you should not scale trade them.CoffeeCoffee is a good scale trading play, even though it does not meet allthe criteria. It is not a perfect market on the production side of the
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6-2
The Grain ComplexCornSoybeansWheatOatsRiceSoybean MealSoybean Oil
supply-demand equation. Coffee is grown on large plantations, usually owned by small groups of growers. It takes four years beforecoffee trees produce “cherries,” which become coffee beans. On thedemand side of the equation, coffee is more of a perfect market, butmost of the beans are funneled through a few brokers. In some cases,the government of the country in which the beans are producedmanages the inventory. This can be a positive for the scale traderbecause, as with cocoa, the government of the producing countrywill hold product off the market when prices are unacceptably low;thus the scale trader can completely close his or her scale. Theseinterventions can also give you a few oscillating profit opportunities.Being a major crop, coffee is watched carefully from the firstbudding of the trees to harvest. You will have no problem findinginformation. The only problem is that most coffee is grown outside the United States, Hawaii being the exception, so the government of the producing country may attempt to occasionallymuddy the waters.The major producing areas are in Africa, which produces therobusta variety, and South America, known for its Arabica. The latter is the most highly prized by coffee drinkers. Since the wholeworld drinks coffee, it is a global commodity on both sides of thesupply-demand equation.Coffee prices, particularly at retail, are inelastic. The price cango to the moon and still find buyers. But the scale trader is not worried about that end of the pricing scale. The only problem is that
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coffee can stay high for long periods of time and not offer any scaling opportunities.The scale trader is usually more concerned about politicalevents. Since the main growing regions are in the underdevelopedcountries of Africa and South and Central America, production orother problems that prevent product getting to market can interrupt the normal supply chain. Usually these delays are not longlasting, but they are followed by large amounts of product hittingthe market. This, in turn, impacts price. With a little luck, you willalso have some oscillating profit opportunities. There is also thepossibility that one of these undeveloped countries will dumpproduct on the market to obtain foreign currency in a financialemergency, thus trapping you in a scale.Another political consideration is the International CoffeeAgreement, which sets annual production quotas for countries thatbelong to it. Seventy-five countries, including the United States, aremembers. The purpose is to stabilize the price. Organizations likethese are usually a boon to scale traders.From a technical standpoint, futures contracts on coffee at theCSCE (