Martin Kronicle

“Better regulation is the key to avoiding future financial excesses, Federal Reserve Chairman Ben S. Bernanke said Sunday, arguing that the Fed’s low-interest-rate policies early in the decade were not a major cause of the housing bubble.”

Victor and I co-wrote an article on regulation in the commodities industry for the Ludwig von Mises Institute a few months ago. Although it’s a bit technical, the end result is that we believe further and future interference from academics and lawmakers will result in more bubbles and blowouts. Capitol Hill has proven that they are very bad traders.

I think we’re going to have a lot more “liar outbreaks” in some of these sessions, especially those featuring testimony from Bernanke.

If you’re a discretionary trader, you might be developing your exit rules on profitable trades. This in my opinion is one of the hardest things to develop. Exiting losing trades is very easy in a way. Calculate how much you’re willing to lose, enter your protective Stop Order, and you’re done.

But how much can you make? That is the million rupee question. Trend Following does not predict the maximum move, so you are left with looking at the price chart and picking your exit point. (You can be a Trend Following Discretionary trader – learn to read the tape.)

In these markets, it is entirely possible for you to make large unrealized gains in a short period of time. And these large quick gains can be more destabilizing if you are just starting out than consistent small loses. Are you good or lucky? You’ll get your second million rupees for knowing the answer to that question. For example, with $20,000 in starting equity, a $50 move on one Gold contract will result in a 25% increase in your account. Let’s assume these are unrealized gains – the position is still open.

In order to protect your capital, most of your unrealized gains, and most importantly, your positive emotional level at this point, you must pick a spot – a price – after which point you are willing to transfer the risk to someone else.

Example (For illustrative purposes only): Assume the trader is new to trading and it not adequately capitalized to run a system.

Say you are long Gold at $1,100 and it rises 4.5% to $1,150 – what to do? Your instincts tell you to stay with the trend. But you also know that you cannot let a winning trade become a loser. If Gold can rally $50 in one day, it can also drop $100 – a good rule of thumb.

You enter, in this case, a Sell Stop order at $1,135 to exit the trade profitably. You won’t capture the whole $50, but you won’t let it go back to $1,100 either. You will preserve your capital, some of your gains, and you will end up in 100% cash, feeling good, and thinking with a clear head towards your next trade. You’ll have to pick and choose the levels that work for you. I am not recommending these numbers, they are only to illustrate general price movement and what a trader will have to consider.

What NOT To Do

Do not lever up your account at this point. In the early goings, you’re not going to know whether you are good or lucky or both. If you are trading 1-lots, stay with 1-lots. We’ll talk more about increasing your trading size in later posts.

How Professionals See This

Don’t calculate moves in $$$, but see them in % terms. Most of the media reports will undoubtedly report big moves in dollar-terms. Professionals see moves in percentage terms. That’s the fist step to calculating the odds and bet sizes. We’ll cover that in the future also.

If you have feelings of regret because you didn’t catch the top, go take a yoga class and take the day off. Preserving your capital and always managing risk are the keys to longevity.

How does one start out given that with a small account ($10K-$30K) one seems to be “priced out” of some of the markets, and the risk seems to be a higher percentage-wise (relative to the account size) with fewer markets available?

Great question and it’s one that we all had to face at the beginning of our careers. I knew ahead of time that my own account was NOT going to be my model account. Therefore, I didn’t have to worry about wild swings in my equity – which you can experience with a smaller account – although I always tried to keep small drawdowns.

That said, you are correct – it’s hard to run a systematic, rules-based methodology with a small account. However, you can pick one market in each of the areas of the metals, grains, indices, etc. and trade them with your model or rules until your equity grows. For example, you might consider gold, crude oil, S&P, soybeans, US Dollar Index, and the 10-Year Note —- just as an example. I’m just giving you a for instance.

If that’s too much, just go with one of them like gold and apply your rules there. Plenty of traders became experts in one area before branching out. Eric Bolling comes to mind. You can do that too.

Many traders normalize risk using an expression of the Average True Range (ATR) so that emotionally, they are indifferent from one contract to another. In doing so and adjusting for volatility, 3 Gold contracts, 1 soybean contract, and 2 S&P contracts might all be equity with respect to the overall risk to your portfolio. If that’s too much for you at this point, trade 1-lots. The idea is if you lose all your marbles, you can’t come back and play tomorrow.

One reality is that your margin to equity ratio will be high compared to the level of larger CTAs. Nothing you can do about it at this stage. Most large CTAs will have no more than 15% at the max, and that is probably high. For example, if you trade 1 Comex gold contract with a $30,000 account, your M/E ratio is (5,400/30,000) or a little more than 16% – more than any large CTAs would have for their entire portfolio of maybe dozens of commodity positions. You can trade the mini contracts too, nothing wrong with that.

You’ll have to measure your risk as the distance between your entry and your exit stop, multiplied by the # of contracts and what percentage that is of your overall equity. $300 is 1% of $30,000. I would focus on that as you begin your trading. I’ve never thought of my initial margin as the amount I was willing to risk on a trade.

Things to consider

—Don’t pyramid or add to winning positions at this stage. Grow your equity along the slow and steady route. You hear romantic stories about guys ramping up their accounts 10-fold over the course of a year, but in my experience, there are hundreds more who have blown up and lost it all going for those same gains. The Ex Ante Expectation of high reward comes with the Ex Post Realization of losing all your capital.

—Manage your losses as a percentage of your total equity and be very rigorous in placing your offsetting/exiting Stop Orders. Mental stops are for Professionals – which is not you at this stage. Enter your orders into the computer. No one cares about your model and no one is going to try to reverse-engineer it.

—Write your trades down on a piece of paper BEFORE you type them or call them in. This will minimize the severity and frequency of the mistakes that you can make. And you will make them too.