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Lesson 11: Drought

I was sitting in a restaurant back in the early 1970's and in the booth next to me there was a salesman. He was talking to his friend and it was clear that he was troubled. He was looking for new sales job. He knew what he did best and what he did best was to sell a dream. All he had to do was to believe in the dream himself and he could sell anything. "I don't care what it is. I can sell anything, just as long as I believe in what I am selling", he told his friend. He was looking for something to believe in so he could earn a living, for himself and perhaps for his family, if he was married. I hope he found what it was that he was searching for.

Believing in a dream is an admirable quality for a salesman. It is a quality that the pianist has when she spends hours and hours at the piano while her peers are at the swimming pool, or at the school dance, or just hanging around the local drive-in. It is the same quality that keeps a student studying, a machinist working in order to own his own machine shop, a waitress saving money to pay for her daughter's dance lessons. It is a wonderful thing to believe in a dream and most people who have succeeded in life have had a dream they believed in. In life, if you have a dream and if you believe in it, you can do almost anything. But having a dream won't work for you in futures or options trading or even in stock investing. Futures and options trading and stock investing are about making money. If you are trying to make money on a dream in futures or in options, most likely you will not succeed.

Let's talk about drought. It may be that a drought will occur in the Midwest this year and that the crops will not be as bountiful as they have been in previous years. There may be a shortage of corn or soybeans or wheat or numerous other commodities for which there are no futures markets. This may well happen. And then again, it may not. The rain may come, the drought may end, the crops will grow and the harvest will be sufficient to meet the demand; the harvest may even exceed the demand. When you buy or sell based on that happening which has not yet happened (which is, after all what a dream really is) you have to be very careful.

If you are long soybeans based on your belief that the drought will come, and the market moves 20 cents against your position before it runs in your favor, you are risking $1,000 per contract that the event which has not yet happened will happen and that when it does happen it will make you a profit. If the market moves 40 cents against you before it moves in your favor, you are risking $2,000 per contract on an event that has not yet moved the market in your favor. If the market moves 80 cents against you before it moves in your favor, I won't even tell you how much you are risking by betting on a dream. Whenever you buy a "dream or a story" in commodities or options or even stocks, be very careful that the story does not overtake your common sense. Be from Missouri. Believe it when you see it.

There were two investors in an office, one said; "I am long ten contracts of soybeans because I am sure there will be a drought and prices will rise". The other said, "I am from Missouri, I look at what might not happen as well as what might happen and while it looks like the drought may come, I hate to invest a lot of money buying dreams. I am long one contract, if the market closes $200 against me today, I am gone". Which trader would you bet has the best chance of becoming rich in the short run? If anyone is going to become rich in the short term, it will be the trader with the ten contracts. Which trader would you bet has the best chance of becoming not rich in the short term? Once again, it is the trader with the ten contracts.

It is said that when one wades across a river, he or she never steps in the same water twice. When a foot is lifted and moved forward, the old water flows downstream and the water that you now step in is brand new. It is the same with futures and options and stock investing. The fact that you were successful on a previous occasion when riding a market through a $2,000 per contract decline against your position does not mean that the market will bail you out again. In fact, your very survival the first time may actually work against you the second time. You may adopt the philosophy; "Oh, I rode the market out last time and I came out okay, so this time I am going to ride it out again and everything will be fine." This philosophy may be the short story of your short career as a futures, options or stock market investor. When you buy a dream, or a story, or an event that has not yet happened, the very fact that the dream came true the last time you believed in it does not mean that it will come true for you this time. You are not a salesman who can sell anything he or she believes in. You are an investor. There are two important things in every investor's life. The first is not to lose your money. The second is to make a profit. Looking at these two events, the former is far more important to you than the latter. You may be able to invest tomorrow if you do not make a profit today. You may not be able to invest tomorrow if you lose most of your money today.

I was having breakfast on New Year's Day in Seattle when a waitress asked her favorite customer, "Well, Jack, and was last year a good year for you"? And Jack replied, "When you reach my age, any year you make it through is a good year". The important thing for Jack was making it through the year. The important thing for you, as an investor, is not to lose your money. To keep from losing your money, you must remember that if you buy a dream and the dream works out, that is wonderful. But you will not be able to build a long-term investment program based on buying dreams. You have to build an investment program based on cold, hard reality. You have to have a plan. You have to be able to use your plan in years when there is a drought and in years when there is rain. You have to be able to use your plan in markets where a drought is not a factor, such as trading silver. You have to be able to use your plan in wintertime or in spring or in summer or in the fall. You have to have a plan that you can understand. Your plan has to make sense, at least to you if no one else.

Suppose you were lucky enough to have a spare $10,000 and decided to turn it over to person (A) or to person (B) to invest on your behalf. Since it was your money, you would most likely interview both (A) and (B). Person (A) told you she was sure that the drought would come and that she planned to buy ten contracts of soybeans for you Monday morning on the open. Person (B) told you she had no idea if the drought would come, but what she was going to do for you was this: She would buy one contract of soybeans for you Monday morning on the open and enter a stop/loss order $200 below your entry price. If you were not stopped out and if the market closed in your favor, she would buy a second contract for you on the close. After the close, she would enter a stop/loss order for you $200 below each position. If the market opened higher on Tuesday, she would raise your stop/loss orders for both positions to the break-even point while at the same time entering a profit/exit order for you 40 cents above your average purchase price. These would be OCO orders (one cancels the other), whichever filled first, the break-even stop/loss order or the profit/exit order, the order which would no longer be needed would be cancelled by her for you. If the market did not close in your favor on Monday, she would liquidate your one contract at the market on the close and re-examine the market when it opened on Tuesday.

Now this proposal of person (B) might not be something that anyone would actually do. It might be too complicated or it might be too simple or it might not involve enough contracts for you. It might be a lot of things; there is one thing it certainly is. It is a plan and it is a low-risk plan. The proposal of person (A) to buy ten contracts for you Monday morning on the open is not a plan, it is an event and it is a high-risk event. If soybeans open sharply higher on Monday, say up 20 cents on the fear of a drought, and you buy ten contracts "on the open" 20 cents higher than Friday's close, and the market then subsequently declines to the same price it closed at on Friday, you have a paper loss of 20 cents per contract, or $1,000. Since you only had only $10,000 to invest and since you bought ten contracts, you have a paper loss of 10 times $1,000 or $10,000 or 100% of the money that you turned over to person (A) to invest for you. It is quite possible that this could actually happen within a few minutes or a few hours of a single trading day. It is possible to lose 100% of your capital before one day is over. It is possible when you buy a dream, a story, a tale, a drought, or a flood, or one catastrophe or another to suffer a substantial loss of your capital within a single day. Buying ten contracts of soybeans "at the market on the open" because you believe a drought may occur is not a plan; it is an event. It is also a high-risk event. This high-risk event may make you rich if you are lucky. If you are not lucky, it may make you the opposite of rich.

Believing in what one sells works very well for salesmen and this belief helps salesmen earn a living. Even if a salesman believes in something that is, in fact, no good the salesman's belief alone may be enough to make him money. Believing that there will be a drought in the Midwest, however, will not make you money. Belief in a drought requires more than a belief, it requires an actual drought. And the drought may never come. Remember Jack's rule. "Make it through the year". It is more important for your success that you have a plan than it is that you have a belief. Your plan doesn't even have to be a good one, initially. For your long-term success, even a bad plan that you can test one contract at a time is better than the best belief. Plans you can work on, you can improve them, they can be modified, thrown away, adapted, adjusted, readjusted, brought back to life until one day you may actually have a plan that will work. Beliefs are very good for salesmen. Plans are very good for investors. In lesson number 12, I am going to teach you how to build yourself a plan.

 

Bruce Gould
 

 

Always remember that stock, options, and futures trading may involve substantial risks and that past performance is no guarantee of future performance.