How to Make Money in Commodities

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trader should buy wheat futures at $1.71 and place the protective stop?loss order on the other side of the trading range, at the $1.62 level or thereabouts. For potatoes, the price has fluctuated between 5¢ and 6¢ for eight solid months. It has now broken through the 5¢ barrier. Potato futures should be sold at the 4.9¢ level with a stop-loss entered at 6.1 ¢, above the trading range.

      As you can see, a key location for your stop-loss is on the opposite side of the range in which prices previously traded. Normally, the likelihood of the price returning to the opposite side of its previous range, is not very great. However, there is no guarantee that price will not turn and strike into the other side of its former range.

      If prices do return to the other side and you have placed your stop-loss order at that point, then you will suffer a loss, the size of which of course depends on how close to the range you set your stop. For the wheat contract, a reversal that tripped the stop at $1.62 would cost the trader 9¢ a bushel, or $450 per contract. Be very careful when using charts to set your stop-loss. Don't be fooled by the increments of the chart's construction into thinking that a small move on the chart equals a small loss. How much would you lose, for example, if you were "stopped out" of the October Cotton contract?

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Suppose that you are planning to buy cotton when the price breaks upward out of its 3 month range of 3¢, from 70.5¢ to 73¢. You anticipate going long at 74¢, and place your stop-order to buy at that level. Next you set your stop-loss below the previous range, at 69.5¢. Your order limits your loss-risk to 4.5¢, a very small move on the cotton chart. But what does this short distance, those few pennies, translate into per contract? Our "Trading Facts" tell us that every 1¢ move in cotton is worth $500 per contract. The amount being risked here, despite appearances, is a whopping $2,225.

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      In most circumstances, placing the stop-loss order on the opposite side of the trading range provides the best protection in the best location until prices start moving in a favorable direction. Whether or not the trader can afford to follow the rule, as in the case of cotton, will depend on the amount of capital available for risk. If you can't afford to set your stop?loss at such a distance from the established position, then the market is too volatile for you to trade, no matter what the chart looks like.

      If you have set your stop-loss, and prices continue to move in your favor, the distance between the stop-loss and the current price will increase. Your profits will be increasing, but your level of protection will be going nowhere. The solution is to move your stop-loss order in the same direction as the favorable price move, keeping the distance between the stop and current prices about the same as the original difference between the price of the established position and the level of the stop. Then, when prices do finally turn, you will be taken, out of the market with most of your profits intact, having paid a small, predetermined amount for the privilege of riding the price move as far as the market would go.

      This movement of stop-loss orders is in reaction to a new problem. The preceding illustrations were centered around protecting the commodity futures position when the market made an adverse move. We wanted to limit our losses to a preset amount in case our price forecasts were wrong. Now we face the "problem" most traders rarely get a chance to solve: "Where and when do I get out with my profits?" What do you do when you have a profit and at what price do you get out and take that profit? Strangely enough, this can be a more difficult predicament than that of deciding when to cut your losses short. If your stop-loss is set, it will take you out of a losing market quickly, without hesitation. But if profits are piling up,

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what signal tells the trader its time to take the money and run?

      Suppose, for example, that you have a $1,000 profit on your commodity position. Should you stay with the position, hoping your profits will increase, or get out while the getting is good? Many speculators find this the hardest question to face in futures trading. If the market reverses itself, then the $1,000 profit disappears or perhaps turns into a $1,000 loss for the trader who chose to stay in. However, if you do get out, and then the market keeps moving until your profits would have been $10,000, you will feel sick about liquidating so early. The best rule for offsetting or getting out of profitable commodity futures positions is the method known as the "trailing stop."

      Once more, the price chart aids us in demonstrating the principle of the trailing stop. As with the stop-loss order, the chart serves as a handy visual guide to where and when to act. The cotton market shown in the December Cotton graph qualified for trading once prices settled into a lengthy sideways channel in the early summer months. Prices moved out of that range when demand achieved a dominance over supply, pushing prices upward and into a steady climb. When was the time to buy? Once prices penetrated the old ceiling, the trader could have been on board the big move with a stop order to buy at 30¢. The first stop-loss is placed at level S1 -- 27¢. This would be below the old trading range of 27.8¢ to 29.8¢. If the price of the December Cotton contract declined to level S1 shortly after the position was established at 30¢, the trader would lose $1,500, an amount determined beforehand as an acceptable degree of loss. But as we would expect in this kind of market, cotton prices continued their upward trend.

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     After prices have advanced to the point where the trader has broken even on the margin deposit, or scored a significant paper profit, the stop-loss level can be raised. Let us say that December Cotton has hit 33¢. You move your stoploss up to S2 -- 30¢. Then, if prices had suddenly turned downward and tripped your stop-loss, the position would be closed without gain or loss (except for commission costs). Cotton prices, however, kept going up. When the futures price passes through 37¢, the stop-loss is raised once more, this time to S3 -- 33¢. Now if you are "stopped out," a profit of $1,500 is assured. When prices hit 47¢, you again move the stop up, to S4 at 37¢, now allowing a bit more cushion on the downside in respect for an increasingly volatile market (and because a good stock of paper profits covers the risk).

     As prices shoot up beyond 55¢, the stop-loss is moved up to S5 at 47¢, and the process is repeated at predetermined steps so long as the price line continues to rise. Finally, you are stopped out by a large reversal to S8 at 77¢. The stops have been "trailed" behind the price action, keeping you in the market as long as the trend continued, but taking you out of the marekt when it firmly decides to head in an adverse direction.

     There is no hard and fast rule dictating just how far below current prices the stop-loss order should be trailed. The trader who moved the stop-loss from S1 to S2 when prices hit 33¢ was playing a conservative, close stop-loss game. A reversal at that moment would have wiped out the position without a loss, it is true, but it also would have meant missing out on the big move upward if it resumed. Another trader might have left the stop-loss order at S1 until prices passed through 37¢, and then moved the stop-loss up directly to S3. Many traders using stops could have been stopped out by the temproary 6¢ reversal in May, while others with stops set farther away

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COTTON: Careful use of a stop-loss order nets a profit of $23,500 per contract, or 2,937 percent of initial margin deposit.

TRAIL YOUR STOP-LOSS TO PROTECT PROFITS

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stayed in the game. On the other hand, traders who set their stops fairly close would have gotten out of the market far more quickly, and with more profits intact, in October than would have those speculators with distant stops at 70¢ or 65¢. Setting stop-loss points is an art that requires practice and precision. The general rule is to trail the stops far enough below or above the current market prices so that minor fluctuations will not result in an offsetting of the position and yet close enough so that when the market does actually reverse its price direction, the trader is taken out with a substantial profit still intact.

      At level S8, the stop-loss is tripped when the market makes a big decline after hitting the top of its long advance. Let's say your futures contract, bought at 30¢, is sold at 77¢. Your profit per contract is 47¢, with each 1¢ move equalling $500. In this example, the initial investment required for one cotton futures contract was $800. Your total per contract profit was $23,500 or 2,937 percent of invested capital. This astonishing return on a very small amount of investment capital was realized in a mere seven months' time. Only two market decisions were required of the trader:

1. Futures contracts had to be bought when prices were seen to advance out of a narrow trading range.
   
2. "Stops" had to be trailed below the price advance, being kept far enough away from current prices so that a minor fluctuation did not take the trader out of the market, but close enough so that a major price reversal automatically liquidated the position.

The speculator in December Cotton had a relatively easy time of it. There was little to do but follow the market's decisions, buying when the market rose and selling when it turned. No wonder so many investors are finding commodity futures trading so appealing.

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      The examples cited up to this point were not rare, isolated cases. Price fluctuations such as those illustrated so far occur often enough to assure the patient speculator of several rich opportunities each year. In the following pages we will take a look at a 12 year period from 1968-1980, examining actual markets that could have been traded (and were traded by many) for very sizable returns. We look to the pages of history because here history is our best teacher. It confirms the soundness of the method and the practicality of its application. By studying the markets of the past, you will learn how to take positions in the same type of market when it occurs in the future. And you may rest assured that this type of market will be repeated as long as there are futures markets. From 1980 to 1990 to 2000 and beyond, there will be price fluctuations in one commodity or another which substantially qualify for the method of trading under discussion here. Anyone with modest amounts of risk capital and possessing average intelligence should be able to realize significant profits from a majority of these opportunities.

      A commodity futures contract comes naked into the world. It springs up ready to trade, lives tumultuously for a year or so, and then dies into history. Thousands and thousands of contracts in dozens of commodities have come and gone in this way, leaving a rich record of lessons for the prospective commodity futures trader. These are the lessons from which we hope to profit. We have learned already the major principles: buy in an advancing market, sell in a declining market, and stay out of the market altogether when the price is wandering aimlessly sideways. In trading commodity futures, you are really taking positions in relationship to "price patterns" -- advancing patterns, declining patterns, sideways patterns, -- that are formed by the life and death of the futures contract. These patterns are

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