How the Markets Contribute to Risk
Before you even begin to figure out how to manage your own trading risks, you must understand that the markets themselves contribute to the risk that you face. News that changes the fundamental landscape can shock prices at any time of the day or night. Price action itself can trigger a waterfall of buy or sell orders when a certain technical indicator is hit. And, of course, a market’s liquidity—the ability to buy and sell with ease—must always be a consideration when examining the risk, you take when making a trade.
Fundamentals
It’s critical to know the fundamental price drivers that cause a market to move up and down. These might include the discussion of interest rates, sentiment and expectations, economic reports, seasonal effects, the weather and agricultural reports. In short, news about market fundamentals is constantly changing. Often, knowing market expectations for report data and whether or not the expectations are met is more important than the data itself and is key to understanding the market fundamentals and price relationship.
Technicals
Technical analysts use price charts and technical indicators to quantify historical performance and identify repeating patterns as a means to signify buy and sell opportunities. When popular signals are triggered, the market can make a dramatic move. Those who follow technical analysis track historical prices, volume, open interest and internal market conditions in an attempt to identify trends in both the short- and long-term future of the underlying market.
Liquidity
Consider the liquidity of the market as part of your risk management. What is the ease of entry and exit in the market? What is the depth of bid and ask? Bid/ask prices and sizes change quickly in real-time, and therefore supply and demand for the market also changes quickly in real-time. Experienced, short-term traders always pay very close attention to the bid/ask sizes to monitor this ongoing supply-demand dynamic. They usually buy when the demand (bid) is higher than supply (ask) and sell if demand suddenly becomes lower relative to supply.
All traders watch volume and open interest as a measure of market liquidity because the more liquid a market, the faster and easier that trades can be executed. Volume is the number of futures contracts that have changed hands. Open interest is the number of futures contracts outstanding that have not been closed or offset. Even on a day-to-day basis, some futures contracts and some delivery months tend to be more actively traded, i.e., more liquid, than others, so heeding volume and open interest is significantly related to developing a solid risk- management strategy.
Mastering Risk Management
Managing risk is more than being able to afford a losing trade. It’s about taking into consideration all the ways in which the markets and your position in them increase or decrease the amount of risk you can afford—and are willing—to assume.
1. Leverage
Leverage is the two-edged sword in futures trading, and managing it is key to your success. Although each trade has a minimum margin requirement, there is no maximum. Thus, to decrease exposure to risk, reduce your leverage by allocating more of the full contract value to the position via supplying more initial margin.
Another way to manage leverage is to reduce the number of contracts in your position—or even not take the position at all. A third way to manage leverage is to trade “mini” contracts, i.e., smaller versions of typically commercial-sized regular contracts.
Do not underestimate the risk of leverage when trading futures. It is why you can lose more than you invest. Even though the exchange minimum margin requirements typically are 5-20% of the full cash value of the contract, it is wise to hold more funds in your account than are required by exchange minimums. This will allow you to manage your account rather than leaving yourself at risk of being forced out of the market as a result of being over-leveraged with insufficient margin money.
2. Position Size
Even if you can afford to trade only one contract, you need to consider position size in your risk management approach. Otherwise, you will not know when to increase size based on success, or whether to hold off trading until additional capital can be raised.
The first factor to consider is the market’s volatility. If there is not sufficient volatility in the market to achieve profit objectives within the chosen time frame, consider choosing another market and/or timeframe. On the flip side, if volatility is high, consider the maximum risk you can take per trade as well as the maximum amount of risk you can afford in your account.
Setting arbitrary rules for how much to trade and when is a flawed approach taken by many new traders. Trading should be based on a plan, not an arbitrary number of contracts or dollar amounts. Always adjust your position size to a level that enables you to think clearly and rationally. Before you increase or decrease a position, you should have a valid reason for doing so based on a systematic approach that makes trading measurable, quantifiable, and helps preserve capital for winning trades.
3. Risk Capital
How much of your account you commit to margin to carry your positions is one of the most important risk management decisions you can make. Professional traders often use only about one-third of their total capital for margin, leaving two-thirds to absorb position risk.
Understanding your chosen trading strategy— particularly its maximum drawdown history—is another key ingredient in deciding how much capital to put at risk. Combining the statistics of your method of trading with your risk tolerance and appropriate stop placement, you should be able to calculate the optimal number of contracts to be traded at each dollar level of your account balance.
4. Market Diversification
Diversifying your trading portfolio across several markets allows for more consistent performance under a wide range of economic conditions. However, be sure to analyze the appropriate position size for each market individually. Risk and leverage are not consistent across all markets.
5. Market Volatility
Deciding to trade in markets with low volatility or those with high volatility is part of the risk- management equation—not only for capital allocation, but also stop placement. Take a look at the average daily ranges as well as volume and open interest for clues as to the market’s volatility. Initial margin requirements—and how often they change—are another indicator of market volatility.
6. Stop Orders
Stop placement, just like all other aspects of trading, cannot be arbitrary. Setting stops at a set dollar amount because you are comfortable with that amount of risk is not a wise approach. Instead, take a look at the size of swings that occur in the market. However, if the dollar amount of risk is too great for your account size, you simply must not trade in that market.
Using stops based on average market swings is effective. For example, if your trading plan is to risk no more than 2% on any given trade, then the trade has to fit within those parameters. The stop is placed a predetermined percentage outside of that range. This type of risk management is critical to success because it helps you to not lose your entire account (and potentially more). However, always be aware of current market conditions.
If the market swings are outside your maximum comfort level, move to another market or pass on the trade. You might use a stop to exit the market once your profit target has been reached. But, you also could “trail” the stop by moving it as the market continues to go your way. There is no correct answer, but there is one thing to consider—your response to the market achieving the target must fit in with all of the previously discussed concepts.
Trading Strategies and Risk Management
“Plan your trade and trade your plan” is an old piece of market wisdom, but certainly is relevant to developing a sound approach to managing your trading risk.
First, consider what strategy you will follow to produce profits. Do you plan to develop your own strategy or purchase a trading system? Be sure to understand why the strategy has worked in the past as well as whether it fits within your approach and understanding of the markets.
Second, for each market you are trading, understand the details of how your strategy behaves. Where are your stops placed? What is the expected win/loss ratio? How many losing trades can come in a row? What is the average profit objective? Answers to these questions can help you determine if you can afford to take the risk of placing trades based on this strategy. Three popular trading strategies include trend following, swing trading and watching for significant support and resistance levels.
Trend Following
Trend followers normally enter in the market after the trend properly establishes itself. This trading strategy involves three elements—current market price, account balance and current market volatility—to establish your risk-management approach. Exactly how much to buy or sell is based on the size of the trading account and the market’s volatility. As price changes, you could adjust the position gradually up or down depending on how the market moves.
If there is a turn against the trend, trading systems might trigger a pre-programmed exit. Or, you could wait to exit and reverse until the turn establishes itself as a trend in the opposite direction. A more conservative approach would be to step aside when the system signals an exit, and re-enter the market when a new trend is established.
Swing Trading
Swing traders look for relatively short-term changes in price over a period of days. Generally, a swing trade is open longer than a day, but shorter than a trend-following trade. In a market trending in a definite direction, the most active contracts tend not to exhibit the up-and-down oscillation that they would when the markets are relatively stable. Thus, swing traders must be able to identify the type of market condition in which they are trading—trending higher, trending lower or trading sideways— which can be a challenge for many swing trading strategies.
Support and Resistance Levels
Support and resistance levels are price levels on charts that tend to act as barriers to prices continuing the move in a certain direction. A support level is a price level where the price tends to find support as it is going down. Conversely, a resistance level is where the price finds resistance while going up.
Often, prices initially bounce off these levels rather than break through them. However, once price has decidedly passed the support or resistance level, it often continues in that direction until it finds another support or resistance level. The more often a support/resistance level is “tested” (touched and bounced off by price), the more significance given to that specific level. If a price breaks through a support level, that support level often becomes a new resistance level. The opposite is true as well; if price breaks a resistance level, it will often find support at that level in the future. Support and resistance levels can be identified by trendlines and previous tops and bottoms. Some traders use pivot point calculations, based on the previous day’s average price and trading range, to determine the near-term trend as well as near- term support and resistance points.
Discipline and When to Exit
It’s knowing when to exit a trade that can define a successful trader.
Consider the situations of two traders who take different approaches to their strategy and their risk management: Trader #1 uses a method that provides profitable trades 80% of the time, but all trades are only long. This trader’s average winning trade is $750 while the average losing trade is $1,000. After 10 trades, the trader is net positive $4,000.
Trader #2 has a method that is only short the market. It provides profitable trades only 20% of the time. But, the average winning trade is $4,000 and the average losing trade is $500. At the end of 10 trades the trader is net positive $4,000. Trader #2 has a method that only wins two trades out of 10, yet has a profitability that is the same as Trader #1, who is right more often than wrong.
In this example, neither approach to the market is better than the other as measured by final profitability. The importance is in the discipline to execute the method over time. Each trader understood what the method was, what the probabilities were for the method, and put their plans into action. They never deviated from their method, so in the end, they both ended up successful.
Next Steps in Your Management of Risk
Successful traders know that attention to risk management in their trading is what keeps them in the game.
With diligent attention to managing the risk that is inherent in futures trading, you’ll better understand the markets, how big a position to take, where to place your stops and more.
Risk Management Checklist
Ask yourself these questions to make sure you are providing appropriate risk management to your portfolio before trading futures:
- What is my account size?
- What percentage of my account balance will I be risking?
- What is my trading strategy?
- What futures contract, month, and year am I trading?
- How much is a tick worth?
- What is my dollar risk amount?
- What is my position size?
- What is my stop loss on this particular trade?