Monday, February 20, 2012

Sizing your futures Position

One of the most important decisions you will ever make as a trader is the size of your positions.

That's right.  It is up there with what you buy and sell, when to get in and when to get out, and whether you are after capital appreciation or income.

New traders are excited and used to maximizing their efforts at whatever they do.  If you are an accountant, you want to get as many spreadsheets done as you can.  A baseball player wants to get the most hits, a police officer wants to make the most good arrests, and so forth and so on.

This quite natural - and usually correct - assumption that more is better will destroy your chances of succeeding as a trader unless you get it under control.

Focusing just on the e-minis (aka "the spoos" and "the S&P futures"), you need $5000 to trade one contract, $10,000 to trade two contracts, and so on and so forth.  These contracts actually control quite a bit more than that, as their leverage is about 90%.  When you trade one contract, it is quite deceptive, because it looks as though you are trading very little, when, in fact, it is quite a lot.

Each tick of the minis is .25 of a S&P 500 point.  If the contract moves from, say, 1362.50 to 1362.75, you would make $12.50.  You have to deduct your commission, of course, but let's ignore that for a moment.  The amounts increase depending on how many contracts you are trading.  Two contracts and you would make $50, three contracts, $75, four, $100, and so on and so forth.

The mistake when you are new is to look at $12.50/tick as insignificant.  Many new traders who are used to trading equities are used to much bigger Dollar swings for each quarter point.  If you are trading a standard 1000 shares of a stock and it goes up a quarter point, you've made $250.  That is a healthy sum, but if you have $30,000 invested, it is a fairly small amount.   But traders get used to swings of that much money, and their tendency is to transfer that bias over to the futures.

To get a $250 gain for a quarter point move in the futures, you would have to trade 20 contracts.  So, a new trader might think that if he or she "only" trades 10 contracts, that this is being conservative and completely prudent.

It isn't.  Failing to realize the leverage you have with futures contracts is the fatal error.  When a stock is trading at $30, a quarter point move is a much bigger percentage move than a quarter point of an index such as the S&P 500 which is trading at 1362.  While both equities and futures have their fast and slow periods, futures can move with a speed that will make your head swim.  The larger your number of contracts, the more exposed you are to these types of movements.

A trader might have, say, $50,000 in his account and say to himself or herself that ten contracts would be a good size to trade.  Each quarter point is then $125.  Not so bad, right?  Wrong.  Everything is fine until the market moves against you.  When you are down five full points on ten contracts, you are taking a serious $5,000 hit.  Even using tight stops, a move against you hurts.

Factor in that a new trader doesn't have the necessary experience to know what to do in all situations.  When the Dollar losses start mounting, prudence goes out the window.  All sorts of bad natural tendencies set in, such as trying to make back your losses right away.  So, with the market going against you like that, maybe you turn around and go short.  Then, of course, is when the bounce occurs and you are down another $3000.  Yes, it happens that quickly and that horribly.  Getting whipsawed is the result of poor position size, because the losses lead you to poor and hasty decisions due to the natural emotional reaction to sudden large losses.

If you want to be prudent, there is a good way to ease into trading futures that will minimize these learning experiences.  Consider getting an account with a broker that allows you to paper trade using the same tools that you would use to trade for real.  Experiment with that for a while.  Get a feel for how size impacts your account when the market moves with and against you.  You should spend weeks, if not months, doing this.

You should not switch to trading with your account until you can show consistent profits on the paper trading account.  Once that happens, start small.  When I say "small," I do not mean as a fraction of your account.  Instead, I mean one contract.  That's right, just one solitary contract.  Trade that one contract for at least several weeks.  Once you can show consistent profits with that, then move up to two contracts.  You should spend at least twice as long trading two contracts as you did trading one.  After that, increase your size gradually until you are comfortable - and then stop.  Don't just keep increasing your position size because you can.  The key to making big profits is not related to your leverage, but to your decisions.  Believe me when I tell you that you can make more trading two contracts consistently than you can trading ten contracts without the proper experience.  Your risk is lower and your balance sheet will be better.  Don't think that the size of your futures position will make you more money, any more than buying the most expensive skis will make a beginner a better skier.  In the latter case, it will just make you more likely to run hard into a tree.

The final thing you should consider in terms of position size is to always trade the same size.  If you trade two contracts, trade two all the time.  If you mix it up, and trade three this time, five the next, two the third time, you are only asking for trouble.  Have a standard position size and stick with it.  If you are going to vary it, only vary it by trading fewer contracts.  By this time, your average trade should be profitable.  Trading the same size each time will allow your natural skills to work the odds into your favor so that you consistently make more than you lose rather than getting killed on that "obvious no brainer" play that goes against you and gives you sickening losses.

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