Originally published at: https://optimusfutures.com/tradeblog/archives/how-to-manage-risk-in-futures-trading/%20
This article on Futures Trading Risk Management is the opinion of Optimus Futures
The reality of the markets is very different from those faced in most situations in life and work. The difference, of course, is the level of speculative risk. Strangely, many futures traders who don’t quite get this try to develop methodologies, approaches, or even futures trading rules aimed to eliminate all the uncertainty and ambiguity from the process of trading in order to make trading decisions more confidently.
Well, as most successful futures traders might tell you, this can only lead you down the wrong path. Risk embodies uncertainty, as uncertainty is often accompanied by risk. As traders, we don’t shy away from risk. We engage it. We assume it. Risk is our theater of operations. But to eliminate all the uncertainty and ambiguity is to make your measure, your context, your tools “super-fragile”, as Long Term Capital Management (LTCM) showed us with its massive blow-up back in the 90’s.
Their arbitrage system eliminated all statistical “uncertainties” — most of them, at least. There were no “ambiguities” in the way they saw the markets. The problem, however, was that their system got it all wrong. Like, $4.4 Billion wrong. Believing they had a near-perfect “ruler” to measure market activity, they somehow forgot that sometimes the thing being measured (i.e. the markets) reflects more the quality of the ruler than the ruler a measure of the thing.
There is nothing wrong with being uncertain. But where you want to be confident is in your capacity to work with the circumstances that make the market environment uncertain. You want to be agile enough to turn uncertainty into a potential advantage. In other words, success in trading potentially hinges on your ability to adapt to uncertain and often fickle trading environments, rather than trying to find a way out.
Below we list five key aspects of futures trading risk management to help you adjust to market uncertainty.
Distinguish Between High and Low Quality Trade Setups
It isn’t uncommon to feel nervous when entering a trade. But you shouldn’t doubt it either, that is, if you did things right (measure your setup, calculate your risks, etc.). It doesn’t mean that you are 100% confident your trade will work out as planned. It’s more like you’re 100% confident that you know what to do if it doesn’t.
One of the most important ways to settle doubts in your mind when executing a trade is to clearly identify and choose between varying trading setups in terms of quality. Pick the best setup, make sure you understand it completely (e.g. risk/reward, profit, and termination points), and execute it. In the end, it’s really the best you can do. But note that many traders can’t even get this far.
Whatever set of triggers you use to decide your market entries, you need clear-cut rules to distinguish between high-quality and low-quality setups, which can either be too risky (low return-to-risk setups) or whose conditions or potential payoffs are too obscure. In other words, you need to know how to filter trades based on risk and reward.
This, of course, is much easier said than done. It might take a considerable amount of iterations, testing, and tweaks to get your trading method to your desired level of objectivity and effectiveness. But it’s worth it. Knowing whether you are entering a potentially high probability trade setup versus a low probability trade setup can help you go a long way in terms of preparation and dealing with live-scenario outcomes.
You are more likely to accept a loss on a trade that you know is aggressive and high risk, than taken aback by a loss taken on a trade you thought was a high-quality trade setup. Not being able to distinguish between high- and low-quality trade setups is a place you don’t want to be.
Plan Out Contingencies
If you haven’t planned alternate solutions to potential contingencies, then you may find yourself struggling when unexpected market movements take place.
Often, simply relying on high-quality trade setups may not be enough to escape the perils of unexpected price movements. As we mentioned at the beginning of this article, there is no proven way to ensure accurate price predictions and as such, no level of trade setup quality can ever insure you against the likelihood of an uncanny price move derailing your trade.
The solution is to consider all potential outcomes on the trade. This is not just a matter of statically determining whether a trade may be a winner or loser but rather how price action might dynamically change the winning and losing conditions of a trade. Outlining potential support and resistance areas on the chart that you believe could hinder price from moving in your preferred direction is a good starting point. Better yet, plan for potential moves against your initial setup. How might you react if x happens, or x1 or x2 or x3? How might you adjust your position? Try to eliminate most elements of “foreseeable” surprise (as ironic as that may sound).
The chart above illustrates just one potential trading opportunity marked out with various support and resistance levels in close vicinity that could serve as valid checkpoints as the trade develops. During the trade, how will you respond if price broke below the higher lows at [A], [B], or [C]? With potential targets at [1], [2], and [3], how will you respond if price fails to reach each level? Or how will you determine your position size should you anticipate price reaching each target level?
Having a deep understanding of the markets and price action dynamics is a crucial skill that can take the sting out of uncertain trading environments. And all trading environments are relatively uncertain. While predicting the next market move with 100% accuracy is virtually impossible to do, having a deep understanding of a given market can give you a relative edge, providing you with a better grasp of potential outcomes.
Stay Away from Rigid Trading Plans
New traders often intuitively fall back on rigid and inflexible trading plans to eliminate all guesswork and mental strain arising from making ad hoc trading decisions. Bad move. As counterintuitive as it may sound, leaving some level of subjectivity and variance in your trading plan is essential to a well-rounded and competent trading style.
Perhaps you expect the market to tick higher in line with the current uptrend momentum. Instead of merely ticking up, the market skyrockets by several points, possibly on some favorable news development or economic report. Would you want to raise your final target (and exit point) for the trade to benefit from the better-than-expected reaction from the market? Or would you stick with your original price target?
Conversely, you may be expecting the market to break below (or above) a support (or resistance) area. But instead, the price ends up just hovering near your anticipated level. You may want to alter your trading plan, perhaps tightening your stop loss or moving your take-profit level a little closer to account for the dissipating momentum.
The point here is to be able to find the perfect balance between the objective aspects of making trading decisions (classifying trade setups, marking out clear-cut trouble areas for price) and the subjective aspects (some flexibility in trade management) resulting from variance in market conditions.
Let the Numbers Play Out
This might be one of the most important factors to consider while trying to deal with the ambiguity prevalent in your day to day trading. Cumulative trading results hardly ever hinge on a single trade or, for that matter, even a small group of trades.
If you truly have a trading edge, it can only be confirmed over a wide sample size of trades. Your last trade doesn’t really count, so don’t fall victim to the tendencies of “recency bias.” You must take into account all of your trades, and this develops and changes with each and every subsequent trade you make. Analyzing your past trades can also provide valuable insights into how you can improve your system and increase the asymmetric risk and return ratio.
Realizing the importance of the numbers game can go a long way in settling your nerves (unless you are unsuccessful, for one reason or another). Remember, the quality of your method and execution will always be secondary to your live results. When it comes to trading, your overall sustainable profitability settles all–it’s the final and foremost measure.
Practice Makes Perfect
Everything we’ve discussed so far connects with the number of hours spent behind your computer screen. It’s about practice. And we’re not talking about “demo” practice. That should be left behind as soon as possible as it doesn’t come close to the live market.
Planning out all contingencies requires an alert mind that is open to various angles of chart analysis – a skill that gets better with time and practice. Finding the right trading method that clearly differentiates between good and bad quality trades also takes time to develop. As there is no one-size-fits-all trading method out there that guarantees success, any workable method will usually involve iterative and corrective processes to refine it to suit your unique trading personality and style.
Such a system is important to help you manage risk and navigate across uncertain trading environments, but it can also take time to develop. The same is also true for developing trading management strategies with the right amount of flexibility to deal with live market activity.
As long as you are committed to improving your trading and are willing to put in the time and effort required to hone your trading skills, the ambiguous aspects of your day to day trading will cease to bother you given time.
But even with ample practice, you will never be able to eliminate all risk and uncertainty from your trading. Remember, trading is all about managing risk and engaging uncertainty, that is, intelligently engaging risk. That’s why trading is called “speculation.” But with enough practice, you may evolve into a capable trader who is immune to the anxieties of not being able to predict future outcomes. In other words, you may finally learn what trading is about, and how to do it right.
There is a substantial risk of loss in futures trading. Past performance is not indicative of future results.