Risk Management in Futures Trading

Successful futures traders generally have one trait in common: the confidence that comes from being backed by solid risk management strategies. But a trait found among other futures traders is too much confidence, says Jack D. Schwager, a leading expert on futures and bestselling author of the “Market Wizards” book series.

“The big misconception” about futures “is that it’s an easy way to make a lot of money,” he says. “The people who are really successful are obsessively hard workers, and there’s typically a lot of trial and error before they succeed.”

Prudent traders apply data analysis, keep their emotions in check, and react with discipline when the market hasn’t trended their way. They also set trading limits, follow preset rules, and adhere to smart principles to make futures investing a sustainable and profitable enterprise.

Trading futures is about staying in the game and avoiding significant losses—not scoring a big bonanza. “Risk management is more important than your particular approach in trading the markets. And that’s something that retail investors and traders don’t really understand,” Schwager says.

Below, Schwager helps us as we outline the unique risks of futures trading and guide you through how to minimize them for trading success.

Understanding Risk Management in Futures Trading

Risk management is fundamental to minimizing potential losses from the uncertainties in futures trading. Successful traders understand market volatility, accept that losses are inevitable, and have a plan to limit their damage. They also don’t just look at returns—they account for how much risk they have taken on.

“The idea of just looking at returns as a performance measure is a mistake,” Schwager says. “It should always be return-to-risk. Returns are a meaningless statistic otherwise.”

With this in mind, here are some of the major risks in futures trading:

Market Volatility

The crux of trading futures contracts is attempting to profit from or hedge against price movements in an underlying asset. However, no one has perfect foresight into market swings. Prices can change rapidly and dramatically based on surprise news events, changes in supply and demand, and a host of other factors.

Leverage Risk

The high leverage allowed in futures trading enables you to take much larger positions than your capital would otherwise permit. However, leverage increases both risk and reward. Even a small, unfavorable price move against a leveraged trade can result in huge losses and margin calls from brokers.

Schwager says futures trading can be as safe as trading stocks if you don’t overtrade on your margin. “Typically, professional future traders would only have 10% to 20% of their margin committed. The difference in futures and equities is you have to be more cognizant not to fully utilize your margin,” he says.

Leveraging judiciously means reducing your risk significantly. “People think futures are riskier than equities. Well, they’re only riskier if you fully utilize the margin, which most traders shouldn’t do,” Schwager says.

Liquidity Risk

While futures markets in crude oil and metals enjoy deep liquidity, smaller commodity futures or niche sectors can have much lighter trading. Low liquidity makes entering and exiting positions more challenging, increasing the likelihood of slippage (the difference between the expected price and the actual price) or inability to execute in the first place. Factoring volume data into trading strategies helps quantify and mitigate these risks.

Key Principles of Risk Management in Futures Trading

While each investor must calibrate their risk management to their personal style and investment needs, there are core principles that apply broadly across futures trading. Adopting these guidelines can set the stage for success even amid turbulent conditions.

Principle 1: Master the Instrument

You should fully understand what’s involved in any futures contract you consider trading: the fundamentals of the underlying asset, the term, historical performance, delivery, near- and medium-term sector prognosis, etc. Knowing the intraday, weekly, and seasonal patterns in underlying assets also makes for far more intelligent risk planning.

Schwager notes that the danger isn’t just to you, but, as with speculative crazes like the Gamestop mania of the early 2020s, it can forge volatility that creates problems all over the market.

Principle 2: Set Stop Losses

Schwager says stop losses are a prudent trader’s first line of defense. Stop losses automatically close out positions once losses breach predefined limits. Even if your confidence is sky-high for a trade, stop-loss orders keep your investment within your risk tolerance threshold.

Schwager cautions against the psychology where you remember when a stop loss prevented you from pocketing a major gain, but immediately forget the stop loss that prevented your portfolio from being wiped out. A stop loss preventing gains “may be frustrating, knocking you out of the market at the wrong time many times,” he says. “But it will save your hide at other times, which is more important.”

Principle 3: Keep Your Positions Modest

While the leverage that futures offer allows oversized positions, being restrained in how big your positions are gives you more flexibility when addressing any risks. Take the time to determine the thresholds where a price swing would threaten your margin, and follow through on sizing your positions accordingly.

Keeping your positions modest “will allow you the opportunity to come back if it doesn’t work out,” Schwager says.

Principle 4: Diversify Your Positions

Schwager says it is important to diversify among markets and your strategies.

“Because different markets experience adverse moves at different times, trading multiple markets will reduce risk. Also…diversification applies not only to trading multiple markets but also multiple systems (or approaches) and multiple system variations (i.e., parameter sets) for each market, assuming equity is sufficient to do so,” he writes.

Principle 5: Control Your Emotions

Reactive trading causes emotional decisions, which poses an even greater risk. Develop trading plans that account for volatility so that your trading is systematic and follows a plan, not your impulses or gut feeling in the moment. Sticking to a plan can help keep risk in check.

Principle 6: Review, Refine, Repeat

Monitoring wins and losses and adjusting your trading based on market changes are fundamental for managing your risk. This way, too, your losses in the near term can enable more wins in the long term.

“By doing this,” Schwager says, “you allow yourself to have many shots at trying to become a successful trader when you don’t blow it all out.”

Steps to Determine Risk for Futures Trading

A crucial part of risk management is accurately evaluating the potential downsides. Taking prudent steps can help you determine smart risk guidelines that work for your investing goals and risk tolerance.

  1. Begin small: “Always start with an amount that you can afford to lose and won’t change your life dramatically,” Schwager recommends. Beginning with too large of an investment can spell disaster for novice traders. In fact, a 2024 study from economists at the Commodity Futures Trading Commission noted that many retail traders go big with one trade, lose, and exit the market. Alex Ferko et al., via Commodity Futures Trading Commission. “Retail Traders in Futures Markets.” Commodity Futures Trading Commission, OCE (Office of the Chief Economist) Staff Papers and Reports, Number 2023-002 (February 2024), Pages 1–2 (Pages 3–4 of PDF).
  2. Evaluate your available capital: Assess the total investable capital you have for futures trading activities. Set a fixed proportion of your net worth for trading futures, and gauge your base risk limits. “The idea is each time you start trading, start with a smaller amount and pick some percentage that if you lose, you will say, ‘That’s it for now,’” Schwager says.
  3. Pick a trading strategy: Schwager says the more specific you can be, the better. For example, if you’re using chart analysis, you’ll want to specify the patterns that would signal entering or exiting, and you’ll want to know what you’ll use ahead of time to confirm your analysis. Don’t wait to do this—traders who pick criteria in the moment are looking for reasons to confirm what they want already. You want to make your trading as rule-based and disciplined as possible.
  4. Determine the risk profile for each contract: For each futures contract, chart historical daily price movements. Take seriously the worst-case scenarios of extended declines or volatility spikes to understand your potential losses.
  5. Keep your position size conservative: Generally, positions should be limited to a very low percentage of your trading capital so you can withstand a run of losses on successive trades. Schwager advises in his Complete Guide, “Traders can substantially increase their probability of long-term success by restricting the percentage of total funds allocated to any given trade. The maximum risk on any trade should be limited to 2% of total equity and, ideally, 1% or less.”
  6. Define your stop-loss and exit strategy: Use technical indicators or volatility data to set initial stop-loss levels that put hard limits on losses. Chart profit targets based on typical price ranges. Integrate stops and exits into a trading plan. “Know where you’re going to get out before you get in,” Schwager writes in his Complete Guide. “The importance of this rule cannot be overemphasized. Without a predetermined exit point, you can find yourself vulnerable to procrastinating in liquidating a losing position.”
  7. Track returns against risks: “The idea of just looking at returns as a performance measure is a mistake. It should always be return to risk,” Schwager says. Monitoring your profit or losses fails to capture your true performance. Measure your results by comparing them with the risks taken for the best assessment.
  8. Review actual vs. expected returns: Backtest potential positions against historical data sets matching the risk profiles to compare actual vs. expected performance. Tweak position sizing or stops if called for.
  9. Reflect and revise: While it’s best to keep your trading consistent and have a disciplined routine, adjustments will be necessary. Review your markets, underlying assets, and strategies regularly as the market landscape and wider economy change. Revisit all of these elements if losses or volatility spike unexpectedly.

Risk Management Tools and Resources

Futures trading inherently involves risk, but prudent traders can manage risks using internal disciplines and external resources.

Internal Practices

  • Strategic planning: Thorough planning considers risk factors like volatility and liquidity across different futures products when determining appropriate positions.
  • Rule-based trading: Setting stop-loss orders for every trade “saves you from losing all your money,” Schwager says. Include variations like trailing stops and guaranteed stops for enhanced protection.
  • Simulated testing: Before risking real money, backtesting strategies with simulated trading platforms helps validate trading plans and refine risk management techniques.

External Resources

Here’s where technology can greatly support your trading:

  • Analytics platforms: Software and online platforms can help you examine historical data, volatility trends, and other risk factors. This informs position sizes, planning for different scenarios, and backtesting trade outcomes to test different strategies.
  • Risk management systems: Specialized platforms offer automated functions like stop-loss orders, margin alerts, and position size managers, helping to enforce discipline in your trading.
  • Continuing education: “Markets evolve, so traders must keep developing skills,” Schwager says. Staying updated on new products, changing risks, and best practices keep your toolkit up to date. There’s also more to learn.
  • Brokerage resources: Many brokers offer educational materials, webinars, and simulated trading accounts to help you develop your risk management skills.

There are no perfect tools. But discipline is a skill and as important as any technical indicator. Schwager touches on a consistent theme: Markets change, and so must your tactics. You should view risk management as an ongoing process, not a one-time solution.

Example of Risk Management in Futures Trading

Suppose you’re looking to take a long position in crude oil. While analysts suggest that prices might rise because of geopolitical tensions, there’s also the substantial risk around the typically volatile commodity.

Prudent risk management begins with position sizing—given your account size and risk appetite, how many contracts can you trade? Risk modeling helps determine potential loss scenarios if the swing low from recent price changes is reached. Given the factors assessed, you take out 12 contracts, which get you profits if oil rises while limiting your downside when stop losses are triggered.

A stop-loss order is placed 12% below the entry price to protect the downside. While above the recent swing downward, this leaves room for volatility while preventing catastrophe if there’s a deeper drop. To lock in profits if prices surge, a trailing stop loss is set to automatically trigger if gains pull back by 8%.

How Does Futures Trading Work?

Futures contracts are standardized contracts between a buyer and a seller. They allow the trader to buy or sell an underlying commodity at a specific price by the expiry date. These contracts are traded on an exchange, such as the Chicago Mercantile Exchange. Traders often use futures as a way to speculate on or hedge against the price of the underlying asset.

What Role Does Market Analysis Play in Risk Management for Futures Trading?

Market analysis, including technical and fundamental analysis, helps traders make informed decisions and identify potential risks. Understanding market trends, economic indicators, and other factors can guide traders in managing their positions effectively.

Can You Explain How Stop-Loss Orders in Futures Trading Work?

Stop-loss orders are instructions to close a position at a predetermined price to limit potential losses. In futures trading, a stop-loss order is placed with a broker to sell (or buy, for a short position) a contract when it reaches a specific price level. Stop-loss orders can be either market orders or limit orders. A stop-loss market order will execute at the best price once the stop level is reached, ensuring the position is closed but not guaranteeing the exact price of execution. A stop-loss limit order specifies the price at which the order should be executed.

The Bottom Line

Risk management is critical to successful futures trading. It involves a comprehensive approach that includes assessing risk tolerance, setting clear trading goals, choosing appropriate sizes for your positions, utilizing stop-loss orders, and diversifying your positions.

By implementing a well-structured risk management plan, as Schwager suggests, you can best navigate the volatile futures markets with more earned confidence and discipline. While risk can never be eliminated, it can be managed and mitigated through disciplined strategic planning.

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