Actual trading events where things went very wrong - and how to avoid them
The Six Sure-Fire Ways to Fail Trading Commodities:
5) Load Up With Everything You Have in Your Account
We’ve all read the same stuff about commodity trading money management...about how we should only risk 5-10% of our account one any single trading idea, etc. Much of the trading folklore is false, but this one idea is the truth.
During the last 2006 gold commodity market run up, I sometimes chatted with commodity futures brokers about the anonymous results of their clients who traded their own accounts. No names, just results. There was one futures and option trader who stood out. He was right about the gold market. He hated buying way out-of-the-money inflated options on futures (for good reason) and stayed with futures contracts only.
He was a brave soul who had about $100,000 to work with and held maybe 5 futures contracts for the long haul. As gold futures moved from the $500/oz area toward $650, he was making a good score. I was proud hearing of his ability to sit through the corrections and add more on the dips. He was up to about 12 futures contracts. His protective stops were down maybe 25 full points away from the action. His stops were safe at the time because the volatility was mild. His was a textbook campaign so far.
Then came the day when the gold futures market took its first sharp dip and stopped him out. He made about $60,000 on the trade, but was angry he got stopped out. The gold market took off again to the upside. He lost his discipline and started buying breakouts. Gold futures contracts went into a nasty chopping range for a month as he bought futures most days and got stopped out for losses.
He was livid. He then started buying larger and larger lots and moving his stops farther away. The market always figures a way to screw the majority at any one time and continued to take him out. In short order he gave back the $60K profit and some of his principal.
This was his second warning to stop and pull the plug on himself, but he didn’t get the message. The gold market had changed from a trending market to a chop. Finally he decided to change his tactics and join’em in the chop game. He started buying 20-lot futures in the middle of the night with stop loss orders a few dollars away. This wasn’t his game and he lost again, dropping another $50K. The market started to trend up again as he added more new money to his account to buy the breakouts. The days were running out for this gold bull leg. Gold future contracts were sometimes having daily swings of $50. It was totally Jaws V.
Then he decided he needed to buy gold call options to survive this intra-day and overnight volatility. He loaded up on strikes at 900 and 1000, far out-of-the-money. At about this time gold futures contracts finally made their top at over $700/oz as he correctly forecast in the beginning. He would have been up over $120K just by sitting tight.
Since that time, gold futures have declined sharply into the low $530 range. His option account eroded to worthless. While holding call options, he had gotten stubborn and decided the market would not boot him out, no matter what. Does this sound familiar?
What can we learn from this? He started out well, but unfortunately made a multitude of errors in the end. He had a fixed scenario, lost his discipline, traded too large for his account and bought far out-of-the-money gold options that were inflated in value. It’s sad, really. The saddest part is that he was correct on the direction of the gold futures market! He KNEW gold was going up and had started buying futures contracts in the lower $500/oz zone.
He was right as rain for several months and was doing fine. But the market changed from a trending, to a chopping, then finally to a bearish decline. This is quite normal in normal markets. Remember to always trade for a normal market! He was always looking for a classic gold-bug blow-off scenario. Sure it will happen again someday, but not often enough to risk money on it every time.
SOLUTION: The moral of this story is back to our 5%-10% money management rule. ALL the bad things in this tale could have been greatly softened if he risked only 10% or less on any one trading idea. He would still be trading. It’s no crime to get sloppy and lose our discipline. We are human and will always have trading issues. But an all-or-nothing attitude will sink us every time. (Read some of my lessons on "Win-Loss Ratios and Risk")
Part Six of Seven Parts - Next!
There is substantial risk of loss trading futures and options and may not be suitable for all types of investors. Only risk capital should be used.
Thomas Cathey directs the managed futures division of Thomas Capital Management, LLC. Get FREE, the complete 44+ lesson, "Thomas Commodity Trading Course" by visiting: http://www.thomascapitalmanagement.com/commodity/welcome.htm It's brand new and fun reading... a "street-wise" trading e-course. Visit the main Thomas Capital Management trading website at: http://www.ThomasCapitalManagement.com