Tuesday, August 26, 2008

Commodity Trading Basics: Going Long vs. Going Short

Rule number one in trading commodity futures: You have to realize that trading is a zero-sum game. For every winner, there is a loser. Think about it: You’re on one side of the trade, and if it’s going well, you’re making money. At the same time, the person who is opposite your trade (they’re short if you’re long or they’re long if you’re short) is losing money as fast as you’re making it. Although this sounds harsh and pretty cut-and-dry, it is what it is. If you have any feelings of guilt or remorse about the fact that while you’re making money there is someone else simultaneously losing money, you might want to consider another field of endeavor besides commodity futures trading. There are exceptions to this, however, such as when people are trading spreads and so forth (a whole other topic to get into), so there are times when it’s simply considered part of the expense of trading. For instance, if I wanted to enter the Copper market and go long, I might buy a put option with a strike price that’s at or near my entry price, and use it as a hedge just in case the market moves against me early on. Let’s say that the market completely takes off, and my put option expires completely worthless…not a problem, I’m making money due to the long futures contract, and the put option was there for “insurance purposes” anyway; any losses sustained from the put option will (hopefully) be offset by the gains in the futures contract. Well, the guy that wrote the put (the person who is opposite my position) will be happy, because he was able to collect the full premium that I paid for that option, being that it expired worthless, and I’m happy too, because I have just racked up some serious profits on the long side of Copper. We both win. So, in cases like this, the “zero-sum” rule is somewhat subjective. As far as my futures contract goes, however, yes indeed, there is someone losing money while I’m making money. At the end of the day, that’s just the nature of the beast.

Speaking of the terms “long” and “short”, I guess it would be good for me to explain what they mean to anyone that is not fully familiar with commodity futures trading. Basically, when people say “I’m long Coffee”, or “I’m going long Oats”, they simply mean that they’re buying a futures contract on that particular commodity, in hopes of prices going higher. For example, you may buy a Corn contract and enter the market at 275.00, and then the market jumps in price to 310.00. You have made money in this scenario because you were “long Corn”. I know it seems like incorrect grammar to say it that way, but that’s how the lingo goes. “Long” is the most common trading position in most people’s minds, and for some reason (possibly conditioning from the media and so forth), it seems to be the only acceptable position. The reason why I say this is because we are commonly led to believe that when a market drops, it’s a bad thing. Let me tell you, if you are short in a market and the market drops, you are celebrating. “Going short” simply means that you are selling a futures contract in expectation of prices declining. One of the first questions people normally ask is this: “How can I sell something I don’t own?” Well, to be honest, I’m not sure I fully understand how going short works, but I sure have made some money shorting all kinds of markets. In short form, you are basically “borrowing” a futures contract from the brokerage, selling it at a set price, and then waiting for the value of the contract to drop so that you can turn right back around and buy that same contract back with the proceeds from the sale of the contract that was credited to your account when you entered the trade. Once you buy it back (which will close out your position), you pocket the difference in price between the time you sold it and the time that you bought it back (or, closed out the position). It’s funny because I know that this is totally not the best definition of going short, and if you’re still confused about it, I understand why, but that just goes to show you that you don’t even have to have a full grasp of the concept of going short in order to make money shorting the markets. Again, although the world of trading commodity futures is hairy and complex, if you keep it what I like to call “dumb country simple”, you’ll do much better than trying to over-analyze every nuance of the markets. The K.I.S.S. principle (Keep It Simple, Stupid) definitely applies here. As I said earlier, I’m still not exactly sure how it works, but I have made money many times going short. To keep things extremely simple, if you enter a market on the short side (i.e., if you “go short”), as long as the market is dropping in price, you’re doing great. If you don’t remember anything else when trading commodity futures, remember that. When you’re long and prices go up, you’re golden. When you’re short and prices go down, you’re golden. It really is that simple.

Tuesday, August 19, 2008

Commodity Trading Basics: Types of Orders (Part One)

I know it’s been a while since I’ve posted anything here at Commodity Trading Information, and I didn’t want anyone to think that I had fallen off the face of the earth…I have been VERY busy as of late, and one unfortunate “side casualty” has been the neglect of this blog as a result. The cool thing is that I have set aside some time today to post a little about some commodity trading basics, namely the types of orders that you can use to actually place a trade. Understanding the process of placing an order for a trade is a vital element that you have to have in place to be ready to handle the markets. Different orders apply to different situations and “market moods”, but as you gain experience in commodity trading, you’ll find that there are certain order types that you become comfortable using, and after a while you won’t even have to think about what type of order you’ll want to place anymore, it will basically be second nature to you after a while. Me personally, I know that I will always use limit orders, simply because they’re the most efficient order type to use when you’re concerned about conserving capital and not being too “loose” with your trade management. But before I get ahead of myself, let me run through the different order types for you so that you can get a good grasp on what they are and their functions:

Market orders are by far the most common type of order used in commodity futures trading, primarily because of what I call the “convenience factor”—with a market order, it’s very rare that you’ll have a hard time entering a trade, unless the market is extremely violent (i.e., limit moves, which we’ll have to cover in another post). When you place an order to enter a trade, and you are actually able to get into that market, it is known as having your order “filled”. This simply means that you find a seller that’s willing to sell you their futures contract at the price determined by the type of order placed. In the case of the market order, this price can vary greatly…but instead of talking in more abstract terms, let me give you an example. Let’s say you want to enter July Corn…which, now that I’m thinking about it, I need to do a post explaining the actual futures contract and why there are different months for each contract. As a matter of fact, there are a ton of things that are coming to mind now that I’m really thinking about it. I was hoping to really keep things in order and explain the basics of commodity trading in a step-by-step way, but honestly, I don’t see myself sticking to a strict sequential order. I’m pretty sure that at the end of it all, I will cover everything that needs to be covered, but I don’t expect it to be in a perfect chronological order or anything like that. So, hopefully all will be said that needs to be said when it’s all said & done. Anyway, back to the market order. Basically, a market order gives you the right to enter the market at the “going rate”…in other words, with a market order, you don’t have a specific price in mind, you’re just trying to get into the market as soon as possible. I like to call market orders the “impatient person’s order”, because it definitely will get you into the market usually in no time flat. The whole point of placing a market order is that you want immediate execution, you want to be in the market ASAP, and the price is secondary to just getting into the market. The deal with a market order, according to the official definition anyway, is that your order is filled at the “prevailing market price”, which is extremely subjective. What most people don’t realize when they’re placing market orders, ESPECIALLY in markets that are not extremely liquid (i.e., low open interest—yet another post topic), they’re likely to get pimped by unscrupulous floor traders. On days when there is a very wide trading range, for example a 10-cent trading range in Corn, your chance of getting filled at a decent price are greatly reduced when you place market orders. They’ll basically scalp your order to pocket some quick profit in a fast-moving market and then blame your crappy fill on that same “fast market”. Since you cannot designate a specified price that you want to enter/exit a trade when you use a market order, you’re subject to whatever the floor brokers think is the best price for you to enter/exit the market at. This can pose a real problem because of the obvious conflict of interest, especially when they have a chance to make a quick buck (or $500 bucks on a day with a wide trading range). I have placed market orders before (in my days of ignorance), and to my chagrin, I would see my fill price being the day’s high if I was long, or the day’s low if I was short. It leaves you with that sour feeling in your stomach, I’ll tell you that.

Now some people would argue that you’re being too “nit-picky” by using limit orders (probably the subject of the next post), and that you may miss out on getting filled by using limit orders instead of market orders, and then consequently missing a huge move because you were being “penny wise and pound foolish”, by missing an entry into a fast moving market due to using a limit order. But the bottom line is, I would rather take my chances and have a much more controllable trading process than being “at the mercy of the markets” as far as entry/exit price is concerned. So my advice to any newcomer to the markets: Use LIMIT orders, and not market orders. Once you gain a little more experience in learning when market orders are appropriate, it’s much better to be more conservative and controlled in your trading style, and this cannot be fully accomplished with using just market orders.

Wow…this post is long as crap! I’m signing off, but I hope that this discussion of market orders has helped you grasp these commodity trading basics just a little better.