that big fundamentalnews usually seeps into the market, tidbit by tidbit. By the time thewhole story is available, the market has already made its move.This occurs because the people aware of the big changes takingplace in the supply and demand equation—the major grain companies, for example—are trading in the futures markets extensively. The news is traded by the time it becomes totally public; themarket often moves before the information is available to the average trader, even on the floors of the futures exchanges.A classic example is the Great Grain Robbery perpetrated bythe Russians in the early 1970s. Soviet futures traders operating outof Switzerland bought millions of bushels of U.S. grains on theChicago markets before it was revealed that their crops were havingsevere problems. There is no such thing as insider information infutures, as there is in the stock market. Most of the big grain companies, for example, are privately held and most are owned by overseas interests, out of the reach and jurisdiction of U.S. regulatory
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agencies. Major importing-exporting countries also trade on thefutures markets using “top secret” information regarding theirneeds and/or production estimates.Another phenomenon that occurs when trading fundamentalsis the time it often takes for a major correction in the supply anddemand equation to take place. For example, it may be commonknowledge that a commodity is in short supply and that demandis building, but how long will it take for a new crop to be producedand fill the need? Will there be weather or disease problems if it iscorn, wheat, cocoa, or coffee? Will the local government intervene?It can take months or more for a new supply of a commodity tocome to the market—so much can happen in between! When willthe market impact be felt? When will the bulls stampede? It is notuncommon to be dead right using fundamental analysis of a market but bleed to death from margin calls while waiting for “themove of a century.” A major grain company went bankrupt building inventory of wheat, knowing that a shortage was coming. Thecompany was dead right, but could not finance its inventory longenough. That company ended up dead broke. This is also one ofthe risks a scale trader must learn to manage.You will often hear me say: “Have a good feel for when thereis a light at the end of the supply-demand equation before enteringa scale!” You occasionally find situations when a commodity is inposition to scale trade, except the supply side is way out of line.These are times to wait for clarity as to when the supply-demandequation appears to be moving your way. This does not mean youmust absolutely know when a market will bottom and start tradinghigher; you can never know that for sure. It just means you musthave a reason for believing that prices will not remain at their lowsindefinitely. You can make a lot of money with scale trading bybeing near right, as opposed to pure speculation in the futures market which requires you to be much more precise. This will becomemuch clearer in Chapter 5, which delves into supply and demand.With fundamental analysis, there is also the problem of gathering, sorting, storing, processing, and analyzing the enormousnumber of facts and figures required to properly conduct it.Usually only countries, or very large firms, have the capability.Massive computers and large staffs of analysts are required.Information must be collected and deciphered from all corners of
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the world. To create an econometric model utilizing all the factsinfluencing just one commodity is beyond the capabilities of theindividual trader. Consider the fact that the USDA publishes over300 separate reports, many of them weekly.The process becomes even more complex given that somecountries deliberately release false information about the commodities they produce to influence markets in their favor. To try toovercome this problem, fundamental analysts must rely on satellite technology. Governments can do this type of research, andeven some of the major grain companies can, but what chancedoes the average trader have of competing in an arena like this?There are satellite photographs available on the Internet, but theyhave been seen, researched, and probably traded before they hitthe World Wide Web.Then there is the classic question posed by technical traders tofundamental traders: “If a commodity is a good buy at its currentprice, do you buy more when it drops another 5 or 10 points?”Fundamental analysis is not a self-correcting system, as is technicalanalysis, claim the technicians. In comparison, technical traders aretrained to exit trades when trend lines are broken, for example.For all these reasons, I dove into technical analysis when Ijoined Oster Communications. It was going to solve all my analyticproblems. The assumption is that the futures markets are efficient.All the pertinent information moving the markets is already in themarkets. If a Cargill-type grain company were to know about acrop problem anywhere in the world, it would protect itself by taking futures positions, long or short. You may not know what theproblem is, but you could trade it nevertheless because it would bereflected in price fluctuations. As unknown buyers open increasingly larger long positions, an uptrend in prices would develop.Even amateur technicians would spot the move and jump on thebull bandwagon, adding fuel to the move. This is the theory.If this is true, as the theory goes, some genius out there infuturesland must be able to develop a technical analysis systemthat can make sense of the daily price activity in the major markets.Futures magazine was a magnet for every trader or system developer with a trading system. For five years, I watched them pitchtheir trading software, track records, and secrets. Everyone wantedto be recognized as the trader with the most accurate system in the
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world so he or she could either sell it or attract investors. Wereferred to it as the search for the Holy Grail, since it was about asdifficult and fruitless.System after system was tested and evaluated. Some wouldseem to work for a while and then fizzle. Most common were thesystems that worked well with historical data, creating impressive,but simulated, track records. When traded in real markets, theybombed. The problem often was that these systems were designedby their creators to work based on historical trading patterns. Ifvery similar patterns did not occur in actual trading, the lossespiled up. Close analysis of other systems revealed that many ofthem did not make allowances for bad fills (slippage), limit up ordown days, exchange holidays, or other common market aberrations. In plain words, none of them worked satisfactorily.I came to believe two things about technical analysis. First,one of the major problems is that it always deals with past priceaction. All the information comes from the historical records, evenif the data is only minutes old. Can you predict specific future priceactivity based on what has already happened? It always seemed tome that much of the success occurred because enough traders sawthe same price patterns or signal and then reached the same conclusion. Technical analysis can become a self-fulfilling prophecy.These magic systems or silver bullets, as they became known, maywork for short periods of time or occasionally, but they neverproved to be very dependable in my opinion.It also became obvious that certain systems were suited totrending markets and others to choppy markets. The softwarewould look good for a while and then the complexion of the market would change, resulting in serious losses. It seemed impossibleto find a system that could adjust to all types of market conditions.The other problem relates more to human nature. If youdeveloped a trading system that consistently made money in thefutures market, would you share it with anyone? Would you sell itfor a few hundred dollars or even several thousand? Would youwant it described in a magazine being mailed out to 50,000 commodity traders and brokers? Personally, I think I’d be quietly sitting on a tropical island, sipping Singapore Slings, trading mybrains out, and wiring trading profits to my Swiss bank account.How about you?
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In defense of both fundamental and technical analysis, I haveseen professional and nonprofessional traders use either one orboth systems in combination successfully. Is this a contradiction towhat has already been said? I do not think so. There are two reasons why these systems can make a trader successful. First andforemost in my mind is that having a system and religiously following the signals given by that system brings discipline to trading. For example, most technical systems include the use of stoploss orders. If a trade goes against the system a certain percentageor a specified amount of money, the trader automatically exits thetrade. This protects the trader from catastrophic losses.Traders can’t trade if they lose all their money. Preservation ofcapital is one of the key elements of trading. Speculators are like flyfishermen; they must constantly be casting into the market. If theydo not get a bite, they must reel in their lines promptly to preservetheir lures. Most casts produce little or nothing. Winning trades arethe catch. Most are below the limit and must be thrown back,equivalent to a breakeven trade. But when a keeper, or better yet atrophy fish, is landed, it makes up for all the cold feet and wetclothes. With traders, the monthly gains are often attributed to asmall percentage of trades. A good system instills the disciplineneeded to be able to stay in the market without losing all your trading capital.The second reason good systems help traders make money isthe challenge of dealing with the unknown. Uncertainty robstraders of confidence. Belief in their system encourages them to goback into the market daily. It gives them the courage to recoverfrom a drawdown of equity, to get back on the horse that threwthem, and gives them the faith needed to make them trade basedon something that is going to happen in the future.As scale traders, you must become part of the faithful. Youwill need to bend your will to the will of the system and have thefaith to follow it with the discipline of a monk. I call that Zen trading. You will be asked to buy, buy, buy when the market you aretrading is low and headed lower on the blind faith that the marketwill turn in your favor at some unknown time in the future. Havingfaith in the system is your only consolation at times. But do notbecome one of the faithful on blind faith alone. Read, study, andexperiment. Start slowly and build your faith on sound results.
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The next question is why did I write this book if scale tradingis such a perfect system? Why am I not sitting on the beach inTahiti? First of all, scale trading is not a new subject. A lot of people are scale trading; you can find a dozen Web sites and severalbooks on the subject. Next, I am more a writer than a trader. Or youcan say, there are “thems that do it and thems that teaches it!” Lastof all, I think the system deserves someone to speak up and telltraders that there is a better way of doing it than is described in thematerial currently available.As I mentioned earlier, my uncertainty about how best to tradethe futures markets came into very sharp focus when I joined a brokerage firm. I watched the other brokers and how they dealt withtheir customers. The vast majority of the time, our clients had theirown trading strategies and relied on us for information, occasionaladvice, order execution, tracking trading activity, and resolution ofany account problems. There were some clients who asked for traderecommendations, which the brokers were prepared to supply. Butthe vast majority, by my observations, used a technical analysis system of some sort and by and large were net losers when they closedtheir accounts. These observations are critical because, no matterwhether you are new to the futures market or have been trading awhile, you must face the dilemma of deciding how to pick yourtrades. I have spent considerable time researching and observingthese questions and hope you can profit from these insights.I first became aware of scale trading when one of my fellowbrokers called my attention to some of his traders. They were taking substantial losses in their initial positions, yet they continued tobuy no matter how low the commodity appeared to be headed.They even seemed happy about it and talked of adding inventorywhen they entered a trade that immediately began to lose money.Eventually they offset virtually all these losing positions profitably.How could that be when the first thing you are taught as a traderis to cut your losses short and let your winner run? These guys lettheir losers run and cut their winners short. They had patience, discipline, and sufficient trading capital to wait for the market to cometo them. This was my first exposure to scale traders—a new breedof trader for me.Let me begin by describing in detail how scale trading traditionally works. Then, in the next chapter, I’ll describe how the
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brokers I worked with modified it to get a better handle on the risks.Our approach has been called heresy by traditionalists, but thegroup of brokers I worked with always recommended it because wenever believed in, or enjoyed, financial self-mutilation. By the endof Chapter 4, I hope you’ll agree.Scale trading attempts to extract a modest profit from eachtrade by following the most basic of economic laws—that of supply and demand. If a commodity is plentiful, the price decreases. Ifit is scarce, the price rises. The law works just as smoothly on thedemand side. Strong demand translates into higher prices; lowdemand causes prices to head south.When these laws work in tandem—reduced supply withincreasing demand or abundant supply with weak demand—prices will soar or plunge, respectively. Prices consolidate whenthese forces are in opposition, i.e., strong demand with plentifulsupply or weak demand and scarce supply.A corollary to these economic laws states: “The surest cure forlow prices is more low prices.” This simply means that smart people find or devise uses for any commodity available at bargainbasement prices. Every real commodity has a price at which it isjust too cheap. When it gets to that level, someone will figure outhow to turn a profit from it. Corn is a good example. When priceslanguished at lows for extended periods of time, entrepreneurialtypes developed processes to convert corn to a sweetener for dietfoods and drinks or to alcohol as a gasoline additive. Increaseddemand or reduced supply eventually leads to price recovery.Scale traders seek to take advantage of these “natural” laws.They buy commodities trading in the lower third or quarter of theirlong-term—10 years or more—trading range. The theory is thatthese commodities are near bottom and once they bottom, priceswill begin to recover. Scale traders listen to their wives and believethere are always buyers for true bargains. They also believe there isless risk buying a commodity once it is already at or near its historical low. In other words, much of the downside risk is in placealready.This trading system gets its name from the method of enteringand exiting the market. The trader buys each futures contract basedon a predetermined scale, and he or she closes (sells) each openposition using another predetermined scale. For example, a scale
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might call for buying corn each time the price drops 4 cents oncecorn is trading in the lower quarter of its 10-year trading range. Theprofit objective might be to sell each position once there is a 6-centprofit, which would be $300 for corn (5000 bushel contract  $0.06).Notice that scales, even for the same commodity, can vary due tomarket conditions.Here is an example. Studying the 10-year corn price chart, it isdetermined the high is $4.00 per bushel and the low is $2.00, or a$2.00 trading range. The lower 25 percent would, therefore, beginat $2.50 per bushel. In this example, corn drifts lower for the nexttwo months, eventually coming to rest in the $2.00 area. Using a4-cent down and 6-cent up scale, the first position opens (or thefirst “buy” occurs) when corn trades at $2.50. The second isacquired at $2.46; the third at $2.42; the fourth at $2.38; the fifth at$2.34; the sixth at $2.30; and at each 4-cent interval until $2.02 (seeTable 3-1). If corn stopped at $2.02, the trading account would contain 13 positions that must be financed. Of these, 12 are losingmoney and the last is at-the-money.Two types of margin are required to hold these 13 corn contracts. First is the initial margin, which is needed for each contract.Margin requirements are always subject to change. They can go upor down depending on how volatile a market is trading. Marginswill be discussed in detail in a later chapter. In this example, a margin of $500 per contract is used, or $6500 in total, Column 4, Row13. The total loss or drawdown on the first 12 losing positionsamounts to $15,600. The total capital required is $22,100.When corn moves off the $2.02 low and advances 6 cents higher, the last position is offset for a $300 profit. If corn steadily climbsto $2.56 over the next month or so, all 13 positions close for a totalprofit of $3900. This is a gross return on equity of approximately 18percent ($3900/$22,100) over a reasonably short period of time.That is the theory behind scale trading. Unfortunately, it israre for any commodity to move smoothly to a low and retraceitself just as smoothly to a new high. The more common pattern isfor a commodity to stair-step its way down and then up. Priceswill drop a nickel or a dime, only to retrace this move. Then theymay lurch down again, followed by another recovery, makinglower lows and lower highs set each time on its journey to the lowof the cycle.
3-1
Columns
$2.18
9
$3,900.0018%
$2.22
8
Profit% Return
$2.26
7
$2.02
$2.30
6
13
$2.34
5
$2.06
$2.38
4
12
$2.42
3
$2.14
$2.46
2
$2.10
$2.50
1
$500.00
$500.00
$500.00
$500.00
$500.00
$500.00
$500.00
$500.00
$500.00
$500.00
$500.00
$500.00
$500.00
Margin
$6,500.00
$6,000.00
$5,500.00
$5,000.00
$4,500.00
$4,000.00
$3,500.00
$3,000.00
$2,500.00
$2,000.00
$1,000.00
$1,000.00
12
11
10
9
8
7
6
5
4
3
2
1
0
LosingContracts
TotalMargin$500.00
5
4
$200
$200
$200
$200
$200
$200
$200
$200
$200
$200
$200
$200
$0
Loss perContract
6
$2,400.00
$2,200.00
$2,000.00
$1,800.00
$1,600.00
$1,400.00
$1,200.00
$1,000.00
$800.00
$600.00
$400.00
$200.00
$0.00
Total Loss/Contracts
7
$15,600.00
$13,200.00
$11,000.00
$9,000.00
$7,200.00
$5,600.00
$4,200.00
$3,000.00
$2,000.00
$1,200.00
$600.00
$200.00
$0.00
Totalof Losses
8
$22,100.00
$19,200.00
$16,500.00
$14,000.00
$11,700.00
$9,600.00
$7,700.00
$6,000.00
$4,500.00
$3,200.00
$2,100.00
$1,200.00
$500.00
Drawdown
9
8:58 AM
11
Buy Price
Number
3
Down 4, Up 6 Cents
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2
1
Corn Scale
TA B L E
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Once a bottom is put in place, a period of price consolidationor base building occurs. At some point, a bull market—along withits share of false starts, resistance points, and retracements—begins. Prices move higher. Now there are higher highs and higherlows.The stair-stepping price movement can be good or bad newsfor scale traders. For example, the intermittent bull (upward) rallies during the bear (downward) market phase generate additionalprofit opportunities. This occurs when prices move high enough,6 cents in the corn example, to offset the most recently establishedposition. When the market resumes its movement south by 4 cents,the position is reestablished. This type of price action can occuroften on either the down move to the low or on the up move. Inscale trading terminology, these welcome gifts from the market arecalled oscillating profits. Normally, over the course of a scale, therewill be enough of them to add 20 percent or more to the totalreturn, which offsets brokerage commissions and increases thetotal return.The negative side of oscillating prices is that they can drawout the amount of time it takes to complete a scale. Completemeans closing out all positions. If a scale is drawn out too long, theinitial positions may expire. Remember, futures contracts have setexpiration dates. If a contract expires, it must be rolled into a moredistant contract or closed out at a loss. Theoretically, a scale tradercould roll expiring positions into more distant months, e.g., rollMay corn into September and September into December, etc., untilevery position is closed at a profit. Some people use this theory tocreate the myth that scale traders never have losing trades. Don’tbelieve it!Another reason for having to roll positions is that the pricenever recovers enough to liquidate all open positions. This canhappen when an unexpected event disrupts the normal supplydemand equation or if an important factor is overlooked or miscalculated. In Chapter 8, I will detail how and when to roll expiringcontracts.That is the traditional theory of scale trading. It all soundedsimple enough. The broker group I was working with dived rightin. As it turned out, scale trading was not all that simple once webegan actually doing it, but it was as profitable as expected.
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Understanding HedgedScale Trading
Now let me describe how to incorporate a few basic option strategies into traditional scale trading to manage some of the risks thetraditionalists brush off as immaterial. Once you have completed allyour research—which will be covered in detail in later chapters—and a commodity has been selected to scale trade, it is time to beginopening positions. The first risk to consider is entering a scale toosoon.If you start a scale trade too soon, one of two things couldhappen. First, the entry point of the scale, which would be thelower third or quarter of the 10-year trading range for the commodity being scaled, could turn out to be the low. No problemhere, since any positions you opened will be closed out at a profitas prices move higher off the low. If any protective puts had beenestablished, which will be discussed in detail shortly, they can beoffset or they will expire worthless. This should amount to abreakeven proposition at worst. No harm, no foul.The second possibility is that the downtrend that took thecommodity to the entry point might stall. Prices oscillate up anddown in a tight trading range but are basically moving sideways.The positions that are opened are offset as the price of the commodity bounces off resistance. These are called oscillating profits.This is good, but precious time is being wasted. If this continuestoo long, the contracts you are in will be approaching expiration.If this happens and it is obvious the scale is not developingbecause prices are stabilizing as a bottom is being established,61
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offset any protective puts acquired to salvage any time valuethey may have left. Simultaneously, offset all long futures positions or sell some covered calls against them.Covered calls are options that have long futures positions backing them up. These are hedged positions. For example, you have along corn position at $2.50. You sell a $2.60 call for a dime a bushel.When you sell that call, you are paid the premium. If the marketmoves higher to the point the owner of the option you sold exercised, say $2.65, you can deliver your long position and keep thepremium. If the market stays flat, the option you sold expiresbefore the futures. You then offset the futures and use the premiumfrom the call or calls to cover any losses on the futures positionsand any puts that might have been purchased.If for some reason the market breaks through the resistance,moving lower, you still have a hedged long position. You canresume the scale, but you might want to use a more distant futurescontract. At least you are not stuck with a naked long as the market heads south. As expiration of the option approaches, you closeboth positions simultaneously. Any loss on the futures is offset bya gain on the short call.Now study the scale in Table 4-1. It is a corn scale, similar tothe one in Chapter 3, beginning at $2.50 per bushel, but prices golower and it has a different scale.Remember, the scale you create will vary, even when tradingthe same commodity. The reason for this is volatility, which can bemeasured several ways. One measurement is the size of the average daily price move—the bigger the move, the greater the volatility. There are times when, from the opening price to the closingprice over a given period of time, corn can move as little as a pennyor two per bushel to as much as a dime or more. The reason is inthe minds of the traders. Are they confident they know what thetrue supply-demand situation is? Or are they confused and uncertain? Are “scary” news stories, like summer droughts or excess rainat harvest, bombarding the trading pits?Keep in mind that this pattern of thinking about corn fits allcommodities, and it is key to developing a scale. With any commodity you scale, you will be concerned with the uncertainties ofproduction and demand. What can possibly disrupt supply?Flood? Drought? Transportation? Strikes? War? Acts of God?
4-1
Columns
$1.52
15
$1.94
9
$1.59
$2.01
8
14
$2.08
7
$1.66
$2.15
6
$1.73
$2.22
5
13
$2.29
4
12
$2.36
3
$1.87
$2.43
2
$1.80
$2.50
1
$500.00
$500.00
$500.00
$500.00
$500.00
$500.00
$500.00
$500.00
$500.00
$500.00
$500.00
$500.00
$500.00
$500.00
$500.00
Margin
$7,500.00
$7,000.00
$6,500.00
$6,000.00
$5,500.00
$5,000.00
$4,500.00
$4,000.00
$3,500.00
$3,000.00
$2,500.00
$2,000.00
$1,500.00
$1,000.00
14
13
12
11
10
9
8
7
6
5
4
3
2
1
0
LosingContracts
TotalMargin$500.00
5
4
$350
$350
$350
$350
$350
$350
$350
$350
$350
$350
$350
$350
$350
$350
$0
Loss perContract
6
$4,900.00
$4,550.00
$4,200.00
$3,850.00
$3,500.00
$3,150.00
$2,800.00
$2,450.00
$2,100.00
$1,750.00
$1,400.00
$1,050.00
$700.00
$350.00
$0.00
Total Loss/Contracts
7
$36,750.00
$31,850.00
$27,300.00
$23,100.00
$19,250.00