The commodity futures markets involve a great deal more leverage than most other types of investments. To put it into comparative terms, if the stock market were a race car, then the futures markets would be a rocket ship. While a car going 200 miles hour is certainly "fast," its speed pales in comparison to that of a rocket ship traveling 3,000 miles an hour. Also, futures trading offers speculators the opportunity to generate spectacularly exciting rates of return, far beyond those available from other forms of investment. Maybe that is part of the problem.
One of the greatest dangers in futures trading is the danger of high expectations. By focusing optimistically on how much money he or she is going to make, a trader can easily overlook the more important task of planning out how to deal with all of the bad things that he or she will inevitably experience. Traders, who focus too much attention on how much money they might make, run a very high risk of a frightening slide down a steep slope. Here, the first step begins with developing a well thought out trading plan that covers all of the key elements involved.
One of the most difficult things for many futures traders to do is to ride a winning trade. When you get into a trade that immediately goes in the right direction the desire to "take the money and run" can be overwhelming. It can also be a huge mistake.
Effectively cutting losses is generally considered to be the NUMBER ONE key to long-term success in futures trading. As a result, your answer to the question "what criteria will you use to exit a trade with a loss" may have more of an impact on your ultimate success or failure as a trader than any other single factor. The truest thing that there is to know about futures trading is that there will be losing trades.
Futures trading is not about being right. It is about being right enough at times to offset all the times you were wrong and also to never be "too" wrong. Every time a trader enters a trade, he hopes to make money. When a trade starts to go the wrong way, many traders take it personally and have a great deal of difficulty with acknowledging that they were "wrong". Yet one of the great ironies of futures trading is that very often the best thing that you can do is to take a loss and exit a trade before your loss becomes too big.
True success in any enterprise results from laying out a well thought out plan, following the plan, adapting to unforeseen problems, and always keeping one's head above water. Futures trading is no exception.
It is not the volatility of the markets that causes the majority of problems. What causes most of the problems is the amount of leverage used when trading futures. In fact, in terms of raw volatility (i.e., the average annual price movement as a percentage of current price), commodity prices tend to fluctuate less than stock prices.
The answer to the question "why do traders use too much leverage" is "ignorance". The antidote for using too much leverage is referred to as proper "account sizing". Account sizing simply refers to a process whereby the trader attempts to arrive at the "right" amount of leverage for him. Determining the proper capital requirements for trading a given portfolio is a difficult & often overlooked task. The impact of failing to carefully consider capital requirements for trading a given portfolio can be disastrous.
If you start losing a battle in the futures market, your best bet is usually to turn tail & run for cover. Unfortunately, because this kind of thinking runs counter to the way most of us have been taught to think, many traders focus on fighting the good fight rather on cutting loses. Your very first priority as a trader is to always do whatever you have to do in order to be able to trade again tomorrow. In the final analysis, proper risk control is the key determinant in separating the winners from the losers in futures market.
The costliest mistakes in trading are usually made when the pain of losing money (and/or fear of losing more money) becomes too great. It is the number one cause of bailing out when you should be staying in, doubling up when you should be cutting, tightening stops arbitrarily (thereby guaranteeing that they will be hit) & widening stops arbitrarily (thereby guaranteeing an even bigger loss on an open trade).
Margin to Equity Ratio - There is a simple rule of thumb measure that can tell you how heavy you have your foot on the gas. This measure is referred to as the margin-to-equity ratio. To calculate this ratio, simply add up the initial margin requirements for all the positions in your portfolio. Then divide this total by the equity in your trading account to arrive at your margin-to-equity ratio.
What is the right M/E ratio to maintain? -As far as this is concerned, the right margin-to-equity ratio is nothing absolute. The general rule-of-thumb regarding a prudent maximum margin-to-equity ratio is 30%. In other words, most traders would be well advised to maintain a margin-to-equity ratio below 30%. Trading with a margin-to-equity ratio greater than 30% should be considered an "aggressive" approach to trading futures. The ultimate goal is to maximize profitability while minimizing your exposure to risk.
Stop - Loss Orders - This is referred to as a money-management stop. The purpose of a money management stop is to attempt to limit your loss on each individual trade to a certain maximum amount. The PURPOSE of a stop-loss order is to minimize your losses on any bad trade enough so that you can still come back to trade again tomorrow. The purpose of a stop-loss order is to save your assets.
Risk control is what keeps you in the game long enough to have a chance to win. While cutting a loss and exiting a trade does not get you closer to your goal of making x-dollars, it does keep you from getting further away from that goal. Refusing to employ effective risk control measures can ensure your long-term failure.
