Lessons from the Pros


Before You Dive In, Check The Depth First

I remember a vacation in Aruba where the water was a beautiful turquoise color and you could see the bottom of the ocean, even when the water was twenty feet deep. Diving into water like this reduces the risk of an injury because you can see the ocean bottom. If this were the markets I would say it was a good risk/reward decision.

Another vacation was in California and the water was a lot different. Not only was the water so dark you could not see your feet, it was a little colder than the ocean waters in Aruba also. To dive into this California water without knowing how deep the water was at any point could have been a very dangerous situation. Again, if this were the markets I would say this was a very poor risk/reward decision due to the chances of injuring oneself.

When Futures traders are looking for which Commodity markets are the best to day trade, they should take into consideration this analogy of transparent and opaque water and the dangers of diving into it without knowing the depth.

One criteria traders can use is how much volume a market has to provide us liquidity for both entering and exiting the trade with little slippage (bad price fills on our orders). Unlike stock traders, Futures traders should not say that if a Futures contract does not have 1 million contracts traded per day that it is an illiquid market to trade. Futures traders can find liquid markets by looking at a very short term intraday chart of the market they want to trade and seeing full bodied candles and no intraday gaps. This would probably be a good market to trade.

After a trader identifies a liquid market, the next thing they should consider is: does this market have enough daily range to meet their risk/reward requirements?  Without a large enough daily range the trader is taking a chance that they will not be able to meet their profit objectives based on a good risk/reward trade.

Let’s review some rules you can use to identify if a particular market is worth the risk for you to trade.

For every trading day, every market creates a price range inside of its high and low for the trading session. For example, if the Crude Oil market traded yesterday from a high of 87.50 to a low of 85.30 then the day’s price range would have been 2.20 points. Unfortunately just one day’s price range does not tell us what we might expect the price range to be tomorrow or the next day. To solve this we can use an indicator called Average True Range (ATR). This indicator was developed by Welles Wilder many years ago as a volatility tool. As traders we can use this indicator to help us determine if the market we want to trade is a good risk/reward candidate.

ATR will average prior daily price ranges allowing the trader to see what the average price range was for the period selected. I have my ATR set to 10 trading days for my personal trading. There is nothing magical about 10 days, but this allows me to see what the average price range has been for any market I may want to trade.

So now we know what the average price range has been over the last 10 trading days. How can we use this to help us decide if this is a good risk/reward market to trade?

Next we need to know what the tick or point (also known as a handle) value is in dollars for the market we want to trade. This information is available for any market on all of the Exchange websites under contract specifications.  The three major Exchanges are:

Let’s look at the average daily range of January Crude Oil. Currently the 10-day ATR is 1.67 points. Crude Oil trades for $10.00 per tick or $1,000 per point. Since Crude Oil is averaging 1.67 points from high to low over the last 10 days we can say that on average Crude Oil has an average dollar range of $1,670. (1.67 X $1,000 = $1,670). Meaning if you bought the low and sold the high each day on average you could have made $1,670 per contract. But let’s be realistic and face the fact that nobody ever buys the low and sells the high every day or on any regular basis for that matter.

Now we will examine another market for its daily dollar range. The Sugar market has a 10-day ATR of 37 ticks and every tick equals $11.20. Currently the March Sugar contract has an average dollar range of $414.40. Notice how much smaller this value is compared to the Crude Oil example.

Any time a trader places a trade they must use good risk/reward values for each trade. Typically we try to achieve a 1:3 risk/reward ratio for our trades. This will allow us to have one winning trade and then it will take 3 losing trades to be back to even. Also, our percentage of wins for each trade does not have to be so high.

Many of you know that in reality most traders average 45% to 55% win ratios, but not much higher. After a trader has some experience, if they see an advertisement for 90% successful trades and selling for $29.95 they know this is probably a bad deal to buy.

To have good risk/reward a trader must have a market that offers this each time they place a trade. When trading Crude Oil you will usually have a protective stop of about $200 (anything less and I would say just write a check to a charity and give the money to somebody who can use it). This is due to the extreme volatility of Crude Oil. If we are risking $200 we will need the opportunity to make at least $600 to have the proper risk/reward management. Since Crude Oil has an average range each day of $1,670 we have plenty of room to enter the trade without having to try and sell the high or low of the day. This makes Crude Oil Futures a good day trade candidate.

Back to Sugar we see the average daily range is $414.40. While Sugar is not as volatile as the Crude Oil market we still need at least a $125 protective stop. This means our potential profit objective should be $375 (1:3 risk/reward). Now compare this $375 to the average daily dollar range of $414.40 and you can see that you would have to buy or sell the daily high or low almost every day to fit your risk/reward requirements. While some traders think they can do this I can tell you it is virtually impossible to do this consistently if ever. Sugar has a very small daily range and this would make a poor candidate for day trading. Sugar is a very good swing trading contract, but at the moment it is not a very good choice to day trade.

Back to our analogy of the difference between opaque and transparent water. We can see that diving into Crude Oil to day trade will offer us a much better chance of consistently reaching our profit objective compared to a smaller daily range market like Sugar.

I hope this article allows you find a market with great daily ranges and allows you the chance to vacation in a place as lovely as Aruba. Now where is my travel agent’s phone number?

“Ninety-nine percent of failures come from people who have the habit of making excuses.”  George w. Carver

– Don Dawson

DISCLAIMER This newsletter is written for educational purposes only. By no means do any of its contents recommend, advocate or urge the buying, selling or holding of any financial instrument whatsoever. Trading and Investing involves high levels of risk. The author expresses personal opinions and will not assume any responsibility whatsoever for the actions of the reader. The author may or may not have positions in Financial Instruments discussed in this newsletter. Future results can be dramatically different from the opinions expressed herein. Past performance does not guarantee future results. Reprints allowed for private reading only, for all else, please obtain permission.

Join over 170,000 Lessons from the Pros readers. Get new articles delivered to your inbox weekly.