Sunday, October 15, 2006

Why so many futures trader fail

Most of the futures traders I know have started trading stocks and somewhere along the road decided to try their hand at futures. And most trade something between 2 to 5 contracts using the margin given to them by their broker to the fullest. For example, for trading 5 Russel contracts intraday an account of 10.000 USD would be sufficient. You know I don’t recommend that, actually I consider that reckless trading and a sure way to disaster and bancruptcy, but it is possible and it is done.

Have you ever stopped to consider how many shares these 5 Russel contracts equal to?

I don’t look at the contract value. I use a very simple approach to determine this. I just say a tick is a tick. It doesn’t matter if this tick represents 0.1 (eg. the Russel) or 1 (eg. the Dow futures) or 0.0001 (eg. most currency futures) or 0.000001 (eg: the USD/YEN currency futures) points.

A single tick usually pays 10 USD to 12.50 USD. (I know the Dow pays less and the Bonds pay more, but let’s concentrate on the most common tick value)

To earn 10 USD per tick with a stock, you need to trade 1.000 shares, as stocks are now priced in pennies and the tick value is 0.01. Of course there are a lot of stocks, which move in bigger increments, which never ever have a trade at every 0.01 increment. But there are also futures which move a lot faster and jump easily 10 tick levels. If you ever tried trading the ZG Gold futures you know what I mean.

On the other hand there are a lot of stocks (examples coming to mind are MSFT, CSCO and a lot of other high volume stocks) which trade at every 0.01 tick level quite heavily and for our comparison to work we will look at these.

So if you trade 5 contracts ER2 with your 10.000 USD account, could you trade 5.000 shares MSFT as well?

To trade 5.000 shares MSFT fully margined (4 : 1) you need an account of at least 36.000 USD and that’s the absolute minimum. Considering the volatility of most of these high volume stocks a 2 : 1 margin rate would be more appropriate for most traders, meaning with a 36.000 USD account you would reasonably trade something between 2.000 to 3.000 shares MSFT.

Still, I’m sure, most futures traders would think nothing of trading even swing trading 3 Russel contracts with a 10.000 USD account, not to say 5 to 10 contracts with a 36.000 USD account.

This has nothing to do with inappropriate risks. This has to do with perception.

Most consider trading 1 contract not worth the effort. But trading 1.000 shares, well that’s something different. Most start trading 1 lot or 100 shares and work their way up to 1.000 shares or 10 lot sizes. But with futures, if you compare them with stocks, most start with a 20 lot.

Do you now really wonder why a lot of traders fail trading futures?