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,
First, he told the young employee to be ready to walk out of
his office.
Second, he told the young cotton trader never to walk into his
office again until he already knew the answer to the question he was
going to ask.
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.
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