Yesterday I was talking to Tom, a friend of mine with whom I hadn’t spoken for some time. He was in the futures business back when I started (23 years ago!), had been out for the past few years, and was getting back in.
We had always been interested in trying to educate stock traders about futures trading, to show them that their stock trading knowledge was very applicable to the futures markets and that with some education, futures would allow for diversification of their trading. Not only that, futures actually had some benefits over futures as a trading vehicle. (In fact I wrote a whole piece explains the opportunities in futures. Sign up on the upper right corner of my home page to get a copy.)
I told Tom about the piece I wrote, and explained how with electronic trading, the information available on the internet, and the blurring of the lines between futures, commodities, and stocks (ETFs, ETNs, media coverage of the futures markets), stock traders were closer than ever to being ready to be futures traders.
I told Tom that I’m trying to educate stock traders, to show them why they should look into futures, what misconceptions about the futures markets they were likely to have, and problems new futures traders were likely to face. I’m writing a new eBook that will be a practical introduction to futures trading, I told him what I was going to cover, and asked if he had any suggestions.
In discussing pitfalls for new futures traders, he said he thought one of the big differences between futures and stocks was the “buy and hold” idea. If you buy shares of Microsoft at $30 and it goes to $20, you might decide to hold on to it, waiting for it to come back. As you (usually) have paid the full purchase price for your stock, it’s easy to think you just have a paper loss. By holding on to it, sure, there’s the opportunity cost of keeping you money tied up, but you can hold on to the hope that it will rally back up and at least get back your initial stake.
A buy and hold strategy is much less likely to work for futures; there are two problems with this strategy for futures. The first problem is leverage. When you initiate a futures trade, the margin required is usually around five percent of the full value of the contact. For example, a 100 oz. gold futures contract has a full contract value of around $100,000; the margin required to trade a gold contract is currently $4499.50. That means you get leverage of about 22 times your margin. This means that an adverse move of about 4.5 percent wipes out your margin.
The leverage in futures is a double edged sword. Leverage allows efficient use of trading capital. You can achieve a high rate of return on your investment.
On the other hand, the high degree of leverage means you can lose a lot of money in a hurry if you’re not prudent. Understanding the risks before you trade and using proper risk management are the keys to prudent trading.
The other problem with the buy and hold strategy for futures is that futures are marked to market daily. If you have a futures trade on in your account and the market moves $500 in your favor today, that $500 is credited to your account after the close of business that day. These are called “open trade profits”, and this money is as real as money you deposit into your account. You can withdraw it, or use it to trade other contracts, as long as you maintain margin for your positions.
This also means that open trade losses are real as well. Many times I’ve been asked by traders to help them “do something” about a losing trade. By this time, there’s usually little I can do to help them. The time to do something about it is to figure out an exit strategy when a trade is put on. Figure out how much you’re willing to risk on a trade, and get out when that point is reached, usually with a stop loss order.
The trader sitting on the big loser usually hasn’t come up with risk management for the trade when it was put on, and by the time they’re talking to me, it’s too late to prevent a big loss.
This loss often gets compounded when I suggest they liquidate the position, take the loss, and move on. The trader will often say. “I don’t want to get out and take the loss”.
In addition to the fact that often times the losses on losing trades grow, they have already taken the loss. It was taken out of their account as the trade went against them. Staying in the trade doesn’t prevent the loss from happening; it already has occurred. All the trader has done is to avoid facing up to their loss. Losses are inevitable in trading; facing up to them helps you trade logically and dispassionately.
If you ever find yourself in a losing trade and you’re trying to decide whether you should stay in it or not, I’ve found the following exercise helpful. Ask yourself, “If I didn’t have this trade on now, would I put it on here? If so, where would I stop out?” If you would put it on IF it was a new position, then stay in, and use the stop for the “new” trade. But if you wouldn’t put it on as a new trade, it’d probably be best to get out, face up to the loss and move on. In addition to the financial loss, losing trades also have an emotional cost, and getting out of a loser and putting it behind you frees you up, financially and psychologically.
The information contained here includes information from sources believed to be reliable and accurate, but no guarantee is made as to accuracy, nor do they purport to be complete. Opinions are subject to change without notice. Past performance is not necessarily indicative of future performance. The risk of loss in trading futures contracts or commodity options can be substantial, and therefore investors should understand the risks involved in taking leveraged positions and must assume responsibility for the risks associated with such investments and for their results.
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