at the expiration of the futures contract. This keeps themarket honest and true to the supply-demand situation.This is the reason users and producers closely follow the futures market even if they don’t trade it. They know that what happens in the pits will eventually be felt in the fields, or the mines, orthe bank vaults.Additionally, the inventory manager can be a hedger, shiftingthe risk of futures’ usage to a speculator. This would be another reason to closely follow the futures markets.Once you accept this close relationship, you gain insight intohow to anticipate price activity by viewing the markets through theeyes of the inventory manager. Now, look at some specific price-trendmoves and decide what action an inventory manager would take.MANAGING AN UPTREND
The inventory manager of a large soybean crusher is responsible formaintaining a 30-day inventory of beans. The inventory manager’sannual bonus is based on the profitability of the operation. For thesake of profitability, the inventory manager must time bean buyingcarefully.Harvest is now over. The seasonal trend is up, and the SouthAmerican crop is in trouble. Each time the manager goes into themarket, the price is higher. Faced with this prospect, most inventory managers begin to build inventory. Each purchase becomes a little larger.
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What does this do to the uptrend? It causes the trend to movesharply higher. As prices begin to skyrocket, everyone panics. Herdpsychology takes over. The buyers buy at any price. The sellers holdthe product off the market because they think it will be more valuable tomorrow. The poor inventory manager fears being completely shut out of the market and out of inventory.At some point prices become ridiculous—$13 per bushel. Themanager of the soybean processing plant instructs the inventorymanager to quit buying. Prices are too high to process the beans andgenerate a profit. It makes more sense to shut down the plant.About the same time, the sellers realize they have a windfalland begin to send raw materials into the cash market. Shorts in thefutures markets take delivery, thus squeezing the cash market evenmore. Then sellers begin to fear they are going to totally miss theboat. This causes them to sell as fast as they can, which drives pricesdown—just when the buyers have backed off. This behavior helpsexplain why markets tend to top with sharp peaks and fall twice asfast as they rise.MANAGING THE DOWNTREND
If the soybean market was trending downward, the inventory manager would not build inventory. The inventory manager would buyfrom hand to mouth because each subsequent purchase would bemade at a lower price. Patience may pay off, but at some point abundant supply fosters increases in usage and increases demand. A baseis eventually built and prices level off.MANAGING CONGESTION
What does the inventory manager do when prices are in a sidewaysor consolidating pattern? As prices move in a channel, the buyerperceives the top of the price channel as being too high or prohibitive. The buyer backs off. Prices move lower and become a “bargain.” The buyer steps in and his buying generates support at thebottom of the channel.Eventually something upsets this pattern. It could be some fundamental news, such as a drought or news of record yields. The supply-demand scale tips one way or the other and a new trend begins.
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Your emotional or instinctual reaction to price changes is avalid input. After all, the market is the sum total of all the players’reactions to what has happened, what is happening, and whateveryone expects to happen. In short, it can be said that a commodities futures price is the composite opinion of all market participants and influencers.GET THE RIGHT HAT ON!
When you put yourself in the position of an inventory manager, youmust first give some thought to the specific situation you’ll be facing. An inventory manager can just as easily represent a country asa company. Therefore, you want to match the commodity and thesituation with the inventory manager’s motives. If you are lookingat the long-term outlook for grains, you may want to look at the situation from a variety of viewpoints. Then you will be able to anticipate what each player will do and the cumulative impact on theprice of grains.The motivation of the inventory manager from a South American country, which is a net exporter, differs substantially from thatof an inventory manager of an Eastern European country, which isa net importer. You must also sort out the political motivations ofcountries like the United States, which has a history of using foodas foreign policy. In our current situation, the grains appear to bemaking a technical bottom. What is going through the minds of inventory managers around the world?The United States Department of Agriculture (USDA) has theadministration pressuring it to reduce its budget. Therefore, theUSDA wants to force the price of grain higher to reduce subsidypayments to farmers. At the same time, the State Department andthe White House refuse to issue credits to the foreign country because of its human rights violation. Your analysis indicates that political pressure will be strong enough that the USDA will win. Credit will be given. This will have a positive effect on price.The people in South America, who control the flow of grain,are also under a lot of political and financial pressure. They need thesales badly. Therefore, they will be aggressive sellers, but they arenot in a financial position to offer credits. This means they will probably discount prices.
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As an inventory manager, you must analyze the net impact ofthis tug-of-war. You conclude that the need or the demand is sostrong, it will push prices higher. However, it also looks as if priceswill move up slowly and in an orderly manner because there aremany willing sellers but the aggressive buyers are cash poor.Historically, big net importers of grain, like the Commonwealth of Independent States (the former Soviet Union), have beenvery active buyers of U.S. grains around harvesttime. This is thecyclical low for the grain market. Inventory managers for thesecountries would naturally be buyers at this time of year. You havejust seen what a bottoming market looks like. What positions do inventory managers take when a market is topping?First, you must distinguish whether you are thinking like aninventory manager for a seller or a buyer of the commodity. As amarket tops, inventory managers for buyers try to hold back asmuch as they can—buying from hand to mouth. They are hopingthe market will break before it breaks them.Inventory managers for sellers might also hold back, expectingto sell their commodity at an even higher price tomorrow. Thisdrives prices into a blow-off top, sometimes followed by a shortterm rebound.OPEN INTEREST IS A KEY TO THE ACTIONSOF INVENTORY MANAGERS
Another key to understanding both topping and bottoming situations is open interest. It can be defined as the sum of all long or shortfutures contracts in one delivery month or one market that havebeen entered but not yet liquidated by an offsetting transaction orfulfilled by delivery. This information is reported by the futures exchanges and published daily in the major financial newspapers. Inventory managers, by virtue of their size, have a noticeable impacton open interest when they act.If open interest increases when a market is near record lowsand prices start to stabilize or move higher, inventory managers forusers are aggressively accumulating inventory. If, on the other hand,prices are topping and open interest is declining, the inventory managers for producers are selling. Generally speaking, as the inventory managers go, so go the markets they trade.
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The strongest hands that ever hold a commodity are those belonging to a bona fide hedger. The bona fide hedger is a producer orsomeone with a business need for the commodity. Plans are madeto sell it or use it. Business can’t be conducted without it. The bonafide hedger is not easily swayed by transient political or economicpressures, but is neither crazy nor foolish. If prices get too far out ofline, hold will be relinquished on the commodity in question.ANATOMY OF A BULL MARKET
Understanding the concept of bull (uptrend) and bear (downtrend)markets is critical to success in the futures market.There are usually seven distinct stages in every major bull market. You must learn to recognize each stage before it is in full swing.By developing this skill, you’ll be able to trade with the trend, whichis often the difference between winning and losing in the markets.1. The birth of the bull. Surprisingly, the origins of a bull marketare found in surplus situations. Surplus commodities widen the arteries, fill the pipelines, and foster new sources of demand. An industry whose raw materials are in surplus is likely to expand usage.Low-priced, surplus supplies build confidence in users—the confidence to expand, to develop new uses (corn sweetener, oils, gasohol, etc.), to solicit new customers, and to contract long-term commitments. All these factors result in an increased appetite and awider demand base.From a technical analysis perspective, a surplus market is observable as a rounded bottom, the early signs of which are progressively shallowing downtrends and narrower trading ranges. Theabsolute bottom of a rounded bottom often occurs when the fundamental information is the most bearish while the commodity pricemeanders sideways in a narrow range. You can be comfortable, forinstance, with a major market bottom when all the news reports saythat corn is going to the “price of gravel” while the corn price wanders aimlessly in a 2-cent range. Passive market activity in responseto bearish news is your first bull sign.2. Shallow uptrend. The next benchmark is modestly increasingprices at the right side of the rounded bottom. It is a very shallowuptrend, usually accompanied by wider price ranges. Fundamentally, there is little change in the supply of the commodity, but com-
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mercial interest in the commodity does change slightly. A “what-if”stage develops among the fundamentalists. What if there is a shortwheat crop in Canada? What if Brazilian coffee has a freeze? Whatif housing starts increase by 10 percent? What if war breaks out? Dueto the intangible nature of the what-if stage and the fruitless natureof most what-if scenarios, stage 2 offers very little price improvement other than the gradual increase in price due to carryingcharges. Yet this is the place to begin to build your position as themomentum picks up.3. The breakout. The third stage of development is a very interesting one that often occurs with very little public supply and demand information. It is frequently described in business publications as a “technical breakout.” This is a way of saying, “The markethas made a dramatic move, but we don’t know why.”Technically, the market is breaking out of the rounded bottom,and it usually shows a modest rally for a few days, sometimesweeks. This rally often subsides without fundamental followthrough and develops a platform or plateau. This is sideways market activity at the area of the rounded bottom breakout and a timeof confusing information. Fundamental and technical data are oftenconflicting and often contradictory.4. The rally. Stage 4 of the bull market develops as market information becomes more detailed. Often, seemingly minor fundamental (supply and demand) information comes into play, such aserratic weather patterns across the Midwest affecting the grain market. More what-if scenarios also begin to develop. This nervous rally tends to be choppy, with labored price increases and sharp, quickdips. The rallies and subsequent dips are usually able to hold a 45degree trend line. Traders feel confident in buying when prices dipback to the trend line.5. The explosive newsmaker. On a technical basis, gaps are oftenleft on the charts during this phase, while the bullish fundamentalscenario gains wider acceptance. Users scramble to purchase rawmaterial, while sellers become reluctant to release supplies. Interestingly, advisory newsletters during this stage usually become nervous and indicate a bias that the market may be topping.6. The steep rally. The sixth stage of the bull market is typicallya steep rally with few market retracements and wide trading rangesfueled by bullish fundamental information. Often, public attention
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turns toward the market rally, and people who have never tradedcommodities suddenly think about trading the long side. Duringthis period the news media report on users who are going bankruptbecause they have left themselves exposed to price increases in rawmaterials.7. The shearing. Stage 7 occurs when investors decide to selltheir blue-chip stock at a loss and go long in the commodity marketjust when bullish information is being offered to the public, inspiring them to become involved. When you read about it in the WallStreet Journal, check to make sure you have your protective stop orders properly placed. Technically, the market will gap higher withlimit up moves, even for 2 or more days; then, the sheep are shorn.It is after stage 7 that the futures industry is plagued with outcriesfor greater regulation.BEAR MARKETS
Bear markets usually move down faster than bull markets move up.One of the reasons is lower volume. The less volume, the more erratic and violent market moves become since there is less activity toabsorb and cushion the fall. Low-volume markets are very dangerous to trade for this reason. Staying informed is essential. The volume of each market is reported by exchanges and published dailyin the major financial papers.Like bull markets, there are several stages to these markets.1. The first stage occurs when bullish news enters the marketbut the market doesn’t move higher. It appears that eithernobody believes the news or everyone believes the markethas already taken the information into consideration.2. Next, the market makes a severe retracement—usually 33,50, or 66 percent of the previous bull move. A lot of traderson the long side, often small individual traders, lose money and are forced out of the market. Since no new longsenter the market when this retracement starts, the marketis said to “fall by its own weight.”3. Once the market finds some support, completing the retracement stage, there may be a period where the marketmoves sideways or even up. This is a bear market rally.Traders are often very confused during this time period.
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4. Sooner or later, the bullish news becomes scarce or nonexistent. At this point, the market makes its final descent tothe point where inventory managers can’t resist buildinginventories. This actually brings the bear market to an end.THE PRICE DISCOVERY PROCESS
Obtaining a firm grasp of how the market discovers price is a key tosuccessful trading. What may appear to the novice trader as totallyrandom price movement eventually conforms to recognizable andtradable patterns.Think about the futures market as a public poll. The futuresbrokers are the pollsters. They go out and survey the general trading public. “Where do you think the price of gold is headed?” “Inyour opinion, is the price of crude oil too high or too low?” The answers to all the questions are communicated to the trading pits,where they are processed. The results are published daily in variousfinancial papers, are transmitted on the financial wire services, andcan be found on several websites.The people who answer these surveys are very sincere abouttheir answers. They have backed their opinions with margin money. Collectively, they represent all the thoughts, research, and emotions surrounding the entire financial community. The peoplepolled may have been influenced by the media, their personal financial situation, and what has happened or is happening in theworld.Can studying and evaluating all these surveys be meaningful?Yes, they help in the discovery of long-term trends. If you look at thetrends—as someone like John Naisbitt, author of Megatrends, woulddo—you begin to think about them as being the collective responseto stimuli. By reading, studying, and collecting a wide array ofseemingly unrelated data, experts can deduce, with a good deal ofaccuracy, various interesting trends that planners and businesspeople can use.This work is very similar to fundamental analysis of the futuresmarkets. However, even if you can deduce the overall, long-termtrend, it doesn’t necessarily tell you which specific opportunity ortrade to take. Nor is it much help when it comes to timing. Mosttraders revert to technical or chart analysis at this point.
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LEFT- AND RIGHT-BRAIN TRADING
As learned from scientific research, the brain has a left and a righthemisphere. The left side deals primarily with the logical side of ournature, the right with the creative or artistic.In selecting trades you use your left side to do fundamentaland technical research. Once all your homework is done, either byyourself or in consultation with your broker, you digest the facts. Atthis point, the hard data moves to the right side of the brain for interpretation. The artist in the trader uncovers the patterns in thecharts. Intuition takes over in many successful traders. They maytrade what appear to be hunches, but are, in reality, a synergisticblend of the left- and right-brain functions. A behavioral pattern isoften seen in successful traders and brokers, where they study thefacts, sleep on the information, and trade successfully the next day.Good commodity trading advisers (CTAs) substantiate theiranalysis at different times with different analytical tools. One timea CTA may seem to be a fundamentalist; the next, a strict technician.The experienced analyst selects the correct analytic techniquebased on the current market conditions. Some techniques work wellwhen the markets are trending up or down, but are useless or dangerous in choppy, trendless markets. Some chart formations aremore reliable than others. Sometimes, the fundamentals are clearand meaningful. At other times, they are conflicting.Nowadays there is so much access by traders and advisers toboth technical and fundamental information, the well-known signals become self-fulfilling prophecies. Everyone sees corn break atrend line or drop through a support level. This causes a rush to theshort side of the market. The lower prices foretold by the brokentrend line are realized.Wouldn’t a totally automated system be best? True enough, afreestanding computerized trading system would eliminate theneed for subjective judgment on the part of the analyst. However,you wouldn’t want this any more than you would want to ride in aplane that didn’t have human pilots who have the capacity to override the autopilot when conditions warrant it. Futures trading is ablend of cold, calculating statistics and a warm, human touch.Traders who rely too heavily on either—to the neglect of the other—are not usually successful.
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You must accept the law of probability to be able to handle thestress of futures trading. Futures trading can be a hit-and-miss investment. Some trades work; others don’t. You must keep trying onetrade after the other until you pick the profitable trades. “Cut losingtrades short and let winners run” is the rule to go by.You diversify your portfolio by trading several different markets in order to increase the probability of being in the right trade atthe right time. This requires discipline and money management.Both are essential for you to survive the markets and utilize the lawof probability to your best advantage.
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Setting Goals andCreating a Portfolio
Key Concepts◆ Set Realistic Goals◆ Have a Written Trading Plan◆ Keep a Written Trading Journal◆ Select Trading Portfolios
The futures industry, more than just about any other, is filled withstories of office clerks becoming millionaires virtually overnight.Some of these stories are even true, but the reality of the situation isthat most small individual traders lose money. For this reason, it isvery important that you develop realistic goals. These are milestones you can use to measure your success. Learn to do this often,so you know when you are ahead and when you’re falling behind.SETTING REALISTIC GOALS
Success in achieving goals often depends upon putting them inwriting. This makes them more real. More importantly, you have abetter chance of reaching written objectives because they don’t goaway.At the same time you dictate your goals, also prepare a list ofyour limitations. What will limit your success in reaching your futures trading goals? It could be lack of, perhaps, equity, or knowl-
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edge of the markets, or a tested trading system, or time to devote tothe market. Or it could be something you have too much of, like optimism, greed, or self-confidence. Or it could be an equipment limitation. You can’t day-trade without tick-by-tick price quotationequipment. You might need a computer to run the trading systemyou wish to use. Does your current work keep you out of touch withthe markets during the day or for other periods of time? No matterwhat your limitations are, you must take them into consideration asyou develop your goals.The primary goal of just about every trader is, or should be, totake money out of the market. The question is usually how muchand how fast. Do you want to double your equity every quarter? Ormake 200 or 400 percent or more return on your trading equity?The more aggressive your goal, the greater the risk you have totake. Keep in mind that one of the keys to reaching financial goalsis being in the right market at the right time. You may have to diversify to do this and trade several markets at the same time.In the futures market, an account can trade only a few marketsat a time. Even if the analysis is absolutely right, your timing maybe a week or two off. Once the trader loses some money (drawdown of equity), it may not be possible to get back into the marketwhen the time is right. For this reason, goals must be tempered withwhatever limitations you impose or are imposed on you from without.
DEVELOP A WRITTEN TRADING PLAN
A written trading plan doesn’t have to be formal or extensive, but itshould answer the following questions:Trading Plan Checklist1. Am I psychologically and financially suited to tradein the futures markets?2. What are my goals?3. What are my limitations?4. How will I keep a trading journal?5. Will I trade futures, options on futures, or both?6. What commodities and contracts will I trade?
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7. How will I do my analysis?8. What trading system will I use?9. Do I have hard-and-fast money management rules?10. What trading strategies will I use?11. What type of orders do I plan to use?12. What do I need from my broker?Once you have answers to these questions, you’re ready to begin thebroker selection process.KEEP A WRITTEN JOURNAL OF OUTCOMES
Another important record you should maintain is a daily tradingjournal. A good written record of your trading activity could separate you from the majority of traders who fail. The function of thejournal is twofold. First, it reminds you why a trade was selected orrejected. Second, it provides an audit trail.Why bother is a common attitude among futures traders. Theyjust don’t see the value of chronicling their trading activity. Theyhave the attitude, “I get a monthly statement—isn’t that enough?”The most important piece of information missing from yourmonthly statement is the reason you got into the trade in the firstplace. What did you expect to happen? What was the risk-to-rewardratio? What alternative trades did you turn down in favor of theones you took? What fundamental or technical signals triggeredyour trading decision? What attracted you to the trade initially?Remember the quotation (Santayana), “Those who cannot remember the past are condemned to repeat it.” Trading is an extremely personal and emotional endeavor. Our minds interpret theinkblots on the price charts and rationalize trading decisions. Somegreat traders talk about their instincts. According to them, they cansmell a trade when it is still 10 ticks away!The essence of what these traders are saying is basically believable, but writing stimulates thought and clarifies thinking. Researchers who have studied the papers of some of the world-classtraders indicated that their trading wasn’t by the “seat of theirpants.” The great traders documented what they did before, during,and after the markets were open. Learn from mistakes. Why repeatthem? Learn from success. Why not repeat it? This historical record
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overcomes the tendency to mold the past by the perception of it inthe present. Without the facts it is difficult to be brutally honest.For these two reasons, you should put your thoughts and emotional reasons for each trade on paper before you call your broker.This is needed even if all you have to go by is a “gut feeling that cornis going higher.” Record when you first noticed that feeling as wellas what might have triggered it. Was it a news story, a chart formation, or what? Later on, you may be able to piece the puzzle together and make concrete sense of it.Reliable instincts are as meaningful in commodity trading asthey are in any other human activity. The price trends and patternsof the futures market reflect the instincts and emotional state ofevery trader that is getting in or out of the market at a given time.You may be able to instinctively sense where a market is going attimes, just like a hunter can sense where game can be found.Your trading journal helps you hone your instincts and/or ridyourself of them if they are not valid. You really learn to sort out unfounded hunches from brilliant insights, but what should be included in a trading journal? When do entries need to be made, andwhere do you keep your journal? The journal reflects your tradingsystem. Start by asking, “How do I select trades? What are my keyindicators? What are my goals?” For example, the first thing manytraders do is determine if the trend is up or down for the marketsthey are tracking. This may be your first entry. You would then dothe same for the other signals that you regularly check. Be consistent in your logging of this information.How often do you need to make an entry or update your journal? There are a couple of ways to look at this. First, do you normallytrade for the long or short term? Second, do you trade slow-movingmarkets like oats or speedier ones like the S&P 500? You shouldmake an entry each time you “check” your markets. Checkingmeans evaluating your current position and giving serious consideration to entering or exiting a trade.What format is best for a trading journal? It might be hieroglyphic notes scratched on a Daytimer by a day trader or an elaborate record maintained on a computerized word processing program. The what, when, where, and how of keeping a journal is a lotlike the question of how long should a person’s legs be? Longenough to reach the ground. Your journal should satisfy your needs.
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It is created only to help you trade more successfully. The worstthing it can become is a chore. If you find yourself dreading thethought of updating it, something is wrong.Simplicity often makes diaries more meaningful. Say you receive a weekly charting service that you update once or twicethroughout the week. You could make your journal entries right onthe charts as you are filling in the daily trading ranges. Then cut outthe charts you use and put them in a three-ring binder. Once a tradeis closed, record the results. Then page back through the chart pagesand evaluate your performance. On the last page, write a two- orthree-sentence summary. It can be as simple as that.SELECTING A TRADING PORTFOLIO
Your portfolio choice could help you compensate for a shortage ofmargin money or trading equity, two common trading limitations.For example, the amount of margin money required to trade one futures contract varies by commodity. The various exchanges (Chicago Board of Trade, Chicago Mercantile Exchange, New York FuturesExchange, New York Board of Trade, etc.) set the margin requirements for each commodity traded on their exchange. The margin isset based on the size of the contract and the amount of price volatility of that specific market. It can range from a few hundred dollarsto several thousand and can change dramatically depending onmarket conditions. It is always recommended to keep at least twicethe margin money required in the trading account to cover unexpected price swings.The purpose of margin money is simply to ensure that tradersstand behind their trades. This is critical since the books on everytrade are balanced every day. The oats futures contract has a lowmargin requirement, usually less than $500 per contract. The Chicago Board of Trade contract specifies 5,000 bushels. The price perbushel has ranged from less than $1.00 to just over $4.00 over thepast 25 years. Most of the time, however, the price range was between $1.00 and $2.50. This calculates to a total contract value of$5,000 to $20,000.The price swings in this contract are usually small on a day-today, and even week-to-week, basis. It is a market with low pricevolatility. Therefore, a trader who wishes to trade futures with a
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small amount of equity would do well to start with oats. One or twocontracts could be traded at a time. As an oats trader, what kind ofreturn could you expect? What should your income goal be? Is itworth your while?During a 5-year period the author’s in-house trading system,the Wasendorf Trading System (WTS), generated a simulated profit of $11,425 trading one contract of oats. This doesn’t include a deduction for brokerage commissions and fees, which could varywidely. If you divided this gross simulated profit by 5, you have$2,285 per year. To produce this profit, approximately 7 trades wereconducted each year. If you paid $125 for commissions and fees, youwould still have netted over $1,400, or about 3 times the marginmoney required, and your $2,500 equity would have increased byabout 50 percent. There were periods of time during that 5-year period when the simulated performance record lost money. That’swhy funds over and above the margin required by the FCM couldbe needed. Always remember that whenever someone discussespast performance of a system, it is not necessarily indicative of future performance.A complaint often heard is that it is dull to trade oats contracts.If