Open a newspaper, and thousands of listings leap at you from the pages-stocks, mutual funds, futures, options, bonds, historical treasury bonds, currencies. Your data provider may offer a menu of 20,000 items or more. Were you to download and review all of them, spending just two seconds on each, that process would take 11 hours.

Beginners worry about missing opportunities and try to look at as many markets as possible. They often ask for advice on scanning soft ware. They want to sift through thousands of stocks for something like a bullish divergence in MACD-Histogram. First of all, divergences, so visible to the naked eye, are notoriously hard to program. The best programmer I know tells me he's done it-it is the pinnacle of his success-using the most expensive software. Even if a beginner could get hold of his program, that expense would be wasted because he wouldn't know what to do with the stocks he found in that search. He wouldn't know how to trade them correctly. A beginner is better off focusing on a handful of markets, learning all about them, and trading them with care and attention.

You are better off limiting yourself to as many markets as you can realistically follow each day. Professionals study their markets daily to detect transitions from sleepy trading ranges to new trends. The best time to profit from a trend is before it becomes overpriced and volatile.

Markets that make headlines tend to be overpriced and volatile. If you read an article on the front page of a financial newspaper about a bull market in biotech stocks or see a report on the evening news about the high price of coffee, those trends are probably nearer the end than the beginning, and buying biotech stocks or coffee futures is probably very dangerous.

To understand a person or a group, it pays to know what they want and what they fear. Journalists and editors most fear making a mistake that will make them look foolish. They report trends only after anyone can see them because that way there is no mistake. Even if they knew how to catch trends early, which they don't, they wouldn't dare print their findings for fear of being wrong and appearing ignorant. Traders aren't afraid of mistakes as long as they use money management, but journalists cannot afford such risks. By the time they write up a trend,

it has been going on for a while, volatility is high, risk management is difficult, and a major reversal is probably in the cards. Should you trade stocks or futures, currencies or options? Options are rough for beginners, who should learn to trade the underlying securities first, whether stocks or futures. People outside the United States are often drawn to currencies, forgetting that those are truly global markets, and when you trade them, you go against banks that have traders in all time zones. The choice between stocks or futures is seldom made on a rational basis. Trading stocks seems more respectable, while futures have more of a swashbuckling reputation. Futures get their wild image from their enormous leverage. If you scrupulously observe money management rules, they become much safer and less nerve-racking.

Stocks

Stocks tend to move more slowly than futures, thus reducing risks for beginners, especially those who avoid margin. It is one of the mysteries of markets that cash traders are more likely to win, and margin traders to lose. Why? Interest rates on margin loans are a serious expense, rais ing a barrier to winning, but there's more. People who buy stocks for cash tend to feel more relaxed, buying as much or as little as they want. Margin traders are more likely to feel stressed. An anxious trader is a troubled trader. It is better to buy only what you can afford, polish your skills, and the money will follow.

The sheer number of stocks drives people to distraction. Beginners throw their arms in the air and beg for a list of stocks to follow. A dis ciplined trader makes several choices that help him concentrate. He begins by selecting an industry group or groups and then zeros in on individual stocks.

A beginner should start with one or two groups, an intermediate trader can go up to four or five, and an expert knows how many he can handle. Chances are, he sticks to the few groups he knows well. Begin by choosing a group that you think has a great future or one in which you have a personal interest. For example, you may decide to concentrate on biotechnology because of its promise or the hospitality industry because that's where you work.

Select a broad rather than a narrow group. For example, if you decide to track autos, look not just at car manufacturers, but also at companies that make auto parts, tires, etc. The disadvantage of focusing on a single group is that you miss spectacular moves in others, but there are several advantages. You learn which stocks tend to lead or follow. When leaders start to move, they give you an advance signal to trade the laggards. You can use relative strength, that is, buy the strongest stocks when the group moves up and short the weakest on the way down. You can create an index that includes all the stocks you follow in your industry group, and then analyze that index. This ana lytic tool is not available to any other trader. If you use fundamental analysis, then having your finger on the pulse of a single industry, such as software, puts you miles ahead of competitors who trade Microsoft today and McDonald's tomorrow.

A broadly defined industry group may include over a hundred stocks, but an intelligent beginner should not follow more than a dozen. We can divide all stocks into blue chips and speculative "cats and dogs." Blue chips are the stocks of large, well-established companies, held by many institutions and followed by many researchers. They have a fairly well-established consensus of value around which they more or less gently oscillate. If you design a system for catching their swings several times each year, the potential gains can be very attractive. Don't ignore the big Dow-type stocks. Their orderly swings from the moving average to the channel wall create good trading opportunities.

The so-called cats and dogs may spend months, if not years, flat at the bottom, in a speculative doghouse, until a fundamental change, or even a rumor of change, propels them to a breakout and a new uptrend. Other cats and dogs may go nowhere or expire. Those stocks offer much higher percentage gains than blue chips, but the risks are greater and you must spend a great deal of time waiting for them to move. It makes sense to trade a large portion of your account in blue chips, while keep-ing a smaller portion in longer-term speculative positions.

What if you've paid your dues, learned to trade a few stocks in a few groups, and now want to forage in wider pastures? After all, tech nical patterns and signals are not all that different in various markets. What if you want to scan a larger number of stocks for MACD diver gences, Impulse breakouts, or other patterns that you learned to recognize, trust, and trade?

Go on the Internet and find a website that gives you the 100 most active stocks on the NASDAQ (and if you do not know how to find such a website, you haven't got what it takes to trade them). Keep an eye on any stock that floats by you. A newspaper article mentions several companies-look up their stocks. People at a party talk about

stocks-jot them down, drop them into your system, and see how they look on your screen. Many tips call for an exercise of contrary thinking. In summer 2001, Lucent (LU) was in the news with another earnings disappointment, having slid from 80 to 6. The journalists were aghast, but that stock has completed its bear market, traced an attractive bullish divergence, and was poised for a rally. A rise from 6 to 9 is a 50% increase. Stocks that people tout at parties are often good candidates for shorting. By the time outsiders become interested, the rise tends to be over. The idea is to maintain your curiosity and use tips not on their face value but only as invitations to look at this or that stock. I find that my yield, the percentage of tips that I end up trading in either direction, is about 5%-I end up trading one out of 20. I have a friend, a brilliant trader, who often calls me asking to take a look at this or that stock. My yield on her tips is 10%-she is the best.

The Turnover Ratio The Turnover Ratio (TRO) predicts expected volatility of any stock by comparing its average daily volume with the available float. This formula was brought to my attention by Roger Perry of The RightLine Report

TRO = monthly volume divided by the available float

Volume for the past month is easy to calculate. The available float refers to the total float, or number of shares issued, minus the holdings of institutions and insiders. Those groups tend to hold positions more tightly than private traders, who are more likely to sell if the price is right. All of the above figures are widely available from financial databases.

You can calculate the average monthly volume by multiplying the daily volume by 22, the number of trading days in a month. Using the daily volume makes the TRO more responsive to changes in volume as a stock rolls into or out of favor with traders.

TRO shows how many times the float trades in a month. For example, if a stock's monthly volume is 200 million shares and its available float 100 million, its TRO is 2%. If monthly volume of another stock is also 200 million, but its available float is 50 million, its TRO is 4.

If the average volume is much lower than the float, that stock has a low turnover rate and an onrush of buyers is unlikely to move the price much. However, if the volume is high relative to the float, then a lot of people compete for few available shares, and a sudden rush of buyers can move the price dramatically.

High-TRO stocks tend to be more volatile. Whoever wants to buy them has to pay a premium to pry them out of the hands of relatively few holders. When a selling wave hits the markets, the stocks with high TROs tend to go down harder because they do not have a large pool of institutional holders looking to pick up extra shares at a discount. All other factors being equal, the stock with a higher TRO will make a bigger percentage move.

For example, at the time of this writing, the monthly volume in GE was 355.9 million, with the available float of 9,809 million, resulting in a turnover ratio of 4%. The figures for JNPR were 387.2 million, 155.6 million, and 249%. No wonder; GE is a slow-moving blue chip, whereas JNPR is a high-flyer. Check these numbers once a month, as they keep changing. Stock splits reduce TROs by increasing the float. One split too many in DELL has oversaturated the market maker to the point where the stock has become unattractive for day-traders.

Blue chips, such as General Electric and IBM, are widely held by institutions and individuals. Their daily volume, no matter how high, is but a tiny percentage of their float. New unseasoned stocks often have very small floats, but when they catch the public's eye, their daily volumes go sky-high, lifting the TRO.

You can keep close tabs on the TROs of stocks you track. Whenever the market is active and running, switch into high-TRO stocks. When ever the market goes into a choppy stage, switch to low-TRO stocks and trade their swings. TRO can help you switch between aggressive and defensive positions.

Trading Swings or Trends Whenever you glance at a chart, your eye is immediately drawn to major rallies and declines. Big moves attract us with their promise of a killing. Exactly who gets killed is a question that seldom crosses beginners' minds. The trouble with major rallies and declines is that they are clearly visible in the middle of the chart, but the closer you get to the right edge, the murkier they become.

Big uptrends are punctuated by drops, while downtrends are interrupted by rallies. Emotionally, it is extremely hard to hold a position through a countertrend move. As profits melt away, we begin to wonder whether this is a temporary interruption or a full-blown reversal. There is a strong temptation to grab what little money is left and run. Shorter swings are easier to catch because price targets are closer and stops are tighter.

Should you trade long-term trends or short-term swings? Be sure to decide before you put on a trade; it is easier to be objective when no money is at risk. Different stocks have different personalities, which is why trend traders and swing traders tend to follow different stocks.

Traders have three choices. Trend traders identify major trends which run for months. Swing traders catch short-term swings between optimism and pessimism, which last from a few days to a few weeks. Day-traders enter and exit during the same trading session, with trades lasting only minutes or hours.

Successful trend trades that catch large moves bring in more money per trade. Other advantages include having more time to decide when to enter or exit, not being tied to the screen, and having the emotional satisfaction of calling major moves. Trend trading does, however, have its drawbacks. The stops are farther from the market-when they get hit, you lose more. Also, you have to sit through long periods of inac tivity, which many people find hard to tolerate, and you miss many short-term trading opportunities.

Swing traders have more opportunities than trend traders, gaining more experience from frequent trades. The dollar risk is lower thanks to closer stops, and quick rewards provide emotional satisfaction. Swing trading also has its drawbacks. Expenses for commissions and slippage are higher, due to more frequent trading. You must work every day, actively managing trades. Also, you are likely to miss major moves-you can't catch big fish on a small hook.

Trend trading-buying and holding in a major bull market-works best with the type of stocks that Peter Lynch calls 10-baggers, those that go up by a factor of 10. They are usually newer, cheaper, less sea soned issues. An Internet or a biotech company with a hot new inven tion, a new patent, or a new idea is more likely to go up by a huge percentage than the stock of an old established firm. A small company may bet its future on a single idea or product, and its stock will soar if the public buys that bet or stay in the doghouse if it doesn't. Had a large multinational company come up with the same invention, its stock would have barely budged because one more product makes little difference for a huge firm.

The lure of big trends makes stocks of small companies in promis ing new industries attractive to trend traders. Swing traders should select their candidates from among the most actively traded stocks on major exchanges. Look for large-cap stocks which swing within broad, well-defined channels.

Once you choose a stock, don't assume it will continue to behave the same way forever. Companies change, and you must stay on top of your picks. For example, DELL, started by Michael Dell in his college dorm room, used to be a tiny public company, but grew into one of the largest computer firms in the world. A friend of mine bought $50,000 worth of Dell in the early 1990s and cashed out three years later at $2.3 million, but DELL's days of spiking through the roof and doubling twice a year are gone. Instead, this widely held stock has become a vehicle for swing traders, and not a very active one at that.

A beginning trader is better off learning to catch swings, because profit targets and stops are clearer, feedback comes faster, and money management is easier. The choice between trend trading and swing trading is partly objective and partly subjective. Should you trade trends or swings? My impression, after meeting thousands of traders and investors, is that the elite tend to trade the big moves and ride major trends, but people who can do it successfully are few and far between. There are many more traders who make money-sometimes very serious money-by trading swings. The principles of Triple Screen work for both, even though the entries and especially the exits are different.

T REND T RADING Trend trading means holding your positions for a long time, sometimes for months. It requires holding while your stocks react against the main trend. Bull and bear markets are driven by shifts in the fundamentals, such as new technologies and discoveries in the case of stocks, weather patterns in the case of agricultural markets, political shifts in the case of currencies, and so on. Fundamental factors are behind bull and bear markets, but prices move only in response to actions by traders and investors. When your fundamental information forecasts a major move, you need to analyze the charts to see whether the technicals confirm the fundamentals.

A market doesn't send you an invitation before it takes off. When a trend first climbs out of the cellar, few people pay attention. Amateurs are fast asleep, while professionals monitor their markets and scan for breakouts and divergences. Active markets get into the news because the lows and especially the highs attract journalists. One of the key differences between the pros and the outsiders is that the pros always track their markets, while amateurs wake up and look at charts only after a market hits the news. By that time the train has already left the station. The ABC Rating System, described on page 255, can help you handle the challenge of tracking stocks through inactive periods.

A new breakout is easy to recognize but hard to trade and even harder to hold. As a trend speeds up, more and more people pray for a pullback. The stronger the trend, the less likely it is to accommodate bargain hunters. It takes a lot of patience and confidence to hold a position in a trend. Traders tend to be active men with the attitude of "don't just sit there, do something." Learning to be passive comes hard to them. One reason women tend to trade better is that they are more likely to be patient.

How can you teach yourself to trade trends? You may begin by studying historical charts, but remember, there is no substitute for experience. The idea is to learn by doing. Start by putting on positions so small that you can be relaxed and not tie your mind into a knot. Trade only a few hundred shares or a single futures contract while you're learning.

To apply Triple Screen to trend trading, monitor long-term charts for breakouts or look for well-established moves, identified by a weekly EMA. When the weeklies tell you to be bullish or bearish, return to the dailies and use oscillators to find entry points. Put on long positions in uptrends when prices touch their rising daily EMA and keep adding on pullbacks. You can also add when daily oscillators, such as MACDHistogram or Force Index, give buy signals, especially when they coincide with pullbacks. Reverse the procedure in downtrends. When the weekly trend is down and daily oscillators rally and reach overbought levels, they signal to sell short, especially when they coincide with ral-lies to the EMA.

The idea is to position yourself in the direction of the market tide and use the waves that go against that tide to build up your initial position. As a beginner, learn to trade a single small position, but once you start making money, the size of your positions and the number of addi tions become a function of money management.

Once you recognize a new trend, get in! New trends, springing out of trading ranges, are notoriously fast, with few or no pullbacks. If you think you have identified a new trend, hop aboard. You can reduce your risk by trading a smaller size, but do not wait for a deep pullback. Those may come later, and you will be able to add to your position. Jumping aboard a new trend feels counterintuitive, but being in the market makes you more alert to its behavior. The great George Soros was only half-joking when he said, "Buy first, investigate later."

Place your initial stop at the breakout level, where the new trend erupted from the range. A rocket that takes off from its launching pad has no business sinking back to the ground. Do not hurry to move your initial stop. Wait for a reaction and then a new move before moving your stop to the bottom of that reaction. The SafeZone stops, which work so well for swings, are much too tight for big trends. While riding a tide, you must expect the waves to swing against you and still hold your position.

Trend trading means retaining your initial position through thick and thin. You are fishing for very big fish, and you need plenty of room. One of the reasons so few people make big money from big trends is that they become anxious and hyperactive and forget to hang on. Trends are unlike swings, where you must take profits and run fast. Stay with the trend unless weekly trend-following indicators go flat or reverse.

Amateurs often outsmart themselves by trying to pick the end of a trend-a notoriously hard task. As Peter Lynch aptly put it, trying to catch a bottom is like trying to catch a falling knife-you invariably grab it in the wrong spot. Trends tend to overshoot rational expectations. News, daily chart patterns, and other distractions try to throw you off the saddle. Hang on! Consider trading a core position and supplementary positions. You may put on a core position with a wide stop and no definite profit target, while swinging in and out of additional positions-buying on declines to the EMA or selling on rallies to the upper channel line. Consider using two different accounts for easier record keeping.

SWING TRADING Markets spend most of their time going nowhere. They rally a few days, pause, decline a few days, and rally again. Small swings-weekly, daily, or hourly-are more common than big trends. By the end of the month the market may be higher or lower, but it has traveled up and down several times. Newcomers get shaken out, while professionals enjoy the short rides.

Markets' tendency to swing above and below value has been statistically confirmed by several researchers. Swing trading means buying normalcy and selling mania (buy near the rising moving average, sell near the upper channel line) or shorting normalcy and covering depression (sell short near the falling moving average and cover at the lower channel line). The best swing-trading candidates are among the most active stocks and blue chips that tend to rock, more or less

regularly, within their channels. Cats and dogs are best left for trend trading. To draw a list of candidates, start with the 20 most active stocks and a handful of famous blue chips, and choose the ones with the widest channels and the most regular swings.

Be sure to select only those candidates whose daily channels are wide enough for a C-level trader to take at least a point out of a trade. A C trader is someone who normally takes 10% or more out of a channel. The only way you can prove you are a B or even an A trader is by trading at that level for at least six months. Even A traders are bet-ter off with broad channels because profits are fatter. Beginners have no choice but to use the "1 point for a C trader" rule. This translates into 10-point channels. Technical signals may look delicious, but if a channel is narrower than 10 points, click on to the next stock.

Some stocks give better technical signals than others. Look for a handful of regular performers; you need six or seven, certainly no more than 10. Tracking just a handful of issues allows you to keep up your daily homework without running ragged or falling behind. Learn the personalities of your stocks, rate yourself on every trade, and once you become a steady B trader, increase your trading size.

When the weekly trend is up, wait for daily oscillators to become oversold while prices decline toward the EMA. When the weekly trend is down, look for sell signals from daily oscillators while prices rally toward the EMA. If an oscillator falls to a new multi-month low while prices are moving toward the EMA, it shows that bears are extra strong and it is better to put off buying until the following bottom. The reverse applies to shorting.

In a weekly uptrend, the bottoms of daily charts tend to be very sharp affairs. The best time to buy is when the market stabs below its daily EMA. The best time to short is when the market stabs above it. To place an order near the EMA, estimate its level for tomorrow. The math is simple. You know where the EMA was yesterday and where it closed today. If it has risen, say, by half a point, expect tomorrow's rise also to be half a point and add that to today's EMA.

Take a look at how your stock has behaved since the latest trend began. If the trend is up, look at the previous declines. If the stock has returned to the EMA three times and penetrated it by an average of a point and a half, place a buy order approximately a point below the moving average, a little more shallow than the previous declines. Estimate the EMA for tomorrow and adjust your buy orders daily. Electronic brokers do not become irritated when you change orders each day!

Swing trading, like fishing, demands a great deal of attention and patience. You need to do your homework daily, calculate the estimated EMA for tomorrow, and place orders. You also must calculate your profit targets and stops.

After entering a swing trade, place a protective stop, using the SafeZone method. Swing trading is a high-wire act, requiring a safety net. Stops and money management are essential for your survival and success.

Take profits near the channel line. The exact level depends on the strength of the swing. If MACD-Histogram and Force Index are making new highs, the market is strong, and you can wait for the channel line to be hit. If they act weak, grab your first profit while it's still there. What if a strong swing overshoots the channel line? An experienced trader may shift his tactics and hold a little longer, perhaps until the day when the market fails to reach a new extreme. A beginner must train himself to take profits near the channel wall because he does not have the skills to switch on the fly. Being able to take a limited profit without kicking yourself for missing a big part of a move is a sign of emotional maturity. It is liberating to accept what you asked for and not worry about the rest. Profit targets help you create a structure in an unstructured environment. Measure your performance as the percentage of the channel width. You must grade yourself to know where you stand.

Early in your trading career, it is safer to concentrate on swings. As your level of expertise rises, allocate a portion of your capital to trad ing trends. Major trends offer spectacular profit opportunities-the big money is in big moves. You owe it to yourself to learn to trade them. Concentrate on quality, and money will follow.

Options

The number of shares in any company is fixed, but options are created out of thin air by writers responding to buyers' demand. An option buyer hopes that the price will get to his target fast enough, and the writer sells him that hope. Most hopes never get fulfilled, but people keep hoping and buying options. Fund managers, floor traders, and exchange members sell hope by the truckload to amateurs who buy calls in bull markets and puts in bear markets.

A call gives its holder a right, but not an obligation, to buy a certain quantity of a specified security at a specified price at a specified time.

It is a bet on a price increase. A put is a right, but not an obligation, to sell a certain quantity of a specified security at a specified price at a specified time. It is a bet on a price drop.

Each option has an exercise price (also called strike price). If a stock fails to reach that price before the exercise date, the option expires worthless and the buyer loses what he paid; meanwhile, the writer keeps his loot, the polite name of which is option premium. To profit from buying or shorting stocks, you must pick the right stock and the right direction. An option buyer's job is much harder because in addition to that he must bet on how fast the stock will get to his level.

An option is at-the-money when the current price of the underlying security equals the exercise price.

A call is out-of-the-money when the current price of the underlying security is below the exercise price. A put is out-of-the-money when the current price of the underlying is above the exercise price. The farther out-of-the-money, the cheaper the option.

A call is in-the-money when the current price of the underlying security is above the exercise price. A put is in-the-money when the current price of the underlying is below the exercise price.

An option can be at-the-money, out-of-the-money, or in-the-money at different times in its life, as the price of the underlying security changes. The price of every option has two components: intrinsic value and time value.

An option's intrinsic value is above zero only when it's in-the-money. If the exercise price of a call is $80, and the underlying security rises to $83, the intrinsic value is $3. If the security is at or below $80, the intrinsic value of that call is zero.

The other component of each option's price is time value. If the stock trades at $74 and people pay $2 for an $80 call, the entire $2 represents time value. If the stock rises to $83, and the price of the call jumps to $4, $3 of that is intrinsic value ($83 - $80), while $1 is time value (the hope that this stock will rise even higher during the life of that option).

Option price depends on several factors:

The farther out-of-the-money, the cheaper the option-the underlying security must travel a longer distance to make it worth anything before it expires.

The closer the expiration day, the cheaper the option-it has less time to fulfill the hope. The speed with which an option loses value is called time decay, which becomes steeper as the expiration nears. The less volatile the underlying security, the cheaper the option, because the chance of that security making a large move is lower. Other factors influencing the price of an option include the current level of interest rates and the dividend rate of the underlying stock.

When a stock trades at 100, a 110 call is worth more that a 120 call because that stock is more likely to rise to 110 than to 120. A stock is more likely to rise to 110 in five months than in two, making a longer call more valuable. Finally, if two stocks are selling for 100, but one has moved 50 so far this year while the other has moved only 30, then a 110 call for the more volatile stock is likely to be priced higher.

Different factors of option pricing may clash and partially cancel each other out. For example, if a market drops sharply, reducing the value of calls, the increase in volatility will lift option values, and the calls may lose less value than expected. There are several mathemati-cal models, such as Black-Scholes, widely described in options literature, to determine what is called a fair value of an option.

The simplest option strategy is to buy them. That's what beginners do, especially buying calls when they cannot afford to buy stocks. They miss the fact that options are more complex than stocks and someone who can't make money in stocks is doomed in options. A more sophisticated strategy involves writing, or selling, options. A writer may be either covered or naked.

Covered writers own the underlying securities. For example, a fund may hold IBM stock and sell calls against them, figuring that if the stock does not reach its exercise price and the options expire worthless, they'll pocket the extra income. If IBM rises to the exercise price and their option is called, they'll sell their stock at a profit, use the money to buy another, and sell calls against it. Covered writing was very profitable in the early years of exchange-traded options. By now the field is very crowded, and the returns have shrunk. Naked writing, to be reviewed later involves selling options without owning the underlying securities, with writers backing up what they sell only with cash in their accounts.

The above was a brief summary of option terms. To learn more, please turn to the literature on options, listed at the end of this chapter. Just watch out for the books that promise a "simple strategy for tripling your money in a year, working 15 minutes a day, with no math." People who make money in options tend to be mathematically savvy and highly capitalized, the exact opposite of an average wide-eyed gambler who hopes to make a quick buck from his $5,000 stake. Let us now review options strategies for buying and writing.

Buying Options - The Major Reversal Tactic It is harder to make money buying options than stocks. You face all the usual problems, such as choosing the right stock, identifying its trend, and selecting entry and exit points. In addition, you must worry how fast your stock will get where you expect it to go. If you buy a rising stock and it takes five months instead of three to reach its target, you still have a winning trade. Do the same with options, and they'll expire worthless. If you decide to buy more time by getting longer-term options, you'll lose money in a different way, because those options are more expensive and move more slowly. All options keep losing time value. Poor beginners who buy them as a substitute for stocks rush in where the pros fear to tread!

Professionals tend to buy options only on special occasions, when they expect a major reversal, especially to the downside. If you expect not a little downtrend in a stock but a massive crash, buying a put may be a good idea. When a long-term trend begins to turn, especially near the top, it creates massive turbulence, like an ocean liner changing its course. A stock may collapse today and soar tomorrow, only to collapse again. When volatility goes through the roof, even well-heeled traders have trouble placing stops. A stop belongs outside the zone of market noise, but where do you put it when the noise level rises to a roar? Options allow you to sidestep this problem, at a price which can only be covered by a major move.

Prices tend to fall twice as fast as they rise. Greed, the dominant emo-tion of uptrends, is a happy and lasting feeling. Fear, the dominant emotion of downtrends, is sharper and more violent. Professionals are more likely to buy puts because of shorter exposure to time decay. When you expect a major downside reversal, buying a put can be a sensible trade. The same principles apply to calls, but uptrends are better traded with stocks.

A trader who expects a downswing must decide which put to buy. The best choice is counterintuitive and different from what most people get. Estimate how low you expect a stock to collapse. A put is worth buying only if you expect a waterfall decline.

Avoid puts with more than two months of life. Buying puts makes sense only when you expect a sharp decline. If you anticipate a drawnout downtrend, it is better to sell short the underlying security.

Look for cheap puts whose price reflects no hope. Move your finger down the column of put strikes. The lower you go, the cheaper the puts. At first, each time you drop to the next strike price, a put is 25% or even 35% cheaper than the previous level. Eventually you come to the strike level at which you would only save a tiny fraction of price. This shows that all hope has been squeezed out of that put, and it is priced like a cheap lottery ticket. That is the one you want!

Buying a very cheap, far-out-of-the-money put is counterintuitive. It is so far-out-of-the-money and has so little life left in it that it seems likely to expire worthless. You can't place a stop on it, so if you're wrong, the entire premium will go up in smoke. Why not buy a put closer to the money?

The only time to buy a put is when you're shooting for an exceptional gain from a major reversal. In an ordinary downtrend it's better to short stocks. Cheap far-out-of-the-money puts provide the most bang for the buck. Aim for a 10-fold gain or better, rather than the usual 2:1 or 3:1 ratio. Returns like these allow you to be wrong on a string of trades, yet come out ahead in the end. Catching one major reversal will make up for a string of losses and leave you very profitable.

The best options trade I ever made was during the October 1989 minicrash in the stock market. On Thursday the market closed weak, with new lows exceeding the new highs for the first time in over a year, which gave me a long-awaited sell signal. On Friday morning, while at a trade show in Chicago, I bought OEX puts at 3 / 8 . On Friday afternoon the bottom fell out of the market. On Monday the market opened sharply lower and my puts, purchased just a few trading hours ago at less than half a point, were bid at 17.

Why don't more people use this tactic? First, it requires a great deal of patience, as opportunities are very infrequent. It offers very little entertainment value. Most people cannot stomach the idea of being wrong three, four, or five times in a row, even if they are likely to make money in the end. This is why so few traders play one of the greatest games in the options market.

Writing Options Beginners, gamblers, and undercapitalized traders make up the majority of option buyers. Just think of all the money lost by those hapless folks in their eagerness to get rich quick. Have you sent a few dollars down the options hole? Who got all that money? Brokers, of course, but mostly options writers. Well-capitalized professionals tend to write options rather than buy them. Covered writers sell options against securities they own. Naked writers sell options without owning the underlying securities.

A stock or a future can do one of three things: rise, fall, or stay flat. When you buy a call, you can profit only if the market rises, but lose if it goes down or stays flat, and sometimes even if it rises but not fast enough. When you buy a put, you win only if the market falls fast enough. An options buyer makes money only if the market goes his way, but loses if it goes against him or stays flat. A buyer has one chance to win out of three, but the odds are two out of three for an option writer. No wonder the pros prefer writing options.

Large funds tend to use computerized models to buy stocks and write covered calls against them. If a stock stays below the strike price, they pocket the premium and write a new call with a new expiration date. If a stock rises high enough to be called, they deliver it, collect the money, invest in another stock, and write calls against it. Covered writing is a mathematically demanding, capital-intensive business. Most serious players spread their costs, including staff and equipment, across a large capital base. A small trader doesn't have much of an edge in this expensive enterprise.

Naked writers sell options without owning the underlying securities, similar to shorting. A naked writer collects his premium at the outset of the trade but his risk is unlimited if the position goes against him and he fails to get out. If you own a stock, sell a call, and that stock gets called, you have something to deliver. If you sell a naked call and the stock rises to its exercise price, the option buyer can demand delivery, whether you own that stock or not. Imagine selling calls on a stock that becomes a takeover play and opens $50 higher the next morning-you still have to deliver. It can hurt.

Limited reward with unlimited risk scares most traders away from naked writing, but the reality and perception are usually quite different in the markets. Writing naked options seems very dangerous, but most of the time a far-out-of-the-money option with a short time to the expiration is very likely to expire worthless, to the benefit of the writer. Its chance of reaching the exercise price and causing a loss to a writer is very low. The risk/reward ratio in naked writing is a lot better than it looks, and there are techniques for reducing the impact of a rare adverse move.

Savvy naked writers tend to sell out-of-the-money calls and puts at levels that a stock or a commodity is unlikely to reach during the option's life. They sell distant hopes. Good writers track market volatility to find how far a stock is likely to move, based on its recent conduct, and sell options outside that range. If a stock took a year to rise from 60 to 130, the pros are going to fall all over themselves trying to serve some greenhorn who wants to buy 170 calls that will expire in a few weeks. The chance of that stock rising 40 points before the option expiration is exceedingly low. A gullible amateur wants to buy hope, and the pros are delighted to sell it to him. This game goes into high gear during the week or two prior to option expiration, when the floor mints money out of thin air, selling naked puts and calls that have almost no chance of reaching their exercise price.

Cautious writers may close their positions without waiting for the expiration date. If you write a call at 90 cents and it goes down to 10, it may make sense to buy it back and unwind your position. You've already earned the bulk of profit, so why expose yourself to continued risk? It is cheaper to pay another commission, book your profits, and look for another writing opportunity.

Becoming a naked writer requires absolute iron discipline. The size of your writes and the number of positions must be strictly determined by money management rules. If you sell a naked call and the stock rallies above its exercise price, it exposes you to the risk of ruin. You must decide in advance at what level you will cut and run, taking a relatively small loss. A naked seller cannot afford to sit when a stock moves against him. Amateurs hang on and wait for the underlying security to turn around. They wait for the wasting time value to get them off the hook. The longer you wait for a miracle, the deeper the steel hook of the market lodges in your intestines. Stay away from naked writing if you have the slightest problem with discipline!

WRITER'S CHOICE All options buyers know this sad sequence: you're right on the direction of the market, right on the stock, but still lose money on the option. Time is the enemy of options buyers. Buyers lose when the underlying security takes longer than expected to get to the level at which they can collect on their bet. As the expiration date nears, an option becomes worth less, and less, and less.

What if we reverse this process and write rather than buy options? Now time will work in our favor because each passing day will reduce the likelihood of that option having any value before it expires.

The first time you write an option, and do it right, you'll experience the delicious sensation of time working in your favor. The option loses some of its time value each day, making the premium you've collected safer and safer. When the market goes nowhere, you still make money, as time value evaporates with each passing day.

If living well is the best revenge, then taking a factor that kills most options buyers-time-and making it work for you is a gratifying experience.

We must not forget that an option is a hope, and it is better to sell empty hopes which are unlikely to be fulfilled. Take three steps before writing a call or a put. First, analyze the underlying security, decide which way it's moving, and estimate its price target. Second, decide whether to write a put or a call. Third, choose the strike price and the expiration date for the option you'll write. If any one of these steps seems unclear, stand aside, do not force a decision, and look for another opportunity.

One of the key factors in pricing options is the volatility of the underlying security. A tool included in most trading software, called Bollinger bands, can help you rate volatility. Those standard deviation bands are centered around a moving average but unlike envelopes, whose walls are parallel, they expand and contract as volatility changes. Bollinger bands become narrow when markets are sleepy and wide when they grow wild. Flat, narrow bands indicate a sleepy market where options are cheap and it is better to buy them rather than sell. When Bollinger bands go to a wide spread, they mark an overheated market where options tend to be overpriced, creating an opportunity for writers. Here are the steps to follow:

Analyze a security against which you want to write options. Use Triple Screen to decide whether a stock, future, or an index is trending or nontrending. Use weekly and daily charts, trend-following indicators, and oscillators to identify trends, detect reversals, and set up price targets.

Select the type of option to write. If your analysis is bearish, consider writing calls. If bullish, consider writing puts. When the trend is up, sell the hope that it will turn down, and when it's down, sell the hope it'll turn up. Do not write options when markets are flat and Bollinger bands are tight because premiums are low, and a breakout from a trad ing range can hurt you.

Estimate how far, with a generous safety margin, the market would have to move in order to change its trend, and write an option beyond

that zone. Write an option with a strike price the market is unlikely to reach before the expiration. Suppose a stock is at 80, having risen from 50 in the past year and is now rising half a point per week, with 8 weeks left to option expiration. The trend is up, and selling a 70 put under those circumstances means selling an option that is likely to expire worthless.

The temptation to sell naked options close to the money and get fatter premiums is dangerous, because a slight countertrend move can push your position underwater. Look at the number of weeks remaining to the expiration, calculate the distance the market is likely to travel based on its recent behavior, and write an option outside that range.

Write options with no more than two months to the expiration. The shorter the time, the fewer surprises. The erosion of time value accel erates in the last few weeks of option life. When you write options close to the expiration, you benefit from faster time decay. You can get more money for options with longer life, but do not get greedy. The goal of a writer is not to make a killing on any single trade but to grind out a steady income.

LIMITING R ISK A trader can keep writing naked calls or puts, but do it long enough, and some day he will get caught on the wrong side of a powerful move. Profits of several years can be wiped out in a single day.

For example, whenever there is a great bull market, the pros look at selling puts like a license to print money. The contrarians, the alarmists, and "the end is nigh" crowd keep buying puts for years and losing money, but suddenly there is a crash and buyers have their day in the sun. The pros who have been feeding off them for years face their day of reckoning-the quick ones survive, while the slow ones are carried out feet first.

A trader can grow fat and greedy writing naked options, selling useless contracts created out of thin air and pocketing profits. A smug feeling of self-satisfaction blinds people to reality. Naked positions in options need to be protected by stops and money management rules.

Use a mental stop-loss on the underlying security. Set a stop on the underlying stock, future, or index and not on the price of your option. Buy back that option if the underlying security reaches your stop level. For example, if you sell a naked 80 call on a stock trading at 70, place your stop at 77. Get out of your naked option position before it gets into the money by crossing its exercise price.

Your stop is like an ejection seat on an aircraft. If you write an out of-the-money option and the market starts moving into the money, there is no point in sticking around, waiting to see what happens next. You are wrong, and you're losing-push the eject button before the damage turns deadly. If you sold an option for 1.50, by the time it hits your at-the-money stop level it may double in price to 3. If you use stops, you'll be nowhere near the "unlimited loss" that makes people afraid to write options.

Set your profit-taking zone-consider buying back your naked option. When you write a call or a put, you sell a wasting asset. When the underlying security moves far from the exercise price but there is still time left to the expiration, the price of that option may reach its rock bottom. It loses value only in tiny dribs and drabs. The loser who bought that option still has a bit of a chance that the market may reverse in his favor. He continues to hold that call or put like a lottery ticket, and once in a rare while his ticket may win.

Why hold an open position in an option that has already given you most of its value? You have little to gain, while remaining exposed to the risk of an adverse move. Consider buying back that option to close out your profitable trade.

Open an insurance account. A naked seller needs insurance against a catastrophic reversal. You may write a put and the market crashes the next day, or you write a call and suddenly there is a takeover. You hope this never happens, but trade long enough and eventually every thing will happen! That's why you need insurance. Nobody will write it for you, so you'll have to self-insure.

Open a money market account, and every time you close out a naked writing position, throw a percentage of your profit, 10 percent or more, into that account. Do not use it for trading. Have it sit there, in a money market fund, for as long as you write options. Your insurance account grows with each new profit, ready to cover a catastrophic loss or to be taken out in cash when you stop writing options!

Option writers get hurt in one of three ways. Beginners overtrade and write too many options, breaking money management rules. Intermediatelevel traders get hurt when they fail to run fast enough when their options move against them. Experienced traders can get blown out if they do not have a reserve against a major adverse move. The longer you trade, the greater your risk of a catastrophic event. Having an insur-ance account confirms your position as a professional option writer.

WHERE DO I GO FROM HERE ? Every options trader should own Lawrence McMillan's Options as a Strategic Investment and use it as a handbook. Most professional traders read Sheldon Natenberg's Option Volatility and Pricing Strategies. Harvey Friedentag's Options: Investing without Fear has a nice angle on covered writing.

Futures

Futures used to have such a bad reputation that several states tried to outlaw them a century ago. They used to have Sunday sermons against futures in parts of the agricultural belt. None of that prevented futures from evolving into a potent economic force.

Futures markets have prospered because they serve two groups that have a great deal of money. On the one hand, futures permit major commercial producers and consumers to hedge price risks, giving them a fantastic competitive advantage. On the other hand, futures offer speculators a gambling palace with more choices than all the casinos in Nevada. Between the hedgers and the speculators, on a ground richly soaked with blood and money, are professional futures traders. They help move the wheels of commerce and take a fee for their services. A sign of their profitability is the fact that many of those public servants pass their craft to their sons and now occasionally even to their daughters.

Hedging means opening a futures position that is the opposite of one's position in the actual commodity. It removes the price risk from holding a cash commodity or planning to buy such a commodity in the future. Hedgers transfer price risks to commodity speculators. This allows them to concentrate on their core businesses, offer better con sumer pricing, and obtain a long-term competitive advantage over their unhedged competitors.

For example, I have two friends, brokers in Moscow, who teach sugar importers how to hedge (Russia has become the world's biggest importer of sugar since the breakup of the Soviet Union). Their clients are big players in the food industry, who know up to a year in advance how much sugar they're going to need. Now they can buy sugar futures in London or New York when prices are low enough. They are going to need their trainloads of sugar many months from now, but mean-while they hold sugar futures, which they plan to sell when they buy their cash position. In effect, they are short cash, long futures. If sugar prices go up and they have to pay more than expected, they will offset

that loss by making roughly the same profit on their futures positions. Their unhedged competitors are in effect flipping a coin. If sugar prices fall, they'll buy on the cheap and reap a windfall, but if they rise, they'll be hung out to dry. The importers who are hedged can concentrate on running their core business instead of watching the price ticker.

Producers of commodities also benefit from hedging. An agribusiness can presell its wheat, coffee, or cotton when prices are high enough to guarantee profits. They sell short as many futures contracts as it takes to cover their prospective crop. From that point on, they have no price risk. If prices go down, they'll make up their losses on cash commodities by profits on futures. If prices go up, they'll lose money on their short positions in futures but make it back selling the actual commodities. Producers give up a chance of a windfall but insulate themselves from the risk of lower prices. Survivors thrive on stability. That why the Exxons, the Coca-Colas, and the Nabiscos are among the major players in the commodity markets. Hedgers are the ultimate insiders, and a good hedging department not only buys price insurance, but serves as a profit center.

Speculators step in to assume market risks, lured by the glitter of profits. Hedgers, with their inside information, are not fully confident about future prices, while crowds of cheerful outsiders plunk down money to bet on price direction. It reminds me how, years ago, I walked into a liquor store with a scientist friend to buy some wine for dinner. This was soon after the state of New Jersey introduced a lot-tery to pay for education. There was a huge line at the counter, as lottery tickets in those days were sold only in liquor stores. When my friend, who owned a house in New Jersey, saw what was happening, he doubled up laughing, "You mean these people are lining up to keep my taxes down?!" That's pretty much what most speculators do in futures.

The two largest groups of speculators are farmers and engineers. Farmers produce commodities, while engineers love to apply scientific methods to the market game. Many small farmers enter futures markets as hedgers but catch the bug and start speculating. There's nothing wrong with that, as long as they know what they are doing. It never ceases to amaze me how many farmers end up trading stock index futures. As long as they trade corn, cattle, or soybeans, their feel for the fundamentals gives them an edge over city slickers. But what's their edge in the S&P 500? Faster reflexes than the rest of us? Gimme a break!

There is one profound difference between futures and stocks, mak ing the futures game extremely fast, furious, exciting, and deadly. The futures markets are turbocharged by a simple but potent device of low margin requirements.

United States securities law demands that in the stock market you pay at least half the cash value of your position. Your broker can give you a margin loan for the other half. If you have $30,000 in your account, you may buy $60,000 worth of stocks, and no more. The law was passed after the Crash of 1929 when people realized that low margins led to excessive speculation, which contributed to the viciousness of declines. Prior to 1929, speculators could buy stocks on a 10% margin, which worked great in bull markets but wiped them out in bear markets.

Margins of only three to five percent are common in the futures markets. Here you can bet big with little money. If you have $30,000, you can control $1,000,000 worth of merchandise, be it pork bellies or gold. If you catch a 1% move in your market, you'll make $10,000, or over 30% profit on your account. A few trades like that, and you've made it. A small trader looks at these numbers and thinks he's found the secret to getting rich quick. There is only one problem. Before that market rises 1% it may dip 2%. It may be a meaningless blip, but at the bottom the amateur's equity will be nearly wiped out, and his broker will sell him out on a margin call. He'll go bust even though his price fore-cast was correct.

The mortality rate among futures traders is over 90 percent, even though brokerage houses try to hide statistics. Easy margins attract gamblers and adrenaline addicts who quickly go up in smoke. There is nothing wrong with trading futures that money management won't cure. Futures are very tradable, as long as you observe money management rules and do not go crazy with an easy margin. You have to be more than disciplined-to trade commodities you must be colder than a freezer. If you cannot follow money management rules, better go to Las Vegas. The entertainment value is just as high and the outcome is the same, but the drinks are free and the floor show more glitzy.

Precisely because they require a high degree of discipline and excel lent money management skills, futures markets are hard for beginners. A new trader is better off learning to trade slower-moving stocks, but later on, futures definitely deserve a look.

If you know how to trade and want to make a quick fortune, futures are the place to be. You may put on small initial positions, fenced in

by strict money management rules, but then you can pyramid them to the hilt as a trade moves in your favor and you keep moving stops beyond breakeven and adding new contracts.

There are only a few dozen futures, making the choice of which to trade much easier than among the thousands of stocks. Be sure to focus on markets in your own time zone. It is shocking how many beginners, especially outside the United States, want to trade currencies. Few of them stop to think that this is a 24-hour market, operating around the clock, in which an individual trader has many disadvantages. You may brilliantly analyze a currency and forecast a move, but that move is just as likely to take place in another time zone while you are sleeping. Try to select markets that trade in your time zone that are open when you are awake and closed when you're asleep.

It is a good idea to make your first steps in those markets where you know something about the fundamentals. If you are a cattle rancher, a house builder, or a loan officer, then cattle, lumber, or interest rate futures are logical starting points, if you can afford to trade them. If you have no particular interests, your choice is limited only by your account size. It is important to make your first steps in relatively inexpensive markets. All markets have a certain amount of random noise, or quick countertrend moves. The high dollar value of random moves in expensive markets can be deadly.

Take yourself through a simple exercise. Create a spreadsheet on your computer and write down the names of several futures markets that interest you in column A. Write the value of their price units in col umn B. Corn trades in cents, and the value of a cent is $50; S&P trades in points, and the value of a point is $250, so those values go into column B. Write the latest closing price in column C. Now complete the exercise by creating column D which multiplies B by C and shows how much each contract is worth. How much more expensive is the richest contract compared to the cheapest contract? Five times? Ten? Twenty? Thirty? Do the exercise and find out.

Beginners are drawn to the S&P 500 futures, but few have accounts large enough for proper money management in this expensive market. In North America, corn, sugar, and, in a slow year, copper are good markets for beginners, allowing you to learn in your own time zone. They are liquid, reasonably volatile, and not too expensive.

Some very good books, listed on page 213, have been written about futures. Most technical analysis tools were originally developed for

futures and only later migrated to the stock market. Let us review a few aspects of futures that make them different from stocks.

CONTANGO AND INVERSION All futures markets offer contracts for several delivery months at the same time. For example, you can buy or sell wheat for delivery in September or December of this year, March of next year, and so on. Normally, the nearby months are less expensive than the faraway months, and that relationship is called a contango market.

Higher prices for longer-term contracts reflect the so-called cost of carry, that is, the cost of financing, storing, and insuring a commodity. A futures buyer plunks down his 3% margin and controls a contract without having to bring the rest of the money until the settlement date. Meanwhile the seller has to store, finance, and insure the merchandise.

The differences between delivery months are called premiums. Hedgers and floor traders closely watch premiums because they reflect the degree of tightness in the market. When the supply shrinks or the demand rises, people start paying up for the nearby months. The pre mium for the faraway months begins to shrink. As the demand grows, the front months become pricier than faraway months-the market becomes inverted! This is one of the strongest fundamental signs of a bull market. There is a real shortage out there, and people are paying extra to get their stuff sooner rather than later.

Whenever you look at the commodity page of a financial newspa per, move your finger down the column of closing prices and look for inversions. They signal bull markets, and that's when you want to use technical analysis to look for buying opportunities.

Serious hedgers do not wait for inversions. They monitor premiums and get their signals from their narrowing or widening. A good speculator can rattle off the latest prices, but a good hedger will quote you the latest premiums of faraway contracts over the nearby ones.

As you scan futures markets for inversions, keep in mind that there is one area in which inversion is the norm. Interest rate futures are always inverted because those who hold cash positions keep collect ing interest instead of paying finance and storage charges.

SPREADS Hedgers tend to dominate the short side of the markets and most speculators are perpetual bulls, but floor traders love to trade spreads. Spreading means buying one delivery month and selling another in the same market, or going long one market and short a related one.

Futures are the basic building blocks of the economy, essential for society's daily functioning. Economic necessities tightly link commodity markets and delivery months. If the price of corn, a major animal feed, starts to rise faster than the price of wheat, at some point ranchers will start using wheat rather than corn. They'll reduce their purchases of corn while buying more wheat, pushing their spread back towards the norm. A savvy commodity trader knows his normal spreads by heart. Spread traders bet against deviations and for a return to normalcy. In this situation, a spreader will short corn and buy wheat, instead of taking a directional trade in either market.

Spread trades are much safer than directional trades, with even lower margin requirements. Amateurs do not understand spreads and have little interest in these reliable but slow-moving trades. There are several books on spreads but not a single good one at the time of this writing, a sign of how well professionals have sewn up this area of knowledge and kept the amateurs out. There is a handful of niches in the markets where professionals are making fortunes without the ben efit of a single good how-to book. It looks almost as if the insiders have posted a sign for the outsiders to keep out.

COMMITMENTS OF TRADERS The Commodity Futures Trading Commission collects reports from brokers on the positions of traders and releases their summaries to the public. Those COT (commitments of traders) reports are among the best sources of information on what the smart money is doing in the futures markets. COT reports reveal positions of three groups: hedgers, big traders, and small traders. How do they know who is who? Hedgers identify themselves to brokers because that entitles them to several advantages, such as lower margin rates. Big traders are identified by holding the number of contracts above "reporting requirements," set by the government. Whoever is not a hedger or a big trader is a small trader.

In the old days, big traders used to be the smart money. Today, the markets are bigger, the reporting requirements much higher, and big traders are likely to be commodity funds, most of them not much smarter than the run-of-the-mill trader. Hedgers are today's smart money but understanding their positions isn't as easy as it seems.

For example, a COT report may show that in a certain market, hedgers hold 70% of shorts. A beginner who thinks this is bearish may be completely off the mark without knowing that normally hedgers hold 90% of shorts in that market, making the 70% stance wildly bull ish. Savvy COT analysts compare current positions to historical norms and look for situations where hedgers, or the smart money, and small traders, many of whom are gamblers and losers, are dead set against each other. If one group is heavily short while the other is just as heav ily long, which one would you like to join? If you find that in a certain market the smart money is overwhelmingly on one side, while the small specs are mobbing the other, it is time to use technical analysis to look for entries on the side of hedgers.

SUPPLY AND DEMAND MARKETS In futures, there are two types of bull and bear markets: supply-driven and demand-driven. Supply-driven markets tend to be fast and furious, whereas demand-driven markets tend to be quiet and slow. Why? Think of any commodity, say coffee, which grows in Africa and South America.

Changes in demand come slowly, thanks to the conservatism of human nature. The demand for coffee can go up only if drinking becomes more popular, with a second espresso machine in every little bar. The demand can fall only if coffee drinking becomes less popular, which may happen in a deteriorating economy or in response to a health fad. Demand-driven markets move at a leisurely pace.

Now imagine that a major coffee growing area is hit by a hurricane or a freeze. Suddenly the world supply of coffee is rumored to be reduced by 10% and prices shoot through the roof, cutting off marginal consumers and rising to the point where supply and demand are in balance. Supply-driven markets are very volatile. Imagine torrential rains in the cocoa-producing areas of Africa, or a new OPEC policy sharply curtailing oil supply, or a general strike in a leading copper mining country. When the supply of a commodity is reduced and rumors of further damage swirl, the trend shoots up, reallocating tight supplies to those best able to afford them.

Every futures trader must be aware of key supply factors in his mar ket and keep an eye on them, such as the weather during the critical growing and harvesting months in agricultural commodities. Trend traders in the futures markets tend to look for supply-driven markets, while swing traders do better in demand-driven markets.

The United States grain markets often have price spikes during the spring and summer planting and growing seasons as dry spells, floods, and pests threaten supplies. Traders say that a farmer loses his crop three

times before harvesting it. Once the harvest is in and the supply is known, demand drives the markets. Demand-driven markets have narrower channels, making profit targets smaller. Channels have to be redrawn and trading tactics adjusted as seasons change. A lazy trader wonders why his tools stopped working. A smart trader gets out a new set of tools for the season and puts old ones in storage until the next year.

FLOOR AND CEILING The fundamental analysis of futures is more straightforward than that of stocks. Most analysts monitor supplies since demand changes very slowly. What is the planted acreage? What are the warehouse stocks? What is the weather forecast for the growing areas? Fundamentals put a floor underneath most, though not all, commodities. They also have a natural ceiling above which they almost never rise.

The floor depends on the cost of production. When the market price of a commodity, be it gold or sugar, falls below that level, miners stop digging and farmers stop planting. Some third-world governments, desperate for dollars and trying to avoid social unrest, may subsidize production, paying locals in worthless currency and dumping the product on the world market. Still, if enough producers go broke and quit, the supply will shrink and prices will rise to draw in new suppliers. If you take 20-year charts of most commodities, you'll see that the same price areas have served as a floor year after year. Curiously enough, those levels have held without being adjusted for inflation.

The ceiling depends on the cost of substitution. If the price of a com modity rises, major industrial consumers will start switching away from it. If soybean meal, a major animal feed, becomes too expensive, the demand will switch to fishmeal; if sugar becomes too costly, the demand will switch to other sweeteners.

Why don't more people trade against those levels? Why don't they buy near the floor and short near the ceiling, profiting from what is similar to shooting fish in a barrel? First of all, the floor and the ceiling are not set in stone, and markets may briefly violate them. Even more importantly, human psychology works against those trades. Most spec ulators find it impossible to sell short a market that is boiling near the high or go long a market after it has crashed.

SEASONALS Most commodities fluctuate through the seasons. For example, grains tend to be cheapest soon after the harvest, when the supply is plentiful and the demand pretty well known. The spring

planting season, when the coming weather is uncertain, is the most likely time for price spikes. Freezing spells in the northern parts of the United States are bullish for heating oil futures. Orange juice futures used to have wild runups during the frosts in Florida, but have become much more sedate with the growth of orange production in Brazil in the Southern Hemisphere.

For some, seasonal trading degenerates into calendar trading. Spinning past data to find that a certain market should be bought during the first week of March and sold on the last week of August is a misuse of technology. It is easy to find what worked in the past, but any pattern that has no justification in the fundamentals or mass psychology probably is due to market noise. Seasonal trades take advantage of annual swings, but you have to be careful. They shift from year to year, and seasonal trades must be put through the filter of tech-nical analysis.

OPEN INTEREST All exchanges report trading volumes, but futures exchanges also report open interest, that is, the number of contracts outstanding on any given day, reported a day later. In the stock market the number of outstanding shares doesn't change, unless a company issues more or repurchases existing ones. In the futures markets, a new contract is created whenever a new buyer and a new seller come together. If both of them get out of their positions, a contract disappears. Open interest goes up and down each day, and its changes provide important clues to the commitments of bulls and bears.

Every futures contract has a buyer and a seller, a winner and a loser. Rising open interest shows more winners are coming into that market. Just as important, it shows more losers are coming in, because without their money there would be nothing for winners to win. An uptrend in open interest reflects a rising level of commitment on all sides and indicates that a trend is likely to continue. A downtrend in the open interest shows that winners are taking away their chips, while losers are accepting losses and quitting the game. Falling open interest shows that the trend is becoming weaker, which is a valuable piece of information when you need to decide whether to stay or take profits.

S HORTING Few traders active today were in stocks in 1929, but the aftershocks of that year's crash still impact us. The government responded to the hue and cry of the hurt and angry public. Among its many acts

was an attempt to root out evil short sellers, accused of driving stocks down. It promulgated the uptick rule, which allows shorting a stock only after it has ticked up. The bad bears can no longer hammer down innocent stocks with their sell orders. They may only sell short stocks that are rising. How about a parallel law to outlaw buying stocks that have ticked up and permitting people to buy only after a downtick, to prevent excessive bullishness?

The uptick rule is an example of a bad law passed in response to mass hysteria. It is short-sighted because during bear moves it is the short sellers who break declines with their profit taking. There is no uptick rule in the futures markets. A futures trader is much more likely to be comfortable shorting than a stock trader.

In stocks, most people are long and very few are short. Exchanges report short interest each month, which almost never rises into double digits. In futures, short interest is always 100%-there is a short contract for every long because if someone is buying a contract for future delivery, someone else has to sell them a contract for future delivery, that is, go short. You have to feel comfortable shorting if you want to trade futures.

LIMIT MOVES Now that the stock market has its own "circuit breakers," fewer newcomers to futures are shocked to discover that most have daily limits beyond which prices are not allowed to go. Limits are designed to prevent hysterical moves and give people time to rethink their positions, but they have a downside. Just like a pedestrian can get crushed against a traffic barricade put up to protect him, a trader can get crushed in a limit move. A string of limit days is especially terrifying, as a loser is stuck, unable to get out, while his account is being destroyed.

Fears of limit moves are greatly overdone. Their heyday was during the inflationary 1970s, and the markets have become much more peaceful since then. If you trade with the trend, a limit move is much more likely to go in your favor, not against. With the globalization of the futures markets, many more emergency exits appeared, allowing you to unwind a trade elsewhere. A good trader learns to find those exits before he needs them. Last but not least, a futures trader may consider opening an "insurance account," as recommended above for naked options writers, albeit on a much smaller scale.

MINICONTRACTS Futures traders with tiny accounts sometimes ask whether they should trade regular contracts or minicontracts. For example, a regular contract of S&P represents $250 times the index, but a minicontract is only one-fifth its size, representing $50 times the index. In British pounds a regular contract represents ? 62,500, but a minicontract only one-fifth its size represents only ? 12,500. Minicontracts trade during the same hours as regular contracts and closely track them in price.

The only advantage of minis is the reduction of risk, but their com-missions take a bigger percentage from each trade. Beginners may use them for practice, but full-size contracts are much better trading vehicles.