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Trader Savvy Newsletter

July 6 , 2006

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Risk Management:
Minimizing the uncertainty in your trading plan.

Name: Lance Gaitan

Company: GSV Futures

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Most market “gurus” are more than willing to boast about their trading successes or maybe tell you how much money you could make with their software program. Some might even offer to teach you how to trade or for a fee, be able to follow their actual trades. New traders hear about all the opportunities in the markets and how much money they could make but…..Risk management is usually the last thing new traders think about, or are told about or even want to hear about.

Experienced traders are well aware that the disclosure statements (required on all futures/commodity related materials) are true and you really can lose more than your initial investment! No one likes to lose but experienced traders know they will lose on some trades and plan for it.

Risk management is a plan within a plan and is not simply limiting loss on your trades. Your goal here is not only to make money but, to be around to trade for the long term, even if you are wrong on a few trades. In fact, many traders are forced out of trades they were ultimately right about because of market volatility and limited trading capital. If a trader can consider (and act on) as many possible pitfalls in their plan, the more likely they will reach their objectives. Your risk management plan should help you remove some of the uncertainty in your trading. There are several factors we deem important considerations as to how much to risk on a trade and whether or not to take a position.

Trading capital: This is simple; you should not risk more than 2-5% of your stake on any trade. This rule should be applied to all trades, all traders, all markets and all strategies. So, if you have $50K to trade, don’t risk more than $2500 on any trade. Of course, that $2,500 might be more than you should risk depending on the situation. Undercapitalization will handicap your ability to risk enough while skewing what you should risk (as a percentage of your account). So, if you are planning on starting with $2,000 just to see if you can make some winning trades, don’t bother. There aren’t many trades you will be able to stay in while only risking $40-$100 (2-5%).

Planned longevity of trade: How long do you think you will be in the trade? One trader’s strategy calls for profit taking intra-day (scalpers or day traders), others look for larger objectives in a 3-5 day time frame (swing traders) and yet others are looking for much larger moves over a longer period of time (position traders.)  The length of time you plan to be in a trade is important because the degree of price movement (volatility) is usually higher over a longer period of time. For example; the average price swing in a 10 minute time frame is usually much lower than the average price swing in a day. Without getting too complicated, a statistical analysis of volatility can easily be calculated for the market you intend to trade and for the appropriate time frame. Volatility can change in markets due to various factors such as seasonality, increased/decreased demand and fund participation to name a few. What may have been a contract you may have considered trading six months ago may within an acceptable range of volatility now.

Market depth: The quantity of daily volume (contracts traded) and open interest (contracts held) will measure how deep a market is. Market depth is also referred to as liquidity. In a highly liquid (efficient) market, you should feel confident that you can exit a market at or close to your stop loss point. The lower the daily volume and open interest, the higher the impact a few large trades can have on a market. Remember, there has to be a buyer for every seller and in small markets imbalances can cause sharp market movements. Generally, traders should avoid markets with less than 10k in daily volume and 50k in open interest. Trading in markets that lack depth (thin) can result in greater slippage or losing more than you planned for.

Daily limits: The maximum price that a market can change within a trading day is the daily limit. Make sure you check what the limit is on the market (if any) you plan to trade because those limits can be a risk to be considered. For example; frozen pork bellies (traded on the CME) have a daily limit of 300 points. If there were a surprise announcement stating a newly found health benefit caused by eating bacon could cause increased muscle tone, a sudden surge in buying (pork belly futures) might occur. The market could only rise or fall by 300 points that day. The limit is meant to put the brakes on irrational moves but that could leave a trader that is short contracts unable to exit the market until sellers return. That could result in margin calls but more important, a loss much larger than planned for.

Trading hours and order types: If your strategy calls for holding positions overnight (swing or position traders), the ability to protect your position overnight could be very important to your risk management plan. It seems silly to think in our global marketplace that risk factors only apply to our U.S. trading hours! There are typically less participants in the overnight markets and there can be more slippage. In some markets, stop loss orders are not allowed in the overnight market. Sometimes it makes more sense, from a risk stand point, to trade a market that allows for resting (GTC) stop orders. In any case, check with your broker or the exchange to find out what types of orders are accepted by that exchange and beware of the reduced liquidity overnight.

Your plan to manage risk should be well thought out and comprehensive. It is your responsibility as a trader to be informed of the risks surrounding your trades and strategy. Once you are aware of the risks surrounding your plan, you can decide whether your plan should be executed. Your plan to make money by executing a tested strategy must include a plan to minimize or even avoid unwanted risk. Draw downs and losses are not welcomed by most traders but a well thought out plan for managing that risk will help keep you trading long enough to hit the big winner!


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