There are several approaches to futures and options trading. Generally, methods are separated into two broad categories; 1) Technical, and 2) Fundamental. Popular applications of technical and fundamental analysis frequently involves interpretation by the individual practitioner. For example, a crop report might indicate a decrease in wheat production for the United States. It is up to the trader to determine how this information might effect prices. The trader would need to know other information about the wheat market which could include the total projection for supplies, carry-overs from the previous harvest, and production from other countries. Demand for wheat is also an important fundamental factor.
Technical analysis is often associated with evaluating chart "formations" and "patterns." A significant drawback to this technique is the subjective nature of the evaluation. Pictures present different images to each individual. Therefore, it is difficult to determine if chart reading is effective from one person to another. In addition to charts, technical analysis involves the measurement and comparison of market-generated statistics. The most commonly used market statistic is price. For stocks, trading volume is sometimes considered important. In futures and options, "open interest" can become part of the equation. Most of us are aware of the value of measuring price changes. Volume is simply the number of transactions (buys and sells) during a specific trading session. Open interest is unique to futures and options because it represents the number of "contracts" existing between buyers and sellers. Some relate open interest to the number of outstanding shares in the stock market. However, this is not an appropriate analogy because open interest begins at zero and is variable throughout the life of the futures contract or option.
These are basic concepts that can be reviewed in any beginning text covering futures and options markets. If you are new to these financial vehicles, it is wise to review a few books. Philip Gotthelf, Publisher of the Commodex System, has written "TechnoFundamental Trading" which does cover these topics in greater detail.
Once you understand the dynamics of futures, options, technical analysis, and fundamental analysis, you might ask, "What now?" One of the most frustrating experiences for new and even experienced traders is the need to sort through information to arrive at a money-making decision. There are several components to a successful trade. First, you must decide which market has the potential to move either up or down. Then, you must decide where and when to place your trade… buy if you believe prices will move higher, or sell if you predict a lower market. You must also consider protecting yourself if your decision is incorrect. Therefore, stop-loss levels are an important consideration. Stops can be based upon "support" and "resistance," or determined by a dollar exposure level associated with risk. You may decide that a particular price cancels your technical or fundamental premise for a trade. In the alternative, you may decide that you can only afford to risk a certain amount on the transaction.
As you can imagine, a comprehensive trading program can become complex… even if you are only dedicating a small amount to your speculative venture. There is a need to objectively put all of the components of trading into a streamlined, automatic routine… This is called a : "trading system."
Unlike popular technical tools such as the Relative Strength Index (RSI), stochastic indicators, price averages, momentum oscillators, Market Profile®, and more, a system packages market forecasting with a total decision-making process so that all trading action is consistent and in accordance with a set of procedural rules.
Here’s how it works:
STEP 1. The Market Forecast
The first essential of any system is a model for forecasting potential price direction. This model may be technical or fundamental. The critical criteria is that the model must be consistent. The basis for making the forecast should be fixed. Too often, traders try to change their model the instant a trade doesn’t work. When you change the forecasting tool, you lose any consistency to your market approach.
The measurement for any forecast is its "accuracy." This is a narrowly defined term when dealing with systems. Accuracy is the degree to which your model can make a correct prediction of price direction. But, the prediction, alone, cannot yield a profitable trade. You must add "decision rules" that are based upon the "forecast."
STEP 2. The Decision Rules
Once you have an idea about the possible price direction, you must make a decision whether to trade in accordance with your prediction. For example, suppose you correctly pick the winning million dollar lottery number… but, you didn’t buy a ticket! Obviously, your prediction is of little use. The same is true for trading. The forecast must be accompanied by action to trade. This may appear simple, however, it is not always properly incorporated into a market approach.
Let’s assume you have predicted a price rise. Here are some considerations:
What is the margin?
What is the contract size?
How does this fit my portfolio?
How far do I believe prices will rise?
What is the commission relative to my predicted price move?
All of these questions lead to the ultimate question, "Should I take the trade?"
Because every trader is different, there is no way to answer all of the pertinent questions without some subjective and personal input. This is extremely important to understand since a system like Commodexis designed to generally fit the needs of most traders. Commodexis not a customized system. You must create your unique trading routine based upon the amount of capital you have for your account, your aversion to risk, and your profit objectives.
A systems approach to the decision process is to base buy and sell action upon identical circumstances. For example, a simple system might be to buy long when price crosses a 10-day moving average to the upside and sell short when the same average is violated on the downside. The forecast is that prices will continue rising when price is above the average and will continue falling when below. The decision is to buy or sell based upon the moving average.
Just as accuracy plays an important role in determining the effectiveness of a forecasting method, "efficiency" is essential to a successful decision process. Efficiency is the degree to which a decision is able to capture profits from a forecast. Let’s say your decision is to buy when the 10-day average is crossed by rising prices. The price moves up and you have an initial profit. Yet, by the time prices reverse and move down through the average for your sell decision, you have not accumulated sufficient profits to cover commissions. This system would be "inefficient." Efficiency is usually measured as a percentage of maximum profit. Your decision rules might capture 30% of the best possible profit potential after the forecast. Believe it or not, as little as 10% efficiency can be a highly profitable decision process in fast-moving futures and options markets.
3. Stop Loss Orders
There is no such thing as a "perfect forecasting system." At least, not one that we know exists. With this in mind, you should protect yourself against excessive losses if your initial forecast is incorrect or if the efficiency of the decision is deficient. Therefore, a comprehensive system should include stops losses.
A stop loss is an order to exit a position. It can be used to protect capital against excessive exposure or to lock in profits as a trade moves favorably. You will notice that stop losses are part of the Commodex® System. This is one more feature that sets systems apart from indicators.
Commodex stops are based upon support and resistance measured using price comparisons in conjunction with open positions. However, Commodex also allows you to move stops based upon profit objectives. Again, all traders are not the same. Your level of exposure is directly linked to what you can afford and what you want to risk.
Let’s face it… Some people will jump out of an airplane with a parachute because they like the thrill – even at the risk of a fatal accident. Others find the risk outweighs the thrill. This is call your "risk aversion profile." No two traders are likely to be exactly the same. Some like to jump; some don’t!
PUTTING IT ALL TOGETHER
The Commodex® System seeks to put all of the essential elements of successful trading together into a complete self-management package at an affordable price with convenient access. Commodexis not an indicator like the RSI. However, components of the system like the TREND INDEX may be used in a similar fashion. Commodexputs all the pieces together. It remains the oldest daily futures trading system published in the world.
If you have further questions about systems or COMMODEX, write us an e-mail at firstname.lastname@example.org. Or, call toll-free in the U.S. at 800-336-1818. Foreign callers can dial 201-784-1235. Our fax is 201-784-0854.
Systems trading is exciting. If you have the financial capacity to trade highly leveraged futures and options, please explore using Commodex as part of your regular routine