Risk is defined as “a situation involving exposure to danger.” In the arena of active trading, it’s an unavoidable aspect of doing business ― a trader or hedger places capital in harm’s way with the hopes of realizing financial gain.
Gone unchecked, risk can be a monster. When put into the proper context, risk becomes manageable. If you are going to engage the derivatives markets, there are three futures risks to be especially aware of:
- The human element
The futures markets have earned a reputation for being particularly unforgiving venues. Tales of high-frequency traders and fraudulent practices “tilting the playing field” litter the internet. Many financial periodicals of note have deemed futures day trading to be a fool’s errand. Stories and anecdotal evidence of this ilk boil down to one thing: risk.
Of all futures risks, pricing volatility is truly unavoidable. Price action can vary wildly as market fundamentals, technicals, and breaking news items collide. Order flow drives volatility and can be unpredictable at best.
Holding an open position in any market puts a trader at the mercy of periodic volatility. However, a trader can take a few basic precautions to mitigate the negative impact of pricing volatility:
- Study market tendencies: Simply put, know your market! Understand normal levels of volatility and liquidity, as well as times of enhanced participation.
- Daily economic calendar: Each day’s economic calendar is readily available online from dozens of sources. Be aware of the times in which economic news, events, and reports are to become public.
- Access to a news feed: Breaking news items are unpredictable and often shock markets. Having access to a real-time news feed can help you stay abreast of current events.
Understanding how a product regularly behaves, the schedule for fundamental market drivers, and staying up on the news can take much of the risk out of periodic volatility.
The Human Element
Roman philosopher Cicero wrote “man is his own worst enemy.” If you have ever taken an ill-advised trade or practiced haphazard money management, then your trading account is able to attest to the quote’s validity. The human element, specifically emotional trading, tops any list of futures risks.
Here are a few common pitfalls to which traders fall victim and tips on how to successfully manage their negative impact on profitability:
- Physical errors: Regardless of experience level, mistakes happen. Botched order entry/exits cost money and must be minimized. Outside of complete automation, practice makes perfect. Be fluent and familiar with the functionality of your software trading platform.
- Overtrading: Overtrading is a terrible habit, stemming from negative trade-related emotions. It inevitably leads to the compromise of any perceived edge in the markets. One way to avoid overtrading is to implement concrete rules for trade selection.
- Reckless use of leverage: Increasing position size to cover a loss, adding to a losing position, or euphoric risk taking destroys profit in the long run. Again, adhering to steadfast guidelines pertaining to leverage is the key to effectively managing these issues.
Developing or adopting a comprehensive trading plan is a catch-all solution to many problems posed by the human psyche. Greed and fear are two formidable opponents to profitability ― a detailed plan can eliminate them from the equation.
Outright fraud can be the most difficult of all futures risks to avoid. Cases of systemic fraud featuring both brokers and traders may be found in almost any market. Fortunately, U.S. futures markets fall under the jurisdiction of the Commodities Futures Trading Commission (CFTC). Operational oversight is extensive to preserve the integrity of the marketplace.
Nonetheless, there are several fraudulent activities to be aware of and steps to be taken to avoid falling victim to their malicious intent:
- Trader fraud: Individual retail and institutional participants have been documented engaging in fraudulent trading activities. Spoofing, quote stuffing, and layering are a few examples.
- Broker fraud: Unfortunately, not all brokers are on the up and up. However, the CFTC RED List and SmartCheck database can be used to verify that your broker is licensed and in good standing.
While gaining market experience is the only remedy for recognizing trader fraud in real-time, avoiding broker fraud is straightforward. Securing the services of a reputable and competent brokerage firm is the number-one way of guaranteeing your best shot at success.
Understanding Futures Risks Is a Key to Profitability
The futures markets are dynamic atmospheres ― what was fact yesterday may not necessarily be true today. Risk is an ever-evolving topic, and one that a trader must address on an ongoing basis.
For more information on the current risk profile of the futures markets, talk with a broker at Daniels Trading. Experience is the best teacher, and the team members at Daniels are veterans of the commodity, currency, and equities markets.