The Basics of Risk Management

The private client division of R.J.OBrien & Associates

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The risk of loss in trading futures and/or options is substantial.

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Introduction
Preparing to trade futures is similar to training for a marathon. One doesnt simply show up to a 26.2mile marathon and begin to run; you must enter into a systematical series of steps to lead up to peak performance. Without these preparations, it is likely that the runner will not finish the marathon, or even make it to the starting line. Like failing to methodically train, the biggest reason for failure in trading is a lack of risk management. The key to successful risk management starts with a defensive approach. If every action taken is not defensive, then the odds of success are going to be limited. Most trading approaches consider risk management as a separate factor, but its principles are the basis or cornerstone of every action taken, not a separate principle. Risk management is the number one focus of a successful trader - it is the essence of managing your capital to prevent losing it and giving back gains in a position. At the same time, it promotes maximum upside potential. This guide will lead you through some of the more fundamental steps of managing risk within your trading plan. Risk management is identifying the risk within a trade. It is also the process of identification, analysis and either acceptance or mitigation of uncertainty in investment decision-making. Essentially, risk management occurs anytime a trader analyzes and attempts to quantify the potential for losses in an investment and then takes the appropriate action (or inaction) given investment objectives and risk tolerance. Once the risk is identified, the amount is then placed into a formula to identify how much capital should be used. From here you can then adjust your risk-to-reward ratio, keeping the odds stacked in your favor.

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Understanding the Markets

FUNDAMENTAL DRIVERS

pay very close attention to the bid/ask sizes to monitor the supply-demand dynamic. They usually buy when the demand is higher and sell if demand suddenly becomes lower relative to supply. All traders watch volume and open interest. Volume and open interest are measures to determine the liquidity of a futures market - the more liquid a market, the faster and easier that trades can be executed. Volume is the number of futures contracts that have changed hands. Open interest is the number of futures contracts outstanding that have not been closed or offset. Even on a day-to-day basis, some futures contracts and some delivery months tend to be more actively traded or liquid than others, so heeding volume and open interest is significantly related to risk management strategy. While real-time data streams into most available trading platforms, the official figures are calculated and disseminated by futures exchanges at the end of the trading day.

Its critical to know the fundamental price drivers that cause a market to move up and down. These might include the discussion of interest rates, sentiment and expectations, economic reports, seasonal effects and farming reports. Knowing market expectations for data and whether or not the expectations are met is more important than the data itself and is key to understanding the market fundamentals and price relationship.
Technical Drivers

Technical analysis is another key tool and sometimes the sole strategy followed by traders. Those who follow technical analysis track historical prices and volumes in an attempt to identify trends. Technical analysts use charts and graphs to quantify historical performance to identify repeating patterns as a means to signify buy and sell opportunities. Historical price trends are very important. Most traders use a combination of both fundamental and technical analysis.

Risk Management Concepts

Leverage

Liquidity

Leverage can be damaging, but it can managed. There is a minimum margin requirement in every trade, but there is no maximum. To decrease exposure to risk, reduce your leverage by allocating more of the full contract value to the position. If your risk capital is limited, reduce the number of contracts in your position, or do not open the position. If you are a day trader with less than overnight margin, it is likely that you should re-evaluate your entire plan. Day trading the E-mini S&P with a $2,000 account is not recommended. A single handle (the whole dollar price, or stem, of a quote) in the contract is a full 2.5% of your account. The attraction is the large percentage returns that can be made when you are right, but the best trading plans make the assumption that you will

Consider the liquidity of the market as part of your risk management. What is the ease of entry and exit in the market? What is the depth of bid and ask? A large bid size indicates a strong demand for futures contracts, while a large ask size shows that there is a large supply. If the bid size is significantly larger than the ask size, then the demand is larger than the supply and therefore, the price is likely to go up. If the ask size is significantly larger than the bid size, then the supply is larger than the demand and therefore, the price is likely to drop. Bid/ask prices and sizes change quickly in real-time, and therefore supply and demand also change quickly in real-time. Experienced, short-term traders always

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be wrong a good percentage of the time. Work with the appropriate risk capital, or work toward acquiring the amount of capital you are willing to risk. Example If corn is averaging $3.50 a bushel, then a 5,000 bushel contract has a total value of $17,500, but the margin requirement is only $1,620. The maintenance minimum is $1,200. (The minimum margin levels for the initial margin are determined by the futures exchange in which the contracts are traded.) Therefore, at current margin requirements, the exchange allows you to hold one contract of corn in your account with only 9.25% of the total cash value without being charged interest. (Compare this to stocks: if you dont put up the entire cash value of the stock purchase, you can trade on margin with up to 50% of the full cash value and pay interest on the margin.) If you open an account for $10,000 and lose $500 or 10 cents in the corn market, you would recognize a 5% loss of your account. If you opened an account with $5,000 and lose $500 or 10 cents in the corn market, you would recognize a 10% loss of your total account value on one trade as a result of trading on more leverage. Therefore, higher leverage equals higher risk. If you reverse this scenario and recognize a profit of 10 cents in the corn market, a 10cent move can amass a 10% gain on a $5,000 account in a very short period of time which is why futures becomes appealing to many people. The same rules apply to the mini contracts, but obviously the margin requirements are much smaller at $324, or $240 for the minimum margin. It is always important to remember that you can lose more than you invest as a result of the ability to trade with leverage. Therefore, it is important not to underestimate the risk of leverage when trading futures. Even though the exchange minimum margin requirements are typically between 5 15% of the full cash value of the contract depending on the

market conditions, we recommend holding more than exchange minimum margins in your account. This will allow you to manage your account rather than leaving yourself at risk of being forced out of the market as a result of being overleveraged with insufficient margin money.
Position Size

Even if you are able to trade only one lot, you need to consider position size in your risk management approach. Otherwise, you will not know when to increase size based on success, or whether to hold off trading until additional capital can be raised. Always adjust your position size to a level that enables you to think clearly and rationally. What is your investment tolerance level? Is it an optimal point at which to add risk? You must be able to quantify your approach. You do not have to be completely methodical, but using a system makes trading measurable, quantifiable, and helps preserve capital for winning trades. In terms of position size, the first factor to contemplate is volatility and how much you can handle. If there is not sufficient volatility in the market to achieve profit objectives within the chosen time frame, consider choosing another market and/or timeframe. In addition, if you arent comfortable with large swings, you can decrease your risk exposure by hedging the position. Consider what the maximum risk is that you can allow per trade, and the maximum amount of risk you can apply to the portfolio. You must be able to quantify your levels of increasing or decreasing position size and have a valid reason for doing so. You should have an idea of how large your account will be to start; what is your total potential risk capital in your portfolio? This will determine what you can do with your money (i.e., your risk strategy).

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Risk Capital

Trading Method Statistics

It is also imperative to examine what percentage of your capital will be applied to the strategy you choose, and you need to be sure you understand why the chosen strategy has worked in the past. Can it meet your profit goals? What percentage of your capital will be applied to it? Will it provide a maximum drawdown that is within your financial and psychological limits? Combining the statistics of your method of trading with your risk tolerance and appropriate stop placement, you should be able to calculate the optimal number of contracts to be traded at each dollar level of your account balance.
Market Diversification

For each market you are trading, you need to have some idea of what type of market movement can be expected based on your method. Where are your stops placed? What is the expected win/loss ratio? Considering these two factors, how many losing trades can come in a row? What is the average profit objective? Does it make sense according to the win/ loss ratio and average market range?
Stops

Stop placement, just like all other aspects of trading, cannot be arbitrary. Setting stops at a set dollar amount because you are comfortable with that amount of risk is not a wise approach; potential swings in the market must be considered first. If the dollar amount of that risk is too great for your account size, that market needs to be removed from your trading plan. Once that is determined, you can approach stops as part of your overall risk management plan. Using that approach in combination with the average market swings is effective. For example, if a plan has rules to risk no more than 2% on any given trade, then the trade has to fit within those parameters. The stop is placed a predetermined percentage outside of that range. If that total amount is more than the account percentage your risk management rules state, pass on the trade until all parameters fit the rules. It is acceptable to have levels of comfort, such as a maximum dollar risk or a percentage of the account. This type of risk management, especially the percentage risk, is actually critical to success. It is designed to keep the trader from losing the account. However, these concepts must be used within the scope of current market conditions and price levels. If the market swings are outside your maximum comfort level, move to another market or pass on the trade. If the swings are inside the maximum risk, adjust accordingly from the arbitrary to the precise.

If your method will be to trade multiple markets, you will need to analyze appropriate position size for each market individually. Risk and leverage are not going to be consistent across all markets. You may not want to allocate as much risk capital in grains vs. currencies, for example. Diversifying allows for more consistent performance under a wide range of economic conditions.
Arbitrary Rules

Setting arbitrary rules is a flawed approach that is frequently seen with newer traders. Lets assume the trader begins with $10,000 in the account. The trader begins by saying he or she will trade one contract in one market until comfortable, and then begin to increase size. Trading should be based on a plan, not an arbitrary number of contracts or dollar amounts.
Market Volatility

The markets being traded should be analyzed for volatilitynot only for diversification purposes, but also for stop placement. This can be done by examining open interest and volume levels in any given market. Volatility should measure price movement the high and low trading ranges within the market.

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The profit target is also important, but it is crucial to ask: do you take profits when the market reaches that target or do you trail the stop? There is no correct answer, but there is one thing to consider: your response to the market achieving the target must fit in with all of the previously-discussed concepts.

but shorter than trend-following trades or buy and hold investment strategies. Swing traders look for changes in price caused by oscillations, buoyed by optimism or sunk by pessimism over a period of days, weeks, or months. Swing trading may have unique challenges in a market

Trading Strategies

trading flat or sideways than in a bull market or bear market. In a market trending in a definite direction, the most active futures markets tend not to exhibit the up-and-down oscillation that they would when the markets are relatively stable for a few weeks or months. In trending markets (either a bear market or a bull market), momentum may carry it for a much longer than usual time in one direction only, making swing trading strategies that do not incorporate the trending less profitable than trend-following strategies. Identifying whether a market is currently trending higher or lower or trading sideways is a challenge for many swing trading strategies.
Support and Resistance Levels

Consider what strategies you will follow to produce profits. Do you plan to develop your own strategy or purchase a trading system? It is also important to understand why the strategy has worked in the past, and whether it fits within your approach and understanding of the markets.
Trend Following

Many traders choose trend following as a trading strategy. This involves a risk management component that uses three elements: the current market price, equity level in the account and current market volatility. An initial risk rule determines position size at time of entry. Exactly how much to buy or sell is based on the size of the trading account and the volatility of the issue. Changes in price may lead to a gradual reduction or increase of the position; on the other hand, adverse price movements may lead to an exit for the entire position. Systems traders normally enter in the market after the trend properly establishes itself and for this reason, they ignore the initial turning point profit. If there is a turn contrary to the trend, trading systems trigger a pre-programmed exit or wait until the turn establishes itself as a trend in the opposite direction. When the system signals an exit, the trader re-enters when the trend re-establishes.
Swing Trading

Support and resistance levels are used by traders to refer to price levels on charts that tend to act as barriers from preventing the price of an asset from getting pushed in a certain direction. A support level is a price level where the price tends to find support as it is going down. Conversely, a resistance level is where the price finds resistance while going up. In each instance this means the price is more likely to bounce off this level rather than break through it. However, once the price has passed this level by an amount exceeding some noise, it is likely to continue dropping/ climbing until it finds another support or resistance level.

Many traders practice swing trading, which is executed when a traded instrument is bought at or near opposite cycle swings caused by daily or weekly price volatility. Generally, a swing trade is open longer than a day,

Support and resistance levels can be identified by trend lines. Some traders believe in using pivot point calculations. The more often a support/resistance level is tested (touched and bounced off by price), the more

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significance given to that specific level. If a price breaks past a support level, that support level often becomes a new resistance level. The opposite is true as well; if price breaks a resistance level, it will often find support at that level in the future. Examples An experienced trader is adequately capitalized. This trader is working with risk capital and can trade with a clear head. He or she takes losing trades in stride because they are executing a complete plan based on market knowledge. By applying risk management techniques to the trading strategy, this trader is able to manage drawdowns (i.e. price moves against the position) and compound success. It is important to understand is that the trade entry is not as important as the exit. An example: Two traders: one is short the market, and the other is long. They both offset the same day, same time, and same fill price. They both recorded a profit on their trade. That can be confusing; if one is long and the other is short, how can they both be profitable? The answer is the trader who offset his short position was short from higher prices, while the long trader was long from lower prices. The time frame in the example does not matter; it could be one day trader and one position trader, or both could be day trading or position trading. The traders could have gotten in on different days or the same day. The point of this example is the importance of the exit. Here is a visual example. The chart below is a daily chart of December 2009 gold. Let us assume we have two traders trading this market. On 5/4/2009, Trader #1 buys on the close at 907.0. Trader #2 gets an entry signal and sells the open on 6/8/2009 and is

short from 955.40. Both traders offset on the close of 7/17/2009 at 940.30. Trader #1 bought at 907.0 and sold at 940.30. This would be a profit of $3,330.00. Trader #2 sold at 955.40 and bought for 940.30 for a profit of $1,510.00. Which is more important, the entry or the exit?

Examine discipline in accordance with the importance of the exit over the entry. Trader #1 is using a method that provides profitable trades 80% of the time, but all trades are only long. This traders average winning trade is $750 while his or her average losing trade is $1,000. After 10 trades, the trader is net positive $4,000. Trader #2 has a method that is only short the market. It provides profitable trades only 20% of the time. But in this example, the average winning trade is $4,000 and the average losing trade is $500. At the end of 10 trades the trader is net positive $4,000. Trader #2 has a method that only wins two trades out of 10, yet has a profitability that is the same as Trader #1, who is right more often than wrong. Let us assume that Trader #1 is trading with a counter-trend method and Trader #2 is using a trend following method. In

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this example, neither method is better; the importance was the traders discipline to execute the method over time. They understood what the method was, what the probabilities were for the method, and put their plans into action. They never deviated from the method, so in the end, they both ended up successful.

Risk Management Checklist:

After reading, ask yourself these questions to assure you are providing appropriate risk management to your portfolio before trading futures: 1. What is my account size? 2. What percentage of my account balance will I be risking? 3. What is my stop loss on this particular trade? 4. What futures contract, month, and year am I trading? 5. How much is a tick worth? 6. What is my dollar risk amount? 7. What is my position size? As a next step, we invite you to contact one of our Trading Advisors here at RJO Futures. He or she will be able to walk you through some of the principles detailed in this introas well as take you to the next level in your understanding of risk management. Contact us at: Phone: (800) 441-1616 or (312) 373-5478 Email: info@rjofutures.com Web: www.rjofutures.com

In Conclusion
Traders often overlook risk management, choosing to focus on more compelling areas such as stochastic crossovers, convergences and divergences, and technical versus fundamental analysis. However, with any strategy in any market, risk management is imperative when it comes to successful trading. It provides a better understanding of control, position size, stop placement, and more. Like training for a marathon, trading futures should begin with a methodical approach, following a series of steps to reach goals and ultimately, the potential for success.

2009 RJO Futures

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Additional Resources
RJO Futures Trading Advisors RJO Futures Sr. Trading Advisors provide the experience and background to help you with your trading needs, and assist you with reaching your investment goals. We invite you to review each Advisors profile, experience, and techniques here: http://www.rjofutures.com/brokers/index.php Or, call to reach one of them at 800-441-1616. RJO Futures eView, E-newsletter This bimonthly newsletter from our trading advisors features market analysis, reports, commentary, and education geared to both new and experienced futures traders. Subscribe here: http://www.rjofutures.com/forms/newsletter_signup.php The CMEs Strategy Guide to Futures and Options The CMEs Strategy Guide to Futures and Options offers a step-by-step format that leads the reader through 21 trading scenarios and follow-up strategies. The 42-page manual clarifies everything from initiating a market position to put and call ratio backspreads, with an emphasis on explaining the trade set-up and things to watch. Follow the guide through long and short futures, long and short calls and puts, strangles and straddles. You can obtain this free handbook here: http://www.rjofutures.com/learning_center/pdf/ Beginners%20Guides/AN%20IN TRODUCTION%20 TO%20FUTURES%20AND%20OPTIONS.pdf Commodity Futures Trading Commission (CFTC) Congress created the CFTC in 1974 as an independent agency with the mandate to regulate commodity futures and option markets in the United States. For answers to some basic questions about the futures markets and how they work and answers to other frequent questions, click here: http://www.cftc.gov/educationcenter/index.htm. National Futures Association (NFA) Investor protection begins with investor education. From its inception, NFA has committed resources to provide investors with the tools they need to make informed financial decisions. NFA has developed several publications that discuss a variety of futures-related topics. All of the publications are available for free by clicking here: http://www.nfa.futures.org/investor/indexInvestor.asp

Disclaimer: The risk of loss in trading commodity futures and options can be substantial. Before trading, you should carefully consider your financial position to determine if futures trading is appropriate. When trading futures and/or options, it is possible to lose more than the full value of your account. All funds committed should be risk capital. Past performance is not necessarily indicative of future results.