Futures For You
| INSIDE THE FUTURES
WORLD
Want to learn how the futures markets really work? Dan
O'Neil, a principal at online futures and forex broker Xpresstrade (www.xpresstrade.com),
responds to your questions about today's futures markets.
To submit a question, post your question to our website
at https://Message-Boards.Traders.com. Answers will be posted there, and
selected questions will appear in a future issue of S&C. |
Dan O'Neil |
STOP BEFORE THE RED
How important are stop orders in futures trading?
Most successful traders agree that good risk management is essential in the futures markets. To this end, trading with protective stops is an integral part of a disciplined trading methodology. While some traders avoid using stops for fear of being taken out of a good trade too early, the risk of inaction is often far greater.
A stop is an order that becomes a market order when the futures contract reaches a particular price level; a sell-stop is placed below the market, while a buy-stop is placed above the market. The underlying idea is to minimize losses should the market turn against you.
In recent years trailing stops have gained in popularity because they allow the trader to profit from favorable movement in the market while also having protection in place. A trailing stop is usually entered with a primary order to establish a new position. It is not entered at an exact price, but rather at a specified distance from the price at which the primary order will be filled. Once the primary order is executed, the trailing stop will begin to work according to market fluctuation.
To get an idea of how this setup behaves, think of the market and the trailing stop as though they were connected by a chain. When the market moves in your favor, the chain becomes tight and the trailing stop is dragged along. But when the market changes direction and starts to move against you, the trailing stop price remains steady. Once the designated price has been reached, the trailing stop immediately converts into a market order to offset your open position in the market.
Because of the importance of risk management in trading the futures markets, the effective use of stops and trailing stops may be one of the most important fundamentals for traders to grasp.
THE MYTHS OF FUTURES TRADING
I'm considering diversifying my portfolio by getting into futures, but I'm concerned about things I've heard. It sounds like I'll need a lot of money to get started, the risks seem high, and I don't really want a truckload of soybeans in my front yard. Am I right to be worried?
Despite the attractiveness of commodity futures and options as investment vehicles, the fact that they don't get as much coverage as stocks has allowed a number of misconceptions about these markets to circulate. Let's take a look at the real story behind three myths about the futures markets:
1. I need a lot of money to trade futures. While this may have been true years ago, many products now available to retail investors have made investing in these markets easier and more affordable than before. Emini contracts in many popular markets like the Standard & Poor's 500 and gold futures can represent thousands of dollars, but investors need only pay a small percentage in initial margin to begin trading, often as little as $500.
However, it's possible to trade commodities that don't offer mini versions as long as you manage your money wisely. If your account size is limited to $5,000 or $10,000, make sure you're discriminating in choosing your positions and calculate your potential loss before you enter into a trade. Many smaller traders can be active for a long time simply by applying a disciplined strategy to their trading.
2. Futures are too risky - I can lose my money before I know what hit me. Like all investment vehicles, futures carry risk. In fact, because these are often highly leveraged transactions, not only can you lose the principal you invest, but in some cases, you might lose more. That's why brokerage firms monitor your account and positions. When the amount of capital in your account draws down due to adverse market movements, your broker will issue a margin call, allowing you to add funds into your account before your positions are liquidated. This helps prevent your entire account capital from being depleted. If you deposit the full contract amount in your account rather than trading on margin, this is not an issue.
It's worth pointing out that maintaining an investment portfolio without futures can be considered risky, as futures can be used to hedge other positions. If most of your portfolio is invested in stocks, you'll lose money when the market goes down. But by holding positions in commodities such as gold - which moves contrary to the stock market - you may make money to offset those stock losses.
3. I'm going to get a load of corn delivered to my door! This is a common concern for newcomers, but in reality, many contracts available these days to retail investors don't even offer the option of taking delivery of a physical commodity contract - they are purely speculative and hedging instruments.
In other cases, it's going to be difficult for you to accidentally take delivery of a commodity. To do so, you need to hold the contract past its first notice day, and then begin a process that includes financing the entire underlying value of the particular contract. Most brokerage firms will notify you if you're holding a contract that is approaching the day, and unless you have specifically made arrangements with your firm, most will liquidate the contract even if they cannot get in touch with you.
Originally published in the January 2007 issue of Technical Analysis
of STOCKS & COMMODITIES magazine. All rights reserved.
© Copyright 2006, Technical Analysis, Inc.
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