Managing risk is a critical component of being an effective futures trader. First and foremost, since trading futures and other financial vehicles is inherently risky, only risk capital should be used for futures trading.
Identify Your Risk Tolerance
Defining your risk “comfort level” is essential to having a balanced trading methodology. This is known as risk tolerance. Another way to describe risk tolerance is how much of a loss a trader is willing to endure – one with a higher risk tolerance is willing to lose more risk capital (with the possibility of greater returns) while a conservative trader with a lower risk tolerance could not stomach the same loss.
Having a realistic risk tolerance is a crucial component of a trading foundation and will allow you to manage both gains and losses more effectively. Factors which often play into risk tolerance include age, investment goals, income, available risk capital and overall risk aversion.
Some questions to ask yourself to help determine your risk tolerance include:
- What percentage of your initial investment are you comfortable losing?
- What amount are you comfortable losing in a day? A week, month?
- How much futures margin is required to enter & maintain a position?
- How historically volatile is this futures contract? Maintaining funds in your account above the minimum margin requirement while in a position, known as excess margin, may be needed in order to anticipate contract volatility.
Always remember that past performance in not indicative of future results. Only funds that can be lost without jeopardizing your financial security or lifestyle should be used for trading. The importance of ensuring that your trading strategy appropriately reflects your risk preferences cannot be overstated.
Use Stop Loss Orders
Stop loss orders can help to protect trading capital by closing a position when the market turns unfavorable.
“Stop loss” refers to a category of orders, not one specific order type. Understanding both basic and advanced order types will help you determine which type of stop loss order to use in each particular situation.
There are 3 distinct order types used when implementing stop loss orders as a risk management technique.
- Stop Market Order – A stop market order is a basic order type which issues a market order once a specified price has been reached, known as the stop price. Once the stop price has been touched or surpassed, the stop market order becomes a market order and will execute at the best possible price.
- Stop Limit Order – A stop limit order is similar to a stop market order, except that when the stop price is touched or surpassed, a limit order is issued. This gives you more control of where the order will execute but on the other hand, does not guarantee a fill.
- Trailing Stop – A trailing stop is a dynamic stop loss order which “trails” behind the price if it moves in your favor. Trailing stops can only move in one direction. For example, once a trailing stop has moved up, it cannot move back down. In this way, trailing stops are not just for preventing losses, but can be used to lock in profits for favorable trades.
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