Understand the risk before you take it
In Mexico, several years ago, my wife nearly cut her finger off.
As she was lowering the back of her heavy wooden lounge chair, she released the supports and it crashed down on her finger; creating a scissor effect on her finger between the back and the frame.
This whole situation could have been avoided if she would have taken just 3 minutes to ask how the process of lowering the chair back worked.
The cost of her not understanding the process before she started?
A $3,000.00 emergency room bill in a foreign country where my insurance was worthless.
But, failure to understand the process and the potential risk involved before acting could have cost us much more if it had involved our investment portfolio. In that case, our entire net worth could be at risk and the loss of our financial security could be the cost!
Understand the risk before you take it
The futures market can be a lot like an emergency room in Mexico when you really see how it works. You have people trying to sell medical commodities and people wishing to purchase them. And once you understand how to assess either of these markets, you can quickly tilt the odds for success in your favor.
To understand how any market functions and avoid losses, three things we must understand are:
The bid and ask: What they are and how they are established.
The meaning of the important term “spread” and why you absolutely MUST understand how to interpret it.
Actual prices you pay and receive are largely driven by the “price ladder”. This is a display of buyers and sellers along with desired prices from each. It allows us to see imbalances in supply and demand. Very important information if we want the best price.
The first step in making a successful investment is acquiring the underlying asset at the right price. A firm knowledge of just these three aspects of the futures process will go a long way toward making sure we don’t get our results chopped off by paying too much.
I found myself being the individual commodity buyer in that institutional emergency room. Just like trading futures back home. Fortunately for me, I understood how the market determines the actual selling price of anything…supply and demand.
What are the bid and ask prices and why do I care?
The bid price for any asset represents the highest open offer in the market at any moment. In that emergency room in Mexico, I told them I was willing to pay $2,500.00 to have my wife’s finger sewn up – that became the “bid” price for stitches. A quick glance around the emergency room told me I appeared to be the only buyer in the market for stitches at that moment and could get a deal. The doctors in the hospital told me they would sew up my wife’s finger, but they were going to charge me $3,500.00 to do it. Their offer to perform the service then established the “ask” price for stitches in the Mexican market.
They probably thought they had the advantage because the stitches were necessary. They overlooked the fact that it wasn’t my finger but it was MY money.
Defining the “Spread”
Once the bid and ask prices had been established at $2,500.00 and $3,500.00, the $1,000.00 difference between them became the “spread”. There is almost always a difference between what the buyer wants to pay and what the seller wants to get. Knowing the spread is crucial. It is a strong indicator of how anxious the potential buyers and sellers are to execute their orders.
The amount of the spread will normally be closely related to how many interested buyers and sellers there are. The more anxious buyers and sellers, the smaller the spread tends to be.
In this case, the spread between my bid for stitches and the doctors’ offered price was 40%! That gap might have seemed insurmountable had there not been one more factor that needed to be considered…the price ladder.
Why is the price ladder a powerful bargaining tool?
Looking around that emergency room lobby in Mexico I could see at least FIVE medicos that appeared not to be assigned to anything urgent. But, my wife only had ONE finger that needed stitches. I immediately determined that there were more people willing to sell stitches than there were needing to purchase them.
I was going to get the stitches for my wife. But, at least four medicos were going to get NOTHING. They would still be there when the process was over. But, their time would have produced no income. Five medicos asking $3,500.00 for stitches…only one potential buyer offering $2,500.00. You can clearly see that, as the only potential buyer, my position was stronger.
This established the “price ladder” for buying and selling stitches in that emergency room at that moment. You see, a price ladder is nothing more than a list of willing buyers, the quantity they wish to buy and the prices they are offering to pay, below a list of willing sellers that includes the quantities they wish to sell and the prices they would like to receive.
The price ladder always wins
One of the men stated: “We are doctors. We don’t negotiate price.”
I could plainly see there were five sellers and only one buyer. Three people were leaving without anything they wanted and two of us were going to get it.
I simply said: “$2,500.00. Who wants it?”
Suddenly, one doctor said: “$3,500.00.”
In my rough Spanish, I replied: “I will not pay that! $2,500.00. No more.”
A second doctor spoke up. “$3,250!” It seemed at least some sellers were more anxious than the buyer…excluding my wife. It was, after all, her finger.
“No. $2,750.00! No more.”
Suddenly, a third doctor stepped forward and said emphatically: “$3,000!”
Understanding market pricing — and what moves it — was the key
By quickly assessing the number of potential sellers compared to the number of buyers, I was able to see that the price ladder was stacked in my favor. As a result, I knew I was in a very good position to negotiate a better price by making a low offer and letting the sellers come to me.
If I had held out a little longer, I might have gotten a better deal; but my wife’s finger was bleeding and she didn’t seem to be enjoying the negotiating as much as I was.
When you understand how to use these very same tools in the futures market, you can assess the positions and strength of other participants in the market just as easily as I could count the idle doctors in that emergency room that day.
If you choose not to educate yourself and use the tools available to maximize your trading results, you will have chosen to hand the market a HUGE advantage. Giving away that kind of advantage in the futures market will cost a lot more than a few stitches in the emergency room.
Laugh your way to the bank
My wife and I left the emergency room that day and I was proud. I had applied my knowledge of how the markets set price to emergency room processes. My wife said I came close to being a patient myself. She said she was about to whack me for taking too long to negotiate.
All I could say was: “No pain, no gain Baby. Sometimes you have to take one for the team.” Fortunately, the knot she put on my head healed up very quickly.
Leaving your trading desk with success each day is not easy. Understanding what drives the movement in the market is critical to success. The basic factors setting market prices are the bid/ask, spread, and price ladders. Now that you see how they work together, use that to your advantage.