Trading Tip #11 : Healthy respect for the markets

Markets are powerful things. When you first start trading, you are likely to hear a lot about the risk that comes with the potential opportunities in trading. Don't just pay it a lip-service. It is important that before you risk one dollar, you understand and respect how the markets work and what your responsibilities are.

Understanding the mechanics of risk and reward will help you plan trades

One key thing to remember about futures trading is that you are leveraged in your positions. What is leverage? Well, you are basically able to control (buy or sell) an exponentially greater value of contract with a fraction of the overall price. You use a smaller deposit (margin) as a performance bond to trade a much larger total value.

Leverage can bring big dreams or big nightmares

If each trade is leveraged, then the risks as well as the potential rewards are multiplied accordingly and that means you are on the hook big time. Consider this scenario:

The S&P 500® Index is the most widely used barometer for large-cap U.S. stocks. Day trading is not done using the cash index itself, but instead using a futures contract that closely follows movements in the Index. This futures contract, dubbed the E-mini® S&P 500, is listed by CME Group, the largest futures and commodities exchange in the world. Each e-mini S&P contract is worth $50 multiplied by the index futures price. That means when the market is trading at 1275.00 that contract is worth 1275 x $50 or $63,750. So, for instance, if a day trader buys a September E-mini at 1275.00 and then sells it later in the day at 1278.00, then this would result in a profit of $150 (calculated as 3 points x $50 per point), minus fees and commissions. The minimum price fluctuation or "tick" is 0.25 points or $12.50.

Initial Futures Margin is the amount of money that is required to open a buy or sell position on a futures contract. Margin essentially acts as a good faith deposit demonstrating your financial ability to tolerate the risk of the trade - as well as cover any potential losses. Initial Futures Margin for the e-mini S&P is set by the CME Group and is currently $5000 per contract. Add another contract, and you have to have twice the amount on deposit. The good news is that margin for day trading is reduced considerably. You should check with your brokerage to inquire about their day trading margin requirements. Also keep in mind that margin rates are sometimes updated or adjusted according to market volatility.

So for every long or short position you have, a mere $5,000 (or in the case of day trading, considerably less) is enabling you to be in charge of over twelve times that value. Isn’t leverage great? Until it isn’t. It also means you can lose unlimited amounts of money, far greater values than you have on deposit. That responsibility is constant – you can lose money even while a position remains open. Every time your account dips below maintenance margin levels, you have to make an immediate deposit to bring it back up. If margin rates change while you have a position open, you are responsible to add funds to meet that level.

Consider the value per point and you will be able to respect the power of the market

If each point in the e-mini S&P 500 contract represents $50, it only takes 10 points for $500 or 100 point move to that $5,000 level. Some days have smaller trading ranges, or a tighter point spread between the high price and low price. Other days might have extremely volatile trading where 30 points can be given or taken away. 30 points is $1,500 per contract that you would have to celebrate if it is in your favor. It is also the amount you would have to deposit if you needed to bring an account up to margin levels. Trading more than one contract? Two will mean $3,000. Five contracts? You get it now – that means a large move in the market will cost you $250 per point. Things add up pretty quickly, and that is why it pays to appreciate and respect what you are getting into with every trade.

Never lose sight of the risks – it helps keep you grounded

It is easy to get carried away with the potentially glamorous parts of trading, but it pays to be aware of the real risks for every minute detail of a trade. I recommend planning every trade with these details in mind. I have specific targets for entry as well as profitable or losing exit strategies. Knowing when and where to pull the trigger every time is important whether the market it moving in my favor or against it. It helps me maintain a healthy respect for the power of the market, and keep me from letting my emotions dig me in too deep.

Best Trades to you,

Larry Levin
Founder & President - Trading Advantage