By nature, the American futures market is inherently risky. Money is at stake each and every time a position is opened in the market. No matter if you’re an institutional player or an independent retail trader, capital preservation is an integral aspect of successful trading.
The beauty of the futures markets is that each trader is able to determine exactly how much risk is assumed. Decisions regarding degrees of leverage, implementation of stop losses, and trade frequency all influence the amount of capital in jeopardy at a given time. When these elements are brought into alignment, a trader is able to place trades efficiently and affordably.
Trade with a Plan
Behaving recklessly within the American futures market is often a costly endeavor. A comprehensive trading strategy can help to eliminate untimely mistakes while promoting sustainable profitability.
A complete strategy consists of concrete rules governing market entry, trade management and money management. Operating within the framework of a detailed strategy reduces undue risk attributable to the following common pitfalls:
- Over trading: taking too many trades too often
- Emotional trading: chasing or doubling down to make up for a loss
- Haphazard money management: ill-informed or reckless use of leverage
It’s a simple point, but one that is worth emphasizing: A predefined plan can take the guesswork out of executing trades. Through the elimination of self-inflicted unforced errors, a trader can mitigate a great deal of unwarranted risk.
In futures, a trade’s degree of risk is the amount of capital put in jeopardy with respect to the account size. The first step in effectively managing risk is quantifying how much money may be safely put into play for an expected return.
Here are a few time-tested money management devices:
- Protective stop loss: A stop loss is an order that traders use to protect an open position against catastrophe. It is placed upon the market at a location where the trade is proven to have failed.
- Risk vs reward (R/R): Quantifying R/R is a huge part of active trading. A functional R/R quantifies the return on equity for a given trade. The important thing to remember about R/Rs is that they must operate in concert with the trading style and market conditions to be effective.
- The 3 percent rule: Many professional traders use the 3 percent rule as a general guideline for quantifying the amount of capital to risk on a given trade. Under the 3 percent rule, 1 percent to 3 percent of the account balance may be risked on a single trade. This is a conservative guideline, but one that eliminates a rapid depletion of the trading account.
The most important aspect of selecting an approach to money management is suitability. Adopting a methodology that is the best fit for both the capital resources and type of trading is the key to effectively managing risk facing the trading operation.
When, What and How to Trade Futures
It’s vital to understand that the American futures market periodically experiences rapid, dramatic swings in pricing. Although this volatility creates opportunity, it also enhances risk.
Not all futures products behave in the same manner. Some contracts are prone to wild fluctuations while others consistently trade within relatively tight ranges. However, no matter the product’s disposition, there are several specific times a trader needs especially vigilant:
- Economic data release: The release of official economic reports — such as GDP, unemployment or crude oil inventories — are capable of drastically impacting related markets.
- Breaking news: It’s difficult to account for breaking news. A momentous news item can move markets in the blink of an eye. Being aware of the current geopolitical atmosphere and relevant hot-button issues can help prepare for the unexpected.
- Contract rollover: As a futures contract nears its expiration, interest shifts to a contract of longer duration. Volume becomes diluted, price action choppy, and trading risky.
During these periods, market participation may become inconsistent and price action chaotic. Being aware of the daily economic calendar, contract expiration dates and relevant news items is a great strategy for eliminating unwarranted risk due to enhanced market volatility.
Putting It All Together
There are many different schools of risk management. Ultimately, each individual trader is responsible for determining which framework gives the trading operation its best shot at success.
For an in-depth look at self-directed trading and the many assets available to aid in risk management, check out dt’s Trade On Your Own services suite.