Analyzing Your Opponents and the Market

Futures predate stocks by several thousand years. One of the earliest recognized futures transactions was the Chinese rice futures of 6,000 years ago. In the seventeenth century, Japan instituted the first organized rice futures exchange. Japanese merchants would store rice in warehouses for future use. Warehouse holders would in turn sell receipts against the stored rice. Gradually, these "rice tickets" became accepted as general currency, and rules were developed to standardize their exchange. The agricultural problem that existed 6,000 years ago in China-maintaining a year-round supply of a seasonal product-reared its ugly head in the U.S. Midwest of the 1800s.

Just like in seventeenth-century Japan, the United States began to deal with its seasonal crops in much the same way. Contracts between buyers and sellers were created to lock in prices. These contracts were well received and became collateral for bank loans. Since these contracts were well respected, both dealers and farmers were able to sell their contracts to third parties.

These third parties were often other dealers and farmers willing to deliver or accept delivery on the contracts. Some third parties also purchased and sold contracts solely to capitalize on weather or market conditions that affected the price of the grains. These parties became known as "speculators" because they never intended to take delivery of the grains. They wanted to simply buy high, sell low or sell high, buy low.
From this system the U.S. commodity exchanges developed. Until this day, we have the same set of market players: buyers, sellers, and speculators. Each group has its own objectives and goals. As a trader, you must find a way to compete on the same level as the actual buyers and sellers while at the same time outsmarting your fellow speculators. The secret to doing that will be your ability to distinguish the difference between money management and risk management.

While the task is not impossible, the majority of traders constantly confuses money management and risk management. The two strategies work in tandem, although they clearly have different end goals in mind. How often you trade, how much you trade, and how much you are willing to lose have nothing to do with the risk associated with what you do in an actual trade. All these questions can be answered before you execute a trade. So what is risk management?

Risk management deals with one thing and one thing only: the trade, and more importantly-losses in a trade. Risk management gives you the guidance on how to minimize and eliminate loss in your day-to-day trading. Risk management does not focus on profits. It cannot help you make money, nor can it determine what trades you should be making. Your money management and technical analysis strategies deal with profits and trade selection. Risk management lets the profits take care of themselves and focuses on what you can control yourself. This is an essential skill that is rarely explained.

If you hope to succeed at understanding risk management, you need to understand who your opponents are-the actual buyers and the sellers of currencies and raw materials-and know how they operate. Unlike the stock market, in which almost everyone has a vested interest in seeing the price of a stock increase, in futures and forex there is an equal amount of a pressure in forcing the price down. The buyers want the cheapest price possible for raw materials and products. The sellers want to extract the maximum amount of profit possible.

It is naive for the retail investor to assume that it is easy to figure out the desires of either of these two groups. One prime example is the U.S. economy. In George W. Bush's first term in office, he made it clear that he believed in a strong dollar. At the same time, Treasury Secretary John Snow was asking the G8, "What's wrong with a weak dollar?"

Who's right?

Traders are often caught unaware in the futures and forex markets because of this kind of blatant ambiguity filtered from the top down. Sudden changes in a market's direction will catch them unaware because they have assumed that the motivations of the real buyers and sellers are the same as theirs. So the question to ask yourself is: If there is constant pressure on both the up- and downside, how do the actual buyers and sellers protect themselves from each other?

It is no secret that there is no insurance company that would insure buyers and sellers of actual corn, sugar, or oil against price fluctuations. The insurer would point out the unpredictability of supply, the volatility of demand, and the uncertainty of people's taste and desires as reasons to avoid insuring companies against price changes. The insurer would go one step further by stating that price changes are inevitable and are simply the cost of doing business.

Because of this reality, the futures and forex market is very difficult to predict. The buyers and sellers don't want to be 100% exposed to uncertainty. Unfortunately, in order to make the futures markets work, they need to entice investors. They need a sucker-someone who isn't going to actually buy or sell the products, someone who isn't a farmer or has no intentions of reselling the goods, someone who has no problem in trying to predict the market. That's you, the speculator.

Speculators really have only one purpose: to provide the capital and liquidity needed to cover the buyers' and sellers' hard cost, thus creating a zero-sum game. The money that leaves a speculator's account gets dumped right into the buyer's and seller's accounts, and sometimes into the account of another lucky speculator.

The average speculator feeds into the system by picking one side to trade, long or short, and bets in hope that one side will win out over the other. While a speculator may win from time to time, eventually he will pick the wrong side and lose. This scenario is played out over and over again. Statistics are dismal for futures and forex traders-95% of them lose their trades. Many speculators will find success early on and eventually become disappointed with their long-term results, all the while blaming the markets and not looking at themselves as the source of the problem.

In the futures and forex markets, the actual buyers and sellers are called the commercials. Their knowledge of the underlying mechanics of how the markets operate have them laughing all the way to the bank. The secret to their success is both simple and elegant. Every commercial is always both long and short the market at the same time. It couldn't be any clearer. They call this behavior hedging. However, it's an advantage that is not exclusive to them.

By being both long and short, any movement in the markets is a benefit to the commercials. If the buyers want to protect themselves from prices moving up, they are long the futures. What they would like to see happen is the actual cost of the products they intend to buy drop in value; this is known as being short the cash. Since they are long the futures and short the cash simultaneously, the likelihood that they will benefit in some way is pretty good.

On the other hand, the sellers want to protect themselves against the price drop, so they are short the futures, and they hope the actual prices of the goods they sell will go up in value, so they are long the cash. Being short the futures and long the cash at the same time is a mirror reflection of how the buyers set themselves up.

Both the buyers and the sellers are well protected from one another. If there is activity in the markets, they have the ability to benefit regardless. This is why a loaf of bread or a carton of orange juice does not always reflect the tremendous price shifts that occur on the charts.

The ability to weather any kind of volatility is a huge advantage for the commercials. Hedging is not the exclusive domain of the commercials, though. Hedging is also a superior way to trade, even for speculators. Once a speculator discovers how to properly hedge, a world of opportunities unfolds before him.

Hedge trading is given preferential treatment throughout the futures industry-lower commissions, lower margins, and lower fees. The clearing firms realize that when the commercials go both long and short the market, at the same time, both the clearing firm and the commercials reduce their level of exposure to risk. This gives the Futures Commission Merchants a level of security that they cannot find with speculators.
So what is risk management?

It is the ability to go both long and short the market, even when you have a market bias, with the goal of minimizing or eliminating loss and the added benefits of enjoying reduced fees, commissions, and margins that the commercials receive.

Money management alone simply cannot reduce your commissions and margins on its own. When you manage your risk in the same way that the commercials do, you put yourself in control of your trading, whether it's futures or forex. You give yourself the opportunity to succeed whether the market moves up or down; you change the way you pick trades and how you approach the market.

Noble DraKoln is founder of Speculator Academy, http://www.speculatoracademy.com. After becoming a licensed broker at the age of nineteen, he has gone on to author seven trading books. He is a former editor of Futures Magazine, regular contributor to Forbes, has been a featured guest on numerous financial channels, and is a sought after consultant speaker in the futures, forex, and options world. Needless to say his twenty-one years in the industry have been well spent.