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Thursday, July 24, 2008

Trading FKLI, FCPO

This article is dedicated to "starter" and fellow chatters who has asked me about trading futures.

Disclaimer: I am not an experienced futures trader - I have only opened my first futures account recently, although I have known about futures for an extremely long time. If you are a newbie, futures are definitely much riskier than stocks. This article is mainly about one type of risks of trading futures. Like all risks, if you don't manage them well, I believe you will eventually suffer losses. If any part of my article is incorrect, do feel free to let me know.

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“Nine out of ten (futures) traders go bust in their first year” – Dr Alexander Elder

There is no question that trading futures is sexy, alluring and simply irresistable!

Once you’ve had the sweet taste of success, you think the market is tailor made for you. You feel you just discovered a free ATM machine!

However, like stock trading, we shouldn't extrapolate our initial success indefinitely into the future. Trading results (like investing) should be measured over long term, if not life-time. Buffett is fond of saying - as you multiply 25 x 24 x 23 x ... x 0, the end result is always zero. With futures, you must always watch out for that zero.

So, to me, there is no starker statement than what Dr Alexander Elder stated above.

90% of all futures trader go bust in their first year of trading.

Yes, 90%!

Yes, Go bust! Not just 10% loss, but 100% loss of capital.

Simply unbelievable isn't it?

I too felt skeptical when I first read this.

After all, 90% is a very large number. And we are not talking about small loss, but "go bust". Is this figure true?

Well, I'm not Dr Alexander Elder, so, I won't try to explain on his behalf. I also don't have a pHD degree, so, I won't pretend to have the facts.

But allow me to walk you through - day by day - a specific scenario that actually happened in Bursa recently.

This is not hypothetical, but real past “live” prices.

If you were physically long on FCPO from Friday July 18 to Wednesday July 23, then, you will automatically know what I mean. If not, then, continue reading.

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Ok. Let's imagine you are a futures newbie. You’ve eyed FCPO for some time. You’ve traded plantation stocks like IOICORP, ASIATIC, etc. successfully using Technical Analysis, even during this bear market. Yes, let's ass-u-me you are already an A-grade (if not a high B-grade) stock trader.

You obviously know CPO prices drive future plantation stock earnings and prices. You cast an eye on past CPO prices. You know CPO prices peaked earlier this year to over $4,400+, and you recalled a certain Minister said he expected CPO prices to average around $3,500 this year.

Day 0 - Thursday, July 17

And let’s pretend today is Thursday, July 17, 9 PM, i.e. after market closing. You've just finished dinner, and do your usual routine looking at EOD charts. You called up FCPO daily chart, and it looked like this:




The first thing that strikes you is the beautiful uptrend over the past couple of years. This particular one is long, since 16 August 2007. You're excited because Thursday’s closing price seems to rest on this uptrend line.

You know that technically, if the uptrend holds, there's a good chance to buy FCPO “on the cheap” tomorrow. More often than not, it worked in past stock trading. You get excited, and want to hit FCPO hard the next day.

Let say you had allocated an initial capital of $80,000 to trade futures.

You know the initial margin for FCPO is $8,000 per contract. It means you can buy 1 contract and if you hold it overnight, you'll need to deposit an $8,000 margin with the broker, assuming the price did not move against you.

And just for the purpose of this article, let say you think like a few of the investors in my chatbox. (you might not, but let's ass-u-me)

You "like to plunge in" with stocks with at least 50% of your capital. Your reasoning is that you like to “maximize utilizing your capital”. You believe "greed is good". To you, capital that remains in cash is “a waste” because “it’s not really doing anything or not earning anything”.

So, you might not agree with just using 50% of capital, but let's assume this first. This means you plan to use $40k (=50% x $80,000 capital) to buy 5 FCPO contracts. In theory, you can control 10 contracts, but let's be prudent and say you control just 5 contracts.

And so, you have decided to call your broker the next morning, to buy 5 FCPO contracts at market open.

Day 1 – Friday July 18.

Your order was given to the broker, and filled at market open. Your 5 contracts were filled at $3,397 and you feel excited! Mentally, you calculate that if the price goes back to $3,500, that’s over $100 profit per contract. Since every $1 FCPO is equivalent to $25, this means $100 is equivalent to $2,500 per contract. And 5 contracts is $12,500. Which means if the price move up modestly to $3,500, you just made $12,500! Or 15.6% return on capital from just one trade! And if the price move up to $3,700, the % returns are simply phenomenal!

Anyway ... per your normal stock trading style, you wait.

Intraday prices moved up and down and closed $3,392 on Friday night.

That’s just $5 below your entry of $3,397, so, you are not too worried yet. That night, crude oil closed near support also, you also noticed soyoil also found support, so, you are not worried going into the weekend. As expected, the additional margin will come on Monday July 21, i.e. 5 contracts x $7 x $25 = $825, making your total margin of $40,000 + $825 = $40,825. You are only 51% invested, with 49% cash. No problem.

You slept well over the weekend.

Day 2 – Monday July 21

At 10.25 AM, you start observing pre-market FCPO prices and got a shocked! At 10.30 AM, FCPO market opened at $3,320!

Since your entry was $3,397, it means you just lost $77 right from the opening!

Your immediate reaction might be … WTF!! Didn’t soyoil found support over the weekend? Wasn’t crude stable?

If you are a new trader, it might take you some time to realize that $77 = $77 x $25 x 5 contracts = $9,625 lost! Which is a lot of money already lost from holding overnight!

And you just used $40,000 to start with!

So, that’s 24% (= 9,625 / 40,000) loss on that trade!

The question now is what do you do? Sell immediately to cut loss? Or hold, and hope for a rebound?

If you are a pure stock trader, chances are you will rarely, if ever experienced this before. Stock prices rarely gapped down 24% at the open, if you’ve stick to trading sound, fundamental, blue chip stocks like IOICORP or ASIATIC.

I believe chances are you will do nothing if at 10.30 AM, you haven't got a clue where your stop loss is. Even if you have, if you are not experienced in cutting losses, you might "freeze" because the fall is quite large, but not completely large enough yet. You will most likely "hope" and rationalize that maybe - if you don't panic and if you exercise emotional control - the price might go up. You might even tell yourself – “if the price don't go up and keep going down, I'm going to wait till bottom, then, I’ll buy some more to average down. Then, when it move up, I’ll get out”.

So, you waited for the rest of the day …

And at 6 PM, Monday closing price is $3,260. Another 60 point loss from Monday Open of $3,320.

It means your total unrealized loss is now = $3,397 - $3,260 = $137 per contract. That’s $137 x $25 x 5 = $17,125! Or 43% unrealized loss on initial trade margin of $40,000!

But you console yourself that it's still unrealized. You might even think "a loss is not a loss until it's realized" ... or ... "there’s still a chance it might go up right?" ... or … "After all, this is just a knee-jerk reaction right?"

Anyway, on Tuesday, you must cough up more dough for margins. Your total margin is now $40,000 + $17,125 = $57,125. Suddenly, you cash balance seems a lot smaller, even though you started with 50% only.

Day 3 – Tuesday, July 22

10.25 AM - you stared nervously at the monitor. Not nice to be down 43% in just 2 days.

Pre-market prices came in around $3,230 … !!! OMG!!

Another $30 fall from Monday closing of $3,260, right at the open!

What should you do? Get out? Do nothing? Don’t panic? Emotional control?

Again, you might be thinking "... I already lost $137 per contract, what’s another $30 more?" ... So, you might do nothing.

And later that day, Tuesday close is $3,252, which is $22 higher than the open!

You felt relieved!

You didn't panic and cut loss!

So, you congratulated yourself that you exercised emotional control.

You console yourself that maybe the downtrend is over. You might say "... Most of the sellers have sold already, and now, the price can only go up .... After all, $3,252 is a very low price compared to $3,500! "

You went to sleep that night, feeling excited.

Day 4 - Wednesday, July 23.

10.25-10.30 AM. Pre market opening = $3,210!!! OMG!

Another $42 loss from Tuesday closing! Why?? What happened?? How come?? Did Malaysia CPO just got bombed??

Ok. Calm down. Reflect for a moment calmly.

If you’ve gone through Day 2 (Mon) and Day 3 (Tue) without selling, chances are you probably also froze and not sell Wednesday opening. From the "lesson" learned on Day 3 (Tue), you will not panic. On Day 3, closing turned out higher than opening, so, you "hope" price will move up later, just like what it did on Day 3.

And unfortunately, your luck ran out.

On Day 4, the price hardly moved up after opening, and just plunged down rapidly. The CPO price made new lows, and every time it tried to rally, it’s a weak rally so far below the opening price …

The closing turned out to be the lowest point at $3,027!!

Yes. By Day 4, unrealized loss stands at $3,397 - $3,027 = $370 per contract!

Additional margin required is $370 x $25 x 5 = $46,250!

When added to the initial margin of $40,000, it means the new total margin is now $86,250.

Unfortunately, you don’t have $86,250!

You started with only $80,000 just 4 trading days ago!

You are now faced with an extremely difficult position.

Either you come up with additional money ($6,250), or your broker will be forced to sell all 5 contracts come Day 5.

And the trouble is you don’t even know what the forced sale price will be!

Now, FCPO price of $3,000 might look cheap to you, if you “anchor” against the $3,500 that the Minister said. But if you look at the charts long enough, in 2006, the price didn’t even go past $2,000 … So, is $3,000 cheap? Or is $2,000 cheap?

In short, I believe no one can accurately predict with any certainty, how low FCPO price can go down to.

And you have an immediate problem. You must either come up with extra cash, or be forced out of your position.

What do you do?

You might think of the implications under forced selling.

Force sell scenario

Let say the forced sale price is $2,900.

If this happens, what is the total loss?

Realized loss = $3,397 - $2,900 = $497 per contract. Equivalent loss = $497 x $25 x 5 = $62,125. Commissions = 6 x $25 = $150. Total deduction = $62,125 + $150 = $62,275. That's 156% loss from initial trade margin of $40,000!

And your cash balance is left with $80,000 - $62,275 = $17,725!!

In short, if you are forced out at $2,900, you just lost 78% from just 1 trade that lasted 4 days!!!

Remaining capital is only 22%!!!

Just 1 “unlucky entry” on Friday, and you might not even make it by end of this month!

Let’s not even talk about surviving 1 year!

Now, can you see why Elder says that 90% of futures traders go bust in the first year of trading?

But what if you cough up another $6,250 margin?

Additional margin scenario

The thing about doing this is that you must make sure you understand what happens if the price continue to move against you. Let say the price move another $100 against you, how much more margin can you meet? Will you have enough cash?

And what if it falls all the way down to $2,700? $2,500?

Will you still have cash to just meet margins?

Do you think you will have enough cash to “average down”?

Review time

Now, losing 156% in a single trade of just 4 days is emotionally wrecking!

In stocks, the most you lose is just 100% and even that is extremely rare for stocks like IOICORP or ASIATIC.

So, where did you go wrong?

Is it due simply to unlucky entry on Friday? (But your chart say your entry on the "bounce" of uptrend line is good odds).

Or is this simply due to inaction over the last 4 days? (But in stock trading, you can afford to hold and wait for bottom to appear).

Was the initial position size of 5 contracts too large? (But you thought it only used up 50%, and not big enough initially)

Should you have gotten out on the very first day on Monday morning at the open, when premarket showed that you've made a huge mistake?

Or should you have gotten out on Friday evening, i.e. every trade is intraday and no carry over night positions?

Was it wrong to hold the trade overnight on Friday? (If you always did that, will you earn the big money from long-term position trades? If sometimes you hold overnight, sometimes you don't, when and how do you decide to hold or not hold overnight?)

Or should you have cut loss when the loss first exceed your tolerance limit? Did you decide on the initial stop loss before you put on the entry trade on Friday?

etc.

These are extremely tough questions to answer if you don’t have a successful trading experience. In fact, if you don't know your stop loss point before you entered the trade, I believe you have no business trading futures. If you don't know whether your stop loss is set carefully in relation to the charts, and in relation to your capital, you should avoid futures.

Some concluding thoughts

It should be obvious that to survive in futures markets, you must adapt to futures and not blindly follow stock trading strategies.

Unlike stocks, futures requires additional margins when price moves against you. So, you can quickly lose and lose a lot more than your initial margin if you blindly hang on to your losing contracts.

What appears to be a small utilization of capital at Day 0, can quickly cause you to go bust by Day 4 or 5. In my live example above, just a week, and you've gone bust.

And this is even before you even had the chance to “average down”!

So, know your stop loss before entry.

The first loss is usually the best loss, because if the "break-out" turns out to be a strong trend move against you, you are dead if you try to average down. A trend can last longer than you can predict, and you don't want to be around holding the wrong end of the stick when a trend first broke out against you.

If you still believe futures can give you easy money, then, make sure you are fully prepared as best as you can. Have you tried live paper trading? Have you back-tested your Entry and Exit rules on a day-by-day basis? If you have, and you are eager to trade live, then, my next best advise is to limit your capital to an amount that you can afford to lose completely. By now, you should know chances are high that you will lose 100% of that capital within the first year. So, set aside a small % such as 1% or not more than 5% of your total capital as initial capital. Be prepared to lose all of this.

I hope you will not fall in the 90% category, but the exceptional 10% group who still have a capital by end of the year. However, if you belong to the 90% statistics, then, promise yourself that if this happens, stop trading. Walk away. Go back to paper trading. Go back to live back-testing. Write down everything you learn. Review from that entire experience. Make sure you know how to act differently the next time. And if you're unwilling to do all this, then, just walk away and chalk that entire experience up to "life lessons".

As you trade every day, keep a trading journal. Write down your trade details. Your entry, exit, position size reasons. Your overnight holding reasons. Print out the charts, and arrow the entry and exit points, and study carefully. I kid you not, that you must be seriously professional about this, if you want to survive the first year.

And no matter how large your capital is, just trade 1 contract at a time. 1 contract to enter, 1 contract to exit. Your goal in the first year should not be to make big bucks, but to just survive. And to consistently grow equity. You're learning a new market, and your immediate goal is to acquire new skills. When you have excelled, the money will come.

Always have a stop loss in mind before you put your entry trade. Tell that to your broker after your entry is confirmed. Keep your maximum loss to no more than 2% of your capital. Price moves extremely quickly in futures - expect large slippage, plan for it.

I feel one should avoid FCPO when one first start trading futures. Unlike FKLI, FCPO is full of larger opening gaps. I believe they can either make or break you if you don't know how to take advantage of them ... Also, FKLI initial margin requirement is smaller, at $4,000 per contract.

If you find even one out of the points I mentioned here new, or surprising, then, consider the possibility that you might not be ready yet to trade futures.

Someone will always tell you futures are exciting. That futures will make you fast money. Someone will post comments and messages like “wow, today’s range is 100 points. That’s $2,500 per contract profit opportunity”. Or messages like … “Today, I caught 50 points!”.

But the reality is that futures is high risk / high return / high loss market.

Many tend to forget that for every $ win, there is a loser who has lost more than $1, because it is a negative sum game after subtracting transaction and other costs.

So, when you hear messages like $2,500 per contract profit opportunity, remember that someone else must have lost $2,500 per contract! You don't want to be that party that lost.

I think I'll stop here since this rambling is very long.

My best advise is if you find yourself having to ask others whether you should trade futures or not, then, take this as a sign to avoid futures because chances are good you are simply not yet ready.

Take care.

6 comments:

Starter said...

Seng, thanks for the detail explanation on futures trading. You’ve listed all the known risk associated with futures trading and included practical trading example which could possibly wipe out one’s capital in a few days . I totally agree with you and its quite irresponsible of me to say that futures trading is interesting which in its simplistic form only applies to me but not to fellow chatters who are beginning to venture into futures trading. As such I would like to take this opportunity to say that I’m sorry for posting that dangerous statement and please heed Seng advice before plunging into futures. One can easily get slaughtered in the futures if you don’t have the edge . Seng suggested backtesting and live paper trading which are important and if one still couldn’t find the edge after that then futures is not suitable for you because its damn risky to experiment with it. One may never survive if the damage is too big and crippling.

Seng,I’ve done all the necessary research and also did the backtesting and live paper trading and words cannot describe my excitement when I discover my edge in futures. Its quite complicated for me to explain in detail here but I will share my strategies with you one day . In current volatile condition one cannot keep any open position in the futures especially the FCPO. The drop can be so severe that one don’t know how to get out of a losing position and instead reason oneself into staying in the trade longer to minimize the losses which eventually ballooned beyond one’s comprehension.

My worries now are the futures brokers that might use my entry and exiting strategy in the future. Its not so much about discovering my strategies but its their larger bet along with my bets that makes it difficult for my poison to be filled .Initially I’m not that worried but at a later stage I must come out with ways to camouflage my trades so that its not so obvious. Perhaps executing some small loss trades or even to the extent of opening as many futures accounts as possible to spread my trades.

Seng, my trades are not large and I stick to the single contract in and out because I’m still new to futures but it’s the frequency of the trades that is surprising to me. Anyway,I’m still a newbie in futures and things might not work out as I expected or hope but I’ll definitely keep my risk minimal and many thanks to you Seng for the article and good luck in your futures trades also. Cheers !!

dvd said...

Thanks, Seng. Good account. Very sobering. Think what might have happened if someone had tasted the reverse previously, made huge profits and then entered on that Friday.

VERITAS said...

Interesting. I do not trade FCPO but my view is that the price is going to go below RM3,000.
Can you also write something similar for FKLI, particularly with regard to how the discount to cash market can swing from extremes of minus 25 to plus 10. I think this is what the newbie has to understand and appreciate. I started trading FKLI just before the recent general election. Had a great windfall following the results, lost it all and more after entering into too many indisciplined trades. Had to claw my way back into positive territory. Still learning the ropes..

Salvatore_Dali said...

seng,

very good example of how one can lose tons of money playing futures ... good job

if i might add, if one were to trade in and out on a daily basis, you will take out the overnight risk ... carrying overnight positions increasing the risk immeasurably, gain as well as losses, but if one were to do only day trading, your losses and gains will be much smaller as well but the transaction cost as a ratio of your gains and losses is very high.. thus eating into actual returns

Seng said...

starter,

Thanks for sharing your experience and concerns. I sincerely hope we both won't turn out to be part of that 90% statistics in 12 month's time ...

dvd, veritas,
Thanks for sharing your thoughts and experience.

Dali,
I agree intra-day traders must factor in transction costs too. The long term statistics are very sobering to for intraday players, not just the first year players. I vaguely remembered seeing statistics something like 80%-90% of intraday players don't beat the market, and this include veterans. One must really have a significant edge to win this game in the long run.

Cheers,
Seng.

ccdev said...

Seng,nice write up for newbies. Yeah, would be nice to see one with some specifics for FKLI too.