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Trader Savvy Newsletter

September 21, 2006

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My Super Secret Trading Technique - Part 1

Name: Chad Butler

Company: RJO Futures

Learn More About Today's Author
Years Trading: 16

Favorite Movie
: Glengarry Glen Ross

My Super Secret Trading Technique - Part 1

Throughout my professional career, I have taught trading seminars and webinars, written newsletters and advisories, and generally spoken to a lot of people about trading.  The most common topics people want to discuss are what indicators do I use and how do I time an entry.  While these are important things to consider, they are not actually the end all, be all of trading.  Probably the least common question is the question that I feel is most important – what about money management and risk?

“What’s that,” you say?  “I thought you were going to teach me your super secret trading technique!”  Now, I know you all want the key to the vault, the one thing that is going to either turn around a losing attempt at trading, or make a good method great.  And I’m going to.  But that super secret thing is not a special stochastic, or a custom flim-flam indicator.  It is knowledge, and knowledge is power.  You will never know it all about trading.  No one does.  But trading, as a zero sum game, is about knowing more than the next guy, especially the guy on the other side of your trade.

So how does money management fit into all of this?  As I stated in the beginning, it is the least focused on topic in trading.  Yet it is the most important.  And if it is the least focused on topic, but it is the most important, understanding this can give you an edge.

The number one reason that traders fail is not because they don’t have a winning approach, or that they didn’t time their entries right.  The number one reason is that they lack money management.  Whether you are a short term day trader or a long term trend follower, inability to understand money management as it applies to trading is a recipe for disaster. 

If it is the most common problem, then why don’t more traders focus on it?

Here’s a homework assignment for you, and it’s an easy one.  Take a trip to the Barnes and Noble or Borders or whatever mega-bookstore you have in your town.  Go to the section that has books on trading and investing.  Try to find just one with money management in the title.  Try to find more than five that have that as a main topic.  Oh, you’ll find a great many like “How to Quit Your Job and Become a Day Trader” or “Why Do You Trade Stocks When Options Are So Easy” and I’ll grant you that many of these cover some type of rudimentary money management.  But it is usually relegated to the back of the book and probably comprises a single chapter somewhere after the fat section of idealized and optimized trading examples.

The fact is, money management is not sexy.  It doesn’t have marketing sizzle.  It doesn’t sell books or trading courses.  But, it is the single most important topic you will study if you are to be a successful trader.  Remember the old adage “Preservation of Capital.”  That’s money management, my friend.

So if you are still with me, you are certainly a dedicated soul.  I am quite certain that the majority of readers have moved on to something else already.  Now the question is, “What are your money management techniques?”  Well, the answer certainly cannot be summed up in a single newsletter.  But we can begin to cover some concepts that should help you.  First off is a discussion of risk.  Before we can discuss money management, we have to fully grasp the concept of risk, because these two things go hand in hand.

You’ve all seen it.  It is everywhere there is talk of trading.  It is even at the bottom of this newsletter.  It is the disclaimer “There is Risk of Loss in Trading.”  That goes for futures, options, or forward contracts on widgets.  If you enter a trade, you have the potential to lose money.

Take that to the next level.  There is risk of loss the minute someone puts a dollar bill in your hand.  If you do nothing with your money but hold onto cash you could lose it, or your house could burn down.  Uninvested, you have risk that your money will lose value over time.  Invest in CDs or stick it in an insured savings account and your risk is that you won’t keep pace with inflation or rates will be lower when your CD comes due.  You can do your own extrapolation and see that the minute that dollar enters your possession, you have some type of risk.

I assume that most of this audience is comfortable with some degree of risk, otherwise you wouldn’t be reading about trading.  But the number one objection that I hear to trading futures is that they are so risky.  “My brother-in-law’s neighbor had an uncle who lost his house trading soybeans.”  True, leverage can hurt you.  But did you know that you can manage your degree of leverage? 

Sure there is a minimum margin requirement in every trade.  But there is no maximum.  If you want to reduce your exposure to risk, reduce your leverage by applying more of the face value of the contract to the trade.  Here’s an example:

If corn is averaging $2.50 a bushel, then a 5000 bu. Contract has a total value of $12,500.  But the margin requirement is only $608.  That is only 4.8% of the contract value.  That’s a lot of leverage.  Market regulations require that you put up at least $608 per contract.  But no one says you can’t put up more.  Let’s say you put up half the contract value - $6250.  Corn would then have to go to $1.25 per bushel for your account to turn negative, but at $608 in margin, at $2.37 bu. you are in the hole.  On the short side, with 50% of the contract as margin, corn has to go to $3.75, but only $2.63 for your account to turn debit if you are using minimum margin as a rule.

Now understand that when you apply more toward the contract and reduce your leverage, you are reducing the amount of return on invested capital.  A 10c move in corn is a much bigger percentage of minimum margin that it is on full contact value.  Which brings up another interesting point.  The conventional “wisdom” (and I use that term lightly) is that commodities are more volatile than stocks.  But I would argue that that is an incorrect assumption.

Grasping this concept is, in my opinion, critical to understanding risk management.  If you can understand that you are starting to see key points of money management.  Choosing the number of contracts, or position size, is critical to success.  I know that this is the boring part of trading education, but it is definitely the most important.  You are to be commended for coming this far.  As Tim Robbins character, Andy Dufresne, says in The Shawshank Redemption, “If you’ve come this far, perhaps you are willing to go a little farther.”  In PART-II of this article, I will discuss money management in terms of determining position size and how to build a money management strategy to fit your objectives and risk tolerance. Click here to get PART-II now.


About Today's Author

Chad Butler is currently Chief Market Strategist with RJOFutures, a division of R.J. O'Brien.  Mr. Butler’s 16 years of market experience includes trading Dow and S&P option spreads as well as gold futures and options. He has also developed a number of short-term index arbitrage programs and published numerous articles on various derivatives. Chad has published work in McGraw-Hill's Complete Guide to Single Stock Futures and various trade publications, such as Futures Magazine.  He currently writes for various commodities newsletters, including RJOFutures MarketNews and has been a featured seminar speaker teaching his various trading techniques to audiences large and small.

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