Futures and Options. Quick Start.
Lessons 11-12

Contributed by  Bruce Gould,  BruceGould.com

Lesson 11

Drought

I was sitting in a restaurant back in the early 1970's and in the booth next to me there was a salesman. He was talking to his friend and it was clear that he was troubled. He was looking for new sales job. He knew what he did best and what he did best was to sell a dream. All he had to do was to believe in the dream himself and he could sell anything. "I don't care what it is. I can sell anything, just as long as I believe in what I am selling", he told his friend. He was looking for something to believe in so he could earn a living, for himself and perhaps for his family, if he was married. I hope he found what it was that he was searching for.

Believing in a dream is an admirable quality for a salesman. It is a quality that the pianist has when she spends hours and hours at the piano while her peers are at the swimming pool, or at the school dance, or just hanging around the local drive-in. It is the same quality that keeps a student studying, a machinist working in order to own his own machine shop, a waitress saving money to pay for her daughter's dance lessons. It is a wonderful thing to believe in a dream and most people who have succeeded in life have had a dream they believed in. In life, if you have a dream and if you believe in it, you can do almost anything. But having a dream won't work for you in futures or options trading or even in stock investing. Futures and options trading and stock investing are about making money. If you are trying to make money on a dream in futures or in options, most likely you will not succeed.

Let's talk about drought. It may be that a drought will occur in the Midwest this year and that the crops will not be as bountiful as they have been in previous years. There may be a shortage of corn or soybeans or wheat or numerous other commodities for which there are no futures markets. This may well happen. And then again, it may not. The rain may come, the drought may end, the crops will grow and the harvest will be sufficient to meet the demand; the harvest may even exceed the demand. When you buy or sell based on that happening which has not yet happened (which is, after all what a dream really is) you have to be very careful.

If you are long soybeans based on your belief that the drought will come, and the market moves 20 cents against your position before it runs in your favor, you are risking $1,000 per contract that the event which has not yet happened will happen and that when it does happen it will make you a profit. If the market moves 40 cents against you before it moves in your favor, you are risking $2,000 per contract on an event that has not yet moved the market in your favor. If the market moves 80 cents against you before it moves in your favor, I won't even tell you how much you are risking by betting on a dream. Whenever you buy a "dream or a story" in commodities or options or even stocks, be very careful that the story does not overtake your common sense. Be from Missouri. Believe it when you see it.

There were two investors in an office, one said; "I am long ten contracts of soybeans because I am sure there will be a drought and prices will rise". The other said, "I am from Missouri, I look at what might not happen as well as what might happen and while it looks like the drought may come, I hate to invest a lot of money buying dreams. I am long one contract, if the market closes $200 against me today, I am gone". Which trader would you bet has the best chance of becoming rich in the short run? If anyone is going to become rich in the short term, it will be the trader with the ten contracts. Which trader would you bet has the best chance of becoming not rich in the short term? Once again, it is the trader with the ten contracts.

It is said that when one wades across a river, he or she never steps in the same water twice. When a foot is lifted and moved forward, the old water flows downstream and the water that you now step in is brand new. It is the same with futures and options and stock investing. The fact that you were successful on a previous occasion when riding a market through a $2,000 per contract decline against your position does not mean that the market will bail you out again. In fact, your very survival the first time may actually work against you the second time. You may adopt the philosophy; "Oh, I rode the market out last time and I came out okay, so this time I am going to ride it out again and everything will be fine." This philosophy may be the short story of your short career as a futures, options or stock market investor. When you buy a dream, or a story, or an event that has not yet happened, the very fact that the dream came true the last time you believed in it does not mean that it will come true for you this time. You are not a salesman who can sell anything he or she believes in. You are an investor. There are two important things in every investor's life. The first is not to lose your money. The second is to make a profit. Looking at these two events, the former is far more important to you than the latter. You may be able to invest tomorrow if you do not make a profit today. You may not be able to invest tomorrow if you lose most of your money today.

I was having breakfast on New Year's Day in Seattle when a waitress asked her favorite customer, "Well, Jack, and was last year a good year for you"? And Jack replied, "When you reach my age, any year you make it through is a good year". The important thing for Jack was making it through the year. The important thing for you, as an investor, is not to lose your money. To keep from losing your money, you must remember that if you buy a dream and the dream works out, that is wonderful. But you will not be able to build a long-term investment program based on buying dreams. You have to build an investment program based on cold, hard reality. You have to have a plan. You have to be able to use your plan in years when there is a drought and in years when there is rain. You have to be able to use your plan in markets where a drought is not a factor, such as trading silver. You have to be able to use your plan in wintertime or in spring or in summer or in the fall. You have to have a plan that you can understand. Your plan has to make sense, at least to you if no one else.

Suppose you were lucky enough to have a spare $10,000 and decided to turn it over to person (A) or to person (B) to invest on your behalf. Since it was your money, you would most likely interview both (A) and (B). Person (A) told you she was sure that the drought would come and that she planned to buy ten contracts of soybeans for you Monday morning on the open. Person (B) told you she had no idea if the drought would come, but what she was going to do for you was this: She would buy one contract of soybeans for you Monday morning on the open and enter a stop/loss order $200 below your entry price. If you were not stopped out and if the market closed in your favor, she would buy a second contract for you on the close. After the close, she would enter a stop/loss order for you $200 below each position. If the market opened higher on Tuesday, she would raise your stop/loss orders for both positions to the break-even point while at the same time entering a profit/exit order for you 40 cents above your average purchase price. These would be OCO orders (one cancels the other), whichever filled first, the break-even stop/loss order or the profit/exit order, the order which would no longer be needed would be cancelled by her for you. If the market did not close in your favor on Monday, she would liquidate your one contract at the market on the close and re-examine the market when it opened on Tuesday.

Now this proposal of person (B) might not be something that anyone would actually do. It might be too complicated or it might be too simple or it might not involve enough contracts for you. It might be a lot of things; there is one thing it certainly is. It is a plan and it is a low-risk plan. The proposal of person (A) to buy ten contracts for you Monday morning on the open is not a plan, it is an event and it is a high-risk event. If soybeans open sharply higher on Monday, say up 20 cents on the fear of a drought, and you buy ten contracts "on the open" 20 cents higher than Friday's close, and the market then subsequently declines to the same price it closed at on Friday, you have a paper loss of 20 cents per contract, or $1,000. Since you only had only $10,000 to invest and since you bought ten contracts, you have a paper loss of 10 times $1,000 or $10,000 or 100% of the money that you turned over to person (A) to invest for you. It is quite possible that this could actually happen within a few minutes or a few hours of a single trading day. It is possible to lose 100% of your capital before one day is over. It is possible when you buy a dream, a story, a tale, a drought, or a flood, or one catastrophe or another to suffer a substantial loss of your capital within a single day. Buying ten contracts of soybeans "at the market on the open" because you believe a drought may occur is not a plan; it is an event. It is also a high-risk event. This high-risk event may make you rich if you are lucky. If you are not lucky, it may make you the opposite of rich.

Believing in what one sells works very well for salesmen and this belief helps salesmen earn a living. Even if a salesman believes in something that is, in fact, no good the salesman's belief alone may be enough to make him money. Believing that there will be a drought in the Midwest, however, will not make you money. Belief in a drought requires more than a belief, it requires an actual drought. And the drought may never come. Remember Jack's rule. "Make it through the year". It is more important for your success that you have a plan than it is that you have a belief. Your plan doesn't even have to be a good one, initially. For your long-term success, even a bad plan that you can test one contract at a time is better than the best belief. Plans you can work on, you can improve them, they can be modified, thrown away, adapted, adjusted, readjusted, brought back to life until one day you may actually have a plan that will work. Beliefs are very good for salesmen. Plans are very good for investors. In lesson number 12, I am going to teach you how to build yourself a plan.

Lesson 12

Building a Plan

How does a trader start to build a plan that he or she can use for the balance of that traders investment career? Here is one way. Suppose a friend were to tell you that a great way to make money is to buy December corn futures on October 1 and sell December corn futures on December 1 of each year. This would be a plan. It would also be a plan that would pose several questions. Historically, how often has the plan worked? What has been the average profit earned with this plan? What risk in the past has one had to assume in buying December corn futures on October 1. Is there a way that this plan could have been modified to increase the profit in those years when there was a profit? Is there a way that this plan could have been adjusted so as to avoid trading in those years when there was no profit? A plan can be like a classic car that you locate behind a red barn in rural Vermont. You feel that the potential is there, but you will have to do a little work to realize that potential fully.

Where to start? The first thing you will need to know is what was the price of December corn was on October 1st and December 1st for as many years in past history as you care to examine the price of corn. Let's say that you want to research this for 40 years, examining the years from 1959 to 1999. Looking at the price of December corn for 40 years should give you some idea of what December corn futures normally do in the time period between October and December. If you can't learn something from examining 40 years of history, you probably can't learn much from examining 50 or 60 years. Let's start with the years 1959 to 1999.

Question #1: In those 40 years, if one followed this plan and bought December corn futures on October 1 and sold December corn futures on December 1, how many years would one have realized a profit and how many years would one have suffered a loss? If you have the data, this should be easy to determine. The data may be in the form of prices you obtained free of charge by looking at old copies of the Wall Street Journal at your local library, it may be obtained by looking at a set of graphs showing December corn futures in those 40 years of trading, it may be obtained off the internet from companies that supply this sort of information. Let's assume that you have this data in one form or another and let's assume (and this is only for the sake of illustration, this is not a correct answer) that you conclude that in 32 of those 40 years you would have made money and in 8 of those 40 years you would have lost money. Hypothetically, this plan produced a profit in 32 of the past 40 years or 80% of the time. What do you do next?

Question #2: Focusing only on the 32 profit producing years, you might want to know how much you had to risk to earn the profit earned in each of those 32 years. In other words, (a) How deep was the water before the profit was produced and (b) How long did you have to hold your breath? How low did December corn go in those 32 winning years after October 1 and how long did it stay below its October 1 price. Naturally, the answer will differ from year to year, but by having the data (and here the best data to work with visually might be a set of 40 graphs for those 40 years) you can isolate the 32 years where a profit was made, draw a horizontal line across the graph starting with the price on October 1 (using the opening or closing price consistently) and determine how far price declined below that horizontal line (how deep was the water) and how long price remained below that line (how long did you have to hold your breath).

You can put these numbers down on paper, (the depth of the water and the time you had to hold your breath), and you can come up with an average for both the depth and the time involved. For the sake of an example (and again this is not the correct answer), let's say that in the 32 years when one bought December corn futures on October l and sold profitably on December l, the market declined an average of seven cents below the October l price and the market stayed below the October l price for an average length of two weeks. Now you know something about your plan. You know that in the 32 winning years, you should expect an average price decline against your position of seven cents (with the greatest decline being xx cents and the least decline being yy cents) and you should expect to have to ride out a decline lasting an average of two weeks (with the greatest time being zz weeks and the least time being ww days). It is a little bit like researching the value of the car that you found behind the Vermont barn. What did the car sell for originally, what was the size of its engine, how many were produced and sold, and how long was it in production.

One immediate side benefit of this type of research may be an unexpected conclusion. Suppose your research revealed that in these 32 successful years the market always declined somewhat after October 1st. You may conclude that you need not be in a hurry to buy on that date. Remember, a purchase 1-cent lower than the October 1 price means 1-cent more profit on December 1 when there is a profit on December l. If you buy October l at $3.00 and sell December 1 at $3.15, buying on October 15 at $2.90 and selling December 1 at $3.15 will produce ten cents more profit or $500 more profit per contract. If your research reveals to you that prices always decline somewhat after October 1, it might make sense to wait to make your purchase until the market gives you a better buying opportunity than the opening or closing price on that date.

Question #3: Once you know something about the number of years that this trading plan is successful, and you know how long you had to ride through a dip in order to achieve success in those winning years (remember, we have not yet looked at the losing years), you would be interested in learning about the profits you might expect to make with this trade. To arrive at this, compare the price on October l with the price on December l in the 32 successful years and arrive at the profit earned in each of those years. To arrive at an average simply add up the 32 profits and divide by 32. It is important for you to know what the average profit is for a couple of reasons. The first is that if the average profit is only 1-cent, you probably won't want to consider this a plan worth your further consideration. If the average profit is 34 cents, or $1,700.00 per contract traded, then the plan may have your attention. If the average depth of water in the 32 winning years is 7 cents and the average profit in those same 32 years is 34 cents, this may be a plan worth your time and effort to refine. It will probably be a plan that you will use for the balance of your investment career. Owning a few good plans that you can use for a lifetime can be well be worth the time required to develop them.

Question #4: The next thing you will want to do is to separate the more successful years from the least successful. Here might be a way. Assume you have charts or data for December corn for 40 years. Take the highest and the lowest price during those 40 years and divide that price into four sections. Hypothetically, let's say that the highest price is $4.00 and the lowest price is $2.00. You then have sections running from $2.00 to $2.50 and from there to $3.00 and from there to $3.50 and from there to $4.00. Now, look at your 32 winning trades. Suppose that when the price of December corn was between $2.00 and $2.50 the average profit was 20 cents and that when the price of December corn was between $3.50 and $4.00 the average profit was 5 cents. You might conclude that this plan shows more historical profit potential when the purchase price is between $2.00 and $2.50 than when it is between $3.50 and $4.00. If the price of December corn on October 1st of this year is $2.04 you might be more interested in trading the corn market than if it were at $3.54. You are gradually learning how to take a simple plan and modify it for your long time use or non-use as a futures trader or investor. Remember, once you get a good plan, you can use it for your lifetime and pass it on to your children to use for their lifetimes too. A very good plan may be the most valuable asset you leave your children in your estate.

Question #5: Finally, you may wish to consider the trend of prices for December corn on October l as being a factor in those 32 winning years. There are several different ways you can consider trend, but one of them might be to draw a line from the lowest price that December corn traded in the period from January l of each year through September 30th of that year and connect this lowest price with the October l price. If this line is trending upward, then you may consider this an uptrend. If it is trending downward, you might consider prices downtrending. For example, if December corn was $2.05 on February 5th and this was the lowest price between January l and September 30th and if December corn was $2.27 on October l, you might consider this an uptrend. If December corn was $1.87 on October l of that year, you might consider this a downtrend. You would then want to label each year you examine as "uptrending" or "downtrending" on October l. You would then want to look at your 32 winning trades and consider whether you made more money during uptrending years or during downtrending years. You might find that trades during uptrending years were 10 cents more profitable on the average than trades during downtrending years and you may wish to limit your use of this plan to (A) years when December corn was trading between $2.00 and $2.50 and (B) years when December corn was uptrending on October l.

You started with a bare bones plan. You examined it and arrived at some conclusions. The method you have used can be used for examining other markets than corn and for different periods of time. If you want to research this plan out fully and arrive at your own conclusions, but don't have set of December corn charts for the years 1959 to 1999, click here to order some. In my next lesson, I am going to teach you how to examine losing years.

 To read more lessons of  Bruce Gould please click here.