My Potato Car 
by Paul Niquette
Copyright ©2008 Paul Niquette All rights reserved

 
ot the best time to take a phone call, let alone to make a financial decision.  It was a catered party for friends and neighbors, a celebration of sorts.  Clinking glasses.  Guests splashing in the pool.  Brubeck on the stereo.  Laughter in the livingroom.  And why not!  My commodity futures program -- my secret algorithm -- was paying off. 

The next week, I was all set to make an offer on Baron Six-Three Niner-Seven Lima. 
 

Someone handed me the phone, saying it was my broker.  I frowned at the clock.  Must be trouble.
 

"Paul, Pete."

"Yeah, Pete."

"Eggs."

"What about eggs, Pete?"

"Frozen eggs.  Demand has gone crazy. Production can't keep up."

Not trouble after all.  I exhaled and took a sip of Gentleman Jack, grinning at my guests. 
 

"Right now, Pete, I am shorting russets in May, so -- "

"Troop ships are leaving for Vietnam.  They need eggs by the ton.  I'm still in the office.  We need to take a long position first thing in the morning."

There were plenty of ways I might have assessed the impact of that conversation with Pete.  However, my ego was on autopilot.  The following exchange would cost me the full purchase price of the Baron: 
 

"What's my cash strength?" I heard myself ask.

"Five, maybe six.  I say let's go for five contracts."

"Five it is then, Pete."

At that hazy moment, I had no idea how a contract in frozen eggs was structured.  All my trading was in potatoes.  Not eggs, not pork bellies, not grains, not metals -- potatoes, damn it! 

The next week, instead of buying the Baron, I took a bath in eggs.

n futures trading, margins are famously generous and risks are notoriously trecherous.  While working full time as an engineering manager for a computer company in 1967, I hunkered down each evening with publications on potato futures, studying crop reports from all over the country, meticulously charting prices and volumes and product demands.  Always careful to set up 'round-turn' transactions at the Chicago Board of Trade, I never exposed my growing commodities account to open-ended catastrophes. 

Thus, with peace of mind, I was able to spend weekends flying my family all over California in Two-Four Fox -- oh, and shopping for my next airplane, a Beechcraft Baron.

Commodity Futures

The stock market in the sixties was not being good to me.  My mounting losses ranged from National Video and Murray Ohio both clobbered by Pacific Rim competitors respectively in color television tubes and cheap bicycles.  Astroturf was the precursor to an immense market for outdoor carpeting.  Or so I thought.  Of course, I blamed my broker.  About that time a distant relative named Pete began a new stock brokering career and prevailed upon me to open an account.  In a packet of pamphlets he sent me were tutorials about commodity futures.   Today, informative references are available on the web (see for example Investopedia).  One evening of study in 1967 and I became captivated.

The contrast with owning common stock in a company was striking.  Stock prices are often decoupled from the business performance of the company.  I never liked that.  Indeed, some investors pay no attention to the 'fundamentals' of a business and instead go about making wagers with each other based on 'technical' aspects of the stock price itself.  In sharp distinction from that paradigm, a 'speculator' in commodity futures derives his or her compensation by taking business risk, thus providing a vital service for commodity stakeholders, the "hedge." 

ake potatoes.  The future price of potatoes is not known with certainty.  That's a problem for the farmer and also for, say, the potato chip producer.  In the extreme, if the future price is too low, the farmer could lose the farm; too high and the potato chip producer faces bankruptcy.  To avoid unacceptable risks, both are motivated to 'hedge' -- to establish a future price right now. 

In concept, a farmer and a potato chip producer might get together and negotiate a contract with each other, thereby assuring a mutually acceptable price.  The farmer would then be committing to supply some quantity of potatoes at that price after the harvest and the potato chip producer committing to buy those potatatoes when harvested.  Such a static, one-on-one model is not practical.  Commodity trading is best accomplished in many-to-many transactions. Commodity exchanges address that reality. Moreover, future prices are dynamic, as forecasted supplies and estimated demands fluctuate over time. 

For illustrations see hypothetical scenarios.
 

My Secret Algorithm

Commodity trading is characterized by a number of salients.  Here are five of them...

  1. Price quotations move fast, changing by the minute for some commodities.
  2. Volatility is pronounced, limited by exchange rules and ultimately by governmental regulations.
  3. Transactions are in cash, a prescribed level of cash must be maintained in each account.
  4. A near-symmetry prevails between buying and selling, "long-interest" and "short-interest."
  5. Rapid turn-over is encouraged, with exchanges offering sharp discounts in fees for "day-trading."
A serious speculator must be able to follow events in real-time and make immediate decisions.  In 1967, that would not have been possible for me. 

Agricultural commodities were more interestng to me than metals, but the prices for grains jumped around too rapidly to follow on a part-time, day-by-day basis.  Potato futures moved more gradually -- and something else.  I began plotting daily quotes from the newspaper on a pad of quadrilled paper and discovered a 'technical' pattern for market prices in the form of a zig-zag within what I called a 'channel'.  Thus did the recent past seem to offer clues about the near future.  Groping for First Principles, I theorized that the top of the channel ("resistance level") resulted from long-interest profit-taking, and the bottom of the channel ("support level") resulted from short-interest profit-taking.  Compliant reasoning might call for going 'long' at the support level and 'short' at the resistance level. 

oday there are abundant, up-to-the-minute plotting services on the web, some actually automating the analysis of patterns like "point-and-figure," "head-and-shoulders," and other technical totems.  To my astonishment back in 1967, I found no published graphical presentations for commodities.  I began developing an algorithm for my own speculations.  After a few paper-only test cases, I sent Pete a check with instructions to open a commodity account.  Later that week, I dialed him up.
 

"Pete, Paul."

"Yeah, Paul."

"Potatoes in May."

"What about potatoes in May?"

"Place a buy order at market for three contracts."

Without describing My Secret Algorithm, I instructed Pete to place two sell-orders, one at a price 10% below market and the other at 10% above market. 
 

"Stop-Loss, I understand, but why the second sell-order?"

"Call it a 'Stop-Profit', Pete."

" 'Stop-Profit'?  Never heard of it."

"Before today, you mean."

'Stop-Profit' was the best feature of My Secret Algorithm, I think: Give half of the profit (and risk) within the 'channel' to somebody else.  Then, too, setting up 'round-turn transactions' relieved me of all real-time decision-making.

A few days later, I received a slip in the mail from the broker's back-office reporting that the 'Stop-Profit' sell-order had been executed and that my account had been credited accordingly. Hoo-hah!  Next day, I studied my quadrilled paper with the jagged lines on it, then called Pete.
 

"Pete, Paul."

"Potatoes in May again?"

"This time let's place a sell-order at market for four contracts?"

"You want to go short for four?"

"Yeah, and place two buy orders: 10% Stop-Loss and 10% Stop-Profit."

A few days later, I received a slip in the mail, this one indicating that the 'Stop-Profit' buy-order had covered my short interest and that my account had been credited accordingly.  The story repeated itself for several weeks.  Pete and I kept our conversations terse in the extreme.  Kind of bravado, I suppose.  Or superstition.  My commodity account suffered only one 'Stop-Loss' in potato futures. 

Here is a flow-chart for My Secret Algorithm...

The sketch below depicts how the round-turn transactions were structured.  Relatively greed-free, don't you think?  Successful transactions, both long and short, exploited the fluctuations within the channel.  There were idle periods in between, giving up half the potential profit to other speculators.  For illustration, the channel is shown trending upward, then changing direction, triggering a Stop-Loss.
 

Months of successful commodity trading can do wonderful things for one's bank account -- and ego.  On the way home from the office one day, I saw a 1966 Corvette Stingray on a dealer's lot.  Inasmuch as commodity accounts are pure cash, at any time and without closing out open transactions, you can request the broker to send you a check from your account.  That's exactly what I did. 
 

Naturally, I christened the Stingray My Potato Car.

ack to that midnight phone conversation during a raucous party.  Seems I abandoned proven disciplines in My Secret Algorithm.  No systematic plotting of market prices, no confirmation of 'channeling'.  Foremost, I did not know eggs from my elbow.  In my ego-driven state-of-mind, I neglected to assure that a Stop-Loss would be put in place.  It appears that Pete had something of an ego, too.  He must have felt a need to assert himself, to make a big play, to garner family recognition.

Because of sudden volatility, trading in eggs was suspended by the exchange, which meant that an emergency sell-order could not be executed.  As the bottom fell out, my account was depleted by an amount corresponding to the offer for Baron Niner-Seven Lima -- plus a "margin call," which I had to cover immediately.  Cash, remember.  I dialed Pete's number for the last time.
 

"Pete, Paul."

"Yeah, Paul."

"Close my account."

"OK, Paul.

The check from the brokerage house was a few bucks less than the total cash I had invested.  Whew! 

All I had to show for My Secret Algorithm was -- well, My Potato Car.
 

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Hypothetical Commodity Future Scenarios

Farmer John, sells a contract for $100 in March on the Chicago Board of Trade to deliver 10 tons of potatoes in May at the price being quoted on the exchange, $500 / ton.  That's called "going short" or "taking a short position." Farmer John expects to harvest 20 tons in May.  His intention is to 'hedge' half of his harvest against a drop in price, which could wipe out his profit for the season. Speculator Paul, buys a contract for $100 in March on the Chicago Board of Trade to purchase 10 tons of potatoes in May at the price being quoted for delivery, $500 per ton.  That's called "going long" or "taking a long position." Speculator Paul's intention, of course, is to sell the contract well before the month of May, inasmuch as he really does not need all those potatoes. 
Next day, the price quoted for potatoes in May rises to $510 / ton.  Farmer John goes on about his business.  Sure, he could hedge the rest of his crop at that price, but then he would be locked out of prices higher than $510 / ton in May.

The price quoted the next day may drop to $490 per ton.  Farmer John goes on about his business, secure in the knowledge that no matter how far the market price falls, at least half of his crop will be sold in May at the contract price of $500 / ton.

Next day, the price quoted for potatoes in May rises to $510 per ton.  If Speculator Paul sells the contract for $100, an addtional $100 will be credited to his account ($10 / ton difference on 10 tons), a gain of 100% in one day. 

The price may drop to $490 per ton.  If Speculator Paul sells the contract for $100, a total of zero would be credited to his account.  If he does not sell and if the price continues to fall -- well, shudder, the expression "margin call" is quite well known.

Potato Chip Producer Mack, buys a contract for $100 in March on the Chicago Board of Trade to purchase 10 tons of potatoes in May at the price being quoted, $500 / ton.  Mack's intention, of course, is to keep the contract until May to assure that at least part of his needs for potatoes can be met at $500 / ton. Speculator Paul, sells a contract for $100 in March on the Chicago Board of Trade to deliver 10 tons of potatoes in May at the price being quoted, which is $500 / ton.  Paul's intention, of course, is to buy back -- "cover" -- the contract before that date, inasmuch as he has no ability to deliver any of those potatoes.
Next day, the price for potatoes in May rises to $510 per ton.  Potato Chip Producer Mack goes about his business, glad that he will not have to pay that price -- or higher -- for at least part of his potato requirements.  In May, Potato Chip Producer Mack receives a warehouse receipt for 10 tons of potatoes plus a bill for $5,000.

The price quoted the next day may drop to $490 / ton.  Potato Chip Producer Mack goes about his business.  Sure, he could hedge more of his requirements at the lower price, but then he would be locked out of lower prices later on.

Next day, the price quoted for potatoes in May rises to $510 / ton.  If Speculator Paul covers the contract for $100, an addtional $100 will be deducted from his account, a loss of 100% in one day.  If he does not cover and if the price continues to go higher, a much dreaded "margin call" becomes a likely outcome. 

The price quoted the next day may drop to $490 per ton.  If Speculator Paul covers his short interest with a contract for $100, a total of $100 would be credited to his account (10 tons at $10 / ton), a gain of 100% in one day. 

 

 
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algorithm
noun:   A step-by-step problem-solving procedure, especially an established, recursive computational procedure for solutions in a finite number of steps. 

1699, from Fr. algorithme refashioned (under mistaken connection with Gk. arithmos "number") from O.Fr. algorisme "the Arabic numeral system," from M.L. algorismus, a mangled transliteration of Arabic al-Khwarizmi "native of Khwarazm," surname of the mathematician whose works introduced sophisticated mathematics to the West. The earlier form in M.E. was algorism (c.1230), from O.Fr. Modern use of algorithmic to describe symbolic rules or language is from 1881.