Here are a few shots:

Before:

These next few pics show the background design:

Day two:

This is the end of day 2. There is still a little more to do this coming week.

And now to the final touches:

More on Propex Trader Training here.

So why the difference? That resources tax? RBA minutes? Weakness in China? Lower commodity Prices? Take your pick…

GOLDMAN SACHS NEWS & ANALYSIS
On Friday the SEC announced they are charging Goldman Sachs with civil fraud. As many of you know, I got my start professional right out of college with Goldman Sachs (New Associate class of 2000), they paid for my MBA (NYU Stern School of Business 2004), and I am a member of the Goldman Alumni Association. I thought I should just get that out for full disclosure.

The Goldman fraud announcement sent the markets into a near panic as the stock market and commodities declined materially. As usual in these cases, the US Dollar, US Treasuries and Japanese Yen all gained against the overall market, as they are seen as the top 3 “flight to safety” assets during heightened periods of uncertainty.

When uncertainly reigns, investors tend to sell riskier assets and move them in to less riskier assets. That is why the US Dollar, Treasuries and Yen always seem to gain on days like Friday. For those that need further proof of this, take a look at the rallies in the US Dollar, Treasuries and Yen when the S&P was on its way from 1300 to 675 from October of 2008 to March of 2009. You will see major rallies in the US Dollar, Treasuries and Yen.

We received a lot of inquiries from clients and subscribers on Friday and during the weekend about what the Goldman civil fraud case means. While the facts of the case are still coming out, we know a lot more than we did on Friday afternoon.

First, it is important to note that Civil Fraud differs from Criminal Fraud, in that Civil Fraud starts out as unintentional while Criminal Fraud is intentional from the start. This means that the US Government thinks that Goldman never meant to defraud anyone but along the way some type of fraud occurred. If the Federal Attorney General or a State Attorney General decides to get involved too, that would most likely be for Criminal Fraud.

At the center of the allegations is a CDO (Collateralized Debt Obligation), called ABACUS, which is a portfolio of subprime residential mortgage-backed securities (RMBS). The buyer (and eventual loser) of ABACUS was ACA Management, an insurer specializing in RMBS, that actually picked out the securities that ABACUS was made of.

ACA Management was long subprime mortgages and the US housing market in general. To take the short side of investment like subprime residential mortgage-backed securities, investors can purchase Credit Default Swaps (CDS). Credit Default Swaps are bets against the RMBS. A hedge fund called Paulson & Co asked Goldman to put together a CDS of the ABACUS subprime residential mortgage-backed securities. In other words, hedge fund Paulson & Co wanted to be bet against ABACUS

Here is where the potential issues come in:

1. ACA Management, the buyer of ABACUS, did not know Paulson & Co hedge fund were taking the opposite side of the trade. Paulson & Co actually met with ACA Management to talk about ABACUS before ACA got into the deal to get their thoughts on the RMBS. Did Goldman have a responsibility to disclose that information?
2. Should Goldman be on both sides of this trade as the Broker? This is a tough question because there is no exchange for these products like the NYSE or CME. If these products were cleared through exchanges, then most likely one broker would be representing ACA and another would be representing Paulson. However, since these complex and unique financial products are just between the banks and the client, this becomes a very gray area.
3. Should Goldman and other investment banks both be brokers and proprietary traders? It may come out that one side of Goldman (proprietary investments) was short the Housing Industry while another side of Goldman (structured finance) was brokering deals, matching buyers and sellers of mortgage backed securities.

What does it all mean for Market Regulation?

We will most likely see Financial Reform passed in the House, Senate and signed by the President. Derivatives need more regulation and transparency. Creating a central exchange for complex financial derivatives would be a good start. Setting limits on how much leverage you can take on (like the Futures Exchanges presently enforce) would also be a good start.

Mortgage Backed Securities and Credit Default Swaps have their place in our Financial Community, but with no transparency or risk control, they can be hazardous to the system. Let’s hope this is the kind of regulation the government wants to bring about.

We may also see regulation that brings back aspects of the Glass-Steagall Act. This would include separating the traditional services of Investment and Commercial Banking. It also could include regulations on banks and their role in proprietary trading.

What does it all mean for Turner’s Take?

The markets were down on Friday, and we expect the uncertainty to work its way out of the market this week. Due to the insecurity in the market and how it will react to the Goldman Fraud case, we will not be entering any new positions until the dust settles; however, we will be looking for exits on trades where we have profit and positions we were considering liquidating before the Goldman news. For now, we will just review our positions, watch the market closely, and look for the next opportunity.

EQUITIES

Right now we are long the mini Russell 2000 and short the Emini S&P 500. This position is a great example of what Turner’s Take is all about. We were bullish the stock market, but didn’t want to just get long the S&P 500 because it exposes us to so much systematic risk (just look at what happened to the stock market after the Goldman announcement). We are big believers of hedging systematic risk whenever possible.

Instead of getting long the Emini S&P at 1183.50, we sold the Emini S&P at 1183.50 and bought the mini Russell 2000 at 692.50. Why would we do this? A few reasons:

1. In a bull market, we know that small cap stocks generally grow at faster rates than large cap stocks. In times of economic recovery or expansion, it is easier for smaller companies to grow than larger companies. Small companies can easily double their growth in a year or two, while it is much more difficult of for a large cap to grow that fast. Therefore, a small cap index should outperform a large cap index in a bull market (also note the small cap index should underperform the large cap index in a bear market).
2. Index spreads have reduced margins. The margin on the S&P is $5625 to hold overnight. The margin on the Russell is $4000 to hold overnight. But if you have a 1:1 spread between the two there is a 70% spread credit. $5625 + $4000 = $9625. $9625 X .3 = $2887.50. The margin needed to be long the mini Russell 2000 and short the Emini S&P 500 is only $2887.50. Why are the margins reduced? Because spread trading related products helps reduce systematic risk.
3. If we had just been long the Emini S&P (which is what most traders do when they are bullish on the stock market), we would be long from 1183.50. The Emini S&P 500 closed on Friday at 1190.25, up 6.75 pts or $337.50. Consider we had an intraweek high of about 1210.00 in the Emini S&P; we would have given back $1000 of a $1300 move. While giving back profits is unavoidable in successful trading, we want to limit it as much as possible.
4. If we were just long the mini Russell 2000, we would be up about 21.30 pt, or $2130, based on our 692.50 entry and Friday’s close of 713.80. However, the volatility of that position has been significant. If you were only long the mini Russell 2000, there would have been almost a $2000 swing in P&L from Thursday to the close on Friday. That kind of volatility can be difficult to handle when the markets are going against you. It makes position and portfolio management extremely difficult.
5. The spread “long Russell and short S&P” did not change a whole lot in terms of overall value from Thursday to Friday. It stayed between +$1500 to +$1800 during the entire session of trading on Friday. Obviously the market is either still bullish on the economy or everything just got sold together. The latter is the best explanation, which is usually the case in panics (big and small). That is why we try to spread our trading ideas whenever possible. It prevents us from getting knocked out of a position because of a major news event. The spread allows us to step back, re-evaluate the market, and not have to make a rash decision heading into the close on a Friday.

Right now we are still bullish on equities, but we are certainly interested how trading will go on Monday and Tuesday. If the spread starts to weaken because small caps are being sold more than large cap stocks, that is a sign of bearish market conditions and we will consider exiting the spread. If we do exit, it will be primarily to get flat and let the dust settle after the Goldman news.

One thing to note is the Emini S&P chart below. We are testing the recent uptrend. If we break this uptrend, it will most likely be best to get flat and take our profits off the table. However, the break could just be a result of the knee-jerk reaction to the Goldman news on Friday. Monday’s trading should give us a better read on the market.

Emini S&P 500 Chart:

Mini Russell 2000 Chart:

CURRENCIES

The USD and JPY rallied on Friday for two reasons. The first is the Goldman Fraud news and the “flight to safety” knee-jerk reaction. The second reason was China announcing they are raising mortgage rates for home buyers. This is leading investors to think China will be raising interest rates soon. When this happens, the JPY and USD both tend to rise.

We are still bearish on the EUR and JPY while bullish CAD and AUD. However, with the current volatility we are considering adjusting the currency basket to better reflect global market conditions going forward. As for the GBP, we would rather be short the EUR than the GBP at this point. The charts are mixed as well as the fundamentals. The elections in May will have a new parliament and possibly a new Prime Minister. We will be looking to get out of the GBP sooner rather than later.

We feel it is only a matter of time before the EUR sells off again and trades through 1.34, than 1.33 and finally down to 1.30. Europe’s recovery is lagging behind the US, Asia and other major economic regions. When you add in the debt problems Greece is going through and the potential debt problems for Spain, Portugal, Italy and Ireland, the EUR is the most bearish of all currencies. The EUR/JPY will most likely go in JPY’s favour, which is another reason why we will be looking to reduce exposure to JPY and increase our exposure to short EUR.

EUR Chart: The most recent Greek Bailout news broke the recent downtrend line on the weekly charts. Now that the market realizes the Greek bailout is temporary and the Eurozone is still going to have economic difficulty, the EUR is coming back down. Major resistance is at 1.3800 while support is 1.3400 and than 1.3000.

JPY Chart: A month ago the JPY broke its multiyear uptrend that started during the early days of the US subprime crisis in 2007. Now that the subprime crisis is over and we are slowly on our way to recovery, we have been waiting for the JPY to make its way back down to 1.0000 and eventually to 0.9000. While the uptrend has been broken, “flight to safety” buying will most likely be the biggest risks this trade has.

CAD Chart: The Canadian Dollar sold off this week when the stock market sold off. The recent uptrend from April 2009 is still intact on the Weekly Charts. We feel the CAD should break through 1.000 and beyond, as Canada’s economy is recovering faster than the United States.

AUD Chart: Like the Canadian Dollar, the uptrend on the weekly charts is still intact. We like the Australian Dollar for the same reasons we like the Canadian. The Australian economy is improving faster than the US; Australia and Canada do not have the same banking issues in their home residency and mortgage sector as the US; and Australia and Canada are “Commodity Currencies,” meaning that they benefit when commodities are in demand, like during economic recoveries.

Craig Turner is a Senior Broker at Daniels Trading in Chicago. He writes the Turner’s Take newsletter.  Click here to trial.

Good article Craig!

GB

1. It has broad based coverage of data from most countries.
2. It gives rankings (low, medium, high) to the market significance of data releases.
3. ChartClicking on the detail icon opens a section that shows data specs including description and market impact. It also has links to historical data and related news.
   
4. Trading off data releases requires knowing what others are looking at and expecting. The ForexFactory site is popular site. In terms of visitors, it actually ranks in the top 3000 sites of all sites globally. That means a lot of people are looking at the site and that means the data estimates on offer are more significant.
5. Clicking on the chart icon displays the data history – both forecast and actual.
6. When you join up you can change the time setting to local time. It’s a handy feature.
7. It’s free.

(Note, this is not a paid ad. I just think it’s a great site…)

Article provided by Capricorn Investment Partners Limited, Australia.
http://www.capinvest.com.au

Behavioural finance is a relatively new field of expertise which is starting to impact on the broader financial industry. Don’t be put off by visions of tweed-clad Oxford dons discussing Pavlov’s dog and what it means for the stock market, there are a number of useful messages and findings for which behavioural finance can claim the credit.

Behavioural finance (and its older established cousin, behavioural economics), attempts to understand why investors and other individuals make decisions and the impact that these decisions can have on markets, prices and investment returns. It may come as some surprise, but as clever as we think we are, people are governed by a number of basic impulses.

Those impulses influence our decisions and our reactions to the consequences of those decisions. A predisposition toward emotions of either hope or fear has a significant effect on the decision investors make.

Emotional decisions can be irrational. For example, it has been proven that investors feel a loss twice as much (in a psychological sense) as a gain¹. As far as the psychologists are concerned such a response is irrational – isn’t a capital gain of $100 the same as a capital loss of $100? Not if you are like 99 per cent of society. Wanting to avoid a loss more than making an equivalent gain is known as loss aversion.

Loss aversion may sound obvious, but it is quite significant. Decisions like these, made by hundreds of people, introduce inefficiencies into the stock market. Astute investors may be able to use this to their advantage.

Loss aversion also leads investors into ‘get-evenitis’, where investors who hang on to shares that have fallen in value, in the sometimes vain hope that one day the share price will get back to the price at which they first bought it, allowing them to sell without incurring a loss.

We are not advocating that every share which falls in price should be sold off immediately, just that we need to be aware of falling into the trap of ‘get-evenitis’. It is often said, very truthfully, that the hardest decision is not what shares to buy, but what to sell.

Another favourite of the behavioural finance crowd is gambler’s fallacy, a neat name for the erroneous belief that the odds of a fixed odds event occurring increase or decrease depending on recent occurrences. For example, if we toss a coin 30 times and it lands on heads each time, you would be forgiven for thinking that there was a very high chance of it finally landing on tails on the next toss. Of course the odds are still no more than 50 per cent that it will be tails on the next toss.

Gambler’s fallacy too has a role in the stock market, as people see (or think they see) patterns in price movements based on previous movements, and attempt to try and take advantage of the next perceived movement. Again this introduces inefficiencies into the market, which allows other investors to earn an excess return for taking an opposite position.

We’ve included this article to highlight CIPL’s role in helping to manage through difficult economic times, and to take advantage of better conditions. The media would have had clients sell everything last year. With markets now recovering it would have been the worst choice of all.

¹ Tversky, A. & Kahneman, D. (1991). Loss Aversion in Riskless Choice: A Reference Dependent Model. Quarterly Journal of Economics 106, 1039-1061.

While putting together some training material for some new traders, I started thinking back to my time racing motorcycles.

I started racing after several years of riding road bikes and just being fed up with those annoying speed limit signs. At first it was just a paid track day once in a while; then once or twice per month; and then it all became rather serious with a complete racing bike and garage full of expensive parts.

By the way, there is a great trading related point to all this, so please read on…

Back to the track, the road to racing kinda went like this:

Back in 1999, I had a very good trading month and within hours of funds hitting the bank account, I paid cash for a brand spanking Suzuki Hayabusa – at the time the fastest production road bike ever built. Very nice pic below.

I obsessed over this thing and rode it every chance I had. I soon realised this missile was quite dangerous with my limited riding skills so set about taking lesson after lesson. The way I thought about it was my bike was at a certain level and I had to catch up to it. I completed multiple courses run by the Superbike School, Stay Upright and a couple of others.

I soon realised that as much as I loved the Hayabusa, it was not ideal on the track – super fast down the straightaways, but terrible around corners given its size and weight. So I replaced it with a new road going Suzuki GSX-R1000. After modifying with better brakes, exhaust, suspension as well as full race fairing, I had a very credible track bike. See pic (me on left).

This is where I stepped things up and started competition racing. I was still hooked on doing as many riding courses as there were available. I repeated a few and then hired my own personal instructor. I even had personal instruction from a couple of top level Australian riders. Brilliant stuff.

At this stage, I also tossed the modified Suzuki and bought a proper racing bike. This was another Suzuki, the same model in fact, but one that came from the factory as a full race bike with all the proper trimmings. I wanted to give myself no excuse for going slow.

Going through the Superbike School courses was a great experience. They essentially give you certain things to work on for each track session. For example it might be a vision exercise, body positioning or something to do with throttle control.

The interesting thing was that each little component built on the previous and in the end, I had created an entire plan for riding. I was far from a Mick Doohan prodigy, but my riding confidence went through the roof, my lap times fell and all in all I was getting a whole lot more out of the experience. I also started to experience a new level of focus and concentration.

Pretty quickly I saw the parallels with trading. At the time I was trading a large options account, but the lessons apply to any type of trading.

(No) Fear
Naturally there were still challenges. Interestingly, I knew all the challenges were in my head. Take for example the Eastern Creek track in Sydney’s west. Turn One was a very fast left hander (205-210kph – for me at least). This was followed by a slow and tight left hairpin that was off-camber, had noticeable seal lines and an uneven surface. It was where everyone had at least one spill – including me. It was the corner you’d talk about with the other guys in the pits between sessions.

Anyhow, the braking-point for that left hand turn would often psych me out. I knew the spot at which I should be braking but often fear made me grab a handful of brakes 2-3 metres before it. It was something I would be aware of on the approach to Turn Two every lap. Sometimes I would nail it. Sometimes it would nail me.

Have you ever been in front of the trading screen, knowing you should pull the trigger to either enter or exit, but find a reason not too? That was my Turn Two at Eastern Creek.

It’s very easy to keep a fear alive. All you have to do is change your focus and rationalise. I could have for example thought “my overall lap time is improving therefore that little bit does not matter”.

In trading that’s like knowingly making a mistake and thinking “at least I came out of the day/week/month in profit”. That’s pretty much a formula for repeating the mistake and who knows, that mistake me be the one that empties your bank account.

Getting past fear is requires awareness and repetition, not ignorance. My Turn Two was far from perfect, but I was honest with myself and consciously worked on improvement.

Confidence
A friend from NRMA Insurance once told me they ran a survey where more than 80% of people thought their driving skills were above average. Before taking my riding seriously, I thought I was a good rider – better than average at least. Looking back, I think I was closer to average.

Some of my friends thought I was overdoing it when it came to attending riding courses. I disagreed. As my skill improved so did my confidence. Then more and more things became second nature. Things that would previously be in the front of my mind became automatic.

This cleared the mind of clutter, allowed me to focus and the bottom line was I was riding faster with less effort. Think about all the things you need to do when coming up to a corner:

• Where do I brake?
• How much do I break?
• How much front brake, how much back brake?
• When should I turn in?
• How fast do I lean the bike?
• How much lean angle?
• Where should I be on the track?
• What gear should I be in?
• What is my body position?
• Where should I be looking?
• How much throttle to use and where?

The list is actually longer than this, but you get the point. Imagine how difficult riding would be if you are thinking of all these things. It really does slow you down. However, repetition serves to automate these processes. The effect is a clearer head and faster times.

The parallel with trading is obvious. Regular education is very important. So is repetition. It’s that repetition that makes something second nature, boosting confidence and skill.

Focus
The thing that really stood out is the need for focus. On a track at race speed, there is no time for thinking about anything else than what is ahead. I would think of extra thoughts as extra weight and weight slows you down.

An interesting thing happened on my first ever day of racing. It was Lap 1 of Race 1 at Eastern Creek. Coming around Turn 11 into Turn 12, the final turn, the rider right in front of me stepped out a little wide and his front wheel hit the dirt immediately pulling the bike out from under him. His helmet hit the ground so hard I even thought I heard it.

A natural reaction is to think and hope he was OK and of course think about the incident itself. The problem there is it would take away focus from what is important i.e. the next corner and the rest of the race. I put the incident out of my mind until I came back around and saw he was OK. Then it didn’t cross my mind again until the end of the day. That is the focus you need for performing.

The same goes in trading. You need to determine and apply the right amount of focus for the type of trading you do. For position traders, checking markets once a day may be enough. For intraday traders, you need your eyes on the screen and no thinking about shopping, picking up the kids, the phone bill etc.

Goal Setting and Planning
Goal setting is important and logical in most pursuits. When it came to racing, I was inspired by something Valentino Rossi said. It was something like:

“My goal for each lap is a perfect lap. I pick the optimal braking and turning points for each corner and try to hit it every time. It’s a challenge I set for myself.”

There is a lot of art in motorcycle riding, but there is also a lot of science. Breaking it down into a science and putting a plan together works. On practice days for example, I would literally stick a note to my petrol tank detailing what I wanted to work on. Each session was different and I’d never make it too complex. Here’s an example:

When I first thought of the idea of putting notes on my petrol tank, it seemed a bit silly. Realistically, you don’t have time to sit there and read your bike… However just the process of writing out the note and sticking it there made it worthwhile. I could have just as easily put the note in my toolbox and it would still work as the issues were clear in my mind.

From a trading viewpoint, what’s wrong with making small notes and sticking them next to your PC? A ‘trading translation’ of the above note might be:

This is hardly a complete trading plan, but that’s not the point. The idea is to work on a few small issues at a time. Don’t overdo things – keep it simple. Then regularly change the note. If you’re day trading, perhaps have a new note every day. “Today I will focus on…”.

The Zen of it all
The biggest improvement in my lap time came during an instructional day. I remember the lap well. Without looking at my timer, I would have guessed it was a slower lap than normal. I was relaxed and almost out of body. It was a weird combination of focus and detachment.

For some time, I had been stuck at a certain lap time and I just could not get below it. After this particular lap, I looked down at my timer and saw I was two seconds faster. Two seconds was a really big jump. I immediately came into the pits to think about what happened and I realised that it was detachment. I was relaxed and in the moment.

There is an interesting paradox in trading. I’ll bet there is not one speculator that got into the business without the goal of making money, yet we are taught not to think about the money that is being made or lost.

How do you get around something like that? How can you detach yourself from the money in your trading account? It’s not an easy question. Ed Seykota in Market Wizards talks about the difference between winning/losing trades and good/bad trades. A good trade is one that was put on the right reasons and the rules were followed. A good trade may well lose money, but if you follow the rules, it’s a good trade. Strive to make every trade a good trade.

Book Reader: The Kindle
Kindle Wireless Reading Device (6″ display)

Kindle DX Wireless Reading Device (9.7″ display)

Trader Interviews:
Market Wizards: Interviews with Top Traders

The New Market Wizards: Conversations with America’s Top Traders

Trading Psychology:
The Daily Trading Coach: 101 Lessons for Becoming Your Own Trading Psychologist

The Trading Athlete: Winning the Mental Game of Online Trading

Market Basics:
Starting Out in Futures Trading

Technical Analysis:
Technical Analysis of the Financial Markets: A Comprehensive Guide to Trading Methods and Applications

Study Guide to Technical Analysis of the Financial Markets

Fundamental Analysis:
Futures: Fundamental Analysis

Options Trading:

See detailed list here

General Reading:
Reminiscences of a Stock Operator Annotated Edition

How I Made $2,000,000 in the Stock Market

As usual our society remains fixated on instant gratification. We suspect that waves of uninformed officials and uneducated bandwagon journalists will foster desires to “do something” about “high prices.” After almost 30 years of market analysis we are fascinated with the unwavering knowledge in the mainstream press that certain commodity prices are too high. Perhaps the pundits have a case that oil prices are expensive relative to “classic” physical supply measures, but the IEA projecting only a 2.3% decline in global oil consumption from its historical peak to the sub-prime recession trough suggests that even the worst economic conditions in 60 years weren’t enough to markedly slash world oil use. The IEA also expects that 2010 world oil demand will climb back above the 2007 peak that was estimated by the US EIA.

With December 2010 corn prices as recently as September trading within close proximity to their cost of production, low milk prices forcing a large contraction in the dairy industry and a doubling of gold prices failing to expand gold mining output, commodity prices aren’t too high, they are too low! With the increased cost of energy, transportation, processing, security and increased demands for environmentally-friendly or sustainable output, society simply can’t expect to have prices as low as they have been for most of the past 30 years.

Historically, commodity producers have received a small portion of the cost of the finished products, and with those producers periodically presented with deflated pricing, they face an unacceptable risk in ramping up production without the prospect of significant returns. In looking at charts of cost of production for corn and soybeans, it is clear that production in those markets needed support from the government for the better part of the last 15 years. In the book Fast Food Nation, the author suggests that farmers growing potatoes might be lucky to get 2 cents out of $1.50 spent on a large order of fries at a fast food chain. Another author is even suggesting that the high cost of oil could restrict commodity production to the geographical area where it’s produced, which highlights some of the backward thinking that is often directed towards commodity markets.

Certainly livestock producers were hurt by the ramping up of corn prices in 2008, but instead of liquidating a massive portion of the livestock herd because of a lack of profitability that in turn could create a shortage of meat, the prices of pork, beef and chicken need to rise to high enough levels to sustain an appropriate level of production to meet demand. In our forthcoming book Big World – Small Commodity Markets, we will highlight the need to ramp up production in almost every commodity market. At this point it would seem the US government has too many irons in the fire to attempt to take over commodity production, too. In retrospect, rapidly expanding middle class across the globe, commodity output will needs to increase, and the best way to encourage that is to allow market forces to work.

Keep a pulse on the industry and access more industry news.

About Daniels Trading

Daniels Trading is a relationship-focused commodity futures brokerage located in the heart of Chicago’s financial district. Founded in 1995, they have a history of providing effective and reliable trade executions to both individual traders and institutional investors around the globe. In addition to a focus on relationship and execution, Daniels Trading is a leader in providing ongoing education opportunities and resources for customers.

From a total of 136 respondents, there was a clear trend in what people thought important. Here are the results:

It’s no surprise to see ongoing education at the top of the list, but I was surprised to see having ‘the right software’ (including data feeds) did not get more votes.

To be honest, I thing all of the above have merit.

-GB

Super Trader: Make Consistent Profits in Good and Bad Markets

1. The trading process. The things you need to do daily to be a good trader.

2. The wealth process. Exploring your relationship with money, how you deal with it and how it deals with you.

3. Developing and maintaining a business plan to guide your trading. Entry into the world of trading may be very easy. All you need to do is sign a few forms, deposit some cash and away you go. Newcomers want trading to be easy fast and profitable. ‘Successful’ trading however, like success in any business, requires a development of and adherence to a solid plan.

4. Developing a system. Often people consider a system to be the magic secret for picking stocks or commodities. In reality, the entry decision is one of the least important aspects of good trading. The keys to a moneymaking system are elements such as determining objectives and risk management strategy. It’s the whole picture not the entry signal.

5. Position sizing to meet your objectives. Tharp showed by way of simulation games that 100 people at the end of a set of 50 trades will have 100 different and varied results. What was extreme variability in results was thought to be a function of the money risked on each trade (position sizing) and the personal psychology that determined their position sizing.

That last point is an interesting one. Those that have read anything about the Turtles or other trading system developers would have heard a similar message. I can also say I have seen this played out time and time again in the markets.

Anyhow to read more, buy the book…

Super Trader: Make Consistent Profits in Good and Bad Markets

The chart shows the spread between CME Live Cattle and Feeder Cattle futures. Given the different tick value, it’s calculated using the dollar contact size rather than just the spread in prices.

It’s interesting to note the bearish divergence with the MACD, lower trend line break and a rather text book quality head and shoulders all pointing to lower levels.

There is probably a good trade in going short this spread.

As for the seasonal data, the second chart shows the historical pattern played out over 15years. That red oval shows an optimal period in which to be long the spread. It has in fact been a profitable trade 14 in the last 15 years.

That profitable period is right now. In other words the seasonal data is calling for the spread to move higher from around now until February. As mentioned, the chart shows the seasonal trend measured over 15 years. Interestingly the seasonal data measured over 10 years and 20 years say the same thing. That is, the spread is going up not down.

So what to do? Trade the seasonal data or trade the technicals. Well the lesson here is to do neither. Conflicting signals do not a good trade make.

That’s the thing with spread trading. At times there is some waiting involved. However the idea is to only select trades that tick all the boxes.

In the last article we started looking at the concept of change and how it affects an option’s fair value. Specifically we used discussed the delta and the gamma – concepts used to quantify the behaviour of an option given a change in the underlying market itself.

In this article, we move a little further down the track and look at how changes in other factors can affect an option. For any option trader, it is interesting information, but more importantly essential in understanding the risk in a position.

In the last issue noted four factors that can impact the fair value of an option position. These are:

1. Market price
2. Time to expiry
3. Volatility
4. Interest rates.

Changing levels in the underlying market price is what we looked at last time. Here we will look at the rest, starting with time.

Time Decay and Theta

Theta measures the effect of time on an options price.

Let’s look at the Gold futures market, currently trading at $720. Consider buying a 720 Gold call, paying $48. That $48 can be said to represent the chance that the market will go higher and the option move in-the-money.

An option however, has a finite life. As each day passes, the chance of the underlying price reaching the strike and moving beyond it decreases. Therefore the value of the option premium will fall. Even if the Gold futures price stays at $720 exactly, the value of the option will diminish as time passes. This is called time decay.

Do not underestimate the value of understanding time decay. In fact, strategies of many options traders are designed solely to take advantage of time decay.

The Time Decay Curve

The actual rate of time decay as each day passes does not stay the same. Assuming all other factors in an options price remain constant (including the underlying price), the rate at which an option premium will decay increases the closer you get to expiry. That is, the option premium will lose more of its value the closer it gets to expiry.

Rather than give a theoretical explanation of this fact, let’s think about it logically. Back with our Gold call, the underlying futures is trading at $720. At the time of writing, a 31 day call with strike of 720 was trading at $48.

Now consider what might happen as time passes. Assuming all other factors remain the same, would you still buy the option tomorrow for $48? What about next week? What about when ti has one week to go? Will it still be worth $48 with say one day to expiry? As time passes, the logical value of the option will diminish.

Remember to think about the price of an option as the odds that the option will finish in-the-money. The reason a 31-day option is priced higher than a 10-day option is the longer life of this option means there is more chance that it will go in-the-money before its expiry date. Simple.

Consider also what happens when one day passes. The 31-day option now has 30-days remaining—it has effectively lost 3.2% of its lifetime (1 day divided by 31). If you have a 10 day option and one day passes, it has lost 10% of its time. Which do you think should lose more in fair value given this one day passing?

Obviously the shorter term option will lose more in value than the longer term option, given the simple fact it has lost more of its life in proportional terms.

If all other factors remain constant, a short-term option will always lose its value at a faster rate than a longer-term option in proportional terms.

When to Place Strategies to Take Advantage of Time

The important thing to remember when considering a strategy that takes advantage of time decay is that the rate of time decay increases the closer the option gets to expiry.

Therefore, sticking to the shorter-term options means your rate of time decay will be greater (larger theta). Refer again to the time decay curve. The closer the option is to expiry, the faster it loses its value. Therefore, when trading a net short strategy, the shorter the time period, the better.

Traders experienced in selling options understand the underlying market and will only sell options so far out-of-the-money that there is little chance the strike will be reached in the life of the trade. Unfortunately, there is no quick way to learn this. It takes homework and experience. As an options trader, you must understand the key factors that influence the market, both fundamental and technical. Only then can you make an estimate of how far a market can move within a certain time period.

Volatility and Vega

The ‘vega’ of an option is a measure of the rate of change in an option’s fair value given a one-percentage point increase in the level of volatility.

The vega is normally expressed as points or dollars gained, given a 1% increase in volatility. The vega for a portfolio is calculated as the sum of the vega for each individual option. An increase in volatility will always have a positive impact on an options price. Therefore, the vega will always be positive. In some texts and software packages, the vega is also known as ‘kappa’ (just to keep you guessing).

Interest Rates and Rho

The ‘rho’ measures the sensitivity of an option, given a change in interest rates. The interest rate component of an option’s price is associated with the cost of carry and is not normally a significant component. In fact, most traders pay little attention to the rho.

So where do you start?

If you are not new to options, but new to the concept of these Greek symbols, should you be calculating your delta, gamma, theta, vega and rho for all your position all of the time?

You could guess that things could get a little messy.

Suffice to say you should be aware they exist and you should at least know how to interpret them. Additionally it is worth knowing how these measurements apply to positions that involve more than one option.

If at any point, any of the ‘Greeks’ get a little confusing, you remember all these measurements do only one thing. They help you understand how the profit and loss of an option position will react to a change in a certain variable. These are measurements of risk. Understand your risk.

This is a fantastic tool for downloading eBooks (including the free eBooks from this site). You can read them anywhere, anytime, show them to friends and share them with the person next to you on your flight who is constantly bugging you for a look at this great gadget.

The cool feature is that is has built in wireless that allows you to search the Amazon site and download books. The wireless is free, but of course the Amazon books are not. Details here:

Kindle Details – click here

The positives:

• The wireless internet works really well. It comes preconfigured so there is no messing about when you get it. All you need is to be in an area with a signal and it is working.
• Buying and downloading books takes about a minute. Really easy. It’s set up to work with your existing Amazon ‘one-click’ account settings.
• The unit is light and a good size for reading in bed or while travelling.
• Battery life is very good – and it charges with a USB.
• There is a large range of investment books available on the Kindle. Plus you can set it up to automatically download the Wall Street Journal, Investor Business Daily and other newspapers and magazines.
• You can email or PC sync other documents such as Word or PDF.

The negatives:

• I’ve now been on two different flights with it and each time the person next to me has asked me about it and wanted to have a good look. So until they become more popular, don’t expect privacy.
• There is also an issue with books that are heavy on graphics. Some of the formatting is a little messed up. That said, it’s not a major issue and you can read around it. The PDF display is not perfect, but they are apparently working on it.

This is not really a trading topic. I just felt like writing about it…

(Originally published in Active Trader magazine)

What a boring game all this would be if option prices showed no fluctuations! The price, or premium, of an option is constantly changing for whatever reason. As an options trader you must be prepared, armed with the knowledge of how an option price can react in certain scenarios. You can look at that from a reward or a risk perspective.

If you are relatively new to options, you may have heard the terms “delta” or “gamma” or several of the other Greek letters. These terms are used to measure how an option price can behave in certain environments.

This two part article (this being part one) seeks to explain “the Greeks” and more importantly give perspective to their relative importance in day to day option trading.

The Background

Those familiar with option pricing models such the Black-Scholes (B-S) Model will know certain inputs used to determine the theoretical or fair value of an option. These are:

Market price and strike price

1. Time to expiry
2. Volatility
3. Option type (put or call)
4. Interest rates
5. Dividends or coupons
6. American or European style option.

Now, if you picture yourself in any option position, which of the above factors can vary? That is, what factors can change so that the value of the option might change?

The answer:

1. Market price
2. Time to expiry
3. Volatility
4. Interest rates.

A change in any of these four factors will most likely change the value of the option price—or at least change its fair value.

The next obvious question is: ‘How significant are these four factors in relation to an option position?’

For example, if you have just bought a call option, what will your profit position look like if the market rallies 1 per cent, one day passes, volatility increases, and the Central Bank raises interest rates? To be an educated options trader, you need to know how these factors will affect you in real life.

That is where ‘the Greeks’ come in. They are measurements that describe the relative importance of these changing factors. These measurements are given names from the Greek alphabet given their initial derivation from the mathematics of calculus.

Interestingly, calculus is a branch of mathematics that is used to measure the rate of change of one factor, given a change in another. Throughout this article you will see the phrase ‘rate of change’ quite a lot. This is, in essence, the basis of this topic: analysing the rate of change of the option premium given a change in one of the above factors.

However, the mathematics is kept to a minimum since modern option software will easily handle the task. What you need, as an options trader, is an understanding of these concepts and the ability to apply them to your position. Rest assured, this is a formula-free zone.

Not all the following measurements will be applicable to your trading, but these are important concepts to learn and you are encouraged you to at least think about how you might apply them in real-time trading.

This month, we will only look at the concept of a change in the underlying market price and how this affects the fair value of an option position. Next week, we will look at the other factors.

The Delta

One could easily argue that delta is the most important and commonly used of the ‘Greek symbols’ in options trading. It is therefore prudent we spend a good deal of time here.

Suppose we have a 1 percent rally in our underlying asset. Think for a moment how the fair value of a deep in-the-money call option will change in relation to a far out-of-the-money call option.

One would think the fair price of the in-the-money option is more likely to move a greater amount than the price of the out-of-the-money call option. In fact, picture a call option way, way, way out-of-the-money. The price may not even move at all!

There is a way to measure the degree that an option price will move in relation to a movement in the underlying asset price. The measurement is called delta.

Measurement and Interpretation for Calls
The delta can be expressed in two ways:

• As a percentage. For example, the delta of a $10 strike call option in Silver futures could be +26%. This means for every 10c rise in Silver, the fair value for the $10 call will increase by 2.6 cents.

• As a decimal. In the above example, you would say the delta for the $10 call is +0.26. For every one unit rise in the Silver futures contract, the call option will increase 0.26 points. This is the more common method, but the interpretation is essentially the same.

Now, think about the range of values for the delta of a call option. Really far out-of-the-money call options would hardly move if the underlying asset were to increase by just a little. You could confidently say, therefore, that the delta for a way out-of-the-money call option would be close to zero. The further out-of-the-money you go, the closer the delta moves to zero.

What about in-the-money options? Well, assuming all other factors remain constant (especially volatility), it is fair to say that an option’s fair value would not increase at a faster rate than the underlying market. Right? Sure, if the other factors changed (interest rates, volatility, dividends and coupons), then it might be possible. But, holding all those factors steady, the option price would not increase at a faster rate than the underlying, given a solitary change in the underlying.

This means, the most the delta could be is +100 per cent, or +1.0. A delta of +1.0 means the fair value of the option will move ‘tick-for-tick’ with the underlying. A 5-cent increase in Silver will result in a 5-cent increase in the fair value of that particular call option.

Now, the deeper you go in-the-money, the closer the delta will be to +1.0.  That means that deep in-the-money call options tend to behave just like the underlying asset. (It’s an interesting thought when you want to hedge a position, but that is another story.)

A general rule of thumb is an at-the-money option will have a delta of close to +0.50.

Therefore, we have established that the delta ranges between zero and +1.0 for all call options. Another rule of thumb is, the longer an option has until expiry, the higher its delta will be, although the difference is never huge.

For example, an out-of-the-money call with 90 days left to live will have a higher delta that the same option with 10 days to live. The difference is may not be so big for at-the-money options, but can be significant as soon as you move in- or out-the-the-money.

Put Option Deltas

So far, we have talked about call options only. What about puts? Wouldn’t they just be the same? A $10 call should have the same delta as a $10 put right? Certainly not!

Think about it. If a market rallies ten cents, the fair value of our calls would increase by a multiple of the delta. Put options however would decrease in price. And yes, you guessed it; each put would decrease by a multiple of its very own delta.

The delta for a put option is a negative number. An at-the-money put delta will be close to –0.50 (where an at-the-money call delta will be close to +0.50). Out-of-the-money put deltas will approach zero, just like call options. In-the-money deltas for put options will approach –1.0 just like call deltas approached +1.0.

Delta and your option position
So from these basic rules, we can now apply the concept of delta to commonly know option strategies. Table 2 summarises each position:

You will notice that some of the more complex strategies, such as ratio spreads, have been left out. This is because the delta on these positions is not so clear-cut. It is very much dependent on your choice of strikes.

For example, in the case of a ratio call spread, if there is a large gap between the bought strike and the sold strike, then the sold component will have a small delta, relative to the bought component, thereby having little impact on the net delta. If the sold strike is close to the bought strike, it will have a greater impact and may even cause the net delta to be negative.

The Gamma
As discussed above, deltas range from zero to +1.0 for calls and zero and -1.0 for puts. The deeper the option is in-the-money, the closer the delta is to +1.0 or -1.0. What then happens to the delta of an option as the market moves in one way or another? Does it stay the same? Does it change?

Consider an at-the-money call option. Let’s say its delta is exactly +0.50. What would happen to the delta if the underlying market price started to fall and kept falling? Well, for a start, the at-the-money call will no longer be at-the-money. It will be out-of-the-money. We already understand that out-of-the-money options have deltas approaching zero.

So the delta of that call option would change. The further the market falls, the smaller the delta would get. Likewise, should the market rally, an at-the-money option would then become an in-the-money option. The deeper that call option goes in-the-money, the closer the delta will be to +1.0. In other words, the further an option is in-the-money, the more it will react to changes in the underlying market.

So it’s fair to say that, as the market moves up or down, the delta for each and every option changes. There is a measurement for the rate of change of the delta. It is called ‘gamma’. The gamma measures the rate of change of the delta given a change in the underlying price.

At first thought, the gamma does not seem like a very important measurement, but it really is. If the delta never changed throughout the life of your position, risk would be very easy to quantify. But, if a market starts to trend, your delta can change dramatically. And if the trend is not in the direction that you want it to be, you could be in trouble!

This point is best explained by example. In the mid-1980s a US-based clearing member collapsed after several traders with accounts at the firm took on positions where the gamma worked against them. These traders had built up large short positions in out-of-the-money gold call options. The deltas in these positions were small, since the strike prices were distant. That ordinarily meant small ticks up or down in the market that would not affect the options prices too much.

The gold market subsequently staged a strong rally. What were once options with very small deltas suddenly increased. As the market rose, not only did the price of the options increase, but the rate of change of the options also increased. The deltas got larger, hence, so did the losses. A few of the traders were unable to meet margin payments and the clearing firm collapsed. That is gamma!

So, what lesson could one learn from this example?

For a start, it is highly recommended that you understand what a market is capable of, before taking on any positions. Think about worse case scenarios in the market and how they may affect your chosen options position. It may pay to consider what some call ‘insurance’. In the above example, instead of selling call options naked, the traders could well have created a credit spread by buying a call strike even further out-of-the-money.

For example, they may have sold call options for 50¢ each. It might have been possible to go further one or two strikes higher and buy an equal number of calls for say 10¢ each. The net income received would have fallen from 50¢ to 40¢, but buying this call option would not only reduce the margin, it could have helped reduce losses as the market started to rally. The bought call will always have a smaller delta and gamma than that of the sold call, but it could still significantly reduce risk.

Can you see how adding such a seemingly small and insignificant component to a position can change your risk profile? That is the nature of trading options. You must always be prepared for the worst to happen—even if it means giving up some profit potential.

The best way to start thinking about gamma is not in its numerical form. Think about the concept itself, not its measurement. Think about your total delta when you buy some calls, or sell a strangle, or buy a bull call spread. Think about how small and large changes in the market will affect your delta and your profit and loss. A changing delta simply means a changing risk profile.

As an options trader, you must constantly re-evaluate your total risk and make sure it fits with your objectives. Do not be afraid to exit a position because the market has moved in such a way that your delta and gamma have moved against you.

Delta and Gamma in Perspective

So what is the big deal? What do we do with the delta and gamma? Is it worth all the bother? Most if not all options traders will tell you it is. Understanding your delta and gamma allows you to understand risk, because that is essentially what these things are: measurements of risk relative to market movements.

Even when you do not know what the actual numerical figures are, you should know if your delta is negative or positive and know if your delta is large or small and how that delta can change. It is simply measuring risk.

Some professional options traders would not be able to tell you what their exact delta and gamma are, but they do understand how movement in the market affects their positions.

The most important point from this article is you should be thinking in terms of risk and how your position changes relative to the market.

In the next article, we will look at how to measure the risk in an option given changes in other factors such as time and volatility. For an Active Trader, it is knowledge worth having.

This video is aimed at a beginner level and assumes some knowledge of futures.

This video is aimed at a beginner level and assumes some knowledge of futures.

This 5 minute video covers:

• What is a Spread?
• Types of Spreads.
• The 5 Great Reasons For Trading Spreads.
• Where to Get Spread Trading Information.

If you’ve been trading options for a while, you no doubt have heard many others. But, when you hear comments such as these, all you’re hearing are opinions of one person’s preference for a particular risk-reward profile. In order to really understand option trading, you need to understand that all option strategies come with their own sets of risks and rewards and the market will price them accordingly. Be careful of anyone telling you that a particular strategy is superior to another; they either do not fully understand options or are trying to sell you something.

The best option strategy is… the one that directly matches your set of risk and reward tolerances for a given outlook on the underlying. The best strategy is also the one that makes the most of the current market environment.

This is the level of option trading knowledge a trader should have. Learn to dissect a position into its component parts and see if you are willing to accept the associated risks. Learn the various strategies and how to further tailor them to match your needs better. Don’t spend your time looking for the one superior option strategy. It doesn’t exist.

To fully understand the relationships between risk and reward with options, you can just look at payoff diagrams. If you compare the profit and loss diagrams of any two strategies, there will always be a part of the diagram where either strategy dominates.

For example, some elementary books on options will explain how call options are superior to owning the stock. So let’s look at this one.

Assume one of us buys a stock for $50 and another buys the $50.00 call for $0.80. We can plot the profit and loss at expiration for each position, and we will get the following diagram:

Source: OptionVue

The trader who buys stock at $50 will make $2 profit if the stock is trading for $52. Likewise, if the stock is trading for $48, the trader will incur a $2 loss.

The call buyer will lose $0.80 if the stock is $50 or below and will break even if the stock is $50.80. At a stock price of $52, the $50 call buyer will make $1.20 profit (the call option will be worth $2.00 less cost of $0.80).

So the profit and loss from the stock is superior to the call option for smaller movement in the market. Additionally, the dollar return from owning the stock remains superior even as the stock rises and rises.

The downside of owning the stock is firstly if the market falls more that $0.80. Cent for cent this will lose money. Loss from the call option however is limited to the $0.80. Additionally, there is the cost of capital to consider. Buying the stock (unless on margin) will cost you the whole $50. The call cost just $0.80.

It should be evident that one strategy is not better than the other; it depends on your outlook of the stock and the amount of risk you are willing to accept.

The investor who believes the stock will stay above $50 is better off buying stock. Of course, there is a tradeoff of accepting a potential $50 maximum loss. Conversely, an investor who believes the stock is heading higher but doesn’t want the exposure to the downside is better off buying the call. The tradeoff is that he will pay $0.80 for the stock instead of $50 and only be subjected to a $0.80 maximum loss. In return, the breakeven level is higher and the dollar profit will never be as great at the stock.

What about naked puts? They must be better than holding the underlying because it’s like getting paid to buy the underlying, right? This is what some argue, but it’s not always the case.

Let’s look at the profit and loss diagram in Eurodollar futures where we have (a) purchased the futures and (b) sold an at-the-money put for 22.5pts:

Source: OptionVue

Again, in some areas of the chart the long futures position dominates, and in others it does not. The long futures position is better for prices above 98.725. With the futures above here, the long position will realize increasing profits, while the naked put will profit only by the premium received from the sale of the put.

However, if the futures price is below 98.725, the naked put is the better strategy. Below 98.73, the naked put will always make more money or lose less.

Pick any two strategies and look at their profit and loss diagrams. You will always see that any one strategy will dominate over a given range of underlying prices. Try switching one position from long to short. Try changing strike prices. You will soon see that it does not matter; one strategy cannot dominate another for all prices.

Strategies come in all shapes and sizes. Now you should have a better understanding why. Different strategies alter the risk-reward relationships and it is up to you, the trader, to decide which is best. Do not be afraid to alter the strategy to meet your taste that is what option trading is all about. If you accept somebody’s strategy as the “best,” you are, by default, accepting his or her risk tolerances too. If those tolerances are not in line with yours, you will eventually learn, the expensive way, that no strategy is superior to another.

Trading in futures and FX have been placed at the risky end of the scale mostly, if not completely, given the leverage factor. However there are strategies that offer a reduced risk profile while maintaining excellent profit opportunities.

Enter ‘spread trading’. Futures spread trading has been around for a long time, but it is gaining popularity among the smaller traders looking for something new.

A lot has been written on the basic definitions of spread trading, so here we’ll only offer a 10 second definition (below). This article takes things one step further and looks at what is called the soybean ‘crush’ spread.

The 10 Second Definition

Futures spread trading involves the buying and selling related contracts simultaneously in an effort to profit from a change in the price differential. An intra-commodity spread involves going long in one expiry month and short in another in the same – long December Corn and short March Corn for example. An inter-commodity spread involves going long in one market and short in another: Long Corn and short Wheat for example.

What is the Crush Spread?

Crushing is the process applied to raw soybeans to derive soybean oil and soybean meal. Think of squeezing a hand full of soybeans. What drips out is the oil and what is left in your palm is the meal. A crude example, but you get the idea.

On the CBOT we have the three contracts available: Soybeans, Soybean Meal and Soybean Oil.

Soybeans by themselves do not have a lot of use. Soy meal on the other hand is used as a source of high protein livestock feed. Soy oil has industrial and food uses. It is the difference in usages between these three contracts that creates fluctuations in the spread and hence the trading opportunity.

Most discussions on futures spreads involve two parts or “legs”: a long side and a short side. The crush spread on the other hand involves positions in all three soy contracts. It’s just that little bit more complex, but easy to understand when you break it down.

The crush spread involves buying soybeans and selling its products: oil and meal. Think of this one from the point of view of a processor or ‘crusher’. The crusher will buy physical soybeans, crush them, and then sell the meal and the oil in order to make a profit. The whole idea is the price of the meal and oil will be greater than the price of the raw beans. That’s what is called a profit margin!

The reverse crush spread is just the opposite of the crush spread. It involves buying the products – the meal and oil futures – and selling bean futures.

Calculating the Spread

Calculating the spread price is a little tricky given soybeans are quoted in cents per bushel; meal is in dollars per ton; and oil is in cents per pound. The conventional method is to convert everything into cents per bushel.

The following table shows the process along with conversion factors.

Think of the 79.11 cents per bushel as the profit margin for a crusher.

There is no need to go too deeply into this calculation as there is one already done for you. In eSignal, the code is BCX followed by the month & year codes. The December spread therefore is BCX Z9. While this is a futures code, it does not actually trade as a standalone contract. To initiate the spread, you still need to transact in the three contracts.

Ratios

The poor man’s spread is simply a 1:1:1 ratio. A crush spread would therefore involve going long one soybean contract, short one meal contract and short one oil contract. The proper ratio however is 11:9:10. That is 11 soy meal, 9 oil and 10 soybean contracts. The margin discount for this ratio is significant 90%.

Trading the Spread

The laws of supply and demand act to keep this spread within a rough upper and lower limit. At the lower end, if the spread price gets too low, crushers tend to slow production thereby seeing a drop in demand for beans and less supply of the processed products. This supports and/or widens the spread.

At a higher spread price, increased crushing activity means stronger demand for beans and greater supply for meal and oil. This works to narrow the spread. Naturally speculative interest also helps keep the spread within a range.

Overall, this makes for a good market to trade using relatively simple technical analysis. Things such as oscillator divergences at extreme spread values can offer relatively low risk spread trades. The two Stochastic divergences shown are good examples.

Seasonal Data

There are fundamental differences in the underlying products. That is, the supply and demand factors are different for each soybean, meal and oil. For the fundamental trader, it is essential to understand these differences to understand the spread.

These differences also work to create tradable seasonal variations in the spread. In fact this year’s Nov/Dec crush spread (SX9, SMZ9 and BOZ9) followed the 15yr seasonal pattern very closely. The same can be said for the Nov/Oct spread (SX9, SMV9 and BOV9).

The seasonal influences along with what is a spread than does not have the volatility (risk) of the underlying contracts make it a good instrument to trade in longer term positions.

This video is aimed at a beginner level and assumes some knowledge of futures.

What are Eurodollars?

First of all, let’s clear something up. We are not talking about the currency here. This is not the Euro (EUR/USD). The Eurodollar is an interest rate product based on a 90-day bank deposit. It has become the benchmark for US Dollar based, low risk (but not government guaranteed) bank deposits.

Eurodollars futures are quoted as 100.00 minus the interest rate. A rate of 1.00% would therefore be a price of 99.00. Price and rates therefore have an inverse relationship. As rates fall, prices rise. As rate rise, prices fall. Each basis point (0.01) is worth $25.

The CME launched the Eurodollar contract in 1981 and it has since become the most actively traded futures contract on the globe. Contracts are listed on the March quarterly cycle (Mar, Jun, Sep and Dec)

extending out 10 years. Serial contracts are also offered on the nearest four calendar months (those not part of the March quarterly cycle).

Given deep liquidity across expiries for at least several years out, the contract is popular among spread traders and provides some terrific trading opportunities.

The opportunities come by way of movement in interest rates and more importantly changes in interest rate expectations. For this reason, some may argue the best time to trade Eurodollar spreads is when interest rates are at or near a turning point – e.g. right now. More on this in a moment, but first some theory…

What are Spreads?

The simplest of all spreads involves simultaneously trading in two related futures contracts – a long position in one and a short position in the other. The idea is to profit from a change in the price differential.

More complex spreads involve three, four or even more contracts combined. For now, we’ll just stick with spread using two contracts. Specifically, we’ll look and bull spread and bear spreads in the Eurodollar market.

The main benefits of trading spreads are a significantly lower margin than outright futures and lower volatility. Some spread traders also point to more reliable technical signals, but that is a matter of opinion and experience.

Bull Spreads

To create a bull spread, a trader would buy the nearer to expiry contract and sell short the distant contract. Examples of bull spreads are:

Bear Spreads

There are no points for guessing a bear spread is the opposite of a bull spread. To create a bear spread, a trader would sell short the nearer to expiry contract and go long the distant contract. Examples of bear spreads are:

Bulls, Bears and Roses by Other Names…

For the purists out there, it is true that some Eurodollar traders refer to a bull spread as defined above as a bear spread and a bear spread as defined above as a bull spread. There is a reason for this, but it’s unimportant. What is important is the concept not the name.

Calculating and Charting Spreads

There are two popular ways to quote and display ‘two-legged’ spreads. One is calculating the spread as the buy side minus the sell side. The other is to calculate the spread as near month minus far month. Analysts prefer the former. Brokers prefer the latter.

I prefer to use buy side less sell side as it is just makes more sense on a chart, but for this article, we’ll look at one spread and one spread only to save confusion. Charting the Sep 2010 – Sep 2011 would look like this:

To enter a bull spread, you would buy the Sep 2010 and sell the Sep 2011. In the chart above, you would want that price to then increase. To enter a bear spread, you would sell the 2010 contract and buy the 2011. In the chart above, you would want the price to decrease.

Trading Bull and Bear Spreads

Now, all the definitions are behind us. This is the important part. The key question to answer is “Why bother with spreads?”

The reasons for trading spreads vary from market to market, but for Eurodollars, you are taking a bet on the expected direction of interest rates. Just like the underlying contracts, spreads are driven by economic news, comments from Fed officials, movement in the US Dollar and all those macro events.

The best way to understand how spreads move is with an example. Here is that Sep 2010 – Sep 2011 chart again:

Point 1 shows the impact of Lehman Bros. The weeks that followed the news of the bankruptcy saw Eurodollars rally. The rally in the spread at Point 1 shows the nearer contract rallying more than the deferred contract.

To get a good feel for Eurodollar spreads, you have to think about why. Why did the nearer contract rally further? The Lehman news was negative for the economy. Negative economic news means lower interest rates, hence the rally in Eurodollars overall. At Point 1, the nearer contract rallied further as the market simply assumed the problem would affect the affect the economy more within the nearer term. Kinda seems logical.

Now consider Point 2 where the spread falls. Without looking any deeper, you could easily assume Eurodollar prices corrected what was an overbought move. However, this was not the case. Over this period, Eurodollar price continued to rally not fall (implying lower interest rates).

The chart below shows the rally and pullback in the spread (the candlestick chart) and the rally in the underlying contracts over the same period (the solid blue and orange lines and red arrow).

The reason the spread fell was the distant contract started rallying more than the nearer one. So interest rates overall were still falling (prices rising), but it was the deferred contract that was leading the way. Again, to understand Eurodollar spreads, you have to think about why this was happening.

While there were other news and bailout details coming out at the time, the spread was moving thanks to a change in perception. The idea that this was more a longer term problem was starting to sink into the market. As such this spread fell back given the rally in the Sep 2011 contract.

It’s interesting to note there were two distinct moves in the spread (up and then down) while Eurodollars themselves were going in just one direction. The difference was the changing perception on how long the GFC would affect the economy.

Now to Point 3. At the start of the bull move shown as Point 3, the rally in Eurodollars abated and towards the end of that rally, Eurodollar prices fell.

Again this was driven by perception. It was the perception that the economy would over time begin to show signs of recovery. The low in the spread was in fact at the same time much of the stimulus package details were released. A stimulus package itself could not change the market in the blink of an eye. What changed was the perception of the strength of the economy given those measures.

So from this, we are starting to see how the mood of the market is represented in the Eurodollar spread. It’s interesting isn’t it?

And so to Point 4. This is where we are right now. The spread is currently around that 1.40 level. That is, Sep 2010 Eurodollars are trading at 1.40 points higher in price than the Sep 2011 contract. This means the market is pricing in short term interest rates at 140 basis point higher in Sep 2011 than in Sep 2010.

For an interest rate position trader, the question you have to ask is if this is a fair amount? Has the market undervalued economic prospects? Remember, all current perception is factored into the market. The thing that will change the spread is a change in perception.

If anything, you could argue that spread is a little high. Any more news that would imply a prolonged recession is not going to have as much of a positive impact on the spread as strong economic news will have a negative effect. Does that make sense? All the doom and gloom news has already been through the market and had its impact. The market moving potential is in the recovery.

In other words there appears more risk of a drop in the spread. Stronger economic news will impact the longer dated contract more than the near one and as such see a drop in the spread.

Spreading in Perspective

All of the above can get a little confusing if you haven’t thought about these things before. Those readers that studied economics back in high school will remember being taught a whole series of ‘if A happens, then B will follow’.

For example if the government spends more then things like GDP, interest rates and inflation will increase.

To understand Eurodollar spreads and spot opportunity, you have to do the same. Think ‘if A happens, then the spread will do B’.

Right now interest rates are low and so much bad news is in the market. That one spread we looked at has hardly moved since June. A bad piece of data here and there is not going wake that one up and see it continue higher. However should we see more positive economic figures start to emerge, then that spread has to potential to start a move lower as longer dated contract would fall further than the nearer contract.

Conclusion

The Eurodollar is probably the best futures market in which to trade spreads. High liquidity for contracts several years out means there is a huge range of spreading combinations.

The best opportunities seem to pop up around the time of economic and interest rate uncertainty. Choosing a position is often as much about understanding the market’s mood as it is using technical or fundamental data.

The thing about options is that there are so many terms and concepts to learn and you’ll find even an introductory level article will be full of them. It means these things called “options” can be a little hard to understand at first.

Well with that in mind, let’s try and write an article without a single piece of options jargon. Instead of coming from the ‘what are options?’ point of view, let’s consider why you should trade them or better still ‘what’s in it for you?’

Options in perspective

While options were initially developed as a tool for protecting the downside in a stock, commodity or portfolio, they have since grown as a trading tool in their own right. Most of the volume in option markets around the world comes solely from traders buying and selling for profit.

One thing that does attract traders to the option market is the ability to place a strategy based on a very specific or even a vague view. In this respect, options are extremely flexible.

Consider having a view on your favourite stock. Well in most cases all you can do is buy it and hope it goes up. That is, you can make money solely from the share price moving higher. In some cases, you may also be able to sell the stock before buying it back to profit from a fall in the price.

With a stock, that’s about it – you can buy it or you can sell it. Options however make available a much wider range of strategies.

Consider the analogy of gambling down at the race track. The bookies set the odds and take bets from the punters.

The strategy of buying shares is much like the punter placing a single bet on a specific horse. The horse will either get a place or it won’t. The share price will either go up or down.

Think about things from the bookie’s point of view. They’re in a pretty good position. They are there to sell the bet to the punter. That is, to be on the opposite side of the punter’s transaction. Not only that, they can make just as many bets as you can. So the gambling strategies available to them are much greater than that of the punter. The bookie can be both the buyer and the seller.

You can do that in options. Think of any option strategy as simply a bet that the market will do one thing or another. As an options trader, you can be on either side of the bet. That is, you can make a bet that the market will do a certain something or you can sell that bet to someone else. You can be the punter or the bookie.

Much ado about options…

Down at the race track, there are a wide range of strategies you can place. You can bet that a horse will win or take a place. You can bet on trifectas, quinellas etc.

That is nothing compared to what you can do with options. Let’s look at a range of strategies and remember – no jargon. You will not walk away from this article, ready to leave your job and become an options trader. The idea here is to give you an idea of what you can do with options.

First and foremost we will lay some ground work. Options give you the ability to make a bet not only on whether your stock will go up or down. You can also bet on exactly how far it will go AND over what time frame. Not only that, but you can also take the opposite view of anyone on the market (much like the bookie does). Not only that! You can also make multiple bets.

If you consider just that last paragraph, you can come up with many, many, many combinations of strategies. Here we will look at a few different strategies and look at what you could do with just shares and with options.

Outlook#1: You think the share price is going higher

With shares, this one is pretty simple – you buy the stock. With options, you can place a similar strategy that will tie up less capital and have similar profit potential. Alternatively, you could even risk the same amount as you would the stock but stand to make a much greater amount.

Where the share trading strategy falls short is when you want to be more specific with your view. Let’s say you have a view about the magnitude of the move. With shares, there is still just one strategy.

With options, you can place a strategy that will profit from a small, medium or large in the share price. In fact you can be very exacting with your view and place an appropriate strategy at an appropriate cost.

If we think back to the bookie analogy, they will set their odds based on the chances of that horse winning or taking a place. Consider two horses: one with odds of 2:1; the other with odds of 100:1.

With a 2:1 horse, you can bet $1 and stand to win $2. With the 100:1, you bet the same dollar but stand to win $100. The difference represents the chances that each horse has of winning the race. They are priced according to their probabilities.

Options work in exactly the same way. Consider Rio Tinto at $124.00. You can place a bet that the stock will go to $130 or $150. If you look at ‘option bets’ as having a specific cost, which bet do you think will cost more and why? Dollar for dollar, the $130 bet must cost more because there is a higher chance of the market getting to $130 than $150. It’s just like the 2:1 and 100:1 bets.

By the way, you can do all of this over different time frames. Your view might be for a quick move, say over a month or over the longer term, like six months. Again you will get what you pay for. A longer term bet will cost more. A short term bet might be cheaper, but you’ll have a lower chance of being right.

Outlook#2: You don’t think the share price is going higher

You could sell the stock (if that stock is available for short selling).

With options however, there are dozens of different strategies you could place here depending on your exact view. So you can place a strategy that says Rio will fall to $100 or $90 or $50 or wherever. Each of these bets would have their own cost and payoff (also called risk and reward).

Another thing you can do with options is not bet where the market is heading, but where it’s not heading. So you could say “I think the market will go down, sideways to even a little higher, but never get to $130 in the next two months”. Well you can place a strategy that makes money from this view.

It is important to remember that the options market allows you to be either the punter or the bookie. So here you can do the opposite of betting that the stock will go to $30. In a way, you are acting like the bookie here. You are in fact taking the bet from someone else.

Outlook#3: You think the share price is going to be stuck in a range for a while – a few months at least.

Well this is similar to outlook#2 above, but you will in fact be taking two bets. One that the market will not go up and one that it will not go down. With options, you can specify what range you expect the market to remain within over a certain time.

Looking at Rio again, we can place a bet that says the market will stay within $120 to $130 over the next month, or we can have less exact view of say $100 to $140.

Thinking back to concept of each bet having a certain cost and a certain payoff, you would say the $120-$130 bet should have a greater payoff than the $100-$140 bet. It is logical isn’t it? The $10 range bet has a smaller probability of being correct than the $40 range bet. If you are taking the best, you’ll need to be paid more for it.

Outlook#4: You are unsure about direction, but you feel the share price is set to break out and become much more active.

Well this is just the opposite of the previous outlook. We know you can take a bet that the market will stay in a range. You can instead take a bet that the market will not stay in a range. In fact, you are just standing on the opposite side of the transaction (or ‘trade’).

Now think about the costs of betting on a breakout from the $120 to $130 area compared to the $100 to $140 area. What one will cost more? It’s simple. It’s the $120 to $130 bet. Why? Because this bet has probabilities on its side. It has a better chance of making money than the $100-$140 bet.

Outlook#5, 6, 7, 8…

This list could go on and on, but you get the point by now. Options allow you so much more flexibility in the type of strategies you want to place.

This is the most important thing of all. You really need to spend some time teaching yourself a few things.

A good tip is not to waste any money on expensive seminars that claim to show you some type of secret and amazing technique. Start with a couple of good books and read them over a couple of times. Two good books are:

• Options: A Complete Guide. 2^nd Edition. Guy Bower

• Options Trading Strategies that Work. William Eng /Daryl Guppy

These two will cost you about $80 all up and if you read these a couple of times, chances are you will know more than most brokers and other traders. That’s a fact! After this, you will then consider choosing a broker, buying software, getting data etc. First things first however.

Conclusion

Hopefully this article has got you wondering ‘how?’. We have listed a few possible strategies: ‘you can make money from this or that’, but not talked about how to do it. Well learning about the mechanics is the next step.

From a general point of view, if there is one word we can use to describe options, it is flexible. Options give you the flexibility to take very specific or very vague views on the market and potentially profit from it.

How flexible are shares? You buy them and hope the go up or hope you get a nice dividend. That’s about it really… Options on the other hand open up a range of new strategies. These strategies all have varying degrees of risk and varying degrees of profit potential.

For the person that wants to take an active interest in their trading, options markets are ideal. Given their diversity, they can be suitable for the risk seeker or the risk adverse or anyone in between. It may take a little homework before you can be armed with all the strategies, but it can be a good bet to make.

While around for many decades, pivot points have grown in popularity since the 90’s with what has been an increasing focus on intraday trading. Pivots are derived from a simple calculation based only on the previous period’s data and are designed to provide traders with potential support and resistance levels for the coming session.

While pivots certainly do not fall into the ‘Holy Grail’ category, I have found them very useful for intraday trading, both as a signal for short term direction and as entry and exit levels.

This article will set out the calculation of pivots and some ideas on how to use them.

Calculation

For one sessions’ data (high, low and close), there are five calculations. The first is the mid pivot (MP):

MP = (H+L+C)/3

The MP is simply the average of the high(H), low(L) and close(C). From here four more levels (two support and two resistance) are derived from this figure:

As you can see from this calculation, pivot levels assume some sort of trend or correlation is readable from the previous session’s data. That is, after a bullish session, where the close is the nearer the high, the next day will hold a bias for further upside by way of higher pivot levels. Likewise for a bearish day (lower close = lower pivot levels).

Charting Pivots

When I first started using pivot points, it was a matter of tapping numbers into Excel and printing out a ‘daily levels’ sheet before the bonds opened. Then someone showed me how to program my Telerate Computrac (anyone remember that one?) and things became a little easier.

These days many software packages will have a pivot calculation built it. The way eSignal displays pivots is quite useful. Using Chart Options -> Formulas -> Pivots, you can display not just the different pivot levels, but pivots calculated over different time frames.

For example, you can show monthly pivots on a daily chart or daily pivots on a 60min chart. It’s really handy. At first, the five added lines on a chart can look like too much information, but it does not take long to get used to.

Different Time Frames

As implied above you can have pivots points calculated over one time frame (e.g. monthly high low and close) applied to another time frame (e.g. a daily chart). In fact, this is where you’ll get the most value from pivots, particularly daily pivots on intraday charts.

How To Use Pivots

The traditional application is to use the break of a session’s Mid Pivot as a directional signal then setting the first target as the Pivot High or Pivot Low, depending on the direction of the break. A continuation through this first level would then set the 2nd Pivot High/Low as the next target.

In these days of choppier intraday trading, the mid pivot is less significant and the 1st and 2nd pivot levels work best in range bound markets for selling strength or buying weakness.

Among those that use pivots, there are probably dozens or hundreds of trading rules and ideas. I’m not going to try to define all of these, but here are a few I have used:

A RANGE BOUND MARKET. Pivot levels can work as good targets and entry levels for buying weakness and selling strength. To find a good example, I didn’t have to look far. The first chart I pulled up was a 30 minute Dec S&P with daily pivot levels. There are several times throughout the one day where the market found support/resistance at pivot levels as shown below.

Back in 1998, I wrote an article about pivot points and I mentioned that the first pivot and mid pivot tends to be of most use in range bound markets. Judging from the above, that is still useful today.

TREND = GENERALLY BULLISH. 1st and 2nd Pivot Low levels are great for buying any intraday weakness in a market that is considered generally bullish. Allowing for a margin for error, setting buy levels a few points above and stops a few points below can offer a good rate of success with relatively low risk. Targets can then be set at the 1st or 2nd Pivot High levels.

Below is an example of Feb Gold in the middle on a bull market finding support at the 1st pivot low twice in one day.

TREND = GENERALLY BEARISH. As you’d expect, 1st and 2nd Pivot High levels are great for selling any intraday strength in a market that is considered generally bearish. Allowing for a margin for error, setting sell levels a few points below and stops a few points above a pivot can offer a good rate of success with relatively low risk. Targets can then be set at the 1st or 2nd Pivot Low levels.

TREND = STRONG BULLISH/BEARISH. When a market is moving in one way or another without taking a breath, you generally do not have the luxury of buying weakness (in a bull market)or selling strength (in a bear market). In these markets, pivots still have their use. Some use pivot levels as you would a breakout level. That is buy on a break of the Pivot High or sell on a break of the Pivot Low. Generally I have found less success with this method as it does rely on a market having one strong direction without a pullback. To each their own…

Other Pivot Trading Tips

• Determining the Trend. It’s common to use ADX or MACD to determine the direction of a trend. For using pivots at an intraday level however, a better idea is to use a shorter signal for a trend. Such as a break from an existing volume area or channel.
• Confluence. Try using pivot levels with other support/resistance calculations such as Fibonacci or psychological levels. A level will take on greater significance if it is backed up by another.
• After-Market. For those markets with electronic sessions along with floor trading (e.g. Globex markets), using the combined session data will result in more accurate or significant levels.
• Timeframe. Always keep an eye on the pivots levels from the next time frame up. That is, if you are trading intraday, use daily pivots. If you are trading off daily charts, use weekly or monthly pivots.
• The Good, the Bad and the Ugly. The best markets for using pivots are ones that have a decent amount of volatility. The worst markets are those that have either very low volatility or changing volatility. Using pivots in a fast market (extreme volatility) can be hazardous to your health – but you could say that for many trading methods out there.

Conclusion

Calculating pivot points is a method for estimating support and resistance levels and seems best suited to short term trading. The general interpretation of pivot levels however are not set in stone. Please feel free to experiment with pivot points either as a reference for target levels or as a potential signal of market trend.

The concept of hedging has always been a controversial one. There are some investors that would not enter the market without it. Then there are others that just do not see the point of hedging and that the whole exercise is just too expensive.

Before being able to develop an opinion however, one must know the options. That is, one must understand what hedging actually is. There are a greater range of hedging strategies out there than just selling futures or buying a put. Some strategies will have an outright cost, like buying a put. Other strategies may cost less but instead somehow limit your overall return.

You can see this in some capital guaranteed products in the market. Some capital guaranteed products will put a cap on your potential returns. That in essence can be considered the cost. Now as long as you are happy with this cap, then this type of product may suit you.

So too with options. That is, you can use options to place a stock or portfolio hedging strategy at the cost of capping your upside.

Most people are familiar with buying puts as a hedging strategy. The put works much like an insurance contract. Sometimes however (maybe even a lot of the time) this cost of insurance is too high. A hedging strategy that simply involves buying put options may turn out to cost more than it’s worth.

Buying puts however is not the only strategy around to protect your stock or total portfolio. This article will show you a very simple options strategy that can be used not only for a cheap speculative play, but as a low cost and effective hedge.

Let’s say you have a portfolio of German shares. Up until about late December, we have seen some pretty good gains as measured over the course of the year or even just the previous few months (see Figure 1).

After gains like these, it would be quite reasonable to build some protection against a fall in the market. One thing to consider is a hedging strategy using options.

Figure 1: shows the DAX Index. Some great gains over 2003 could leave the average investors thinking it may be time for a correction.

Source: eSignal (www.esignal.com)

Current volatility, while not at its lowest level, is still quite low and therefore the first option would be to look at buying puts. It is a simple strategy that when combined with a long position in shares give a payoff that looks like a long call.

How? What? Think about it. Long shares plus long put… Here you will make money if the market gains and your backside is protected if the market falls. That payoff is just like a long call option.

That strategy is a pretty simple one to get your head around. The put option works just like an insurance contract. For a cost of the premium, you have a certain amount of coverage.

To add a little complexity and fun to it we could look at selling a call with a strike above the current market level. Why? Well the put will cost money. It is the cost of insurance. If we sell a call as well, we will receive some premium which will pay for (or at least partly pay for) the cost of the put insurance.

However selling the call does not come for free. Selling the call has the effect of putting a cap on your share profits given a gain in the market. You see the short call will lose money if the market rises and the shares will make money if the market rises. The two offset each other at or above the call strike price. This is called a “cap”.

Now back to the put (don’t worry, we will explain all this with an example in a moment. For now think about the concept not numbers). The put will make money as the market falls. The shares will lose money as the market falls. Here, these two offset each other. Buying the put has created what is called a “floor”.

Together, the long put and the short call creates what is called a “collar” on the long share position. It simply means downside is fixed and upside is fixed. The point at which the floor or the cap cuts in are the respective strike prices chosen.

As a side point, if you have ever looked at the various warrants or structured products on the market with profit caps and/or stop loss guarantees, then maybe now you can see how the issuer creates them… Most of those complicated structured products can be broken down into optional components like a short call or a long put. That’s just a side point though. Back to the trade.

So let’s look at an example. Let’s say we have $100.000 in diversified shares. By “diversified”, it is meant these shares mimic the overall market index (the DAX Index) tick for tick. Given this, it is very easy to use index options to create the collar rather than the individual share options.

The first thing to do is consider the put option. How much protection do you want? Buying a put close to the current market value gives greater protection but will cost more. Further out-of-the-money options will be cheaper but this is because they offer less protection. So you must ask yourself how much protection you want.

To keep things simple, we will look at a timeframe (and options) with approximately three months to run. In this example, we will protect against a fall of more than 10% over this time.

Since we have a portfolio that is tied to the DAX, we can look directly at the index (it makes things much easier). The index is around 3900 and if we want to protect against a fall of more than 10% over the next month, it means we would have to buy 3500 puts (3500 is around 10.3% below 3900). At current put volatility levels, a three month 3500 puts costs around 59 index points (forget the euro cost for just a moment).

As for the call, here we really want to pay for all or part of the put purchase. We have the choice of the following prices:

Source: Eurex 19^th Dec 2003

Now we could look at selling the 4100. The premium received here would more than offset the cost of the put (no commissions considered). But remember this is where our profit would be capped, so 4100 might be a little close.

What about 4300? That gives us plenty of room for the market to gain and the shares to profit. The downside is the premium level. For 35pts, it does not quite cover the cost of the put.

So perhaps the 4200 call for 56pts would be the option the take. It would leave a net cost of 3pts for the total collar (59 less 56).

The Payoff

So what does our payoff look like? Well for a cost of 3pts, you have protected yourself for a fall below 3500 (10.2% or more). Note you are still subject to any smaller losses from the shares.

On the upside, you can still gain from the position but only so far as the market stays below 4200. If the market moves above this point, it does not really matter since the trade has capped your gains here (capped at around 300pts or 7.7%) for the month.

Figure 2: The DAX Index chart shows the cap and floor levels from the trading example.

Source: eSignal

Trading the Index

It is true you do not own the index. We have just assumed the portfolio matches the index so all the talk above has been on the index.

To equate things back to our $100.000 portfolio, we just have to work out how many contracts to trade and that’s pretty simple. Just divide the portfolio value by the put strike multiplied by the put option point value. Eurex DAX options have a point value of 5 euro, so the number of contracts needed would be:

= 5.7 (round to 6 contracts)

So we would buy six 3500 puts and sell six 4200 calls. Now assuming we can get filled at the above prices (which may or may not be the case), we could place this strategy at a 3pt debit since calls are worth 3pts less than the puts. Over six contracts, this equates to 18pts or 90 euro plus commissions.

The way to think about this trade is to consider the cost of the six puts by itself 59pts or 1770 euro (6 contracts times 5 euro times 3pts). That is the cost of put insurance. Adding the short call cut this cost down to 90 euro but at the expense of capping profits at 7.7% for the three months. Is that worth it? Maybe, maybe not. The question of hedging or not hedging comes down to individual choice.

The strategy is good one once you understand what it costs. The true cost is in the profit cap. If you are happy with this cap over the life of the options, then the strategy will make sense.

This article shows just one possible hedging strategy. The great thing about options is you can create pretty much any risk profile you like with a combination of positions. The key to remember is you get what you pay for. Like any type of insurance, the greater the hedge the more it will cost.

When you hire a car, you pay a deposit. When you take out a home loan, it is normally secured by a mortgage. Why do you have to do this? It is because there is a liability that may have to be covered. You might smash the rental car or you might be unable to meet your loan repayments.

Futures and options trading is no different. Buying or selling futures or selling options leaves you open to a liability. Given this, the exchange clearing house and your broker will take measures to ensure you are able to meet your financial requirements, should the position move against you.

There are a number of different methods of covering this liability, depending on the underlying asset itself and the exchange on which it is traded. The requirements may differ from exchange to exchange but generally speaking, a holder of a futures contract or a short option will be required to lodge and maintain a deposit called a “margin”.

A margin is like a deposit that is revalued every day, based on specific risk calculations. If for example you are short out-of-the-money call options and the market kept moving against you, your daily margin would increase.

Generally speaking, the clearing house of the exchange will set the deposit or margin required for futures or short options but in most countries, a broker has the right to increase the requirements for one or all of its clients.

Before trading in a certain market you should speak with your broker and check out the exchange website regarding requirements for trading in short options.

For future options, just remember that a margin can never get any great than the corresponding futures margin since the delta (risk) of an option can never be greater than 1.0. However, it is your mark-to-market valuation that can cause problems if the market is going against you.

You can think of a margin as a measure of your risk at a single point in time, but not a measure of your total risk moving forward.

There are two parts to this question:

1. How much capital should you commit?
2. How many contracts should you trade?

1. Capital to commit

Futures and options trading is far from a risk-free pursuit. Careful consideration, therefore, must be given to how much of your total purse to put towards derivatives trading.

Risk adverse logic tells you the less, the better for the beginner. It all comes down to your aversion to risk. Those who find it hard to sleep while positions are open should not risk very much (in fact, they should probably not be trading in the first place). Those who can place a position and have the confidence that it is under control can afford to risk a little more. Many think 10 to 20 per cent of your total investment pool is an ideal place to start.

The correct answer differs from one person to the next.

2. Contracts to trade

There is also the issue of how much of your trading stake to risk on any one trade. If you read Market Wizards: Interviews with Top Traders by Jack Schwager, you will see the majority of successful traders interviewed suggest no more than 5 per cent of your money should be risked on any one trade. This 5 per cent refers to your stop-loss level, not the theoretical risk of the trade (since some strategies have theoretically unlimited risk).

Whatever you decide to place on any one trade, keep this in mind: use small amounts when you first start, since this is when you will make the most mistakes.

The most common approach to money management is the Percent at Risk method and this is best explained by example. Let’s say you have an account size of $50,000 and want to risk no more than 10% ($5,000) on any one trade.

You’ll need to make an estimate of your maximum risk on anyone trade. Let’s say it is $2,500. This means you can trade just two contracts ($5,000 / $2,500). If your stop levels are tighter and prefer to risk only $1000, you can trade 5 contracts ($5,000 / $1,000).

It is a relatively simple method but is actually quite common.

To be fair the subject of money management is a large one. Entire books have been written on the subject. It is a fascinating area, particularly for those that like reading about numbers. Two great books on the subject are:

Trade Your Way to Financial Freedom by Van Tharp
and
Portfolio Management Formulas by Ralph Vince

A concern for the available supply of higher quality coffee from both Colombia and Brazil along with the potential for a flow of more money from fund traders to commodity markets leaves the outlook for coffee into early next year bullish. Colombia growers believe that exports of coffee for 2009 will reach just 8.1 million bags, down 27% from last year. Production is expected to recover for the coming season, but the recovery is coming much slower than expected and disease issues are still a concern. Continued talk that the Brazil crop this year received too much rain during the normally dry harvest period, which resulted in up to 40% of the crop slipping to a lower quality grade has also lent support to prices. As a result, the supply of higher quality coffee is tightening into 2010, and up to 3 million bags of the Brazil harvest may move into government storage. Brazil exported 2.439 million bags of coffee in November compared with 2.396 in October and 2.857 million bags a year ago. A tighter supply from producing countries is beginning to provide solid underlying support to the market, and if we begin to see tightening supply from consuming countries, the market may see the need for pushing to a higher price level.

The trade has seen the outlook for a bumper crop out of Brazil next year as a major obstacle to moving higher, but the first production outlook from Brazil last week may have eased this concern. While the region has seen regular and consistent rains during the flowering period of the past few months, the Brazilian crop estimate came in last week at near 44 million bags, down form trade estimates that had been running from 45 million to as high as 55 million bags. While the official Brazilian government production estimate typically comes in below trade estimates by 3-4 million, the new government estimate is still well below the trade forecast, and this may provide a solid base of support for the market into early next year. US ICE certified exchange stocks have declined in recent months to their lowest level since February of 2003, to reach just 3.18 million bags at the end of November. Coffee stocks in Japan at the end of October totaled 111,477 tonnes, which was down from 123,127 in September and down from 131,542 tonnes in August. While stocks at key consuming countries are still considered relatively high, the downtrend in supply is still a positive force, and this may provide some underlying support.

If you’d like to receive daily information on the coffee market, click here.

Trading Strategies:

* Buy March coffee at 140.55 with an objective of 152.05. Risk to a close under 138.75.
* Buy the May coffee 145.00/160.00 bull call spread from 490 with an objective of 945. Risk 120 points from entry.

If you’d like to further discuss these strategies to determine the best execution strategy for you, contact Daniels Trading.

About Daniels Trading

Daniels Trading is a relationship-focused commodity futures brokerage located in the heart of Chicago’s financial district. Founded in 1995, they have a history of providing effective and reliable trade executions to both individual traders and institutional investors around the globe. In addition to a focus on relationship and execution, Daniels Trading is a leader in providing ongoing education opportunities and resources for customers.

Google Shortcut link: Once you have created your iGoogle page, simply click this Google link to populate your iGoogle page with some selected news feeds. That’s easy!

The one I have designed looks like this:

One thing I like about the toolbar is many of the features will display in a drop down box, rather than directing to a new window, so it’s quick and easy to use. The Bloomberg podcast window below is a good example.

INSTALLATION
It’s easy to install (and uninstall). Just go here:
http://guybowercom.ourtoolbar.com/

CUSTOMISE Once installed, you can customise the buttons to your heart’s content. There is news, games, internet radio even movie players. Once installed, just click on the + sign on the right of the toolbar. By the way, the feature I like the best is the internet radio – and yes I listen to the BBC!

Go forth and enjoy…

DESKTOP ALERTS and GENERAL SETTINGS

The application I used to build this toolbar also has the ability to send desktop alerts. Once a few people download it, I’ll trial sending a few alerts re page updates (not spam stuff). Please let me know what you think. I’ll only continue with it if people enjoy it and let me know. At this stage, I can’t see it being that popular, but you never know.

By the way, you can change your alert preferences by clicking on the left side icon on the toolbar and selecting Toolbar Options.

-GB

http://guybower.com/?p=812

Of course, all things are not equal in terms of 2009/10 demand, and ethanol may turn into the real change factor. This was signaled by the latest monthly report on ethanol production from the Energy Information Administration. The EIA showed a surge in ethanol production in July to record levels. This implied actual corn usage of a record 347 million bushels that month. If this high rate of usage continued into August, it would have added 60 million bushels to the USDA’s previous projection of 3.675 billion bushels for ethanol use during the 2008/09 crop year. (EIA reports lag by two months.)

The USDA’s September 1st Stocks-in-All-Positions report seemed to confirm that this is exactly what occurred. The report pegged stocks at about 45 million bushels below trade expectations but slower feed usage by about 15-20 million accounts for the usage.

The accompanying charts show the monthly corn-for-ethanol usage rate along with the monthly rate of production for ethanol itself. The latter chart highlights the sharp uptrend in US ethanol production in recent years, and this is where the real change in demand for 2009/10 is likely to come. This starts with the latest USDA September projection for 2009/10 corn ethanol usage at 4.2 billion bushels. The big July corn-for-ethanol usage number we mentioned earlier has already reached to very near the average monthly rate needed to meet the 4.2 billion bushel usage projection for all of 2009/10. This means that if ethanol production were to flatline at the July level for the following 13 months, we would come in near the 4.2 billion ethanol usage projection. However, the steep long term uptrend in actual ethanol production shown on the second chart makes that scenario seem highly unlikely. It is far more likely that this uptrend will continue into 2009/10, resulting in much higher than expected corn-for-ethanol usage. (Note to readers: the USDA released its Crop Report and Supply/Demand reports on October 9th, after we went to press.)

Some analysts have already bumped their corn usage numbers for ethanol to as high as 4.6 billion bushels for 2009/10. This is considered high at present, but we would not rule out a number that high or even higher when all is said and done. US ethanol capacity is already far above that level, and some traders are talking about possible US ethanol exports to India and Europe. In addition, the allowed blending rate might increase, which could increase ethanol demand even further.

If we do see a loss of 100-150 million bushels of corn from a freeze on Oct 9-11 and we add another 200-400 million bushels (or more) in ethanol usage for 2009/10, this could push 2009/10 ending corn stocks down near 1.1 billion bushels. That is very manageable and could easily support a price of over $4 in the nearby corn contract in 2010. If this comes in conjunction with a continued slide in the dollar and the inflationary surge that so many Americans fear, the pace of imports could also surge as buyers around the world try to stay ahead of the next wave of food inflation.

Suggested Trading Strategies:

* Buy March corn/sell March wheat at 125 1/2 cents or better premium the wheat with an objective of 75 cents premium wheat. Risk 19 cents on the trade.

* Buy March corn futures at 352 1/2 with an objective of 415. Risk the trade to a close below 333.

If you’d like to further discuss these strategies to determine the best execution strategy for you, contact Daniels Trading.

Courtesy of:

About Daniels Trading

Daniels Trading is a relationship-focused commodity futures brokerage located in the heart of Chicago’s financial district. Founded in 1995, they have a history of providing effective and reliable trade executions to both individual traders and institutional investors around the globe. In addition to a focus on relationship and execution, Daniels Trading is a leader in providing ongoing education opportunities and resources for customers.

Just a quick question: do you see a specific amount in an account to make this type of trade viable? Is it $5,000 or closer to say $50,000? And what is the margin for these contracts? I see in your performance section an allocation could be $20,000. What would a margin be for this?
Thanks, B

Answer:
Re finding the right thing to trade, what I do is a niche within a niche. Not just futures, but futures spreads. It scares some people off since it appears it has that extra level of complexity. The reality is different. This stuff is far easier to learn than options for example. Regarding risk, it’s always there, but I cannot remember ever seeing anyone get into a major problem with a futures spread.

Regarding how much to start trading with, I think that’s another age old question. Margin is normally a small fraction of the allocation level. In fact it is more often an insignificant issue. Take for instance, a Eurodollar spread entered this week. Allocation was 1 contract per $25,000, but margin is just a few hundred dollars.

The allocations posted on in my newsletter are guidelines. I’ve always taken the approach people should do what make them comfortable, (or as close to comfortable as possible). I recently had a conversation with another trader on a blog where he has recommended trading one spread per $1,000. I honestly thought it was a typo and he meant $10,000, but he really meant $1,000. I think $1,000 is far too risky, but $10,000 or $20,000 given you enough margin coverage and stop loss breathing space as well as not taking on too much risk.

Regards,
GB

Question:
Dear Guy. Great video on iGoogle [this one]. I noticed on your page you had a link to a few stock quote gadgets. They seem like a great idea. Would you mind supplying the links to those?

Answer:
Thanks for the feedback. Yes the iGoogle thing is fantastic. It’s amazing how much you can get for free. Here is the link for quote gadget: click.

And here are a couple of other interesting ones:
News and charts: here

ASX quotes: here

Portfolio quotes: here

You can also just search general finance gadgets here.

Another one that I use, and it has nothing to do with finance, is a ‘to do list’. I actually came across this while putting together the video. For me, it’s more useful that outlook calendar and my whiteboard. I found it here.

Regards,
GB

The 200-day moving average is often used as a market barometer. You’ll read something like “XYZ has broken its 200-day average” or “so-and-so is above the 200-day average”.

With that in mind, it was interesting to read that since the 1930’s there have been only four occasions when the S&P moved from more than 20 percent below the average to 20 percent above within one year. It happened twice in the 1930s, once in the 1970s and has happened now. All four were during bear markets – and a move lower followed.

The first three occurrences were followed by a weaker market 1-6 months later but a strong market one year later.

Take a look at the current chart.

At the March low, the market was about 36 percent below the average. As at the high a few days back, it is close to 20 percent above. This has happened all in the space of above six months. Interesting times lay ahead…

A: This question is based on a misunderstanding of the mechanics of futures and options trading.

Options:
With options, including options on futures, you pay a “premium” when you buy an option and receive the premium when you sell an option.

If you pay 10 cents for an option that 10 cents is debited from your trading account. If you sell an option for 15 cents, that 15 cents is credited to your account.

Taking the example further, suppose these two options make up a spread. That is, you buy one option for 10 cents and sell a different option for 15 cents. The net amount (5 cents) is credited to your account.

Futures:
For futures contracts, it’s different. The price paid or received in a transaction is not actually debited or credited from/to your account. All that applies is a margin deposit. This goes for both single positions and spreads.

For example, suppose we have Dec Wheat at 450 and March Wheat at 470.

If you buy Dec Wheat at 450, you don’t actually fork out the contract value of 450 cents per bushel. Likewise if you sell short the March contract at 470, you do not receive 470 cents per bushel in your hand.

With futures you are entering into an agreement to buy or sell. You do not pay the full amount. You are instead subject to a small margin deposit.

Let’s take the example further. Suppose you enter into a spread whereby you buy the Dec contract at 450 and sell the March contract at 470. The ‘spread price’ is therefore a credit of 20 cents. That credit is not credited to your account. The futures contracts are just agreements, not a transaction where the net debit/credit is transferred.

An Analogy:

Hmmm, I don’t want to confuse the issue here, but here is an analogy. Suppose you are on the way home from work and pass the local Virgin Megastore. You see Tropic Thunder II: Grossman’s Revenge is coming out on DVD next week and you want to make sure you get the first copy.

Unfortunately you do not have the full $20 in your pocket to pre pay the entire cost of the DVD, but the store manager offers you one of two deals.

Deal 1 – the manager says pay him one non-refundable dollar now for the right to come back any time this month and pay $20 for the DVD. Even if prices rise, all you pays is $20 (plus the original dollar) to buy the DVD. You don’t have to come back to buy the DVD, but if you don’t, you lose the dollar.

Deal 2 – The manager say pay him a dollar deposit now on the promise you will come back and buy the DVD. He says the dollar deposit is refundable against the purchase, but you must make the purchase.

Deal 1 is an option contract and the dollar is the premium paid. Deal 2 is a futures contract and the dollar deposit is a margin.

The difference between the two is not only a right (option) versus an obligation (futures), but the flow of funds. Deal 1 (the option) was a payment whereas Deal 2 (the futures) was a deposit.

This analogy is not perfect, but it does get the point across.

Note for both futures and futures options, relevant margins and mark to market adjustments also apply, but that’s another conversation.

In this video I show you how to set up an ‘iGoogle’ page as your homepage and use RSS feeds to give you the info you want from multiple websites all in one place. It’s pretty easy to set up and it’s free. Plus it is simply a fantastic tool. The video is best viewed on a full screen setting.

Note, if you are a current subscriber to the PTD newsletter, I’ll even set this up your iGoogle page for you for free. Just email and let me know.

As mentioned in the video below is a list of RSS feed addresses for building your iGoogle page. If you have no idea what an RSS feed is, just watch the video…

Recommended Feeds

Essential

GuyBower.com – Futures & options blog updates:

http://guybower.com/?feed=rss2

PTD Newsletter Headlines:

http://www.protraderdigest.com/feed.rdf

Guy Bower’s Twitter feed – includes business and commodity market news:

http://twitter.com/statuses/user_timeline/16859833.rss

Business News

Reuters Business News:

http://feeds.reuters.com/reuters/businessnews?format=xml

CNN Business news:

http://rss.cnn.com/rss/edition_business.rss

Market Stuff

Reuters Commodity Corner Blog:

http://blogs.reuters.com/commodity-corner/feed/

Pit Guru – Weekly Market Reports:

http://www.pitguru.com/article-rss.aspx?channel=all

Futures Portal:

http://feeds.feedburner.com/futuresportal?format=xml

IBTimes Commodity News:

http://www.ibtimes.com/rss/feed/commodities.rss

MarketWatch.com – Market Pulse:

http://feeds.marketwatch.com/marketwatch/marketpulse

General Interest

The Art of Nonconformity:

http://chrisguillebeau.com/3×5/feed/

Reuters Weird News (just a good fun read):

http://rss.feedsportal.com/feed/metro/2

Others

Other items such as market quotes can be found by following the “Add Stuff>>” link on the iGoogle page. Also, just remember you can grab feeds from any website that has RSS functionality. Just look for the RSS link or the RSS symbol.

We have a new staff member! Harvey, the red toy poodle, is being groomed to monitor a few special markets such as pork bellies and chicken neck futures. Harvey is welcomed by his brothers Gucci and Reno.

Trading with Optimal f
The mathematics of this system has its roots in solving the problem of interference in data transmission over telephone lines – truly. However the system was adopted for gambling and then again for trading futures.

Optimal f refers to the mathematically optimal fixed fraction of total equity that is allocated to any one trade. The optimal fraction is defined at the one that offers the maximum long term growth of equity.

This is really no different than the previous version except we have mathematically determined the figure with will produce the best long term profits.

For trading systems, the mathematics of Optimal f simply takes into account system parameters as defined by your past results or hypothetical results and returns a figure that represent the dollars in your account that should represent one contract.

Now the formula itself is just a little to detailed to list here. For those wanting to head down this path I strongly recommend Ralph Vince’s first book Portfolio Management Formulas. It is heavy on the maths, but the proof is very convincing!

Playing with coins
The Optimal f formula will return a decimal that represent the fraction of the total equity. To then come to the amount to trade, you divide the largest loss by this fraction.

In our coin example, the optimal f is 0.25. The largest loss as we know is $1.00:

$1.00 / 0.25 = 4

Therefore we would be one unit (dollars) every $4.00. This is the figure that without question offers the best long term growth given the payoff levels ($2 profit and $1 loss) and probability (50% for each).

The same goes for more complex futures trading systems where you have a measurable string of profit and losses. You can use the Optimal f calculation to determine the fixed fraction position size that would have resulted in maximum equity growth given those parameters.

The Proof Is In The Tossing
So how much advantage does Optimal f give you? Is it really worth learning the maths? Would it just be OK to make a rough guess at the optimal faction and trade that way?

Well, the numbers are nothing short of astounding. Let’s say we give three traders a bankroll of $100,000 each and have them trade a fixed fraction of equity.

For some reason the first three names that have popped into my head are Peter, Paul and Mary – so we will use those. Peter is conservative and bets 10%. Paul has done some homework and knows to bet 25%. Mary arbitrarily chooses 40% – thinking “it’s only risking less than half” of my money and that’s not too bad”.

If we simulate using alternating returns (profit, loss, profit, loss…etc), then after 50 trades we would have the following equity curves:

Part 1 – Chapter 11 – Introduction to Money Management

If you have read Jack Schwager’s book Market Wizards you will recall that all traders each had their own way of trading; their own experiences; their own philosophies and their own outlook. One common theme among them all however seemed to be their reliance on what they called “money management”.

When I read the first book in 1990, I had no idea what money management actually was. Was it making sure your stops are in place? Was it just being careful with your cash? What was it?

Money management in this context refers to what a gambler might call bet sizing. It is how many contracts or shares to trade on a certain strategy given a certain bankroll.

Now in my experience with retail investors, this is normally an arbitrary consideration. One contract, five contracts, ten contracts – whatever you can afford really. I have known traders that spend countless hours per day studying Gann or testing indicators or drawing little lines all over their charts. But when it came to placing the bet, there appeared no consideration to the position size.

I even had someone say to me “it doesn’t matter how much you bet as long as it’s a good trade”.

This article uses a really simple example to help explain why this thinking is incorrect. Suppose you are invited to play a coin toss game. Tossing heads means you win two units and a tails means you lose one unit. Suppose you were given $4 as a starting bank roll and you can bet as much of as little as you like and play the game many times over.

Now it is clear the odds are stacked in your favour. $2 for a win versus $1 for a loss. That’s a “good trade”. But how much do you bet? Well there are a number of ways to approach this one. We will look at three:

• Fixed dollar
• Percent at risk
• Optimal fixed fraction

Fixed Dollar Amount

This is an arbitrary decision of placing one bet (or trading one contract) for a fixed amount of account equity. It is probably the simplest and for that reason, most common money management technique.

In the coin toss example, we would for example place one bet every $2.00 in the account. So in this case we would win $4.00 or lose $2.00 on the first toss. Based on the outcome, we would then adjust the amount bet, but still keep it at one bet per $2.00 equity.

When trading futures, this is the same as trading one contract per $XXX in your account. The downside in trading multiple futures markets is this technique does not address the unique characteristics of each market with respect to your system.

For example, trading one contract per $5,000 in Eurodollars is probably rather conservative. In contrast, trading one contract per $5,000 in Nasdaq futures would just be ridiculously risky.

Additionally, this method does not distinguish between a volatile trading system and nice and steady one. A volatile system should trade fewer contracts than a more steady system to reduce the risk of going broke. The Fixed Dollar method does not address this issue.

Percent at risk method

The next most common and quite a sensible approach to money management is to risk only a fixed percentage of your capital on any one bet or trade.

In the coin toss it would mean picking a percentage loss you are comfortable with and betting that proportion of capital each and every bet. You might for example be willing to risk 10% of your capital each and every bet. Given six alternating outcomes, your equity would look like this:

The advantage with this method is your bet size and potentially equity grows at a steadier pace.

Looking at futures, let’s say you have a trading system in the S&P where you run with $200 stops. Giving a small allowance for slippage and comms, let’s say the worst outcome is a loss of $300 per contract on a trade.

With the percent at risk method you trade a certain number of contracts that would make your maximum loss no more than a fixed percentage. If you are trading with a bankroll of say $100,000, and wish to risk not more than 5% of that value on any one trade, then you take 5% of $100,000 or $5,000. Then divide this by $300 and you get:

(5% * $100,000) / $300 = 16.7 contracts

So with this system and method, you would trade 16 contracts (rounded down from 16.7).

In the Market Wizards books, many of the traders said they would risk anywhere from 1% to 5% of capital on any one trade. So there is some suggestion that this is the method many of them have used.

The first and obvious disadvantage of this method is having to round up or down on contract amounts. This has particular impact on smaller equity amounts.

The real negative of this method is that most people would pick a percentage based on their risk preferences, but that is not necessarily the best percentage of the system being traded.

Think about it. If we have a mechanical system where we can define things like maximum loss and probability or frequency of loss, then surely there must be some type of mathematical method of working out the optimal amount to risk.

Well there is! It is called the Optimal f or Optional fixed fraction trading. That article comes next week!

That article spoke about how markets, like people, can panic and do silly things. We saw how Lean Hog futures sold-off on the break of the initial Flu reports and how once things settled, the market settled too.

The article also showed how the spread between distant Hog futures (December expiry) and nearby Hog futures (August expiry) traded relative to each other. In time of panic you would generally see the nearer month contract react more and therefore creating a ‘spread trading’ opportunity.

As it turns out, it’s been a terrible time to trade individual Hog futures, but a great time to trade the spreads. I am writing this short article to illustrate the advantages of trading spreads over individual futures.

OK, so let’s look at the August contract.

Point 1 shows the sell-off when the news hit. Point 2 shows the two weeks where the market recovered and let us think it was all over. Point 3 and beyond is where the market fell to pieces. That’s a tricky market to trade by anyone’s standards (without hindsight that is).

Trading in the December contract has been even more choppy.

Again, Point 1 shows the initial news. Point 2 shows a recovery to back above where the market was before the news. Point 3 was a sell off. Since then there has been just a choppy state of confusion. Perhaps some of this could be seen as logical after the fact, but at the time, it would be too choppy to trade.

So then, what do you think Hogs spreads look like? By ‘spreads’, I mean the price difference between the near expiry and distant expiries. In this case, let’s look at the December versus the August contract.

From the above charts, you might guess the spread prices have also been choppy and confusing. Truth is the opposite has happened. Look at the chart below.

Point 1 shows where the news broke. The subsequent move has been a pretty much uninterrupted bull market.

As I pointed out in the previous article, this spread started to turn from lows BEFORE the Swine Flu news broke. In fact, some technical traders out there would be long the spread purely for that reason alone.

The really exciting thing about this chart is it shows how near perfect this bull trend has been. The last few days have seen a runaway market but apart from that, it’s been a rather steady bull market. Bottom line is it has been heading in one direction, not chopping about. Herein lays the one of the great advantages of trading spreads.

Spreads often have less ‘noise’ or confusing volatility. As a result spreads are often more predictable.

When newcomers enter the market, they often look for the simplest instrument to trade and often get chopped up in the process.

Wouldn’t it make more sense to start with a trading method that gives you a better chance of winning? In my view that is what spreads offer.

]]> http://guybower.com/?feed=rss2&p=49 0 http://guybower.com/?p=48 http://guybower.com/?p=48#comments Tue, 09 Jun 2009 15:41:00 +0000 GB http://guybower.wordpress.com/2009/06/09/qa-on-trading-risks-in-futures-trading/ I recently saw the following post on an investment forum. I thought it would be an interesting topic for my newsletter. So here is my long answer:

Question: Is the risk factor of investing in commodity futures greater or lesser than that in funds?

Answer: Generally speaking the risk of trading futures is greater than investing in funds. I stress the word “generally” here as futures are not riskier all of the time.

Consider trading in futures versus investing in Madoff’s fund. Before the scandal broke, pretty much anyone would agree investing in futures would be riskier. In hindsight of course, the opposite is true.

Scandal and fraud aside, there is the issue of control. With trading futures (or actively managing your own investments of any type), you have control of what you money is doing. One reason I have never been a fan of managed funds is you really have no idea what the individual manager is (or managers are) actually doing day to day, except maybe in hindsight.

If you are invested in a fund, your money is also at risk of key staff leaving or taking leave. All funds will have ways of dealing with this, but it is still a risk to the investor.

With futures you know where you money is at all time because you control it.

Another issue is flexibility. With futures you are free to buy and sell whenever the market is open. This way you can adjust you market exposure virtually instantaneously. Some funds have limitations on when you can take your money out, waiting periods and so on. Not having flexibility is a risk.

Another point relating to risk of futures trading is that risk is very much dependant on how you go about trading futures. A statistic you’ll often hear in book on futures is 80 to 90 percent of people lose trading futures.

I cannot say whether or not that number is true, but in my own past as a broker, trader and adviser, I have seen a lot of people lose money because they approach trading without a plan or without the right information.

I have never flown a helicopter and I bet if I tried without the proper lessons and tools, it would be a short lived hobby. The same goes with trying anything new including trading futures. You need the right tools and the right approach.

What tools and what approach? The answers to these vary from person to person. I started out trading outright futures positions, and then I moved into options. I’ve even written a few books about options trading. I love the flexibility of trading options. You can create any type of position you like once you know how to.

I also trade futures ‘spreads’. That is, I trade the value of one futures contract versus the other based on certain information. I have found this style of trading to be significantly less risky than trading outright positions. Plus it is in fact one of the more reliable trading methods I have come across.

Regards,
Guy Bower

Here is an interesting article on how Coffee is trading relative to the US Dollar right now. It also stands to illustrate a benefit of trading spreads versus outright long or short positions.

Full article here

-GB

Answer: To answer the second question first – no it’s not always simple. Anyone that tells you they have a trading method that is fool proof is either a fool or a liar. This is why you need to get good information.

There are times when any trading method works well and other times when it does not. Seasonal trading is no different. 2008 year was a great year for seasonal trading. 2007 was not so good for seasonal trading but 2006, 2008 and 2009 (so far) has been terrific.

So, how reliable is seasonal data? The data I use goes back as far as 25 years and looks for high correlation patterns – patterns that appear to be reliable. In fact normally I look for trades that show a strike rate of at least 80%. Sometimes the trades I look at have a historical strike rate of 100%. But that is the past. That is no guarantee that the trade will work tomorrow. What is guaranteed is that all trades are based off sound historical data and reasoning that offer a higher probability of success.

Pick up Market Wizards or any other similar book and the traders will tell you short term trading success ebbs and flows, but the key is to have a sound trading method with respect for risk as this will win in the long run.

Answer: The concept of being long or short a spread relates to how a spread is quoted or displayed on a chart.

I have recently been following a spread in US Treasury note futures, specifically the spread between the December 10yr note and the December 5yr note.

On the following chart, the spread is shown as the 5yr price minus the 10yr price. Generally speaking, this is how the spread between the two is shown – it is the 5yr contract minus the 10yr contract.

To go long the spread would involve buying the first contract and selling the second. In this instance it would mean buying the 5yr note and selling the 10yr note. In this case you would make money from an increase in the spread – hence you are “long the spread”.

To go short the spread, you would sell the first contract and buy the second. That is, sell the 5yrs and buy the 10yrs – making money from a fall in the spread. You would be “short the spread”.

All in all, terms such as going long, going short, narrowing, widening etc are just that – terms. They can confuse at first but learning them is helpful when reading up on trading ideas. There is no rocket science though. Most terms describe pretty simple concepts.

The way I write the ProTrader Digest newsletter is so the subscriber learns these things as we go along. It is not a black box trading system. Concepts and terms are explained and a subscription comes with as much support as you need.

-Guy Bower

I could not have put it better myself.
-GB

Look, I am still not sure about this Twitter thing. I started a page some time ago, followed a few interesting people and companies, posted a few updates of my own – and still felt rather empty. Just because Ashton and Demi ‘tweet’, does it mean all of us have to?

If you are not familiar with the Twitter concept, here is the basic idea: it is a website where you update your latest thoughts and activities. You can also follow what others are saying. I for example am following the CBOT, the CBOE, Governor Schwarzenegger, CNN, Eddie Izzard, BBC, Jimmy Fallon, Jack Welch and the Whitehouse among others. Updates are no longer than a SMS message.

I’m not sure when the site started, but the concept has become very popular in the last year or so. Given its critical mass, it’s now a great way to keep in touch with businesses, your friends and even your kids or grandkids (ask them, I bet they know all about it).

Perhaps there is something in the water, but today I decided to rehash my Twitter page. Wearing my serious face, I deleted my old tweets and have started afresh. Along with general ramblings, I’ll be posting daily trading tips.

If you are new to it all, have a look at www.twitter.com. Look for people or things you may be interested in. I think it only works if you follow a dozen or more interests.

If you are already on Twitter, follow me (www.twitter.com/guybower). Also feel free to tell me what you’d like to see there.

On a trip to the CME floor just a few days after the initial news, I had some interesting conversations with a few traders in the Lean Hogs pit. Most of the initial news hit the market on the weekend of the 25th and 26th or May, so on return to trading Monday, the markets gapped sharply lower. The trading day caught a lot of people out and those that tried to cover positions didn’t do too well.

Remember all the hype on the news at the time? Pandemic? Epidemic? If we listened to the news, particularly the US news, no one was safe. But those media producers know what will sell. For example, which headline below do you think will attract more attention?

Markets, like people react to these things too. People overreact and markets overreact. Here is what happened in the pit for the August and December contracts that day.

If you were long going into this trading session, you were in trouble. Getting fills on days like this, particularly if you scrambling to cover a losing position is very hard. Volume did increase on this day, but it was a tough day in the pits.

So how to do you make money from movement like this? I’ll get to that, but first let’s look at how/why each contract moved.

From Friday close to Monday close, the August contract fell 2.975pts. The fall in the Dec contract was not as severe, losing 2.40pts.

Both contracts fell as worries about the “swine” flu may have meant a drop in demand for pork products – that’s common sense when you think about it. But why didn’t they each move by the same amount? The nearer contract fell further that the Dec one because the market saw a higher chance of the flu having a temporary impact as opposed to a prolonged one.

Again, this is a common sense concept or at least a fair bet. It’s a fair bet that someone would work out how to contain or resolve the problem pretty quickly (despite what the media said).

The next few days
Remember that “sell fear, buy reality” idea? Have a look at how the market traded in the days subsequent to the initial news. Below is the Dec contract. The worst day of “fear” was the Tuesday. Then as people and media calmed down, the market not only returned to where it was before the news, it moved higher. So much for a pandemic, huh?

As for the August contract, than one rallied too, but not as much (for the same reason the market fell further to start with).

OK, so let’s get back to the question on how to make money from news like this? One way is to just trade the futures contracts outright. Go short into fear, go long when things begin to settle. The problem with that however is the volatility. It’s not difficult to manage if you can afford to sit in front of the screen all day. Without constant monitoring, you can get squeezed pretty bad.

An alternative to trading outright futures contracts is the trade the spread price between the two. That’s what most floor traders I have spoken with including those in the Hogs pit do. It’s also what the ProTrader Digest shows you how to do.

Along with far lower margin deposit rates, the benefits are lower volatility in your trading and a trading style that is less reliant to exact to the minute timing. In other words, it’s easier to make money – at least that is my opinion and experience.

Remember how volatile the outright contracts were in the above discussion? Now take a look at the spread price between the August and Dec contract.

The chart shows the December price less the August price. You can buy this spread by buying the December contract and selling the August one.

Just by looking at this chart, you can see trading the spread is a more sensible way of doing things. You can also understand why many floor traders prefer spreads.

For the technical traders out there, spread trading can offer more predictable trends and simple signals. Just look at the above spread chart, several indicators including.

In a way, you could think of it as a smarter way to trade the markets. It’s interesting to see many new subscribers to the ProTrader Digest are new to futures trading. Most have traded stocks and maybe some FX, but not futures.

At first spread trading may seem a little difficult, but recent action in the Hogs pit shows there is a lot of logic to it. The trading ideas posted on the ProTrader Digest site not only explain the statistics behind the trade, but the logic also. It means you learn as you go and feel comfortable with what you are doing.

Not only that, the trades posted to date have shown pretty impressive results. Click here for complete trades and performance details.

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Go to: www.ProTraderDigest.com.