From the August 01, 2006 issue of Futures Magazine • Subscribe!

Sound money management is key

What is the most important part of successful futures trading? Identifying the right trading opportunity, entering a position properly, having the latest trading tools or having a defined exit strategy would all get votes but not one of those is the most important.

You may be filled with trading knowledge or have a dynamite trading system with the latest technical indicators, but professional traders will tell you that the single most important factor in futures trading success is using good money management principles.

Goal: Survival

Having a higher percentage of winning trades or yet another trading tool may be helpful, but if you do not have a good money management plan in place for trading futures, you are not likely to remain in the trading game long. To be successful, you need to develop your own money management program for entering and exiting markets, sizing your positions and placing stops.

You still have to understand technical or fundamental analysis, but money management will make or break a futures trader. The reason is leverage.

When you are stopped out of a losing trade but have followed your trading plan to a T, you should be satisfied. That’s the correct thought process every trader should follow. Succeeding at trading is more about survival than seeking winning trades.

Every trader will have losing trades. If a trader does not employ good money management principles, they will likely have squandered their trading profits.

Conversely, the novice trader who uses good, conservative money management techniques will be able to withstand some losses and be able to trade another day. The ability to take a loss and stay active in the market is the key to survival and ultimate success.

Many successful futures traders will tell you that during the span of a year they usually will have more losing trades than winning trades. Yet, they are still successful because of good money management. On the balance sheet, a few bigger winning trades will more than offset the more numerous losing trades.

Protective stops

One of the most important money management tools in futures trading is the use of protective stops. Successful traders set tight stops to get out of losing positions quickly, and they let the winners ride by employing trailing stops.

By setting a protective stop upon entering a trade you know approximately how much money is at risk for that trade. You cannot assume your stop will be filled at its price, and accounting for slippage is a big part of your overall money management scheme. This is important because the risk management decision is made before you are in the trade and not in the heat of battle. One of the most popular and effective methods for placing stops is to find a support or resistance area that is within your loss parameter for that particular trade.

“Which stop can you afford?” provides an example. After sliding for nearly a month, euro currency futures appear to be in a sideways range and ready to move above the 10-day moving average, a crossover buy signal used by many trend-following traders. Assuming you want to trade with the trend, you enter a position through a buy stop at $1.20 because it is a breakout of the recent range.

Framing up this potential trade, you should know ahead of time where your sell stop will go once you get long at $1.20. The logical point for a sell stop is below the technical support level provided by the lows of the recent range. That would put the stop at about $1.1860. If you are long at $1.20 and the market drops, a stop at $1.1860 would mean a loss of $1,750 per contract (140 points at $12.50 per point for euro futures).

Too much? Too little?

Money management is about making the right decisions. For example, you must consider whether you should even trade a contract that carries a certain level of risk. Perhaps you should be trading only smaller accounts or markets with less volatile swings.

You also need to consider whether the amount of risk in a trade is too great for the size of your account or for the potential gain if prices do go your way. There may be better opportunities with tighter entry-exit signals.

If you go long at $1.20 and do not want to lose more than $500, you would have to place your sell stop at $1.1960, which does not give your position much room to survive in a market as volatile as the euro.

If you are long at $1.20 and lower your sell stops to technical support points that are more likely to ride out market swings, you have more money at risk. A stop at $1.1820 would risk $2,250; a stop at the longer-term lows of $1.1720 would risk $3,500. If you buy at the current level around $1.19 and have a sell stop at $1.1860, you also risk $500, but you are taking a bigger gamble that the uptrend will ever materialize.

Note that it usually is not advisable to place a stop at a major number. Other traders who watch charts also can see where the logical places for protective stops are, so you should tweak your stop placement a bit to stay away from the obvious. The disadvantage of this theory is that your stop may be hit anyway if a bunch of stops are triggered above your stop and prices cascade lower, adding to the damage of a losing trade.

What is ‘good’?

A good money management practice for one trader may not be a good money management practice for another. If you have a $50,000 account, your decisions may be somewhat different than if you have a $5,000 account.

Say you are up $3,000 in a sugar trade and your total trading account is only $4,000. You would have to think about ringing the cash register and building up your account so you could withstand those drawdowns and losers that will occur eventually. On the other hand, if you had a $30,000 account and a $3,000 winning sugar trade, you might want to let the winner ride a little longer, staying in a position but tightening stops to protect against a reversal. Pocketing the profit in this case would not nearly double your trading account size as it would with the smaller account.

In other words, don’t be a greedy trader. There’s a trading adage that says bulls make money, bears make money, but pigs get slaughtered.

Trading guidelines

In general, you should avoid basing your trading on the many overused trading axioms but here are a few general guidelines that have stood the test of time:

• Don’t move the placement of a protective stop in a trade that is under water. That would defeat the purpose of making your decision on how much of a loss you’ll absorb before you make the trade and are in the heat of battle.

• On winning trades you should tighten protective stops daily or more often if the market is moving rapidly.

• If you have a small account, don’t commit more than one-third of your trading capital to one trade.

• Medium – and larger – capitalized traders should not commit more than 10% of their capital to one trade.

• The larger your account, the smaller percentage you should commit to one trade.

• Never add to a losing position.

• Your risk/reward ratio should be at least 2:1.

Money management is the most critical factor to your long-term trading success. Poor money management can ruin a perfectly good system, and a perfectly good system cannot overcome the consequences of poor money management.

Jim Wyckoff is a market analyst for www.TradingEducation.com, where his commentaries on money management and other trading subjects appear. He has been involved in the financial markets for more than 20 years.

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