Futures were originally created to help farmers hedge against changes in the prices of their crops between when they were planted and sold. Since then, futures trading has exploded to include contracts linked to a wide variety of assets including precious metals, energy, stocks, bonds, and industrial metals. In this article, we’ll take a look at 10 rules that futures traders should follow in an effort to limit risk and maximize reward.
10. Get Familiar with the Terminology
Trading futures contracts without knowing the lingo is like driving on a curvy road with a blindfold. From terms like backwardation to mathematical Greeks, like delta, traders should be familiar with futures terminology in order to understand the trades they are making and avoid potentially costly mistakes.
Futures traders should at least be familiar with basics like:
- Convergence – Convergence is the tendency for prices of physical commodities and futures to approach each other, especially as the delivery date approaches, giving traders an idea of where futures are headed.
- Maintenance Margin – Maintenance margin is the amount of money needed to hold on to a futures contract; failure to maintain maintenance margin could result in the position being automatically closed by a broker.
9. Plan the Trade, Trade the Plan
Sun Tsu once said, “the general who wins a battle makes many calculations in his temple ere the battle is fought.” Carefully planning a trade in advance can eliminate emotion from the equation, reduce the likelihood of error, and increase the odds of a successful trade, as well as the long-term success of an account.
Here are some ways to effectively plan trades:
- Define SLs & TPs – Traders should have a specific idea of where their stop-loss and take-profit points lie before making a trade. That way, there’s no emotion involved in deciding when to close the position.
- Consider All Scenarios – Traders should consider adverse scenarios in addition to expected scenarios. Having a good emergency plan can avoid catastrophic losses resulting from an unexpected turn of events.
8. The Trend Is (Usually) Your Friend
Catching a falling knife usually results in getting cut. Traders are usually best off trading along with the trend rather than trying to pick market tops and bottoms. In 1984, the famous Turtle Traders demonstrated just how successful trend-following could be by following a simple set of rules to generate consistent profits [see also 25 Stocks Day Traders Love].
Traders should keep the following advice in mind:
- Moving Averages – Moving averages represent the easiest way to view short- and long-term trends by smoothing out short-term volatility. Moving average crossovers are also a common trading strategy in futures markets.
- Reversal Indicators – The relative strength index (“RSI”) and moving average convergence divergence (“MACD”) can indicate the strength of trends. When these indicators turn one way or another, traders can adjust their positions.
7. Be Patient and Don’t Overtrade
Overtrading tends to result in lower overall returns, particularly in rising markets, according to some studies. Many beginner futures traders make the mistake of buying and selling more frequently than necessary. These traders also tend to sell winning positions too early, resulting in potentially large opportunity costs.
Here are some tips to avoid overtrading:
- Risk Capital – Futures traders should only trade with capital that they can afford to lose in order to prevent the urge to trade based on emotion. Excessive worrying can result in knee-jerk decisions to sell.
- Let It Ride – Traders should try and hold on to winning positions until there’s a good reason to sell. That being said, it’s usually a good idea to lock in profits along the way in order to reduce portfolio risk.
6. Always Use Money Management
Many successful traders succeed due to effective money management rather than picking more winners than losers. After all, picking just a few winners can produce high returns over time if losers are quickly eliminated. Despite the importance of money management, it’s a practice that traders commonly ignore in futures.
Here are some money management tips to keep in mind:
- Position Sizing – Traders should carefully consider the amount of risk that they’re willing to assume on a trade and size it appropriately. Conservative traders often limit positions to 5%-7% of their total portfolios.
- Smart Stops – Traders should place smart stop-loss points based on key technical areas rather than assigning arbitrary price points. For example, placing a stop-loss just under trend line support may be a good idea.
5. Use Leverage Carefully
Leverage is a double-edged sword. On one hand, 50% initial margin means that traders can purchase twice as much as they would be able to purchase with cash alone. The catch is that traders can also lose money twice as fast, and they can lose more money than the futures position is worth in the first place.
Here are some tips to manage leverage-related risks:
- Watch Volatility – Trading futures contracts that have low volatility involve significantly less risk than futures with greater volatility. Volatility can be measured by looking at beta coefficients in futures and physical markets.
- Use Spreads – Traders can simultaneously buy and sell two different commodities to reduce risk. These spreads limit risk by offsetting losses on one trade with gains in another trade.
4. Always Maintain Excess Margin
Trading on margin enables traders to leverage their positions. While this means they can control a larger amount of assets with a smaller amount of money, traders have the ability to lose more than the value of their assets and cash. Brokers initiate a margin call when futures drop below a threshold known as a maintenance margin.
Here are some general guidelines to avoid these issues:
- Keep Cash – Traders should deposit funds into their account beyond what is required to fund basic margin requirements. By staying well above the maintenance margin, there’s a lower probability of a margin call occurring.
- Risk Capital – Traders should only trade with risk capital in order to avoid losing money they can’t afford to lose. Having money on the sidelines can also help shore up margin and prevent a margin call on risk capital.
3. Know Your Technicals
Most traders hear things like “the market is bottoming” or “the market is breaking out” all the time. These phrases are associated with technical analysis – the use of statistics to interpret past price performance and make predictions. A significant number of futures traders make trades based on technical analysis.
Here are some basic concepts to know:
- Indicators – Technical indicators include statistical studies like stochastics, relative strength indexes, or moving averages. They provide key insights into the strength and direction of trends as well as market behaviors.
- Chart Patterns – Futures charts show a less quantitative and more qualitative picture of what’s happening in the market. Certain chart patterns can be indicative of breakouts, reversals, or other important price movements.
2. Avoid Directional Bias
Many futures traders prefer to be long-only traders, which means that they may not entertain the idea of taking a short position. These types of attitudes can lead to significant opportunity costs by eliminating a full 50% of potential traders. Traders should instead keep an open mind, considering both long and short positions.
Here are some tips to avoid directional bias:
- Don’t Just Sell – When selling a long position, consider the possibility of making it into a short position if the trend has changed. Reversals often create the opportunity for a bearish position in the market.
- Limit Risk – If short selling causes apprehension, traders can try and limit the risk of short positions. For example, engaging in spread bets or setting tight stop loss points can limit the potential losses from a short position.
1. Know Your Fundamentals
Fundamental investors like Warren Buffett have become famous in the equity markets, but many futures traders excel primarily at technical analysis. These traders could help improve even further by considering the many fundamental factors that influence commodities, currencies, and other futures.
Here are some examples of fundamentals to watch:
- Economic Indicators – Economies around the world ultimately drive demand for futures, which means that economic indicators are important to watch when deciphering long-term macroeconomic trends.
- Commitments of Traders – Commitments of Traders reports from the CFTC can provide valuable insights into open interest in commodities. For instance, traders can tell whether hedgers are moving in or out.
The Bottom Line
Futures provide sophisticated traders with the ability to speculate on unique markets, but certain precautions should be taken to limit risks and maximize returns. The 10 commandments of futures trading highlighted above can help you achieve these goals by avoiding many of the mistakes that novice (and expert) futures traders make.