Money Management Matters in Futures Trading

What sets good traders other than the masses? It’s not necessarily the power to select precision entries and exit points, but relatively an understanding of risk and risk management.

Risk management when trading futures shares lots of the same features as that of stocks—as an illustration, futures traders are exposed to cost risk available in the market. But, unlike stocks, futures are derivatives contracts with set expiration dates that require the delivery of the underlying asset. Futures are also far more friendly to the usage of leverage on margin that may amplify each gains and losses.

Read on to seek out out about among the unique risks that futures trading brings with it, and what you may do to attenuate your exposure to them.

Key Takeaways

  • Futures contracts are popular financial instruments, but they differ in vital ways from more traditional assets like stocks or bonds, and so your risk management will even differ.
  • Futures are highly marginable, so you may increase your leverage way over when buying stocks.
  • This will result in margin calls in case you’re not careful about setting stops.

Practicing Discipline

Risk management is usually an missed and misunderstood area of trading. It might probably sound boring in comparison with a discussion of stochastics patterns, Fibonacci sequences, and other matters of technical evaluation. Nonetheless, it’s critical to any successful trading plan.

Even a trading strategy so simple as a moving average crossover system could be ruinous if proper risk management isn’t applied. This discussion of risk management will show you how to construct a foundation of concepts you can apply to any trading plan.

A risk and money management plan will show you how to in one other key area—discipline. Many investors don’t hesitate to enter a trade, but sometimes have little idea of what to do next and when. Having a plan in place will keep you disciplined and forestall the emotions like fear and greed from taking on and causing you to experience failure.

Starting From Square One

A very good place to start out is with the concept of risk control. Traders are drawn to futures due to leverage that’s provided—vast sums could be won on little or no invested capital. Nonetheless, the associated fee of that leverage is the actual fact that you would be able to lose greater than the balance of your account. So, how are you going to control that risk?

First, consider that the foundations regarding margin are about minimums. There are not any rules that affect the maximum margin you may apply to a trade. In other words, in case you are concerned with the leverage of potential losses of a market, apply more capital. True, you shall be reducing your overall return, but this also brings the whole lot into balance. Then again, highly leveraged positions can quickly result in margin calls if the futures market turns even barely against you briefly order.

Example of Margin in Use

If corn is trading at $3 per bushel and a contract is 5,000 bushels, then the total contract value of a single contract of corn is $15,000. The exchange generally requires a minimum margin of around 5%-7%, which could be between $750 and $1,050. That is the minimum. If our trading plan requires that we risk a $0.10 move in corn, we’re risking $500, or around 48%-66% of our investment.

Nonetheless, if half the contract value were applied to the trade, or $7,500, that very same $0.10 move would account for less than 6.6% of our invested capital. That is quite a difference. Increase that to investing the total contract value and a trader on the long side (buy) removes the opportunity of losing greater than the initial investment.

Plan Your Trading Risk

So what’s the precise amount to risk on a trade? There is no such thing as a hard and fast rule on this, but account size, risk tolerance, financial objectives and the way it suits the entire trading plan should all be taken under consideration. You’ll be able to see from the instance above that there is sort of a spread. Conservative traders generally risk around 5%-7% on a given trade, but this also requires either a bigger amount of capital or precise entry and exit points. Increasing that to a 12% risk allows for taking up slightly more leverage and wider market swings. Greater than that quantity is not necessarily fallacious—it just will depend on other aspects of your plan. Nonetheless, in case you’re taking up greater risks, you will need to also consider whether your profit objective is realistic.

Consider this rule of thumb when you concentrate on where your risk tolerance suits in to the above discussion: If you happen to take a 50% loss on a trade, it is advisable to achieve a 100% return to get it back. For instance, in case you own 100 shares of a stock at $50 per share and it loses 50%, your $5,000 will drop to $2,500. You should now achieve a 100% return to get back to $5,000. Desirous about risk in this fashion can put your risk tolerance back into perspective.

Stop Runaway Trading Losses

The importance of the stop-loss order as a part of money management can’t be missed. A predetermined stop keeps a trader disciplined in executing his or her money management. Nonetheless, many traders don’t understand the “how” of stop placement. Stops can’t be placed arbitrarily—careful consideration must go into where to set a stop.

Traders sometimes set arbitrary stops, but this is usually a nasty idea. That is when a trader says, “I’m placing my stop at a risk of $500 per trade because that’s what I’m comfortable losing on a trade—no more.” Let’s assume that this trader employs a system of technical evaluation and swing trading. The swing low of the market in query is a move of $750. Does this trader’s $500 stop make sense? Absolutely not! Furthermore, it might be as near a guaranteed loss as you may get. What if the swing low was a $250 move? The $500 risk still doesn’t make sense since it is an excessive amount of risk.

The important thing to bear in mind whenever you’re setting your stops is that the stop price must fit the market. If the required risk on a trade is simply too much for the trader’s risk tolerance or account size, then the trader should discover a market that matches. It’s silly to trade a market with too little capital. There’s an old saying that warns against bringing a knife to a gun fight. Likewise, in case you come to a market with too little capital, you might as well save everyone plenty of time and cut a check for the trade’s counterparty right then and there.

The Bottom Line

Ensure that the markets that you simply are trading in fit together with your account size and risk tolerance. Ensure that the proportion you might be willing to risk per trade suits the plan and the market. And keep in mind that none of those components exists in a vacuum. Give attention to one without the opposite and you might be headed for trouble. Weigh these aspects together and also you shall be putting yourself on the track to constructing a successful trading plan.

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