Lessons for the Beginner
by Rick Thachuk

The WLF Futures, Options and Forex Education Network has been helping the beginning trader for many years. Below are some observations that may, in turn, help you with your trading:

Don’t set stops too tightly.

It is appealing to think that risk from trading, whether futures, options or forex, can be minimized simply by setting stop orders so that the most that can be lost on a trade is restricted to some small amount, say $150. Unfortunately, what tends to happen in this case is that the stop order is elected or hit 99 out of 100 times, and often within a day or two. While loss may be small for any one trade, the odds are high that you will suffer a long string of such losses before making a winning trade and this can seriously erode your capital base.

If you consider that the tick value of most futures contracts is about $15, then by limiting loss to say, $150 per trade, you have to buy within 10 ticks of the low or sell within 10 ticks of the high over the entire holding period which may be several weeks, or else you will be stopped out of the trade. This is difficult to do at any time and almost impossible to do on a consistent basis.

Don’t put on a spread as a hedge against loss.

Let’s say that you buy a futures contract and the price goes down. You feel confident that the downward movement is only temporary and that prices will soon rally and will do so for a long period of time. The problem is that, in the mean time, prices have continued to fall and this has seriously eroded your capital base. You determine that by selling the same contract of a different expiration month, the new position will protect you from any further loss until the downward period is over. (You have essentially established a hedge position.) Once prices have bottomed, you can simply buy back that short position (leaving you long the original contract) and ride the bull market to the top. Sounds simple and appealing, right?

Unfortunately, this strategy assumes that you can pick the bottom, and you can’t. It won’t be obvious when the market has bottomed. Instead, this strategy will keep you guessing. You will find that you put on the spread, then take it off prematurely, then put it back on again, then realize that it should have been taken off last week, etc…., and this will generate more stress and ultimately, worse performance than simply closing the initial position. Let’s face it: if you think that the market is bullish but prices keeps falling, then you are wrong. It’s best to close the long position and re-think the trade.

Beware the cost of option premiums.

Buying a call option if you think that prices will rise, or buying a put option if you think that prices will fall have the appeal of limited downside risk. The most that you can lose on a trade is the premium paid for the option plus transaction fees. Unfortunately, option premiums can be expensive and this, coupled with the fact that the majority of options expire worthless, means that it is difficult to make profits over the long run from a strategy of only buying options.

Realize that when you buy an option, you are expecting two things: that the price will go in your direction, and that it will do so by the time that the option expires. The best way to evaluate this strategy is to calculate the break-even point of the option purchase (ie. where the futures price has to be in order to recoup the cost of the option and commissions), and then decide the likelihood of that event occuring prior to the option’s expiration. If you do this, you will realize that the purchase of deep out-of-the-money options, while inexpensive, have an unrealistic break-even point and are usually a bad investment.

So what does work?

Most beginning traders wish to start with an investment of $5,000 or less. Unfortunately, such a relatively small account means that many commodity and forex trades will be out of reach because the risk is too great. To improve the odds of success, the trader must look to minimize risk. The best way to do this is to choose futures or forex contracts that are not very volatile and that have correspondingly low margin. The trader can also look at trading mini-sized contracts which have a smaller contract value than their regular-sized counterparts and therefore only a fraction of the risk. Trading activity will have to be confined in this way until the account balance can be brought up to higher levels.