Trading Method
Courtesy: Futures Pro by Essex Trading Co., Ltd.
What Type of Trading Method Will You UseWith the proliferation of computers, trading systemdevelopment seems to have replaced stamp collecting as thehobby of choice. Trading system development is the areawhere a lot of traders focus the bulk of their attention. Andthis is not necessarily a bad thing. Using an unemotionalsystematic approach to trading can greatly increase yourodds of success because it can remove your ego from theday-to-day decision-making process and can reduce youremotional attachment to the money in your trading account.The beauty of a trading system—which automaticallygenerates buy and sell signals based on some presetobjective criteria—is that it doesn’t care what the weatheris. It doesn’t care if a big announcement is forthcoming,if the Fed chairman is speaking in 20 minutes nor aboutthe price of tea in China. All it knows is that if a certainset of criteria is met it will say “buy” and if another setof criteria is met it will say “sell.” In essence, it never
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THE FOUR BIGGEST MISTAKES IN FUTURES TRADING
makes a mistake. This is not to say that it won’t have losingtrades. It just means that it always does what it is supposedto do.Compare this to the trader who flies by the seat of hispants, buying or selling short based on subjective decisionmaking. He buys and the market goes down; he reversesto short and the market rallies. He thinks he should buybut decides to wait. The market then explodes higher andhe misses the big move, the one which would have madeback the losses and amassed a sizable profit. This scenariocan happen to a trader using an objective trading systemalso. However, the difference is in the emotional aftermath.The system trader may begin to question his system aftera particularly bad period of trading, but this is a far easierposition to be in than the subjective trader who just madethree big mistakes back to back to back. It is hard enoughto stomach losses when the markets knock you around. Itis far more painful when you do it to yourself. Subjectivetrading involves entering into trading with the idea in theback of your head that when the time is right to enter orexit a trade “I’ll just know.” This approach is fraught withperil. On the other side of the coin, it should be clearlyunderstood that utilizing a purely mechanical trading systemin no way guarantees that you will be trade profitably.What it does mean is that you may be able to drag arounda lot less emotional baggage than the subjective trader. Asubjective trader who “makes it up as he goes along” willlikely have a number of opportunities to “beat himself up”over the bad trades he has made that he shouldn’t haveand the great trades that he didn’t take when he had thechance.21
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Whether you choose to trade systematically, subjectively orsomewhere in between there are certain criteria that youneed to address. The more clearly stated and objectiveyour answers to these questions, the greater the likelihoodof your long-term success.
What Criteria Will You Use To Enter a TradeA systematic trader may look for some type of movingaverage cross-over. A subjective trader might look for amarket that is starting to trend, and an astrologer mayshort the S&P 500 when Jupiter aligns with Mars. Thepossibilities are limitless. The key here is to devise somemethod of trade entry that has some realistic probabilityof generating profits. One advantage the systematic traderhas is that he can formalize his trading rules, run themthrough the computer, and see if his method actuallygenerated some profits in the past. This can lead to a wholeother set of problems if the system developer “overoptimizes” the results. With enough indicators it is possibleto devise a system that fits the past almost perfectly. Thebad news is that such systems almost never perform wellin the future when real money is on the line. Still it isgenerally preferable to have some idea of what you canexpect from your trading approach than to say, “well, Ithink my theory is really going to hold up,” and to thenstart risking real money to prove your theory—which isessentially what a subjective trader does.The point here is that if you develop some set criteria forentering trades, and if you have some realistic reason toexpect this criteria to generate good signals and you follow
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THE FOUR BIGGEST MISTAKES IN FUTURES TRADING
each signal as generated, you give yourself the best chancefor success.
What Criteria Will You Use To Exit A Trade With A ProfitOnce you reach this stage you are starting to get into thenitty-gritty of trading. Market makers generally make onlya few ticks on the majority of their profitable trades. Onthe other hand, long-term trend followers often need to ridemajor trends for a long time in order to maximize theirprofitability. Once again this is a personal decision but itis important to make some decisions ahead of time forseveral reasons. First, oddly enough, one of the mostdifficult things for many futures traders to do is to ride awinning trade. When you get into a trade that immediatelygoes in the right direction the desire to “take the moneyand run” can be overwhelming. It can also be a hugemistake. For example, if you are a trend following traderwho generally experiences 60% losing trades, youabsolutely have to have some big winners in order to offsetthe majority of smaller losses you incur along the way. Ifyou take profits too soon on a regular basis you areessentially shooting yourself in the foot by doing exactly theopposite of what you need to be doing given your chosenapproach to trading. (The “hard work” of trading usuallyinvolves making and sticking to difficult decisions. Fightingoff the urge to cash out a winning trade when yourapproach tells you to hold on is a perfect example of histype of “hard work.”) On the other side of the coin, ifyou are a counter-trend trader—selling into rallies andbuying on dips—you may need to take profits more quicklybefore the trend turns back against you.
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If you develop some objective profit-taking criteria whichhas a realistic probability of helping you to make moneyand you stick to it trade in and trade out, you are farahead of the majority of other traders.
What Criteria Will You Use To Exit A Trade With A LossIn the end it is not so much what you make when thingsgo well that will decide your fate as a futures trader, butrather what you keep when things go poorly. Effectivelycutting losses is generally considered to be the number onekey to long-term success in futures trading. As a result,your answer to the question “what criteria will you use toexit a trade with a loss” may have more of an impact onyour ultimate success or failure as a trader than any othersingle factor. If you doubt this is true then you should read(and re-read) Market Wizards by Jack Schwager. In thatbook Schwager interviews a number of top professionaltraders to get some insight into what separates them from theaverage trader. Several common themes are evidentthroughout but none more so than the need to cut losses andto keep losses small.The truest thing that there is to know about futures tradingis that there will be losing trades. There was a broker whowould always discuss his “guarantee” with new clients beforethey made their first trade. His guarantee was this: “the onlything I can guarantee you is that there will be losing trades.”Most people probably didn’t care to hear this but he actuallydid them a favor by injecting this dose of reality into theirmindset before they got started.
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THE FOUR BIGGEST MISTAKES IN FUTURES TRADING
Nobody likes to lose money, even on a singe trade. Yetexiting a losing trade in order to cut a loss can actually beviewed as a positive step because it serves the purpose ofkeeping you in the game for another round. Futures tradingis not about being right. It is about being right enough attimes to offset all the times you were wrong and also to neverbe “too” wrong. Every time a trader enters a trade he hopesto make money. When a trade starts to go the wrong waymany traders take it personally and have a great deal ofdifficulty with acknowledging that they were “wrong.” Yetone of the great ironies of futures trading is that very oftenthe best thing that you can do is to take a loss and exit atrade before your loss becomes too big.As with all of the other questions posed in this section thereis no one right answer. You can use tight stops, you can usewide stops, you can use stops that vary depending uponvolatility and so on and so forth. The key at this stageis to select some method that you will use when you havemoney on the line and then stick to it once you areactually trading.
A Word Of Advice: Adhere to the Four CornerstonesAs you develop answers to the questions that have beenraised in this section, it can be helpful to have anunderlying framework within which to fit the pieces. Oneexample of such a framework can be referred to as TheFour Cornerstones of Successful Trading. They are:• Go With The Trend• Cut Your Losses• Let Your Profits Run• Don’t Let The Big Winners Get Away25
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Go With The TrendOne of the most useful skills that any trader can developis the ability to identify a trend. If you can identify amarket in an uptrend and enter a long position or identifya market in a downtrend and enter a short position, youhave the potential to make a great deal of money. Toomany traders spend all of their time trying to “predict”what will happen next, rather than simply focusing onanswering the question “what is the trend right now?”The fascination with predictions is understandable. If youcould predict today where a given market will go tomorrowwith any consistency you would be rich beyond your wildestdreams. Unfortunately this desire is just that, a dream.The heart of the problem seems to be that there are somany people making so many predictions that the naïvetrader almost can’t help but to think, “well there must besomething to it. These guys on TV can’t all be wrong canthey?” In fact they can, just not all at once. And thereinlies the fascination with predictions. If someone makesenough predictions eventually he may get one right. If amarket prognosticator on TV gets a prediction right he islikely to be sought out for more predictions for a fairly longperiod of time, regardless of how many of his subsequentpredictions actually fail to pan out.Expecting to trade profitably in the long run by latchingonto somebody’s predictions or by relying on your own issimply an exercise in hope. Successful traders learn thatthe ability to identify the current trend is far more usefulthan a thousand predictions.
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THE FOUR BIGGEST MISTAKES IN FUTURES TRADING
Cut Your LossesThis topic will be discussed in greater detail in Sections 2and 3. For now simply note that the effectiveness withwhich you cut your losses on trades gone bad will probablyhave more effect on your success or failure as a trader thanany other single factor.
Let Your Profits Run / Don’t Let BigWinners Get AwayAt first these two objectives seem to be at cross purposes.If you are holding a winning trade and you take a profityou are no longer letting your profits run. Conversely, ifyou are holding a big winning trade and you let it ride,then you run the risk of letting a big winner get away. Sowhat is the right thing to do? The answer to this paradoxlies in your answer to the question “what criteria will youuse to exit a trade with a profit?” Whatever technique youdecide upon for exiting a trade with a profit you must applytrade after trade after trade.Constantly refer back to these four cornerstones whendeveloping your trading plan. Doing so will help you todevelop a solid approach to trading, one which has arealistic probability of making money in the long run. Itwill also help your confidence to know that you are buildinga framework which is based upon the most importantconcepts in successful trading.
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SummaryPlanning plays a key role in the success or failure of anyendeavor. The more prepared an individual is whenstarting out the greater his likelihood of long-term success.Unforeseen problems that must be dealt with as they occurare inevitable and can cause even the best laid plans tounravel. As a result, true success in any enterprise resultsfrom laying out a well thought out plan, following the plan,adapting to unforeseen problems, and always keeping one’shead above water. Futures trading is no exception.Your trading plan will serve as your roadmap to help youthrough the twists and turns that the markets will throw atyou. It should also serve as a constant frame of reference,particularly when things are not going well. When youencounter difficult times in trading, it is not unlike flyinga plane in bad weather at night. Under such circumstances,your inner ear will lie to you and tell you that your wingsare level even when they are not. In order to keep yourwings level you must rely upon and trust your instrumentscompletely. Likewise, when trading during a bad stretchyour inner voice will lie to you and will tell you to dothings that you normally would not, and that deep downyou know you should not. But because you are losingmoney at the time you may be tempted to say “why not?”In order to keep your head level in such circumstances youmust rely upon and trust your trading plan completely.And given that you will at times have to rely so implicitlyupon your trading plan, it will hopefully be clear to youwhy forming a comprehensive trading plan is your first steptoward trading success.
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THE FOUR BIGGEST MISTAKES IN FUTURES TRADING
MISTAKE #2:Using TooMuch LeverageWhat is Mistake #2Among the general public futures trading is generallyconsidered to be a wildly speculative activity. Most peoplehave little trepidation about moving money into stocks orbonds or mutual funds. But ask them if they haveconsidered trading futures and they get this incredulouslook on their face and say “whoa, what do you think I am,crazy?”What is it about futures trading that has earned it such adisreputable reputation? The common perception amongthe general public seems to be that the individual marketsthemselves—whether it be Silver, Soybeans or NaturalGas—are wildly volatile and that volatility is what causesmost traders to lose money. While there is no questionthat futures markets can be volatile at times, the marketsthemselves are not nearly as volatile as many people think,and it is not the volatility of the markets that causes themajority of problems. What causes most of the problemsis the amount of leverage used when trading futures. This29
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fact is not widely recognized, however. Before illustratingthis let’s consider what causes futures prices to rise or fall.The price of a stock tends to rise or fall based upon thecompany’s earnings per share, or more accurately, on thepublic perception of that company’s earnings outlook.Conversely, the price of a physical commodity moves basedupon supply and demand for that product, or moreaccurately, the perceived supply and demand for thatproduct. For example, if there were a terrible drought inthe Midwest the general perception would likely be thatgrowing conditions are bad and that farmers will not be ableto grow as many Soybeans as usual. Thus, based onperceptions of lower supply, the price of Soybean futurescould be expected to rise. Likewise if growing conditionswere perfect and supply was expected to be great, Soybeanprices would likely fall. Now let’s consider the volatility ofthe markets themselves.The first thing to understand is that there is nothing abouta bushel of Soybeans or an ounce of Gold that make theminherently more volatile or more risky than a share of stockin IBM or any other tradeable security. In fact, in termsof raw volatility (i.e., the average annual price movementas a percentage of current price), commodity prices tend tofluctuate less than stock prices. Figure 2-1 shows thehistorical volatility of a group of stocks and futures markets.While this is admittedly a very small sample, note that theaverage volatility for the stocks in this list is greater thanthe average volatility for the futures markets in the list. Sowhat’s going on here? Does the investing public have itbackwards? Are futures really less volatile, and by extensionless risky than stocks? Well, not exactly.30
THE FOUR BIGGEST MISTAKES IN FUTURES TRADING
Figure 2-1 – Stock Volatility versus Futures Market VolatilitySTOCKABBOTT LABSAMER EXPRAMGENANALOG-DEVICESAPPLIED-MATERIAASAATMELBANC ONE CORPORBANKAMERICABARRICK-GOLDBIOGENBOEINGCABLETRON SYSTECCUBECHASE MANHATTANCIRRUS LOGICCISCO SYSTEMSCMG-INFO-SERVICCOMPAQCOMPUWARECONSECOCREE RESEARCHCYPRESS-SEMIDELL COMP
AVERAGE
STOCK
VOLATILITY%36.741.145.359.358.541.568.937.839.250.145.834.976.657.638.078.744.468.752.167.555.467.778.053.0
54.0
FUTURECATTLE FEEDERCATTLE LIVECOCOACOFFEECOPPERCORNCOTTONCRUDE OILDJ FUTURESDOW FUTURESGOLDHEATING OILHOGS LIVELUMBERNYFES&P FUTURESS&P MINISILVERSOY MEALSOY OILT-BONDSTNOTE5UNLEADED GASWHEAT
AVERAGE
FUTURES
VOLATILITY%8.714.640.365.128.224.523.835.413.323.934.137.236.035.213.317.519.830.029.625.88.94.433.026.4
26.2
Understanding LeverageThe purpose of the previous example is to illustrate thatthe key difference between stock trading and futures tradingis not the volatility of the underlying tradeables. The keydifference between trading stocks and trading futures is theamount of capital required to enter a trade and theresultant percentage return on investment. This can bestbe illustrated with an example. First let’s consider stocktrading. In order to buy $100,000 worth of IBM stockInvestor A must put up $100,000 in cash (you can buyIBM stock on margin. To do so you would put up31
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$50,000 in cash giving you 2-for-1 leverage. However,for the purposes of our example, we will forego marginbuying). If Investor A puts up $100,000 cash to buy$100,000 of IBM stock and IBM stock rises 3%, InvestorA will make 3% on his investment. If IBM stock declines3% he will lose 3% on his investment.Prettystraightforward. Now let’s consider a futures trade.Each futures contract has a standardized contract size.When you buy a Soybean contract you are buying the rightto purchase 5,000 bushels of Soybeans. For Soybeans aone cent move ($0.01) is worth $50. Now let’s do somemath. Let’s say Soybeans are presently trading at a priceof $5.00 a bushel. With a current price of $5.00 a bushel,the contract is currently trading for the equivalent of 500cents. 500 cents times $50 a cent means that you wouldbe purchasing $25,000 worth of Soybeans. Thus, ifInvestor B buys four Soybean contracts at $5.00 a bushelhe is buying $100,000 worth of Soybeans. Now herecomes the key difference between trading stocks and tradingfutures: to purchase (or to sell short) a futures contract atrader does not need to put up cash equal to the full valueof the contract. Instead, he need only put up an amountof money which is referred to as a “margin.”Minimum margins are set by the futures exchanges and maybe raised or lowered based on the current volatility of agiven market. In other words, if a particular marketbecomes extremely volatile, the exchange on which it istraded may raise the minimum margin. As this is written,the amount of margin required to trade one Soybeancontract is $750. So in order to buy $100,000 worth of
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Soybeans, Investor B in our example must buy fourcontracts at $5.00 a bushel (500 cents x $50/cent x fourcontracts). However, unlike Investor A who had to ponyup $100,000 cash in order to buy his IBM stock, InvestorB need only put up $3,000 of margin ($750 per contractx four contracts) in order to make his trade. And thereinlies the quality that makes futures trading a highlyspeculative endeavor—leverage.If IBM stock rises 3%, Investor A will make 3% on hisinvestment. If Soybeans rise 3%, from $5.00 to $5.15,Investor B will make a 100% return on his investment (15cents x $50 per cent x four contracts = $3,000). So whatwe are talking about in this example is the differencebetween 1-to-1 leverage versus 33-to-1 leverage. Whenyou boil it all down, it is this leverage which gives futurestrading its great upside potential as well as its frighteningdownside risk. If IBM declines 3%, Investor A will lose3% on his investment. If Soybeans fall 3% from $5.00to $4.85, Investor B will lose 100% of his investment (15 cents x $50 per cent x four contracts = -$3,000).Leverage is the double-edged sword that makes a fewpeople very rich and upon which the majority of futurestraders fall.Very few individuals have the stomach to trade withleverage of 33-to-1. More unfortunately many traders donot clearly understand that they are using this kind ofleverage when they trade futures. Those in the greatestdanger are the ones who read about “how to make afortune in Soybeans for just $750!,” or “how you cancontrol $25,000 worth of Soybeans for just $750.” Also,33
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some traders are unaware that futures trading involvesunlimited risk. If you enter the aforementioned Soybeantrade, buying four contracts at $5.00/bushel, your initialmargin requirement is $750 a contract, or $3,000. Basedon their prior experience in stocks or mutual funds or evenoptions, some traders mistakenly assume that this is all theycan lose. Not so. If Soybeans happened to trade downlock limit ($0.30/day) just two days in a row, this traderwould be sitting with a loss of $12,000 ($0.60 x $50/centx four contracts) and counting. This illustrates theimportance of having a “cushion” and not “trading too big”for your account. The phrase “trading too big” can bedefined as the act of trading with more leverage than isprudent given the size of your trading account and yourown tolerance for risk.
Why Do Traders Make Mistake #2Unfortunately, the blunt answer to the question “why dotraders use too much leverage” is “ignorance.” This is notto imply that everyone who trades futures is ignorant(although there are those who might debate this). Whatit means is that many traders are unaware of the amountof leverage involved. Too many traders get into futurestrading without realizing or understanding the amount ofleverage involved. People who trade stocks for years(putting up $1 of cash to buy $1 of stock) often mistakenlyassume that they are doing the same thing with futures.They simply don’t realize that when they put up $1 theymay actually be buying or selling $33 worth of theunderlying commodity. Few people are prepared to dealwith 33-to-1 leverage. To make matters worse, those who
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don’t even realize they are using 33-to-1 leverage havealmost no hope of surviving. It is sort of like taking a testdrive in an Indy race car. You know it can go fast so youprepare yourself a little, but you are used to driving thefamily sedan whose top speed might be 80 miles an hour.So you strap yourself in, put your foot on the gas andsuddenly find yourself hurtling down the track at 220 milesper hour. The odds of your avoiding a serious accidentare slim. And so it is, too, for the unenlightened futurestrader.Another problem is that there are few warnings givenregarding how much leverage is too much. Brokeragehouses make money based upon the number of trades madeso they don’t have a great incentive to tell somebody“you’re using too much leverage; you should trade less.”Another problem is that although there have been manygood books written regarding money management, thereremains no standard method for determining the properamount of leverage to use when trading futures.
How To Avoid Mistake #2The antidote for using too much leverage is referred to asproper “account sizing.” Account sizing simply refers toa process whereby a trader attempts to arrive at the “right”amount of leverage for him. The goal is to strike abalance. You want to use enough leverage to be able togenerate above average returns without using so muchleverage that you expose yourself to too much risk. Theultimate goal of sizing an account is to limit anydrawdowns in equity to a percentage amount which willnot be so large that it causes you to stop trading. In35
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order to do so you must prepare yourself as much aspossible both financially and emotionally for the magnitudeof drawdown you are likely to experience using your chosenapproach to trading.There is no one best way to arrive at the “perfect” amountof capital to use to trade a given portfolio. There are,however, several key factors to take into account. Theideal method is to develop a portfolio of markets andtrading methods, figure out the proper amount of capitalneeded to trade each market, and then allocate that muchcapital into your trading account. From a practical pointof view most traders do not have this luxury and mustapproach the problem from the other end. In other words,most traders don’t say “here is the optimum portfolio andthe required amount of capital to trade it so let me justwrite a check to my broker for this amount.” Most traderssay “I have x-number of dollars to commit to futurestrading. What can I do with it?” If your optimum portfoliorequires $50,000 to trade (according to the methods wewill discuss in a moment) but you only have $25,000 withwhich to trade, you must either alter your optimumportfolio or save up another $25,000.Assuming you are going to trade a diversified portfolio ofmarkets, the first step is to build a test portfolio and lookat the historical trading results for each individual marketusing the trading approach you have selected. What youwant to accomplish is to arrive at a reasonable amount ofcapital to have in your account in order to trade onecontract of each market. If possible, you will also wantto consider the performance of the portfolio as a whole,
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to determine if more or less capital is required. In orderto obtain the most useful results it is best if you have somemethod available to generate a trade listing for eachmarket that you intend to trade using the approach youhave chosen. It is also helpful to be able to analyzemonthly profit and loss data for the portfolio as a whole.If you have actually been trading for a while you may beable to use your past monthly statements to obtain thenecessary data.
The Role of Mechanical Trading SystemsThere are several benefits to be gained by using amechanical approach to trading. First, doing so caneliminate a vast array of emotional and psychological issuesby virtue of the fact that you are relieved of the burdenof having to subjectively make trading decisions on a dayto-day basis. The other key benefit is that by formalizingrules and testing them over past data you can arrive at anobjective estimate of the expected risks and rewards. Thisinformation can be used to estimate your trading capitalrequirements. In order to get the most out of theapproach to be described you should be using some typeof mechanical system for which you can generate eitherhypothetical or actual trading results, or some combinationof the two.
Determining The Amount of Capital Required toTrade One MarketThe following discussion is not intended to offer thedefinitive method for arriving at a proper capitalrequirement for trading a given portfolio of futures37
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markets. It does, however, address several key factors thatshould be considered when determining your capitalrequirements.
Single Market Factor #1: Optimal fIn his 1990 book titled “Portfolio Management Formulas,”Ralph Vince popularized a formula known as optimal f. Thetheory behind this method is that:• There is a “correct” amount of capital to apply to anycontract using a particular trading approach.• Trading using the “correct” amount of capital will maximizethe profitability experienced without sustaining a total lossof capital.• Trading with less than the suggested amount of capital willlikely result in a total loss of capital.• Trading with more than the suggested amount of capitalwill result in an exponential decrease in the percentagereturn compared to using the “correct” amount.In brief, using a listing of actual and/or hypothetical tradesgenerated by trading one market using a given approach,a calculation is performed and a value is arrived at between.01 and 1.00. The largest losing trade within the listingof trades is then divided by this value to arrive at thesuggested amount of capital with which to trade onecontract.As an example, if the largest losing trade within a particulartrade listing was $2,000 and the optimal f value turns outto be 0.40, then the suggested capital amount would be$5,000 ($2,000 / 0.4). According to this theory, if youwere only going to trade one contract of this one market
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using this one trading approach, then you should place$5,000 into your trading account. If future results mirrorpast results your percentage rate of return will bemaximized by trading with $5,000. Also, according to thetheory, if you trade with less than $5,000 you will likely“tap out” and if you trade with more than $5,000 youmay trade profitably. However, your rate of return will befar inferior than if you had traded with $5,000. Needlessto say this is a bold theory.This approach makes the assumption that future tradingresults will be similar to past results. If future results arefar inferior to past results then the end result using optimalf can be disastrous. However, in testing using tradingsystems that have a positive expectation, and for whichfuture results were similar to past results, optimal f hasdefinitely shown the ability to increase profits exponentiallycompared to simply trading a preset number of contracts.Unfortunately, the reality of the situation is that usingoptimal f to trade one market is generally not practical.The big problem with a strict usage of optimal f is that itdoes not consider drawdowns in its analysis. The onlymeasure of risk that is used is the single largest losingtrade. While the case can be made that this is statisticallycorrect, the fact of the matter is that using this methodalone will invariably result in large percentage drawdownsat some point in time. Because the drawdowns that canresult on a single