Sterling Smith:
“Understanding risk and containing risk is the most important thing you can do...."
Sterling Smith has found that successful trading involves far more than picking winning positions. Traders also need an exit strategy, whether they win or lose, and must comprehend the power of leverage.
Smith is a commodity trading adviser and market analyst for Country Hedging, based in Minnesota, after previously working at a number of futures firms in Chicago. He follows a wide range of markets, including agricultural commodities and metals. Over the years, he has worked with retail, institutional and commercial clients and also did a stint as a risk manager for a futures brokerage.
“Understanding risk and containing risk is the most important thing you can do, whether you are an industrial concern that has commodity price risk, if you’re a farmer or you are a speculator,” Smith said. “If you do not know where you are going to get out of a trade when it fails, and if you don’t have a plan in place, you will fail. It’s not a question of if. It’s a question of when.
“For example, if you have somebody buying gold all of the time right now and have no plan about when they are getting out, as long as the market stays bullish, they’re fine. But if they don’t have a plan in place for when the tide turns, that’s usually when I see disaster strike.”
He has seen many an instance in which traders held onto a position too long. One way to avoid this is the use of buy or sell stops, which are orders activated when prices hit to certain chart points.
Traders can even use stops to make sure they hang onto profits. Say they bought gold futures and the market rises. Smith would lift the original stop so that if it gets activated on a market pullback, a trader would be kicked out of a position while still ahead. “Never, ever, ever let a winning trade become a loser,” Smith said.
Stops are also used as protection in case a market moves against a trader. Smith favors putting them just above or below widely recognized chart support and resistance to avoid getting kicked out prematurely. For instance, suppose there is a clear support level for gold. The market could fall there but then bounce again. So Smith might put his stop slightly below so he would still be in the market if the support holds.
“You want to get stopped out because you were wrong and not get stopped out because of static,” he said.
Smith warns against trying to hold onto a losing trade for too long so that the losses just pile up. His experience has been that successful trades usually become a winner within the first two or three days. “If a trade isn’t working pretty well right from the get-go, you’re usually better off getting out.”
He has seen traders get in trouble when they had five winners but one “absolute stinker.” The traders were willing to exit the winners to book a profit, but held the loser hoping to recapture their loss, only to end up farther in the red.
“At that point, you’re not in control. The market is in control,” Smith said. “You’re not trading any more. You’re hoping.”
Another key to risk management, he said, is thinking ahead about how much of a trading account to put in any one position—whether it be a fixed dollar amount or a percentage of an account.
‘The Most Killing Mistake Is Misusing Margin’
Futures traders can get in trouble by not grasping the full power of leverage. They put up money for a “margin,” or collateral, but this is a small percentage of the total value of a contract. Thus, they can lose their entire investment even when the price of a commodity moves by only a small percentage.
“The most killing mistake is misusing margin,” Smith said.
He gave an example: a $100,000 account is enough for margins on 30 soybean contracts at 5,000 bushels each which, as of this interview, was worth $1.89 million. If a trader bought 30 contracts and the market moved against him by 60 cents, forcing him out, his account would be whacked to $10,000.
“It (leverage) is your friend when things work well,” Smith said. “But it is an equal enemy when you’re wrong.”
Smith feels comfortable being involved with a wide range of markets since he often works 10-hour days. But for somebody with only an hour or two, he recommends following just one or two markets, preferably “simple” ones. By this, he means markets less likely to make sudden major shifts. One might be sugar, which has production around the world, meaning less chance of abrupt changes in global supply/demand fundamentals. By contrast, such a large portion of cocoa production is concentrated in one nation—the Ivory Coast—that a political insurgency could mean a sudden shift in supply and thus prices.
Among the metals, he views gold as one of the simpler markets for newcomers due to the multiple sizes of contracts to control risk, as well as limited volatility. “Gold, when it’s bullish, is bullish and goes up rather nicely. You simply have to be aware of the one problem—when it turns the corner, it’s going to turn hard and be severe for two or three days. By simply keeping a stop around and being prepared…it becomes a much friendlier market. It’s a comparably easy market to day trade as well, in my opinion.”
He considers silver one of the more challenging commodities for trading (in which somebody takes a futures position for a limited time period of say two weeks, as opposed to somebody planning to buy and hold a physical product for years.) “The volatility is so exaggerated….A winner could very quickly become a loser.”
Smith looks at both fundamentals (such as supply/demand and news events) and technical-chart analysis when making trading decisions.
However, he emphasized the importance of being truly “objective” when studying fundamentals. Too often, he said, traders end up surfing the Internet only to support ideas they might already have. “That is not being objective. That is trying to build a case for yourself.”
As for chart analysis, Smith looks for areas of “congestion” that suggest a market might be about to change direction. For instance, suppose a market puts in a major low, recovers and falls again…but the new low is above the prior major low.
“That’s a good sign of a market beginning to make a bottom,” Smith said. “Or, if you find a spot where the market is clearly having trouble, that’s a good area to look for resistance.”
He also pays attention to the positioning of small speculators in weekly positioning data released by the Commodity Futures Trading Commission. These would be the “non-reportable” positions in the so-called legacy reports. These accounts are often viewed as late-comers to the party by futures veterans since by the time these accounts collectively build a large net long or short position, markets may be getting ready to turn. An exception to this rule of thumb, Smith added, might be gold since small speculators tend to be always long.
He is also cautious about any commodity in which such a large move has occurred that regional newspapers are running stories. Say they pick up a story on soaring coffee prices. There’s a good chance that much of the bullishness is already factored into the market.
“When the move has become so much that the mainstream media is covering, it’s usually a sign that the futures market is probably exhausting itself,” Smith said.
Original article: http://www.kitco.com/reports/KitcoNews20120203AS_Smith.html
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