Winning at Commodities

If you have the capital and the constitution, here's a guide to commodity systems and advisors.

Commodity futures trading is "the fastest game in town," as one author so aptly entitled his book. It offers the speculator the highest stakes of any game available. Whether the economy is in an inflationary or deflationary trend, the futures markets provide us with one of our greatest profit-making opportunities. They are, literally, the markets for all seasons.

In the commodities game, success is richly rewarded and failure exacts its pound of flesh. If you have ever dreamed of making a fortune in commodities, though, be prepared to "pay your dues" first. Everyone does sooner or later. "The simple truth is that most successful speculators have been bloodied at least once before achieving success, but all have tried again" (The Commodity Futures Game: Who Wins? Who Loses? Why? Tewles, Harlow, Stone, 1974).

Since beating the commodities markets is probably the toughest business there is, it is an endeavor strictly for those with genuine risk capital and a hardy constitution. The more well-capitalized and disciplined you are, the greater your chances of success.

The nature of futures trading is such that your psychological makeup is critical, especially if you make the trading decisions yourself. Perhaps more than any other attribute, you must have the temperament for it. You must be willing to accept the fact that you may realize substantial losses. You'll be wrong more often than not. You'll experience strings of consecutive losses between profitable trades. You may experience strong emotions of elation and despair regularly as you ride the roller coaster markets.

DO-IT-YOURSELF

If you think you have the temperament and the genuine risk capital for futures trading, you need to figure out whether or not you will make your own trading decisions. Individual trading means a great deal of ego involvement and the gratification that goes with it. Unless you are willing to control your emotions when trading, you will eventually lose your shirt. You have to be able to let go of your need to be right all the time and to win all the time.

Individual trading involves emotionalism no matter how you slice it. When you trade based upon your own analyses, hunches, angles, or whatever, you are likely to discover a compulsive desire within you to rationalize your positions in the markets at every turn. It's you against the market, and you want to be right! As a result, with each adversity that you encounter, you will want to make the market wrong and write off unexpected occurrences as "temporary aberrations" that will eventually be overcome and prove you right.

Probably the single greatest reason why the vast majority of commodity futures traders are losers is that they allow their losses to accumulate and are eager to cash in their profits quickly. The Association of Commodity Exchange Firms pointed out in one of its booklets: "It comes easy to take a profit (this is a happy occasion). It is more difficult to take a loss (this is an unhappy occasion—one has to admit one is wrong). It is typical to feel that, when the market price is more against one's position, the market is wrong and will eventually correct itself to one's own estimate of the situation. So one holds on against a current trend: he lets his losses run."

Individual trading is normally done via price charts for the technically oriented speculator and via fundamental information for the speculator who prefers to interpret market factors. The latter is analogous to securities investors who rely on research reports about companies regarding their balance sheets, earnings, etc. Many commodity traders who choose to use their own judgment subscribe to advisory services, study research reports distributed by brokerage firms, and specialize in specific groups, such as the grains or precious metals markets.

There are several advantages to individual trading, as opposed to following a mathematical trading system or employing a professional commodity trader to manage your speculative capital.

• You have more flexibility and a greater degree of latitude.

• You are able to avoid more easily the erratic or especially volatile markets and restrict your trading to those with acceptable risk-reward trade-offs.

• You are able to trade more easily the counter-trend reactions within the direction of the primary trend and trade the market from one direction, that is, long or short positions only.

• You can design a trading plan that combines the market-fundamental outlook with technical action—a technofundamental approach—whereas mechanical systems generally ignore fundamental information.

• You can more easily change your entry points, stop-loss points, and price objectives. You can also more easily take your profits on the rallies and cover your short positions on the declines.

• You can trade the consolidating, choppy markets that are anathema to most mechanical systems, provided you are nimble enough to catch the swings within the trading ranges.

• You can analyze commodity price charts to identify trendlines, support and resistance levels, as well as volume and open-interest (number of contracts outstanding) patterns for market timing.

FORMULA FOLLOWING

Trading commodities via systems is essentially a mathematical approach, very often by means of a computer program. You can create your own trading system or subscribe to one offered by an advisory service. When you choose a mathematical system with which to direct your trading, you are opting for a mechanical approach. It will tell you what and when to buy long and sell short and when to close out your positions.

The majority of computer systems incorporate trend-following approaches predicated on Newton's first law of motion, namely, "a trend once established is more likely to continue than to reverse." In conjunction with riding the trends, computer systems by and large use one or more moving averages (progressive means, that is, for mathematicians) to identify when trends are under way as well as when they are not.

The input to these systems includes such data as market prices, trading volume, and open interest (outstanding futures contracts, that is). These data are structured to create momentum oscillators, time cycles, or on-balance volume patterns, for example, as objective criteria to identify market entry and exit points. Some computer programs are very sophisticated, indeed. In fact, some even incorporate data on market fundamentals, such as seasonal factors, cash market activity, and other economic variables.

Employing a mathematical trading system will greatly reduce the emotional involvement in your trading. Its use, however, requires your confidence that it will ultimately prove to be successful. Needless to say, no system works all the time. In fact, few systems work most of the time. Consequently, when the system you choose to follow experiences a particularly difficult episode, you are likely to begin to lose confidence in it and abandon it for something allegedly better. What so often happens, however, is that if you had stayed with the original system, it probably would have produced for you. Again, you have an emotional involvement factor, and you end up not consistently following a system you had put your faith in and your money on. If it is to work for you, you must stick with it consistently.

SYSTEM PROS AND CONS

The mathematical system you choose to follow will not be infallible, of course, but it does offer clear advantages over individual trading. Its greatest strength is that it substitutes an objective strategy for personal judgment and emotional involvement in each trading decision.

• It imposes a discipline upon you because it is mechanical and thereby tends to greatly reduce the emotional and ego involvement in trading.

• It significantly reduces the risks inherent in commodity futures trading because it is likely to have you stay with the major trends and limit your losses when the markets do not move as expected.

• It diversifies your equity capital into several positions, thus reducing the risks of having "all of your eggs in one basket."

• It generates unequivocal signals for entering and exiting the markets, thereby eliminating the tendency to procrastinate about initiating or liquidating positions.

There are several disadvantages, however, to following a mathematical trading system, not the least of which is the tendency among many traders to stray from a sound method to something else during episodes of temporary adversity.

• Systems tend to work only some of the time because markets are likely to predominate in trendless consolidation patterns. Since the majority of systems are trend-following, they tend to fare poorly in congesting markets.

• Systems tend to overdiversify into several commodities markets without regard to their respective volatilities and point values, thus oftentimes absorbing large losses in some markets and making modest profits in others. There are significant differences in the risk-reward ratios among the various futures markets.

• Systems tend to apply the same trading strategy to the whole universe of markets, thereby ignoring the various technical personalities. There are some markets, that is, that tend to have sustained trends (e.g., gold) and others that have a history of volatile swings (e.g., silver).

• Systems tend to have you buying long and covering short positions in advancing markets and selling short or liquidating long positions in declining ones. As a result, unless there is a subsequent follow-through in the same direction, losses will occur.

• Systems tend to trade markets from both sides, that is, long-short-long-short. As a result, there will be many times that you will experience whip-sawing losses in trendless or choppy markets.

• Systems tend to be slow getting into new trends and getting out after the trend has reversed. Substantial, unrealized gains from open positions may erode before the trades are actually closed out. It is not uncommon for some trend-following systems to give back 20-40 percent of an unrealized profit before closing out after the trend direction changes, especially in fast markets.

• Systems are generally designed to trade several markets simultaneously and to accept many relatively small losses in anticipation of catching several major trends each year. Unfortunately, too often a trader's capital will be depleted as he plays for the big ones or, once having captured a major trending market, he finds that his profits barely make up for all the previous losses incurred in the attempt.

• Systems tend to do poorly in signaling market-entry and stop-loss points because so many of them use moving averages, which tend to have little to do with the actual support and resistance levels illustrated in commodity charts.

In sum, systems are used because they make commodity futures trading relatively effortless. The "computer" tells you when to buy and sell. You don't have to make any decisions—it is not yours to reason why, but to do. As a result, there is a trade-off of your judgment and control for a system of mechanical risk management.

CALL IN THE EXPERTS

The third way to play the game is to opt for professional management, employing a pool operator, a registered commodity advisor, or a commodity broker to manage your commodity capital on a discretionary basis. Once you have agreed to the general features of the account, you have nothing whatsoever to do with the day-to-day trading or money management. You may, however, cancel your agreement in writing at any time and close out your account if you are not pleased with the results.

Commodity account management comes primarily in three forms. You can place some risk capital in a pool operator's fund. Several of the major securities firms offer multimillion-dollar commodity funds for minimum investments of $5,000. Another option is to have your speculative capital managed as an individual account by a registered commodity advisor who would be independent of the brokerage firms and therefore would not have a stake in the commissions but only in the profits he could accumulate for you. It should be noted, however, that advisory firms generally have minimum-size accounts from $20,000 to $100,000. The third alternative is to have your account managed by a commodity broker. He definitely has a great interest in the commissions your account will generate.

There are several advantages to employing a professional commodity trader to manage your account on a discretionary basis.

• Professional advisors tend to be very disciplined and objective in the way they trade and manage your capital. They are also likely to have the data and computers and the requisite knowledge, experience, and temperament to do the job competently.

• Professional advisors will generally provide better control of risk.

• Commodity advisors tend to stay with trending markets rather than cash in the quick profits. As a result, there is less likelihood of overtrading which tends to eat up your equity with commissions.

• There is usually no conflict of interest with registered commodity advisors because there is no incentive for them to generate commissions. There is, however, a real conflict of interest present when a commodity broker manages your account, because some brokers may be tempted to "churn" accounts to increase the output of commissions.

The only real drawback of professional management is the commodity advisor's "take." Since advisors usually work on a percentage-of-profits basis, investors have to agree to their terms—normally, anywhere from 10 to 30 percent of cumulative realized profits over realized losses. These are usually paid out of your account monthly or quarterly, provided your account has been profitable.

Needless to say, the registered commodity advisor must make money for you if he is to make any for himself. He has, therefore, every incentive to trade your account conservatively and prudently. He must control risk and stay with those major trending markets that make the big difference between winning and losing in commodities. Accumulating substantial profits for his managed accounts is the professional advisor's whole raison d'être. If he doesn't, he won't be in business very long.

CHOOSING TIPS

There are hundreds of active registered commodity advisors, according to the Commodity Futures Trading Commission. So how would you select a suitable one for your own speculative capital? There are essentially four criteria, in my opinion, for evaluating advisors. In order of priority:

• Look at the respective lengths of time they have been in existence. Longevity is an excellent indicator by which to judge performance. Brand-new advisors with new "sophisticated systems" may best be avoided. An established commodity advisor with years of experience and, especially, with greater quantities of capital under management, may be a better choice.

• Look at the actual track records of the respective advisors. Do not accept hypothetical trading results or back-traded systems generated by a computer. Ask to see actual historical performance over a number of years. In fact, ask to see the trading results and equity of a few real individual accounts. If they can't produce them or refuse to, the best advice is to pass.

• Try to determine the respective trading strategies of suitable commodity advisors. What are their approaches to the business of commodity futures trading? Do they diversify into a dozen markets, or do they concentrate more often in certain groups, for example, grains, livestock, metals? Do they show a pattern of realizing relatively small losses and large profits? Do they add to their positions as a major trend evolves?

• Lastly, look at the fee structures of the commodity advisors. Many work strictly on the basis of a percentage of profits. Some have a monthly or quarterly management fee on the equity in addition to a percentage of profits. Others may exact a front-load fee, as well. As a rule, try to avoid those which charge a management or front-end fee. The better ones may be those who are compensated only by a fair share in the cumulative profits.

Given the three alternative ways to play the commodities markets, you, of course, have to determine which is suitable for you. Do you have the psychological makeup to do your own trading and manage your own money with discipline and control? Will you follow a mechanical program faithfully and consistently? Perhaps you would do best with a professional commodity advisor managing your money for you.

Regardless of the alternative you choose, remember that commodity futures trading entails a high degree of risk. Only individuals who can willingly assume the risks should consider such an endeavor. For those who relish speculation and can afford to bear the risks, there are intelligent ways to take part in the commodity trading boom that offers extraordinary opportunities to reap fortunes.

If you have sufficient genuine risk capital ($20,000 plus) to invest with a registered commodity advisor, that may be your best alternative. If you have less than $20,000 available for speculation, you may be better advised to diversify into one or two commodity funds. Never forget that a fool and his money are soon parted. If you don't have what it takes to manage commodity trading, shamelessly acknowledge it and opt for professional management. You and your money may live longer.

Ray Pastor is a senior account executive with a major securities firm in Hallandale, Florida. He specializes in financial planning and tax-avoidance investments.