In any business, you always can tell the novice from the pro, and the commodities business is no different. Some of the most important lessons to learn and some of the most common early mistakes a new commodities trader makes fall into a few categories.
Mistake: Not Having a Clear-Cut Trading Plan in Mind for Profit Objectives, Maximum Drawdown, and General Strategy
Everyone wants to make money, obviously, but the way most traders approach the markets, you wouldn’t know it. The first thing traders should do once they enter the market is place a stop order—not always an actual, real-life stop but at least a clear-cut mental one. Traders should know in absolute terms how much they’re willing to lose on a specific trade; then, if it isn’t going their way—bang! They place a stop to protect the position. For example, each time the market moves a point in December crude oil, it’s worth $10.00.
Now, how did I figure that out? Simple—I looked it up, and so can you. All commodities have a per-point or per-tick value (a tick is the smallest increment of price movement possible in trading a given contract), which is known as the multiplier. For example, crude oil’s tick value is $10. Each commodity is unique. Sugar is $11.20 per point, cotton is $5 per point, and so on. Getting back to crude oil, remember that it’s $10 per point or penny. Confused? Don’t be. Think about it: Crude oil trades in dollars and cents, so if you’re in long (you’ve bought) at $72.08 and it trades to $72.09, you just made $10; if it trades to $72.10, then you’ve made $20, and so on. So if you were long from $72.08 and want to protect yourself to a loss of $500, your stop should be at $71.58 (which is $.50 on the downside). Simple, right?
Mistake: Not Taking Profits
The second mistake—and in my opinion, an even worse one—that most traders make is that by not taking profits, they get greedy. Why wouldn’t you take profits when given the opportunity? In other words, if the crude oil market moves up to $72.58, that’s a $.50 profit, for a total gain of $500. The trader could exit the crude market, taking his or her profit off the table, and then jump back in when presented with another opportunity. Most of the time, however, they don’t. The reality is that most people hold onto the position until it turns around and they are losing so much they are forced to liquidate. Avoid this at all costs by setting your goals from the start, by grabbing gains, and by not being greedy.
Another way to play it if you have multiple positions is to simply liquidate one of the contracts and hold the other. In other words, if you buy two contracts you can sell one as the market starts to go up if you’re long. Then as the market, as hoped, goes even higher, you would sell the other one. An even smarter move is to take your protective stop order and keep moving it up behind you as the market moves higher.
Eventually the stop will be above where you initially entered the trade, and even if the market reverses itself you will likely be stopped out with a profit or minimal loss. Bravo!
So if you were holding onto two contracts or positions in December crude oil from $75.00 and the market rallied to $75.50 and you sold the first contract, you would make $500. Then if the market continued higher to $76.00, you could sell the second contract for a profit of $1,000. Nice!
Mistake: Not Moving the Stop with the Market to Protect Profit
Let’s illustrate with a trade in sugar. Say we buy an October sugar futures contract at $15.44 and then we set our sell stop order below the market at $15.00. Now the market moves higher, to $15.95. Our smartest strategy is to move our stop up now from $15.00 to our entry point of $15.44, or breakeven. In other words, we would break even on the trade, more than likely. Later, if the market moves even higher, we can move the stop again, and now almost guarantee a profit. This type of activity is called placing a trailing stop, because it trails behind our trade and moves as the trade moves. This is smart trading. Master it, and use it.
Mistake: Letting Losses Run and Taking Small, Quick Profits
This is one of the worst mistakes new traders make (I know from vast, often painful, experience in my youth). I remember playing the game of hoping my Dollar Index positions would turn around when I was first starting out in the trading pit; they rarely did. Wishful thinking is not a good trading strategy—being disciplined is. Not having a well-thought-out game plan and strict trading rules is truly a recipe for failure.
Often new pit traders in particular will get hit hard and then become overly cautious. They resort to taking small profits even though those miniscule gains might have turned into a large profit that could have offset all their losses if they had just been a little more patient.
I still find myself tending to let losses run rather than doing what I know is right and getting out of the position to reevaluate. As I mentioned in Chapter 1, it’s all too common for traders to talk their book, or live in denial, hoping against hope that the market will turn their way. This is almost guaranteeing that it won’t. Traders in the midst of losing tend to live on the misplaced hope that the market will retrace and then let them break even. Instead, this mentality actually leads to the opposite and creates even bigger losses. The markets can be cruel, and they seldom come back or retrace to let you off the hook. All of this can be avoided or dealt with quite easily. Simply use discipline and, more important, predetermined stop orders to prevent your losses from closing your account. Equally important is to have a plan to take profits at a very specific level and stick to it.
Mistake: Greed and Lack of Discipline
These are the two biggest hurdles new commodity traders face, and overcoming them is a long and ongoing process. Contrary to Gordon Gekko’s famous (or infamous) line in the film Wall Street, greed is not good. In fact, in this business it could be lethal. How do you overcome these tendencies? Well, life on the floor is kind of like living in a big support group: not always pleasant, and certainly not always good for the ego!
When I was getting my feet wet and was still green as grass, I was surrounded by traders who had been in the pit for a very long time, some since the founding of the exchange. And believe me, they were the first to let me know when I messed up! A cardinal sin in the pits is to bid into someone’s offer. In other words, when you step into the pit, you announce yourself. Usually you simply shout out the month you’re trading—for example, SEP or OCT (September or October).
Then people in the pit will yell back something like “2 bid at 8.” That means they are willing to pay 2 or sell at 8. It’s just an indication, but it gives you an idea of where the market is. To bid through some-one’s offer means that if I entered the pit and bid 9 when they were offering at 8, it would be a very big no-no. And they let you know about it! So I only did that a couple of times before I wised up. Either you learn quickly down there or you’re out, no two ways about it. Those people who beat me up for that stuff are the very same ones who taught me the valuable lessons I needed to learn to trade these markets on and off the floor with incredible success.
By having experienced people around you or within your network you can find support and advice that can prove invaluable. Building an information and trading network can make implementing and adhering to trading discipline far less cumbersome and more enjoyable. Nobody will help you enforce your own rules—that’s each trader’s private responsibility—but a good network often can tell us as traders when we may be on the wrong path or simply talking our book. How do you build a network? In today’s world, it’s not hard at all.
As with everything in life, it’s good to have friends in the right places; one commodity that I value above almost all others is my network of traders.
The old saying that “two heads are better than one” is right on the money. Before I make a move into any trade, I get a feel for market sentiment by checking in with my network. Now I don’t rely entirely on them, not at all. I don’t always consult with them, but if I want another opinion I can always get one. I get thousands of e-mails a month, which help to give me a clear picture of what market participants are thinking and doing, and that can prove invaluable, too. You may not get thousands of e-mails (if you’re lucky), but chat rooms and other sources can be good places to see what others are thinking.
Fatal Mistake: Self Will Run Riot
Emotions, good or bad, are of little benefit to the commodities trader. Overexuberance at a good trade and feeling suicidal when a loss occurs serve no purpose. Wins happen and losses happen, and a trader needs to stay level-headed and focused, or be consumed by the market frenzy.
The phrase “married to a position” is used when someone has a losing position and won’t let it go, no matter what. Take my advice— get a divorce. When you see a position isn’t working out as you expected, get out of it. Being married to a position means you’re not being rational and looking at the trade objectively; you’re letting your emotions get in the way. Don’t do it. Go back to the reasons you initiated the trade in the first place. If the situation has changed, the best advice may be to change the position, too.
Liquidity and Open Interest:Two Vital Ingredients
Two major factors a successful trader must look for in any new trade are liquidity and open interest. Liquidity simply allows us to more effectively enter and exit the market; a liquid market is far safer to trade and exposes us to less price volatility. Open interest is an indicator of just how liquid a market is by showing how many open trades are in any particular contract. This can be especially important when trading options, so as not to get stuck in an option with very little activity. Like a roach motel, you will get in but you won’t get out if it’s illiquid. Remember, higher open interest equals better liquidity. More liquidity means a more competitive market, and a more competitive market means more opportunity for you to make money.
Lesson: It’s Important to Look at the Big Picture
If Trader A makes 20 trades of which 15 are winners and 5 are losers, and Trader B trades 20 of which 15 are losers and only 5 winners, who in your mind has won? Well, duh! The answer’s pretty simple at first glance. But not so fast—we have to dig deeper. How much profit did Trader A make on those 15 winning trades compared to Trader B and his gains from his 5 transactions? Also, how much did each lose on his respective transactions? In other words, Trader A may have more winners than losers, but at the cost of losing most of his money in the process, while Trader B may have more losers, but his winners may be much larger.