Futures contracts are a highly affordable way to trade the financial markets, and like many forms of stock market trading, is one that is also tricky, let’s see the hidden advantages of this trading instrument and how to trade futures contracts safely.
On the positive side, futures contracts offer high leverage and this makes financial trading really affordable, on the negative side however there is this misunderstood and completely wrong perception that one has to have a risk / reward ratio of 1:3 or better.
Here’s the big illusion, first of all it’s impossible to actually do swing and position trading with that kind of risk / reward ratio, it can only be possible in day trading, but as regards these longer term trading objectives a risk / reward ration of 1:3 is much more of a myth spoken about among dreamers rather than a fact of real world trading.
If you truly want to learn how to trade futures contracts efficiently and smartly, this is one of the most important tips because it relates to trading money management.
1:3 Myth Has No Place In Longer Term Trading
Any trading strategy that involves holding overnight trades is really highly profitable and actually less risky than day trading, but it’s impossible to achieve with the 1:3 myth in mind. First of all the people who invented this myth look at price action magnitude alone, while completely ignoring probability, then they do some lame math calculations and try to figure out what trading method is sustainable and what is not.
Stock market investing today, works on probabilities, as long as you truly know the probabilities of your trading system (Which is very difficult) you can afford to trade successfully and make a lot of money with a risk reward ratio of 7:3! That is risking $7 to make $3, on a market such as the Dow Jones, you would have to have a 700 point stop in place and the average exit point (If things were to go well), would be 300 points away from entry level. It sounds like nonsense but that’s how much your stop loss orders have to be, otherwise you risk getting stopped out unnecessarily, if the probability is high enough then the risk reward ratio of 7:3 is perfect, and it is sustainable in the real world.
The only way to learn how to trade futures successfully is to bear the metric of probability in mind, something that only becomes apparent after studying many charts and many trading days.
Some Days Futures Fail – No Matter What
The flash crash that happened in the markets in 2010 wiped out many long leveraged instrument positions, even our 700 stop Dow futures trading system would have failed on that day.
How to trade futures successfully has a lot to do with probability:
Nothing could have prepared us for a 1000 point drop, yet it would have been the only case in many years, where the entire 700 point stop was taken out, in all other occasions we may predict the market wrong, but we will close out our trade before the 700 stop is hit, resulting in a much smaller loss, usually 200 -300 points. But on the positive side, we also never get stopped out unnecessarily when the Dow swings up and down 150 – 200 points for many days before finally moving in the expected direction. The amount of money we save by not getting stopped out unnecessarily is phenomenal in the long run.
How to trade futures profitably, has a lot to do with probability, and probability requires many sample days. The 1:3 myth has nothing to do with the real world and is just a fancy numerical fantasy in the minds of writers and trading educators who DO NOT trade for a living.
Stock Market Investing Tips and Market Speculation by..
Scott Smith – Investing In The Stock Market © 2008 – 2010
Previous Post >>> Online Stock Investing
Interesting article there Scotty.
Although I don’t trade Futures contracts myself, what you are saying here goes to the contrary to what many believe, including myself.
A Trading System can be easily backtested with a little trading software knowledge, and its something I recommend all traders do, to help them find a high probability Trading system. But there is no Holy Grail System out there, and any system can go though a run of losers. Probability is only one aspect to a successful trading system, average winners size compared to your average losers is also important, and if you can manage both, all the better.
But sorry mate, this is where I disagree with your Risk to Reward method to help avoid being whipsawed. To my way of trading, it is about keeping your losers short and letting your winners run. There are ways you can keep your risk short and avoid being whipsawed intra-period, without increasing your accepted risk.
Hi Cade. The problem is that there is no guaranteed way to profit over the long-term from trading futures and everyone has different opinions on what works well, and what doesn’t. The article above is not written on opinions, but written on what has worked well for me and many of my fellow traders in the past.
I do however hear what you’re saying, and opinions are surely welcomed here. It’s important for readers to listen and learn from different points of view, then test and measure different strategies in order to find something that works to their investing advantage over the long term.