Investing Daily

Once upon a time a broker took on a customer with whom he was told to be very careful. The money was thought to have come from organized crime.

The customer opened the account with $100,000 and initiated a long platinum position. The market went down, and they bought more. The market went down even more, and it was margin call time.

The broker was becoming a bit nervous with the position, but when he called the customer the reply was, “Sure we’ll send you more money, no problem.”  When the margin call went that easy, he felt much more relaxed.

The market kept going lower, they kept adding to the position, the margin calls continued, and the crime boss continued to send in more money. The broker was talking with the customer one day and confided that he wasn’t sure platinum was going to rebound any time soon.

The response was simple: “Let’s get this straight. You can have all the money you want, just remember we don’t take losers!”

Zero-Sum Game

An old saying goes like this: “To make a small fortune in commodities, start with a big one.”

Perhaps as an amateur you feel the odds are stacked against you, however I don’t feel that way at all. It’s true that most people lose trading commodities, but not because the odds are stacked against them.

Every buyer of every losing trade could have been a seller and made money on that same trade, and every seller of every losing trade could have been a buyer and made money on that trade. There’s a profitable minority doing just that--not on every trade, mind you, but on balance.

So what’s the key? Is it how you analyze the market?

The bottom line determinants of success or failure are the trader’s state of mind, the psychology. All winning traders understand this. Trading emotionally--or on “gut feelings”--will ring your death knell. You’ll need to understand mass psychology because this is the reason markets move in trends. You’ll also need to understand when the trends are turning, and why the majority will be wrong at turning points.

The key to this whole equation is smart money management. 

Money Management

If emotions can kill you in the markets, then the opposite must be true: Being unemotional will enhance your prospects.

Years ago, a friend of mine who I respect as a successful trader cashed in on what I knew was a major score in the wheat market. I saw him in the Members Dining Room and I said to him something to the effect, “You must be feeling damn good with that great call having cashed in at the top.”

He was a calm sort of fellow, and I still remember what he said.  “George, when the markets treat me well, I don’t dance in the streets. And when they don’t treat me well, I don’t beat myself up. Always remember this: Slow and steady wins the race.”

Years later, I fully understand what he meant by these words. What a trader needs to do is to think not about the money but rather concentrate on trading correctly.

If you trade right, the money will come. If you trade wrong, you’re doomed.

A loser hopes too much.  He has an inability to get out of a losing trade early enough because he keeps hoping the market will turn back his way. Sometimes it does, but too often his broker is the one forcing him out. Invariably, once he’s forced out the market comes back the way he thought it would, but it’s too late.

Why do so many people sell at the bottom, or buy at the top?  It’s because they’re acting emotionally instead of intellectually. There’s one simple way to avoid this: Don’t get attached to any position. Trading shouldn’t be an ego thing. There’s always another market tomorrow, and another yet the week after.

I’ve witnessed literally thousands of trades from hundreds of brokerage clients over the years. I’ve seen what it is those who make money do, and I’ve seen what the losers do.  Invariably, the losers make the same mistakes. They may make money initially, and they might even have more winners than losers. But there always seems to be those few large losses that wipe out whatever good came before.

Many years ago the Chicago Mercantile Exchange rolled out a campaign in which it tried to teach the public how to trade (an impossible undertaking). One of the full-page ads pronounced, “Do not risk thy whole wad.”

How profound. Yet this is the one major mistake the majority of novice traders make.  They bet too much on one trade, or on one market, which brings us to the first tenant of good money management. You must know in advance how much you’re risking on a trade, and unless it’s a small percentage of your total risk capital, don’t take it.

I could get into probability theory here, but common sense works better. Some of the most important advice I can give is to plan for slow and steady gains and look to minimize the drawdowns. The way to do this is cut the losses quickly on the bad trades.

How much should this be? In my experience, the answer is never more than 10 percent of your total trading capital per trade, and ideally 2 to 5 percent per trade.

Think of it this way. When you start to trade, if you risk 5 percent on each trade you’d have to be wrong 20 times in a row to be totally wiped out. You’d have to be using a very poor trading system to do this.

Consider this: If you win on just half of your trades, but your net profit is 10 percent on each winning trade, with your net loss 5 percent on each losing trade, on your first 20 trades you’re up 50 percent. Not bad, and you were only right half the time.

On the other hand, if you’re risking 25 percent of your capital on each trade, it only takes four losing trades in a row, and you’re done for. It’s a certainty that if you trade long enough there will come a time when you have four losing trades in a row.

The key here is to avoid major drawdowns.

Another word to keep front of mind is “diversification.” Don’t put all your eggs in one basket; don’t place all of your chips on one roll of the dice. This will lessen the opportunity for any one trade to be your last. Stick with the trades that are working, and cull the ones that aren’t.

If you don’t have the discipline to get out of the bad trades when you need to, make it your own personal rule to place a stop-loss order physically in the market the moment you enter any trade. Tell your broker that if you haven’t given him that stop, his job is to get you to place it.

Believe me: Your stops won’t be hit on the very best trades. Then, once you have a reasonable paper profit on a trade, move your stop to never let it turn into a loss.

For additional trade recommendations, consider George Kleinman’s subscription-based service, Futures Market Forecaster. And be sure to check out George’s new book, The New Commodity Trading Guide, available now at Amazon.com.

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Risk Disclaimer
Futures and futures options can entail a high degree of risk and are not appropriate for all investors. Commodities Trends is strictly the opinion of its writer. Use it as a valuable tool, not the "Holy Grail." Any actions taken by readers are for their own account and risk. Information is obtained from sources believed reliable, but is in no way guaranteed. The author may have positions in the markets mentioned including at times positions contrary to the advice quoted herein. Opinions, market data and recommendations are subject to change at any time. Past Results Are Not Necessarily Indicative of Future Results.

Hypothetical Performance
Hypothetical performance results have many inherent limitations, some of which are described below. No representation is being made that any account will or is likely to achieve profits or losses similar to those shown. In fact, there are frequently sharp differences between hypothetical performance results and the actual results subsequently achieved by any particular trading program. One of the limitations of hypothetical performance results is that they are generally prepared with the benefit of hindsight. In addition, hypothetical trading does not involve financial risk, and no hypothetical trading record can completely account for the impact of financial risk in actual trading. For example, the ability to withstand losses or to adhere to a particular trading program in spite of trading losses are material points which can also adversely affect actual trading results. There are numerous other factors related to the markets in general or to the implementation of any specific trading program which cannot be fully accounted for in the preparation of hypothetical performance results and all of which can adversely affect actual trading results.