Natural Wave Trading Theory[1]

Natural Wave Trading Theory Club Member Manual

™2000-2009 Natural Wave Trading Theory All Rights Reserved. No portion of this manual may be copied or reproduced in any form without written permission. For more information contact: [email protected]

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DISCLAIMER: The opinions expressed herein are based on our judgment and our experience of commodities, futures and options. We do not guarantee that profits will be achieved, or that any losses will be incurred. These opinions should not be construed as an offer to buy or sell commodities. Commodities and futures trading involves risk and is not necessarily appropriate for all investors. Past performance is not necessarily indicative of future results. Consult commodities professionals before placing real trades.

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RISK DISCLOSURE STATEMENT THE RISK OF LOSS IN TRADING COMMODITIES CAN BE SUBSTANTIAL. YOU SHOULD THEREFORE CAREFULLY CONSIDER WHETHER SUCH TRADING IS SUITABLE FOR YOU IN LIGHT OF YOUR FINANCIAL CONDITION. IN CONSIDERING WHETHER TO TRADE OR TO AUTHORIZE SOMEONE ELSE TO TRADE FOR YOU, YOU SHOULD BE AWARE OF THE FOLLOWING: IF YOU PURCHASE A COMMODITY OPTION YOU MAY SUSTAIN A TOTAL LOSS OF THE PREMIUM AND OF ALL TRANSACTION COSTS. IF YOU PURCHASE OR SELL A COMMODITY FUTURE OR SELL A COMMODITY OPTION, YOU MAY SUSTAIN A TOTAL LOSS OF THE INITIAL MARGIN FUNDS AND ANY ADDITIONAL FUNDS THAT YOU DEPOSIT WITH YOUR BROKER TO ESTABLISH OR MAINTAIN YOUR POSITION. IF THE MARKET MOVES AGAINST YOUR POSITION, YOU MAY BE CALLED UPON BY YOUR BROKER TO DEPOSIT A SUBSTANTIAL AMOUNT OF ADDITIONAL MARGIN FUNDS, ON SHORT NOTICE, IN ORDER TO MAINTAIN YOUR POSITION. IF YOU DO NOT PROVIDE THE REQUIRED FUNDS WITHIN THE PRESCRIBED TIME, YOUR POSITION MAY BE LIQUIDATED AT A LOSS, AND YOU WILL BE LIABLE FOR ANY RESULTING DEFICIT IN YOUR ACCOUNT. UNDER CERTAIN MARKET CONDITIONS YOU MAY FIND IT DIFFICULT OR IMPOSSIBLE TO LIQUIDATE A POSITION. THIS CAN OCCUR, FOR EXAMPLE, WHEN A MARKET MAKES A “LIMIT MOVE.” THE PLACEMENT OF CONTINGENT ORDERS BY YOU OR YOUR TRADING ADVISOR, SUCH AS A “STOP LOSS” OR “STOP LIMIT” ORDER, WILL NOT NECESSARILY LIMIT YOUR LOSSES TO THE INTENDED AMOUNTS, SINCE MARKET CONDITIONS MAY MAKE IT IMPOSSIBLE TO EXECUTE SUCH ORDERS. A “SPREAD” POSITION MAY NOT BE LESS RISKY THAN A SIMPLE “LONG” OR “SHORT” POSITION. THE HIGH DEGREE OF LEVERAGE THAT IS OFTEN OBTAINABLE IN COMMODITY TRADING CAN WORK AGAINST YOU, AS WELL AS FOR YOU. THE USE OF LEVERAGE CAN LEAD TO LARGE LOSSES AS WELL AS GAINS. IN SOME CASES, MANAGED COMMODITY ACCOUNTS ARE SUBJECT TO SUBSTANTIAL CHARGES FOR MANAGEMENT AND ADVISORY FEES. IT MAY BE NECESSARY FOR THOSE ACCOUNTS THAT ARE SUBJECT TO THESE CHARGES TO MAKE SUBSTANTIAL TRADING PROFITS TO AVOID DEPLETION OR EXHAUSTION OF THEIR ASSETS. THIS BRIEF STATEMENT CANNOT DISCLOSE ALL THE RISKS AND OTHER SIGNIFICANT ASPECTS OF THE COMMODITY MARKETS. YOU SHOULD THEREFORE CAREFULLY STUDY ADVISOR’S DISCLOSURE DOCUMENT AND COMMODITY TRADING BEFORE YOU TRADE INCLUDING THE DESCRIPTION OF THE PRINCIPAL RISK FACTORS OF SUCH INVESTMENT.

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A COMMODITY TRADING ADVISOR IS PROHIBITED BY LAW FROM ACCEPTING FUNDS IN THE TRADING ADVISOR’S NAME FROM A CLIENT FOR TRADING COMMODITY INTERESTS. YOU MUST PLACE ALL FUNDS FOR TRADING IN THIS TRADING PROGRAM DIRECTLY WITH A FUTURES COMMISSION MERCHANT.

Natural Wave Trading Theory

CONTENTS

INTRODUCTION ……………………………… 6

1. GETTING STARTED ………………………… 10 2. FUTURES (“AND YOUR FUTURE”) ............. 15 3. OPTIONS (“ON YOUR FUTURE”) …………. 30 4. NATURAL WAVE TRADING THEORY …….. 41 5. NEW BEGINNING ……………………………...56

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INTRODUCTION (1) Commodities Trading is ancient and dates as far back as the beginning of human civilization. It was conducted originally as the means for the exchange of goods among individuals and merchants. The idea was to exchange something of a “lesser” for something of a “greater value”. There was an immense degree of subjectivity with this approach, because value was determined upon individually desired needs rather than based on any objective criteria. With the introduction of gold and “money” the trading process became more sophisticated and efficient. It was possible to sell and re-sell the same “thing” over and over. Henceforth, there were people making a living by knowing what different vendors were charging for the same “commodity”. They were the predecessors of the presentday arbitrageurs and savvy traders who inhabit the skyscrapers of Wall Street today. But it wasn’t until the 20thcentury, especially the second half, when trading became available to anybody who wanted to turn a profit from the “price” fluctuation. The idea was old –buy low and sell highbut because of the regulated nature of exchanges it gained a new foundation. The rules were known now and information was available not only to the “chosen ones” but also to an ordinary person, such as you or me. It became possible for a small investor to compete in the “ultimate game”, wherein fortunes could be instantaneously generated and lost within minutes. This manual’s purpose is to attempt to teach you how to “buy low and sell high” and how to apply a more sound risk management approach to your trading, thus becoming a more successful trader. Of course there is no universal method or system (as far as I know) that works 100% of the time, and performs flawlessly for everybody --- yet I’m hoping that the Natural Wave Trading Theory will give an edge that you need in order to stay in the trading game and walk away a winner. The Natural Wave manual should help you

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to develop a unique way of thinking, which in return may transform your frustration with trading into a success story of skilled confidence. (2) How do I know that you are frustrated with your progress in trading commodities, futures and options, and that you’re maybe looking for an ultimate business? Well, you probably wouldn’t be reading this otherwise. An interesting situation nudged me to write this manual: I used to be an Account Executive (broker), which means that I used to place orders with exchanges (in commodities, futures and option) on behalf of my clients. Doing this over many years has given me a unique opportunity to observe a variety of trading styles, techniques and methods. Summing up my experience I would say that the most of the traders lose money and stop trading. After a while, however, many of them return to trading in an attempt to discover what went wrong and why. Also, at that point, psychologically, most are ready to resume their trading activities, but seek to locate a “system” that would teach them how to make money WITHOUT losing. Being in such a state of mind they become an easy prey for persuasive advertisers and “trading system gurus”. Understandably, they become willing to spend anywhere between $199 and $299 (or even several thousand dollars) on courses, tapes, and the like that supposedly reveal the “secrets” of trading. And believe me when I tell you, that there are no secrets in those courses. I believe better information might be found, in most of the cases, in professionally written books by authors like Jack Schwager or John J. Murphy. Some time ago, through one of my acquaintances, I came across a so-called “commodities trading course” that supposedly teaches you how to trade. The only telling catch is that the author himself had only a smidgen of trading expertise! And to make things even worse – he didn’t have a clue what options were, and how to trade them. (In my professional opinion, options are an alternative trading vehicle about which every trader should know, either he uses it or not).

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He had simply “hand picked” the information on trading commodities and after packaging it, named it “MY Course” (I am declining to name this particular author, since there is so many others like him). Amazingly, he was selling it for about $ 200! I wouldn’t be surprised if he’s now already picking up tips, from various sources, about options, in preparation to write his “My Options Course”… Well, after all, it is a free country.

(3) I think I know what you are thinking now (about the Natural Wave Trading Theory manual): Is he cutting the branch he’s sitting on? Or to put it differently: What sets the Natural Wave Trading Theory manual apart from the previously mentioned author who wrote “My Course”? For one thing, it is offered for free… What is presented in the Natural Wave Trading Theory manual is an actual working strategy (not a compilation of information on trading derived from different sources). I lead you by hand, showing the practical aspect of trading commodities, futures and options. This “actual strategy” should be also understood as the flexible way of thinking as a trader. For you don’t find here any mathematical formula that would guarantee you profits (there are no guarantees in trading). What you find here though is the idea of trading that could quite possibly become a springboard for your own actions in commodities trading. Also I’m hoping that this “idea” would bring you closer to making commodities, futures and options trading your parttime or full-time occupation – a real, viable and potentially profitable business for you! Why the title Natural Wave Trading Theory? I’ve carefully considered it, and now that it’s attracted your attention, here is the wisdom behind it. First of all this manual describes a natural and practical approach to trading. The word “theory” was chosen to indicate the reference to a set of information that exists “out there” in the commodities, futures and options universe, but for one reason or another is not readily presented before us in an organized fashion.

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The “Natural Wave” accentuates my belief that just like in surfing, where one has to take advantage of the forces of nature in order to stay above the water, in trading, in order to be successful, one has to evolve along with (and be sensitive to) the forces that shape and influence the Market’s Reality. Therefore my purpose is to bring this information to the center stage and out into the open, so that you might benefit from it. A certain aspect of this “out there” information may also be called “common sense trading wisdoms”, which could be found outside technical indicators, moving averages, oscillators, fundamental and technical recommendations etc. I also believe that you don’t have to use a state of the art computer technology or so-called “trading program” to become a successful trader.

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1. GETTING STARTED

(1) But let’s get started at the beginning. What is the most likely scenario to occur when you first begin pondering the idea of trading in commodities, futures and options markets? In all likelihood, you are going to search the World Wide Web and the Internet for any information that is related to trading. And in today’s business environment it is one of the better ways of finding out what you need. You don’t have to strain yourself emotionally by talking on the phone to anybody, or drive around the city visiting different businesses. So, use the computer and the Web as much as possible. Most of the brokerage houses (IBs – Introducing Brokers) offer free charts and price quotes, directly from their web sites. The quotes are usually ten to thirty minutes delayed, but if you don’t trade the SP500, Dow, or Nasdaq Index, it should be more than enough. There are also some major data providers – like Future Source (www.futuresource.com), or Quote.com for example – that can provide you with free comments on different markets in conjunction with free quotes and charts. There is no point in purchasing something, which you can get for free! The reason I’m even mentioning this is because, yet not so long ago, there were some brokerages that used to charge as much as $340 a year for the same information that you could get for free on dozens of sites.

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(2) The next step is to find your own broker or Account Executive (if you prefer this expression). You may ask: Do I really need a broker, if I can place orders on-line, directly with the exchange? Well, you’ve got a valid point here. However, let me explain the importance of having your own broker in the process of trading. Let’s assume that you are placing an order on-line. You press the “Enter” button and … nothing happens. Your screen is frozen. You are trying to “Escape”, but you are stuck. The perspiration droplets are forming on your forehead. And to add even more drama to this burgeoning nightmare, the market in which you are trying to place the order, is going to close in just five minutes… What are you going to do? Call 911? No. You are going to call your broker, even though you may not have very close rapport (and you don’t have to) with him/her. The important thing here is that you have “somebody” to call when you need help. This is why it is so important that you find a broker and a brokerage house that you feel comfortable with for whatever reason. Even though you might be trading on-line, you still need a brokerage through which your orders are being placed. …….Of course, if you buy a seat on the exchange for a few hundred thousand dollars, you don’t need any brokerage house. When you have a broker, you may decide that you prefer to place your orders through him/her, as opposed to on-line. For if you are not a very seasoned trader you might be trying to place a bad order (wrong price, wrong contract month, etc.), and if your broker is any good he/she can catch it, and by doing so help you to prevent a costly error. Trying to save ten or twenty dollars on commissions could possibly backfire in the long run. So remember that the lowest commission rate could sometimes mean “the poorest results”.

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When you choose a broker, it doesn’t mean that you have to listen to his so-called “recommendations”. You can simply say that you prefer he keeps his recommendations to himself. Most brokers are professionals and will appreciate your directness.

(3) Okay then, so what is the advantage of choosing a full service broker versus a discount broker? Well, if you really know what you are doing you can go with a discount broker. You can find places that will charge you only $ 15 to $ 20 per round turn commission. (Or even $5-10, if you trade electronically). On the other hand, if you are not 100% “confident” choose a full service broker. This way you probably won’t “get lost in the shuffle” and you would get full attention when you need it. Some years ago there was a big gap between these two types of services (full and discount). But in today’s trading environment you can locate many professional full service brokers that will charge you only $ 30 to $ 50 per round turn commission. Also you may need somebody to bounce your trading ideas off of, and in this scenario a full service broker could come very handy. Do you really think that most of the discount brokers would give you the time of day? I’m not suggesting you obtain a full service broker so you can have a friend (although I’ve seen this happening as well). I’m just proposing that you find “your broker”, who is somebody with the possible potential to become a vital part of “your team”- - - somebody who can help you and somebody that you feel comfortable with. You can also ask your friends if they’ve come across a friendly, knowledgeable and professional broker. I’m sure that many of your friends and colleagues have dealt with some more or less “interesting” account executives, and probably they would be more than happy to refer them to you.

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(4) Next thing you need is risk capital, which is the same as trading capital. (The “risk capital” simply means that you can lose it without any financial distress and that your life style will continue as before). How much do you need to start your trading account? Well, let me ask you this: how much do you have? Your chances of success are greater if you have twenty or thirty thousand US$ as an initial trading stake. The reason for this is so you’ll have enough cushions to sustain an adverse price action, and still remain in the game. On the other hand, if you are very lucky, you could possibly become a very successful trader while starting only with $ 2000. I do recommend starting the account with whatever you can afford (to lose). Make sure that you don’t borrow any money for this purpose though. You don’t really want to have an extra “debt” stress on your mind. This situation (the need to return the borrowed money) could be compelling you to trade, making you see an “opportunity” where none really exists. The other end of the spectrum: even if you could start your account with millions of dollars, start with only $100,000 (even if you were a so-called “experienced” trader in the stock market, for example). It is very easy to get carried away by your own or your broker’s imagination. You may end-up taking too many positions even for your account size (over-leveraging), which could have quite tragic results for you. There is nothing wrong with adding more money to your account later on, when you’re thinking straight and with a cool head. After a test drive, you can take the plunge with more capital, when you feel more comfortable with your initial progress. But no matter how much money you initiate your account with, remember at least one thing (even if you forget all others) that this money must be only risk capital (money that you can afford to lose – which does not mean that you want to or have to lose). You don’t want any loss to affect your life style or cause you any undue financial distress.

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Also from the psychological point of view, if you trade with money that you cannot afford to lose, you are destined to do a lot of “bench sitting”, while genuine trading opportunities are passing you by…

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2. FUTURES (“AND YOUR FUTURE”) If you have been trading commodities, futures and options for a while, chances are that you’ve heard some stories about the incredible “fortunes” that were made. For example, somebody starts an account with $ 5,000 and turns it into $ 30,000 or $ 250,000 in twelve months or less. It is achievable (not easily sometimes) because of the leverage that exists in futures and options markets. The terms “Commodities” and “futures” are going to be used interchangeably throughout this manual - although some traders assign “commodities” to the contracts that represent tangible goods (corn, soybean, sugar, gold, copper…), and “futures” mostly to financial markets. It is also true that the same leverage that could potentially lead you to significant returns could also become the source of your nightmares. A lot of fortunes have been lost because of this kind of leverage. In other words, as a trader you constantly walk the thin line between risk and reward. If you are an experienced trader you can skip this and next chapter and go to the “heart of the Natural Wave Trading Theory”. On a second thought, you could come along for a ride. Maybe you could learn something new… So, what’s a big deal about the leverage anyway? Well, let’s take a closer look. I’m going to use mostly a corn contract, throughout this manual, for exemplification purpose. However, as we’ll find out later, the corn market seems to be an ideal trading ground for the NATURAL WAVE TT. But let’s don’t get ahead of ourselves too much… All exchange traded commodities and options have defined contracts’ specs, like size, point value, minimum tic, limit move, etc. Some of the contracts trade in points (like sugar: if October Sugar moves from 657 to 667, it is a 10 points move. And because 1

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point=$ 11.20, the 10 points move in sugar equates to $ 112 – per contract). Some contracts trade in cents (like corn: a move from 211 to 212 equals only 1 cent. And 1 cent in Corn is valued at $ 50. Therefore if you bought 1 contract of Corn at 211 and got out at 212, you would have made $ 50 profit. The minimum price move in Corn futures market is ¼ - quarter of a cent, which = $ 12.50). You can find the details about those specs with any exchange or brokerage house. It is free. So how does the leverage fit into all of this? Again, the best way to demonstrate it will be with an example. Let’s take a price of Corn at 211. What it means is that if you were to buy 5,000 bushels (the equivalent of one contract of Corn in the exchange traded futures/commodities) of Corn in the open market you would have to pay $ 10,550 cash. $ 2.11---price of corn per bushel X 5,000---bushels _____________________________________ = $ 10,550 ---total amount paid for 5,000 bushels of Corn Other words, if you expected that corn prices will go up, and if commodities exchanges didn’t exist, you would have to come up with $ 10,550 in Cash (!) in order to purchase 5,000 bushels of Corn (and if you of course had the room to store it). Theoretically speaking you could hold on to it forever. And even if Corn price declined to ZERO, you could wait for as long (providing that the corn is not going to spoil) as necessary for the prices to recover, and go up again to 211 or beyond. Just remember though that through the whole “waiting period” you would be tying up the entire $ 10,550, and you would worry if Corn can be preserved in good enough conditions for the future resell to somebody else. And of course later on you would have to convince the buyer to buy from you the “old crop” as opposed

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to the “new crop” that is readily available (most likely) from another seller. Let’s continue our Corn Story with an assumption that Corn prices eventually recovered after…let’s say… 1 year later, and went to 241. At that point you’ve decided that it was time to get rid of your Corn, and you were lucky enough to sell the whole 5,000 bushels at 241… So… a quick calculation, and you realize that you made $ 1,500 profit [$ 2.41- $ 2.11 = $ 0.30, times 5,000 bushels = $ 1,500]. It took you $ 10,550 to make $ 1,500 profit. “Not bad”, you say. I say: it is only 14 % return, for this much headache for the whole year (!). At the same time if you were trading on the exchange (CBOTChicago Board Of Trade), and went long (bought) only one contract of Corn at 211, and sold it (got out) at 241 you would have made also $ 1,500 profit. But in this case it would be 122 % return on your money. Am I trying to trick you? No, I’m not. In order for you to trade on the Exchange one contract (5,000 bushels) of Corn you need only $ 675 an initial margin (this amount could vary, pending CBOT’s decision, but over the years it remained within a few hundred dollars range). This $ 675 is nothing more than a good faith deposit, which means that if you make money on your trade, this $ 675 will return back to you on top of the profit you had made. If market went from 211 to 241 and you got out of your long position -you were “riding” the market- you would be paid $ 1,500 profit. Your original $ 675 deposit is called: Initial Margin So using only $ 675 (oppose to $ 10,550) you made also $ 1,500 profit. Isn’t this amazing? Try to imagine than how much Corn you could control with $ 10,550:

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$ 10,550 divided by $ 675=15.63 (contracts) It is hard to believe, but with $10,550 you would be able to buy 15 contracts of Corn (on the exchange), and by doing so you will be in a control of 75,000 bushels of Corn. That’s the power of leverage. At this point, if you went long (bought) at 211 on your 15 contracts, and exited your position at 241, you would have made… $ 22,500 {241-211=30, times $ 50 (point value in Corn)= $ 1,500, times 15 contracts=$ 22,500}. So what would you rather do with $ 10,550, control only 5,000 bushels and made $ 1,500, or control 75,000 bushels (15 contracts) and made $ 22,500? PLEASE, REMEMBER THAT LEVERAGE WORKS BOTH WAYS. AND IN THE REAL WORLD OF TRADING YOU COULD ALSO LOSE YOUR MONEY JUST AS QUICKLY AS YOU MADE IT.

If understanding leverage were enough to make money in trading commodities, futures and options, then we would be walking among a greater number of millionaires. But this obviously isn’t the case. The leveraging concept is therefore a double-edged sword. When you trade on margin (as you do with exchanges) your risk could be as great as your profit potential. (The Natural Wave TT that will be covered in the 4th Chapter of this manual demonstrates to you how to keep your risk under control, while potentially having an unlimited profit potential.) This is mainly why the trading is so challenging, and why so many traders are “out of the game” before they’ve even had a decent chance to develop their own trading plan. Let’s use an example to illustrate the challenging nature of the futures contracts.

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Example: Let’s assume that you opened your trading account with $ 5,000. You are looking at the Corn Daily Chart that looks something like this:

(I’m not going to spend much time here to analyze the chart formations. Later on, it will become more apparent: why (?). If you are “hungry” for more information on the commodities markets, please refer to a classic by John J. Murphy: “The Technical Analysis of the Futures Markets”. It is well written and could be understood even by the novice trader, and it gives very comprehensive overview of different chart formations.) You are expecting that Corn prices will go up. They do go up and you: 1. Buy 3 contracts of Corn at the market. 2. Your fill price is 224. 3. Your Initial Margin (the amount of money used out of your account as a “good faith deposit”) is $ 675 x 3 contracts=$ 2025. 4. So how much money do you have left for trading?

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5. $ 2,975 (?) 6. Not quite. You have to subtract the commission cost. If your Round Turn commission is $ 50, you will be paying a half of it ($ 25) to initiate this trade- $ 25 x 3 (contracts)=$ 75. 7. So you have left not $ 2,975 but $ 2,900. (Don’t confuse this amount with your account balance, which would be about $ 4,925). 8. Next day Corn market goes to 234, but you decide to remain in your position overnight. What would be your account balance after market closed at 234? Let’s calculate this together: a) you made a profit of $ 1,500 (10 cents per contract times 3 contracts, times $ 50-cent value in Corn), b) your initial balance was $ 4,925 (after paying half of the commissions), c) …so your second day account’s balance would be $6,425 ($ 4,925+$ 1,500). So now you have more money available for trading. Right? $ 6,425 - $ 2,025 (Initial Margin) _______________________________ =$ 4,400 This $ 4,400 is called Margin Excess. It is all the money on your account that is not tied up for the Initial Margin Requirement. (Theoretically speaking, you could use all this money for trading additional contracts, but from the practical point of view it isn’t recommended. It’s a great idea to have a cushion on your account. So if markets move adversely against you, you have some money on the sidelines to “absorb the blow”. As an idea for you – try to keep roughly 50% of the money on your account in form of cash, if you trade future contracts…) So now you tell all your friends how much money you are making, and how easy it is to trade commodities…

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But what you are forgetting is that you are still in the market and you still holding on to your original position, and that money is not yours until your close your position. “But I have a stop loss @ 229 protecting my profits. If market declines to 229, from 234, I’ll be out of my Corn position…” – you say. “So when I’m stopped out @ 229 I would end up making $ 750 profit.” Well… the keyword in your last statement is “when”. It should be rather “if”. Because what could very well happen is that for the next three trading sessions the Corn market goes down limit, and remains locked “down limit”. Limit move means that the market cannot move more than the specified distance. In Corn this distance is -let’s say- $ 600 or 12 cents (unless exchange changed that amount to 20 or 30 cents, due to increased Corn market volatility). In some other markets this limit will be different. Yet some other markets don’t have any limit. So from 234, Corn goes down (through your stop loss @ 229): ---First Day to……222. ---Second Day to 210. ---Third Day to…..198. During those three trading sessions you were not able to exit your position, because there was no active trading going on in the Corn Pit. Try to imagine how damaging to your emotional state this situation is. You can’t sleep well. When at work, you keep thinking about your Corn position rather than about doing your job. When at home you are short with your wife… your kids, and you are “mean” to your dog and your neighbor. There is a dark cloud hanging over your head. Even though $ 5,000 was your risk capital (money you could afford to lose), yet you thought you could use this money for a family vacation… And suddenly you turn religious, and start praying. You know that if Corn goes down limit for one more day your account will go

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negative or “upside down” (you lose more than you started your account with). Luckily for you, your prayers are answered, and on the Forth Day the Corn market opens @ 196. Your stop loss of 229 is triggered then, and it becomes a market order. You are stopped out @ 196. What is your account balance now? 234-196=38, 38 x 3 (contracts)=114, 114 x $ 50 (point value in Corn)= $ 5,700. When Corn was @ 234, your account balance was $ 6,425. And a few days later when you “got out” of the market, you balance is: $ 6,425 - $ 5,700 = $ 725, $ 725 - $ 75 (half a turn commission times 3 contracts) = $ 650. The final balance on your trading account would be 650 $. REMEMBER: THERE IS NOTHING WORSE IN TRADING THAN SEEING THE MARKET MOVING AGAINST YOU AND NOT BEING ABLE TO DO ANYTHING ABOUT IT, EVEN IF YOU WANTED TO. Chances are that after this “roller coaster” ride in the Corn market, you will call your broker and close your account. What is the moral of this story? Don’t praise the day before the sunset, or putting it differently, don’t spend your money, while still in the trade. Of course the above example of the Corn trade is somewhat simplified. Nevertheless, generally speaking, it captures the “ups” and “downs” of an average trading account in commodities. Also, due to increased volatility of the grain markets, in the recent years, the limit moves were adjusted up, so the limit

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move in Corn could quite well be 20 or 30 cents. Before trading, make sure to obtain up-to-date specs on the contract and markets you are intending to trade. My intention here is not to discourage you but rather to “invite” you to search for a “better” way of trading. And I do hope that this very manual will help you in this process.

IT’S TIME NOW FOR SOME GENERAL REFLECTIONS ABOUT THE FUTURES MARKET: This manual’s purpose is to demonstrate to you a unique way of looking at the reality of trading. Under no circumstances it should be treated as an encyclopedic source of information about the technical chart formations or fundamental “gossip”. There are more than enough books, trading programs and courses that discuss those matters. I’m sure that you wouldn’t have any problems with finding the right ones for you. Throughout this manual, I’m going to keep my reference to the technical chart formations only to the very minimum. For I do believe that, if you look at the market from the historical point of view (where prices of this market are recorded in the graph format), and see that the market is trading in the level of ten or twenty-year lows or highs, statistically speaking, your odds of predicting correctly the direction of the market -over the next few months- are greater. On the other hand, if you are looking at the chart that covers only three to six months price data, and you are trying to predict the direction of the market for the next few months (without referring to ten or twenty year chart) your chances of being correct are lesser. Knowing this is worth money. For if you are going to treat trading as business, you need to take advantage of everything that could increase your odds of success. *

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Of course when you trade markets like SP500 or NASDAQ -which were offered as the trading vehicle only in recent decades- and are getting in and out quickly, you don’t really care as much about the twenty or thirty year chart. In here though, I’m focusing more on markets that have long tradition and history of trading (grains, gold, silver, meats, softs, coffee…). There, in multi-year graphs, you can see how the human mind works. If something is at ten-year lows and the distance from there to all time lows is “not far”, chances are that it would be a good time right now to start establishing your long position. However, even though you could be right on the direction of the market, you may run out of money or time before the market takes off. And this is another reason why so many traders lose in trading. This is where the Natural Wave Trading Theory will come handy.

In the “Introduction” I referred to the principle of trading: “buy low, sell high”. The reason for it is my belief that in today’s trading environment we tend to forget this basic principle. What we see instead in front of us is the number of different oscillators, moving averages, buy and sell signals, etc. We simply forget that many of the trading systems are just the hypothetical models, constructed on the selected market data. And since markets evolve in terms of volume (number of contracts traded daily), sophistication of participants, volatility (how fast and how much markets move in a certain period of time), many systems or trading models –that were valid not so long ago- are no longer compatible with “live markets”. That’s why there is a need for a unique way of thinking about markets and trading them, the need that is rooted in this traditional “buy low, sell high” principle. This will force us in a way, to be patient, and to trade only markets that are either multi-year low or high. The idea is not to just trade for fun, but to trade for fun and money. In Chapter 4, I’m going to demonstrate the style of trading that could not only save you money, but also insure that you remain in the market, even when it moves against you. This way you can wait and adjust your position accordingly.

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As a trader, you should learn how to be flexible, how to adapt yourself to ever changing market conditions. Yet with change don’t forget what is constant: markets go up and down and they are attracted to price equilibrium. Just think about the expressions that we hear or use every day: “extreme low”, “extreme high”, “flat market”, “extreme volatility”, etc. Those expressions are possible, because we refer to some information in us or in historical data (or both) that is “objective” or typical. Just think about it---if we didn’t perceive the usual conditions of the market, we wouldn’t be able to notice what is “unusual”, “extreme”, or “strange”. And knowing this is worth money: If Corn, for example, is trading at the “extremely low level” (ten-year low), the chances are that sooner or later, it is going to move “up”. And not even oscillators or moving averages are going to change it. However, keep in mind that “knowing” is one thing and “doing” is another. You probably have heard somebody saying: “I knew that this market was going to move UP. And look what it happened – it really did.” YOU:

“Okay, so how much money have you made?”

Somebody: “Actually I didn’t. I didn’t have enough money to trade this market.” Or: Somebody: “Actually I was right, but was stopped out (2) and then the market moved in the direction I thought it would…” REMEMBER: You may be right on the direction of the market, yet end up losing money.

The NATURAL WAVE TRADING THEORY is designed in such way that using its ideas you might be able to stay “afloat” (even while the market is moving against you) and not being stopped out.

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The Natural Wave Trading Theory’s purpose is to limit your initial margin requirement, sometimes as much as to ZERO (That’s right, you “read me” correctly). So even if you are afraid of losing your “initial stake”, the Natural Wave TT could give you more confidence and staying power, and “dramatically” reduce your risk exposure. I will address this more in the following chapters. But before we go there, I want to make sure that you have a good grasp of the following concepts: • Initial Margin • Maintenance Margin • Margin Call (!) And as a bonus [ ☺ ]- I’m going to include the concept of “selling short”- How can I sell something I don’t own? Initial Margin. It is the good faith deposit placed with an exchange. It is withheld from your account with a brokerage house. It allows you to participare in trading in a particular market. An exchange decides how much of an initial margin is needed to trade in a particular contract. The criteria of risk is being used to decide on the amount of money that is needed to control one futures contract in a particular market. For example, the initial margin on Corn is lesser than on Dow Jones (about $675 and $6,000 respectivelly –as of 2000), because the Corn is “less risky” than Dow. Generally speaking, initial margins don’t change that much, although they could go up and down quite significantly if the volatility in a particular market changes. And if you are already in the market you are also a subject to the new margin requirement. The initial margin is per contract basis. So if you want to trade 5 contracts of Corn, you need $ 675 x 5= $ 3,375. Maintenance Margin. I call it “the policeman on your account”. Let’s assume that your account size is $ 1,000, and let’s forget for now about the commissions. Also, let’s say that the exchange had established $ 400 maintenance margin on Corn. So because of the initial margin on Corn ($ 675) you can trade 1 contract of Corn with your $ 1,000 account.

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However, if the future market moved 11 cents against you (11 x $ 50=$ 550) your account balance would be $ 450 ($ 1,000-$ 550). Even though the balance of your account is below the initial margin requirement ($ 675), theoretically you are still okay. You could remain as you are with doing nothing. However, if Corn moved 1 more cent ($ 50) against you, your account balance would be at $ 400. Your account will be at the level of the maintenance margin. At this point “the account’s policeman would blow his whistle”. The Maintenance Margin will be reached, and you will be on the… Margin Call (!) And if you wanted to maintain your position as it is, you would need to deposit to your account the difference between the current account balance and the initial margin requirement - $ 275 (675-$ 400). When you are on the “margin call”, you have to bring you account balance back into black, which is “at” or “above” the initial margin requirement. If you fail to do so (as soon as possible, usually 24 hours), you would have to close your position. The ideas of margin and margin call are an important background of the Natural Wave Trading Theory. It is why I had spent some time on them. This will become more apparent in Chapter 4.

However, before we shift to the next chapter, I would like to try to explain one more concept that seems to keep many of the new traders awake at night: “How can I sell something that I don’t own?” As you already know, this concept has to do with shorting the market (“selling”, or “going short”). It has to do with establishing a short position in anticipation of price decline. In this case what you are simply doing is – reversing: “buy low, sell high”. You are selling high and trying to buy back lower. Okay…okay…but how can you sell something you don’t own? Well, do you think that you really own something when you are going long in the market (?). Think again. When you are “buying low” and expecting to “sell it higher” later on, do you really think that you are the owner of the contract? No, you are not. If you were, you

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wouldn’t be on a margin call in the first place, or wouldn’t be forced out of your position. When you are establishing your initial position in the market by “buying”, you simply taking control of the contract at the specific price. Other words, with your initial margin (good faith deposit) you are borrowing the contract at the specific price. You are hoping that price will rise, and that you will be able to return (sell) this contract to the exchange later, and “pocket the difference”. By the same token, if you noticed that a commodity is very high, and expecting for it to decline, you may want to take advantage of this scenario by selling at that higher price and bying back later at the lower price (to offset your original short). In this case your initial transaction would be selling. You are “borrowing” a contract from the exchange with the promise (insured by your good faith deposit) of returning it later. So if you sold 1 contract of Corn @ 234, and bought it back later @ 214, you would have made $ 1,000 (234-214=20, 20 x $ 50). Let’s illustrate this “selling something you don’t own” with yet another example: Your collegue at work is getting married and he is looking for one carat diamond ring. A friend of yours is a jeweler. You go to him and he lets you borrow a diamond ring, which you think your colleague at work could be interested in. ( To add an extra twist to the story, let’s say that you have to return this or identical ring to your jeweler friend within two weeks). Surely enough you colleague at work gives you $ 5,000 for the ring. You put $ 5,000 cash in your own pocket and…You start looking around to buy the identical ring for less than $ 5,000. And you have to by the identical ring because you promissed your jeweler friend that you would return the ring not later than in two weeks. One week later you are able to buy an identical ring that you’ve sold to your colleague at work for $ 4,200; and you use Cash ($ 5,000) from your pocket to pay for it.

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How much money have you made in the process? $ 800. ($5,000 minus $ 4,200). You made this profit by selling something that you didn’t own (!). On this note, we are ready to wrap up this chapter and move on to the next.

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3. OPTIONS (“ON YOUR FUTURE”) Maybe you’re one of those people who are simply “paralyzed” by the uncertainty of the trade’s outcome. Even if the market is moving in your favor you are so self-conscious of the “built-in” risk factor of your position that you are afraid to remain in it any longer. You make an irrational decision of getting out, and the market keeps on going in the same direction for what it seems like forever. And no matter how brilliant and eloquent you are in justifying your decision of “getting out”, the bottom line is still the same: somewhere in the dark corners of your mind a doubt is lurking that you left a bunch of money on the table. To simplify the above situation I would say that the fear of risk – the uncertainty about the amount of capital you could lose on a trade – could reduce dramatically your potential as a trader. It is why the options on futures seem to be an ideal trading vehicle for traders who “can’t handle” or can’t afford excessive risk. What is an option? It is the right but not the obligation to be long or short in the future market from the specific price within certain period of time. (When you trade options you’re trading those rights, not the future market.) But what it really means? It means that you have to pay a premium if you want to purchase this right. And the amount of premium varies, depending on the number of factors: 1. How close to the current price of the future market your option is. 2. How much time to expiration your option has. 3. How volatile the underlying future market is.

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Let’s use an Example: Consider December Corn: (It’s called “December” because it expires sometime in December. At this point you could switch –roll over- to the next available Corn contract, which in case of Corn would be March. The average contract life in non-financial markets is 9-12 months.) Let’s say December Corn is trading at 221. You are expecting that Dec. Corn is going to move “up” to 260 by the end of November. And since it is only July now you have about 4 months before December Corn options expire. (Usually options in non-financial markets expire 2-3 weeks before their underlying future contract. But check with your broker or a trading advisor for more detailed information.) If you expect the price to go UP you want to buy a CALL option. If you think that prices will go DOWN you want to buy a PUT option. The “Calls” and “Puts” have pre-established (by the exchanges) strike prices. And the strike prices “mark”-in the identical intervalsdifferent levels of futures prices. So in the case of Corn market, strike prices are established in the increments of 10 cents. It means that you could buy: 250 Call 240 Call 230 Call 220 Call 210 Call etc. By the same token you could buy some Put options if you were expecting that prices would move down:

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220 Put 210 Put 200 Put 190 Put 180 Put etc. And each of these strike prices has a different value (premium/price). Generally speaking, the premium/value of an option is based on the following factors: ☺ Intrinsic value. ☺ Time to expiration. ☺ Volatility. The intrinsic value: If the December Corn future contract is traded at 221, and you have 220 Call option, this option is 1 cent in the money or has 1 cent of the intrinsic value. And the value of such an option will be greater than one that is farther away from the current future price. If your 220 Call were costing you for example $ 600 sometime in July, a 250 Call would cost you probably somewhere around $ 200. The reason for this is you have a greater chance of making a profit on 220 Call than you have on 250 Call. Time to expiration means “when does your option expire”. Obviously the more time to expiration there is on your option, more valuable this option is going to be. Volatility of the option is “absorbed” from the future market, which underlines a particular option. The SP500 market is by far more volatile than Corn market. This is why SP500 at the money option can cost as much as $10,000 or more, while at the money option in Corn runs usually a few hundred dollars… What exactly is meant by the term “at the money” anyway? Well here lies the gist of it:

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• An option is at the money when its strike price is at the level of current price of the underlying future contract. If Corn future is trading @ 220, 220 Call option would be considered at the money. • An option is in the money when an underlying future contract is above (in case of a Call) or below (in case of a Put) the strike price. For example, if you have Corn 220 Call option and the future market is trading at 227, this 220 Call is in the money. • An option is out of the money when it is not “touched” by the future contract. If Corn future is traded at 211, 220 Call would be considered out of the money.

REMEMBER that more time to expiration your option has, and closer to the current price of the underlying future market it is, and more volatile the underlying future market is, more expensive (and more valuable) this option is going to be.

Options provide you with great leverage. If the future market moves significantly in your favor, and your option “becomes” deep-inthe-money, you have a chance of making almost as much money with your option as you would have with a future contract. On the other hand, options give you great comfort in case of the future market moving dramatically in the other direction than you expected. In those moments you’re very glad that your total risk on the trade was the premium cost and commission paid for such option. WHEN YOU ARE AN OPTION BUYER, YOUR TOTAL RISK ON A TRADE IS THE “PREMIUM” AND “COMMISSION” THAT YOU PAY FOR IT, PROVIDING THAT YOU LIQUIDATE YOUR OPTION PRIOR TO IT’S EXPIRATION. To illustrate the difference between the future and option trade, let’s assume that you bought 1 December Corn contract at 220, and that you didn’t place any protective stop loss. And let’s just say, for

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the sake of example, that Corn declined 60 cents ($ 3,000 on 1 contract=60 x $ 50). So you lost $ 3,000 on just 1 contract. At the same time infamous “John Doe” bought 220 Call option in December Corn, for which he spent about 12 cents or $ 600. In reality you lost $ 3,000, while “John Doe” only $600. And the best part for “John” is that he still owns his option until the expiration date. So if December Corn went eventually UP (after such a big decline) not that only he had a chance of recovering some of the option’s premium, but maybe even making a profit, if the underlying future contract “exploded” UP and went way above 220 level. As for you, possibly you ran out of money and had to exit your future trade… Next question that practically jumps at us here is: Can I make any money on the option if the future market never exceeds my strike price? (Can I make any money on an option if it never becomes significantly in-the-money?) Yes, you can. Just remember that the money is not yours yet, if you didn’t liquidate your option. Your option is a “wasted asset” (like the new car you just bought). It means that even if the option, which you bought for $600, becomes worth $ 3,500, you can’t use its profit for any other trade, until you offset (exit) it. (IN A FUTURE MARKET YOUR PROFIT IS REALIZED INSTANTLY --SO-CALLED “MARKET-TO-MARKET” SCENARIO. YOU CAN USE THIS PROFIT RIGHT AWAY, WHILE YOU STILL IN THE ORIGINAL POSITION THAT MADE YOU THIS PROFIT.) Buying an option as an initial transaction is not the only thing that you could do with an option. Another one, for example, is selling an option as an initial transaction. In this case you want for your option to lose value. If it expires worthless, than you will be able to keep the money you’ve collected originally, by selling it. The major problem, however, with selling an option as an initial transaction is that there is only limited profit that you can

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make –value of the premium at the time of sell. Worse still is that should the future market dramatically move against you, you’ll virtually have an unlimited risk. This is why, in the case of the Natural Wave Trading Theory, we‘re mainly interested in options, which are bought in the initial transaction. We want to have limited risk with unlimited profit potential. Other words, if you bought 250 Call in December Corn at 8 cents (8 x $50), and it went to 70 cents in value, after significant rally in the future market, if you sell this option at this point, you will be putting $ 3,500 back to your account (70 x $ 50). But since you paid for it $ 400 in premium, and $ 50 in commission, your net profit on this trade would be: 3,500 - 400 50

=3,050 ($)

Although not impossible or unusual, in the case wherein you make a few hundred percent return on your money, this doesn’t happen very often.

Most likely what’s going to happen, more often than not, in your trading career is this: You purchased 250 Call option in Dec. Corn, when the future market was at 219. You paid for the option 8 cents or $ 400. Over a period of two months prices on Corn went up to 247 (notice that the prices don’t reach your strike price yet). And now because the future market is so close to your strike price, the value of your option could be then around 13 cents, or $ 650. At this point you could liquidate your option, and put $650 back to your account. And your profit then would be $ 200.

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650 -400 (premium you paid) -50 (commission) =200 ($) As you see in the latest example, you’re not making as much money on this option as you would have had you been in the future trade: If you bought 1 December Corn future contract at 219, and got out at 247, your profit would have been $ 1,400 (28 x $ 50) - $ 50 (comm.)= $ 1,350. But even though you’ve made only $ 200 profit (oppose to $ 1,350), you had known your risk exposure whole time. You chose safety…and there is nothing wrong with that. * We spoke much about an option’s liquidation, but we didn’t mention exercise. What is the difference between liquidation and exercise? Generally speaking, you could liquidate all options as long as they have any value. However, you can exercise only those options, which are in the money. (Actually you could exercise any option, even one that is out of the money, but it wouldn’t make any sense, for you would be losing money on this procedure). Example: You bought 250 Call in December Corn a couple of weeks ago, when future market traded at 219. Let’s assume that Corn future is trading today at 300. At this point, if you exercise your right (option) to your 250 Call, you will be long one Corn contract from 250, even though the future contract is trading at 300. You will be required to put up the margin (about $675, or more, which depends on the current margin

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requirements); which in this case wouldn’t be a problem since the distance between 250 and 300 is 50 cents or $ 2,500 (50 x $50). So through exercise you are gaining access to the cash that was “frozen” in your option, and you can start using it immediately for either purchasing additional options or future contracts, or simply to add some of it to your checking account. The downside to this scenario is that if future market goes sharply down, you could be stopped out (if you placed the stop and market isn’t locked “limit down”), losing more money than you felt comfortable losing…etc. Also when you exercise an option you are giving up the original premium for which you paid so dearly. This is a very important issue when it comes down to exercising options that have a lot of time to expiration. For if you have 250 Call in March Corn, and it does not expire for six months, it wouldn’t make any sense for you to exercise this option if the future market for March was trading at 255. Chances are that your option would be worth around 20 cents or $ 1,000. And if you had exercised it at this moment you would be gaining only 5 cents or $ 250 (255-250=5, 5 x $ 50), and your entire $ 1,000 value (which contains also your originally purchased premium) would vanish, leaving you only with $ 250. So it would be better for you to liquidate this option in this case. SO, WHAT’S BETTER: EXERCISE OR LIQUIDATION? Well, it depends… Generally speaking, most options on the retail (non-commercial) levels are liquidated. However, there are some unique market situations in which exercise might make more sense. Please, check with you broker or trading advisor regarding this issue. (If December Corn future contract went up to 300, and you had 250 Call option, this option could be worth 55 cents or $ 2,750 –it depends on volatility of the market and time to expiration. This option would be obviously composed mostly out of intrinsic value –50 cents. However, if it still had some significant amount of time left

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before the expiration, this “significant time to expiration” could possibly add an extra value to it. In such case liquidation would make more sense). Keep in mind though that the reality of trading is much richer than any theoretical analysis or description of it. This is why you should learn how to be flexible in your trading. Oftentimes market conditions and circumstances could appear “identical” to what you’ve already experienced or read about. But remember that every market situation is unique in its own way (even if it appears as something that you already know), and it can surprise you at any moment. It is important that you stay attuned to the markets (watch prices daily, read any pertaining information, yet keep your own opinion), which you trade. Also you should feel comfortable with methods that you trade these markets with. When as a trader you have a peace of mind and you’ve taken care of risk exposure on your positions, you are more inclined to notice certain new ways, in which you could possibly trade. And this is a part of this “flexibility” that I’m talking about… I know, I know, you’re probably waiting to see an example of such “flexibility”… Well, the entire next chapter is dedicated to it. However, before we go there, I would like to give you an example that would illustrate an advantage of using an option (in this particular case at least) versus future contract. Example: Let’s say that you’re expecting Corn to go UP. You are buying 1 December Corn contract at 219. John Doe is expecting the same, but he is buying 2 December 250 Call options instead, for 6 cents each. On your trade you are tying up $ 675 (or more if the official exchange established requirement is higher) for the initial margin, plus you have virtually “unlimited risk” (actually in this case your risk is $10,950, if Corn went down to ZERO), if Corn went down limit for many days.

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John Doe is spending: 2 x 6=12, 12 x $ 50= $ 600, + 2 x $ 50 (commission)= $100. So the total is $ 700. And this is total risk he is taking, as long as he is going to liquidate his options prior to expiration or let them expire worthless. And 6 weeks later December Corn is trading at 350. You and John Doe decide to exit your respective positions. Who is going to make more money? You would be making: 350-219=131 131 x $50 (point value)=$ 6,550 $ 6,550 - $ 50 (commission)= $ 6,500 (net profit). John Doe would be making: 350 – 250=100 100 x 2 (options)=200 200 x $ 50 (point value)= = $ 10,000. $ 10,000 - $ 700 (cost on 2 options)= $ 9,300 (net profit). So, in the above case John Doe made $ 2,800 more than you did, and his risk was limited. (Of course the situation would be different if Corn went UP only to 255 when you and John decided to close your positions…but that’s the different story).

Why would anybody want to trade futures then? For the following reasons: (1) having the “profit” money available instantaneously for additional trades, (2) in most cases better liquidity than in options, and… Although you and John expect that prices will move “very high”, it isn’t guaranteed. And what could have very well happened is that December Corn didn’t go beyond the 240 price level, before the option’s expiration. At this point 250 Calls would be worth “ZERO”. And if John got out of his long Corn position in future contract, at the same time that your options expired, he would’ve made profit of $ 1,000.

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AS I SAID BEFORE, IT IS VITAL THAT AS A TRADER YOU ARE “FLEXIBLE” IN YOUR TRADING. OR PUTTING THIS RATHER DIFFERENTLY, YOU HAVE TO EVOLVE ALONG WITH EVER CHANGING MARKET CONDITIONS. The next chapter is dedicated to the “flexible way” of thinking about the markets. We’ll be trying to outline a special paradigm of trading, in which you’re probably more concerned with managing your risk exposure, than with profits themselves. Ultimately, the winning part will take care of itself, and having learned how to control your risk well, you probably will have easier task of managing your profits (and your every day life).

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4. NATURAL WAVE TRADING THEORY In previous chapters I tried to outline some ideas on trading commodities, futures and options markets. It was only an outline, focused mainly on simple trading strategies that purposefully illustrate a basic nature of the market movements, and the basic ways in which a trader wants to take advantage of those movements. It was only an outline, but hopefully it was informative enough, so even if you’re a brand new trader you could’ve gained initial knowledge as a stepping-stone on the road to the development of your own style of trading. I didn’t discuss different chart formations or fundamental analysis because there is number of well-written books covering those areas, and there was no point of duplicating something that is already plentiful. The books by John Murphy i.e. “The Technical Analysis of the Futures Markets” or some by Jack Schwager, are the great source of market knowledge and inspiration. You’ll find also plenty of “courses” on trading commodities. In many cases they are well crafted. Some of the courses are better than others, and I believe that you could learn something from every single one of them. The Natural Wave is not a summary of information about the markets that you could find easily in various sources. It is rather an invitation (an initiative) to creative and flexible thinking about the way you could trade. I believe that if you treat trading in futures and options as a business, you have the chance of achieving not only “good profits” but also personal satisfaction. Over the years I’ve realized that one of the major reasons why traders (most of them at least) lose are: • • • •

Poor risk management. Lack of patience. Fear of losing, fear of being wrong. Lack of a trading method.

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Although these are not the only reasons, I believe that they’re most significant. Looking closely at all of them, we realize that they are different aspects of the same thing – the trading experience. We realize that they all are connected, and that one is affecting another. So if you can implement “good” risk management strategies, chances are that the “fear of losing” would dissipate. By the same token you’ll become more “patient”, because your “unique method of trading” (of which risk management is part) would prompt you to wait for the right market conditions, in which the odds of a profitable trade are greater. On the other hand the “good risk management” is the result of applying sound (the one you feel comfortable with) method to your trading, a method which gives you confidence. This confidence is born out of your ability to control your trading “environment”, your ability to control your risk exposure. At this point you have “no fear” (hopefully) of losing. And chances are that the trading decisions you are going to make will be more accurate, for they’re not going to be “soiled” by the negative thinking and emotions. MAKING MONEY IS DEFINITELY THE REASON WHY YOU ARE IN THIS FUTURES “GAME”. This is why it is so important that you believe in yourself; believe that you can (and will) make money in trading. If you don’t have a right frame of mind, don’t even bother; you would be only wasting your time. When you implement trading the “right way” (it doesn’t mean it is the only way) you’ll find yourself facing more free time on your hands than you know what to do with. You will have more space to do things that you only dreamed of. You’ll have more time to focus on the “important things in life”.

So what is this “right way of trading”? I call it the “NATURAL WAVE TRADING THEORY”.

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1 In preceding chapters we’ve discussed the fact that if you just trade futures contracts, theoretically you are facing an unlimited risk. Putting it differently, the amount of money you have at risk is not well defined (even with a “stop loss”). When you just buy options on futures, your risk exposure is limited, with virtually unlimited profit potential. But oftentimes the futures markets don’t move enough in your favor to realize profit on your option. As a consequence, your option expires worthless. (There are different strategies in options, which involve “selling an option” or “granting” it, as an initial transaction. In most of those strategies you benefit when futures markets never come even close to the strike price of your options –time decay works here in your favor. You could learn more about this type of trading from many books on options trading that you can find in your local or on line bookseller.) So naturally the following question comes to mind: “Is it possible to forge futures and options into one trading style that would combine best features of both “worlds”? The answer is: “Yes.” You could use futures and options together in the variety of ways. The Natural Wave TT is exploring some of those ways. The Natural Wave Trading Theory isn’t a “trading system” though. It is rather a “paradigm of thinking”, a paradigm in which “flexibility” plays an important part. We believe that if you develop your own style how to think like a trader –where controlling your risk exposure is one of your primary objectives- you’ll be able to enjoy all those “perks” that come with “success”: • Peace of mind • Independence • Extra time on your hands • “Freedom of space”

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IF YOU DON’T HAVE BASIC UNDERSTANDING OF FUTURES AND OPTIONS, PLEASE, DON’T READ THE SECTION THAT FOLLOWS.

2 Let’s start with charts, which by many are considered to be “the window to the market’s soul”

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DAILY CHART gives you a daily range of price in a particular contract month (December Corn). This daily range is usually represented in form of a vertical “bar”. The length of the bar tells us what was the “high” and “low” on the particular date. One vertical bar represents one day’s price action. So when you have number of those bars together, you have a graph of behavior of this particular contract month over a certain period of time. WEEKLY CHART gives you weekly price range. One vertical bar represents one week’s price action. Top of the bar gives you “high” for the week while bottom of the bar gives you “low” of the week. MONTHLY CHART usually covers a period of ten, twenty or more years. One vertical bar represents one month’s price action. This chart is very important because it “puts” current futures prices in the historical perspective. For example, if you see that December Corn futures is traded at 190, only after looking at the Monthly Chart in Corn you can realize that for the Corn market, “190” is “very low price” , because “usually” Corn trades around 250-300. So when you compare all of those charts, you will realize that “objectively speaking” being at “190”, Corn is traded very low

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historically. So it seems that it is only a matter of time before the Corn prices start rising. Here is the moment when Natural Wave Trading Theory comes in. It will present itself to you through different examples that follow. (Keep in mind that the Natural Wave TT should be mainly used in the markets that trade either very low or very high historically. Natural Wave TT is designed to help you with the “search” of the “bottom” or “top” of the market. So in my opinion it should be incorporated mainly in those market conditions, which would “indicate” that possibly a particular market is trying to make a bottom or top.)

Example 1: You go long 1 December Corn from 205, and instead of the “stop loss” you buy December Corn 200 Put option, for 9 cents or $ 450 (please be advise that the cost of the premium will vary in different market conditions). Your total risk on this trade is: • 205 – 200= 5 cents ($ 250) • + $ 450 (option premium cost + $50 commission) • + $ 50 (Round Turn commission cost on 1 future contract)

Example 2: How would your $ 1000 account look like if you used this method, and if Corn dropped 20 cents or $ 1,000 against your futures position? 1. 205 – 20 = 185 (new price level of December Corn after 20 cents decline), 2. The value of your 200 Put would be at least 15 cents or $ 750.

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3. Even though your option is appreciating, you can’t use this appreciation to offset your futures loss. 4. You could still be on a Margin Call even though your risk is very well defined [remember (?), options are “wasted assets”]. 5. After you’ve purchased your 200 Put option you’ve taken out of your account $ 500 ($ 450 premium + $ 50 commission). 6. So you have BALANCE of $ 500. But because you’ve purchased the futures contract at 205 you have to pay half commission; on futures you pay half commissions when you get in and the second half when you get out of your trade. After paying $25 your BALANCE would be $ 475 (before the futures market dropped 20 cents). 7. How could you trade then, if the initial margin in Corn is about $ 675 and you have only $ 475 balance? Well, most likely the initial margin requirement your account (for this particular trade) would be reduced, because you have a 200 Put option for protection, which makes your futures trade relatively safe. And if an initial margin was imposed, most likely it would be for the amount of $250, which equals the distance between the buy price of the future contract and the strike price of the option. 8. So Corn could drop 9 ½ cents or $475 against you before your account balance becomes ZERO. And before you’re on the Margin Call. 9. So in this case, if Corn price is at 185, chances are that your account will reflect a negative balance of $ 525 (475 – 1,000). It will be the same as Margin Call. You would be required to either deposit to your account $525 immediately, or close your position. 10. If you choose to close your position, you could do it in two ways: a)

You could liquidate your 200 Put, and close your long Corn contract, by selling it. After that your account balance would be about $ 200. + $ 750 (from liquidation of your 200 Put) + $ 475 (your initial account balance before Corn declined 20 cents) = $ 1,225.

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- $ 25 (half commission for sell of 1 contract) Total = $ 1,200 Minus $ 1,000 (205 – 185) Ending Account Balance = $ 200.

b)

You could exercise your 200 Put on Corn. And by doing so, you would be offsetting your long contract with a sell at 200---remember that your 200 Put is your “right” to be short a futures contract from 200, if you choose. So in this case you’ve decided to utilize or exercise this “right”. In this case your Ending Account Balance would be also $ 200. How? $ 475 (initial balance of the account, before 20 cents decline) - $ 250 (205 – 200 (strike price))= = $ 225. $ 225 - $ 25 (half commission on the futures trade, which would happen when you exercise your 200 Put) = $ 200.

11. In both cases (liquidation and exercise) the Ending Account Balance would be identical. 12. “So, what is the advantage of LIQUIDATION vs. EXERCISE?” During very “high volatility” of the futures markets, options premiums could be trading in the “fast mode”. It means that if (for example) the last value of 200 Put was 15 cents or $ 750, when you sell it at the “market”, you might get for it only 12 cents or $600, because somebody else had a bit to buy 200 Put for 12 cents or better (If you think it’s not fair---too bad. That’s how markets work. You can either accept this as the part of “trading reality” within which you have to operate, and be happy, or just simply walk away from trading altogether. But regardless what you’ll do – do not whine.).

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In my opinion the best strategy in this case would be the “exercise”. During “fast trading mode” you want to be in control of your trading as much as you can. And with exercising a 200 Put, you would’ve known “all the numbers” thus controlling “all the pieces”. 13. So why would you even bother with “liquidating” options, as opposed to “exercising” them whenever they are in the money? Because if you still have a lot of time left on your option you may have an extra “time premium” on top of your intrinsic value. In the described above case, instead of your 200 Put being worth 15 cents or $750, it could have been valued at 17 cents or $850, if there was still “plenty” of time until expiration.

Example 3: (Better scenario) Since the market can move both ways, it can also work in your favor, so there is no need to always expect the worst. You are long 1 December Corn from 205, and you have 200 Put as the hedge, for which you spent $500. Then, over the next two weeks Corn goes to 250. And if you were to close/exit your futures contract you would’ve made $2,250. “Wow…” you say. But don’t forget that you have also spent money on your 200 Put. So, your actual net profit would be: $ 2,250 - $ 500 (option cost) - $ 50 (round turn commission on the future contract) = $ 1,700 You’ve made a “cool” $1,700 with very limited risk. And this is only on one contract. Try to imagine how much trading power you have with this type of trading when you can have very limited risk and virtually “unlimited profit potential”.

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Have you had just 10 contracts your profit potential would have been $17,000; on 100 contracts, it would have been $170,000. (You still have 1, 200 Put option left. You bought it---you own it. It isn’t worth much after Corn rallied to 250, maybe ½ cent or $ 25, or maybe not even that. By liquidating it now, you are not going to accomplish much. It is a better choice to just keep it –if you still have one or two months left until its expiration- in case the Corn market declined sharply. In such case what could very well happen is that your option might become worth a few hundred dollars again. Since you’re already out of your futures contract, this appreciation could be an extra (“gift”) profit that you didn’t expect. At this point your original $1,700 profit, which you had already taken, can grow much more, thanks to this “forgotten” option, which was already discarded as the loss.) What would be your account balance now, after you exited your long futures contract at 250, and after assuming that the remaining 200 Put is worth ZERO? $ 1,700 +$ 450 (“cash” that left on your $1000 account after $ 500 cost on 200 Put, and after paying $ 50 Round Turn commission on futures contract) =$ 2,150 (your new account balance) ☺ I believe that when you apply “sound” trading methodology, there is a strong possibility that over an extended period of time you would be able to take “small trading account” and turn it into a “larger one”. ☺ SO FAR I’VE DESCRIBED A SIMPLE TECHNIQUE OF HEDGING ONE FUTURES CONTRACT WITH ONE OPTION.

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HOWEVER, THE TRUE POWER OF THE NATURAL WAVE TRADING THEORY IS IN MODIFICATION OF THIS “ONE-ON-ONE” APPROACH.

Example 4: To give yourself better a chance of succeeding in trading, I’m hoping that you are able to start a commodities trading account with at least $5,000. From here on, I’m not going to break down specific “trade examples” into the details, which include commissions cost, margin requirement and account balance. You are smart enough to figure this on your own.

You’re going long 1 December Corn contract “at the market” (first available price after your order hits the trading pit on the exchange). Your fill price is 205. At the same time you are buying: • 1 200 Put for Dec. Corn. • 1 190 Put • 1 180 Put Also you’re placing following “open orders” (check with your broker if you’re not sure how they work): • to Buy 1 Dec. Corn (future contract) @ 190 or lower, • to Buy 1 Dec. Corn (future contract) @ 180 or lower. If the futures market never comes down to 190 and starts going UP, in order for you to break even, 1 Corn contract, which you bought at 205, would have to go UP enough to cover the cost on 200 Put, 190 and a 180 Put. So, if you spent $ 800 on your options, Corn would have to go to about 221 before you break even on this whole trade, assuming that you let your options expire worthless. By the same token, if Corn declined to 179, or so, you would be a proud owner of 3 December Corn contracts with an average price of “about” 191 ¾.

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What actually happened, if Corn declined, is not only that you got filled on your future contracts opened orders (Buy at 190, Buy at 180), but at the same time your 200 Put, 190 Put and 180 Put appreciated quite significantly. So even though you are loosing on the futures side of this trade, the options “absorb” some of this loss. These options also give you the confidence of knowing what is your total risk exposure. Sure, your account statement would show that you are losing about $ 1,700, when Dec. Corn is trading at around 180. But it would also show that the value of your Put options increased. And although “options” are “wasted assets”, you most likely could liquidate or exercise them, if you need to (and then they are “no longer wasted in their entirety”). Other words if Dec. Corn instead of going UP ended up declining to 155, you probably would be on a “margin call”, because your loss on 3 Corn contracts will be about $5,500, which is more than your initial starting capital of $5,000. At the same time the values of your 3 Puts increased, and their combined market value would be approximately $5,250. So, if you don’t want to add any more money to your account when Corn futures is trading at 155, you simply would exercise your 200 Put option. And with doing so about $2,250 would be released to your accout, and you still will be in the market with 2 remaining futures contracts, 190 Put, and 180 Put… And if you believe that Corn has still plenty of potential on the upside stay with your trade. Otherwise, close your position altogether and get ready for the next one. What could also happen is that Corn never dropps below 179, and bounces back to 205. At this point you would be making about $2,000 on your 3 contracts (your average price is 191 ¾). Have you had only 1 contract you would be about “breaking even” on your futures contract. It is apparent, how important cost average is in your trading. It so, because of the cost averaging, you are insuring the “average” price on all 3 contracts of Corn at approximately 191 ¾. But do not forget that, if you overextend yourself (you get too many contracts) the “cost averaging” can turn disasterous (if you’re not

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hedged with options). You may end up with the greater loss than your account’s initial balance. But let’s get back to the scenario in which Corn never dropps below 179. Let’s assume that Corn (bouncing off 179 level) ended up making the sharp rally and you find yourself at the price of December Corn @ 271 ¾ . Also now you find yourself in a situation that seems also very uncomfortable, almost as much as the “losing situation”. Now you are making roughly $12,000 profit on your 3 Corn contracts. And even, if you subtract the loss on the 200, 190 and 180 Puts (which probably would expire worthless), that still leaves you an approximate profit of about $11,200 (including commissions). You could “panic” here because you could be thinking about a down payment on the house or new BMW, or maybe those vacations that you were putting off year after year. And you might decide to take profit on all three contracts of Corn… Of course there is nothing wrong with taking profit, especially as nice as this one. What would be wrong though is to get out of the market, which could possibly be on the way to reach the price level of 400 or beyond. But of course we don’t know that for sure. The strategy I would propose at this moment would be getting out (selling) of 1 contract, and remaining in the market with 2. This way, since your cost average on 3 contracts was about 191 ¾ you are “putting away” about $4,000 (271 ¾ - 191 ¾ = 80, 80 cents x $ 50 = $ 4,000). And if Corn indeed went up all the way to 401 ¾ , you could be making 210 cents per contract. And since you had 2 contracts left, your profit would amount to 2 x 210 x $ 50 = $21,000. It’s almost hard to believe this, isn’t it? And if scenarios such as just described above don’t happen every day, you as a trader want to be ready to take adventage of them when they do happen. The Natural Wave TT could possibly help you with catching a major “move in the market”. The Natural Wave TT can’t make a decision for you though. You have to do your homework, get comfortable with

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the markets you trade, and then use the “Natural Wave Trading Theory” to possibly increase your chance of success. ☺ Read as many books on trading as you possibly can, without getting confused and having your head spinning. At the same time don’t lose the main objective – you want to “make money” in trading, not just getting an intellectual stimulation… Because the time would come when you would have to make the “decision” about your position in the market. And this is when –from somewhat unemotional perspective- you would have to look on all those “oscillators” and “buy” and “sell” signals that you’ve read so much about. This is where you migth find the Natural WaveTrading Theory to be quite handy. For ultimately you are as much after the “unlimited” profit potential as you are after the “limited” risk. ☺

Example 5: Corn is trading around 210. You buy 1 contract and hedging yourself with 210 Put. Corn is declining to 200. You are adding 1 more contract (going long) and buying 200 Put as the hedge, and so on… You can use this strategy when you want to create “solid hedge”. In this case your Put options are at the money, any time you buy them. They cost you more, but also your hedge seems to be more effective -if the future market didn’t go up soon, didn’t go in the direction of your futures contracts. In this case you could start to liquidate or exercise Puts with higher strike prices, one at a time, if you were running out of money for initial margin, to support your futures side of the trade.

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Example 6: This example relates to the market that is having a mid-range of trading from the multi-years lows and highs. If you’re expecting that the market is going to continue within certain price levels (like in Corn between 260 and 300), you could bracket this market with options in anticipation of trading futures contracts within the bracketed price. Let’s say that December Corn is traded at 282. You’re buying 260 Put, and 300 Call. If futures Corn goes down to (let’s say) 262, you’ll buy 1 December Corn futures contract. And if from there Corn goes up to about 296, you will be getting out of your long Corn –taking profit- and initiating sell of 1 December Corn, which will be your new “short position”. In the described situation you are not using any stop losses, but rather taking advantage of your 260 Put, and 300 Call, which you probably purchased for cheap (originally when Corn was at 282) and using them as protective hedges. You were setting up your “pieces” strategically in anticipation of a certain development in Corn. You were building up your position, as your reaction to the Corn market development. “Your reaction” was a result of seeing the Corn market from the perspective of several years. You had determined that Corn most likely was going to trade within 260-300 range. And when Corn was at 282 the price of 260 Put was cheaper than it would be when Corn was at 262. Or by the same token, 300 Call was cheaper when Corn was at 282, than it would be when Corn prices reached 296 levels. There are no guarantees in trading. But you as a trader have to learn how to prepare yourself for certain market conditions. And by “preparing yourself” you’ll most likely have an edge that would bring you closer to becoming a successful trader. The Example 6 could be developed into more leveraged position through buying more Puts and Calls, and trading with multiple futures contracts. This would even add more flexibility to your approach. However, the downside to this is that your cost on the trade/position would be higher. Yet, with the multiple contracts and options your profit could become much more significant as well.

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5. NEW BEGINNING As you very well know there are different styles of trading in futures and options. Some even believe that there are as many styles as traders. But only a small percentage of traders make money and survive –on somewhat consistent basis- the “commodities game”. So what separates them from the rest? I believe it is their positive state of mind toward trading. They are also confident that they are “able” to “control” their trading environment, where risk and reward are concerned. But what helps them to maintain this high level of confidence is the methodology they use to trade. The “methodology” or the way of thinking described in this manual is one of many ways of looking at the “Universe of Commodities”. And I believe that it could be particularly helpful to those of you who are busy with other aspects of life, and to those of you who don’t want to spend their days and nights in front of the computer screen. The NATURAL WAVE TRADING THEORY (NWTT) should provide you with confidence that “your risk is under control”, and that your “profit potential is virtually unlimited” (given right market conditions). The NWTT is not a trading formula that would guarantee your profits, but rather it is the unique way of controlling the risk exposure in the markets. It gives you also an ability of “chipping away your profits” whenever the markets let you have them. This “chipping away of profits” is especially important in today’s markets because the “volatility” –inspired very often by the technical price action and fundamental news- makes oftentimes today’s markets look very chaotic. It means that some chart formations (like descending or ascending triangles, wedges, flags, 1-2-3 tops and bottoms) -that were quite accurate technical point of reference in the past trading decades- are no longer as predictable and viable. Also it

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seems to be more difficult to find well-defined “developing trend” that the flow of fundamental information would support it. Because of the number of sophisticated participants (very often with “deep pockets”) in the futures markets grew significantly over the past decade, your presence in the markets becomes more challenging. And so you want to find the way, which will help you in keeping a competitive edge and not being “forced out” of the markets more often than you would like it. With help of the NWTT, most likely, you would be able to achieve this goal. You would be able, probably more often than not, to “wait through” the difficult market conditions. Even more, if you have enough cushion on your account, while the market is moving against you, you actually might be able to establish better cost average price, by adding more contracts. In my experience the NATURAL WAVE TRADING THEORY is quite useful in the following markets: corn, oats, wheat, soy meal, bean oil, silver, gold, copper, cotton, sugar, coffee and cocoa. It could be also incorporated in some other markets, like currencies or coffee, although it may not be cost effective in some situations. Some of the options’ premiums can cost as much as $ 1,000 or $ 2,000, or much more. On the other hand if your account size is $ 10,000-$ 20,000, even paying $ 2,000 for an option (which is used as the protective hedge) might be the way to go, especially when it’s not unusual of seeing coffee market moving 1000 points ($ 3,750) in one direction within one hour. The “Natural Wave Trading Theory” manual intends to be just that: a manual. I invited you to look at the TRADING from the vantage point from which you can see the importance of risk management. The whole idea is not to ignore RISK but “embrace it” and make it your friend (something you feel comfortable with). If you build the trading “around the RISK”, there is a strong possibility that your trading will become successful. You want to be a successful trader, don’t you? But you have to ask yourself how you understand “success”. If you are looking at it as the consistent accumulation of cash (without any regard for your personal growth), at the end, you might

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become disillusioned about the whole process of trading -even if you end up “sitting on the pile of cash”. On the other hand, if you’re looking at “success” as a way of improving (not only materially) your own life and the lives of others, than it’s a different story. “Natural Wave Trading Theory” may help you gain more control over your trading destiny. By using options as hedging tool, you could stop being “a market victim” and you wouldn’t need to worry about your “risk exposure” all the time. That should free your mind to be active in other areas of life. And along the way, if you develop your own method, you mind be making more money than you thought was possible, with a minimal effort on your part. But even with the NWTT you’ll have to do your homework, and find your own style of being a trader. With the Natural Wave Trading Theory though, you’ll have the luxury of “controlling” your trading environment to a great extent. Ultimately, the decisions you are going to make about trading should become less emotional and more rational. GOOD LUCK AND GOOD TRADING!!! - Jack Sroka

***Information in this manual is for education purpose only. It isn’t trade recommendation. Past performance is not necessarily indicative of future results. There is risk in trading commodities and futures markets. Please, consult your broker or advisor before placing any real trades***

IF YOU ARE INTERESTED IN ONGOING EDUCATION IN TRADING, PLEASE, CONTACT: Natural Wave Trading 30012 Ivy Glenn Dr #135 Laguna Niguel, CA 92677 [email protected]