T Investment advice from Marc Barhonovich.
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 against them.

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.” That’s 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 can’t 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 can’t 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 doesn’t 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.


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