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The Four Essentials of Trading Commodities and Financial Futures

In this introduction to his book, George Kleinman presents various methods designed to identify profitable market patterns and the four essentials you'll need to start trading commodities and futures.
This chapter is from the book
  • “It’s tough to make predictions...especially about the future.”
  • —Yogi Berra

A floor broker once told me the following story, and he swears it’s true:

In the 1960s, there was a corn speculator who traded in the pit at the Chicago Board of Trade. He was known for plunging: taking big positions.

Early one summer, he put on a large short corn position for his own account. (Short positions make money if prices fall but lose if prices rise.)

Within days, the weather began to heat up in the midwestern United States, where the corn is grown. The corn crop needed rain, and prices began to rise. Day after day, the sun shone, the temps rose, not a cloud in the sky—the corn crop was burning up. The market continued to rally against this guy, and he knew if this continued, he’d go broke.

Late one trading session, the big trader started a rumor in the corn pit. His rumor was that it was going to start raining the next morning sometime around 10:30 a.m. The other traders laughed at this prediction.

The following morning, the sun was shining without a cloud in the sky, and the market opened higher once again. Then, almost miraculously, at precisely 10:30 a.m., rain started pouring down the windows that surrounded the grain trading room. (The old grain room, located on the fourth floor of the Chicago Board of Trade Building, had tall windows that looked out over La Salle Street.) Inside, in the corn pit, a selling panic immediately developed, as the pit traders scrambled to sell out their corn futures. Traders around the world saw prices crashing and joined in the selling frenzy. The market quickly went down the limit! On this break, the speculator covered his entire short position and was saved from bankruptcy.

How did the floor broker know it would rain at 10:30 that morning? It seems he was owed a favor from his drinking buddy, the chief of the Chicago Fire Department. The chief brought out the hook and ladders, and decided it was a good day to wash those tall windows that looked out on La Salle Street!

So you’re thinking of trading, but you don’t know the chief of the Chicago Fire Department? Actually, today, even if you do know him, it wouldn’t matter much because computer traders from tens of thousands of locations globally have replaced the pit traders, and computers don’t care about the weather.

So, let’s assume you’ve just finished reading a private newsletter, a firsthand report of how the “witch’s tail disease” is devastating the cocoa crop in Ghana. Cocoa sounds like a moneymaker, but you have no way of knowing for sure how true all this is. You do like chocolate, but you didn’t even know it all starts with a bean called the cocoa bean. (You thought it came out of a can.) Hey, you don’t even know where Ghana is, and you’re thinking of trading cocoa against the likes of Hershey and Nestlé and whoever else really does know what’s going on? Why would you do this? To make money, of course!

You do know one thing: You can observe that the cocoa market is moving higher, and it’s moving fast. Although you aren’t exactly losing money by doing nothing, it’s starting to feel that way. Do you have the guts to act? Do you have the money? Is now the time?

You assume that the shorts (those betting on lower cocoa prices) are beginning to experience financial pain. The longs (those betting on higher cocoa prices) are experiencing the opposite emotions: elation and the satisfaction that comes from being right. The accounts of the longs are growing bigger—money from nothing. The shorts are watching their money evaporate.

Let’s think about this for a moment, because it’s time for your first lesson: Even though trades are now entered using computers, trading is a human game. As a result, emotions affect price as much as, or perhaps more than, the news. You will learn that price movements themselves affect future price movements. It’s all a function of who is being hurt and who is benefiting. It’s a function of which side of the market is being “sponsored” by the “strong hands.” Shorts and longs act differently, based on price movements, and those movements affect their emotions as much as their pocketbooks.

Your job as a trader is to identify what happens next. To do that, I want you to start thinking about how others feel because feelings affect actions. People who are generally right tend to do certain things (on balance). People who are generally wrong tend to act differently. The majority acts a certain way, but be warned: The majority is usually wrong at major turning points (although they also can be right at times).

So, determine whether the majority is now long or short cocoa. The shorts are in pain, the longs are not; but then again, this can change just as fast as the market’s tone changes.

Here’s lesson number two: On balance, when talking about futures trading, the uninformed majority will lose. Because the profitable minority act in a completely different manner, you must learn what makes these people tick and how to act like them. One fact is certain: People make markets and, generally, people tend to act the way they did in the past. With certain stimuli, they could act opposite how they generally act, but you are playing the odds here. You need to identify what manner of move the market is in now. Is it a “normal” move, or is it extraordinary? (At times, the market acts in an extraordinary manner, and these can be the best times to play.) If you, as a trader, are able to accurately predict what the next pattern will be, your rewards will be substantial.

In this book, I present various methods designed to identify profitable market patterns. No method is foolproof, and the best I can do is try to put the odds in your favor. My goal is to teach you to approach commodity futures and options trading like a business. This is not a casino. In a casino, risk is artificially manufactured for risk’s sake, and the odds are engineered in favor of the house. In the commodity futures and options markets, you are dealing with natural risks associated with the production and consumption of the materials that make life possible and worthwhile—food, metals, financial products, and energy. You cannot bend these risks to your will, but you do have tools to manage them. Unlike in a casino, in the market, I believe you can move the odds to your side of the table. To do this, you must be disciplined.

You will need patience, and you will need guts. I cannot force these qualities upon you, but I can describe how a successful trader acts. It will then be up to you to act the right way. To profit in the commodity futures and options markets, you will need a systematic approach, a well-thought-out strategy. I will present you with some good ideas, but it’s up to you to implement them systematically. After all, a strategy is just a consistent approach to trading.

Do you have what it takes?

If you’ve decided to risk some of your hard-earned cash, go for the big bucks, and trade commodities, you need to know that this is a zero-sum game—that is, for every dollar someone makes, someone else loses it. Some of the money goes to your commodity broker in the form of commissions, and a small amount goes to the Exchanges for their fees. Then, if you are lucky or skillful enough to win, you owe the taxman some of your profits. When you lose on any particular trade, most of your loss is transferred electronically to someone else’s account (and you still pay that commission). You will never see this person on the other side of your trade, but he (or she) is out there somewhere.

You will be pitted against some of the best financial minds in the world. Professional traders, hedge fund managers, commercial firms that use commodities, and other commercial firms that produce commodities. Then there are those other individuals with more experience than you have. Can you hope to compete? The answer is, emphatically, yes! But I didn’t say it would be easy, did I? You will need to develop a sensible trading plan and a feel for the markets. This book will help you. You must develop certain human qualities, too, which nobody can give to you.

More than 50 years ago, the legendary speculator W.D. Gann discussed the four qualities essential for trading success: patience, knowledge, guts, and health and rest. Gann’s observations are just as valid today as they were half a century ago, and trust me, you must have these qualities if you ever hope to compete and win. (If you don’t have them now, then develop them!)

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