Scale Trading Demo

What is Commodity Scale Trading?

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 tangible commodity has an intrinsic value and, therefore, will not become valueless. For example, it becomes more difficult for prices to drop as they approach zero.

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.

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.

Scale Trading uses common price oscillations in a defined range to execute trades. This approach to trading commodities maps out when to buy and when to sell which would be in the lower end of their historical trading range, especially at or below the cost of production. 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. It is our opinion that 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, it is also our opinion that the principles which drive the law of supply and demand are the best tools we have found for long term success in the commodity markets.

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 to this 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.

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. This time wheat continues 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 then rallies 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 original $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.

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 used a worksheet, but the calculations can be done by hand. We use the maintenance margin for our calculation. It is important to keep in mind that margin requirements can change without notice.

What Can Go Wrong?

In selecting the scale parameters you have now evaluated current supply/demand fundamentals with your commodity broker and have 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 maintain the scale.

However, 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 the other. This can be a hair-raising experience if one is not prepared for it. This is not a 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 analysis suggests.

· The lowest conceivable price under the worst imaginable 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 get out 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, it does have risk. The primary risk involved is that the law of supply/demand would somehow stop working. While this routinely seems to occur in the short run, it is unlikely to happen in the long run.

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 where 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 drawdowns in equity as well as drawdowns 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 wheat is going to $1.00 per bushel or Crude to $5.00 per 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 instead confirming adequate cash reserves and then re-affirming your belief in the principles driving the law of supply and demand.

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 never returned to those levels, we can reasonably expect that at some point in the future soybeans will exceed those levels. 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.

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 by your broker can require close monitoring, so it is important that other brokers in the office also understand scale trading and be able to fill in when your broker is at lunch or on vacation.

Your broker should be able to provide you with long term fundamental information on the scales you are pursuing. Day to day fundamentals are not nearly as important.

What Does Byrne Investment Services, Inc.Offer?

Byrne Investments has a wide range of experience in scale trading many different markets. A significant percentage of Byrne Investments clients are Scale Traders so we devote a large amount of our 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.

If I Want to Pursue Scale Trading, What Should I Do?

Call Byrne Investments at 1-800-250-3450 and get whatever answers you need to feel comfortable with Scale Trading.
Let the broker know what level of capital you have to work with and get a sense of what scales might be appropriate for you.

Testimonials:

C. Albright
Georgia

S. Lucek
Ohio