Fat 'n Happy the Rooster Trader Vic the Trading Rooster

Just Another Jim

Commodities Trading



An Explanation of Commodity Volatility

How do you maximize profits in commodity trading? The obvious (and incorrect) answer is that the more contracts I trade the more potential I have for profit. But increasing the number of contracts also dramatically increases the loss potential. Trading too many contracts is the fastest way to go broke. Another approach to increasing profits is to consider volatility. Instead of just looking at the number of contracts, I want to consider potentially how much money I can gain (or lose) with any given contract. This is volatility. Volatility can be defined in different ways; I use Van Tharp's definition.

NOTE: Tharp describes this in his book,Trade Your Way to Financial Freedom. It's not a helpful name because the title makes it sound like a self-help book. The book is actually a detailed description of how to control risk in a trading account and how to objectively determine how much risk a trading account is exposed to—this latter part is called expectancy. The book is a must, in my opinion, for anyone that wants to objectively control their trading account risk.

But there's a catch if one wants to use Tharp's system. It requires the use of volatility charts. He describes how to determine volatility and it's quite a bit of work. For a hefty fee he provides the info. I used to create my own volatility spreadsheed but I found it to be rather overwhelming. I carefully charted volitility for three years and now have a feel for what it is without actually crunching the numbers. As a result, I will no longer be providing volitility charts on the web site.

Let's use corn as an example. During the summer of 2004, the price of corn would fluctuate an average of 7 or 8 cents a day. This does not mean that the closing price would change 8 cents a day, rather that the price movement during the day might be that much. This daily movement is called the Daily Trading Range (DTR).

The other piece of volatility has to do with how those moves translate into value changes for the contract. To continue with our corn example, a penney move in corn translates to a $50 change per contract. This number is the Full Point Value (FPV). When the ADTR (7 to 8 cents) and the FPV ($50) are multiplied together we discover how much the dollar value of a contract of corn can change, from its daily high to daily low, on any given day. The Average Daily Volatility (ADV) of corn was $350 to $400 during the summer of 2004.

The Daily Trading Range (DTR) can change dramatically from day to day. Technically, the only limit to the DTR is the exchange imposed limit that the price can move. Somewhere between these two extremes (yesterday's actual trading range and the theoretical maximum trading range) is what we can expect the trading range to be. I use a ten day average to balance these two extremes. I call this average of DTRs over the last ten days the Average Daily Trading Range or ADTR. The ADTR for July 2004 corn during the month of June has varied between 6.15 and 7.98 cents. That means the average daily volatility has varied from $307.50 to $398.75. Of course, since it is an average, the number is always changing. For the grains, that daily change can be dramatic, especially in the summer.

I use the average daily volatility (ADV) number to control my risk. My rule of thumb is that I do not risk more 5% of my account on any one trade. I determine that risk with the ADV. Assuming a trading account of $25,000, since the ADV of July 2004 corn in June 2004 is about $350 per contract, I would not trade more than 3 or 4 contracts of corn at a time as an initial position.