Futures Trading – Money Management Basics

Futures Trading – Money Management Basics

 

 

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.

Money management rules can be as complex or simple as you would like. Many traders use highly elaborate formulas for calculating risk levels and asset allocation that serve them very well. However, don’t think that it is necessary to create a complex money management plan in order to profit – it isn’t. The degree of complexity is up to you, but simplicity of form is often best because it is more easily understood and executed.

 

A Basic Money Management Plan

1Total invested funds should not exceed 50% of total capital. This means that if you have $20,000 in trading capital, no more than $10,000 should be used for margin money. You may not like the idea of barring half of your available capital from it’s full earning potential, but this is a measure of security that will keep some of your capital safe from losses during periods of adversity. This measure will help you avoid the tendency of becoming too heavily margined with all of your funds.

2Restrict commitments in any one commodity to 10-15% of total capital. This refers to the amount of margin money that will be committed to any single commodity, not the amount you are willing to risk in losses for a particular trade.

3The total amount risked for any one commodity (not contract) should be limited to 5% of total capital. This 5% refers to how much a trader is willing to lose on a trade that doesn’t go as planned. Some actually consider 5% too high of a risk level, but this is up to the individual’s level of risk tolerance. I think that one should definitely not exceed the 5% rule.

4Total margin commitments in any market group should be limited to 20-25% of total capital. This would mean limiting all trading activities within a certain related group, such as the metals or grains, to 20-25%. Related commodities tend to move in step with each other. This can mean large losses if you are too heavily committed in any single market group. Yet, the 20-25% still offers enough earning potential if the entire market group moves in the direction you would like.

infoNote: these percentages are based upon your total capital, not just the 50% portion available for trading. By treating your total equity as the basis for allocation and the size of commitments you are giving yourself a cushion that will protect your total equity against adversity.

 

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An Example

Ok, I said these rules were simple, but they may seem confusing on first glance, so let's use an example.  Let’s say I have 20,000 dollars in total capital. The first rule only allows me 10,000 of this amount for futures trading.  Using my own particular trade selection method I decide that selling silver is a worthy venture. Let’s say that the margin requirement for a silver contract is 1,500. Rule 2 allows me 2,000-3,000 (10-15% of total capital) for margin commitments. So, I sell two silver contracts, requiring 3,000 in margin.

I then decide that selling gold would be a smart choice also. Let’s say the margin requirement for a gold contract is 2,500. While this is within the limits allowed by Rule 2, it breaks Rule 4 because gold and silver are in the same market group. If I were to sell one gold contract as well as the two silver contracts that would put my total margin commitments at 5,500, which breaks the 4,000-5,000 (20-25% of total capital) allowed by Rule 4.  So, I instead decide to buy two corn contracts, for a total margin requirement of 2,500, which is within the 10-15% boundary set by Rule 2. My total margin commitments for all trading is at 5,500, which is in accordance with the 10,000 set by Rule 1.

Now I must pay attention to Rule 3 and set loss objectives. I am allowed a maximum of 5% loss for each trade. So, I place stop loss points for both the silver and and corn trades at 1,000 (5% of total capital). Note that according to Rule 3 this 1,000 risk level is for each commodity, not each contract. For instance, I am allowed a 5% loss for the entire silver trade, not 5% for each contract of silver – likewise with the corn trade. So, I can risk 250 for each silver contract and 250 for each corn contract, for a grand total of 1,000.  This sets a predetermined point at which I will exit the market if things go sour. This must be followed or all four of these rules will be rendered useless.

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Limiting Your Risk

When considering the distinct possibility of losing on both trades, which means you would lose 10% of your total equity, it is easy to see why it is advisable to observe Rule 1. In this case I only used $5,500 in trading margin, which still left me $4,500 in available margin money. If I had used the rest for two other separate commodities then that risk level would have increased to 10% more, bringing me to the possibility of losing 20% of total equity if all four trades went wrong. This is one reason that many might suggest lowering the 5% risk level by a couple of percentage points.

From the above four rules it’s also easy to see that with these percentages, which are necessary to reduce the risk of ruin, it is difficult for small traders with undercapitalized accounts to trade safely and effectively. However, for large and small traders alike, these four guidelines will work to preserve your capital, even in the worst of circumstances. But they must be used consistently and in concert with each other – using any one of them apart from the others will defeat the purpose of the whole.

Risk-Reward Ratio Calculations for Traders

Risk-Reward Ratio Calculations for Traders

 

 

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 in order to capture these returns.

 

Calculating a risk/reward ratio for prospective commodity trades should be an integral part of your overall trading plan. Many novice traders make the mistake of only calculating the potential rewards of a trade.

This is great if the trade goes your way. If it doesn’t, as is very likely, you stand to lose heartily – because you haven't set an exit point based upon an analysis of risk.

 

Risk/reward analysis essentially falls under the trade selection process of a trading plan because if a potential trading opportunity doesn’t meet the ratio it should be discarded as a possible trade. However, it can also placed under the money management part of an overall trading plan since it deals with defining risk levels. I typically consider it part of my trade selection process because it deals with weeding out good and bad trades rather than dictating how much capital to allocate and commit for trading. In either case, it is a necessary step in your trading plan.

Calculating a risk/reward ratio

A simple and oft-used ratio is 3:1.  This means the expectation of profit should be three times the amount risked or the trade should not be made. One might reasonably ask how a risk/reward ratio can be accurately made if the amount of reward (potential price movement) is unknown. This is a valid point since nobody can possibly know if or how far a price will move in the near future.

However, there is a quantity that is clearly defined and can be known in advance of a trade – your risk. This is why it is best to start with the risk portion of the ratio. Using your money management guidelines, which dictate how much capital can be risked, you can now build the risk/reward ratio upon that figure.

Now, this doesn’t alleviate the difficulty of forming a fairly accurate estimate of a reward that is three times your risk level. But, it does put the onus on a known figure instead of an unknown figure, which is a much more reliable solution.

However, an estimate of potential reward must still be made. This can be done with a wide assortment of price forecasting tools such as momentum indicators, chart patterns, trendlines, support and resistance levels, etc. The trader must have the confidence to decide and trust his own judgment in this matter.

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Focusing on the risk figure

It is important to approach the ratio calculation this way because of the dangerous habit that many traders have – entering trades solely based upon their expectation of reward. By placing the risk amount first it forces you to keep that figure preeminent in your mind during the trade selection process.

You don’t have to worry about being deadly accurate on the reward estimate now, just use your best judgment and technical indicators to come up with a reasonable estimate. You’ll never be able to determine the precise amount that the market will move. The important thing to remember is that you have firmly fixed your risk amount and based the ratio upon that number.

Remember:

Risk = known quantity that is predetermined.
Reward = educated guess that is preferably 3x the risk.

The Dangers of Undercapitalized Trading

Commodity futures trading offers the potential of immense rewards with only 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 or price movements that erase their entire capital very quickly. 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 selected trades very carefully.  But, more importantly, they most definitely employed very rigid methods of risk management from the very outset of their trading.