, considerusing a working or enhanced scale spreadsheet (see Table 9-7). Thisone has 7 additional columns, for a total of 12. The followingcolumns have been added:Date Buy Order PlacedPrice Buy Order FilledNumber of Contracts HeldDate Sell Order PlacedPrice Sell Order FilledProfit or Loss on OrderNumber of Losing ContractsThe purpose of these extra columns is to help you keep trackof the progress of the scale. You need to know when orders areplaced or filled because there may be days or even several weeksbetween the time you give a limit order to your broker (or place itelectronically) and the time it is filled. One of the worst and mostembarrassing things you can do is place a duplicate order. If youhave forgotten you’ve put an order in and you place another, bothwill be activated when the commodity reaches the trigger price. Atthat point, you either live with the larger number of contracts orclose the one(s) placed in error at a loss.The next column is the fill price. Naturally you want to recordthe fill price so you can calculate the profit when it is offset. The fill
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TA B L E
9-7
Expanded Corn Scales: 25%, 10-yr. RangeScale: 4 cents down; 8 up1
2
TradeCount
BuyPrice
1
$2.43
2
$2.39
3
$2.35
4
$2.31
Oscillator
4A
Oscillator
4B
Oscillator
Oscillator
5
$2.27
6
$2.23
6A7
$2.19
8
$2.15
8A
Oscillator
8B
Oscillator
8C9
$2.11
10
$2.07
Oscillator
10A
Oscillator
11A
11
$2.03
12
$1.99
13
$1.95
3DateBuyOrderPlaced
4PriceBuyOrderFilled
5NumberofContractsHeld
6DateSellOrderPlaced
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7PriceSellOrderFilled
8Profitor LossonOrder
Total Profit (Loss):Less Commissions:Net Profit:Return on Equity:
9MaintenanceMargin
159
10NumberofLosingContracts
11
12
TradingLoss
CumulativeDrawdown
$500.00
$0.00
$500.00
$500.00
$200.00
$1,200.00
$500.00
$400.00
$2,100.00
$500.00
$600.00
$3,200.00
$500.00
$800.00
$4,500.00
$500.00
$1,000.00
$6,000.00
$500.00
$1,200.00
$7,700.00
$500.00
$1,400.00
$9,600.00
$500.00
$1,600.00
$11,700.00
$500.00
$1,800.00
$14,000.00
$500.00
$2,000.00
$16,500.00
$500.00
$2,200.00
$19,200.00
$500.00
$2,400.00
$22,100.00
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you get may not be the exact price as it is on your scale. You can getprice improvement, since you will be using limit orders. Priceimprovement simply means you get a little better price thanexpected, which can happen with limit orders. These orders saybuy (sell) at a certain price or better. In the case of a buy, the pricemust be lower and for a sell, higher.Number of Contracts Held is the next column, which includesall the positions you own, including oscillators. You will also wantColumn 6, Date Sell Order Placed, to make sure no duplicates sellorders get placed in error. Column 7 is the fill price on closed positions, and Column 8 calculates profit and/or loss. On an electronicspreadsheet program, many of these columns can be set up as formulas so there is no human error to contend with.Notice how easy it is, using an electronic spreadsheet, to insert anew row and plug in your oscillating profits as they occur.Remember, you will catch oscillating profits on the way down as wellas on the way up. These are the ones numbered alphanumerically. Atthe bottom of the spreadsheet are the total profit and loss calculations.The last part—and what will be most important in the longrun—of your scale trading binder is the scale trading journal andresearch analysis section. Begin your journal with a writtendescription of the scenario exactly as you expect it to occur basedon the research you have gathered. Use the technique of visualization, which has become very popular and very useful. Let’s usecocoa as an example. We know from the quickie survey in Chapter6 that cocoa is a good scale trading commodity. From varioussources [e.g., the International Cocoa Organization (www.icco.org)or the International Monetary Fund (www.imf.org)], we obtain thesupply-demand tables.A source, such as Hartfield Management’s CommodityReference Guide breaks down production (supply) and grind(demand) into a variety of charts covering the last two decades togive you a good picture of the world cocoa balance. It even provides a list of the key fundamentals for cocoa for the upcomingyear and predicts price ranges under bearish, neutral, and bullishconditions. Add these lines to your long-term charts. Using variouscolor pens often helps keep all the lines straight in your mind. Tothis information you add what you have learned from othersources and write your scenario for the scale you are planning.
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Note whether you agree or disagree with the public predictions,and why. This is important as you develop your analytic skills.One of the key elements of your scenario will be a list of themarkers (or milestones) that will alert you to how well the scale isperforming. For example, when you start a scale, one of two conditions exists. There must be an excess of supply or a weakness indemand to cause the price of cocoa to be in the lower one-third ofits 10-year trading range. If the cause of the price deflation is on thedemand side, I am more concerned than if it is on the supply side.My reasoning is that supply will eventually be used up, and thisproblem takes care of itself in most cases.But loss on the demand side of the equation can be permanent.Something may have replaced the commodity in question. Thisoccurred to cotton to a limited degree when rayon and other chemically produced fabrics first hit the market, and these cotton substitutes still distort the supply-demand equation as fashion trendsfluctuate. Crude oil is another commodity the environmentalistsdream of making extinct. With livestock, there has been a permanent shift in demand for white versus red meat and, in some countries, the fear of mad cow disease. It is because shifts in demandtend to be more permanent that I take them more seriously. You donot want to get into a scale you will have problems exiting.As mentioned, an overabundance of supplies tends to workitself out, particularly with expendable commodities. But your scenario must detail what caused the excess, how it is measured, andall the possibilities for correcting the imbalance. In other words,you must have a good idea of what needs to happen to turn on thelight at the end of the supply-demand tunnel. Knowing this—or atleast having a good insight into what is expected to happen—givesyou an idea of how long the scale should last.In our cocoa scenario, we know that most of production comesfrom Africa, specifically the Ivory Coast, Nigeria, and Ghana. Somecocoa also comes from South America (Brazil) and Asia (Indonesia).If we are going to have a problem with an overabundance of supply, it most probably would be due to above-average growing conditions in Africa. World stock figures bear out our analysis that thecurrent supplies are plentiful, but not overbearing.On the demand side, the major players (the United States andEurope) have strong economies, and there should be no problems
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using up the supply over the next six months. Your analysis indicates the key factor to watch is Ivory Coast production. If it is in the1 million ton range, prices will correct and take us out of our scale.If it exceeds 11⁄4 million tons, prices may stay depressed. A glance atthe economy of the Ivory Coast indicates that it can afford to holdcocoa off the market if prices get too soft. Therefore, the switch thatwill turn on the light at the end of the cocoa supply-demand tunnelis the weather in the cocoa-growing areas of the Ivory Coast.This is a simplified example of a scenario that a scale tradermight prepare for his or her trader’s journal. The value of writingit down is that it clarifies your thinking. It forces you to specifically state the results of your research. Later, when the scale is complete, you can look back at what you have written and make someevaluations. You will know if you are getting adequate research orif you need to look for new sources. Did you fully understand theimpact of each element that influenced the supply-demand equation? Your strengths and weakness are revealed; it is the path toself-improvement.Depending on how a scale is trading, fast or slow, you need tomake periodic assessments as to how it is going. Part of this exercise is to update your milestones. In our example, one of the majorfactors being plotted is the progress of the Ivory Coast cocoa crops.There are two crops a year: one that flowers in May–June and isharvested in the fall and a second one that flowers in the fall forMay–July harvest. We would be tracking rainfall, heat degree days,etc. until we know both crops are made.If we saw problems, we might tighten up our scale. Our keyswould be increased trading volume and price volatility. Our objective would to get more oscillating profits. We would also keep awatchful eye on demand for any signs of weakness or strength.During this process we would update the supply-demandequation and read all reports related to cocoa. Charts would bestudied for areas of support or resistance as well as long-termtrends that are being challenged. Again, the more we can do toincrease oscillators or take option profits without reducing protection, the better off we will be in the end.We would run our journal by our mentor, a coach, or even abroker that we believe knows more than we do about scale tradingand the commodity that we are trading. The big question is, What
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has been overlooked? Is there some important facet of the businesswe are not aware of? Perhaps a link between cocoa and cancer thatwill severely change the supply-demand equation? A new producing region? A synthetic replacement?Some of this may sound farfetched, but we had a cancer andmad cow disease scare in the livestock area, the soybean marketwill never be the same since Brazil and Argentina got into the business, and rayon gave cotton a run for its money. Even failures ornear failures, such as corn alcohol in gasoline, as a sugar replacement, and as a fuel for heating homes, can be worrisome.A change of this nature usually does not affect a single scalethat will be completed in a matter of weeks or months, especiallyone that is already started. But over the long haul, we need to keepthese developments in mind.Include a section on your feelings, particularly during yourfirst year of scale trading. Tell the journal what your emotions arewhen your positions begin to lose money, when you experienceyour first limit-down day, at your first margin call, and when youget your first oscillating profit. It is very important to think aboutand discuss your emotions, as you will learn when we talk aboutthe psychological aspects of scale trading later in this text.Finally, your primary purpose in keeping a journal is to avoidmaking the same mistake twice. The second time you scale tradecocoa, review the journal. Use this material to do a more efficientjob the second time. Look for areas that caught you off guard lasttime so you are prepared the next time.Additionally, if the journal is done properly, you will havebasic research material at your fingertips—all it will require issome updating and augmenting as you learn more. As GeorgeSantayana once said: “Progress, far from consisting in change,depends on retentiveness. Those who cannot remember the pastare condemned to repeat it.” (Life of Reason, vol. 1, Ch. 12, 1905.)
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A Little Technical AnalysisCan Go a Long WayWhen Scale Trading
Traditional scale traders rarely use technical analysis with anyintensity. The reason is that classical scale trading gurus expecttraders to plunge, almost blindly, into any scale and hang on, sometimes by their fingernails, as long as it takes to complete the scale.Obviously, I disagree. I teach traders to use every decisionmaking, profit-generating tool available to them to manage riskand enhance profitability. Besides using options-on-futures to manage risk and enhance profitability, technical analysis can have avery positive impact on your bottom line. For example, so far wehave seen in Chapter 7 how to use the 20-day moving average topinpoint the entry point of a scale. I have also discussed brieflyhow technical analysis can alert you to red or hot zones within ascale. A red zone is a price range in which there is a marked increasein price volatility and trading volume. By modifying your scale,you can capture the maximum number of oscillating profits.Let me elaborate on these concepts and provide some additional insights into why these advanced scale trading conceptswork. Keep in mind, this is not a detailed discussion of technicalanalysis any more than the discussion in Chapter 5 is of fundamental analysis was all-encompassing. There are literally hundreds andhundreds of books specifically devoted to those two subjects.Nevertheless, I think I can give you enough information to convince
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you of the usefulness of technical analysis and provide you withenough practical training to allow you to profit from its use.Technical analysis works because the market is often drivenby herd psychology. There are thousands of speculators in, orabout to get in, the major commodity markets with a low level ofconviction as to where prices are headed. Many are strongly influenced by their brokers. If told to jump into the hog market becauseit is about to take off, they do. The broker in turn gets his or herinformation from his own analysis, a Web site, or his firm’sresearch department.In most cases the “facts” presented to the trader or speculatorare technical in nature. “Lean hogs just pushed through somemajor resistance at 69.25 and are headed to 80! You can make 10.75per hundredweight or over 4 grand a contract, but you must actnow!” The reason technical analysis is used is that it is black andwhite—action followed by reaction. It is simple and clear toexplain and understand, so simple and clear that there is no reasonnot to react to it. If a sufficient number of speculators follow thetrading signal that thousands of broker and traders see at the sametime, the hog market will definitely make a bullish move.Whether hogs reach 80 is a different story. They usually do notbecause the speculators are holding positions with weak hands,meaning they get nervous, lose confidence in the prediction, andare underfinanced. The specs fade the 80 price target, and the rallydisintegrates. Whether the average speculator makes any moneyon a trade like this is also questionable. Hundreds of amateurtraders will be holding a contract or two when the trend changes.Like most nonprofessionals, they will continue to hold onto hogsfar longer than they should, taking severe losses. That, unfortunately, is the way too many novices trade.Nevertheless, because there are enough lemmings in the market at most times who will follow any leader, technical analysisworks. Rarely do these phenomena have real sustaining power,but this is not a problem for scale traders. Their task is simply totake advantage of this behavioral pattern and pick up fleeting,oscillating profits.Here is an example. You are in a soybean scale. You know therange, over the last decade or so, was from $11.00 to $4.01 perbushel. The scale you are in began when soybeans penetrated the
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lower one-third of the 10-year trading range at $6.34. The scalecalled for buying every nickel down and selling every dime up.Beans are now approaching $6.00 per bushel, a price that offeredsubstantial support the last few times it was hit. You think this willhappen again. And, you know from past experience that price levelsat even dollar amounts ($7.00, $6.00, $5.00, etc.) create additionalvolatility. People, meaning traders, like round numbers.How do you take advantage of this situation? How do youknow when it is beginning and, more important, ending? First,there are two ways to take advantage of it. You can change yourscale or you can create a scale within a scale. As was discussed earlier, you adjust your scale. Start buying when beans drop 3 centsand sell when they oscillate 6 cents higher. You do this during periods of increased volume and volatility. Once you see volume slowing down, you return to your original scale.Another alternative would be to leave your original scalealone and make no alterations. Instead, open a second scale for thesole purpose of taking advantage of red zones. I would recommendyou do this in a second commodity trading account, called an ancillary account, at the same firm that currently handles your primaryaccount. You are allowed to open as many accounts as you like. (Iwill discuss opening accounts in the next chapter.)In this ancillary account, you would start a scale at the $6.00level, buying every 3 cents down and selling every 6 cents up. Bythe way, the average daily move for soybeans is generally just over5 cents, so our scale is reasonable. You are looking for a profit of$300 per contract (5000 bu  $0.06). The objective is to pick up a halfdozen quick trades while beans are moving through this red zone.Now the risk you take would be getting caught holding a fewpositions after beans move through the red zone, when volatilityand volume subside and the downtrend resumes. If beans make alow in the red zone and move higher, you have no risk since bothscales (primary and ancillary) will be completed. What you do notwant is to get stuck with one or two positions bought in the $6 redzone and have to hold them until beans finally make a low at $5.00or $4.50 and return to $6.06 to close out your ancillary scale. Thiscould possibly entail a rollover.The way to handle this contingency is to cover the first position or two with inexpensive, out-of-the-money puts or sell calls
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close to your exit price. The loss on the puts should be one that youare okay with to close these first positions, if you should be stuckwith one or two when the bean downtrend resumes. The lossequals the difference between the price at which you bought thelong positions and the strike prices, minus the gain on the putswhen offset. If beans move substantially lower, the puts or shortcalls become more valuable and you are protected and can recoverfrom this situation. If prices oscillate in the red zone as you anticipate, your objective of picking up an extra $1800 (less transactioncosts of approximately $300) will be realized. But if beans go higher instead of lower, you lose the premium on puts but gain on thelong positions. Or the price increase takes out your short call atyour exit price.The skill needed to make this work is being able to read threekey technical factors—volatility, volume, and open interest.Volatility is the speed of the market. How quickly are priceschanging? Markets that move slowly are low-volatility markets;markets that move quickly are high-volatility markets. Additionally,you must take liquidity (i.e., the number of transactions made pertrading session) into consideration.For example, a very thinly traded market, say rough rice, witha daily volume of under a thousand transactions, can be labeled ahigh-volatily market if it experiences wide price swings. Prices caneasily change 25 percent or more because it takes only a little actionto move a thin market. There just are not many traders offering tobuy or sell. When an offer is made, it is taken. It is like throwing abrick into a shallow puddle. It will make a big splash. These markets are often easy to get into and hard to exit, meaning they havemore sellers than buyers.Markets with heavy volume—say daily volumes of 50,000,60,000, or more transactions—can also be labeled high-volatilitybecause hundreds of price changes are taking place. It is analogousto throwing the previously mentioned brick into a lake, generatingonly a ripple. But there are times when these markets are morevolatile than others. The periods during which they are most volatileare the red zones.The problem with the highly volatile, thinly traded markets,and the reason I avoid them when scale trading, is that it is oftendifficult to get orders filled. In addition, the swings in price can be
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so wide you could never execute enough trades to make themworthwhile for scale trading. On the other hand, they are attractiveto very short-term speculators (day traders), although they areclassified as very high-risk markets to trade.Therefore, the volatility markets we as scale traders are looking for are the ones accompanied by high liquidity. We want markets with daily volume in the tens of thousands and prices bobbingand weaving all over the place. That way we will get the oscillating profits we need to push our return on equity to a lofty level—combined with fast order execution.We have already selected those markets in Chapter 6. In mathematical terms, distribution curves are used to define the likelyoutcome of random events, in this case the price activity of futurescontracts. Referring back to Chapter 6, Figure 6-1, the most common distribution curve is the bell curve. Three volatility curves,defining the first standard deviation from the mean, were shown.The first standard deviation includes 68.3 percent of all occurrencesor approximately two-thirds of all price activity. The lower andwider the curve, the more volatile the commodity being measured.Scale traders seek commodities and specific trading periods within the life of specific futures contracts that represent high pricevolatility.The volatility curve is a snapshot of price action at themoment the curve is calculated. Theoretically, to use this technique,the scale trader would have to be constantly calculating bell curvesas prices are reported in real time. In the age of computers, this iscertainly feasible but neither practical nor necessary.You can train yourself to spot red zones. First, you can easilyanticipate when they are likely to occur. By studying price charts,you can spot historical price points where trading became congested, and prices oscillated up and down within a tight trading range.This activity can continue for days, even weeks. By measuring theaverage daily trading range during these periods, you decide theinterval of your scale. For example, if the daily trading range was6 1⁄2 cents, you might buy each time it drops 3 cents and sell everynickel higher, rather than 6, 7, or 8 cents. As always with scale trading, you want to maximize your return without getting greedy.As you search for historical red zones, you should look forsubstantial increases in daily volume. This is key. The average daily
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volume should be approximately 20 percent higher than the average daily volume over the previous 30 trading days. A bar graph ofvolume can be found along the bottom of most commodity pricecharts. It is the combination of price congestion and increased volume that defines a red zone.The price congestion can be below or above the current priceon historical price charts. If it is below, it is called price support. Ifabove, price resistance. In the former situation, the price congestionis supporting prices, meaning keeping them from going lower. Inthe latter, it is providing resistance to price increases. Scale traderslook to capture oscillating profits in areas of support as the commodity being traded descends. Once a low has been put in place,the scale trader looks for areas of resistance as prices move higher(see Figures 10-1 and 10-2). The price interval between buys andsells in red zones is determined by your studying the historical redzones of that commodity and then comparing them with the current price activity. You will spot these patterns easily and learn touse them as a guide to future opportunity.Support and resistance are logical reactions to price movement. For example, several thousand amateur speculators buy copper at 80, expecting it to go to 100. Instead, it moves south andpauses at 74.5. (Copper trades in cents per pound.) Their initialFIGURE
10-1
Support90
R E D
Z O N E
Price Support
80As a commodity moves toward a low, there will be price support redzones. Commodity traders find these price levels attractive and buy.Once the buying dries up, prices move lower. You will enjoy these redzones because they offer oscillating profit opportunities.
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FIGURE
171
10-2
Resistance90Price Resistance
R E D
Z O N E
80Commodities often move into areas of price congestion. A certain pricelevel will offer resistance. The bull move will fail. It is in these red zones thatyou will generate oscillating profits. Eventually, prices penetrate theresistance and close out your scale.
reaction is to hold the copper contract in expectation that it willreturn to a price that would vindicate their initial decision. I usedthe adjective “amateur” because the professional speculatorswould be expected to cut their losses at the first sign of weakness.If copper meanders around 74–75 for a while, the traders whoentered the market at 80 will begin to feel lucky if they can exit atbreakeven. When copper does move higher and approaches 80, alot of selling occurs and volume increases substantially. The 80-centlevel is now resistance, at least until all the longs unhappy withtheir trade at 80 exit the market.The opposite scenario could create a support level. Let’s say thetraders sell new positions, or short the market, at 100, expecting copper to be at 80 soon. If copper moves higher, these shorts start looking for a place to exit at breakeven or better. When copper retraces to100, this price level becomes support and volume increases.Traders reversing their positions further augment volumewhen they see that copper cannot penetrate support or resistance.Longs go short and shorts go long. These are periods of confusion.Traders do not know what the equilibrium price should be, andprices vacillate higher and lower, which is ideal for the scale traderseeking oscillation profits.
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Another common behavior pattern on commodity price chartsis that support becomes resistance and vice versa. In our example,copper found support at 75. Once it returned to 80, 80 became resistance. If it then moves to 85, traders will find support at 80 if itmakes a move lower. Traders who missed the boat the first timecopper went through resistance at 80 to 85 will see the return to 80as a buying opportunity. Volume will increase and prices will rise(see Figure 10-3).As a scale trader, you will learn to love the possibilities foroscillating profits that occur at support and resistance levels, or redzones as brokers call them. Before we leave this line of thought,there is one other concept you should become familiar with, especially if you come to scale trading from the securities market, andthat is open interest. You can use it to reinforce your decisionsregarding red zones.Volume and open interest work together to benchmark thedegree and the amount of trader participation in individual futuresmarkets. Volume, as mentioned earlier, measures the amount oftrading, and open interest indicates the number of contracts held atthe end of the day. It measures the conviction on the part of tradersby their willingness to take positions “home” or hold themovernight.FIGURE
10-3
Support Becomes Resistance90
Support Red Zone
Resistance Red Zone
80
LowAreas of support become resistance and areas of resistance becomesupport. These are the price levels that often confuse traders. Learn tospot them to capture oscillating profits.
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Volume is the number of contracts traded, not the sum of thebuyers and sellers. For every contract traded, there is one buyerand one seller. The number of contracts traded includes the creation of new contracts, the transfer of either the buy or sell sides ofcontracts, or the liquidation of contracts.Open interest, on the other hand, is a count of the number ofcontracts outstanding long or short at the end of the trading day.It indicates how many contracts were held overnight, which translates into the level of conviction shown by traders. Information onvolume and open interest is available at the beginning of eachtrading day.Here is an example of how volume and open interest aretabulated:Day 1:
Day 2:
Day 3:
Trader #1 buys one contract.Trader #2 sells one contract