Futures and Options. Quick Start.
Lessons 9-10

Contributed by  Bruce Gould,  BruceGould.com

Lesson 9
Becoming Successful.

In Lesson number eight, it was stated that your ability to control average losses (AL) would be the most important talent you will ever develop as a futures, options or stock investor. I want to spend a little more time examining this issue.

Money chasing Money: Suppose you had the opportunity to invest a nickel to earn a nickel. You might be willing to do so. The game could be a simple one. You and your friend each put up five cents. You flip a quarter. If the quarter comes up heads, you win her five cents. If it comes up tails, she wins your five cents. You are investing a nickel to earn a nickel; it is five cents chasing five cents. A reasonable bet if the odds are around 50/50 for each player.

Suppose that your friend wants to change the bet. Under the new rules, you will have to put up $3.00 to win her 5 cents. The game will be the same; only the amount of money bet will change. The same quarter is flipped; if it comes up heads you win the 5 cents. If it comes up tails, she wins your $3.00. Your $3.00 is chasing her 5 cents. If the quarter is flipped 60 times and you are lucky enough to win 59 of those 60 flips, you will still lose money. This is because you will have won $2.95 on your 59 winning flips and lost $3.00 on the 1 losing flip. Winning 99% of the time can't prevent you from losing money on the series when you have $3.00 chasing a 5-cent profit. The only way you would be willing to take this bet is if it is absolutely certainty that you will win on 100% of the flips. You will play if and only if the quarter you are flipping has a "head" on each side and you are allowed to bet on "heads".

Central High School: In lesson number five, we learned of Central High School, a fairly large school with an average graduating class of 800 students. You and your neighbor decided to make a wager on the number of students that will graduate in the year 2001. You are long. You are betting that more than 800 students will graduate that year and for each student above 800, your neighbor promises to pay you $1. Your neighbor is short. She believes that less than 800 students will graduate in 2001 and for each student below that number, you promise to pay her $1. Every $1 that you win will come out of your neighbor's pocket. Every $1 that your neighbor wins will come out of your pocket. You both expect the graduating class of 2001 to have between 780 and 820 students. If such is the case, you stand to win or lose up to $20 and the same applies to your neighbor. You each deposit $20 with a neutral party and sit back and monitor the class of 2001. The likelihood of either of you winning is 50/50. You have $20 chasing $20.

Troubles in Centreville: The winter was bad, real bad in 1999 and the temperature dipped to record lows. It was reported that over 90% of the fruit trees were killed. New trees would have to be planted with a crop of fruit not ready for harvest for ten years. It was shortly after the cold that the rains came. The planting of the spring vegetable crops was delayed. The delay stretched to three months. The government reported that agricultural production would decline by 80%. The processing plant had to be shut down; there was no fruit for juice and no jobs for those who worked in the packing. It was said that if the lumber mill had not burned down in April that two hundred and seventy-five jobs could have been saved. But the lightening struck at the wrong place at the wrong time and it would be four years before the mill would be back to full capacity. The camel's back was broken with the straw of the auto assembly factory making the decision to relocate itself, lock, stock and barrel, overseas. Everyone was disappointed. The move to Asia cost Centreville another four hundred and fifty-five jobs. The handwriting was on the wall. Would the last person-leaving town please turn out the lights?

The school superintendent announced in February that three hundred students had left school that month. "They had to go where the work is" pretty much summed up his announcement. In March, the town newspaper reported that an additional eighty-six students had left with their families. In April, with the burning of the lumber mill, another four hundred students left town. In May things got a little better, only seventy-five students moved from Centreville that month.

By June of 2000, the graduating class size had shrunk from 800 students to 585. How many would be in the class of 2001 was now "anybody's guess". The rumor was that no more than 400 students would graduate the following year, a decline of 50% from the ten-year average. Your neighbor begins to worry. Not about winning her bet with you, it appears that she obviously will, she is short and student numbers are going down. Short traders win when markets go down. She is beginning to worry about your $20 deposit being enough to cover your now estimated $400 loss. Your neighbor has even heard a rumor that you were thinking about leaving town to start fresh in an area where the economic outlook was more promising. Surely this is only gossip; she hasn't noticed any moving vans or packing crates at your house so far. The questions are really only three (1) will you be around when the class of 2001 graduates? (2) Will your $20 cover the losses from your bet? (3) If 400 students graduate next year, should you put up $400 now to cover what is expected to be a $400 loss on your $20 bet?

$400 chasing $20: If you ignore all the disasters that have happened in Centreville since you and your neighbor first made a bet, the "best case outcome" for you would probably be a profit of $20. If you consider all that has happened, "the current worst case scenario" has you losing $400. Things may actually get worse. It is possible now to believe any bad news story. Who is to say that the graduating class of 2001 won't number 300, or 200, or even 100 students? Can you guarantee that this won't happen? How much money are you willing to risk earning the profit of $20 that you were originally going for? $20? $100? $200? $300? $400? $500? $600? $700? $800? How much is winning $20 worth to you? Aren't you worried about betting $3.00 to win a nickel?

Trading in a Series: In lesson number eight, we worked with a series of trades, three in number, in which losses occur on the first two and there is a profit on the third. We used the number of $200 for your average losses (AL) and the figure $400 for the profit you would need to break even in such a series. The number three is not fixed in concrete.

It makes no difference if you set up your own program to trade in a series of three, four, five, ten or twenty trades. You can even have a series of sixty trades if you like such as our second coin flip example in this lesson. The important thing is not how many trades are in your series; the important thing to remember is that there is a direct relationship between what your average losses (AL) are in a series and what you will need to achieve success from that series.

When you work in a series of three trades and are correct 33% of the time, if your losses (AL) average $2,000, you will need a profit of $4,000 on the third trade just to break even. You will need a profit of $4,200 to make $200 from the series. It is not easy to make a profit of $4,000 or $4,200 in futures or options or stocks. It is relatively easy to make a profit of $400 or $500 or $600.

You don't have to keep your average losses (AL) at $200. I just picked that number in lesson number eight to give us a starting point. What I am saying, however, is that it is easier to make a net profit from a series of trades if your average loss (AL) is a small number. In general, the rule is "the smaller the better".

How do you keep your (AL) number small? You do it by monitoring your losses and by keeping them under control. If you do not keep your (AL) under control, and this is very important to remember, one day you will find yourself in a bet where your $3.00 is chasing a nickel of profit or where your $400 is chasing a profit of $20.

As long as you trade in futures, options or even stocks, you will be able to control, to some degree, your average losses. A single loss may be less or greater than you expected but in the long run you can pretty much control your average losses (AL).

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 by using many different methods or vehicles, such as the four I mentioned in lesson number eight or several others that you can learn from my choppy trading method or other writings. Whatever method you select, you should always remember,

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

Lesson 10

Breaking Even.

In lesson number two, I wrote about one of my early experiences in futures trading. I had an additional experience at about the same time and I want to tell you about it in this lesson. We will call my two experiences, brokerage house B and brokerage house W. Neither of these firms exist any more, having merged with other firms or gone out of business. Think back to April of 1967.

When I made the decision to learn about the world of futures trading, I simply wandered into brokerage house B and asked if they had any brokers there who traded in commodities. I was directed to a desk and to a particular individual. He introduced himself and said that he really did not handle regular accounts but that he worked with a group of investors who all got into the market at the same time and who all got out of the market at the same time. He was this group's broker but he did not make the decisions for the group. He merely raised the money. Another person, who I never met, but who was reputed to be a member of the group, made the actual trading decisions. This other person did the analysis and everyone in the group followed his buy and sell recommendations.

I asked the broker what this group was trading and he said, "pork bellies". Everyone in the group was in "pork bellies". They were long the July of 1967 futures contract. I was invited to join the group if I wished to but I was told that I would have to follow the directions of the third party and do what everyone else did at the same time they did it. I told the broker I would give it a try and I opened an account and the broker bought me some July pork belly contracts. I am not even sure now how many contracts I initially purchased, probably two or three, possibly four or five. I am sure it was not more than five. July pork belly futures were trading in April of 1967 between 34 cents a pound and 37 cents a pound. I happened to open my account when they were trading near 37 cents and that was the area where my contracts were purchased. The market promptly, in less than two weeks, headed to 34 cents and I had my first margin call. I was off to a bad start.

The margin call forced me to make a decision. Should I put up the margin money required to hold my pork belly position or should I get out and take my loss of approximately 2 cents a contract. You can pretty much tell from this choice that however many contracts I had at brokerage house B, I had the maximum permitted by the amount of money in my account. If I had not invested to the maximum, I would not have received a margin call when the market dropped but 2 cents. It is generally believed that meeting a margin call in futures trading is a mistake. It is not always a mistake, but it can be one. Why is this sometimes the case? It is the problem we looked at of chasing a 5-cent profit with a $3.00 bet or a $20 profit with a $400 bet. Suppose that back in 1967 I was aiming for a $500 profit in my pork belly position and that I had put up $3,000 in expectation of earning this $500. When the market moved against me, I was asked to put up an additional $2000 as margin call money to hold my position. I had $3,000 invested aiming for a $500 profit. If I meet the margin call, I would have $5,000 invested aiming for the same $500 profit (after all, the profit expectations had not changed simply because the market had moved 2 cents against me. If anything, my profit expectations were probably less now then they were before). What if there was a future margin call of $2,000, and another one for $3000 to hold my original position? What if eventually I was asked to put up $10,000 in margin money to hold my original pork belly contracts where the profit expectation had only been $500? This is how the rule that meeting margin calls is sometimes not a good idea came into being. In futures and options and stocks, you have to be careful when adding more and more money to an account chasing after a profit that no longer justifies the additional capital required to hold the position.

I was young and inexperienced in 1967 and unwilling to suffer a loss within two weeks of opening my account at firm B and so I met the margin call and put up the additional capital. But when I did this, I told my broker, "If the market ever moves back up to where I am even, I want out". I was no longer worried about the $500 profit, I simply wanted out of pork bellies and I wanted the money I had invested in pork bellies back in my pocket.

The broker told me that this was not possible. He said that everyone got in and everyone got out at the same time. If I wanted out on my own, then I would have to leave the group. I told him that I would accept this condition if being part of the group meant that I had to meet a margin call within two weeks of opening my account. "Take me out of the group if July pork bellies should ever return to the price I paid". The broker said he would do so and he entered an order something like this, "sell July pork bellies if they ever rise to his break-even point again". It was a little more formal than that, but in essence that was his order in my account.

There is another rule that wise men that trade futures, options and stocks have developed based on years of experience. This is the rule that when a market is running for you, it is not the time to get out. Of course, I didn't know that rule back in 1967, just as I did not know the rule about not meeting margin calls and so I ignored them both. There were two reasons that I ignored these rules. The first was that I didn't want to take a loss in pork bellies and the second reason was that my account at brokerage firm W (which I described in lesson number two) was a great deal more inspiring for me than my account at brokerage house B. I decided to close my account at brokerage firm B when the pork belly market rose to my purchase price and then concentrate all my efforts at brokerage house W. The broker entered my order, I was basically kicked out of the group, and the market rose to just below my purchase price but not quite up to my sell order. It opened the next day sharply higher and I was taken out with a profit. I had violated two fundamental rules of successful futures trading. I had met a margin call and I had offset a trade that was running in my favor and yet I ended up with a profit. Albeit it, not a profit as large as I was making over at brokerage house W, but at least a profit. Was I happy? The answer was yes.

And then, of course, the pork belly market took off. This is why you generally do not want to get out of winning positions on the first day that you have a profit. The market rose from my break-even point to 45 cents a pound. That was a lot of profit for long traders who still remained with their positions after the 8 cent run. Did I regret my decision to get out at break-even? Of course, it is like the television game show where you are asked to pick door A, B, or C and you pick (A) only to discover that the better pick would have been C. Would I have rather sold my July pork belly contracts at 45 cents a pound than where I sold them?. Yes. Of the group of traders in this exclusive club, and there must have been twenty or thirty members in the group, I was the first and only one to get out and I sold just above my purchase price. Everyone, and I mean everyone who knew of the group and knew the huge profits the group had at 45 cents thought me one big fool for having dropped out of this semi-exclusive club on the very first day when the market closed in my favor. Did I think of myself as a fool? Not really. I had done quite well at brokerage house W and while I would have preferred to sell at 45 cents, I never thought that I had made a mistake by getting out of the group. I have always been kind of a loner and I didn't really feel comfortable being in a situation where I would have no control over my own account, but had to do what everyone else was doing at the same time everyone else was doing it. I was happy with the money that I made at firm W and I sat back and I watched pork bellies to see how high they would go. To 53 cents, to 73 cents, to 93 cents, who knew? I certainly did not. I was willing to miss the big move, I was happy to have my money back. I never traded with this broker again or with the group from which I had been expelled. For the next 30 plus years, I would go my own way down my own path and achieve success or failures based on my own skills and knowledge. In those 30+ years, I would learn a great deal about futures and options trading and stock investing, but it would not be knowledge learned as part of a group. It would be knowledge based on experience, my own experience.

What then happened to pork bellies? It is almost too sad a story to tell, but it is a true story. If you can locate some 1967 charts, you can take a look for yourself. July pork bellies declined from 45 cents a pound to around 38 cents a pound. The group that was trading as a unit had been buying heavily all the way up. When the market dropped to 38 cents, a decision had to be made. When it was made, it was the wrong decision. If any market makes a sharp advance and then sets back somewhat from the recent top, an investor has to decide if the setback is a short-term dip in prices or if it signifies the end of the advance. If pork bellies had moved to 45 cents and then set back to 38 cents on the way to 93 cents, the group of traders at brokerage firm B would have been very happy. But it did not. When the July contract declined in price, this group stopped buying the July contract and started buying February 1968 pork bellies. The number of contracts they bought was very large. When the February contract was at 39 cents, they bought a large position. When February bellies declined to 38 cents, they bought again. When pork bellies were 37 cents, they bought even more. When the February contract declined to 36 cents, the group had a very large margin call. Everyone held with their positions and put up the margin money. It was $3.00 chasing a nickel all over again. The market declined to 35 cents and to 34 cents and the group had another large margin call. Everything still would have been okay if only the market had turned around and advanced, but it did not. The pork belly market in the summer of 1967 wasn't in the mood for making new highs. The February 1968 contract dropped to 31 cents. Everyone at the same time on the same day acting in unison sold their contracts and got out. The losses were overwhelming. The broker who organized the group and who entered the orders never managed another group of traders again. What happened to the third party who was calling the entry and exit shots, I never knew. Of the entire group of twenty to thirty investors, I was the only one who walked away with a profit from the pork belly market of the summer of 1967 and I got out of my position on the first day that the market moved above my purchase price. Except for me, everyone in the group lost money. The moral of lesson ten is this: (A) The meeting of a margin call is often not a wise thing to do. I met my margin call and I was bailed out, but I credit my entire success to luck and luck only. (B) If a market is running in your favor, it is sometimes not wise to get out on the very first day that you have a profit. I did but I missed out on a much bigger profit opportunity that came shortly thereafter. Had I had a little more experience back in 1967, I might have taken a bigger profit out of this market than I did. Of course, I was young and foolish then and breaking-even was enough to make me happy. I wasn't thinking about profit, all I was thinking about was getting my money back.