Is Futures Spread Trading for you?

I am a futures spread trader too!
Each year many individuals open futures spread trading accounts and begin trading on their own. Their reasons for doing so are diverse, but they generally fall into one of several categories:
  • They have had a lot of success in stocks, mutual funds or bonds and want to parlay their winnings.
  • They have had some degree of success in stocks, mutual funds or bonds but have gotten "bored".
  • They have had little or no success in stocks, mutual funds or bonds and figure they better try something else.
  • They have heard of someone who didn't know much about trading but made a "fortune" in Pork Bellies, Cotton or some other market, and figure "why not me"?

Whatever the primary reason, in most cases it is the lure of easy money that draws individuals to the futures market. And in fact, they come to the right place. Few areas of financial investment offer the potential rewards that successful futures spread trading can generate. Unfortunately, many new futures traders are so busy focusing on the "potential reward" that they overlook the "potential risk". It is this failure to properly prepare in advance for the potential pitfalls associated with futures spread trading that causes the high rate of failure among individual futures traders.

The first question that an individual who is considering entering the futures market should ask himself is NOT "how should I trade"? The first question to ask is "should I trade"? Before answering too quickly, most prospective new traders would be well served to consider the possibilities and potential pitfalls discussed below.

I. The Two Risks of Trading

Financial Risks

1. There are 4 Investment Categories to choose from:

Category Example
Growth Stocks
Income Bonds, T-bills, CD's
Inflation Hedges Precious metals and real estate
Speculation Futures and Options

2. Futures spread trading is Strictly a Speculative Investment.

futures spread trading should not be considered as anything other than a high risk/high reward play. You may make a great deal of money trading futures, however, it is very possible to lose your entire investment. In fact, in futures spread trading you can lose more than your initial investment. If you put $10,000 into an account and enter trades which lose $15,000, you will be required to immediately wire $5,000 to your brokerage firm in order to cover your losses.

3. Generally, you should not commit more than 10% of your net capital to speculative investments.

From a "financial planning" point of view, futures spread trading should not be your first venture into the investment arena. Ideally an individual should put away emergency money, invest in growth and/or income vehicles such as stock, bonds and mutual funds, in order to achieve long-term growth of capital, and buy a house and build some equity before venturing into speculative investments such as futures.

4. To trade futures in your own account, you should have at least $10,000 of pure risk capital.

"Pure risk capital" refers to money which, if lost, would not adversely impact your current life style. If you are considering trading with capital that you will need to pay the mortgage or other bills, you are inviting financial disaster. Applying points 3 and 4 together suggests that an individual should ideally have a net worth of at least $100,000 before entering the futures spread trading arena on his own. Starting with a lower net worth stacks the deck slightly against the new trader by limiting his financial wherewithal. This partially explains the high rate of failure among new traders.

Emotional Risks

1. Consider the Effects of Leverage

Because of the leverage involved in futures spread trading, the opportunity exists not only for tremendous profits but also for devastating losses. To buy $100,000 worth of stock you need to put up $100,000 dollars (even if you buy the stock on margin, you need to put up $50,000, resulting in 2-to-1 leverage). However, to trade a T-Bond contract trading at a price of 100 (each point is worth $1000 so you are trading $100,000 worth of T-Bonds), you only need to put up about $3000 in margin. This represents leverage of 33-to-1. As a result, a trader lured in by the "low cost of entry" of trading with minimum margins, will see his initial investment soar or plunge on a percentage basis. A mere 3% move in T-Bond prices - from 100 to 103 - will result in either a 100% profit or 100% loss of the initial $3000 margin requirement, depending on whether the trader was long or short.

2. Consider Your Own Tolerance For Risk

Don't expect your futures spread trading account to gain 8% one year, lose 2% the next and so on. All traders hope to avoid large swings in their account equity, however, even top professional traders suffer sharp, sudden declines in their account equity from time to time. What separates them from the rest, is that they have the financial and emotional wherewithal to keep trading through the rough periods.

Few novice traders can withstand the emotional pressure of watching a large chunk of their initial investment and/or previously hard-earned profits, vanish in a short period of time. It is quite common for traders to stop trading after a series of losses, only to miss the one big winning trade that would have more than covered their losses. If you suspect that this may happen to you, then abide by the old saying "if you can't stand the heat, stay out of the kitchen".

See If You Can Pass The Litmus Test

To determine if you are truly prepared, both emotionally and financially, to enter into futures spread trading on your own, take the following test. In order to pass you should be able to:

  1. Go to your bank on a windy day;
  2. Withdraw $10,000 in cash;
  3. Go outside, and with both hands, start throwing the money up in the air;
  4. After all of the money has blown away, go home, sit down, look in the mirror and say, "gosh that was foolish, I wish I hadn't done that".
  5. Get on with your life.

If you can pass this test, then you are truly prepared - financially and emotionally - to trade successfully. If you cannot pass this test, you may still decide to trade (let's face it, most traders cannot pass this test at the time they start trading). But if you do, you must go into it with your eyes wide open to the risks involved, and you must be prepared to take responsibility for your own actions.

II. The Two Realities of Trading

It Is Impossible to Predict Market Turns

It has become very common in the financial markets for analysts or "experts" to offer their "outlook", or predictions for various markets. In fact, it has become so common that many traders just assume that if so many people claim to be able to predict the future action of the markets, then it must be possible. Nothing could be further from the truth.

There are two great emotions at work in the markets - fear and greed. However, contrary to conventional thinking, greed is not always manifested as a lustful longing or need to make money. Quite often it is manifested in the form of "hope". And what could give a trader more "hope" than the belief that he may be able to know in advance what a given market is going to do? But, think about it for a moment. Can you think of any other endeavor where people can actually predict the future?

In order to be a successful futures trader, you must learn not to rely on predictions and forecasts. It is possible to find a person or committee or indicator or wave count which will occasionally offer a prediction which actually comes true. However, the fact of the matter is that there is no person, committee, indicator, or wave count, etc. which can consistently and accurately predict tops and bottoms in any market. It is simply not possible to do so on a regular basis.

Once you free yourself of this notion, you open up your mind to the more important task of determining the current trend in a given market. In the long run, such knowledge will be much more useful than a thousand forecasts.

Losing Trades are a Natural Part of Trading

Novice traders have a great deal of trouble accepting the notion that losing trades are a "natural" part of trading. Yet, as explained later in the Four Rules of Trading, if you are actively "cutting your losses" on trades that don't go in your favor, a losing trade can actually be thought of as a positive step, because it is the act of consistently limiting your losses to a manageable amount which allows you to keep coming back to trade another day. While losing money on a given trade is not in itself a good thing, the very act of keeping each individual loss to a minimum is a necessary step in trading profitably over the long run.

When starting out, futures traders often shoot for a high percentage of winning trades, even though that generally means taking profits quickly and missing some big winners. More experienced traders come to realize that the percentage of trades which are winners is often a meaningless statistic. In the end, the only thing that counts is if the dollars earned on winning trades exceed the dollars lost on losing trades. As long as that is the case, it matters little if 3 out of 10 trades are profitable or if 7 out of 10 trades are profitable. The key is to make alot when you win and to lose a little when you lose.

III. The Two Keys To Trading Success

You Must Have a Plan

Every field of endeavor has its Michael Jordans - top professionals who perform at a level that others simply cannot. This is true of futures spread trading. There are professional traders who rely on their wits and instincts and "gut" feelings to decide when to buy and sell - and do it very profitably. However, they are the exception to the rule. Very often new traders go into the markets with the thought of becoming the next Michael Jordan of trading. And it invariably costs them money.

Without a planned, systematic approach to trading, the odds are overwhelming that an individual new to trading will eventually succumb to the emotional pressures of futures spread trading at exactly the wrong time. No right thinking person would start a business without a clear idea as to what they want to achieve and how they intend to achieve it. futures spread trading is no different and should be approached as a business venture and NOT as a sideline or a hobby.

1. Your Trading Plan Must Address All Key Elements

  • Which markets to trade.
  • What criteria will be used to enter a trade.
  • What criteria will be used to exit a trade with a profit.
  • What criteria will be used to exit a trade with a loss.
  • How much capital to risk per trade.
  • Limits on capital committed to margin.

Individuals who begin trading without developing answers to these questions are trading on "hope" and will likely be unsuccessful in the long run. They will jump from market to market, trade too many markets for the amount of capital they have, use tight stops sometimes and wide stops another, hold losing trades in the hope that it will "come back", take small profits too quickly on winning trades, etc., etc.

2. Finished Plan Should Serve As a Road Map

At the time you enter a trade, you should already know what will cause you to exit that trade, whether the market moves in your favor or against you. A carefully thought out systematic approach is the only safeguard against emotional responses to unexpected events. To determine if your trading plan will serve as a good road map, simply ask yourself how often your plan requires you to make subjective trading decisions based on your own "gut" feeling. If your plan requires you to get up each morning and determine where the "big move" will be today, you are probably kidding yourself about your prospects for long term success.

3. You Must Have The Discipline to Follow Your Plan

If you have sufficient trading capital and a solid trading plan, the only thing that can stand in your way is a lack of discipline. A good plan and strict discipline go hand in hand. If you have a good trading plan, then you should be willing to follow it without exception. Likewise, if you are going to follow a plan without exception, it had better be a good one.

IV. The Four Rules Of Trading

Rule #1: Go With the Trend

The really big money that is made in futures spread trading is rarely gained by buying on weakness or selling short into strength. This approach assumes that you can consistently know when market strength or weakness is about to end. As discussed in "The Two Realities of Trading", it is not likely that you will be correct on a regular basis. The key is to buy when a market shows strength and to ride it just as long as that trend remains in motion. To a day trader, a trend may last only a few minutes. To a long-term trader, a trend may last for months. The key is to determine ahead of time what time frame you are most comfortable operating in and gearing your trading to that time frame. If you can't bear to hold a position overnight, then don't focus too much attention on long-term trends. If you can't follow the markets during the day, then don't attempt to be a day trader.

  • Determine Your Trading Time Frame
  • Develop Objective Criteria For Determining the Trend within your Time Frame.
  • Enter Trades Only in the Direction of the Current Trend.

Rule #2: Cut Your Losses

No part of trading is more important than cutting your losses. As discussed earlier, it is impossible to consistently predict market trends. As a result, it is simply a fact of trading life that some of your trading signals will get you in too early or too late. The greatest key to trading success is to keep your losses small and to avoid the big, debilitating hit that jeopardizes your ability to keep trading.

Rule #3: Let Your Profits Run

Rule #4: Don't Let Your Big Winners Get Away

On the face of it, Rules 3 and 4 appear to be contradictory. If you buy and the market moves in your favor and then begins to turn around, you seem to be faced with a dilemma which requires you to violate one of these rules. If you exit your position, you are keeping your big winner from getting away but you are not letting your profit run. Conversely, if you hold your position, you are allowing your profit to run but you run the risk of letting your winner get away. So what is the right answer?

The key is to plan ahead and then be consistent. In developing your trading plan you must develop an objective, systematic approach to exiting profitable trades (trailing stops, profit targets, time stops, etc.). You must then apply this criteria consistently in your actual trading. There is no way that you will always exit each trade with the maximum possible profit. Given that reality, the next best thing is to be consistent in applying your trade exit criteria.

IV. Hope For The Best, Prepare For The Worst

The only thing that is guaranteed when you start trading futures is that you will have losing trades. If that does not sound too encouraging, just wait - there's more. The phrase "hope for the best, but prepare for the worst" is probably the best advice anyone can give to a first-time futures traders. And the first-time futures traders who heed this warning are the ones that will stick around in the long run.

Some things that will almost certainly happen to you at some point if you choose to trade futures:

  1. You will buy at the high of the day.
  2. You will sell at the low of the day.
  3. You will get stopped out of a long trade at the low of the day and the up trend will then resume.
  4. You will get stopped out of a short trade at the high of the day and the down trend will then resume.
  5. You will have more consecutive losing trades than you expected.
  6. If you get stopped out 3 times in a row using tight stops and then widen your stops, that one will get hit too (resulting in a much bigger loss).
  7. If you get stopped out 3 times in a row using wide stops and then tighten your stops, that one will get hit right before a big move that you would have been in on if you had continued to use wide stops.

The difference between winning traders and losing traders becomes very apparent following events like those listed above. Losing traders will get angry, scream that the markets are "fixed", blame floor traders for "running the stops", second guess their system, wonder why they have such "bad luck", etc. Winning traders (who will avoid #'s 6 and 7 simply by consistently following their system) will simply place their orders for the next day, get a good nights sleep and come back the next day.

Just like any other business endeavor, success in futures spread trading relies on:
  • A clear cut goal (are you trading to make money or simply for the "excitement"?).
  • A realistic plan to achieve that goal - one which addresses all of the key issues involved.
  • The emotional wherewithal to believe in oneself when doubt creeps in, and the financial wherewithal to "stay the course" through the inevitable rough periods.

V. The Role of Luck In Trading

Normally, you might expect the author to wish new traders "good luck" as they embark on their journey into the futures spread trading arena. Unfortunately, implying that luck will do them any good would actually be a disservice to new traders.

In the book Market Wizards by Jack Schwager, Richard Dennis - one of the most successful futures traders of all time was asked "How much of a role does luck play in trading"? His answer was "In the long run, zero. Absolutely zero. I don't think anybody wind up making money in this business because they started out lucky".

In other words, don't hope for good luck. Enter the futures markets prepared and ready to hold yourself accountable for your actions. By doing so, you put yourself in charge of your own destiny regarding your success as a futures trader.

"The amateurs in most fields ask for forecasts, while professionals simply manage information and make decisions based on probabilities. Take medicine for example. A patient is brought to an emergency room with a knife sticking out of his chest-and the anxious family members have only two questions: "Will he survive?" and "when can he go home?" They ask the doctor for a forecast.

But the doctor is not forecasting- he is taking care of the problems as they emerge. His first job is to prevent the patient from dying from shock and so he gives him pain killers and starts an intravenous drip to replace lost blood. Then he removes the knife and sutures damaged organs. After that he has to watch against infection.He monitors the trend of a patient's health and takes measures to prevent complications. He is managing - not forecasting. When a family begs for a forecast, he may give it to them,but its practical value is low.

To make money trading, you do not need to forecast the future. You have to extract information from the market and find out whether bulls or bears are in control. You need to measure the strength of the dominant market group and decide how likey the current trend is to continue. You need to practice conservative money management aimed at long term survival and profit accumulation. You must observe how your mind works and avoid slipping into greed or fear. A trader who does all of this will succeed more than any forecaster.

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