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Plan Your Trade, Trade Your Plan.

Many who trade futures successfully rely on a trading plan. Just like a business plan outlines in

detail the establishment and development of a proposed business, a trading plan outlines in detail a

structure for trading. There are two major components of a trading plan: a method of price

prediction which signals if and when to buy or sell a particular futures contract, and a risk

management program which dictates the amount of money to risk on any trade, and specifies when

to cut losses. Trading plans are fluid in the sense that they are constantly being tested and

amended so as to improve overall performance and profitability. Strict observance of the rules of the

trading plan is the hallmark of a successful futures trader.

Price Prediction

Profit on a futures trade is earned if you buy low and sell high, or sell high and buy back low. While

simple in concept, this requires you, the trader, to have some idea of where prices will be several

weeks or months from now. That is, it requires some sort of price prediction methodology. Most

traders tend to rely on some variation of fundamental or technical analysis to predict prices. Many

traders also spend considerable time and energy attempting to identify new measurements or

signals that provide the edge in predicting prices. Stories abound of traders who claim to have

discovered proof-positive techniques for predicting prices, and then offer to sell the information to

you for a price. In my experience, genuine fool-proof techniques are very hard to come by, and I

would advise you to be very careful and skeptical of such grand claims.

Traders tend to begin with a price prediction technique or model with which they are most

comfortable. After use in actual trading decisions, resulting profits and losses provide valuable

feedback on the effectiveness of the technique. This feedback, in turn, is used to refine and improve

the model. It is important that after every adjustment to the prediction model, you accumulate

feedback to ascertain the desirability and effectiveness of the change. Only those changes that

improve prediction performance of the model should be made permanent. With this process, you

may eventually develop a trading model that generates reliable buy and sell signals. Of course, it is

also possible that you may determine that the model is unsatisfactory, and a completely new one

should be developed.

To accumulate feedback on a relatively new prediction model, you may wish to place imaginary or

fictitious trades to determine what the resulting profit or loss would have been had the buy or sell

signal been taken. The advantage of this testing methodology is that you will not risk money until

you are reasonably confident of the merits of the model. There is, however, no guarantee that the

model will continue to be an effective predictor in the future, even if it has performed well in the

past.

Risk Management

Another major component of a trading plan is risk management. Risk management is concerned

with establishing thresholds to limit loss on any individual futures position, and establishing

objectives at which profits on individual futures positions will be taken. The relative size of losses

and gains must be such that, over time, gains exceed losses so that trading is profitable. This, in

turn, depends upon the frequency of loss relative to the frequency of gain. For example, a trader

using a certain predicting model is right half of the time in their prediction, and wrong half of the

time. However, when wrong, loss is limited to $500 per trade and when right, profits are allowed to

accumulate to $1000 before the trade is offset or closed. Over time and after many trades, this

trading program should be profitable, all else constant.

The example above illustrates a simple risk management rule that you will find in almost all futures

trading textbooks: Cut Losses and Let Profits Run. In other words, if you close futures positions that

begin to lose money and leave open those that are profitable, you will make money in the long run.

Successful traders confirm this basic truth. Many even admit that they are wrong more often than

right in predicting prices, but when they are right, they make a considerable sum of money that

exceeds all losses combined. The result: trading is profitable overall.

Determining the exact amount of loss that should be tolerated before a futures position is closed

depends upon several factors. The amount risked on any futures position depends upon the amount

of margin in your account. It is often suggested that no more than 10% of total margin be risked on

any one futures position. The amount risked also depends upon the volatility of the futures being

traded: the greater the volatility, the more is risked since you want to be able to carry the position

through transitory price movements, or "noise," and to not have to exit a position prematurely. The

size of your average trading gain also determines to what level you should limit loss. You need to

limit loss at a level such that, over time, losses do not exceed gains in the aggregate.

Many futures traders find stop orders very useful tools for risk management. Stop orders instruct the

broker to close an outstanding futures position if prices move adversely to a specific level. Stop

orders must be properly used to be effective: they should be placed at the same time that a new

futures position is established. For instance, a trader may enter a market order to buy one gold

futures when gold is trading at $385 per ounce, and enter a stop order to sell one gold futures at

$379 per ounce, thus limiting loss to $6 per ounce or $600 per contract. (Be warned: stop orders do

not guarantee execution at the stop price - greater loss may be incurred.) Using stop orders forces

the trader to contemplate the "worse case scenario" at the outset and act to limit loss. By using stop

orders, the trader eliminates much of the stress and anxiety that is associated with a futures

position that is losing money. Those who don't use stop orders lose sleep instead and, if they talk

themselves into not closing a position when they should have, lose a substantial amount of money

as well.

Just as with developing a prediction model, the parameters of a risk management system should be

evaluated over time, and amended when appropriate. Actual trading profitability performance

provides the trader with valuable feedback to perform such an analysis.

Individuality

Trading plans are individualistic, based on such factors as personal experience, education, risk

capital, and tolerance towards risk. For this reason, trading plans may differ greatly from one trader

to the next, and any particular trading plan may work better with some people than others.

Consequently, you need to develop a trading plan that works best for you. Among other things, this

requires patience, rigid adherence to the rules that you establish, meticulous record-keeping of

trading performance (which provides valuable feedback), and an open mind to try new and

potentially better methods. There are no guarantees of profitability in the world of futures investing,

but the discipline of a trading plan goes a long way toward making you a successful futures trader.

Trading plans may

differ greatly from

one trader to the

next, and any

particular trading

plan may work better

with some people

To accumulate

feedback on a

relatively new

prediction model,

you may wish to

place imaginary or

fictitious trades to

determine what the

resulting profit or

loss would have

been had the buy

or sell signal been

taken.

Traders tend to

begin with a price

prediction technique

or model with which

they are most

comfortable.

Futures Traders Helping Future Traders