Of all the important skills in trading, survival is number one. For unless we make it through the inevitable bad times, we won't be around to capitalize on the good. I've laid out some trading account guidelines that specify the account size required to conduct various commodity futures and option trading activities. Stick within these guidelines and you will have an edge on most of the commodity trading public.
When buying commodity options, I usually think in terms of them expiring worthless. This is the worst-case situation and will keep us honest about the real risk. With a $10,000 account buying a $500 option, this would permit us to make 20 losing trades in a row. The chances of trading this poorly are remote, but its still possible.
Just think of how much better our chances for survival and success are compared to someone risking everything - like the whole $10,000 on two trades. Many traders do just that, believe me. At 5% risk a trade we are trading more within our means and essentially have much deeper pockets to survive than the other guy. Whos going to be around after the commodity market acts badly? And whos going to be gone in a heartbeat?
A trader with a $50,000 commodity trading account has much more flexibility. He can risk 5% ($2500) on each futures or options trade to have the staying power to take 20 losers in a row. A more conservative trader might even risk only $1250 per trade (2.5%) and be able to take 40 losers in a row before being wiped out. Now there is a survivor!
See the point? We are focusing on the worst-case scenario to give us every edge possible for survival. When the big profitable commodity trades come along that go a long way in our favor, we want to be ready and able to take full advantage. Normally, we only want to take high probability trades in the first place. A few good trades that are handled well can make up for the losses and make your whole year profitable! You must be present and liquid when they come along.
The commodity market will not always accommodate our opinion of a low risk, high probability trade. So by splitting the account into many parts we let probability favor us by permitting us to trade longer than the average guy before being wiped out by a long string of losers.
Most commodity traders take on positions that are much too large for their account equity. This is a universal problem with the public. This causes emotional decisions and early exits when the market should have been given more time and space to fluctuate. Some accounts are simply wiped out after a few bad trades. Certainly there are times to get out of a trade that does not work out early in the game. Every commodity trade is different and must be handled as such.
Once we understand these concepts we will find it hard to trade any other way. Ive observed many traders who had tremendous raw trading skills that set them apart from the crowd. These people made serious money for a short period of time. But making money consistently over a long period time is the hard part.
Every one Ive known whos pushed the commodity market too hard has failed in the end. They make money until they start breaking the 5-10% rule. Its easy to say you will follow this rule, but its another thing to stick to it when you are making serious money and want to ramp it up.
The guidelines Im about to lay out will apply to buying commodity options, buying commodity futures on margin and selling commodity options. In my examples, the risk of buying options refers to the options expiring worthless.
The risk of a futures contract is usually where the stop loss order is placed, but not always. It could mean a bigger loss if the stop loss gets triggered by an overnight gap through it. Commodity option writing is similar in risk to commodity futures, since they are sold on the same margin requirements and can go in-the-money lock-step with the futures contract.
Bear in mind these guidelines are for YOUR survival and success. You will be committing yourself to proper money management. If used, your broker will make fewer commissions and at a slower pace as a result. But over time he will have a happier client with better chances of success for a longer-term trading relationship. He should happy to have informed commodity clients who make an effort to keep their emotions and risk in check.
There is nothing wrong with losing money if you have followed your rules and given yourself the best chance possible. The anguish is in losing after you correctly predicted the market direction and took the right position, only to ruin it by over-leveraging yourself.
Taking on a small position that goes a long way is the key. You know its the right size when you dont really care if THIS particular commodity trade works out or not. Its all about being around for a long series of trades to let probability favor you.
Enough said. Now let's look at specific account sizes and recommended trading for each.
Part Three of Six Parts - Next!
There is substantial risk of loss trading futures and options and may not be suitable for all types of investors. Only risk capital should be used.
Thomas Cathey - 27-year trading veteran heads the managed futures division of Thomas Capital Management, LLC. View his TimeLine Trading market predictions and get his complete, free 44+ lesson, "Thomas Commodity Trading Course".
http://www.thomascapitalmanagement.com/commodity/welcome.htm
Main site: http://www.ThomasCapitalManagement.com