Generating Income Does Not Come Without Risk

Don Dawson

Trading Futures contracts is generally referred to as generating Income. While investing in Stocks or Options can be considered Wealth building. The major difference is how long you plan to hold each transaction as an open position.

The longer you hold a position, investing or swing trading the more opportunities you have of increasing your profit potential. Therefore investing in Stocks and Options allows one to stay in the market for a longer period of time.

Futures contracts are not usually held as long and are therefore traded for shorter duration. Futures have far more leverage and in some cases volatility than Stock or Options positions. The additional leverage and volatility creates more emotion in a market among participants because of the potential to lose more money than one has in their trading accounts. Most traders prefer to get into a Futures trade and exit as quickly as possible so as not to expose themselves to these excessive emotions of fear and greed.

Because of this extra risk novice traders try to use very short time frame charts too day trade Futures contracts. The basic reason for doing this is because their stop loss points are closer to their entry prices, resulting in smaller losses when they happen. They view swing trading as being more risky.

A good friend and co-road warrior instructor of mine, Debbie Hague, recently published a well written book called Trade Like a Pirate. In her book she describes 67 golden nuggets to help simplify your trading. She does a good job of identifying many common mistakes that all of us traders have and/or will make in their trading. Golden nugget #43 in her book was “Small Stops Do Not Mean Small Risks.” I could not agree with her more on this subject.

She states “It seems logical at first that a small chart with a small stop equals a small risk. This couldn’t be further from the truth.

The biggest mistake a trader can make is to open a 5 or 10 minute chart first and not take into consideration what the larger time frame charts are doing. As Debbie stated this is done to presumably reduce the risk. But if you do not know what the larger time frame trends or where potential Supply (Resistance) or Demand (Support) levels are you are only fooling yourself that there is less risk trading short time frame charts.

Many times in class we will be looking at a 15 minute chart for some reason and it never fails that somebody asks, “Don, where would you buy or sell on this chart?” My answer is always “I have no clue.” While this may sound like I am avoiding the question it is the truth. Before I even have a clue to buy or sell I must always view a Daily chart first even if it is a day trade.

My style of trading is a top down approach. Just the opposite of many novice traders. And thank you novice traders for taking the other side of my trades. The main reason for this top down approach is to know who drives the Futures markets. Commercial traders make up over 60% of the daily volume. Small speculators do nothing more than provide liquidity for these large Commercial traders.

Let’s look at an example of these two styles of traders. A speculator is very nimble and fickle about their trading. They can be long a Copper contract and 5 minutes later be short the same Copper contract. They carry no large contract size when they trade. So when they wish to exit their position they can literally press the buy or sell at the market button and not even make the market flinch with their small size.

A Commercial trader on the other hand enters the market with so many contracts that they have to scale into and out of their positions. Meaning they are buying (reverse for selling) at different prices as the market falls and this gives them an average price they paid for all of the contracts. If a Commercial trader entered their positions using a market order the sheer size of their contracts would cause the market to spike or collapse for thousands of dollars per contract resulting in absolutely poor fills for their positions.

Now let’s go back to time frames that traders use to make trading decisions. Small speculators can look at short time frame charts like 3, 5, 8, 10 minutes and “try” to make trading decisions. Because most novice traders think everybody in the industry trades like they do, small contract size, when they see a level or trend on a small time frame they think everybody is looking at the same thing they are. In reality that is the furthest from the truth you can get.

Have you ever noticed how quickly price leaves a “valid” supply or demand level that was created on a very short term 5 minute chart? Winner or loser the price stays there for a very short time. Now go look at a “valid” supply or demand level on a larger time frame, 240 minute or perhaps a Daily chart. Notice how much longer the market trades there?

trading time

This extra time the market spends at a price level is exactly what large Commercial traders need to execute their orders because of the significant size they trade. Why would a Commercial trader look at a 5 minute chart to place trades? The smaller time frame price levels do not offer them time needed to liquidate their inventory of orders. So they plot their trades on the larger time frames where time is on their side.

Now the question comes to this, do you want to trade with small speculators who do not have enough money to stop price action or would you like to trade with the smart, well capitalized traders? Even as a day trader you should be trading in the direction of these larger traders. Being the smart money they are they obviously will not be sending a morning email out saying where they are buying or selling. The next best thing we can do is analyze the same charts and longer time frames they are looking at for our own personal trades.

The next time you open your charts and go right to a 5 minute chart first ask yourself this question, “Who is actually looking at this chart other than me?” The answer is, “Nobody who makes a difference in the market’s price action.”

Technical analysis does allow a trader to use short time frame charts, but should only be used after observing larger time frame charts first.

As Debbie mentions in her book, the larger time frames also help to remove much of the noise in price charts that smaller time frames cause.

Novice traders thinking they are going to trade with $50 stops in the Futures markets are only kidding themselves. But these small time frames are where novice traders go to analyze the markets. And the question keeps coming, “Why do I always get stopped out?”

Trading requires capital to be successful. The Futures industry only requires $5,000 to open a trading account. The most a trader should risk on any day trade is 2% of their account. A $5,000 account only allows a trader to risk $100. These types of stops are notorious for being stopped out frequently. A trader with a small account would do better to trade Exchange Traded Funds (ETF’s) of particular Commodity Futures where they can trade smaller sizes than the traditional full size Commodity Futures contract.

Once the trader has accumulated about $10,000 of “RISK” capital they can trade with 2% stops of $200 and have a better chance of succeeding. Otherwise small accounts will continually get stopped out with small stops. This will eventually cause even the most rational of traders to snap and turn into a revenge trader and blowing up their accounts.

I like how Debbie writes, “Trading with a larger time frame means you don’t see all of that noise. You don’t keep taking small pokes at the turn and making small donations. When you add up all the small donations from using small charts, you realize the risk isn’t low anymore. Putting on a twenty point stop one time is not the same thing as putting on a ten point stop two different times. Many times, if the trader had just accepted that larger risk on a larger chart in the first place, he or she would still be in the trade.” 

“Although it feels better to be risking only ten points, what traders are really doing is a slow bleeding. Just remember, slow bleeding still means you’re dying, it just takes longer.”

I am leaving you with this quote that is also from Debbie’s book. She has methodically placed these types of quotes throughout her book. For many traders I would say these quotes alone would be good to help trigger good learning habits.

“It doesn’t work to leap a twenty-foot chasm in two ten-foot jumps.”

– Don Dawson

This newsletter is written for educational purposes only. By no means do any of its contents recommend, advocate or urge the buying, selling or holding of any financial instrument whatsoever. Trading and Investing involves high levels of risk. The author expresses personal opinions and will not assume any responsibility whatsoever for the actions of the reader. The author may or may not have positions in Financial Instruments discussed in this newsletter. Future results can be dramatically different from the opinions expressed herein. Past performance does not guarantee future results. Reprints allowed for private reading only, for all else, please obtain permission.