Futures Trading is as complicated as it sounds, and as risky as people make it out to be. But once a basic understanding of the way the futures markets work, and a working knowledge of one or two commodities or stock index futures is had, futures trading can be a risk well worth taking.

Futures, as the name implies, are contracts on an asset to be delivered at some future date. To make these examples simpler to understand, I’ll use our beloved coffee futures as an example. Coffee futures are traded for five months throughout the year. Which means that if I purchase one May futures contract, and I don’t liquidate (or sell) that contract before it expires, then some time in early may 37,500 lbs of coffee will show up in a warehouse with my name on it and a rather large bill. If I sell this contract prior to expiration however, I only need to worry about profit and loss as related to the paper contract itself, the price of which is determined through free trade on the ICE exchange.

For any commodity, there are a few factors we need to understand before entering a position:
1. What is the size of the contract per commodity?
2. What is the margin requirement and maintenance margin requirement?
3. On a relative basis, how volatile is my chosen market?

(Notice here I am not discussing fundamental factors. While these do influence futures in the long run, they are a futures trader’s worst enemy in the short term. Investing and trading, while in principle are virtually the same, they differ in duration, and this makes them nearly diametrically different in practice.)

The size of the contract is important because it tells me the significance of price movements as it relates to my own profit or loss in that market. For example, a coffee futures contract, as we said, is 37,500 lbs. This means that for every penny that the price raises, I make $375. Likewise, for every penny that coffee futures fall, I lose $375. Depending on my risk tolerance or whether I am trading for short term or long term gains, this knowledge allows me to create a risk-reward money management system for this commodity.

In case you haven’t noticed, one coffee contract is worth a great deal of coffee and cash. And the price of a full contract is too rich for the blood of most speculators. Futures trading allows speculators to own enormous quantities of a commodity for a small sum of money, called margin. At present, the initial margin requirement on a coffee futures contract is in the neighborhood of $3,000. So for that small sum I can control a contract that at current prices represents approximately $45,000. That my friends is the definition of leverage, and there is no investment category out there with more leverage than futures trading. (Possible exception being real estate)

If the price rises a mere 10 cents, then I more than double my initial margin. If coffee futures fall a mere 10 cents, then I lose more than 100 percent of my risk capital. This is where the game shakes out those with a weak stomach. Because of the immense leverage, it is essential to trade according to a reliable system that incorporates both reliable technical indicators and sound money management practices. These are large topics themselves beyond the scope of this post. Nevertheless, they should be structured carefully around our third factor, volatility of our chosen market.

Futures trading is not only notoriously difficult to make money in, futures markets are also notoriously erratic and unpredictable, at least in the short term. Volatility is an inherent characteristic of free trade. The markets are in a constant state of flux, never remaining at one price for longer than a few seconds. So as we select a market, volatility should be a determining factor. Let’s say I have a $20,000 trading account (too small for a beginner), and I want to trade a market like coffee.

At present coffee futures are not terribly volatile (compared to its historic levels). Prices will fluctuate 1 to 8 cents a day. This means that if I want to give this market enough time to make me some money, I probably need to risk 10 cents so I don’t get stopped out on a simple price drop, in addition to buying strategically. This would require me to risk about 20 % of my account equity on a single trade, far too much to risk on a single trade.

Most money management systems consider risking anything more than 5% on a single trade careless, and most professionals don’t risk more than 2 %. This requires either a large trading account, or limiting your trading to markets that are less volatile or require less risk capital. Sugar or cotton futures may be an alternative. Something all those out there should keep in mind is that you are going to lose money in this game in the beginning. And the smarter you think you are, the more you stand to lose.

Futures trading requires you to think in terms of probabilities, and most people of average to high intelligence think in terms of absolutes. And because intelligent people are confident, they don’t take prudent precautions from unforeseen potentialities and their own ignorance. Doctors and lawyers throw a great deal of money into the futures markets and they are notoriously bad traders.

If you are right 60% of the time in futures trading and you apply a sound money management system, that is enough for you to make a great deal of money in the long run. If you’re right 60% of the time as a doctor or lawyer you kill clients and get canned. Futures trading requires you to think in terms of minimizing risk, an exceedingly difficult concept to apply when you believe you’re right about a trade (I speak from personal experience here). It is those who are convinced their view is right who lose the most money. It is the experienced speculator who lets the market tell him he’s right, rather than assuming the market will eventually capitulate to his convictions.

Trading this way requires you to find a system that defines your risk per trade based on the size of your account equity. This system needs to assume that you are going to be wrong 40 or 50 % of the time, and still needs to show you a healthy return on investment. Sound strange? I thought so too at first. Read a book or two on betting strategy in gambling, it will give you a sobering look at a long term risk-reward strategy based on probabilities. This system should contain indicators that define and identify trends, ranges, and reversals. These are indicators which in essence show us market sentiment.

In every price move there is a story of two forces colliding, a battle on the day, week, or month. Indicators should do more than interpret the past price movements, they should read the complex psychological factors influencing the current price. They should tell us when bulls are gaining strength, and when bears are getting tired. They should tell us when all the buying has been done on a long term historical basis, and if these forces are growing in strength or weakening. The best resource I have for all this is A. Elder’s “Trading for a Living”. This book contains 80 % of all the futures trading info you will ever need to learn. The other 20 % will come from studying the markets and getting burned a few times.

Regardless of the pain and suffering futures trading has put me through at times, it has enriched my life all the more. I can’t imagine my life without it.