Value Investing in Commodity Futures: How to Profit with Scale Trading

Value Investing in Commodity Futures: How to Profit with Scale Trading

by Hal Masover

Hardcover(Book & Disk)

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Overview

The only complete guide to an increasingly popular approach to futures trading

This book outlines a highly successful alternative approach to trading commodity futures, specially tailored to today's low-priced commodities markets. Unlike technical analysis, which uses statistics to inform trading decisions, scale trading is a form of fundamental analysis in which a trader slowly buys prices as they reach bottom and sells them as they climb back up. Hal Masover describes scaling techniques that work in every commodity market, including metals, energies, utilities, and agriculture. And he supplies readers with a scale trading system that generates a complete rundown of how much money will be needed, when, and where.

  • Satisfies the growing demand for guides to fundamental analysis-based futures trading

Hal Masover (Fairfield, IA) is cofounder of Crown Futures, a top trading firm with offices in Fairfield, Iowa, Boulder, Colorado, and Cleveland, Ohio. He has been successfully trading futures since 1985.

Product Details

ISBN-13: 9780471348818
Publisher: Wiley
Publication date: 01/28/2001
Series: Wiley Trading Series , #94
Edition description: Book & Disk
Pages: 224
Product dimensions: 6.24(w) x 9.39(h) x 1.13(d)

About the Author

HAL MASOVER is cofounder of Crown Futures, a top trading firm with offices in Fairfield, Iowa; Boulder, Colorado; and Cleveland, Ohio. He has been success-fully trading futures since 1987.

Read an Excerpt


1
SCALE TRADING:
ELEGANCE IN TRADING

(Please note: Figures and any other illustrations mentioned in the following text refer to the print edition of this title, and are not reproduced here.)

Scale trading is one of the simplest, easiest, and most elegant methods of trading I have ever seen. I have searched for years trying to come up with something better. Although I have found a few good things and a lot of promising ideas, I have still not found anything that has proved better. Scale trading offers a way for individuals, even those with relatively modest amounts of capital, to use some of the same methods the big boys use.

Have you ever imagined what it would be like to be one of the big boys? Can you see yourself wading into the trading pit, with everyone's eyes on you to see what you're going to do? Or do you see yourself trading from a large, richly appointed office atop some urban skyscraper? Did you ever see the movie Trading Places with Eddie Murphy? Murphy plays a street beggar who magically winds up living our fantasy of trading big time in the pits and in a fancy downtown office. And, son of a gun, he's good at it (only in the movies)!

I mention this fantasy because I have seen one trader after another seduced by it. Commodity trading can be an exhilarating and highly profitable experience, but it can also bring financial ruin on the unprepared or foolhardy. Although most people are aware of the possibility of ruin, they don't really believe it can happen to them. Because they don't really believe that, they never make plans to avoid it. Instead, they try to pull off some sort of real-life Trading Places, taking huge risks in the hope (always a bad word in trading) of reaping a huge profit. Often they find that instead of leaping into the big time, they fall into deep losses.

The reality of trading is usually quite different from the fantasies. I'm not aware of any big traders who really trade like the individuals in our fantasy. Although they do have a wide variety of styles, from long-term systematic commodity fund managers (whose trades last months or even years) to short-term pit traders (who never hold positions for more than 30 seconds), the successful ones I have come to know are very sober. No matter what kind of approach they use, they are realistic about their chances in the commodity markets, and they have a definite plan to make money.

TAKING A CUE FROM THE BIG TRADERS

We want to discuss one very sane and sober way that many large traders trade. This method was first developed as an adaptation of gambling methods used in Las Vegas. It can be used for gambling, stocks, and commodities. Although the method can work in all three areas as well as other areas of investment, it is particularly effective in commodity futures for a number of reasons that we will discuss shortly.

But first, to help you understand the method, let's fantasize a little more. Imagine that you work for a company with a huge fleet of cars and delivery trucks. Perhaps it's one of the delivery companies, like FedEx or UPS. Your job is to help the company control fuel costs. A critical part of your job involves buying futures contracts of unleaded gas to protect the company against a rise in prices (the process called hedging that we discuss in Appendix I, "Getting a Handle on Commodity Futures"). If you only needed to buy one contract, your job would be simple. You call a broker and buy at a time when you believe prices are cheap to lock in a low price for your company. This is a very large company, and one contract equals only 42,000 gallons. I have no idea how long it would take a nationwide fleet of trucks to use 42,000 gallons, but I wouldn't be surprised if it were less than an hour.

To implement your program adequately, you might need to buy thousands of contracts. As I write this, the most active contract for unleaded gas is the February 2000 contract. There are approximately 16,000 contracts of open interest (the number of contracts being held overnight). On January 26, 2000, approximately 16,500 contracts traded during the trading session (Figure 1.1). if you were going to go into this market and attempt to buy, say, 2,000 contracts all at once, you might shock the market because your one order would represent almost 12.5 percent of the contracts traded all day. Because you probably wouldn't find one individual seller who would want to sell you that much, you'd have to keep bidding up the price to coax more traders to sell. In the end you would have created your own minirally in which your company would be chasing its own tail, paying ever higher prices for its gasoline contracts. At least in the short term, you would not have protected your company from higher prices. You actually would have created an artificially high price for your company to pay.

SCALING IN AND OUT

The way you might solve this problem is to do exactly what many large traders usually do: scale in your purchases. Once you have determined the approximate price at which you would like to buy, you would begin to buy at (you hope) progressively lower prices within a target range. When you buy small allotments at a time, it is usually much easier to find a seller for each buy order. You thereby may avoid the possibility of scaring the market higher. Scaling in your purchases also has the advantage of helping you buy at progressively lower prices if the market continues to decline after your initial purchases.

You might also implement the same program in reverse when it comes time to liquidate your position, and for the same reasons—if you sell all your contracts at once, you can have a temporarily depressing effect on the market, and you might find yourself getting filled at progressively lower prices. By selling on a scale-up basis, you might even—and hopefully will—sell at progressively higher prices should the market continue to rise after you make your initial sell.

Before we leave this particular fantasy, it's important to realize that a large commercial firm is in a very good position to know when to buy and when to sell. After all, our imaginary delivery company is in the market to buy unleaded gas every day, all day long.

Because buying gas is an important part of the company's costs, part of controlling that cost means getting a handle on when prices are likely to rise and to fall. Such firms usually have full-time analysts whose job is to gather as much information as possible and to make projections of what prices are likely to do. Although they may not always get their projections of price movement right, their intimate knowledge of the market gives them the chance to get it right most of the time.

In our fantasy about being a large trader, I have presented two important elements of the method of trading we wish to discuss: (1) scaling in and out and (2) knowledge of a market's tendencies. Our fantasy was that of being a commercial trader, but we could have presented the same principles with only slight and, for our purposes, insignificant differences were we to fantasize about any other type of large trader. Regardless of your trading goal, it can be more practical to scale in and out of large trades than to try to go in and out in a block. A thorough understanding of the market you are trading is a prerequisite for any trader—you have to know how the market behaves to apply this or any other approach successfully.

The genius of the scale trading method is that it gives small individual traders the ability to emulate a trading method that the big boys use. Although the system was developed as an adaptation of a gambling system, it accidentally resulted in giving the individual a very simple, yet very sophisticated, tool used by megatraders. It is a simple but powerful approach that does not require familiarity with advanced mathematical calculations or complex indicators—just knowledge of how a market behaves.

Scale trading, as it is called, involves buying a commodity at progressively lower prices until it stops declining. You then sell the commodity at progressively higher prices as it rises. An illustration will help you see how this works: Suppose you believe that corn prices are approaching a bottom. Using the scale trading method, you might begin to buy corn at specific intervals, maybe every five cents down. You might buy a contract at $2.45, $2.40, $2.35, $2.30, and so forth. If corn prices stopped going down at $2.27, you would own four contracts. Suppose you decide that you would be content to make $400 profit per contract. Every penny in corn is worth $50. To make $400 per contract, you would have to sell each contract at an 8-cent profit. If the price rises after bottoming at $2.27, you would need to sell at $2.38, $2.43, $2.48, and $2.53 to achieve your 8-cent profit per contract. This, in its simplest form, is how to scale in and scale out.

ADVANTAGES TO SCALE TRADING

With this method, the small trader borrows one of the big traders' methods for entering and exiting positions. There are two advantages to trading this way that immediately come to mind. First, the method buys weakness and sells strength. Second, the trader doesn't have to be perfect.

Buy Low and Sell High

By buying at progressively lower prices and selling at progressively higher prices, you set up an automatic mechanism for buying low and selling high—precisely what all traders want to do. Time and time again I have found that scale traders are taking their profits when everyone else is getting excited about a market. Maybe the news media has just reported that it hasn't rained in Iowa for six weeks and the temperature is hitting 100 degrees. The corn market will usually run up on this news. The scale trader who may have bought when nobody else was much interested in corn will be able to sell into this rally when everyone else is buying.

Many times I have seen that, just when the scale trader is regretting having sold all their contracts because the market looks as if it's going to scream higher, something happens, such as rain in Iowa or a temperature drop into the 70s. The price of corn plummets, creating losses and misery for those who were buying higher during the rally and allowing the scale trader, once again, to buy low after having sold his or her contracts to those poor souls who bought high.

There are some occasions when, for good reason, scale traders regret selling all their contracts on a rally. The market really does run up in a sustained rally that is very profitable for people who follow trends and not for scale traders. This may be perceived by some as a weakness in the scale trading method. It is important to realize that these types of rallies occur infrequently and that trying to trade in a way that will capitalize on them is what often leads to the ruin of traders. However, later in the book I will discuss an adaptation of scale trading that may allow the scale trader to participate in these infrequent monster rallies without significant risk.

You Don't Have to Be Perfect

It is very fortunate that scale traders don't have to be perfect because most people, including me, are not perfect. What I mean is that in scale trading we build a position. If you trade using some of the popular methods, such as buying 1-2-3 bottoms or selling head-and-shoulders tops, you will probably put all your contracts on at once.

If you have a small account, your position may be only one contract. Doing things this way, it's important to have a plan that, among other things, deals with what to do when you are wrong. This usually involves using a stop order. Suppose you buy corn at $2.45 and decide to risk maybe $500 on the trade. Then when corn drops to $2.27, as in the preceding example, you will have been stopped out at $2.35 with a $500 loss. When the market later rallies to $2.53 and higher, you probably won't be in it because you were stopped out with a loss earlier.

Trading in this more traditional and more popular way means you have to be almost perfect. If you're going to try to buy a bottom, the market better rally now or you're going to lose money. In scale trading, by contrast, you "build" a position gradually, so you don't need to be so precise. Because you are buying at progressively lower prices, you don't need to have the market turn on a dime; you can give it a pretty wide range and still come out very well. Not being perfect myself, I like any system that is this forgiving.

A couple of questions naturally arise. First, how do you know when to begin a program of scale-down buying? Second, how much capital does this take? We'll cover the question of capital later in the book. Right now, let's proceed to discuss how to know when to start your scale.

Table of Contents

Introduction.

AN INTRODUCTION TO A BETTER METHOD OF TRADING.

Scale Trading: Elegance in Trading.

How to Know When to Start Scale Trading.

Why Is Scale Trading Better Than Other Types of Trading?

LEARNING THE FUNDAMENTALS.

Fundamentals the Right Way.

Grain Market Fundamentals.

Livestock Market Fundamentals.

Metals Market Fundamentals.

Energy Market Fundamentals.

Softs Market Fundamentals.

Using Seasonal Information the Right Way.

SCALE TRADING IN ACTION.

How to Construct a Scale.

Taking Profits.

The Dreaded Contract Rollovers.

Options.

Don't Skip This Chapter: Choosing a Broker.

Appendix I: Getting a Handle on Commodity Futures: A Primer for Beginning Traders.

Appendix II: Other Possibly Profitable Methods.

Appendix III: How to Construct a Scale on Your Computer.

Glossary.

Index

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