Live to play another day.

- Lee Gaus

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June 22, 2007

Room Full of Traders

If you ask a room full of commodity traders which skill is the most important in becoming a successful trader I wonder if anyone would respond the ability to take a loss? I doubt it, because taking a loss is considered a negative. Who wants to talk about the right way to lose money? I think every trader should!

I believe that possessing the mental toughness to accept a loss, and the ability to know when a loss should be taken, are traits I believe to be at the foundation of being a profitable commodity trader. Let us understand each other right now. If you trade commodities some of your trades, if not a majority, will be losers. If you are to be a profitable trader, I believe you must recognize this basic fact and have a bad trade exit strategy determined even before you put on any trade.

Stop-Loss Order

PAY ATTENTION! In my view this order should be used when a trade is entered into and the trader has determined a specific level of risk or loss they are willing to accept.

How Do Stops Work

An aspect of stop and stop-loss orders that often confuses some traders is the level at which they get filled once their stop/stop-loss price is hit. You see, when using stop/stop-loss orders, the order cannot - by regulation - be executed until the stop price is traded. At that point, it becomes a market order -- not a limit order set at the stop value. Let us use the example shown in the definition of Money Stop-Loss where the stop-loss price was $6.90. If the market traded as follows:

$7.00
6.99
6.98
6.97
6.96
6.95
6.94
6.93
6.92
6.91 1/2
6.91
6.90
6.88
6.87
6.86
6.89
6.90

What is the best price you could expect to get filled at? If you said 6.88, you are right. If the market was a fast market, or if the order flow was thin, you might not get a fill until 6.86. Remember, a stop/stop-loss order becomes a market order only AFTER the stop-loss price is traded.

Taking a Loss

If you are going to be a trader of commodity futures, you are going to have trades that lose money ... pure and simple. In my first booklet, “Lessons Learned”, I recounted a true story of one of my clients from years ago. He bought a contract of corn just prior to the release of a government report. The report was a bearish report, but for some reason the market did not react immediately to the government numbers. He had an opportunity to get out of the trade with only a quarter cent loss ($12.50), but he refused.  

In the end, he liquated the trade and lost over two thousand dollars -- all in an effort to keep twelve dollars and fifty cents. Ladies and gentlemen, if you are going to have a chance I contend you must know how to TAKE A LOSS ... and understanding how to effectively use stop-loss orders can be a great help. Like my old account, you can pay twelve dollars and fifty cents now, or two thousand later.

Money Management

What is money management? There are a number of old sayings that I believe give a hint to the true nature of money management. One is simply, “If you are wrong, make sure to live to play another day”. One of the first old wags I learned as a rookie in the commodity business was, “The best loss to take is the first loss”, and the Chicago Mercantile Exchange came out with a popular poster that said “Risk Not Thy Whole Wad”. My personal definition of successful money management is to limit losses to acceptable levels (not risking thy whole wad) while providing the trader with an adequate opportunity to realize a profit from the trade.

What is an Acceptable Level of Risk

What is an acceptable level of risk? For me, it can be answered in two different ways. First, what is the risk-reward ratio? Secondly, how deep are the pockets of the trader? The answers to each of those questions are highly individualized, but at least one of those questions - if not both - should be answered BEFORE entering into a trade. I am not a big believer on determining stop-loss levels based upon what you can afford to lose. Why? Because what you can afford to lose has not a darn thing to do with the market or how it functions. That is why I absolutely find the money stop to limit losses to be without merit. If I feel that way, what do “deep pockets” have to do with anything? It has been my experience that the markets will give a trader several different stop/stop-loss levels of support or resistance to choose from. The depth of pockets will help determine how aggressive or conservative the trader can be in selecting the stop/stop-loss levels.

The Dreaded Mental Stop

What is a mental stop? The dreaded mental stop is usually preceded by having been stopped out of the market only to have the market reverse and go the other way, causing the trader to miss a possible profitable opportunity. That is how one comes to use a mental stop. So now let us address the question of  “what is a mental stop”. A mental stop is a price determined by Trader Jack where he should accept the loss … but with no real intention of doing so.  Do not waste your time fooling yourself. A mental stop is just a way to fool one’s self into believing they are practicing effective and responsible money management.

Last Piece of Advice

In my view a common mistake that is made by those attempting to use stops is placing the initial stop too close to the entry point of the trade. The initial stop in my view should be at the widest point giving the trade a chance to work and then over time progressively getting closer to the entry level.

Lee Gaus is a 54 year old industry veteran of twenty-six years. Lee began his career in the livestock feed business before becoming a grain merchandising/commodity trader with a leading international company.

In 1992, Lee established EFG Group along with his two partners who are long-time friends. Since then, Lee has traveled the U.S. conducting seminars and trading meetings for retail traders and commodity offices.

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