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In spite of what many small speculators may think, the big boys are not involved in a conspiracy to take your money. Although the futures arena is designed to be a zero sum game, it is actually the small speculator's lack of discipline that puts the balance sheet in favor of the big boys.
These top 10 mistakes I'm going to reveal to you are what the majority of small speculators are doing wrong. My purpose in exposing them to you is to help you construct a viable plan for avoiding these pitfalls. These 10 mistakes are described in no particular order. Each one is of equal importance. You should internalize the ways I propose to avoid these mistakes whether you are new to futures trading or an old hat.
Mistake #1: Thinking that leverage is an after-thought in the futures market
Leverage is defined as "the use of investment capital in such a way that a relatively small amount of money enables the investor to manage a relatively large value".
Leverage is a double-edged sword and the foundation of the entire futures industry. If it were not for the incredible amount of leverage available (sometimes 10 to 1), futures could not create as many rags-to-riches and riches-to-ruins stories.
For example, one contract of corn represents 5,000 bushels. At any time, one corn contract can have a cash value of $10,000 or more. You may only put up $400 - $500 to leverage the 5,000 bushels of corn. Every one-cent move in your direction represents $50 in your pocket. Every one-cent move against you represents $50 out of your pocket.
Small investors and newcomers tend to ignore this side of leverage. The demon "Greed" sets in because it only takes a one-cent move to make $50. Greed will tell you it's better to get $100 or maybe $500 for every one-cent move. Therefore, to avoid the greed trap, you must let leverage work for you rather than allow the greed demon to convince you to abuse it.
Mistake #2: Believing that speculation is the same as gambling
My overall experience with gambling is that, no matter how much analysis you put into it, the end results have no rhyme or reason. That's why casinos stay in business and can afford to give away hotel rooms.
Speculation is defined as "the use of money to assume risks for short-term profit in the knowledge that substantial or total losses are ONE possible outcome". In gambling, on the other hand, substantial or total losses are always the MOST likely outcome.
Speculation is not for everyone. Those who are willing to analyze, research and navigate the data will be the least disappointed if they lose money speculating in futures. For them, there is always the possibility of being able to speculate again later.
Mistake #3: Failing to properly fund your trading account
The best way to determine how much to fund your account is to base it on your net liquid assets. Add up your savings, CDs, checking account, real estate income and other sources of income. Then, put in approximately 10% of that figure. It is best if that figure is at least $5,000.
If your net liquid assets don't equal at least $50,000, but the $5,000 is still disposable, you can still speculate in futures. However, if losing the $5,000 would significantly affect your life, do not speculate. No futures broker (who cares) wants your kind of business.
Mistake #4: Letting commission price be the sole determining factor for choosing your broker
There is a difference between a "full service broker" and a "discount broker", and you need to learn it. Someone new to futures should not use the cost of commissions as the sole basis for deciding whether to work with a full service broker or an online discount broker. Claims of $4.95 on each side's commission or $15 round-turn commissions all amount to the same thing -- buying the price, not the value, of the service. The allure of inexpensive trading is highly deceptive.
The amount of commissions you pay correlates to how much you trade. So, while the average number of trades made with a full service brokerage at commissions of $90 - $100 may be 4 to 6 times per month, you may easily do 10 times that amount while trading at a discount.
This is great if you have the discipline to adhere to the trader's golden rule: "Cut your losses and let your profits ride." Unfortunately, too many traders have not mastered that skill yet. An effective full service broker will operate as an advisor who makes you adhere to the necessary discipline it takes to succeed.
When working with a brokerage, full service or discount, look for one that offers the best value.
Mistake #5: Churning your account
Churning is defined as "constantly entering and exiting trades solely to generate commissions." It is written in the rules and regulations of the CFTC that a Series 3 broker must not churn a client's account, or he or she can face possible fines and even lose his or her license.
This being the case, it baffles me that small speculators often decide to churn their own accounts and then are so bold as to give it a legitimate-sounding name, "day trading". Any Series 3 broker would lose his or her job for actively encouraging clients to trade this way.
In all honesty, few markets can even provide the necessary liquidity for day trading. The ones that do require high margins and often have margins that will spike higher during times of volatility. For instance, the S&P 500 Index can easily fluctuate between a $10,000 to $25,000 margin, sometimes in the same day (as during the crash of 1987).
There are opportunities to day trade the E-Minis or eFx, but, to be effective at it, you must understand arbitrage. As a rule, small speculators should avoid day trading. Do not let anyone churn your account. Not even yourself.
Mistake #6: Failing to develop a futures trading plan
Why are you trading futures? Why not invest in bonds? Why not buy more mutual funds? What is the opportunity cost of not trading futures? Can you stomach potentially losing all of your risk capital? What does risk mean to you? What are your goals for trading futures? Are those goals realistic? How will you attain those goals? How long will you give yourself to attain them? Who will help you attain them? How much risk capital will you use?
There are many more questions you can ask yourself. These are the essentials. As with any adventure, futures trading requires you to know what you are in search of: The Golden Fleece, El Dorado or the Holy Grail. Once you've defined your quest, you must determine how best to tackle it. Trading futures can be the most rewarding, exciting experience -- for the prepared.
Mistake #7: Not keeping a trading journal
The trading journal is the twin brother of the futures trading plan. A trading journal tells the story of the futures trading plan. It creates objectivity. It explains in detail why you took the trade you did. What your thoughts were at the time you made the trade. What your thoughts were during the trade and what your thoughts were once you were out of it. It eliminates the romanticism or villainizing of trading and turns you into a speculator.
Mistake #8: Using others to validate your trading positions
Don't listen to or ask others about your trades if you want to be a successful trader. The fact is that the best traders stick to their futures trading plan. Small speculators cannot afford to ignore the parameters set by their futures trading plan. Outside influences interfere with the precision focus they need to succeed.
Listening to other people distorts your resolve. It skews your personal interpretation of the data the market is giving you and makes you second-guess yourself, especially if your friends and analysts agree with you. You can easily fall into the trap of analysis paralysis.
The bottom line is this: No one knows your trade better than you or your broker. Do the trade and let the trade prove itself.
Mistake #9: Trading only options
Options are not less risky than trading futures outright. The majority of options expire worthless, and the majority of novice speculators buy worthless options. Simply because you know your risk ahead of time when you purchase an option doesn't mean the risk is worth taking.
Options have a place in any futures trading plan. Unfortunately, many brokerages make trading options the sole basis of a new speculator's futures trading plan. They suggest that you buy a deep out-of-the-money option because it's cheap. Then, they tell you to load up on it, and, if the market EXPLODES, you will make a profit. Their argument is this: If the market doesn't explode, well, then, it was worth a shot, and you won't lose more than the amount you invested. This is the gambler's mentality.
In no way, do I discourage the use of options. Unfortunately, options start off with a built-in loss and may not always be the most effective way to take advantage of the leverage that futures can provide.
Mistake # 10: Failing to use effective money management techniques
Futures are a zero sum game. The losers give to the winners. You have to be a savvy speculator to understand this. The clearing houses guarantee all long and short contracts, so no one has to worry about whether he or she gets paid. All accounts are settled within 24 hours, and that's all she wrote.
There are no guarantees when you are a speculator. There is always the possibility that you will lose all of your risk
capital. In fact, I can promise you that you will have losing trades. In fact, I can promise you that you will have many losing trades. So, the question is: Is the risk worth the potential gain? Only you can answer that.
Many people have made millions as speculators, and many have lost millions. The truth of the matter is that any type of speculating -- stock, real estate, futures and so forth -- is most similar to batting averages.
Batting in the 300s means that, out of 10 times at bat, you've hit the ball 3 times. You don't know when those 3 times will occur. They may come all in a row at the beginning or spread out intermittently among the 10 different times at bat. The bottom line is that those 3 hits can completely make up for and exceed the 7 times you missed. Anyone of those hits can represent a grand slam or a homerun for your overall portfolio. A savvy small speculator must internalize this concept.
Therefore, a small speculator who uses money management must be able to do three things well: Be patient, be disciplined and be frugal.
Making the Rules for Success the Ones You Trade By
By studying, internalizing and using these 10 rules, you will quickly find yourself ahead of 90% of the small speculators who "dabble" at futures.
*Reprinted (and modified) with permission from Noble DraKoln of http://www.liverpoolgroup.com, author of the best-selling books Futures for Small Speculators and Forex for Small Speculators
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