Stop orders and profit targets
Money in a savings account is typically viewed as low risk, but then there is little return potential. On the other hand, buying shares of a low-priced biotechnology company could potentially result in 100% loss of one’s investment if it goes bankrupt, but there is potential for huge gains if the company makes a breakthrough discovery like a cancer drug. All investments can be plotted somewhere along a risk/reward curve like the one in Figure 1.
Figure 1: Theoretical risk/reward curve
Because risks and rewards vary from one investment to the next, it makes sense to evaluate each trade or position in terms of its possible losses versus potential gains. If, for example, a trader sells 10 futures contracts on Crude Oil, the profit is limited to the commodity falling to zero and the potential risk is unlimited because there is, theoretically, no limit to how high crude oil prices can climb.
Practical management of risks and rewards
In the real world, the risks and rewards can be adjusted in different ways. Setting a “time stop” for a trade is a simple way to limit risk. With a time stop, the trader decides to hold a position for no more than one hour, whether it moves higher or lower. That’s a very strict, easy-to-follow rule that will limit both the risks and rewards of a position.
More commonly, stops are placed at prices above or below the entry price. For instance, Figure 2 shows Crude Oil at $58.55 per barrel. A trader looking to take a long position might enter a stop order just 5 cents below the previous support low of $58. So, if crude falls to $57.95, the trade is “stopped out” for a loss of 60¢ on the position.
(Note that stop-limit and stop-market orders differ in that a stop-limit specifies a specific price to buy or sell, but a stop-market will exit at the best price available after the stop is triggered.)
Figure 2: CL Futures
Loss limits & profit targets
Tip #1: Try using brackets: with the initial order to buy or sell, the bracket includes both a stop-loss and a profit target. This automates the process of exiting the position, whether it’s a winner or a loser.
Brackets allow traders to set both stops and profit targets. Returning to Figure 2, the trader expects Crude to see resistance at $60 per barrel and sets that as a target. Once the price hits $60, the long position is covered. In this example, the risk is to $57.95, or 60¢, for a potential profit of $1.45 on a move to $60. The risk/reward ratio is more than 2:1.
Tip #2: Keep a journal or Excel spreadsheet of your trades and study risk/reward ratios. If your losing trades are consistently greater than your winning trades, then, to become profitable, you will either need to 1) increase your percentage of winning trades or 2) adjust the risk/reward ratio to increase the size of the wins versus the size of the losses.
In the end, a trader’s goal is to generate profits. Risk management is important because one big loss can wipe out gains from many winning trades. That’s why setting a Personal Loss Limit is helpful. Using stops and brackets can help set a fixed exit price while also quantifying the risk/reward of the trade.
Avoid over-trading
The information overload age
Investors have more information today than ever before. Research that was once available only to Wall Street analysts is now readily available through financial websites or brokerage platforms. At the same time, fees and commissions have been slashed to almost nothing. And while brokerage firms have developed a wide array of online tools for investors, the exchanges have created the infrastructure needed to send orders electronically and execute trades with the click of a mouse.
If the financial world today has leveled the playing field by providing individual investors vast amounts of financial information and the ability to execute buy/sell orders in milliseconds, it has also created some unique challenges that didn’t exist in the past.
For example, markets react much faster today; not only can investors react instantly, but language-processing algorithms are digesting headlines – and triggering market moves – before humans can even read the first two words.
Fast-moving markets mean it’s difficult to stay ahead of the latest headlines and simply “trade the news” anymore (not that it was ever easy to do so).
Also, a sudden flurry of buy or sell orders can cause news-driven moves (and occasional “flash crashes”) that result in intraday kneejerk reactions and gap moves, like the one on the S&P 500 (ES) chart in Figure 1 after President Trump unexpectedly quashed hopes for a resolution to the trade squabble with China by announcing a new round of tariffs on Sunday, May 5.
Figure 1: ES Futures
Tips for trading in an information deluge
Tip #1: Have a backup plan. What if there is a power outage or the internet goes out? Do you have the phone number of your brokerage firm’s trading desk, or can you use your cell phone as a mobile hotspot? What if the market makes a gap move and your stop isn’t triggered? Are you ready to place a market order to buy or sell?
With electronic trading platforms, it’s never been easier for anyone, anywhere, at any time, to access the markets. Your three-year-old can click a mouse and buy 10,000 barrels of crude oil in an instant (not recommended).
But when this ease of market access leads to too-frequent trading, problems can arise. For example, a trader might try to make up for a loss by immediately placing another trade. And then that one doesn’t work, so they place another trade, and so on. This is sometimes called “revenge” trading, and it is rarely a good idea.
Tip # 2: It’s sometimes better to take a break after a loss (maybe a 20-minute walk or a trip to the range to take your anger out on a bucket of golf balls) rather than try to make up for losses with more trades. This falls into the category of not “throwing good money after bad.” Take a break and come back with an objective mindset. Maybe your setups are just not good in the current market environment.
Another approach that rarely works is to increase the size of the trade after a loss. The idea is similar to the so-called Martingale strategy in betting systems: a loser of a bet doubles their bet each time because the next win will cover all the previous losing bets. Obviously, margin requirements make it unrealistic in the futures market, and, even if it were possible, the trader is risking financial ruin if the position grows too large.
Don’t try to keep up with the bots
We live in a world where markets don’t stop moving. In many ways, the advances in technology and reduced trading costs are a boon for aspiring traders. But speed doesn’t necessarily give an edge when trading news events; humans are not as fast as machines.
Also, instant market access can create problems when traders start throwing good money after bad and fall into the trap of overtrading. Lastly, doubling down on losing bets might sound reasonable in theory, but it’s not practical in the futures market and can lead to outsized losses that are difficult to recoup.
Keep learning
What might that learning look like? The first step is to learn the ins and outs of the products we trade:
- When are the markets open?
- What is the initial margin requirement?
- How many dollars does one tick represent?
- What is tick size?
Learn what moves markets
Understanding basic product specifications is only the beginning of becoming a successful trader. For any market where you hope to trade well, you’ll have to familiarize yourself with the many forces that can affect it.
Tip #1: Know the key dates and catalysts of the products you trade. Economic data, OPEC meetings, earnings reports, inventory data, and crop reports can all move markets, some more than others. So what’s moving your market? You should know these events and their timelines as well as you know your own birthday.
Another consideration: Markets react to new information. When news flow is absent or if important news is pending, trading can turn quiet or choppy.
Explosive moves typically happen around unexpected or surprise events. For example, Crude Oil might drop if inventory data shows a larger-than-expected build. Treasury bonds often fall when economic data is stronger than anticipated.
No substitute for practice
The best way to get a feel for a market is to watch over time and practice trading. Check charts over different (monthly, weekly, daily) time frames and watch intraday. Identify spikes and dips that seem out of the ordinary and research past news reports for reasons for unusual moves.
Tip # 2: Concentrate on one market that seems particularly interesting to you or where you might have an advantage before branching out to others. Then practice, stay focused, and give it 110 percent.
Markets can and often do change. Have you heard that before? Many brokerage firms use the phrase in their disclaimers, followed by this one: “past performance is no guarantee of future results.” It’s true. Just because a market acted one way in the past doesn’t mean it will in the future. Just because one approach worked in July doesn’t mean it will work again in September.
Yet some things, like the mechanics of how a product trades, are fixed and do not change. In addition, each market has important news catalysts that are often known ahead of time. Knowing these dates can help you avoid opening a new position just before the market makes a big rip in the wrong direction.
That’s where practice trading can help – it’s the only way to get a true sense of how unfolding news events will affect a market and your positions. Always keep learning because products and markets are constantly changing.
