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Lesson 39: Mrs. B - "On Day-2"

At the end of trading on September 25th, 2001, Mrs. B called her commodity broker to see where the Chicago May Wheat Futures Contract closed that day.  Her purchase price had been $2.87 a bushel and she was pleased to learn from her commodity futures broker that on Day-2, the settlement price for the futures contract she had purchased was $2.88 ¾.  The May Wheat Futures contract had moved up 2 cents for the day and was now 1 and ¾ cents above her purchase price.  Mrs. B had a paper profit of $50.00 for the first 1-cent move and $37.50 for the ¾ cent move, which was a total paper profit of $87.50.  This was based on one contract of May Wheat Futures with each standard contract calling for the delivery of 5,000 bushels of wheat.  If you multiply $.0175 times 5,000 you arrive at the total of $87.50 and this is Mrs. B's "paper profit" at the end of Day-2, not considering any commission she will have to pay when she closes her contract out by selling her position to someone else.  The headline of yesterday reporting that,

Mrs. B - "Has a paper loss of $12.50".

Can now be replaced with the headline of today which reads,

Mrs. B - "Has a paper profit of $87.50".

This illustrates how fast the futures markets can move.  A loss of one day may be replaced by a profit the next day and a profit of that day may be replaced by a loss on the next.  Mrs. B has seen her "paper profits" go from the loss column to the profit column in a single day.  She has purchased one May Wheat Futures contract (hypothetically) that required a margin of around $750.00 to trade.  Since Mrs. B has about $5,000 in her commodity account, she did not have to deposit any additional money to make this trade.  The $5,000 she has is more than adequate to meet the margin required to trade one wheat futures contract.  The first day of trading found her down $12.50 or about 1.5% of the $750 margin requirement.  The next day of trading found her with a paper profit of $87.50 or up about 11.5% when calculated on the $750 margin.  If you trade a futures contract that requires $750 to trade and you have paper profits of $75.00, you are ahead (on paper) 10% of your capital.  Mrs. B has a paper profit of $87.50 on her $750 margin capital or 11.6%.  The fact that Mrs. B could (hypothetically in this case) earn over 10% on her capital in a single day (as compared to the 5% she might earn in a year's time if her money had been left in a savings account) illustrates one of the reasons that futures and options trading appeals to many people.  This discussion does not, however, take into account the fact that Mrs. B has about $5,000 in her account on which she may or may not be earning any interest, while she waits to take a position, not $750.  It might be fairer to calculate the $87.50 paper profits as a percentage of that $5,000 rather than on the $750 margin money, but we will leave this issue aside for the time being.  The fact is that Mrs. B's account went from a paper loss on Day-1 to a paper profit on Day-2 and this has made Mrs. B very happy.  What is she going to do now?  Mrs. B is going to enter a stop/loss order.  After the markets were closed on September 25th, and Mrs. B had been given the closing price for that day, she gave her commodity broker the following stop/loss order,

"Sell l contract of Chicago May Wheat at $2.77/Stop - Open Order Good Until Changed or Cancelled"

Mrs. B is going to try to protect her position.  A stop/loss at $2.77 for a contract purchased at $2.87 will (if filled and if one is trading in a perfect world) result in a loss of 10 cents a bushel to which must be added any trading commissions.  The total loss for a single futures contract is calculated by multiplying $.10 times 5,000 bushels, which equals $500, and then adding any commission due to the brokerage firm through which one trades.  This is how one calculates losses in a perfect world.  In the non-perfect world we live in, such a "Sell Order" might not fill at $2.77.  It might fill at  $2.76 or $2.75 or even at $2.65.  It could fill just about anywhere under a variety of situations.  In General, most of the time, a stop loss order will fill fairly close to the level at which it is located. But if there is a war, or if the market does not have many traders (said to be 'thin'), if there is a large sell order by another trader at the same price as your stop/loss order, or if a variety of other events occur (such as 'limit moves'), a stop/loss order may not sell right at or near the level where it rests.  This is part of the nature of the game.  It is simply one of the prices one pays for participation in the futures market where a 10% return on margin money in a single day is not at all unusual.  Remember the General Rule: Most of the time, a stop loss order will fill fairly close to the level at which it is located. The rest of the time is mainly a matter of luck (bad luck, usually) and one simply has to swallow hard and live with his or her bad luck (unless there is outright dishonesty, in which case a complaint may be lodged).

So, at the end of Day-2, Mrs. B has entered a stop/loss order that she will use to try to limit her risk in this trade to no more than $500 plus commissions.  She has not yet entered an order to offset any profits she may earn if her stop/loss order is never hit.  She will worry about her profits later.  After all, she is trading the May 2002 Futures Contract and she has over seven months to be in this position without really having to worry about getting out.  For now, on Day-2, Mrs. B is trying to limit her losses.  A possible loss of $500 plus commissions in an account that has a $5,000 capital balance is not an unreasonable amount of money to risk on a single commodity futures or options contract.  What will Mrs. B do tomorrow, at the end of Day-3, after the markets have closed for the day?  Check back and find out.  In general, the answer is that it will depend on what happens to the price of Chicago May 2002 Wheat Futures on September 26th, 2001".

To order a copy of Bruce Gould's "Choppy Market Method" to understand "Mrs. B's" reason for picking May Wheat Futures at this time, at this price,  click here.

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Proceed to lesson 40 by clicking here.

 

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