Traders are often lured to into the futures markets with a fascination for day trading. 

The thought of buying and selling leveraged contracts without overnight risk is appealing to many, but underestimated by most.  As a retail commodity broker, I have had the pleasure, and the pain, of watching futures day traders attempt to profit through strategies ranging from scalping, to "position" intra-day trading, which spans several hours.  

My observations of the futures markets have led me to the conclusion that day trading is perhaps one of the most difficult strategies to successfully employ.  However, for those that have the perseverance to dedicate themselves to the practice, contain the natural ability to eliminate emotions, and have enough experience under their belt, day trading in the futures market might be one of the most potentially lucrative forms of commodity market speculation. 

The term day trading can be used to describe an unlimited number of futures trading strategies and approaches that involve buying and selling a commodity contract in the same trading session.   Many are system based, meaning that trading signals are executed according to specific technical analysis set ups; others incorporate a trader's instinct.  The approach that you take in the futures markets should be dependent on your personality and risk tolerances; not necessarily what has worked for somebody else.  Let's face it; there are only about twenty to thirty commonly used technical oscillators available in most trading platforms.  If there were absolute magic to any of them more people would have discovered the Holy Grail to futures trading.  Rather than expecting a technical indicator or a computer generated oscillator to do the work for you, I believe it to be more productive to properly educate yourself to the risks and the rewards of the commodity markets.  This includes the less technical, and thus less talked about, aspects of day trading.  

Futures Day Trading is Mental

I believe that becoming a successful day trader in the futures markets come down to instinct and the ability to control emotion.  If you have ever been involved in athletics, you have probably heard the adage that performance is 95% mental and only 5% physical.  I have found this to be true in trading as well, although instead of being physical trading is technical.  Quite simply, it isn't which technical analysis oscillators and indicators you use, it is how you use them.  Perhaps more importantly, how you deal with fear and greed that comes with risk exposure in the commodity markets as you are charting your futures trades.  Here are a few day trading tips that may aid in the mental preparation.

Know the Futures Market Volatility and Accept the Consequences

You often hear futures traders talk about their need for volatility.   It is a common perception among the trading community that higher volatility is equivalent to higher opportunity, and therefore profit potential.  Call me a "girl", but I happen to be a contrarian when it comes to this point of view.  Sure, if the markets are moving there is an increased chance for you to catch a large move and make history in your trading account.   However, there is another side to the story; let's not forget that if the market goes against your futures trade you could be put in an agonizing position.  Also, if you are a trader that insists on using stop loss orders, increased levels of futures market volatility translates into amplified odds of being stopped out prematurely. 

I am not suggesting that you avoid the futures markets during times of explosive trade; however, you must fully understand the consequences and be willing to accept the inflated risk of trading accordingly. 

In my opinion, the most convenient way of measuring commodity market volatility is through the use of Bollinger Bands.  The bands allow a trader to visualize the explosion and contraction of market volatility with similar movements in the bands.  Simply put, as the Bollinger bands get wider, the volatility and market risk is also on the rise.  Conversely, tighter Bollinger bands suggest relatively lower levels of volatility.  Please note that I didn't say lower levels of day trading risk; this was intentional. 

Figure 1: E-mini S&P 500 Futures - Traders can visualize futures market volatility through the use of Bollinger Bands.  It is a good idea to do so on a daily chart to get the big picture of market volatility. 

Narrow bands indicate that futures market volatility is relatively low, but if the contraction is excessive enough it may signal an extraordinary spike in price is imminent.  Markets go through times of quiet trade, but such times are often followed by large and sudden increases in instability.  As you can imagine, being in the futures market at such times could be similar to winning the lottery or they could mean financial peril.  Before executing a futures day trade in a fast moving market, or one that is trading quietly, you must be aware of market tendencies to properly assess the risk of initiating a futures day trade.  Being conscious of all of the potential outcomes of your futures day trade may prevent panic liquidation or the infamous deer in the headlights failure to act. 

Commodity Trader's Tool Box

Technology has provided traders with an abundance of readily available information at their fingertips.   Accordingly, I strongly believe that traders should properly understand and utilize the resources available to them.  It doesn't make sense to pick a single indicator or oscillator and expect it to tell you the whole story; instead it should be viewed as a piece to the puzzle.  With that said, it can often be counterproductive to bog yourself down with too much information or guidance; this is often referred to as analysis paralysis. 

In my opinion, it is a good idea to pick three or four tools that fit your needs and personality.  For example, if you are an aggressive trader with a high tolerance for risk you may opt for a quick oscillator such as the Fast Stochastics.  If you are a slower paced individual, the MACD may better suit your needs as it is a much slower moving indication of trend reversals. 

It is important to note that after you have entered a trade you shouldn't change the oscillator that you are watching simply because the original isn't telling you what you want to hear, or in this case see.  This can be a tempting practice for traders that are caught in an adversely moving market and are in search of a reason to stay in the trade for fear of taking a loss. 

Mental "Stop Loss"

As you are probably aware, a stop order (AKA stop loss) is an order requesting to be filled at the market should the named price be hit. A trader long a futures contract may place and stop order below the futures price to mitigate the risk of an adverse price move.  Likewise a trader holding a short futures position may place a buy stop above the current market price as a risk management tool against a possible rally.  Once executed, the trader would be flat the market at or near the named price. 

Most traders or trading mentors will tell you that you should always use stops; I am not most.  I argue that experienced and disciplined traders may be better off without the use of live stop orders and believe that mental stops may be a better alternative.  Supporting my assumption is the theory that  the dollar amount of the risk on any given trade is conceivably higher through the use of mental stops as opposed to actual working stop orders but the risk in the long rung may be less through the reduction of untimely exits.

The concept of a mental stop is simply picking out a price level at which it is fair to say that your position may have been an incorrect speculation and manually exiting the market once your pre-determined price is hit.  Using mental stops as opposed to placing an actual stop loss order may prevent the natural ebb and flow of the market from stopping you out at what ultimately becomes premature. 

I am sure that you have all fallen victim to the stop order that was triggered to exit your trade only moments before the market reversed course and left you behind.   Not only is this a frustrating place to be, but it often has an adverse impact on trading psychology going forward.  Unfortunately, it doesn't seem to be uncommon for inexperienced traders to behave somewhat recklessly in an attempt to get their money back from the very market that took it from them.  It is easy to give in to this mentality, but doing so will almost always end negatively. 

The use of mental stops requires a considerable amount of discipline and may not be appropriate for all traders and strategies.  If you have a consistent problem controlling your emotions (we all fall victim to fear and greed at some point), stop orders are a must.  Without them you may be put into a position in which a single losing trade can wipe out weeks or months of hard work, or worse put you out of the trading business forever. 

Even those that have an adequate ability to stay calm during unfavorable market moves may find losses pile up in violent market conditions.  For example, there are times in which it is very difficult to exit a position once the named price is hit without considerable financial suffering.  If you are not mentally capable of accepting this possibility, placing outright stop orders may be a better alternative for you despite its limitations.  Remember, if successful trading is largely determined by the mental capabilities of a trader it is imperative that you know yourself well enough to steer clear of situations that may lead you to behave emotionally as opposed to rationally.   

Figure 2: Mini Russell 2000 future - Stop loss orders are a great way to minimize futures market exposure, but I believe them to be a great source of frustration as well.  If you are disciplined it may be better to work without stop loss orders.

Be Creative with Options on Futures

It is no secret that more retail traders lose money than not in the realm of futures and option trading.  I have observed that day traders could face even more dismal odds of success.  However, don't let this deter you from participating in the commodity markets, instead use it as your incentive to be different.  If a majority of people are day trading futures contracts unproductively, perhaps you should be interested in trading strategies that are a bit out of the norm.  

Buy Futures Options Instead of using Stop Loss Orders

During the last few days of the life of a commodity option they time value, and thus the premium, of the instrument has often eroded to affordable levels.  If this is the case, it is sometimes possible to simply purchase a call or put option as an alternative to placing a stop loss order.  This strategy can also be viable in option markets that have more frequent expiration dates; particularly the weekly options written on the stock indices and grains. Keep in mind, however, that during times of excessive volatility even options with little time to expiration can remain too expensive to make them a viable substitute for stop loss orders.  In other words, using long call and put options instead of stop loss orders to limit risk of a futures trade is only situationally beneficial.    

In essence, the purchased futures option creates a synthetic trade in which the day trade risk is limited to the amount paid for the option plus any difference in the entry price of the futures contract and the strike price of the option.   This is because the futures option will act as an insurance policy against the futures price moving above the strike price of the long call or below the strike price of a long put.  Beyond the strike price of the option, losses in the futures contract are offset with gains in the option at expiration. 

The premise of such a day trading strategy is to reduce the possibility of being prematurely stopped out of what would eventually become a profitable trade.  However, it is important to realize that using long options as a replacement for stop loss orders should only be done if the risk is affordable.  If the options are relatively expensive to purchase, the risk of loss will be too high; depending on the situation it might render this approach impractical. Keep in mind, the foundation of buying commodity options instead of placing stop orders is to limit risk of loss, not to increase it.  To reiterate, paying more for a protective futures option than you originally intended to risk on the day trade should be a red flag, and lead you to explore other alternatives.

Counter Trend Futures Trading

Based on observations made during my years of being a futures broker, it seems as though most day trading futures strategies are very simple; identify an intraday trend and "ride" it until it ends.  It sounds easy enough; but is it?  I will be the first to admit that day trading is not my forte.  Nevertheless, through the scrutiny of the futures trading practices of others, compliments of my profession as a futures broker, I strongly believe that intra-day trend trading is much more difficult than one would imagine. 

The problem with a futures market trend is it is only your "friend" until it ends.  By the time many trend trading methods provide confirmation to execute a futures trade, the market move has already been missed.   Psychologically, I have a difficult time buying a futures contract that has already risen considerably.  Likewise, selling a futures contract after it has already established a down-trend may simply be too late.  After all, the overall objective is to buy low and sell high.  Buying high and selling higher may work at times, but the common theory that commodity markets spend a majority of their time range-bound seems to work against intraday-trend trading in the long run. Only during times of exceptional market moves will it be possible for a futures day trader to ride a trend long enough to recoup what may have been lost on false signals and failed break-outs of the range. 

Patient day traders might find that they fare better by looking to take advantage of extreme intraday futures price moves in hopes of a temporary recovery to a more sustainable level.  Doing so may provide less profit potential and if done correctly less trading opportunities but may pose better odds of success.

Identify Extreme Futures Market Prices

Futures market prices have a tendency to overshoot realistic valuations, only to eventually come back to an equilibrium price.  Emotion plays a big factor in this phenomenon but the running of stop loss orders are also a primary driving force.  Traders often place sell stop orders under known areas of support and buy stop orders above known areas of resistance.  As you can imagine, there are often several stop loss orders placed on futures contracts with identical or similar prices.  Once these orders are triggered, a swift move in prices in the direction of the stop orders takes place but often has a difficult time sustaining itself.  Understanding that stop running can artificially move a market quicker, and in a larger magnitude, than what would have transpired without the stop orders, a trader could attempt to take advantage of the subsequent rebalancing in price. 

For example, an e-mini S&P trader may notice the market drop five handles in a very quick fashion with little fundamental news to drive the move.  This type of trade may be the result of a market that has simply triggered a batch of sell stops.  As the futures stop loss orders were filled, the buying didn't keep up with the selling and the futures price dropped accordingly.  However, if our assumption was correct and the move was based on sell stop execution, instead of fresh (legitimate) short selling, it is practical to believe that the futures market will rebound some, if not all, of the losses artificially sustained.  A futures day trader may look at this as an opportunity to buy the futures contract in an attempt to capitalize on a partial or full retracement of the drop. 

Figure 3 : Intraday Wheat Futures Chart - Extreme market moves followed by a retracement to an equilibrium level are common as stop loss orders are triggered creating large commodity price spikes.

Naturally, before entering a futures day trade some technical confirmation must be made.  After all, the theory that a market drop was the result of sell stop running was an assumption not a fact.  Overbought and oversold technical indicators such as Slow Stochastics, Relative Strength Index (RSI), and W%R (Williams Percent R), might be helpful in determining whether or not prices were pushed to a level extreme enough to encourage buying. 

Most of the available technical analysis oscillators were developed with the intention of identifying overbought and oversold conditions.  In their simplest forms, both overbought and oversold markets are the result of prices overshooting their equilibrium price.  

Most technical analysis indicators represent extreme prices relatively well.  Thus, traders looking to buy on dips may find them helpful, but shouldn't expect them to be fool proof by any means.  Computer generated oscillators are great tools but they aren't a guarantee.  They can tell you what the market has done, but only you will be able to translate that into what the market may do next. 

Conclusion

Although day trading in the futures markets is a challenge, there is likely a reason why so many active futures traders of all skill levels and sizes are attracted to the practice.  There are obvious market opportunities in intra-day trading and with enough patience, practice and fortitude you may become one of those that have achieved profitable long-term trading results.   However, there is also rationale as to why we don't all quit our jobs and day trade commodities for a living.  Despite what may be relatively conservative risk on a per trade basis and a lack of overnight event risk, day traders face substantial risk in the long-run through the possibility of several small losses.  If you aren't willing to commit yourself to the labor of futures day trading, I suggest that you consider less labor intensive strategies. 

Investors are on edge ahead of event risk

Thus far the summer of 2016 has been highly volatile, and we don't see any signs of this changing anytime soon. From grains, to energies, to currencies and, of course, the financials, there have been fortunes made and lost in the markets. We suspect this trend will continue well into the fall months. Accordingly, it is generally a good idea to try to keep speculative bets on the small side.

Risk-off assets such as Treasuries and gold are highly overextended despite the fact that equity market are hovering at relatively lofty levels. In our view, this offers a glimpse into the minds of investors; it is clear they are far from comfortable with the current environment. We can't blame them; we've yet to resolve the Brexit vote implications and we will soon be forced to endure the latest US employment report and, more important, it's potential impact on the Fed's interest rate policy. Soon after, the second quarter earnings season will roll out. With all of this in mind, it might be worth unloading some risk where possible.

Holiday futures markets didn't disappoint, but the Santa Claus rally did

As is almost always the case, thinly traded holiday markets made for some exciting trades. Perhaps they were most exciting for those on the sidelines watching from afar. A smart colleague summed up his trading in December with the following statement, "The holiday markets giveth, then they taketh away...and then some."

Volume on Monday was on the skimpy side as traders were still enjoying the holiday environment, but China essentially forced traders back to the markets. The Chinese government quietly implemented circuit breaker rules that forced the Chinese stock market to halt trading for two sessions in a row. In fact, today's session (which occurred last night for us) lasted only minutes before trade was halted.

Failure of the Chinese government to allow the markets to properly react to market conditions triggered a global sell-off. At times like this it is important to remember that the Chinese stock market is in its infancy, and is being regulated by an entity that detests capitalism. Nevertheless, they seem to be learning that markets cannot be controlled. The circuit breakers will be bypassed on tonight's market open. In our opinion, this is a big step toward stabilization; after all, with circuit breakers in place buyers were not allowed to step in to cushion the fall.

As most futures traders expected, the Federal Reserve didn't take action

Going into today's FOMC meeting conclusion, the Fed Funds futures markets were assigning a 15% probability of a rate hike. As it turns out, the majority of traders were correct in assuming the Fed would bypass the September meeting. In our view, we probably won't see any action until December but of course, the November meeting is still up in the air.

We recently took part in a survey conducted by FXStreet.com in which we found the results to be rather interesting. According to the survey, expectations of the rate hike campaign are rather meager. The consensus average of those polled is calling for the rate hike cycle to stop at about 1.5%. Some were even predicting the Fed would stop at .75% (only one more rate hike from the current level). Also interesting, almost 60% of those polled believe quantitative easing is a tool the Fed will continue to use in the mid-to-long term.

If you are interested in seeing the details of the survey, click here: (http://www.fxstreet.com/analysis/fxsurvey-dovish-fed-to-hike-interest-rates-in-december-qe-might-return-in-the-mid-term-201609201150)

It is early, but October has been the least volatile month...EVER.

If today was the end of the month, this would be the quietest October on record and it would also be the quietest month ever. Of course, it is too early to suggest that is what is in store for the markets come October 31st, but it should at least offer some perspective.

Further, it has been almost a year without a 3% drawdown in the S&P 500. This is the second longest run of its kind in history. If the market survives the next 10 days, it will beat the previous record. Keep in mind, 3% is literally a drop in the bucket. At today's price, that would be a mere 75 ES points.

We don't when the dam will break, but we do know it always does, eventually. Traders should be on their toes. Afterall, investor complacency is at an all-time high and historically such environments haven't ended well.

As mentioned in a previous newsletter, the University of Michigan stock market sentiment index measuring the percentage of investors that believe the stock market will be higher a year from now is at an all-time high. Similarly, credit spreads are near historical lows (this is the difference between the yield on high-risk securities and risk-free Treasury securities). Tight credit spreads suggest investors are reaching for yield and lack concern for economic turmoil (in short, they are complacent). The last time we saw such tight credit spreads was mid-2007, just prior to the financial collapse. We aren't predicting a repeat of 2007, we are simply saying the bulls should consider exercising caution. Is anybody familiar with "Old Man Partridge" from "Reminiscences of a Stock Operator"? The trend is only your friend until it ends.

A New Look at an Old Futures Trading Topic

There are an unlimited number of ways to skin a cat, and trading is no different. Despite your futures trading strategy, risk tolerance or trading capital, having a plan is one of the most important components of achieving success in these treacherous commodity markets. However, we believe that the most important characteristic of a profitable futures and options trader is the ability to adapt to ever-changing market conditions. Assuming this, it seems logical to infer that a commodity trading plan should be established; nevertheless, just as rules are meant to be broken, futures trading plans should be flexible to accommodate altering environments and new events.

The premise of properly planning a commodity trade is similar in nature to a business plan. It is a relatively detailed outline of the structure of the futures and options speculation and the contingency plan, or plans, should the market go against the trade. Once again, I believe that trading plans should not necessarily be set in stone; behaving as if they are could lead to financial peril.

There are two primary components of a commodity trading plan: price prediction and risk management. Price prediction is simply the method used to signal the direction and timing of trade execution. This may involve fundamental or technical analysis, or both. Risk management specifies when to cut losses, when and how to adjust a position, or better yet when to take profits.

Commodity Futures Price Speculation (Hopefully Prediction)

The only way to make profitable futures and options trades is to buy low and sell high. This is true whether you are trading derivatives, or baseball cards. Although it is a simple concept in theory, in practice, it is much more difficult to implement than one may think. In order to successfully buy something at a low price and sell it at a higher price, the trader must first be accurate in his speculation.

Determining an opinion on where commodity market prices could, or should, go is only half the battle. Once you have done your homework in both fundamental and technical analysis, you must be able to construct a prospective commodity trade that will be profitable if you are correct and hopefully relatively painless if you are wrong.

Timing is Everything when Trading in Commodities

In futures and options trading, timing is everything. I constantly remind my clients and prospects that there is a big difference between being right in the direction of a commodity market and actually making money. I have witnessed traders be absolutely correct in their speculation of futures price movement, but miss getting into the trade due to unfilled limit orders, or entering the commodity position too early (which can cause the trader to run out of money or patience before the price move occurs).

Attempts at commodity price prediction can be based on technical oscillators, psychological barometers, supply and demand, or anything else that provides clues to price direction and timing. I am a firm believer that there aren't right or wrong trading tools but there are right and wrong ways to use them. Simply put, trading indicators can be compared to guns; guns don't kill people, people kill people. In trading, oscillators or charting tools don't siphon trading accounts; unfortunately traders sometimes do it to themselves by acting too aggressively to trading signals, or ignoring them altogether.

Further, while it isn't important which indicator you use to time a futures trade entry and exit, it is important how comfortable and confident you are in using it. This is especially true in reference to computer generated oscillators such as the MACD and Slow Stochastics. In the long run, I believe blindly taking all buy and sell signals triggered by such indicators would yield similar results. Accordingly, the primary factors playing a part in whether a trader experiences profits or losses are likely the ability to avoid panic liquidation, properly placing commodity risk management techniques in place, and exiting option trades that have gone bad before it is too late. In other words, I believe that good instincts and experience are more valuable than any technical indicator, or supply and demand graph, that you will run across.

Once you have determined your speculative tool of choice and determined your conclusion on the direction, or lack of, it is time to construct a strategy that will benefit if your assessments are accurate and mitigate risk if you are wrong. This may include the use of options, futures or a combination of both. The method that you choose should be based on your risk tolerance, personality and risk capital.

Options, Futures, or Both

Commodity speculators have an unlimited number of "options" when it comes to trading vehicles. The key is to find an approach that will provide you with a manageable risk profile, while still leaving the potential for a profit that you will be satisfied with. Throughout the process, keep in mind that the relationship between risk and reward isn’t linear. Only a fine balance between the two will allow the trader the probability of a reward rather than the dream of one. Accepting reckless amounts of risk may pay off for a lucky few, but for the masses the results will be dismal.

Depending on the characteristics and personality of the trader, a stock market bull might purchase an e-mini S&P futures contract, purchase an e-mini S&P 500 call option, sell an e-mini S&P 500 put option, or even use a combination of long and short options and futures contracts, to construct a trade with various risk and reward prospects.

Likewise, a crude oil bear might opt for a limited risk option spread such as an iron butterfly or he be willing to accept large amounts of risk and volatility by choosing to short a futures contract outright. I couldn't possibly touch on each of the commodity market strategy possibilities in within the realm of this article but you should be aware of the opportunities available to you, and which fits your personal trading profile, before ever putting money on the line. If you are interested in exploring commodity trading strategies outside of simply buying or selling a futures contract, you might find my book “Commodity Options” helpful. It outlines several commodity option spreads and even synthetic strategies in which futures and options are combined to construct a hedged position in the futures markets.

Risk Management is Imperative when Trading in Commodities

The "meat" of a proper futures trading plan is risk management. This is concerned with establishing thresholds of loss that you are capable and willing to accept in exchange for potential rewards. In the case of futures traders, this may simply mean picking a stop loss price and placing the order in conjunction with a profit target (limit order).

Once again, trading plans are for guidance and shouldn't be followed blindly. Don't be the futures trader that misses taking a healthy profit while trying to squeeze out an extra $20 because the price came within ticks of a working limit order but failed to trigger. Also, even if your trading plan doesn't involve a trailing stop don't be a fool. Markets don't go up or down forever, if you have a large open profit tighten your stop loss order, or place protective options or option spreads and walk away.

Managing Commodity Market Risk is an Art not a Science

Creativity can be a valuable tool in futures trading. Think beyond the traditional practice of using stop loss orders to manage risk, because there are an unlimited number of possibilities. For instance, experienced futures traders might choose to incorporate selling option premium against a correctly speculated futures contract as a form of risk management. Doing so converts the trade into a type of “covered call” or “covered put”. The premium collected from the short option not only produces income, but it provides a hedge against a price reversal. This is because a long futures contract and a short call option benefit when the market moves in the opposite direction (they counter act one another). Likewise, in-line with this strategy you may want to use the proceeds of the covered call or put strategy to purchase an option to protect your risk of an adverse futures price movement.

As you can see, well-informed traders have a plethora of strategies to adjust the risk and reward of a futures position. A trading plan couldn't possibly cover all market scenarios, and adjustment possibilities, but writing down a few potential ideas may keep you from freezing in the heat of the moment.

If you are interested in exploring the endless possibilities in regard to futures trading management, and strategy creation, please visit our futures and options trading educational video archive.

Risk and Reward: Give Yourself a Chance!

When deciding how much risk you are willing to take in the commodity markets and setting your profit objectives, you must be realistic. Beginning futures traders are often surprised to hear that many of the best traders struggle to keep their win/loss average above 50%. With these odds in mind, it doesn't make sense to consistently risk more on a trade than you hope to make should you be right. For instance, if your average risk is $500 you should have an average profit target of at least $500. Anything other than this puts the odds greatly in favor of your competition.

Commodity Option Sellers Face Optimal Win/Loss Ratios but That Doesn't Guarantee Success

Because more options than not expire worthless, commodity option sellers often have much better win/loss ratios than futures traders. However, the drawback of an option selling strategy is the reality of accepting theoretically unlimited risk in exchange for limited profit potential. In the game of commodity option selling, winning far more trades than you lose is only the beginning. An option seller must be savvy enough to prevent the small percentage of losing trades from wiping out months of profit. My intention isn't to deter you from selling options, in fact this is the strategy that I prefer and recommend as a commodity broker to my clients. However, those that partake in this practice must be ready and willing to face the consequences during draw-downs.

U.S. futures exchanges don’t accept stop loss orders on options. Even if they did, it wouldn’t be in the best interest of traders. This is because it wouldn’t be feasible to place stop orders on most options, or option spreads, due to the nature of the bid/ask spread and the seemingly high probability of being stopped out prematurely. Remember, a stop order becomes a market order as soon as the named stop price becomes part of the bid/ask spread. If the bid/ask spread is wide due to a lack of liquidity, a stop order will be triggered and filled at a dramatically inopportune time and price (unfavorable slippage).

Instead of placing stop loss orders, short options should be monitored closely; keeping a "mental" stop in mind is important. I typically advise traders to use a double out rule. This means for every naked short option, whether it is within an option spread strategy or sold individually, you should strongly consider buying it back at a loss if its value doubles from your entry point. In essence, if you sell a crude oil option for .50 cents or $500 ($10 x 50) and following your entry the option doubles in value (appreciates to $1.00 or $1,000) it may be fair to say that you were wrong. At this point, a trader should strongly consider liquidating the position and moving to the next opportunity. Failure to do so may convert a moderate loss into something much more.

Unfortunately, in fast moving markets the value of an option sometimes explodes in value very quickly, making the double-out rule impossible to implement. Even so, the double out rule should be part of the overall trading plan. This doesn't necessarily mean it is an exact science; trading is an art and should be treated as such. Imagine being short a put option in a declining market that has reached the designated double out point, but the market is approaching significant support. If you strongly believe that the futures price will hold support, exiting your position at top dollar in panic, doesn't make sense. However, on the flip side; if you find yourself counting on hope rather than rational logic, you have let it go too far. Sometimes the line is difficult to see until it has already been crossed but its times like this that make or break a trader. I believe the ability to properly manage these scenarios come from instinct and experience; it cannot be attained from reading a book or attending a seminar.

The 10% Rule in Trading

Many futures trading courses and literature claim that a commodity trader shouldn't risk more than 10% of their trading account on any one trade. This seems to be relatively sound advice but might, or might not, be feasible for everyone. For example, a risk averse trader may not be psychologically equipped to handle such a loss which can easily lead to irrational trading behavior. On the contrary, a well-funded-trading account might be risking a substantial amount of money if risking 10% of the commodity trading account.

Most beginners underestimate the value of psychology. Once the balance is broken it is hard to regain logic and can lead to large losses. For example, a trader that opens an account with $10,000 and immediately loses $1,000 on the first trade may dedicate subsequent trades to recovering losses sustained on the original. In other words, they are often tempted enter a market prematurely and aggressively to make up for lost ground. This behavior would demonstrate an example of a trader that simply isn't capable of taking such a large loss without detrimentally impacting the original trading plan.

An additional drawback of the 10% rule is the fact that during volatile market conditions, whether trading options or futures and depending on the risk capital available, it may not be possible to construct a trade with reasonable odds of success without surpassing the appropriate percentage. In this case, the market is often best untouched, but as humans we are naturally drawn to that of which we shouldn't.

Leave Multiple Contract Trading to the Pros and Well Capitalized

As a long-time commodity broker, one of the most destructive things that I have witnessed traders do is execute multiple futures contracts in a moderately funded account. Inexperienced traders are under the assumption that trading several futures contracts simultaneously will maximize their "return", but what they are actually doing is maximizing risk and minimizing the probability of a successful trade. Despite the emotions involved, commodity trading isn't about feeding your ego it is about making money...right?

Stop the Loss!

Futures traders often look to manage risk of loss through the use of stop loss orders. A stop order instructs the broker to exit an outstanding futures position if market prices move adversely enough to reach the named price. However, keep in mind that a stop order can also be used to enter a market. Such a stop order is often placed above areas of significant technical resistance or below support in an attempt to capitalize on a potential price break-out.

In order for stop orders to be effective, they must be properly placed. Anything less will result in either too much risk, or premature liquidation of a trade that may eventually go in favor of the position. This too is an art and not a science. Where stop orders should and shouldn't be placed isn't a black and white decision. There are many areas of gray involving market conditions and characteristics as well as the personality, account funding and risk tolerance of the commodity trader.

If you are a beginning trader this may be a good argument in favor of using a full service commodity broker. However, you must realize that even a well experienced futures broker or advisor can't see into the future and is subject to the same frustrations as you may be. Nonetheless, in theory she may be a little more savvy, and that could have a positive impact on performance in spite of the slightly higher commission rate.

Be warned, stop orders aren't a guarantee of risk. Because a stop order becomes a market order once the stated price is reached, there may be slippage; in rare cases, a substantial amount of slippage. An experienced commodity broker might be able to help you in constructing an option strategy to be used as an alternative in risk aversion. The use of options in place of stop loss orders provide traders with additional lasting power because it eliminates the possibility of being stopped out of a commodity market on a temporary price spike. For example, a short option or futures position may be hedged by a one by two ratio write if the volatility and premium allows.

The ability to place a stop order or limit the risk of a futures trade through options and option spreads should eliminate some of the stress and emotion involved in trading. Rather than losing sleep over a trade gone bad, those with stop orders or protective option positions (insurance) can relax knowing that he has done his homework and has mitigated his risk in commodity trading.

It is Your Money

We don't all wear the same shoe size, or have the same hobbies, so why should we all use the same trading strategy and risk management techniques? The truth is that we shouldn't. My perception of what constitutes reasonable timing of entry, and how much money and emotion to risk on a particular trade, is likely far different than yours. Commodity trading is an ambiguous game; there isn't a right or wrong answer to most aspects of speculation. For example, the same trading "ingredients" may work for one person but not for another due to differences in experience, education, risk capital and emotional constraint.

Only you will be able to determine what works for you; discovering what that is requires patience, discipline, and an open mind. The most important feedback on your progress will be your commodity account statements. This isn't to say that you should hang up your trading jacket if you experience a drawdown, or even a complete account blow up, but it is important that you are realistic. Some people tend to only remember the good trades and others only remember the bad. Each of these distorted perceptions of reality can have an adverse effect on your commodity trading. Successful traders remember the good trades and the bad trades, but most importantly learn from all of them.