Steps In Trading Futures - Introduction
Futures, as a derivative instrument with unique trading characteristics, is totally different from trading stocks and shares or the underlying asset itself, otherwise known as spot trading. Spot trading of the underlying asset itself is a simple matter of just buying at one price and selling at a better price. However, the margin trading system used in futures trading is completely different and requires a lot more than just buying at one price and selling at a better price.
There are many ways to trade futures; Futures can be traded for hedging, spreads, outright speculation and arbitrage. This tutorial shall outline the essential steps necessary in making a simple outright speculation position from beginning to closing.
These are merely the most essential and fundamental decisions and steps to take when trading futures. Your specific futures trading plan or system make require even more elaborate steps. Please also take note that the steps outlined in this tutorial deals with outright speculation in futures without intention of taking delivery on physically delivered futures contracts.
Overview of the Steps in Trading Futures
There are five main steps in the process of trading futures contracts for outright directional profit; Determining your outlook, determining your risk tolerance / Position Sizing, determining initial margin requirement, making your entry and eventually offsetting to close out your position. These steps in trading futures assume that you have a good understand of the basics of futures trading especially in terms of the margin trading system used in futures trading.
Step 1: Determining Your Outlook
No matter what kind of underlying asset you are trading futures on, you need to first have an outlook. If you expect the price of the underlying asset to go up, you would go long on its futures contracts in an outright speculation or if you expect the price of the underlying asset to go down, you would go short instead. You also need to determine how long you expect your trade to run when trading futures so that you can decide which month contracts to trade.
Step 2: Determining Your Risk Tolerance and Position Sizing
This is the step most beginners to futures trading miss. Futures trading, as a leveraged trading method, losses can build up very quickly and wipe out an account faster than most beginners to futures trading can imagine. Futures trading is definitely one trading method that is intolerant of losses as profits and losses are settled at the end of every single trading day in a process known as "Daily Settlement".
First of all, you need to determine how much of your fund you are willing to risk for that trade. This is usually determined by percentage. Most futures day traders have a 1% or 2% risk tolerance. You need to decide how much you are willing to loss if the trade did not work out as expected. Once you know exactly how much you are willing to lose, you can now determine how many futures contracts to trade.
Position sizing is a way of determining how many futures contracts to trade in order to make sure when the price of the underlying asset move against your favor in the amount you expect, the total loss on the overall futures position is within your risk tolerance.
Learn how to do Position Sizing in Futures Trading.
Step 3: Determining Initial Margin Requirement
Once you have determined the number of futures contracts to trade, you now need to determine which futures contract to trade and the amount of initial margin needed to trade that many futures contracts. Basically, if you are planning an aggressive short term trade, you would choose near term futures contracts and if you are planning for a less volatile and perhaps longer term futures trade, you would choose futures contracts with longer expiration. This step of choosing which futures contract to trade should actually be completed in the position sizing stage.
Initial margin is needed no matter if you are taking the long side or the short side when trading futures. If you don't have enough cash to trade that many futures contracts, you would have to cut back on the number of contracts to be traded. This shouldn't be the case if you are following a sensible futures trading plan that doesn't require you to trade with all of you money. Trading with all your money means that you would not have cash remaining to meet maintenance margin requirements should the trade move against your favor badly.
Read the full tutorial on Initial Margin.
Step 4: Entry and Stop Loss
Once you have determined which direction to trade, which futures contract to trade, how many contracts to trade, how much cash to pay in order to trade that many futures contracts, it is time for you to make your entry. When trading futures, make sure you go long when speculating on the underlying asset going upwards and go short when speculating on the underlying asset going downwards. Once your futures position is put on, you need to also set your stop loss order as planned in the earlier steps.
There are many futures orders you can use when making your entry and stop loss order so make sure you know what kind of orders your futures broker offers and plan your entry accordingly.
Step 5: Offsetting
No matter if you are taking profit or stopping loss when trading futures, you would need to perform an action known as "Offset". Offsetting means taking an equal and opposite trade in order to neutralise your existing position, effectively closing it out. The actual process is invisible to the futures trader and undertaken automatically by your futures broker. Read the tutorial on Offsetting Futures.