The 10 Commandments
Of Successful Commodity Trading
I've been trading for myself and others going on twenty years.
Most of those years I've been a registered commodity broker, and for the last several
years, I've been a principle at a large West Coast Futures Commission Merchant, American
National Trading Corporation. In all my years trading and watching others trade, studying
the markets and listening to all the different "gurus of the moment," I have
come to find a few simple truths. In no way am I suggesting that these are all the truths
or that there is any monopoly on truth, especially in trading. Never-the-less, if one is
in this game long enough one starts to notice things. One of those things is that a lot of
systems and approaches to commodity trading work a lot of the time, and another is, from
time to time, some work exceedingly well.
So why do so many people lose
money trading in the markets while others consistently make hundreds of thousands-even
millions of dollars each year? It is my contention that for most of us it boils down to a
few simple sins. Sins that a lot of people trading in the currency and commodity markets
tend to repeat over and over again. Like the old man in Las Vegas still hitting on
seventeen at the blackjack table, some people never learn. It can be a basic flaw in the
system or trading approach or no approach at all. But most of the time, in my view, it is
in the trader himself-the one pulling the trigger.
Here, accordingly, is my
take on the ten deadliest sins:
I. Thou shalt not risk more money than
thou can afford to lose. Also known as "if you can't afford to lose, you can't afford
Let's face it -- this ain't bean ball. You can lose money! Stop right here,
throw away this handbook, forget about trading futures, do something else with the rest of
your life if losing whatever money you might trade with would take food off your table,
keep your kids from going to college or change your lifestyle. Repeat, there is no system
or approach available that doesn't sustain losses sometimes. The trick is containing those
II. Thou shalt not trade futures without
the placing of stops.
Also known as "you've got to know when to hold up, know when to fold
up." Show me a futures trader who doesn't use stop loss orders and I'll show you
someone who loses a lot of money. It's that simple. Before initiating any trade if you
haven't already figured out at what point you would be wrong and would want to cut your
losses or, at the very least, reevaluate your position from the sidelines, then you
shouldn't be putting on the trade.* You should also have a profit or price objective that
is at least twice the proposed risk, and you should never take a profit just for the sake
of taking a profit.
Options, of course, are
different because of the inherent liquidity problems in some markets and because
frequently the reason an option is purchased in the first place is to "ride the
wave," or position trade, using the fixed risk of the option premium itself.
*If you need a good example of this consider Nick Leeson, the currency trader who
brought down Great Britain's Barings Bank, who is now resting comfortably in some
Singapore prison for not cutting his losses when his bet on the direction of the Japanese
stock market went against him.
III. Thou shalt not let large profits turn
into losses. Also known as "stupid."
There's always a reason. And I've probably heard them all over the years. The
most common scenario is: You've had a favorable move in the market, maybe you are up a few
thousand dollars per contract. Hopefully, you followed the second commandment and placed
an open stop loss order when you initiated the trade. But now you are afraid to raise your
stop and lock in at least some profit because you don't want to get "whipsawed"
and stopped out. Then the market reverses. So you let the market take back some of your
profits, hoping it will turn around again, until all of a sudden your once profitable
trade is now under water and in real danger of being stopped out at a loss! What went
wrong? The answer is: You didn't raise your stop. Most pros use a trailing stop system, (a
pattern of raising their stop to lock-in profits) one based on either chart points or a
pure money management approach. You should too.**
orders, such as "stop-loss" or "stop-limit" orders, will not always
limit your losses to the intended amounts, due to slippage or market conditions on the
exchange where the order is placed.
IV. Thou shalt not let thy emotions
rule. Also known as "a fool and his money are soon parted."
This is probably the hardest commandment to keep. Yet, I have
never seen a successful trader over the long haul who didn't follow it. Most people want
to be winners. Most people want to make the big score and have the accompanying bragging
rights. We all tend to get greedy, speculators usually more so. But trading is a business.
It's hard work. You must be cool, calm, and always ready for the next opportunity. You
can't have high highs or low lows because you'll make too many mistakes, and mistakes mean
losses. If you start winning and get "too high," the tendency is to over-trade.
By that, I mean starting to make marginal trades or "seat-of the-pants" trades
just for the sake of making trades, instead of waiting patiently for the right
opportunity. If you get too low (this is usually after some losses), you are liable to
skip the trades you should be making, or you might try to "cherry-pick" a system
or an advisor's recommendations for fear of more losses, inevitably making the wrong
choices. To win this game you must remain clear-headed.
V. Thou shalt not place all thy eggs in one
basket. Also known as "live to trade again."
Ask any pro trader how much of their total account they risk on any one
trade and the answer undoubtedly that will come back will be not more than ten percent.
Why? Because the successful trader knows that losses are part of the game, and that
frequently a few big profitable trades during the year more than make up for all the
little losses, and they want to be around when the next opportunity arises.
VI. Thou shalt not buy deep
out-of-the-money options. Also known as "you get nothing for nothing."
brokerages are in business to make money, ours as well as everyone else's. Everyone
accepts that. And commissions are the energy source that makes it all possible. Most
brokers do get some percentage of the commissions as their pay. Since most options are
traded on a round-turn basis, it stands to reason that the more options the customer buys,
the more money the broker makes. Therefore, the cheaper the option premium the more
options the customer can buy. But not all options are created equal. For instance, let's
say gold is trading at $400 an ounce and you think gold will rally. There are usually 100
oz. "call" options offered in strike prices of $400, $410, $420, $430 and so on
for a specific amount of time (there are also lower strike prices offered). Keep in mind
that at expiration gold must be above your strike price to have any value. It follows
then, that at expiration if gold is trading at $420 the $400 "call" option is
worth $2,000 (100 ozs. X $20); but the $430 "call" is worth zero. That is why
the further away from the market the strike price, the cheaper it costs to purchase. The
option unscrupulous brokers will sometimes convince their clients to buy "deep
out-of-the-money" options - options that are five, ten, sometimes fifteen strikes
away from the underlying market. They are usually very cheap and the broker can buy a lot
of them for a small amount of money and therefore rack up a large commission for him or
herself. The problem is they have almost no chance of making any money for the client
because the market will have to make a huge move in a relatively short period of time to
pay off. And although that does happen in commodities, the odds are against it.
my experience that options have the greatest appreciation from roughly two to three
strikes out-of-the-money to two to three strikes "in-the-money." At our firm, we
discourage brokers from recommending buying options much further out than that except in
special situations. It's usually a chump's game.
This is also known as the broker's best friend. Running a large discount operation
I see many accounts with open positions transferring from different brokerages to our
books. It is always interesting to see how other people trade or are traded, and even more
so, if they have been trading the advice of a competing brokerage.
VII. Thou shalt not fight the tape. Also
known as "the trend is your friend."
The mistake speculators sometimes make is trying to buy or be long while markets
are still in a basic downtrend, or selling short when they are in an up trend. Most
professional traders try to identify the major trend and construct their trades in that
direction. They know that when you trade "with the trend" usually your chances
of winning improve. Many times the trend will bail you out of an initially less than great
entry point. There are many ways to analyze trends, but most involve some kind of price
action like moving averages using daily or weekly charts, or somewhat more sophisticated
technical indicators like stochastics or the ADX line.
VIII. Thou shalt not stay in losing trades
too long. Also known as "the best trades are usually right, right away"
Let's face it-you can't turn a sow's ear into a silk purse. You can't change the
spots of a leopard and you can't turn chicken poop into chicken salad. The best trades are
usually right immediately. I know a lot of commodity traders who say, stop or not, if the
trade is not profitable within two or three days they're out, cutting their losses even
shorter. They don't need to hang around just waiting to get stopped out. Experience tells
them they will get stopped out. Remember, people have been trading commodities for a
hundred and fifty years, the smart traders know there's always going to be another trade.
Cut your losses short.
IX. Thou shalt not follow crowds.
If you are around long enough in this business you come to have a healthy
appreciation for the theory of contrary opinion. Simply stated when everyone's bullish,
sell. When everyone's bearish, buy. That's because historically, the public is usually
wrong.* But of course, it's not quite that easy. It is extreme bullishness or bearishness
that you look for. It is not enough to see a lot of bulls around. It has to be everyone
and their mother is bullish, that they've put every available dime in the market, and they
think "this time it's different" and the market will never turn bearish again,
or at least not for a long time and all corrections are nothing more than buying
opportunities. That's what you look for - then you go the other way. Conversely, when the
market has been flat or falling for it seems like forever and everyone's given up, thrown
in the towel, packed it in and sold out all their remaining losing positions saying
"I hate this market and I'll never trade it again." That's when you buy with
*During the mid-to-late 1980's in Southern California, and especially on the west side
of town where I live, we experienced tremendous price appreciation in residential real
estate. In my case, I had bought a house in April 1985. By mid-1988 my house had literally
doubled in value. And, yet, no one I came in contact with was nervous at all about the
direction of real estate. As a matter of fact, by the end of 1988 I could not find anyone
who thought California real estate would ever drop in value again. The worst they could
imagine was a flat period for a year or two then off to the races again. Sensing a market
top, I promptly put my house on the market. It sold in ten days for just under my initial
asking price (the most ever received up to that time for a comparable home), a whopping
225% more than I had paid for it less than four years previous. Seven years later you can
pick up several places just like it for 40% cheaper. I was lucky, but the lesson here is
to always be watching for extremes in public opinion.
X. Thou shalt not step over dollars
to save pennies. Also known as "get a broker."
This may be the most important commandment of all. Although
the "highs" you can achieve when you are successfully trading commodities can be
spectacular, you must always keep in mind that this is a serious business. And like many
things in life, if you haven't done it before you need someone to help showyou the way.
You need a guide. Don't try to navigate these waters alone if you haven't traded before.
If you don't understand how to read a chart or the proper terminology to use when placing
trades, or what supply and demand factors may affect the currency or commodity being
considered, then you should open an account with an experienced commodity broker. Although
it will cost more, in the long run I believe you will save money. That's because it takes
time to learn how to trade, it can't be learned overnight or a weekend. Most professional
traders spend a fair amount of time in the school of hard knocks before succeeding. They
need to live through both bull and bear markets to gain the proper perspective. Don't kid
yourself-experience counts. A good broker can help you greatly in your pursuit of profits.
And if you get the right one, you can even "earn while you learn."
I purposely avoided straying
into a discussion of technical and fundamental analysis. There are many fine books and
newsletters available dealing in depth with these topics, and any serious student of
commodity trading should take the time to read as many as possible before deciding which
methods work best.
What I've tried to do in this
handbook is focus on the psychology and discipline of successful trading. Remember, if it
was as simple as having a degree in economics, or knowing the implication of every known
chart formation, there would be substantially more millionaire traders out there.
Obviously, it takes more. I hope I've been able to help you to become a more successful
© Don Varden
Pacific Palisades, California