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Lesson 12: Building a Plan

How does a trader start to build a plan that he or she can use for the balance of that traders investment career? Here is one way. Suppose a friend were to tell you that a great way to make money is to buy December corn futures on October 1 and sell December corn futures on December 1 of each year. This would be a plan. It would also be a plan that would pose several questions. Historically, how often has the plan worked? What has been the average profit earned with this plan? What risk in the past has one had to assume in buying December corn futures on October 1. Is there a way that this plan could have been modified to increase the profit in those years when there was a profit? Is there a way that this plan could have been adjusted so as to avoid trading in those years when there was no profit? A plan can be like a classic car that you locate behind a red barn in rural Vermont. You feel that the potential is there, but you will have to do a little work to realize that potential fully.

Where to start? The first thing you will need to know is what was the price of December corn was on October 1st and December 1st for as many years in past history as you care to examine the price of corn. Let's say that you want to research this for 40 years, examining the years from 1959 to 1999. Looking at the price of December corn for 40 years should give you some idea of what December corn futures normally do in the time period between October and December. If you can't learn something from examining 40 years of history, you probably can't learn much from examining 50 or 60 years. Let's start with the years 1959 to 1999.

Question #1: In those 40 years, if one followed this plan and bought December corn futures on October 1 and sold December corn futures on December 1, how many years would one have realized a profit and how many years would one have suffered a loss? If you have the data, this should be easy to determine. The data may be in the form of prices you obtained free of charge by looking at old copies of the Wall Street Journal at your local library, it may be obtained by looking at a set of graphs showing December corn futures in those 40 years of trading, it may be obtained off the internet from companies that supply this sort of information. Let's assume that you have this data in one form or another and let's assume (and this is only for the sake of illustration, this is not a correct answer) that you conclude that in 32 of those 40 years you would have made money and in 8 of those 40 years you would have lost money. Hypothetically, this plan produced a profit in 32 of the past 40 years or 80% of the time. What do you do next?

Question #2: Focusing only on the 32 profit producing years, you might want to know how much you had to risk to earn the profit earned in each of those 32 years. In other words, (a) How deep was the water before the profit was produced and (b) How long did you have to hold your breath? How low did December corn go in those 32 winning years after October 1 and how long did it stay below its October 1 price. Naturally, the answer will differ from year to year, but by having the data (and here the best data to work with visually might be a set of 40 graphs for those 40 years) you can isolate the 32 years where a profit was made, draw a horizontal line across the graph starting with the price on October 1 (using the opening or closing price consistently) and determine how far price declined below that horizontal line (how deep was the water) and how long price remained below that line (how long did you have to hold your breath).

You can put these numbers down on paper, (the depth of the water and the time you had to hold your breath), and you can come up with an average for both the depth and the time involved. For the sake of an example (and again this is not the correct answer), let's say that in the 32 years when one bought December corn futures on October l and sold profitably on December l, the market declined an average of seven cents below the October l price and the market stayed below the October l price for an average length of two weeks. Now you know something about your plan. You know that in the 32 winning years, you should expect an average price decline against your position of seven cents (with the greatest decline being xx cents and the least decline being yy cents) and you should expect to have to ride out a decline lasting an average of two weeks (with the greatest time being zz weeks and the least time being ww days). It is a little bit like researching the value of the car that you found behind the Vermont barn. What did the car sell for originally, what was the size of its engine, how many were produced and sold, and how long was it in production.

One immediate side benefit of this type of research may be an unexpected conclusion. Suppose your research revealed that in these 32 successful years the market always declined somewhat after October 1st. You may conclude that you need not be in a hurry to buy on that date. Remember, a purchase 1-cent lower than the October 1 price means 1-cent more profit on December 1 when there is a profit on December l. If you buy October l at $3.00 and sell December 1 at $3.15, buying on October 15 at $2.90 and selling December 1 at $3.15 will produce ten cents more profit or $500 more profit per contract. If your research reveals to you that prices always decline somewhat after October 1, it might make sense to wait to make your purchase until the market gives you a better buying opportunity than the opening or closing price on that date.

Question #3: Once you know something about the number of years that this trading plan is successful, and you know how long you had to ride through a dip in order to achieve success in those winning years (remember, we have not yet looked at the losing years), you would be interested in learning about the profits you might expect to make with this trade. To arrive at this, compare the price on October l with the price on December l in the 32 successful years and arrive at the profit earned in each of those years. To arrive at an average simply add up the 32 profits and divide by 32. It is important for you to know what the average profit is for a couple of reasons. The first is that if the average profit is only 1-cent, you probably won't want to consider this a plan worth your further consideration. If the average profit is 34 cents, or $1,700.00 per contract traded, then the plan may have your attention. If the average depth of water in the 32 winning years is 7 cents and the average profit in those same 32 years is 34 cents, this may be a plan worth your time and effort to refine. It will probably be a plan that you will use for the balance of your investment career. Owning a few good plans that you can use for a lifetime can be well be worth the time required to develop them.

Question #4: The next thing you will want to do is to separate the more successful years from the least successful. Here might be a way. Assume you have charts or data for December corn for 40 years. Take the highest and the lowest price during those 40 years and divide that price into four sections. Hypothetically, let's say that the highest price is $4.00 and the lowest price is $2.00. You then have sections running from $2.00 to $2.50 and from there to $3.00 and from there to $3.50 and from there to $4.00. Now, look at your 32 winning trades. Suppose that when the price of December corn was between $2.00 and $2.50 the average profit was 20 cents and that when the price of December corn was between $3.50 and $4.00 the average profit was 5 cents. You might conclude that this plan shows more historical profit potential when the purchase price is between $2.00 and $2.50 than when it is between $3.50 and $4.00. If the price of December corn on October 1st of this year is $2.04 you might be more interested in trading the corn market than if it were at $3.54. You are gradually learning how to take a simple plan and modify it for your long time use or non-use as a futures trader or investor. Remember, once you get a good plan, you can use it for your lifetime and pass it on to your children to use for their lifetimes too. A very good plan may be the most valuable asset you leave your children in your estate.

Question #5: Finally, you may wish to consider the trend of prices for December corn on October l as being a factor in those 32 winning years. There are several different ways you can consider trend, but one of them might be to draw a line from the lowest price that December corn traded in the period from January l of each year through September 30th of that year and connect this lowest price with the October l price. If this line is trending upward, then you may consider this an uptrend. If it is trending downward, you might consider prices downtrending. For example, if December corn was $2.05 on February 5th and this was the lowest price between January l and September 30th and if December corn was $2.27 on October l, you might consider this an uptrend. If December corn was $1.87 on October l of that year, you might consider this a downtrend. You would then want to label each year you examine as "uptrending" or "downtrending" on October l. You would then want to look at your 32 winning trades and consider whether you made more money during uptrending years or during downtrending years. You might find that trades during uptrending years were 10 cents more profitable on the average than trades during downtrending years and you may wish to limit your use of this plan to (A) years when December corn was trading between $2.00 and $2.50 and (B) years when December corn was uptrending on October l.

You started with a bare bones plan. You examined it and arrived at some conclusions. The method you have used can be used for examining other markets than corn and for different periods of time. If you want to research this plan out fully and arrive at your own conclusions, but don't have set of December corn charts for the years 1959 to 1999, click here to order some. In my next lesson, I am going to teach you how to examine losing years.

Bruce Gould

 

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