TRADETHINK ARTICLES

Commodities Trading With Stop Losses

January 29, 2010

By Chris Morse

Stops are one of the most important tools in the commodity trader's arsenal. Because commodities are actually with futures contracts they are highly leveraged instruments as trading vehicles. When trading anything utilizing leverage it is extremely important to incorporate stops into your trading plan.

Leverage is truly a double edge sword, which demands respect. On one hand leverage can take ordinary returns and turn them into extraordinary returns. One the other hand, if leverage is not respected (like not utilizing stop orders) it will certainly cut you like a knife.

Successful commodities traders rely on the prudent use of leverage to gain incredible returns, returns that cannot be had in markets like the stock market. When trading a stock you may be able to get a 2 to 1 margin ratio. Using a 2 to 1 margin (leverage ratio) can yield returns or losses that are twice as much as if you where to just buy the stock outright. So if you bought 1000 shares of Yahoo "YHOO" at $15 and sold YHOO at $16 you would make $1 per share x 1000 shares for a total profit of $1000. Your initial investment in YHOO buying it outright would be $15,000 ($15 x 1000 shares) without leverage or margin. In return you would have made a 6.66% return ($1000 profit/$15,000 investment) deleveraged or outright. Had you purchased YHOO on margin of 50% your initial investment would have been $7,500 and your return would have doubled to 13.33% ($1,000 profit/$7,500 investment) return.

With commodity futures the sky is the limit. Right now we have a very nice sugar "SB" trade on. This trade was generated by the proprietary TradeThink trading software. The margin on sugar is currently $1,260 to control 112,000 pounds of No. 11 sugar (50 long tons). We got long sugar on 12/11/2009 at 23.57 and sugar closed on 1/27/2010 at 28.36. Currently there is a profit of 4.79 cents (28.36 - 23.57) for $5,364.80 (479 points x $11.20 per point) per contract. The return on our leveraged sugar contract is an astounding 425.77% ($5364.80 profit/$1,260 margin) return thus far (beats the heck out of trading Yahoo).

 

Note the TradeThink daily chart above of the March 2010 sugar contract, our exact entry signal is illustrated by the blue up arrow.

Great, so let's go trade sugar and all the other commodities and forget about the Yahoo's and Apple's of the world. But wait, there is no magic bullet. Had you been on the wrong side of sugar like being short instead of long then you could have lost $5,364.80 for a loss of 425.77%! Ouch, let's think here a little bit and scratch our heads. If I can lose 425% there is no way I am going to do this, well right you are perhaps. However there is an answer an answer that the professional commodities traders use to protect every trade. Professional traders know how to use leverage to their advantage in order to capture these astounding 425% moves and at the same time negate to possibility of a 425% loser. How do they do this you ask? The answer is simple, by using stops.
The best ways to use stops is by placing an initial stop loss order as soon as you enter a position. This way if the trade moves against you or you are on the wrong side of the trend your downside is protected. Continuing with the sugar trade you could place your stop at say $1,300 and if you were to use a sell stop and the market went against you then once sugar was against you by your stop size your order would have automatically become a market order and gotten you out of the trade for a loss of just $1,300. However the sugar trade went in your favor and you currently have a $5,364.80 profit instead of a $1,300 loss.

There are two key components to utilizing a stop order. The first is a stop loss to protect you if you are on the wrong side of the market as previously discussed. The second is a trailing stop. A trailing stop is required to protect your profits or open trade equity. Trailing stops must be used every single day on every single trade, because what comes up must come down. TradeThink will show you once and for all the best way to use these stops. Once a market reverses you need to have a plan to get out without emotion.

On our sugar trade we currently have a trailing stop loss set at 26.59. If the market were to reverse from the close on 1/27/2010 of 28.36 and go down to 26.59 we would be out of the trade with a tidy profit. The trick with trailing stops is to not have them too close as to get you bounced out of the trade prematurely. If you set your stop too tight you will not give the trade room to breathe and continue on if it is to be a big trend.

Bottom line is you want to ride you winners and cut your losses.

Trading signals and charts are courtesy of TradeThink, Inc.

About the Author

Chris Morse is the Developer of the TradeThink trading system. He has been involved in the development of trading strategies for nearly ten years. Mr. Morse developed a very robust system which is now in private use at one of the largest FCM's and has earned sizable returns for the last 4 years. Mr. Morse now focuses his time exclusively on developing and managing his systems.