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Sunday, December 30, 2007

Low Funded Challenge Account: Sugar #11 - March 08

What? A trade? Already? I thought you said . . .

First thing we should discuss is what? Money management principles correct? Ok, so how much does the Challenge Accounts have in them today?

Sharebuilder Investment Account Balance: $130.64
optionsXpress Trading Account Balance: $570.00

For this possible (and let me stress - possible) trade, we will be looking to the Futures options arena. Specifically, Sugar #11. But let's not get ahead of ourselves and start talking about the market mechanics. Let's go back and discuss money management principles.

Money Management:
First thing, let's discuss risk management. We have $570.00. We generally don't risk more than 5% of our account. So what's 5% of our account? $28.50. I can tell you right now, trying to pick cheap options for $28.50? It's just not going to happen. You can nickel and dime your account to death trying to find nothing put purely cheap options. Plus we have to figure commissions on whatever we purchase, in and out of the trade, which is going to run us approximately $15.00 all told. That leaves us with what? $13.50 of actual market position risked. Or does it?

In a few days, we'll have another $100.00 coming into the account (via rule #2 of the Challenge accounts). If we can keep our risk under $100.00 - well, we'll still have our account balance higher than it was last month. That changes things dramatically. Because every once in a while, you can find an option that's under $100.00. There's a put option in the Sugar #11 market that is going for $89.00 right now. Since this trade would be running into January, if you look at our account from the $670.00 balance? Well, the percentage is still high. Of the top of my head about 13%. But if the market doesn't confirm our analysis, we'd sell the option back to the market, and recoup some of the loss there. All told, I see a risk with an $89.00 option? Of about $70.00. Which represents about 10% of our account premium. Still higher than we like. The only reason I'm going to consider this as a trade, is that if we lost out on this trade, our account balance will still end up higher with the $100.00 deposit coming in January. Plus, we have to balance something against risk right? What's that?

Reward analysis. You have to balance all risk against the possible reward. What sort of growth are we looking at? Well, I'm looking at a March 2008 Sugar #11 10.00 put. What are ITM (In the money) options, or options where Sugar is actually trading, going for right now? Well, the Sugar #11 market settled at 10.94 on Friday. An 11.00 put is going for $481.60. What do we want for a risk reward ratio? Our goal is one to three (1:3), or one to four (1:4) right? So if we're risking about $70.00 on this trade, our goal is to sell the option back for $210 (1:3 ratio) or $280.00 (1:4 ratio). Just eyeing it up, approximately, the market would have to move to the 10.40 area for this to happen. Then we'd look to sell for a profit, regardless of what's going on. Why? Because of how low our account is, and because adding $125.00 to our account would represent an 18% growth on this one trade. One of the biggest lessons of taking profits is not to get greedy, in relation to our account size. 18% on one trade is more than enough. Of course, we could be handed a complete gift in a lock-limit move in our favour and we make far past our 18% (I have been in those sorts of trades, which are a pure gift from heaven). But we're not going to bet the farm on that scenario. Those sorts of situations you just have to take when they come. But never seek them out.

Ok, now onto our next money management principle. We need a Trading Plan in regards to this trade that takes into account, time, price and allows for flexibility of evolving market conditions. First item: Time. What tools can we use for timing? Seasonality right? Seasonally, Sugar #11 tends to move lower from January 2nd to about the middle of the month. I am using MRCI's (Moore Research Center Inc.) data for this information. I looked over recent years to make sure this seasonal pattern is holding steady. We did have one year that was completely contra-seasonal a few years back. However, the market was in a huge bull run already, where normal market conditions were not prevailing. When looking at the other years, they were shaping up the exact same way as this year. So no matter what, when it comes to timing, we don't want to be in this swing-trade past the 15th of January.

Now, what about Price? Now let me be clear, in my normal accounts, I'll wait for Sugar #11 to break below it's current support at 10.90 before I'd buy a put option. In other words, I'd allow the price to confirm my thoughts in regards to the market, before I commit. The situation with the low-funded accounts is a little tricky however. If we do this, then our put option is going to increase in price. Perhaps out of our purchase price. So depending on the open we receive in this market on Monday? I might end up buying the option right away. Much depends on the type of open we receive. If our open is higher than 11.20, then I probably wait another day before I purchase the option. If the open is between 10.98 and 11.12, I'll go ahead and buy a March 08 10.00 Put. If the open is lower than 10.87, then I will wait to see if the market climbs higher, and I can get the put option for a cheaper price.

Now what about Evolving Market conditions? Well, if the trade is initiated, then it's all about volatility. If the market becomes very volatile, this is a good thing. Increased volatility increases the premium and value of an option. This might cause us to stay in the trade longer, and we can squeeze out some extra $'s. I mean heck, if the market just jumps down to 9.50, we aren't going to complain. On the other hand, if the market just creeps down, bit by bit towards 10.00? Then we are losing value on something called theta premium. Theta is the 'time premium' of your option. You pay for your time when you pay for an option. So if it just creeps towards 10.00, slowly, then we will look for an exit more quickly. If we enter this trade, and it just pops in the exact opposite direction? Once it hits the 1200 area - and shows no signs of slowing down, we'll sell the option back to the market and recover something.

That seems like a lot to consider for one trade doesn't it? Trust me, you'll get to a point where you can do this all in your head without even thinking twice.

Market Trade Mechanics:
Ok, now onto discussing Sugar #11 itself. We're looking at the March 08 contract. Here is why I see lower prices on the horizon. Let's first look to see if we can detect any bias to the market.

COT Data:
Here's a graph showing you the latest COT information.

(Click to Enlarge)

Note that for the last two years, the Commercials and Public have never been so diametrically opposed. I highlighted the last time this occured. That was the profitable Sugar Trade I was talking about yesterday. Remember, this only shows us bias. There is nothing saying the market can't head higher and the two groups become more opposed. But as it stands, there is smart money bias to the short side.

Accumulation / Distribution:
Here's a graph plotting out the latest Accumulation / Distribution data.

(Click to enlarge)

So we do see a bias. Despite higher prices, the Accumulation / Distribution states there is no real 'volume' for this type of move. And if we look to the volume for the last two weeks, we'll see why. During the holidays, the volume has decreased dramatically. Remember, when you see decreasing volume on a rally? We call that a 'fools rally'. Decreasing volume is a signal that there is no real 'strength' to the movement. Which one reason you see this occur in Sugar #11 every year. Because small speculators start a buying frenzy on small volume. After the holidays, the 'big money' comes back in force, and correct this 'fools rally'. But remember, this is only a type of 'early warning' system. A bias. That's all.

Open Interest:
On December 1st, the Open Interest was approximately 763,000. As of December 28, it was approximately 862,000. When you look over the fact that the Open Interest for the last 9 months has never dipped below 328,000, we see that the recent months increase represents more than a 30% jump in Open Interest. During that same 9 months, the market has been in a sideways channel. What's the rule that Larry Williams states? In a sideways market, a 30% decrease in open interest can be a bullish indication and a 30% increase in open interest can be a bearish indication. So on the Open Interest route, we have bearish indication in Sugar #11.

Looking to the MRCI Seasonal Data (Moore Research Center Inc.) , we see that the 15 and 30 year seasonal averages show a marked decrease until the 15th of the month. What about more recent averages. Well, the 5 year average doesn't show the same strength as the 15 and 30 year averages. But it's still flat to weaker until the 15th. You also have to consider that within that 5 years, we had a huge runup, so that's going to skew the averages a bit. Overall, I'd say that the market is showing seasonal weakness for March Sugar #11 from December 31st until the 15th of January.

Cycles and Support and Resistance:
This gives even more exact timing entrance than seasonality. The market is extended far past it's 1.28 reversal cycle. Seasonally, this is standard. If you look at the larger picture for the last several months, the market has been congesting at an area and zone of resistance that formed last February. The 10.90 to 11.50 area

Despite all of the above confirmations? Remember. This is a) a zero sum game. This isn't the stock market. The stock market can create wealth where wealth did not previously exist. The Futures market cannot. For each winner, you have a loser. It's important to retain that frame of mind when dealing with the Futures game b) Nothing is guaranteed for the future. The price may run up another 20 cents before moving down. The best we can do is seek out a good risk / reward ratio, and try to confirm a movement as much as possible. If we lose out on this option, another $100 will be fed into the Challenge Accounts, via rule #2, and the account balance should either remain the same, or still be a little ahead. Considering the reward of an 18% growth in account equity? I'm going to look to the above trade plan, and if the proper criteria are fulfilled according to the specified plan, I'll go ahead and buy a March 2008 1000 Put.

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