Let’s look at a recent winning trade I had. This trade was based on my interpretation of the CFTC’s Commitments of Traders report, the current futures curve and the historical futures curve surface available at tools.thetradersjourney.com.
The Setup
- Based on the historical shape of the lean hogs futures curve, it seemed that the spread between the front months and back months was larger than occurred, taking seasonal tendencies into account:
- When commercials are at an 18 month (or longer) extreme in the COT report, I consider opening positions that are in the same direction. They are the smart money.
When a futures curve different from its usual shape, I consider betting that it will return. This can take patience and can be expressed with SPREADS.
Pulling the Trigger
To express this opinion, I knew I wanted to use spreads. Why spreads? I’m glad you asked. BECAUSE TRADING IS ABOUT LIMITING RISK WHILE MAXIMIZING RETURNS. Spreads help to eliminate “tail risk”. If some horrible swine disease breaks out overnight, ALL lean hog contracts will rise. If I’m short outright futures contracts, I could take a massive loss (“stop loss” orders will not protect you from massive price moves). But if I’m short a near-month contract and long a longer-dated contract then my losses in the short leg will likely be offset by gains in the long leg.
So, on April 10 I purchased the June / October futures spread at -. This means:
- Sell the June contract AND
- Buy the October contract
On April 11, I purchased two more of the same spread, bring the position to a total of three Jun/Oct lean hog spreads. Maintenance margin was around $3,000.
Managing the Trade
This trade basically moved the way I wanted it to most of the time. A few days into the trade it spiked about $2,000 in my direction. The next morning it gave these gains back. However, of the next few days the spread went in my favor.
I was willing to risk about $2,000 on this trade. The actual risk is higher because I cannot tell what the June contract will do against the December contract each day. But I do know that spreads provide lower risk than outright contracts so I was OK with monitoring the position.
As my profits for the trade increased, my risk also increased. I do not view a trade’s current risk as being P/L from the starting point. I view the risk as being “how much do I have at risk NOW, including unrealized profits”.
Example:
Say you have a $10,000 account.
You just placed a trade where you risked $100
The position moves dramatically in your favor $1,000 and now your net account is worth $11,000.
The position is still on. If you are wiling to “let the trade breathe” and let it trade back down to your entry point up to the $100 loss, how much do you have a risk?
$100?
No. You are now risking $1,100. Those “unrealized” profits are very real!
That is real money that is really in your account. If you let that position trade back to $0 did you “break even”? Or did you really decide to risk $1,100 out of an $11,000 account?
I am not saying that you should always close out a trade as soon as you have a winner. In fact, I believe that taking profits too soon, and “scaling out of winners” kills most people’s chances at trading success. However, I am saying that every trader needs to be honest with himself at all times with respect to RISK.
Luckily, risk is not an overly subjective concept.
If you have a position that has $1,000 of unrealized profit and you are willing to “let the trade breathe” to the extent that you would allow the profit to go back down to $0, that is fine. But you need to accept that you are placing that money at risk and manage the position accordingly.
Closing the Trade
I closed the position on April 17 as the spreads spiked again in my direction, bringing the total realized profit for this trade to about $4,700.
Looking Back
There are three parts to a successful trade:
- Having some idea of what a given market or set of markets might do.
- Expressing the idea through a high-reward, low-risk position
- Manage the position. I am aggressive when I believe it’s time to be aggressive. I will scale into winners, which is how I turned at $15,000 account into a $65,000 account in 8 months on a single trade idea using options. But I also will take profits and be happy. And I will close the trade if it’s lost too much money or if the reason for my trade no longer exists. Losses are difficult to learn how to deal with. But unrealized profits can be even worse.
That’s because:
Unrealized profits = additional real risk
With this trade:
- Based on COT commercial position and historical “shape” of futures curve, I believed the front month contract prices would converge to be closer to back month prices.
- I expressed this opinion through futures spreads, which are hedged positions and which drastically reduce tail risk as opposed to outright futures positions.
- I rode out the position until it had time to work. Once it reached a profit that I was comfortable with, I exited the trade with a nice profit. The margin required to hold the position was roughly $3,000. Booked profit was almost $5,000.
Now I can look for other opportunities and put a portion of these profits to work.
