Wednesday, July 22, 2009

Commodity Trading Basics (Part 3)

Any time you want to discuss commodity trading basics you’re going to have to mention the importance of developing a disciplined trading methodology, and applying sound risk and capital management to your trading habits. There’s no way on God’s green earth that you can expect to have any longevity trading in the futures markets if you neglect to discipline yourself to stick to a well-thought-out trading plan. And this applies to any market; I could be talking about oil trading basics, or corn trading basics, or any of the other derivatives; it really doesn’t matter which particular market you choose, the importance of developing a sound, reasonable trading plan. This, surprisingly, will be the most difficult part of your trading career. Truth be told, if you never settle this part of your trading career, you won’t have a trading career after long. A fool and his money are soon parted—so are a trader and his money if he doesn’t have a well-thought-out trading plan. So you may be thinking “What should I include in my trading plan?” Well, for starters, you need to know how much total capital you want to start with. Most commodity trading advisors recommend starting with no less than $50,000, but this number greatly varies. I didn’t start with anywhere near $50,000. I started with $1,000, and quickly blew that account completely out. When I started again, I started with $4,000 and did much better. Looking back on it, I would never have started with less than $10,000, knowing my own personal risk tolerance and personality. That’s the part that really no one can teach you, is how much money you can handle putting at risk. Many people trade way beyond their emotional tolerance level—in other words, they’re overloading their emotional capacity by risking WAY more trading capital than they’re comfortable with losing…and the one thing I’ve learned over the years is that you NEVER risk more money than you’re willing to outright lose. If you can’t kiss it goodbye without missing it, you will never trade successfully. The chance of that happening is always there, and anyone who’s ever been caught on the wrong side of a limit move can tell you that it’s there.

Commodity Trading Basics: Limit Moves

As an aside, for those who may not know, a “limit move” is when a market moves its absolute maximum in one trading session, up or down. The commodity exchanges have set limits on price moves so that there will be no extreme “runaway” markets in one day. Can you imagine if speculation went completely wild in a trading session, and Wheat moved up 200 cents in a trading day? That would be a $10,000 loss (per contract) in ONE DAY for the guy who’s on the short side of Wheat—talk about no fun!!! So, the exchanges implemented a “limit move” restriction on prices for extreme trading conditions—when a limit move occurs, you’ll see a little horizontal “tick” on the price chart—it looks like a little hyphen—with nothing else around it. If prices move up to the daily trading limit, it’s known as going “limit up”. If prices move down to the daily trading limit, it’s known as going “limit down”. For instance, (if memory serves me correctly) there was a time back in the 1970’s where soybeans skyrocketed, and went limit up for consecutive days. It would suck horribly to be on the short side when a commodity is going limit up, and it would suck horribly to be long when a commodity is going limit down. Many a trader has been wiped out by limit moves; that’s why it’s always good to protect your positions by buying options that are opposite of your position. For instance, if you’re long Coffee, you could buy a put option at or near your entry price to partially shield you from downside risk, or if you’re short Oats, you could purchase a call option to partially protect you from getting caught in a violent upswing in price. As far as the details of these types of trades, we’ll have to cover them in future posts…this one is long enough already (ha ha).

Well, I wasn’t expecting to go off on the “rabbit trail” regarding limit moves, but since this blog is about commodity trading basics, it didn’t hurt at all to cover them the way we did. Hope you got something out of it!