Futures Day Trading - Money Management

By D Bennett

A key attraction of trading futures markets is that the small trader has an opportunity of quickly turning a small amount of capital into a substantial sum of money. Leverage makes this possible, and the tool to harness leverage is money management strategy.

Leverage can only enhance strategies with positive Expectancy. It cannot turn a losing strategy into a winning one. Indeed, use of leverage will accelerate the ruin of a trader utilizing a strategy with negative Expectancy. For that reason the trader must be diligent about thoroughly back-testing the strategy to ensure positive Expectancy.

Leverage is a double edged sword and must be treated with respect. But there is little point in choosing futures as your investment vehicle if you are not prepared to use it (with due caution).

Money Management comes in several different forms, but the focus here is on the technique known as the fixed percentage method.

In this method, the trader calculates a fixed percentage of available capital prior to entering a trade, then divides this by the risk amount in the trade to determine how many contracts to enter.

For example, if capital is $8,000, the chosen fixed percentage is 5% ($400), and the risk per contract is estimated at $175, then you would trade 2 contracts ($175 into $400 goes 2 times).

The biggest decision you have to make is to choose the fixed percentage you are willing to risk on each trade. The larger the percentage, the greater the leverage. The greater the leverage, the greater the risk of ruin. Obviously, if you risk 20% of your capital on each trade, a run of 3 or 4 consecutive losses will decimate the account. However, the same bad run would not have a major impact if you risk just 1% per trade.

Professional money managers with large accounts usually choose 2.5% or less. Given a strategy with a positive expectancy, this keeps the risk of ruin very close to zero.

A trader with a small account will likely choose a higher percentage to accelerate earnings. Doing so introduces a significant risk of ruin which gets bigger as the percentage increases.

This table shows the results of selecting various fixed percentages during a three month simulation of a positive expectation strategy on the electronic soybean market, with starting capital amounts of $5,000 and $100,000 respectively. The table shows the final account balance at the end of the trial period for the fixed percentages shown.

Notice that no figure is shown in the 2.50% box for the $5,000 capital investment. This is because most of the trading opportunities would be considered too risky at that level. For example, if a trade risks $175, it cannot be taken because the risk exceeds 2.5% of $5,000 ($125).

In selecting a strategy it is wise to be a pessimist. Suppose you risk 10% and lose the first three trades? Could you tolerate the resulting draw down on your starting capital? The likelihood is it would cause you to give up, or make you deviate from our strategy, which is just as bad.

Another consideration is the probability of a win for your particular strategy. If P(W) is 30%, then clearly your risk of hitting a long run of losses is greater than if P(W) is 70%. This is the case, even if the Expectancy is the same for both strategies. For this reason, I have more comfort with strategies where P(W) is high.

Despite the mouthwatering returns from higher fixed percentages in this trial, statistics always assert themselves in the end. If you trade long enough with high fixed risk percentages, you will eventually encounter a sequence of trades which will ruin you.

To avoid this fate, consider progressively reducing the fixed percentage risked to 2.5% or less as your capital grows.

Also keep in mind the number of contracts to be traded. You cannot assume that you can trade 100 contracts in the same way that you trade a single contract. The reality is that this volume will move some smaller markets, distorting your results. For this reason, the money management plan should be realistic and trade contracts in relatively low numbers compared to total market volumes.

David Bennett trades US commodity futures from his home on the Gold Coast in Australia. He provides coaching and mentoring services for people wanting to start trading for themselves. Visit http://www.12oclocktrades.com to read more futures trading articles.

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