Conduct and Practices Handbook Course (CPH) Quiz 46

Patience
According to Gann, patience is the most important of the essential qualities for trading success. A good trader possesses the patience to wait for the right opportunity. If you are a good trader, you will not be over-anxious, because overanxiousness consumes capital and, over time, will tap you out. When you are fortunate enough to catch a good trade, you need the patience to hold it when it starts to move your way. Perhaps the primary failing of the amateur is to close out a profitable position too soon. In other words, patience is required for both
opening and closing a position. Hope and fear need to be eliminated. Gann tells us if you are in a profitable position, instead of fearing that the profit will turn into a loss, you should hope it becomes more profitable. You have a cushion to work within this case. When you are in a losing position, instead of hoping it will turn around, you should fear that it will get worse. If you see no definitive change in trend, use your essential quality of patience and just wait.

Knowledge
The stakes are high, and the competition is intense. You need a well-thought-out and thoroughly researched trading plan before you begin, and you need to do your homework. Your plan should always have a mechanism to cut the losses on the bad trades and to maximize profits aggressively on the good ones. You must be organized and remain focused at all times. If your plan is a good one, you need the consistency to stick with it during down periods.
My personal goal is to make money daily, but that is not always possible, so I try not to lose too much on losing days. It is a constant trial to maintain the vigilance necessary to not to let good judgment lapse. If you are a novice, it makes sense to “paper trade” before you trade for real. If you are trading currently, you should keep a logbook. Log your triumphs and your failures. You want to avoid making the same mistakes again, but I must warn you, all traders repeat mistakes. At the very least, learn not to make the mistakes so often. By keeping a record of what you do right and what you do wrong, you can identify areas of weakness and areas of strength. If you are not totally prepared on any given day, don’t trade. You can’t “wing it” in this business because the competition will eat you up. Over time, you will develop what I call a “trader’s sense.” You will know when a trade doesn’t feel right, and when this happens,
the prudent thing to do is to step aside. You cannot ignore the danger signals, and when they occur, you must act without hesitation. You must have a game plan and stick to it, but the paradox here is that you also need to be flexible. At times, it is best to do nothing, and you need to fight the urge to play for every pot. And, as I said before, stay focused. At times, I’ve been distracted by day trades and missed the big move because I missed the big picture. By the time I finally saw the light, it was too late.

Gann’s four essential qualities for trading success are patience, knowledge, guts and health and rest.

Futures markets, in their most basic form, market in which commodities (or financial products) to be delivered or purchased at some time in the future are bought and sold.
A futures contract is the basic unit of exchange in the futures markets. Each contract is for a set quantity of some commodity or financial asset and can be traded only in multiples of that amount. A futures contract is a legally binding agreement that provides for the delivery of various commodities or financial assets at a specific time period in the future. (Prior to the time I was in this business, I envisioned the parties actually signing contracts. It’s nothing like that.)
When you buy or sell a futures contract, you don’t actually sign a contract drawn up by a lawyer. Instead, you enter into a contractual obligation that can be met in only one of two ways. The first method is by making or taking delivery of the actual commodity. This is by far the exception, not the rule. Fewer than 1% of all futures contracts are concluded with actual delivery. The other way to meet this obligation, which is the method you will be using, is termed offset.

The only negotiable feature of a futures contract is the price.

The size of a contract determines its value. To calculate how much money you could make or lose on a particular price movement of a specific commodity, you need to know the following:
• Contract size
• How the price is quoted
• Minimum price fluctuation
• Value of the minimum price fluctuation

A lock-limit move means that there is an overabundance of buyers (for “lock limit up”) versus sellers at the limit-up price, or that there is an overabundance of sellers (for “lock limit down”) at the limit-down price.

Brokers and commissions
Although the margin isn’t a true cost (you get it back at the end of the trade, plus any profits or minus any losses), commissions are a true cost. Commissions are your broker’s fees for his or her services, and they range across the board and by broker. The two major types of commission firms are discounters and full-service firms.

This option is as important in theory as in practice because it is what allows physical commodity prices and the Exchange-traded contracts to come together at price. If the price of the commodity is too high in relation to the futures price, then the people involved in the use of a particular commodity buy the low-priced futures contracts and take delivery. Their buying,
in effect, pushes futures prices up to meet the physical price. If the price of a futures contract is too high in relation to the actual commodity, then producers of that commodity sell the contract to make a delivery because the higher-priced futures (in relation to the physical) just might be their best sale. Their selling pushes the price of the futures down to the cash price. This entire process is known as convergence.

The basis
In these examples, I have kept the basis fairly constant, but in reality, it can change. If a short hedger (one who sells futures) experiences a widening of the basis (where cash prices have fallen to a greater degree than futures—either cash has fallen faster or risen slower than futures), a basis loss may result. In other words, the short hedger’s cash position loss may be greater than the gain realized on the futures side of the transaction. Or, in a rising market, the gain on the cash side of the transaction would not be as large as the loss on the futures side.
Conversely, a basis gain would occur with a widening basis on a long hedge. The futures would rise in price to a greater degree than the cash. A narrowing basis yields additional gains for a short hedger (the cash falls less, or rises more, in relation to the futures) and incremental losses for a long hedger (the cash falls less, or rises more, in relation to the futures). Basis gains or losses are a risk to a hedger, but they’re not nearly as big a risk as what is called flat price risk.

Market if touched
Also called MITs, market-if-touched orders are the mirror image of stops. MIT is placed above the market to initiate a short position and below the market to initiate a long position.
For example, say that you are long platinum in 1405, and you want to take profits at 1420. You could place a limit order to sell at 1420, but you cannot be assured that you will be filled if the price touches 1420. The market would have to trade above 1420 to have a reasonable assurance that you are out. An MIT at 1420 becomes a market order if 1420 is touched, which will ensure that you are out at the next prevailing price. MIT’s tend to be filled better on average than stops because you are moving with the prevailing trend. In a market that moves 1409.50, 1410, 1410.50, 1411, an MIT at 1410 would be filled at either 1410 or 1410.50. If the next tick after 1410 were 1409.50, you certainly could filled at 1409.50 (because the MIT became a market order), but it is more likely that a buy stop at 1410 would be filled at 1410.50 in this example. An MIT could also be used to initiate a new short position above the market. An MIT to buy is placed under the market to exit a short position or enter a new long. If the market is trading at 100, you might place an MIT to buy at 99, but you would place a stop to sell at 99. See the difference?

If you trade options, you possibly will also hear the term delta, which is what I’m referring to above. Delta values range from 0 (for very deep out-of-the money options) to 1 (or 100% for options so deeply in the money that they move just like the underlying futures). At-the-money options have a delta value of 50% (or .5). Calls have a positive delta, whereas puts have a negative delta. If, for example, a 400 copper call trading for 1250 points (or 12 1/2 ¢) has a delta of .6, a 1¢ (or 100-point) move in the copper price results in a move of 60 points in the value of the call to 1310.

Financial futures
Financial futures can be broken down into three basics: interest rates, stock indices, and currencies.

Buying options to protect futures
Buying options to protect futures involves buying a put with long futures or buying a call with short futures. This strategy is also known as creating synthetic options because a put combined with a long future is similar to a call, and the call in conjunction with the short futures is similar to a put. You can make a case that if you buy an at-the-money call option while simultaneously holding a short futures position (synthetic put), or you buy a put option while simultaneously holding a long futures position (synthetic call) that the overall position will act just like a put or a call (so why bother?). Because this can be a better strategy since it gives you added flexibility.

Calendar spreads
Also known as time spreads, calendar spreads take advantage of the tendency of nearby options to decay faster than distant options. This strategy involves the sale of an option in one month and the simultaneous purchase of an option (usually, but not necessarily, the same strike price) in a later month. For example, you might sell a September 2500 cocoa call and buy a December 2500 cocoa call for a net debit. If the market remains fairly stable, you eventually gain the premium in the nearby to cheapen the ultimate cost of the distance, or there will
be a net gain on the entire position after some time passes. (You can, of course, liquidate both sides or just one side at any time.) One of the potential pitfalls in this strategy is that the spread values of the underlying commodity can change, perhaps favorably, but contrary to expectations as well. Many times, the nearby month, which affects the short side of the spread, moves more dramatically because of higher open interest and greater speculative play. The risk cannot always be predetermined to an exact level like the vertical spreads; however,
there is merit in this strategy if it is monitored and used correctly.

Fundamentalists look at trade balances, a country’s wealth, budget deficit or surplus, interest rates, inflation, and political factors such as tax rates.

A fundamentalist would analyze the following data:
• Seasonality: Although it does not happen every year, feeder cattle sales tend to peak in the fall, with the end of the grazing season. At the same time, calf/cow operators tend to sell off unproductive cows, which increases the total beef supply and depresses prices. Hog prices tend to be the highest in the summer months because the December-through-February time frame is traditionally a low-birth period. Also, the demand for pork tends to peak during the summer months.
• Corn and feed prices: The rule of thumb is that high feed prices result in liquidation and low feed prices result in accumulation. The other variable here is the market price of the finished product. If sale prices of cattle or hogs are high, then more money can be spent on feed. In 1996, when corn prices soared to a then all-time record high of more than $5 per bushel,
many cattle feeders found it more profitable to sell their stored corn and take their cattle to market (including breeding animals). Others could not afford the high feed costs, and this added to the liquidation. Prices of cattle spiked downward under the weight of the burdensome supply, but this turned out to be bullish for the longer term. This is pure economics. When
it is profitable to raise or feed animals, this is what producers do; when it isn’t, they don’t.
• Feeder costs: In cattle feeding, the feeder’s cost accounts for, in many cases, more than half of the total cost of production. Higher feeder costs lead to lower placements into feedlots.
• Weather: Tough winter weather can result in death loss and weight loss, which can reduce supply permanently or temporarily. At times, when the temperatures in the major feeding regions get extremely cold, cattle eat more and gain less. Animals that were to be ready for market at a certain date are “pushed back,” creating a temporary shortage, and there is a glut

• Consumer tastes: This can be approached in a macro sense and a micro sense. The per-capita consumption of beef or pork and how it changes over time affects price; this is a macro  fundamental, and it has to do with dietary considerations and media news. On a more focused approach, hot summer days increase barbecue demand, and holidays increase the demand for hams.
• Exports and income levels: When a country achieves a higher level of income, the demand for red meat increases. Exports to Asia have become a much more important factor in recent years, and unexpected new export business can, at times, result in price spikes. China is a major soybean (and at times corn) importer due in large part to its large and expanding hog
industry.

• The substitution effect: Beef, pork, chicken, turkey, and fish are substitutable commodities to a major extent. For example, if the price of chicken plummets, sales increase, which takes away demand from the other meats.

The ability to profit in both up or down situations is one of the advantages of spread trading. Also, the margin requirements for spreads are generally much smaller than outright positions because the Exchange recognizes that, in most cases, spreads are less risky. If you are long May corn and short September corn, and the president declares a grain embargo, odds are that both months will be down sharply. In other words, you are somewhat insulated from dramatic news with the resulting price shocks when spread trading. In addition, spreads tend to
move slower, giving you more time to react, and many traders believe spreads are more predictable.

Limited-risk spreads include carrying charge spreads. Carrying charges are the costs to hold a commodity from one month to the next and include storage costs and interest. For example, if it costs 3¢ per month to hold wheat, and the July/September wheat spread is trading at 8¢ premium to the September, by definition the risk on this one, is low. Unless interest rates rise dramatically, the likelihood that September would rise much more above July is minimal. However, if a bull market develops in wheat due to limited nearby supplies, there is no limit as to how far July could rise above September. These are spreads to watch for. Limited-risk carrying charge spreads can be found only in storable commodities. On the other hand, there is no limit to how spreads can vary in either direction for perishable commodities such as live cattle.

How can you tell if a market is in a blow-off top?
Close to the end of the move, during the top formation, the market surges higher, with only shallow corrections. Compared to the norm, volumes are huge. Technical indicators, such as the Relative Strength Index [RSI], run up to extremely high (overbought) readings, but although these readings appear to be in unsustainable territory, the market continues moving higher than anyone believed possible. Then you’ll hear outlandish price predictions in the mainstream media, along with talk of shortages in this or that. The talk will be that the world is going to run out of X commodity. In many cases, the last 48 hours of a major move can be the most feverish and therefore the most lucrative for the bulls. This final surge that forms the actual blow-off is the most painful for the bears. Their capitulation (short covering) creates the final high prices. Nobody I know of is able to pick the exact top in a situation such as this.
However, in markets that show these signs, if you have been fortunate enough to be on for some of the ride, it’s time to be vigilant because the end is near. The top price will come when nobody is looking and generally when the news is as bullish as it can get.

The one problem with double tops and bottoms is that they don’t always occur at the top or the bottom. You have to be careful because, many times, you’ll see these in the middle of moves (which obviously doesn’t help in identifying a top or a bottom). As I’ve stated before, there is no holy grail. All you can hope to do is place the odds in your favor, using good money management to cut the losses on the trades that don’t go according to plan. To avoid false signals, it is important to wait until the pattern is completed. This removes some of the profit
potentials but also improves your odds. Make sure you look for double bottoms and tops only after a major top or bottom is made and then wait for the market to test the low/high and then rally/break significantly, which increases its validity. How much is “significant”? Unfortunately, I can’t give you a number, but after you have been doing this awhile, and after studying hundreds of charts, you’ll get a feel for this in various market situations.

Pennants work just like flags and rectangles. The basic difference is that the boundaries are not parallel.

How can you tell a breakaway from a common gap? Common gaps are filled fairly quickly. Breakaway gaps are not filled for a long time, sometimes never for the life of a contract. They signify the start of a new and major trend move. Many times they form out of consolidation or during blow-off highs or lows. The breakaway day is accompanied by greater-than-normal volume, usually at least 50% greater than the average volume of the preceding two weeks. These are significant and powerful tools that you should be alert for constantly. Particularly, watch for them when a market appears to be “cheap” or “expensive.” The market could be based on a major bottom or climaxing for a major top.

Six rules for trading OI
The following sections describe six profit rules for analyzing OI.
1. If prices are in an uptrend and OI is rising, this is a bullish sign

2. If prices are in a downtrend and OI is rising, this is a bearish sign

3. If prices are in an uptrend and OI is falling, this is a bearish sign

4. If prices are in a downtrend and OI is falling, this is a bullish sign—the mirror image of rule 3

5. If prices are in a congestion range and OI is rising, this is a bearish sign

6. If prices are in a congestion range and OI is falling, this is a bullish sign

Oversold is the antonym: The market is too low, running out of sellers (at least for the current time period), and ready for a bounce. Oversold is not a scientific term and is bandied about somewhat arbitrarily. The RSI attempts to quantify the degree of oversold or overbought.

The RSI tends to get high in the mature stages of a bull market and low in the mature stages of a bear, but there is no magic number that signals the bottom.

What causes a market to invert? In most cases, an inverted market is the product of a perceived or real near-term shortage of the commodity in question. This can be caused by weather. For example, cold weather tends to push the nearby natural gas over the back or could even push the nearby cattle contracts above the backs because cattle do not gain weight efficiently in cold weather and could conceivably be “pushed back”—not ready for market in a timely manner. Inversion could be caused by a mining strike, a government program, big near-term export demand, or a classic short squeeze—actually, any number of things. The important point here is that the spreads can give you important clues about the strength or weaknesses within a market.

If the news is considered bullish, the SNI is your major support number and, if acting properly, the market should remain above it. If the market is acting properly after a bullish event, you can enter a long position with a stop just below the SNI.

Diversification
When trading using my pivot indicator method, I recommend diversifying into a minimum of three unrelated markets. These markets should be liquid to allow for stop orders with minimal slippage. Although this rule is not written in stone, and I also believe that you can make money using this methodology trading just one or two markets, this generally requires greater patience, particularly if you start at the wrong time. The idea is that the greater the diversification, the greater the chance of catching a major move somewhere. At any point in time, one market might be in a major uptrend and one might be in a major downtrend, with a third trendless. The pivot indicator method works because the major moves will be profitable enough to offset the inevitable smaller losses inherent in those choppy market situations. The odds of catching major moves increase with the number of markets traded. One caveat: They should be unrelated markets.

After a bearish news event, a move above the SNI generates an automatic buy signal, and you can immediately enter a long position with a tight stop just below the SNI.