Scale Trading Tutorial

 

Scale Trading also known as Value Investing or Interval 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.

A question to consider is, is it easier for wheat prices to move from $4.00 per bushel to $2.00 per bushel, or from $2.00 to zero? Each move represents $2.00, however, common sense says that we will never see wheat being given away for free! Therefore, if the price of wheat 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 of wheat 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 scale trading does not necessarily apply to other investments such as bonds or currencies.

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 wheat has an intrinsic value virtually assuring that its price will not go to zero. Since financial assets such as currencies, bonds and stocks do not have a cost of production and can be subject to devaluations or crashes it is advisable to avoid scale trading these paper assets. Therefore, the scale trading technique is geared toward only scaling tangible commodities. My adage is “If you drop it on your foot and it hurts then you can look to scale trade it.”

The beauty of 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 QUESTIONS AND ANSWERS

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The Scale Method: Selecting and Managing a Scale.
1. Look for a commodity that is trading at or near historically low levels, ideally in the lower 30% of its historical trading range.
2. Complete a thorough review of the fundamental factors influencing the commodity in question. What are the short and long term supply/demand expectations for the commodity? Do they support an assumption of the commodity holding at or above its historical lows?
3. Evaluate the seasonality of the commodity in question. Seasonal pattern charts are available for most agricultural markets such as corn and beans. Timing when to start a scale can make a big difference in the performance of your scale account.
4. Enter limit orders GTC (Good till Canceled) to purchase the commodity (going long, never short) on an incremental scale all the way down to a level determined to be a "worst case" scenario.
5. As each interval buy order fills, enter a limit sell order to close out the position at a pre-determined price that normally captures a $250-400 profit (net of fees and commissions), although this will vary depending on your personality and market conditions.
6. As each sell order is filled re-enter the limit buy order at the original scale interval purchase price.
7. Continue along this path until the commodity you are Scale Trading bottoms and rallies
How to Calculate The Amount of Capital Required
Two factors determine the capital required for your scale. How wide or narrow your buying increments are, and the margin requirement for each contract purchased. We use a worksheet, but the calculations can be done by hand. For our scale calculations we use the current maintenance margin requirements. It is important to keep in mind that margin requirements can change without notice. http://www.byrneinvest.com/margin-requirements.html
What Can Go Wrong?
In selecting the scale parameters we have evaluated current supply/demand fundamentals and determined that the commodity is in the lower 30% of its historical trading range. Based on that assessment we come up with our buy/sell lines and the capital required to participate in the scale. BUT, what if the fundamentals change drastically and the price falls below our worst case scenario? If you scale trade for any length of time this situation will eventually occur to some degree or another. This can be a hair-raising experience. However, this is a manageable problem as long as you have adequate capital reserves to back your position and the world still has a demand for the commodity. We like to use three possible downside targets when planning our scales:

• The most likely low that a pool of respected analysts suggest.
• The lowest conceivable price under the worst rational circumstances.
• A price 15-30% lower than our worst case scenario.

Obviously, if you run out of money you will be forced out of the market and will lose the lion's share of your capital allocated for that scale. In an extreme situation, such as that wheat was linked to cancer in humans, then obviously we would most likely exit all positions and take the loss. In the absence of such an extreme, however, the law of supply and demand should eventually work the price of the commodity back in your favor. You should have a clear understanding that scale trading is not a free lunch, we do have risk. The primary risk we have is that the law of supply/demand would somehow stop working. While this routinely seems to occur in the short run, it is very unlikely to happen in the long run.
Why Can't You Scale Trade From the Short Side?
All markets have a downside limit of zero and a likely downside around their cost of production. However, what is the upside limit to a market? The fact is it is very difficult to determine the upside limit. Under the right circumstances, prices can greatly exceed previous highs. What would have happened if you had been short scaling soybeans in 1973? Prior to the end of 1972, the highest all time price for beans was $3.75 per bushel. In 1973, the price went to $12.90 per bushel. While the price has recently returned to those levels, we can reasonably expect that at some point in the future soybeans will exceed these high levels again. Only if you scale trade from the long side can you determine the approximate risk you are taking and manage it appropriately.
What is the Life of a Scale/ What If My Contract Goes Off the Board?
If by first notice day you are still holding contracts in your scale, you must execute a "rollover". In a rollover you close out your positions in one contract month and reestablish the trade in a later month. When a rollover is completed you will realize the paper losses you have been carrying in the scale and enter into the new contracts at the then current price. Your sell orders for these new contracts are established in the new contract month. In any scale, you want to trade in a later month that offers the price, volatility, liquidity and time you need to close out your scale. Typically this is about six months until expiration.
Why Can You Lose Money Scale Trading?
In our experience the primary reason people lose money scale trading is that they let their ego get ahead of their pocketbook. They either pursue too many scales at one time or they get too aggressive in one scale. An important point to consider before you begin Scale Trading is how much "emotional capital" you have. Almost everyone enjoys Scale Trading when they are buying and selling in the top 1/3 of their scale. They are buying and selling and buying and selling and don't seem to care which way the market goes. It is at the point when you enter the bottom 2/3rds of your scale that the going gets tough. It is important to assess your level of tolerance for large draw downs in equity as well as draw downs in your emotional capital.

In our experience, people who lose using this method lose because they bail out, frequently right at the lows, having been influenced by the thinking of the experts that "this time is different" and that Corn is going to $1.00/bushel or Crude Oil to $8.00/barrel. While potentially this can happen, (and you would be well advised to be prepared for that possibility), you would be much better served by providing adequate cash reserves and then re-affirming your belief in the principles driving the law of supply and demand.  
What To Expect From My Scale Trading Brokerage
Make sure the firm you choose has experience with Scale Trading. Like any methodology there are fine points and idiosyncrasies that need to be addressed. The execution of your scale with your broker can require close monitoring, so it is important that other brokers in the office also understand scale trading and will be able to fill your orders. Your broker should be able to provide you with long term fundamental information on the scales you are pursuing. Day to day fundamentals generally are not nearly as important.  
What Does Byrne Investment Offer?
• Byrne Investments has a wide range of experience in scale trading many different markets.
• Several of Byrne Investments clients are Scale Traders so we devote time and research to its proper implementation and execution. You can take advantage of the knowledge gained through years of Scale Trading experience.
• Byrne Investments spends the time necessary with each client so that they understand their risks as well as the rewards regarding their trading. We feel it is important for you to know what is happening with your investment capital.  

Hypothetical Example

On January 1st you decide (after reviewing wheat historical charts and conversing with your broker) to start a 10 cent wheat scale trade starting at $3.00 per bushel. This means that you will purchase one wheat contract starting at $3.00 and an additional contract every 10 cents lower, i.e. $2.90, $2.80, $2.70, etc.

In addition you will also place an order to sell a wheat contract 10 cents above where each contract was purchased. On January 4th the price of wheat falls to $3.00 and you buy your first contract along with placing a profit taking sell order 10 cents above the purchase price at $3.10. From this point on if the market rallies 10 cents you take a profit, however if the market falls ten cents you will buy an additional contract following the scale trading plan.

On January 7th the wheat market has rallied and you are now a seller of the $3.00 buy order at $3.10. However, on January 14th the wheat market falls back to $3.00 per bushel so you are once again a buyer and place a profit taking order at $3.10 again. Now the wheat futures continue to fall in price and on January 27th you buy your second wheat contract at $2.90. When you purchase the contract at $2.90 a profit taking order is also placed at $3.00. Wheat futures the rally and on February 14th you sell the contract that you bought originally at $2.90 for a profit at $3.00. This leaves you with one contract in inventory the first level $3.00 buy. Wheat continues to rally and on February 22nd you sell the $3.00 buy at $3.10 to exit the scale and take a profit, less all commissions and fees.

This hypothetical example has given you three opportunities to buy wheat with each one providing a sell of that contract ten cents higher in price for a $500 profit on each minus all commissions and fees. Commissions and fees average about $25 for each trade.
If I Want to Pursue Scale Trading, What Should I Do? 
• Call Byrne Investments at 1-800-250-3450 to receive the answers you need to feel comfortable with Scale Trading.
• Importantly quantify what level of risk capital you are willing to commit to get a sense of what scales may be appropriate for you.  

 

 

Please call: 800-250-3450 or Email: jim@byrneinvest.com

 

 

 

 

This material has been prepared by a sales or trading employee or agent of Byrne Investment Services, Inc. and is, or is in the nature of, a solicitation. There is a significant risk of loss when trading futures and options contracts. Please read our full disclaimer.

 

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