Lesson 1: A friend of mine once told me...

A friend of mine once told me a very interesting story. It seems that he had an uncle who was the manager of a very large investment bank in a very famous town in Europe. When he was a young man he worked for his uncle and my friend was put in charge of taking a very large position in the cotton futures market. He was told, by his uncle, that he was to manage this futures position in cotton and manage it well on behalf of the investment bank. It seems that this bank did a great deal of business in cash cotton and used the cotton futures market as a hedge against their cash needs.

The young employee, wanting to impress the firm and his uncle, bought many contracts of cotton for future delivery. That was okay as far as it went.

But, unfortunately for him and the firm, the price of cotton declined after the young man's purchases. Declined substantially. At one point, the loss to the firm was over $1,000,000.00. It was not a realized loss, since the young man had not yet sold the cotton, but it was a loss on paper. A loss that would be realized just as soon as the positions were sold. What to do, pondered my friend? What to do?

Eventually, as always happens, he was forced to walk into his uncle's office and confess the error that had been made. It was a straight forward situation. Large quantities of cotton had been purchased on the futures markets, the price had declined, the unrealized loss was over $1,000,000.00. "What shall I do", asked my friend of his relative and employer? "What shall I do"?

What do you think his uncle told him? And how can that advice given so many years ago to a novice cotton trader be helpful to you today as you ponder your own position in stocks, futures, or options? Remember, as in most cases, his superior, who just happened to be his uncle, did not become his superior due to a lack of intelligence or diligence. His superior became his superior because he most likely was superior, in experience, talent, or simply in survival and staying power. This is the advice that his uncle gave him and it is advice which you should write down for yourself and never forget,

And then his uncle proceeded to help his young relative. He said that whenever one takes a position in a stock, in a bond, in a commodity futures contract, in a stock option or in a commodity futures option, one should always ask themselves the "what if" question. No investment should ever be made without having asked that question and having an answer for it.

In this case, the question would have been "what am I going to do if I find myself and the firm with a $1,000,000.00 loss in cotton futures one day?". The time to ask this question, said his uncle, is before one takes a position in cotton, not after the loss has occurred. And the answer should be arrived at before one makes the investment, not after the investment has gone sour. In other words, had the young man wanted an answer to the question, he should have received it from his senior associates prior to the million dollar loss having occurred, not after it had occurred. If such had happened, he would have known the answer before he entered his uncle's office. He and his uncle would have discussed it many days, weeks, months earlier and all the young man would have had to do is to announce what the answer was, not ask the question for the first time.

How does this story affect you as a stock investor, futures or options trader? It should be very good advice to you for one sound reason.

The uncle's merchant banking firm was a privately held bank which had survived for many years during periods of war, depression, inflation, hyperinflation, and stagnation. This was a bank which had been very successful. It did not become successful by accident. It became successful because the owners knew the rules to follow in order to be successful. One of the rules was that just conveyed to the young man who was just starting out - "never ask a major question about your financial investments that you have not already considered and arrived at an answer for".

For my friend, his questions should have been asked before the beginning of his cotton future purchases. He should have knocked on the door of his uncle and asked for an hour of his time. He should have explained to him that he planned to buy contracts at these different price levels and that it was possible the market would move against his position before it moved in his favor. He should have received advice or clearance as to what type paper loss the firm was willing to absorb in order to hold the cotton trades. Was the firm willing to absorb $1,000.00, $10,000.00, $100,000.00, $1,000.000.00. If the limit of risk that the firm would absorb was $1,000.00, should he get out at that level. If it was $10,000.00 should he liquidate then? What if the risk was $1,000,000.00 and what if that level was reached, should the positions then be sold for the $1,000,000.00 loss? All this should have been discussed, considered, resolved before the very first trade in cotton was made. Had that happened, my friend would never have had to walk into his uncle's office with a question he did not know the answer to, the answer would have been decided long before the trade was ever made.

Whenever you buy a stock, a futures contract, an option, you should always, before you invest any money in that opportunity, ask yourself the same 'what if' question. What are you going to do if this or that happens? What are you going to do if you find yourself with a $500.00 or $1,000.00 loss in your stock or futures or option position?

You should, like my young friend, know the answer to that before you take your position and you should have it always present in your mind or in a notebook on your desk or written down in the ledger where you keep track of your stock or commodity trades. Knowing before you start what you are going to do if adversity occurs will allow you to plan for adversity and make the intelligent decisions that you must make if you hope, like the merchant bank above, to survive and prosper for a long long time. It can best be summed up in a single sentence,

Before investing capital in any enterprise, have a plan for what you will do in the event that the markets turn against you.

If you have such a plan, you will always be prepared for whatever may happen. If you have a plan to liquidate your position whenever you have a $1,000.00 loss, you will never have to consider what you will do when you have a $5,000.00 loss. You will never have to consider what you will do when you have a $10,000.00 loss, you will have sold your position long before any such loss ever occurred. You will never have to worry about the $1,000,000.00 loss. You will never be surprised. You will never be without a plan. You will always be prepared.

How did the cotton trade turn out? Actually, it turned out quite well for this merchant bank and there should have been a couple of hints in this story that it would turn out well. What was the first hint? The first hint was that this was a merchant bank. You do not get to be a merchant bank by being stupid. The second hint was that my friend was telling me a story about his firm and his uncle, he was not telling me a story about his ex-firm and his uncle. It seems that this merchant bank was a very large buyer of cash cotton which it bought on the cash market. Whereas, it might have had to spend $10,000,000.00 for cotton at the cash market before, with the decline in prices it now only had to spend $9,000,000.00. Thus a million dollar loss was not actually a net loss to the firm. There is something else that my friend told me. He told me that his uncle knew all the time the amount of the loss he had suffered. That his uncle had simply had the accounting officer keep him appraised of the position from the first day it had been taken. The uncle was not surprised at the loss, he had known all about it from the day it had started to accrue. My friend only thought he was acting alone, actually he was being watched over like a hawk at all times by someone who was not only senior in age, but senior in trading cotton futures experience. It appears that some of the trades my friend made had been offset by spread trades made by his uncle. The firm never actually suffered the million dollar loss, only my friend had thought it had, as most of the losses had been offset by the uncle whose responsibility was making sure that his merchant bank survived long enough so that the trainees could take over and make the necessary decisions to allow the merchant bank to be passed on to yet a fourth and fifth generation. My friend, however, never forgot the advice he had been given and he followed it for the rest of his life.

Always remember,

Before investing capital in any enterprise, have a plan for what you will do in the event that the markets turn against you.

As you follow these lessons, pretend that you are learning from someone like my friend's uncle. In the process of these lessons, I am going to show you what you will have to do to become successful as an investor in these commodity trading markets that I shall be writing about. When you have completed all the lessons, you should be able to look back and say, "that advice really helped me". That is my aim. To "really help you" in your goal to become successful. I will try my best to make you a successful investor. When we are done with these lessons, you be the judge. If I have helped you, then send me an email and let me know. I will always be glad to hear from you.