50 Basic Rules to Trading Commodity Futures - Do's & Don'ts Trading Rules

Apply money management techniques to your futures trading

"Pit Sense" from a veteran traders view-point.

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Do's and Don'ts of trading futures and commodities

Trade and Risk Management

Course Overview

If you have an approach that makes money, then money management can make the difference between success and failure...I try to be conservative in my risk management. I want to make sure I'll be around to play tomorrow. Risk control is essential. - Monroe Trout, Trout Trading Fund

Controlling risk while trading takes many forms. It starts with properly selecting which markets to trade, then moves on to decisions about allocating capital and taking appropriate-sized positions. But managing risk and limiting losses also is accomplished through understanding risk itself as well as human nature. Any trader’s chance for success improves with a disciplined use and understanding of money management techniques.

What you need to know about risk management

•The key to trading success is in managing risks and avoiding over trading. In order to control your risk, you must first identify your risks.

•Risk management begins with each new trade. Futures traders that fail to use the risk-management techniques at their disposal will struggle to be profitable.

•Prior to taking any new trade, you must know where you will exit (i.e., where to put your stop) and how much equity is in your account. The difference between your entry price and stop-loss point (converted into dollars) tells you how much capital to risk per trade.

Trade and Risk Management

THE DO'S

Here are 10 simple steps you can take to increase your potential for success in trading futures.

DO HAVE A TRADING PLAN

One of the most common things written in books and articles on trading (whether stocks or futures) is to have a plan. That means knowing the following BEFORE a trade is put on:

  • Where is the entry point and why?
  • Where is the protective stop going to be placed?
  • Where will you begin to take profits?

DO STICK WITH YOUR PLAN

Knowing the answer to all three of the above questions before you enter a trade also will prevent you from having to make tough decisions as the market is moving. You will already know what to do. Nothing is worse than having your broker call you to tell you bad news, and have him or her expecting a decision immediately on what to do. While some flexibility is also important, remember that you came up with your plan for a reason.

DO KNOW YOUR RISK

This goes hand-in-hand with having a trading plan. Knowing how much you are willing to risk on any one particular trade is just as important as knowing how much you are willing to risk on trading in general. An account should always be opened with risk capital—which is money that you can walk away from if lost, without any hardship. That amount of money is up to you, the trader. Your broker should be made aware of that amount as well. As far as individual trades — have stop orders in place so a market can’t get away from you. Also, be aware that options can be used as a hedge against a futures position. Most new traders are unaware of how that can be done, but it is a vital component of professional trading. Ask your Cleartrade Futures broker how this works.

DO TAKE PROFITS

Most new traders seem to have an aversion to profits. That seems like a ludicrous statement, but it is nevertheless true.

Many traders seem to have the habit of thinking that the market will always go their way—it will never reverse. So Mr. Greed tells them to stay with the trade forever, but that simply is never the case. You have to exit a trade to turn that position into cash. Settle yourself to this fact.

If you have profits, TAKE THEM! The markets have been around for hundreds of years, and they’re not going anywhere. That one trade that is making a lot of money is not the only trade you will ever make.

DO BE AWARE OF MARGIN

Margin is one of the great advantages to trading futures. The margins on futures products tend to be far less than stock margins. That makes futures vehicles more leveraged. And that means that those markets can move your account much faster. Take that one step further, and you realize that the profits—as well as the risks—can come quickly and in larger magnitude than other forms of trading.

The margin on your account tells you how much cash (total equity) is being set aside for margining on your positions. The initial margin is the amount needed to initiate a new position, and the maintenance margin is the amount needed in your account to avoid a margin call. The available cash (margin excess) is the amount of money available to add new positions. Margin calls occur when the cash in your account falls below the maintenance margin requirement. If that happens, you will need to send additional funds or in some cases liquidate enough of your position to eliminate the margin call. That’s why it’s important for traders to stay abreast of market conditions. For some people that can be time-consuming, Cleartrade Futures Brokers are here to offer that additional support.

Most firms will allow a client to meet margin calls in a day or two. But some circumstances occur when a firm might give you as little as 1 hour to meet the call. That is telling you that you’re in trouble. A common guideline is to have no more than 50% of your account used in margin at any one time. (Using less would be even better.) This is also where options can be used to help offset margin. If an option is used as a hedge, margin is often lowered or nonexistent.

DO LEARN HOW TO PLACE ORDERS

There is a common language used by employees in the futures industry. Learning it can save you many problems, as well as a lot of money. The phrasing of an order to a broker is paramount in the execution process. Not a day goes by when a newer trader wants to go short a market and says to “buy me one,” assuming that the broker knows what he or she is thinking. If you think a market is going lower, you want to sell (or short) the market. If you think a market is going higher you want to buy (or go long) the market. If you’re exiting a position, you say the opposite of what is in the account. Meaning, if you are long 5 Dow and you want to exit, you say “Sell 5 Dow.” If you’re short 5 Dow and want to exit, you say “Buy 5 Dow.”

A buy vs. sell error is one of the most devastating errors in this business. It is one of the main reasons why orders are taped, so that there is a record of what exactly was said—because a broker has to do exactly what you say. A good broker will help you through this process and teach you the proper terminology. There are also various types of orders at your beck and call. There are market
orders, limit orders, stop orders and stop limit orders just to name a few. They all have different meanings and effects. And to add to the confusion, some markets accept some and some markets don’t. So ask your broker about the best type of order to use, and learn about them.

Market orders are the quickest and most effective way to get something done. If you are at a point where you want to get out of or into a position, the easiest way is with a market order. Yes, you will experience slippage—but at least you’re filled. This is especially important when taking profits.

DO ASK QUESTIONS

Don’t be afraid to ask questions about trading. There is a variety of sources available for information—including hundreds of websites, advisors, newsletters, etc. But most importantly, ask your Cleartrade Futures broker.

There is a common misconception that your broker doesn’t care whether or not you make money, but that’s just not true. A good broker wants you to make money because you will most likely continue to trade with him or her if you’re profitable. Also, a good broker will encourage you to ask questions because he or she knows that the more informed a client is the better off that client will be.

The communication process between you and your Cleartrade broker is of the utmost importance. And lastly, a good broker will want to educate you so the likelihood of errors and miscommunications is greatly diminished.

DO BE PATIENT

This bears repeating. Be patient and think everything through before making a decision. Avoid the “Chicken Little Syndrome,” where it looks as if the sky is falling. It isn’t. Take your time. And if you find yourself getting too emotional, compose yourself. A well thought out decision is usually better than a hasty one.

DO ACCEPT RESPONSIBILITY FOR YOUR MONEY

The funds you send into a trading account are your money. Only you truly know how important it is to you. A broker, newsletter writer or TV commentator doesn’t know the true value of your money. That money is inherently your responsibility. Trading funds should be risk capital. This means that if all of it is lost, you will not suffer any adverse affects to your life. In other words, don’t risk the mortgage money on trading. Anything can happen in these markets (and often does). That is why they are so exciting.

DO ENJOY THE EXPERIENCE

Done properly, trading can be one of the most rewarding experiences of your life—not just financially, but also mentally. There are certain feelings of accomplishment that traders feel when they do their homework, plan out a trade, and execute the trade to profitability. Some newer traders take their time to learn the business and graduate into more professional traders. Sadly, others do not. Take your time and enjoy.

THE DON'TS

Because Dos are the fun part, we’ll start with the few missteps you should avoid to enable your own potential success—and end on a happier note.

DON’T THINK OF TRADING AS INVESTING

Retail clients might call their brokers up to ask: “How are my investments doing?” The sarcastic answer, always left unsaid, is “I don’t know, call your financial planner.” Trading is a short-term thing. You enter a position with the expectation of exiting it quickly. That can be anywhere from 30 seconds to 3 months, depending on your strategy. Investing is a longer-term process, generally lasting years. The only thing the two have in common is that you need to exit a position to turn it into cash. Other than that, they are inherently different and you should realize this when trading futures.

DON’T LET EMOTIONS GET IN THE WAY

Trading is an extremely emotional exercise. In fact, it is said, 85% of trading is knowing how to handle the psychology involved with trading. The rest is actual “book smarts.” It is emotions that move markets—the emotions of fear and greed being the most prominent. Fear generally makes a market move lower, and greed generally makes a market move higher. Learn to divorce yourself from your fear and greed when making trading decisions because decisions based on emotion are often the wrong decisions.

John Templeton, founder of Templeton Funds, was once asked how to know when to buy or sell a market. His response was simple, yet very complex: “I buy markets when everyone else wants to get out of them, and I sell markets when everyone else wants to get into them.” This means that a mass thought process played an important role in his decision-making process. When everyone else is scared to death to be in a particular market, he would like to buy. When everyone else thinks a market is the next big killing, he wants to sell. The Templeton Funds were one of the most successful groups of funds on Wall Street. Don’t let your emotional attachment to money cloud your decision-making process.

DON’T LET A WINNER TURN INTO A LOSER

Too many times, new traders find themselves in the enviable situation of having a nice winner on the books. Sometimes those winners can be 5O%-75% of a particular account’s value. While traders always want to get the most out of a market’s move, many newer traders let greed and ignorance get in their way. They think that the market will continue in their way forever. Well, the truth of the matter is that markets don’t go straight up or straight down. They fluctuate all the time, sometimes with a tremendous amount of volatility. If you have a winner on the books, protect it. Don’t let it turn into a loser. There is nothing more demoralizing to a newer trader than to have a 10K winner turn into a 20K loser. And don’t think it won’t happen to you; it happens to everyone. Talk to your Cleartrade Futures broker about stop orders and to learn profit taking techniques.

DON’T FORGET THE IMPORTANCE OF OPEN INTEREST AND VOLUME

There are two statistics that all traders should watch: open interest and volume. Those two numbers will tell a trader how deep a market is. A general rule of thumb is that the higher the open interest and volume, the better the fills in that market. And more importantly: The more liquid a market, the more fluid it moves.

Open interest is a number that tells you how many existing positions there are in that market. Volume tells you how much trading has been done in that market. If the open interest in a market is low, it is telling you there are not many market participants in that market. Many times newer traders ignore open interest figures and trade markets with usually low open interest, like rough rice or pork bellies. They say they like those markets; they have an affinity for them. But what they don’t realize is that if they are trading rice and the open interest is 2K-3K, 1500 of it could be in positions from General Mills or Kellogg’s to hedge their business risks.

Unfortunately, many newer traders find themselves on the opposite side of those big positions. Who do you think is going to win that battle, Joe the barber from Iowa or General Mills? The larger the open interest, the larger the number of market participants—therefore, the less likelihood of that market

This leads us into the importance of first notice day and last trading day. First notice day and last trading day are times determined by the exchange, when holders of open positions have to; exit trades, declare the desire to take delivery, or deliver on the underlying asset. In other words, it is when all the speculators get out of the pool. The open interest in markets starts to drop when you get closer to first notice day, thereby thinning out the number of participants. Why is this important? Many times newer traders hold a losing position, going into the last trading day with the hopes that the market will turn around in his or her favor.

The problem is, as more and more traders exit that market due to first notice day, the trader with the losing position can get stuck in a market where it is him or her and a handful of other smaller traders and one or two very large institutions. Once again, who do you think is going to win that one? Please pay attention to open interest, volume, first notice and last trading days.

DON’T PUT ALL YOUR EGGS IN ONE BASKET

While cliché, truer words were never spoken. Diversifying allows you to spread out your risk. This way, when return is down in one area, you have better probability of showing positive in another area. Properly diversified portfolios can help stabilize a lot of the ups and downs in the markets. Studies have shown that over lengthy periods, investors didn’t have to sacrifice much in the way of returns to get reduced volatility. Talk to your Cleartrade Futures broker about a Managed Futures Account.

DON’T FALL PREY TO RUMORS

Rumors don’t follow any rules. Anybody can make up a rumor at any time with no evidence to back it up. Trading on rumors will result in bad decisions more often than not. Don’t do it!

DON’T PICK MARKET TOPS AND BOTTOMS

Watch the trend and wait for it to confirm the direction. You will never sell the exact top of a market or buy the exact bottom of a market. Professional traders don’t even attempt to do that. So why put that type of pressure on yourself? If it happens, it is generally luck.

DON’T WAIT TO “CATCH UP” ON A LOSING TRADE

You should be prepared to cut your losses if a trade is heading south. It might be hard to admit when you’ve made a mistake, but it’s even harder to lose more money. Many experienced traders say that if a position still goes against you the third day in, get out. That’s why stop orders are important.

DON’T FORGET TO LEARN FROM YOUR MISTAKES

Nobody is perfect when it comes to futures trading, but each mistake can turn into a learning opportunity—whether you should have gotten out sooner or held on longer. Examine the trends at the time of your errors, and you could learn some valuable lessons.

DON’T JUST JUMP INTO IT

While the temptation to just get started might be great, trading futures without the proper tools and research can be a scary prospect. At Cleartrade, we have accounts for every level of trader. For beginners, our Full-Service Accounts will help guide you through the process of learning futures trading. As you become a more experienced trader with developed skills and techniques, you might be interested in migrating to a Cleartrade more hands-on Self-Directed Account.

Paper trading.

It's not glamorous and it's not fun but it is probably the most important thing you can do to ensure your success in trading any financial instrument. While you are doing it you will think the opportunities are passing by that will never present themselves again. That is not true. Many investors fail because they get caught up in the excitement or the latest, "can't miss" trading strategy. You should test every strategy, including those presented in any newsletter, to see if they will work for you. Remember, if you cannot turn a profit trading simulated money in an imaginary account nothing different is going to happen when you start using real money.

Know your point of exit before you get in. Always have an objective and how much you are willing to risk BEFORE you buy a contract. Sell when that limit is reached. Ask anybody who ever held a contract too long and lost their money. They will tell you how "they wish they had exited their trade". You can always convince yourself that tomorrow is a turnaround day. Many traders lose money trading because the turnaround never came for them. Plan your trades and your plan.

Risk management is all important.

You will never go broke taking profit. Take a small profit over and over and over again. Better to take a little profit than to hold out trying to double your money again and again. Remember, double or nothing will eventually get you nothing.

Always use a stop-loss. To trade without a stop-loss is like jumping out of a perfectly good airplane without a parachute.

Never put in a MARKET BUY before the open. You will more than likely get filled at the high of the day. Enthusiasm is rampant at the open and everything costs more (as a rule) than it will an hour later.

Never try to pick a top or a bottom, a product is lower or higher due to a reason. You don't have to be on board at the absolute top or the absolute bottom to make a profit. Better to confirm the trend by checking your charts. Remember, the trend is your friend.

Never change your stop-loss.

Do not move your stop-loss to where you are risking more money.

The only time you should move your stop-loss is to protect profits or limit the amount you are risking due to a changing market. You had a reason for placing your stop-loss where you did initially. Don't change it on a whim.

Never trade emotionally.

There is no such thing as "it has to go up", "it can't go down". The market does not care what you think, what you want or what you hope for. It is ruthless and makes its own rules.

Never trade on impulse. If you just heard the news, it is already too late. Plan your trades during non market hours. Once the markets open and the bell rings your mind is clouded, emotion takes over. When in doubt, stay out.

The Trading Plan

A well-defined trading plan and the discipline to follow it are essential elements of a successful trading program. That's because futures and options on futures are not long-term investments that you can just buy and forget. They may require monitoring on a daily or even hourly basis because of the large impact a small price move can have on your account. Stay alert to important market changes.

There are two basic ways to open a position. You can place an order to buy or sell a futures contract. When you want to close your position, you can:

  • Offset
  • Take delivery
  • Exchange for physicals

Offset

Approximately 99 percent of all market participants will close their positions by offsetting them. That means they place their order online that is exactly equal and opposite of their initial futures position. A futures purchase is offset by a later sale of the same quantity and delivery month, and a futures sale is offset by a later purchase of the same quantity and delivery month. For example, if you first bought 2 CBOT July corn futures contracts, to offset the position you would sell 2 CBOT July corn futures contracts.

Take Delivery

Another way to close a futures position is to take delivery of the underlying commodity if you bought a futures contract or deliver the underlying commodity if you sold a futures contract.

Exchange for Physicals

In addition to making or taking delivery of a futures contract, hedgers can enter into an exchange for physicals (EFP). Also known as EFP's which generally are used by two hedgers who want to "exchange" futures position for cash positions.

 

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