The Trading Plan

Many who trade futures successfully rely on a trading plan. Just like a business plan outlines in detail the establishment and development of a proposed business, a trading plan outlines in detail a structure for trading. There are two major components of a trading plan: a method of price prediction which signals if and when to buy or sell a particular futures contract, and a risk management program which dictates the amount of money to risk on any trade, and specifies when to cut losses. Trading plans are fluid in the sense that they are constantly being tested and amended so as to improve overall performance and profitability. Strict observance of the rules of the trading plan is the hallmark of a successful futures trader.

Price Prediction

Profit on a futures trade is earned if you buy low and sell high, or sell high and buy back low. While simple in concept, this requires you, the trader, to have some idea of where prices will be several weeks or months from now. That is, it requires some sort of price prediction methodology. Most traders tend to rely on some variation of fundamental or technical analysis to predict prices. Many traders also spend considerable time and energy attempting to identify new measurements or signals that provide the edge in predicting prices. Stories abound of traders who claim to have discovered proof-positive techniques for predicting prices, and then offer to sell the information to you for a price. In my experience, genuine fool-proof techniques are very hard to come by, and I would advise you to be very careful and skeptical of such grand claims.

Traders tend to begin with a price prediction technique or model with which they are most comfortable. After use in actual trading decisions, resulting profits and losses provide valuable feedback on the effectiveness of the technique. This feedback, in turn, is used to refine and improve the model. It is important that after every adjustment to the prediction model, you accumulate feedback to ascertain the desirability and effectiveness of the change. Only those changes that improve prediction performance of the model should be made permanent. With this process, you may eventually develop a trading model that generates reliable buy and sell signals. Of course, it is also possible that you may determine that the model is unsatisfactory, and a completely new one should be developed.

To accumulate feedback on a relatively new prediction model, you may wish to place imaginary or fictitious trades to determine what the resulting profit or loss would have been had the buy or sell signal been taken. The advantage of this testing methodology is that you will not risk money until you are reasonably confident of the merits of the model. There is, however, no guarantee that the model will continue to be an effective predictor in the future, even if it has performed well in the past.

Risk Management

Another major component of a trading plan is risk management. Risk management is concerned with establishing thresholds to limit loss on any individual futures position, and establishing objectives at which profits on individual futures positions will be taken. The relative size of losses and gains must be such that, over time, gains exceed losses so that trading is profitable. This, in turn, depends upon the frequency of loss relative to the frequency of gain. For example, a trader using a certain predicting model is right half of the time in their prediction, and wrong half of the time. However, when wrong, loss is limited to $500 per trade and when right, profits are allowed to accumulate to $1000 before the trade is offset or closed. Over time and after many trades, this trading program should be profitable, all else constant.

The example above illustrates a simple risk management rule that you will find in almost all futures trading textbooks: cut losses and let profits run. In other words, if you close futures positions that begin to lose money and leave open those that are profitable, you will make money in the long run. Successful traders confirm this basic truth. Many even admit that they are wrong more often than right in predicting prices, but when they are right, they make a considerable sum of money that exceeds all losses combined. The result: trading is profitable overall.

Determining the exact amount of loss that should be tolerated before a futures position is closed depends upon several factors. The amount risked on any futures position depends upon the amount of margin in your account. It is often suggested that no more than 10% of total margin be risked on any one futures position. The amount risked also depends upon the volatility of the futures being traded: the greater the volatility, the more is risked since you want to be able to carry the position through transitory price movements, or "noise," and to not have to exit a position prematurely. The size of your average trading gain also determines to what level you should limit loss. You need to limit loss at a level such that, over time, losses do not exceed gains in the aggregate.

Many futures traders find stop orders very useful tools for risk management. Stop orders instruct the broker to close an outstanding futures position if prices move adversely to a specific level. Stop orders must be properly used to be effective. They should be placed at the same time that a new futures position is established. For instance, a trader may enter a market order to buy one gold futures when gold is trading at $385 per ounce, and enter a stop order to sell one gold futures at $379 per ounce, thus limiting loss to $6 per ounce or $600 per contract. (Be warned: stop orders do not guarantee execution at the stop price - greater loss may be incurred.) Using stop orders forces the trader to contemplate the "worse case scenario" at the outset and act to limit loss. By using stop orders, the trader eliminates much of the stress and anxiety that is associated with a futures position that is losing money. Those who don't use stop orders lose sleep instead and, if they talk themselves into not closing a position when they should have, lose a substantial amount of money as well.

Just as with developing a prediction model, the parameters of a risk management system should be evaluated over time, and amended when appropriate. Actual trading profitability performance provides the trader with valuable feedback to perform such an analysis.

Individuality

Trading plans are individualistic, based on such factors as personal experience, education, risk capital, and tolerance towards risk. For this reason, trading plans may differ greatly from one trader to the next, and any particular trading plan may work better with some people than others. Consequently, you need to develop a trading plan that works best for you. Among other things, this requires patience, rigid adherence to the rules that you establish, meticulous record-keeping of trading performance (which provides valuable feedback), and an open mind to try new and potentially better methods. There are no guarantees of profitability in the world of futures investing, but the discipline of a trading plan goes a long way toward making you a successful futures trader.

Article provided by World Link Futures