Trading futures offers the potential for substantial profit. This outsized profit potential is a function of the leverage involved in futures trading. Unlike a stock trade or buying a call or put option where the trader must put up the full value of the investment in order to enter the trade, a leveraged futures trader is only required to put up a fraction of the value of the underlying position. Not surprisingly, this type of leverage can be a double-edged sword. As a result, it is essential for futures traders to understand just how much risk they are exposed to when entering a given trade and to size their trades accordingly. To illustrate this process, let's first compare a stock trade to a futures trade.
Stock Capital Requirements Versus Futures Capital Requirements
If a trader wants to buy $100,000 worth of IBM (NYSE:IBM) stock, he must put up $100,000. If IBM goes up 10%, the trader makes a profit of 10%; if IBM declines 10% in value, the trader loses 10%. This is a very straightforward concept.
With futures, however, things are quite a bit different. A T-bond futures contract is valued at $1,000 per point. So, if T-bonds are trading at a price of 100, then the futures contract has a value of $100,000 (100 points * $1,000 a point). If the price is 110, then the contract is worth $110,000 as so on. However, in order to enter a long or short position in T-bonds futures a trader need only put up the minimum margin requirement set by the exchange (and possibly adjusted by his or her brokerage firm).
As of January 2009, the minimum margin requirement for T-bonds was $2,700. In other words, if a trader expects T-bond prices to rise, he or she could put up $2,700 in a futures trading account and buy one T-bond contract. If that contract rises 2 points, the trader will earn a profit of $2,000, or 74%, on the $2,700 investment. Of course, if T-bonds fall 2 points instead, then the trader will experience a loss of $2,000.
Futures margin requirements can and do change over time (usually based on volatility and the dollar value of the underlying contract). Still, the range of margin requirements for a given market is fairly stable, and typically averages 1-15% of the actual underlying value of the contract. (Futures provide great investment alternatives, although at substantial risk. For more information check out Top 4 Mistakes That Cause Futures Traders To Fail.)
Sorting Out How Many Contracts to Buy
This non-standard way of setting investment capital "requirements" can lead to some confusion among traders when it comes to deciding how many futures contracts to buy or sell short for a given trade. For example, if the futures trader in the above example had a trading account of $100,000, and wanted to buy T-bonds, he or she could buy as many as 37 contracts ($100,000 /$2,700). Of course, this would be a dangerous move because in reality, the trader would be buying $3.7 million dollars worth of T-bonds ($100,000 contract value x 37 contracts). So, the obvious question for a trader when looking to enter a futures trade is "how many contracts should I buy (or sell short)?"
As it turns out, there is no one perfect answer that applies to all traders in all situations, as some may have a higher or lower degree of risk tolerance or may choose to be more or less aggressive depending on their own level of confidence that a given trade will work out as planned. Still, it is possible to use a common sense approach to position sizing that accounts for an individual trader's own willingness to accept risk as well as the volatility of the underlying market. The key is to consider the average true range for the market in question.
A Primer: Average True Range
Typically the "range" for a given day for a given market is arrived at by looking at the difference between the high and low prices for the current day. However, futures markets can and do gap in price (i.e., today's price action is completely outside the range of the previous day's price action). To account for this, let's consider the following terms:
- True high = Today's high or yesterday's close (whichever is higher)
- True low = Today's low or yesterday's close (whichever is lower)
- True range = True high – true low
By defining true high and true low in this manner, if T-bonds close one day at 100, then gap open higher the next day at 101, and reach a high of 102 intraday, then the true range works out as follows:
- True high = 102
- True low = 100 (yesterday's close, which was lower than today's low)
- True range = 102 – 100
Now let's use true range to help determine how many futures contracts to trade at one time.
Using Average True Range to Calculate Position Size
Before a trader can calculate a reasonable futures position size, there two basic things to consider:
- The percentage of his capital that he is willing to risk on the trade.
- The volatility of the market he wants to trade.
The answer to question No.1 is a personal decision. Still, for most traders a reasonable answer is typically somewhere between 1-5%. In other words, if a trader has a $100,000 trading account, he would choose to risk somewhere between $1,000 and $5,000 on each given trade. The trader who chooses to use a higher percentage is clearly being more aggressive. If he is correct in choosing market direction he will clearly make more money than a trader risking only 1% on each trade. Still, the flipside is that if this aggressive trader loses on four consecutive trades, he will be down 20%. Losses of this magnitude and above can cause traders to alter their trading process, which in turns creates a whole new set of problems. Clearly, determining what percent of trading capital to risk on each given trade is an important - and highly personal - decision.
Doing the Math
For the sake of example, let's assume that a trader with a $100,000 trading account decides to risk a maximum of 2.5% of his trading capital on each trade. Let's also assume that he is bullish on T-bonds and wants to buy T-bond futures to profit from his opinion. Now he needs to determine how many contracts to buy. To make this calculation, we will consider the average daily true range over the previous 21 trading days.
- A = Account size in dollar
- B = Percentage to risk on a trade
- C = Dollars to risk on a trade (A * B)
- D = Average true range in points over 21 days
- E = Average true range in dollars over 21 days (D * $ per contract point)
Let's look at how these numbers work out so far using our T-bond example:
- A = $100,000 (Account size in $)
- B = 2.5% (Percentage to risk on a trade)
- C = $2,500 (Dollars to risk on a trade (A * B))
- D = 1.12 (Average true range in points for T-bonds over 21 days)
- E = $1,120 (Average true range in dollars over 21 days (1.12 * $1,000 per contract point)
So at this point, we know that the trader is willing to risk a maximum of $2,500 per trade (Variable C). We also know that the average volatility in dollars for T-bonds is $1,120 (Variable E). So, in order to calculate the number of contracts to buy, the remaining step is simply to divide the dollars to risk on the trade (Variable C) by the volatility of the underlying market (Variable E) and then round down to the lower integer.
- F = Int(C / E), or Int($2,500 / $1,120) = 2 contracts.
In other words, by using this mechanical approach to trade sizing, the trader in our example would buy two T-bond futures contracts for his $100,000 trading account.
The approach just described for calculating a futures position size is not a hard-and-fast rule. Still, this simple objective approach forces a trader to take into consideration two key pieces of information: his or her own tolerance for risk and the typical dollar fluctuations of the market to be traded. Another advantage to this approach is that it allows a trader to normalize risk across a variety of markets. (To learn how you can assess your portfolio risk, read How Risky Is Your Portfolio?)
In order to be successful in the long run, a futures trader must first determine the percentage of his trading capital that he or she is willing to risk on one trade. Then, the trader must determine how many futures contracts to buy or sell short for each given trade. While this formula is hardly scientific, it has served many successful traders well over the years in helping them to maximize their profitability while simultaneously limiting their risk to a reasonable amount.