The Futures Advisor

Drawdowns are among the most difficult things for futures traders to cope with.  In fact, they are the primary reason that many traders quit trading.  The reasons for this are usually psychological and must be understood if traders expect to be able to continue trading successfully over the long term.  Drawdown is simply the amount of loss between equity peaks over a set period of time.  I’ve heard, though I don’t remember where, that drawdowns are like exhaling – necessary and natural.  One cannot go on inhaling indefinitely, the ups must be punctuated by downs, though ideally of a lesser magnitude.

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What is a risk/reward ratio? A simple definition goes something like this:

A ratio used by traders to compare the expected returns of a trade to the amount of risk undertaken to capture these returns.

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I’m going to present four very simple money management guidelines that every trader can benefit from. I learned them from John Murphy’s Technical Analysis of the Futures Markets. It is a bit ironic that I gained this knowledge from a technical analysis book instead of one on risk management. However, it is one of the first books on futures that I ever read, so I give him the credit for it.

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Commodity futures trading offers the potential of immense rewards with a small amount of capital. This is what lures many traders into the markets. However, it is a rarity for someone to turn, say $1,000-2,000, into a large amount of money without suffering drawdowns that erase their capital. The few lucky souls that have achieved this are few and far between and I doubt that their success happened overnight. Indeed, it probably had nothing to do with luck. I suspect that they had rock-solid discipline, were well-informed, and, most importantly, employed very rigid methods of risk-management from the very start.

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A trading system is simply any logical methodology for selecting, entering, and exiting trades. Most trading systems also include methods for defining risk and money management. A trading system can be as simple as “sell corn when harvesting starts” or it may be much more complex and include a dozen different technical indicators. Essentially, all traders use some sort of a system that takes into account varying amounts of data and formulates an action based upon such data. The difference depends on how rigid or loose their methods are.

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It’s an all too common occurrence. A trader has used his trade selection process to pick a seemingly profitable futures contract. Using his favorite analysis methods and indicators he has narrowed his search from a group of possibilities to a worthy candidate. A trading plan has been developed, specifying entry and exit points along with profit and loss objectives. All seems ready to go. Then, he begins reading the daily market reports and trading recommendations regarding his chosen commodity that have been written by supposed experts. Many of them make predictions that are very different from his own. The trader now begins to second guess himself and vacillation sets in. What is he to do? How can he take a position that is opposite from what the experts recommend?

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Modern futures trading descends from the practice of negotiating commercial agreements called forward contracts, which are as old as commerce itself.  These legally binding agreements, which were entered into by two parties, specified the delivery of a certain amount of a physical commodity at a set price and a predetermined date in the future.  The reasons for entering into this sort of agreement are varied, but all revolve around the unpredictability of future prices.  The price of goods and commodities are dependent upon various events and factors that affect supply and demand.  And since nobody can accurately predict what events will transpire in the future to affect these prices it is easy to see why planning ahead was wise.

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