Futures and Options. Quick Start.
Lessons 7-8

Contributed by  Bruce Gould,  BruceGould.com

Lesson 7

A Two-Horse Race

There are two horses in a race. They are equal. Neither is favored to win the race. You have no idea which horse will cross the finish line first as you know nothing about either of them. You want to bet on horse (A) or horse (B). Just as you are about to decide, you are told that whichever horse you bet on, it can never be 10 feet behind the other horse once you have placed your bet, or you will lose your money. This is true even if the horse you select eventually wins the race. You are, however, allowed to place your bet at any time during the race up to the last fifty feet. You decide to bet on horse (A) and right out of the gate it falls 15 feet behind horse (B). Eventually your horse (A) wins the race by three lengths but you have lost your money. The furthest that horse (A) was ever behind horse (B) was the 15 feet at the start of the race.

You know that horses often fall behind at the start of a race and then catch up as the race continues. Is there any way you could have placed your bet so that you would have won the wager? Of course there is. You could have waited until your horse was 10 feet behind and then bet that horse (A) would never be 20 feet behind. Remember you are allowed to place your bet at any time. Why not wait until your horse is 10 feet back and then place your bet. There is one reason why not. Your horse may never be 10 feet back and thus the opportunity to bet on horse (A) may never arise. But is this a good reason? There will be another race shortly. If you miss betting on the first horse race of the day, then bet on the second. You know that this method of waiting to place your bet works best when the horses are of equal abilities and there are only two horses running in the race.

Gold futures are selling at $300.00 an ounce. You are not sure whether gold will advance or decline. You believe there is a 50/50 chance that either will happen. Should you go long gold and buy futures contracts or options or should you go short gold and sell futures contracts or options? You have no idea. To you it is a two horse race. (A) prices may advance or (B) prices may decline. Which should you pick? Should you bet on horse (A) or horse (B)? One thing you do know. You are willing to risk no more than $20 an ounce whichever way you bet. If you buy gold futures long at $300 then you plan to place a sell stop/loss order at $280. If you sell gold futures short at $300 then you plan to place a buy stop/loss order at $320. Unable to make a decision you flip a coin, heads you go long and tails you go short. It comes up tails and you decide to sell gold futures short at $300 an ounce. You lay out a plan to enter your orders so that if gold rises to $320 your stop/loss is hit and you are out for a loss. If gold declines to $280 you will buy back your short position for a profit. You feel it is certain that gold will do one or the other and a 50/50 probability that it will do either first. You are now in a two horse race and you have selected horse (B).

But then you start to think that with your luck the market will probably rise by $20 before it declines by $20. In simple terms, your horse (B) will probably be 20 feet behind your entry price before it declines to $280 and wins the race. What can you do? You decide to learn a little from the horse race example at the start of this lesson. In futures, stocks, or options, you are allowed to enter the market at any time before the end of the race. Think of gold as racing toward $280 an ounce and $320 an ounce. You win if it first hits $280 and you lose if it first hits $320. You feel there is a 50/50 chance of either event happening.

If there is a 50/50 chance of gold hitting $320 before it hits $280 or vice versa, what happens if you raise the $320 to $340? If gold is $300, would you think the odds are equal that it will rise to $340 (rise $40) before it declines to $280 (decline $20)? What are the odds that a market will move $40 in one direction before it moves $20 the other? Assuming that markets are efficient and that current price is always the best price, the odds should be equal that markets will move an equal amount in either direction but not equal that markets will move $40 one way before moving $20 the other.

You are willing to lose $20 an ounce betting on gold. You don't want to lose $20, but you are willing to lose it. You want to sell a futures contract short and you are willing to sell it on the 50/50 probability that you will make a profit before you suffer a loss. What about delaying your entry until the price has reached your stop/loss order level and then taking your short position? In other words, if you are betting on horse (B) and that it will never be 20 feet behind horse (A) by delaying your bet until your horse is actually 20 feet behind you are giving yourself 40 feet of slack before your bet is lost instead of 20.

Think about crude oil for a while. In Lesson Number 3 we were wondering whether crude oil, then priced at $25 a barrel, would rise to $30 or decline to $20 first. We now know the answer, at least for the year 2000. Crude oil rose to $30. In fact, it rose above $30. If you shorted crude oil at $25 and bet that your horse would never be $5 behind, you are out of the market. Horse (B) did fall $5 behind when prices rose to $30 and all the shorts who had stop/loss orders at $30 were taken out of the market at that level or thereabouts. In hindsight, 20/20 vision, what if you had said that you wanted to bet that crude oil prices would decline, but that you did not wish to place your bet until the original stop/loss price had been hit. In other words, you would wait until your horse was $5 behind before you would bet that it would not be $5 behind. In essence, you would be betting that your horse would not be $10 behind in the race. We now know what happened to crude oil since it was priced at $25 a barrel. We do not yet know what will happen to gold when it is currently priced at $300 an ounce. But whatever does happen to gold prices, isn't it worth considering as a possibility that you might delay your short entry until your original stop/loss price would have been hit had you placed a stop/loss at that level? You can still take the same side of the market, but you do not enter until your originally planned (but not actually entered) stop/loss order has been hit. Is this something you might consider?

Mr. Jones speaking to Mrs. Smith. "I am generally right in picking market direction, but my stop/loss always seems to get hit before the market runs in my favor". Mrs. Smith to Mr. Jones. "Why don't you pretend to put your buy or sell order and your stop/loss order in but not really put either of them in. When the pretended stop/loss level is reached, then and only then enter the market with a new stop/loss the same distance from your new entry price, as your original stop/loss would have been. If you are right, that you are generally able to pick market direction, but keep getting stopped out with your initial stop/loss order, this should help solve your problem". Mr. Jones to Mrs. Smith. "Why didn't I think of that"?

Suppose you want to go long (A) a market or short (B) a market and your number one problem is that when you are long, your sell stop is always hit before the market turns up and when you are short, your buy stop is always hit before the market turns down. If this is your problem maybe you should consider entering the market at your stop/loss points rather than at your original entry points? This idea may be one you might want to think about and discuss with your partner. I will have something more to say about it shortly.

Lesson 8

Achieving Success.

If you wish to be a successful futures or options investor, you must learn to control your losses. No talent that you develop as a trader will ever be as important to you as this. The formula for success in futures and options trading is:

X (AP) - Y (AL) = SUCCESS OR FAILURE

(X) is the number of profits that you have. (AP) is your average profit per trade. (Y) is the number of losses that you have. (AL) is your average loss per trade. You multiply the number of profits you have times the average of your profits to arrive at your total profits. You multiply the number of losses that you have times the average of your losses to arrive at your total losses. X (AP) equals total profits. Y (AL) equals total losses. Total profits minus total losses equals success or failure. Of this formula, the two most important letters to you are (AL).

Why is the (AL) so important in your effort to achieve success. It is important because (AL) is the only element of this formula that you can control. Think about it for a while and you will see what I mean. What result would be easier for you to manage in your own account?

1. An average profit of $800 per trade or,

2. An average loss of $200 per trade?

It is obvious that the answer is (2). You have some control over your losses. You can manage them. You will have very little control over your profits. Concentrate your attention on that which you can control rather than on that which you cannot. How would you answer this next question?

• Do you feel confident that you can guarantee yourself an average profit (AP) of $800 or more per futures contract traded? (Or per option position held?)

Your honest answer would have to be "no". There is no one on the face of the earth who can guarantee themselves or anyone else an average profit of $800 per futures contract or option traded. No one. Even if you trade only one contract one time once in your lifetime, you can never guarantee yourself an average profit of $800 on that trade. It cannot be done. It is hopeless. There is no chance of guaranteeing that result. None. Now, what is your answer to the next question?

• Do you feel confident that you can limit yourself to an average loss (AL) of $200 or less per futures contract traded?

Your answer should be "yes". This you can do. It is achievable. It can be done. Most traders can do it. The person who has never traded a futures contract in his or her life can pretty much limit himself or herself to this $200 average loss (AL) if that person has the will power and the knowledge of how to do so. Then what is your answer to the last question?

• When you are given a choice between concentrating your effort on something that you can do versus something that cannot do - which of these alternatives would you think it more productive to concentrate your attention upon?

How did you answer this question? Should you concentrate upon the achievable or the non-achievable? History and experience answers this question by telling us that it is always preferable to concentrate upon that which can be done. There is a reason for this. If you develop the skill of achieving the attainable, you may be able to achieve the attainable.

Trading in a series: Imagine that you are able to maintain an average loss of $200 per contract or per trade when you are trading in futures contracts or options or even stocks. Imagine that you aim to be correct in your market decisions at least 33% of the time. If such were the case, in every series of three trades you will have a $200 loss, another $200 loss, and an unknown profit. What sort of profit will you need in a 33% success rate program to break even? You will need a $400 net profit. In order to break even in this trading series your profit need be only twice your average loss even though you are wrong 66% of the time.

Remember that you will never be able to control profits in this game; you will only be able to control losses. By keeping your average loss to $200 and by being successful 33% of the time in your trades, you will only need $400 in average profits to break even in any series of three trades. Success or failure is directly related to average losses. The higher your average loss, the greater the average profit that you will need in order to break even in a series of three. The lower your average loss, the lesser the average profit that you will need in order to break even.

The more you control your losses by making them lower and lower, the easier it will be for you to earn a profit from a series of trades. Everyone wants to make his or her job easier. You make futures trading easier by controlling average losses. A quick response might be that "this is easier said than done" and that "no one can control losses." But of course losses can be controlled. Here are four really simple ways to do so,

1. Don't trade. This creates an average loss of "0".

2. Immediately upon entering a position, enter a stop/loss $100 away from your entry price. In most markets, this will result in your being stopped out with a loss of less than $200.

3. Every time you take a futures position, instruct your broker that if the market closes against you at the end of the day, meaning you have a paper loss at closing time, you want to terminate your position on the close. This will accomplish two things. First, you will always go to sleep at night with winning positions. All losing positions will have been offset at the close. Second, if you are trading in relatively stable markets your average loss should be under $200 per contract. It could be higher if you are trading in markets with wide price swings. If such is the case, then simply do not trade markets where the daily price swings are of such a magnitude that your average losses are greater than $200.

4. Enter your positions "at the market on the close" only. Once you know your entry price, enter a stop/loss order $100 away from that price. By using this method, you will always go to sleep at night with little or no loss on your open positions. When the market opens the next morning, it may go up or it may go down. If it moves against your position by $100, you should be taken out by your stop/loss order. Only in those situations of limit moves might this not happen. If the market moves in your favor, you are on board a winner. You may remain with winning positions for as long as you like or for as long as they are profitable.

 These are just four methods you may use to try to keep your losses at an average of $200 or less per contract. There is no guarantee that any of them will work for you except the first. But with time and experience, each method should offer you the opportunity to keep some reasonable control over your average losses, your (AL)'s. It is important to control your average losses because an average loss of $200 requires a profit of only $400 for you to break even in a series of three. This is true even if the market returns you a profit in only 33% of your trades. If you let your average loss run to $400 you start to have problems. You will then have to make an $800 profit just to break even in the series. And to earn a net profit of $200 from your three trades, your third trade will have to return a profit of $1000. In futures trading, it is easier to make $400 than it is to make $800 or $1000.

So remember that if your average loss (AL) is great, your profit will have to be even greater in order to make money on any series. By concentrating upon that which you can control and keeping that sum at a reasonable amount, you will make the net profit that you hope to achieve from any series more likely to be achieved. Isn't that what you want in your trading, small losses and an achievable net profit? If this is what your goal is, then your road to success will be the road of controlling your losses. You can travel this road using many different methods or vehicles, such as the four I mentioned above or several others that you can learn from my choppy trading method or other writings. Whatever method you select, you should always remember,

• You will never be able to control your average profit per trade no matter how hard you try.

• You should always be able to control your average loss per trade, once you make up your mind to do so.

You must learn to control your average loss (AL) per contract traded. No talent that you develop as an investor will ever be as important to you as this one.