Chapter 15: Risk Management in Futures Trading

Futures Trading is one of the most lucrative markets but has its own challenges. After facing streaks of losses, most traders quit. Traders often lose because they ignore the risks involved in futures trader. 

New entrants in the futures market tend to focus on developing skills to enhance  their ability to time the markets by trying to hunt for accurate entries and exit points, rather than an understanding of the concept of risk and risk management. 

This is one of the main reasons why most traders end their trading career in a very short span, as they end up losing more than they could afford. 

Moral of the story here is, to be a pro trader in the futures market , indeed you need to master the art of trading but to become a successful and a profitable trader , you have to learn the art of risk management and this is exactly what we shall be discussing in this chapter. 

Risk Management in Futures Trading

Imagine a scenario where a pro futures trader all set to start trading and when the market opens, his stock future open long positions have tanked more than 20% due to an unfortunate fall in the overall markets. 

A few days back, his trader friends had warned him about his over leveraged positions in volatile market conditions and suggested that such an aggressive style of trading in futures could be lethal in such choppy markets. 

Recalling the advice of his trader friends, he takes a minute to get out of this dreadful picture and suddenly he gets a call from his broker. 

It’s a margin call said the broker and is asking for additional margin money which needs deposited right away or else the broker will square up all his loss making open positions before the expiry of those future contracts. 

The fall has led to a complete wipeout of his capital. 

What’s worse, he has deployed his entire capital on the trades executed  and does not have a dime more left to give as margin money. 

As horrifying it may sound, this is the exact reason why most traders have to quit futures trading as they don’t have a risk management system in place. 

Remember our discussion on how “leverage is a double-edged sword” and as the same sword that can used for wealth creation, has the ability to wipe out practically the entire capital deployed for futures trading as we saw in the above example.

Could this situation of a complete wipeout of capital be avoided? Could Mr Pro trader escape the margin call if he had noted the most genuine advice given by his friends? 

The answer to these questions lies in Risk Management and thats the next step in the process of futures trading. 

Step 6: Risk Management in Futures Trading 

This is the most crucial step in the process of futures trading and has to be given supreme priority by each and every trader in the futures market. 

A good risk management planning can save a trader from having a rough day at markets. 

Here’s the most simplest and easy to implement plan for risk management which can help you to become better at managing risk. Before we focus on an effective risk management plan. 

Consider these points as the pillars of risk management. A disclaimer here is that some element of risk will always be there in futures trading. 

There’s no holy grail that will save you 100% from risk but with time and practise, one can definitely master the art of managing risk to get rewarded from futures trading. 

Understanding Risk

The most important aspect of risk management is what if the view goes wrong? A trader who cannot quantify the defined risk versus the expected returns is believed to have no understanding of risk management. 

Whenever a trader develops a view for any asset or commodity, bullish or bearish, the next question that should be answered is if the view goes wrong, what % of loss is acceptable to the trader? 

Since we know that highly leveraged positions has the ability to amplify gains but also has has the power to destroy the capital base of a trader and therefore a trader always has to take calculated risks on every trade and work out on a defined risk to reward ratio. 

Always remember since leverage is an integral part of futures trading ,  money management skills of every trader is constantly tested, especially during volatile price fluctuations in the markets. 

Money Management to Avoid Margin Calls 

The easiest way to avoid a margin call is , to follow a risk management system which is great money management. 

A trading plan should clearly define what % of capital has to be deployed as a margin for trade or trades in the futures market before every single time a trader takes positions. 

It is always recommended to keep some balance money as cash or cash equivalents as a backup, so that any sudden margin calls can be taken care of.  

Never Overtrade! 

Overtrading occurs when you have too many open positions or risk a disproportionate amount of capital on a single trade as we saw in our example of Mr pro trader who had exposed his entire portfolio to undue risk. 

To avoid over-trading, a trader must adhere to a trading plan and exercise strict discipline by sticking on to a pre-planned strategy. 

Markets are unpredictable, full of surprises and thus every trader is exposed to market risk during trading. 

A trader has to restrict its position sizing based on the risk appetite defined in the trading plan. 

Over exposure in volatile markets is the most dangerous. To eliminate over trading a trader pays greater attention to position sizing. 

Capital Protection Vs Profits

By now you must be aware of all the potential risks in futures trading. Capital protection in futures trading refers to a strategy or investment vehicle designed to protect a trader’s initial capital investment. 

For every trader , the goal of capital protection should be to minimize the potential for losses and maximize the potential for gains. 

Profits will follow but the main aim of a trader should be to protect his capital so that a trader survives the volatility and is able to continue trading. 

Price discounts everything and everything is priced in the pricing of futures. 

This is the golden rule for every trading. 

Price discounts everything, whether any unusual demand supply mismatch due to any event or any uncertainty about to hit the markets  smart traders start building positions based on the anticipation of price movements in a particular direction by the outcome of such events. 

And the best part, by using technical analysis which is the study of price action, traders can spot trading opportunities and execute entry and exit points based on a risk management plan. 

Hence, big moves can be anticipated and potential defined losses against those adverse price movements. 

The above-discussed concepts forms the pillars of an effective risk management plan for every trader. 

And how exactly can a risk management strategy be executed? 

Here are a few steps that can help you draft and execute an effective risk management strategy.

Guide for Risk Management in Futures Trading