If you trade 100 times a year and it costs (on average) a minimum of $45 to enter the futures market on any one trade, you will have to generate $4,500 a year in trading profits (by correctly guessing the direction of the market) just to break even. That's a 45 percent return on a $10,000 futures account! That brings me to Successful Trading Rule #1:
1) Never spend more on trading expense and overhead than your futures account.
A $100,000 futures account opened today will generate about $4,000 in interest (assuming the standard payout rate of 90 percent of today's T-bill interest of around 4.5 percent). If you spend $100 a month on quotes and research, that leaves you $2,800 or about five trades a month (60 x $45) for trading expenses.
Five trades a month from a $100,000 account would drive the average futures broker up a wall in frustration. The system gurus who claim returns of 100-200 percent a year would sneer. But here's why the average investor in futures must follow this rule as closely as possible.
If your total trading expenses (commission, bid/ask, slippage, overhead) are going to exceed your guaranteed interest income, you make it far more likely that you will suffer a drawdown during trading that will exceed 10 percent or even 20 percent of a period's starting equity.
Unless you've experienced the strain of this type of drawdown, you will never understand the enormous temptation to make emotional decisions (by overtrading or withdrawing into a shell) that ruin trading performance.
It's this type of irrational, emotional trading that caused the search for the Holy Grail - a mechanical system, that never suffers emotional lapses. But now that everyone has a personal computer, which can go through umpteen numerical manipulations of the Sacred Six ( High, Low, Open, Close, Volume, and Open Interest), purely mechanical trading is losing its punch.
More and more we are seeing false technical breakouts that never follow through to the downside or upside. There is no fundamental reason behind these price movements, only the hum of thousands of computers making the same dumb decisions at the same time.
If you want a better-than-average return in any investment, you are going to have to do something besides what the average investor is doing. Increasingly, even in stocks, the average investor is looking at momentum indicators (like stochastics) and charts to make his decisions.
If the human brain is in the equation, you must at all costs keep out the emotional factors that ruins trading decisions. One of those factors is large losses, another is the sheer stress that making many trading decisions in a short.
2) Never risk more than 1 percent (trading risk plus commissions) on any one trade.
That means a $5,000 account should only risk $50 a trade, including the cost of commissions. If that means trading only agricultural contracts on the MidAmerica Exchange or options, so be it.
We've talked about the psychological problem of losing more than 10 percent or 20 percent.
But there are two other mathematical reasons to limit your losses to the smallest ratio possible. All trading activity is a struggle to try every investment idea that looks promising in the hopes that one of them will work. The more you lose the less you have to try another trade, another trading method, another investment vehicle.
To illustrate this, we will bring Trader Tom and Humble Harry.
Likely Page Break Trader Tom and Humble Harry both start with $100,000. Both lose five trades in a row. Harry keeps his losses to 1 percent of equity, he ends up with $95,100. Tom risks $5,000 a trade and goes down to $75,000.
To get to $150,000, Tom must make 100 percent. To get to $150,000, Harry only has to make 57 percent. Tom must outperform Harry by 75 percent to get to the same goal! Harry is long one contract of coffee before the late June freeze because the moving averages turned bullish a long time ago.
Tom is long two contracts because his system takes big risks. Harry makes $15,000 and Tom makes $30,000 over one weekend. Harry is still ahead by $5,000 despite the ulcer-producing risks.
3) No matter how intellectually stimulating or exciting to trade, any trading method that, after expenses, couldn't beat a simple 18-day moving average system over the same period has to be dropped.
Charles LeBeau (who used to edit the Technical Trader Bulletin, California) once made a statement some thing like this at a seminar he spoke at: "I've tested hundreds of moving averages and I found an 18-day moving average is as good as any of them in tracking the futures markets."
Intrigued, I called him later on and he confirmed that it didn't matter too much whether you used a weighted, exponential, or simple moving average or whether you used four days, five days, or any specific number of days for the crossover average.
In stocks, the total return (capital appreciation and dividends) of the S&P 500 is the benchmark for advisers and any stock system. Anyone or anything that can't outperform the total return of the S&P 500 isn't worth following. I propose an 18-day moving average standard for the futures industry.
Add up the last 18 days of trading in a specific future. Divide by 18. When that specific future closes above the 18-day moving average, buy the next opening. When it closes below the 18-day moving average, sell the next opening.
Thirty days before first delivery date, start collecting closes of the next viable futures contract. When you've collected 18 days of data, switch over to the new month.
