Chapter 4-2 Risk Control and Money Management

Risk Control

There is an old saying out there, “Mind your pennies and the pounds will take care of themselves.” The corollary to this in futures trading is, “Mind your losses and the profits will take care of themselves.” Clearly, the most important tactic for successful futures trading is to control losses, also known as risk control. If you can control losses and allow profits to run-and that is decidedly difficult to do-you should be a consistent winner.

What we seek is a systematic, objective approach to risk control, which would include the following four steps:

  1. Limit your risk on each position. One approach is to equate your risk to the exchange margin for each market-and limit your risk on each position to a given percentage of the market, say, 60 percent.

Equating acceptable risk to a percentage of margin is a logical strategy. Margins are set by each exchange and are generally related to the volatility and, indirectly, to the risk/profit potential of each market. For example, on the Chicago Board of Trade, margin on a 5,000-bushel contract of corn or wheat is $675, while the margin on a 5,000-bushel contract of soybeans, considered a more volatile and high-flying market, is $1,687. It is, therefore, logical for a trader to accept a risk of 20.50 cents on soybeans versus just 8.25 cents on corn or wheat, because the profit potential on a favorable soybean move IS perceived as being considerably larger than it is on either corn or wheat.

Similarly, one should not use more than one-third of the equity in an account to margm positions. Put another way, at least two-thirds of the capital should be held In reserve, as a!cushion in the event that your positions hit some unexpected setbacks. And, if the equity in your account declines, you should seek to reduce positions so as to try to retain this recommended one-third ratio.

  1. Diversify your positions. Each year, we witness a number of mega-moves. Unfortunately, we cannot possibly predict which markets will produce such huge profits. We can, however increase our chances of participating in such moves by diversifying into a number of different positions and markets (at least six to eight).  Also, one should seek to diversify between long and short positions. Being long in six different markets won’t be very much fun on days when the entire list is heading south.
  1. Avoid overtrading. This admonition pertains both to excessive trading activity and to putting on too large a position in relation to the available capital. You aren’t likely to trade successfully if you are overtrading, if you are excessively focused on short-term scalping, and if the first adverse swing will have the margin clerk on the phone with you-again.
  1. Cut your losses. First of all, when you put on a position, you should know where your bailout point (stop loss) will be, and you should enter the stop with your broker. Experienced traders who sit in front of an on-line screen and who have the discipline to dump the position when and if it reaches their bailout point may not actually put the stop to the floor. The key word here is discipline, because this tactic should never be used as a substitute for overstaying a market, or for rationalizing any delay in liquidating at the designated stop point.

Assuming your newly liquidated position starts to move against you from the outset, the stop will get you out at a reasonable loss. However, if the market begins to move favorably, what do you do about the stop protection? One interesting strategy is to advance your stop (if long, raise the stop; if short, lower the stop) after each Friday’s close, by an amount equal to 50 percent of the week’s favorable move. If the market moves against you on any particular week, you should leave the previous week’s stop intact. Eventually, the market will reverse and stop you out; but if you have had a favorable run, you will have advanced into a no-loss stop position and, ultimately, a profitable one.

Disappointment and discouragement are two basic human emotions. A serious trader must have the discipline to overcome the blues and to stick with an objective, systematic method of futures investing, while, at the same time, maintaining the self confidence necessary to plow through the bad days (or weeks or months). This steadfastness is necessary because it is the only way to recoup the losses, with interest, during the next good period.  And, no matter how grim things may appear, there will definitely be a “next good period” as long as you stay alive by limiting losses on adverse positions.

Money Management

Regardless of which basic strategy you use, discipline and money management are essential. Make sure you trade with stop losses and do not risk too much on any one trade – no matter how good it looks. If you want to make above average returns over the long run, you will need to implement a commodity trading strategy instead of a buy and hold strategy with commodities. However, if you do not have a sound trading plan, do not expect a promising outcome.

Commodity trading strategies are simply the basis for why and when you will buy and sell commodities. You should have some well thought out strategies before you begin trading commodities. This does not mean watching the financial news or reading a commodity newsletter for the latest trading tips. Rather, you should have consistent strategies that will let you know under what circumstances you will buy, sell and limit your losses.

Most commodity trading strategies use some form of technical analysis for the trading decisions. I mainly use technical analysis when I trade, but I also monitor the fundamentals of the markets. I’ll first discuss the basic commodity trading strategies using technical analysis and then I’ll include some information on using fundamental analysis for trading commodities.