Commodities

Show Me the Money!

dondawson
Don Dawson
Instructor

If anybody has watched the Suze Orman show on late night CNBC you have heard the phrase “show me the money!” She takes audience phone calls and people ask her if they can afford to buy a particular object. She either approves or declines their request based on the financial information they have submitted. Perhaps we need a Suze Orman show for beginning Futures traders.  With so much leverage in the Futures markets it is very easy for inexperienced and undisciplined traders to lose all of their starting capital.

We have all heard of the stories of somebody’s distant uncle who lost all his money trading Commodity Futures some 40 years ago.  While I have no way of knowing exactly how that happens I have some pretty good ideas how it turned out that way:

  • No trading education or experience
  • Undercapitalized
  • No Risk management rules
  • Most likely did not have a written trading plan to follow and was winging it

From the above list of “Wanna Be Traders” mistakes I would like to focus on how much capital you may need in your trading account to have a fair chance of surviving in the Commodity Futures arena.  The following should be taken as guidelines only and not hard and fast rules.  As we have heard of traders losing all of their money we have also heard of traders turning small sums of capital into large size accounts.  Unfortunately these stories are not as abundant as the trader losing all of their trading capital.

Keep in mind that anytime you enter the investment world that you should only use risk capital you can afford to lose.  Trying to trade for a living with capital that is needed to pay living expenses will cause you to trade with too much emotion.  Emotion leads to fear and fear leads to losses.  Once the losses start traders become revenge traders and this can lead to losing all of their trading capital.

Depending on your brokerage firm most Futures brokers will let you open an account for as little as $5,000.  Compare that to opening an Equity day trading account for $25,000!  A big advantage to trading Futures as opposed to Equities is that you do not have to maintain that $5,000 balance.   An Equity account cannot drop below $25,000 or you lose your direct access order routing and day trading privileges.  A Futures account can drop down to as low as the minimal day trade margin needed to trade a Futures contract and you still maintain your trading privileges just like a trader with much more capital.  In some cases this day trade margin is only $500.  So if you lose $4,300 through a series of trades and your account balance is only $700 you can still trade. Margin is good faith money used from your cash balance to assure the broker/Exchanges that you are good for the losses you may incur.

At this point Suze Orman would probably deny a Futures trader the right to trade if their account size did drop down to levels under $2,000, and for good reason.  Once your account size drops to this level you are trading with scared money (more emotion based trading than rule based trading).  While it can be done the odds are stacked strongly against you.

My general rule for trading the Futures market is to have at least $10,000 per contract you are going to trade.  Even this amount is met with differing opinions about trading Futures, but at least you have a little breathing room starting with this amount.

Let’s look at some different swing trading account sizes and discuss the pros and cons of each.

Traders with $1,500 to $5,000 in their trading accounts –

Accounts of this size are not recommended for new traders especially because they will not have great risk management skills yet.  When a trader does not have good risk management they take upside down risk/reward trades.  Meaning they will risk $3 to make $1.  Professional traders limit their losses to 1 to 3% of their account size.  Inexperienced traders usually have trouble taking losses and let their losses run to 20 – 25% of their account size.  By doing this they will blow up their trading account in approximately 4 losing trades.

If you do start trading with this size account perhaps you might look at using Options or ETF’s (Exchange Traded Funds) until your account size grows, then consider using Futures contracts.  You still take your technical buy and sell signals off of the Futures charts, but you will use a different vehicle to participate in the price move.  Another choice if you decide to trade with this small of an account is to trade markets with low volatility like Cocoa, Sugar and or Eurodollars (Interest Rate contract, not the Currency contract).

Traders with $5,000 to $10,000 –

Many new Futures traders start with account sizes in this range.  Perhaps because it is still less than an equivalent Equity account.  In the scheme of things you are still trading a small account, but you at least have some flexibility with this size.   With this amount a trader with a written trading plan, discipline and good risk management will have a better chance to be around to see the rewards of their effort.  Until you get experience trading the Futures markets I would not recommend trading more than one contract with this amount.  Do not trade volatile markets with large daily ranges as this will quickly make your losses grow exponentially.  Take it slow and steady and trade conservative markets as mentioned in the previous account size section.

Traders with $10,000 to $25,000 –

An account size like this will allow traders to participate in multiple markets simultaneously.  A benefit of trading Commodity Futures is their lack of correlations to one another.  For example, if you were buying stocks and the trend of the S&P was down it is a good bet those stocks will not go up easily.  In Futures you can be long the Sugar contract and short the Live cattle contract and make money on both if your analysis was correct for both trades.  Also, there are times when some Commodity markets are in a trading range while others are trending.  By having an account of this size you can diversify among different Commodities and take advantage of these opportunities that would not be available to a trader with a much smaller account size.

Any capital draw downs you may experience will not put as much pressure on you with a larger account.  This allows you to continue following your trading plan and not become emotional with your trading.

Remember that the more capital that you have in your account the more likely you are going to get a little careless with your trade selection.  Always have a rule that says you will draw down your account size at the end of the month to an amount that will force you to only take trades that meet all the rules in your trading plan. Being selective at picking your trades is a real skill once your account starts to grow.  Most traders will take trades because they feel the extra funds in their accounts are “house money”.  After you have been trading for awhile you will realize that you earn every dollar you take out of the markets, nobody gives up money easily.  This is a zero sum game so somebody paid you with your winning trade, do all you can to keep it!

Traders with $25,000 or more –

While larger accounts are nice to have from the standpoint of less stress about losing, a trader must be especially careful not to stray from their trading plan.  One way to help from straying from your trading plan is to have a trading goal written down.  Having a goal forces you to take only good quality trades.  If you take poor setup trades while having a goal you will soon realize that you are not getting closer to your goal.  By following your plan you will reach your goal much sooner, so make it a worthwhile goal.

An  account of this size allows you to use strategies that combine Options and Futures.  This allows for good wealth building opportunities because you can extend your trading timeframe.  Smaller accounts do not have this luxury because they need to grab the profits too quick.

Just because you do have a large account you still must adhere to very strict money management rules.  After all, it does not matter what size account you have, a 25% loss is still damaging both financially and emotionally.

These are some guidelines to help gauge where you may want to be when it comes to Futures trading.  As a new trader I would recommend that you have adequate risk capital, but do not necessarily put it all in your trading account at once.  Perhaps start out with $5,000 – $8,000 and take the rest and park it somewhere safe (savings account, etc) and then only use it once you become a well disciplined Futures trader.  Having a smaller account will force you to be more selective in your trades too.

“The things you do for yourself are gone when you are gone, but the things you do for others remain as your legacy”  

Trade well,

Don Dawson

Disclaimer
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.