Lessons from the Pros


Futures Trading Rules: Cool Heads Will Prevail

Successful trading involves getting a grip on your emotions.  Unfortunately most traders never seem to focus on this important aspect of trading.  However, the professional traders that take 90% of the profits from others do pay attention to their emotions.

Free Trading WorkshopOur goal should not be to eliminate emotions from our trading, because we are humans and that would be an impossible feat to accomplish.  But we do need to keep our emotions under control.  Otherwise, we will throw caution to the wind and possibly blow up our trading account by losing all of our money.

Many novice traders have not experienced a major loss in the markets yet.  Though the saying in motorcycle riding, “There are only two types of motorcycle riders – those that have crashed and those that will crash,” applies to trading as well.  All traders will at some point have that major loss that will never be forgotten.

If you are one of the lucky ones who have had this type of loss, I would like you to think back to that day and try to remember your emotional state of mind.  Yes, I said “lucky ones” for now you have been there and know exactly what to expect and how you will react if you ever get close to that again.  For traders who have not had this experience yet, you still have no idea what your reactions will be when it actually happens to you.

To help understand how cool heads can prevail in the markets I would like to compare Limit Moves on Futures Exchange traded products and Daily Max Loss for individual traders.  Let’s see if understanding these two circuit breakers can help to keep your financial house from burning down.

Futures Exchanges have had their own version of an emotional circuit breaker for many years in some markets. They are called Daily Limit Moves and currently apply to the Grain and Livestock markets.  All other markets have Circuit Breakers that will suspend trading temporarily if prices rally or drop a large percentage move too quickly.

Currently in the Grain and Livestock markets the Futures Exchanges have implemented a pre-defined range for the next trading day.  The results would be to stop trading in the direction the market moves to these Limit Moves.  For example, Corn has a Daily Limit Move of 30 cents per day above and below the previous day’s settlement price.  If price reaches these extremes the Exchange will halt trading in that direction.  The market is free to move in the opposite direction, but cannot trade beyond these Limit Move prices for that day.

For many years the Exchanges had Daily Limit Moves on most all of the markets.  Today they remain mostly on the lower volume Agricultural products.  The purpose of a Daily Limit Move is to allow traders to stop trading with so much emotion.  The way prices get to these Daily Limit Moves are through excessive Supply or Demand in the markets.  Another way to look at these moves is from Allan Greenspan’s “Irrational Exuberance” speech where emotions take over trader’s brains and they make bad trading/investing decisions.

The Exchanges felt it was good to stop the trading for the day in these price directions, encouraging traders to leave the trading pits and their screens.  The hope is that they will go home and come back the next trading session with cooler heads, able make better trading decisions.

Another form of a Daily Limit is for a trader to establish a maximum loss per day rule.  It is important they write this down in their trading plan as verbal rules do not adhere well during the heat of the moment in trading.

This could be a percentage of your trading account in dollars or number of losses per day.  The main thing is that you quit trading when you have hit this loss.  Any professional trader will tell you their objective is to be able to come back and trade tomorrow.  Most novice traders think just the opposite, they want their money back that day regardless of how poorly they are trading or erratic the markets may be that day.

Think of this Daily Max Loss Limit as a circuit breaker in your financial house.  Just like in your home if there is an electrical short somewhere, the breaker will kick and prevent your entire house from burning down.  This same analogy applies to your financial house and you should have the same protection as the house you live in. If we do not respect our money, our money will not respect us.

Once a trader has a larger loss than usual they can have an uncontrollable fear set in.  This fear can cause panic, revenge, freezing and inability to take action or a host of other emotional reactions which will be detrimental to your trading account.

Just like the Futures Exchanges implement Daily Price Limits to control Irrational Exuberance, you as an individual trader must devise your own Daily Max Loss rules to control self-inflicted Irrational Exuberance.

You will find the next trading day awaits you with money still in your trading account; and the possibility to find better trades and move forward in your trading career.

Otherwise, if you don’t have these rules, you run the chance of not having any money to trade with for the next trading session.  Of course the bright side is you have a nice tax loss for the year if you blow up your account, but I don’t think most traders want that.

The best way to pay for a lovely moment is to enjoy it” Richard Bach.

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.

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