|Scale Trading is
a disciplined, mechanical approach to buying low and selling high.
It is based on the economic law of Supply and Demand, built on the
premise that a physical commodity has an intrinsic value and, therefore,
will not likely become valueless. For example, if the price of corn
falls below the cost of its production, growers will be motivated
to cut back or switch to another more profitable crop, thereby reducing
the available supply for the coming year. As supply shrinks, price
eventually moves higher to ration demand. This in turn attracts producers
to increase production, thereby increasing supply, and the process
starts all over again.
The concept of intrinsic value does not necessarily
apply to other investments. For instance, the stock of today's hot
company could actually go to zero due to any number of micro or
macro economic circumstances, while a bushel of corn has an intrinsic
value virtually assuring that its price will not go to zero.
The what works for the Scale Trading approach
is that we can outline our trading plan ahead
of time by carefully evaluating current supply/demand statistics
and then comparing those with the commodity's historical price range.
This gives us the ability to then pinpoint the price at which we
want to begin our scale down buying and, most importantly, calculate
the total capital we will likely need to maintain that scale under
our worst case scenario.
By sticking with "Mother Nature" commodities,
particularly those which are grown for human consumption, we ensure
that even the worst case scenario will eventually give way to a
recovery in prices. While our worst case scenario does not represent
a guarantee of what our ultimate exposure will be, the principles
that drive the law of supply and demand are the best tools we have
found for long term success in the commodity markets.
Scale trading provides the edge and hedged scale
trading sharpens that edge, allowing experienced traders to stay
on both sides of the market and use their edge most effectively.
Understanding Hedged Scale Trading covers everything traders need
to know to work with the increased leverage provided by scale trading
while covering their backs against the inevitable moments when,
despite taking every precaution, they find fast-moving markets moving
Working with the Scale Trading example
What we need, then, is to develop a system that
will accomplish this allocation of capital to our strongest and
best-performing stocks. As it turns out, we can do this by simply
reversing the scale trading approach learned about in the last chapter.
So in other words, we add equal dollar amounts to our stock positions
as they move up in price, instead of when they move down in price.
Everybody likes to buy a bargain
- the opportunity to get something they want before prices
get back to normal. Thats the premise behind the
trading approach known as scale trading. Like most methods,
scale trading is not a cut-and-dried, easy way to trade. For one
thing, you might decide the price is already low and just cant
go any lower. And then it goes lower - much lower, as recent traders
in energy, hogs, sugar, copper, soybeans and other markets can attest.
For another thing, even though everyone recognizes
the price is unusually low, not enough buyers step in and the market
just sits at the low end of its historic range for an extended period
of time until buyers give up. In a nutshell, scale trading is for
those who are very patient and have very deep pockets. But the current
situation is unique and may be the ideal climate for scale trading.
Normally, one or two markets may be candidates for scale trading
each year, but virtually every commodity has offered scale traders
the potential for substantial rewards in the last year. In addition
to patience and money, here is the combination you need for scale
trading: Physical commodities only - something that is grown or
mined and is consumed, therefore subject to supply and demand forces.
Historically low prices - you can determine that several ways but
basically all you have to do is look at a long-term price chart
for the last 20-25 years and divide the price range from low to
high in thirds. A market in the lower third is a candidate for scale
trading although you may not want to implement such a plan unless
prices fall into, say, the bottom 10% of the total range or a more
recent range of, say, the last 10-15 years.
Scale Trading Strategy -
If you are Warren Buffett buying cheap silver or stocks, you can just
hold on for a price increase that inevitably will come, although it
may take years. Futures trading, however, requires something more
than just buy and hold to capitalize on low prices. Soybeans provide
a good example of both the promise and problem that scale trading
offers. Soybean prices have been below $5.25 a bushel only a couple
of times since the early 1970s so when prices continued a long slide
to new lows in early 1999, it looked like a good scale trading opportunity.
With $5.25 as your starting point, you decide to buy one contract
every time prices decline 25 cents and sell that contract when it
rallies 25 cents. When prices hit $5, you buy one contract - after
all, prices cant go much lower. You ride out a further decline
and when prices rally at the end of March, you sell the contract.
You have made 25 cents or $1,250. Scale trading looks very promising.
Then prices fall and you buy at $5 again. This time the rally doesnt
go high enough to trigger your sell signal so you are holding one
contract. As prices hit the skids, you buy another contract at $4.75,
another at $4.50 and another at $4.25 (red lines). At the low around
$4.05 in July, your fourcontract position is down almost $21,000,
counting all margins, trading losses and commissions. Now, scale trading
looks a little scary. If prices linger at the lows and positions have
to be rolled over to the next contract month, that would introduce
another element of uncertainty.