Money Management and Futures Trading

Many people believe that most day traders lose money and only a few are profitable. While this view has some merit, the difference between successful day traders and unsuccessful day traders often has its roots in money management technique. In referring to money management, I want to make it clear that I am talking about money management as it relates to your futures account balance and not how you pay your household bills or manage your credit score.

One skill that is universally prevalent in unsuccessful traders is inferior money management skills. And for the record, I will state that discussing money management is very unpopular among traders; it is generally assumed, for unknown reasons, that traders understand proper money management as it relates to trading. Nothing could be farther from the truth, especially for a trader with a smaller account.

I see many brokerages lowering their day trading margin requirements, especially in recent months as the volatility in the market has subsided. I am aware of one futures brokerage that has lowered its day trading ES margins to $300 per contract. While this may be, at face value, very appealing to the average day trader, I’m not convinced that this trend is such a great idea. Lowering margin requirements is often an enticement to traders to trade more contracts in their account, and hence end up taking on more risk than is acceptable. Since e mini futures contracts are highly leveraged, trading more contracts than general money management techniques warrant could lead to massive losses, and unacceptable losses. Overextending your risk tolerance model is a quick way to exit the futures trading business.

So how many contracts should you trade?

Let’s consider an example: Trader A establishes a futures trading account with $3500 as his initial margin balance. Further, he saw the ad on the Internet with the brokerage firm offering $300 day trading margin requirements and quickly signed up with the firm. Every brokerage has a risk management department, and they assign him a maximum contract limit of five contracts. Let’s assume Trader A is a bracket trader and sets his stop-loss at 12 ticks. Trader A is excited about the possibility of trading 5 contracts. Let’s calculate what he is risking on this particular trade. On the ES contract, each tick is worth $12.50. So, $12.50 x 12 = $150. With his plan to trade 5 contracts he is risking $750 (5 contracts x $150). In this example, Trader A is risking approximately 22% of his account balance on this trade. This is nearly 22% of his entire margin account. Obviously, Trader A is far overextended in the number of contracts he traded. This behavior is not unusual.

How many contracts should Trader A be trading?

Proper money management technique would dictate that day trader risk 5-7% of his total account balance on a given trade. I would even grant that an aggressive trader might be justified in risking up to 10% of his account balance on a given trade. At 2 contracts Trader A would be risking $300, or just under 10% of his account balance, which is an acceptable level of risk for an experienced trader. A novice trader should probably only trade 1 contact on any given trade. Either 1 or 2 contracts keeps a trader well within a normal risk tolerance model. Anything more than 2 contracts is excessive and exposes the trader to unacceptable levels of risk. At 5 contracts, a trader could easily be out of money with 4 unsuccessful trades.

Money management is really about managing risk. A wise trader does not expose himself to excessive risk and potential financial ruination. Day trading is not a get rich quick proposition, and one secret to success is managing your money properly. Learning to trade the number of contracts that correlate to your futures account balance is an important skill to learn. All too often, traders over trade their account through poor money management implementation.

Making the grade in the futures trading game requires employing consistent money management technique, and a trader who employs poor money management technique will likely squander his potential profits and in the end, his entire trading account. Keep your potential financial risk under 10% on all trades and you stand a great chance of staying in the game.

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