Check out an excerpt from a post on a discussion forum about futures trading and Money Management:

“Well, I read a couple of cheap books on forex and thought I knew enough and started trading live, lost $1000 in 3 weeks. Thankfully I read a few things about money management and this loss is something I can absorb”

This supports a theme that is repeated throughout ABC Futures - Money Management is critical!

You can find this post and other good articles from this forum
here.

Stop Loss Orders

Discussions about stop placement are often related to discussions about risk management. I like to think of stops as falling into one of three categories:

Three Approaches to Stop Loss Order Placement

1) Absolute Dollar Amounts for Stop Loss Orders

With this approach, a fixed dollar amount is risked on a given trade. Many systems are programmed to use a percentage of equity to determine where to place stop loss orders.

One disadvantage to this approach is that the absolute stop loss level may not be related to a meaningful price point on a chart (for example, a previous bar’s high or low). Therefore, stops can be placed at “illogical” price levels; however, this disadvantage can be mitigated with entry points that are close to “logical” stop loss levels (i.e. a trend line or key support or resistance level).

2) Relative Price Levels For Stop Loss Orders

This approach defines a stop loss level relative to some other condition on a chart or price action. For example, some black box trading systems will enter Long and place a stop below an important low. This level may be the lowest low in the last three trading sessions, the low from the previous day, the low from the previous week or some other level that is already on a chart.

A major disadvantage of this approach is that an entry signal can be generated that is associated with a stop level that is too large for the trade. For example, if the system stipulates that the stop for a long entry is below “yesterday’s low”, and yesterday’s low happens to be very far away, due to a large trading range, then the stop loss may risk too much for that trade.

3) Combined Absolute Dollar Amount with Relative Price Level For Stop Loss Orders
This approach uses an “either or” approach to placing a stop loss order. For example, a futures trading system may signal a buy entry. The stop loss would be placed “either” below a level on a chart (a related level) or at an absolute dollar amount - which ever level is triggered first would represent the actual stop loss level. This approach combines the Relative and Absolute Stop Loss approaches.

Tech Tip - Using Options To Manage Your Trade
Many traders have been able to accomplish a very difficult task - they can predict which direction a futures market will trade and they can predict the price objective for that futures market.

However, being able to pick a winning trade is only a part of solving the puzzle of futures trading. Winning traders are able to select good trades, however they also tend to see minimal draw down on their account equity after getting into the trade. Achieving this - selecting a winning trade without minimal draw down on equity - can be difficult. This matter is addressed through money management.

Money management in futures trading taken on a variety of forms. For example, stops can be placed that provide for loss of a predetermined percentage of account equity for each futures transaction. This percentage amount can vary, depending on the account size. Other futures traders prefer a predetermined dollar amount for each trade. As specified in other areas of this site, there are many different approaches to money management in futures trading. This topic discusses managing a trade by using options of futures.

Figuring out where to best place a stop can be challenging. One way around this is to trade using options on futures. This is the basic outline for the approach:

- Using technical analysis, determine the direction, price objective and expected time frame for a futures market to move to that price objective.

- Trades are entered by first buying an option. If bearish, an at-the-money put is purchased. If bullish, an at-the-money call is purchased. Note that you always

entering a trade by purchasing an option.

- If the market reaches your price objective, you will sell an at-the-money option (if you are long a call, you sell a call; if you are long a put, you sell a put.

Overview:
Using this approach, by first buying options, you limit your risk to the price paid for the option. If the market does not go your way, then you lose your option premium. However, if it does go your way, you will sell an option once the futures market reaches your price objective. In some cases, you will “pay” for your option purchase with proceeds from the sale of an option; however this is not guaranteed. Minimally though, you will pay for most of your initial option purchase price through the sale of an option.

Your maximum risk is either a) the cost of the first option purchase; b) the net cost of the purchase and sale of the options.

Using numbers: if the S&P 500 Futures market is at 1250.00 and you believe it will trade to 1275.00, then you would purchase a 1250 S&P 500 Call Option. Factors beyond the scope of this article influence the price of the option, but for now, we will focus on the mechanics of this approach. Suppose the option cost is $1200 (this is a purely for illustration - these are not “real” price quotes).

If you are incorrect and the market does not trade higher, your option will be worthless - however you have limited your risk. If the market does trade to 1275.00, then you will sell a 1275 S&P 500 Option. The sale or proceeds of this option will be offset against the purchase price of the 1250 Call option.

One of three scenarios will occur - the underlying futures market will settle below 1250 , it will settle between 1250 and 1275, or it will settle above 1275. It will have either traded at or above 1275 or will may never have done so. If it does trade to 1275, then you have a Vertical Option Spread transaction.

Lets assume that we did have the opportunity, or good fortune, to have sold a 1275 Call when the futures traded up to 1275. At this point, if the market settles below 1250, then our maximum loss is the cost of the 1250 Call option less the proceeds from the sale of the 1275 Call option (this may be a positive number, or it may be slightly negative). The important concept is that risk is fixed.

If the futures market settles above 1275, then we effectively assume a long futures position at 1250 and a short futures position at 1275 - we make 25 points on the trade.

If the futures market settles in between 1250 and 1275, then our profit is the difference between the futures settlement price and the 1250.

Summary: you ALWAYS purchase options first - you are NEVER short options without being “covered” by another option position. You offset those options when the futures market moves to your price by selling an at-them-money option with the same expiration. This approach lets you define your risk, eliminate using stops (which can be difficult to use for some futures traders, due to the challenge of finding the right stop loss level) and lastly, you can lock in your profit and move on to the next trading opportunity.

Risk Management is a critical factor for succeeding at futures trading. Some people believe that, regardless of where an entry and exit is made, if solid risk management is applied, then a trader can be successful.

Defining a risk management strategy can be as complicated as devising a trading system. There are “text book” scenarios, such as ‘never risk more than 5% of your equity on any single trade’. Some risk management systems specify an absolute dollar loss per trade, while other approaches specify a maximum dollar amount to risk for an entire day or week.

Risk Management is closely tied to stop placement. One of the most difficult aspects of futures trading is using stops loss orders that adhere to solid risk management principles while preventing those stop orders from being executed. Overcoming this problem may require refinements to trade entry timing.

Futures traders tend to place their stops at similar levels, such as above or below a significant high or low price; or above or below the current trading session’s high or low price. The inherent nature of this results in stop loss orders being executed and then the market mysteriously turns back in favor of the now-exited trade.

There are three primary challenges for futures traders related to risk management:

More will be discussed on this topic, as Risk Management is such a critical component to successful futures trading.