Position and Risk Management

Position and Risk Management for Individual Traders

Risk management is an important aspect of trading. The amount of capital put at risk for each trade is based on many factors. Market participants should have an established plan to confirm that orders that are placed have an appropriate amount of capital for their account size and financial profiles.

Risk can be limited directly by the trader or with requirements placed by the exchange. All parties involved in the trading process will have risk exposure. The trader has risk, the broker has risk, clearing houses have risk and the exchange has risk. Each party has slightly different risk exposure, but all take steps to limit their risk due to an unforeseen market event.

Three Variables to Manage Risk

The first variable is deciding which futures contract to trade. Some markets are more volatile or the contracts have greater tick values than others. This means that some markets have the potential to make or lose more in dollar terms each day. For example, if the S&P 500 moves around 10 points per day and each point is worth $50, a trader might experience a $500 fluctuation in their account for one day. Another example is Crude Oil, which can consistently move $1 or more per day. Due to the tick value of Crude, this would equate to a potential $1,000 swing in a day. Knowing the typical profile of a futures market will help a trader decide if one market is riskier and/or suitable for their account. Individual traders who are not using futures contracts to hedge against physical commodities are known as speculators. Therefore, they can choose from a variety of contracts to trade, based on interest or the risk profile of their account.

The second way traders control risk is the number of contracts they trade. Market exposure is increased by more contracts and decreased by less. Traders should trade the number of contracts in their account based on risk scenarios for that number of contracts, and not simply trade the maximum number of contracts that their broker will allow based on initial margin requirements.

The third way is to set stops that are within your risk tolerances. Setting stops with a loss amount provides protection if the market does not move in your desired direction. Stops are an essential strategy when trading as an individual trader and can assist in exiting an open position if triggered by a pre-defined price level. This helps to prevent creating a loss scenario which is larger than you can handle.

Exchange Controls

Risk can be managed by you, as a trader, based on the decisions you make, but also by the exchange. This is done by setting the margin requirements that individual traders must fulfill to place orders and hold trades overnight.

The exchange limits risk by ensuring that the clearing firms post sufficient margin with the exchange to cover the potential losses for each open position.

Margin is used to limit risk at the broker level, as it requires traders have sufficient capital in their accounts to back the number of futures contracts they have open in the market at one time.

Traders are required to have an initial amount of margin to place an order and must also maintain maintenance margin minimums if the position is open. Typical maintenance margin is 80–90% of initial margin, but it will vary by broker. Brokers will also require more margin to be posted for positions that are held into the next trading day, versus positions that will be opened and closed within the same trading day.

Most brokers keep track of margin electronically in real time and will issue warnings to clients when they are not margin compliant, and may even liquidate their positions immediately upon a margin violation.

Clients will have to deposit funds or close positions to bring their accounts back in to compliance.

MARGIN EXAMPLE

If the initial margin requirement for the S&P 500 contract is $4,800 and maintenance margin requirement is $4,500. The trader must have at minimum $4,800 of cash in their account for each contract they wish to trade.

If the trader buys two contracts with combined maintenance margin of $9,000, in an account with $10,000 they will have used up $9,000 of the $10,000 buying power of the account.

The trader would get a margin call if the account loses more than $1,000 or 10 ES points per contract. If the trader purchased the contracts when the ES was at 2,600 they would receive a margin call when the price of the ES moved below 2,590.

At the end of each trading day, trades are Marked to Market. This means that the settlement price of the futures contract is compared to the purchase price or previous close and money is either deposited to the client account or withdrawn from the client account.

If, at the end of the trading day, the futures contract has increased in value compared to the purchase price or the previous day’s close, then money will be deposited in the client’s account. If the futures contract has decreased in value, then money will be withdrawn from the client’s account.

To keep track of the profit and loss (P&L) of the trades, it is listed in real-time in your account. Watching the P&L allows you to track whether your position is at a loss or a gain, and how to manage the position. This real-time information can help traders decide if it is time to exit a trade based on profit or loss targets being reached.

Risk management is very important for a trader. Understanding the rules of not only a profitable position, but also how to manage a losing position will be key to the success of a trader.

For additional information, please visit:

• Margin Services
• Performance Bonds/Margin
• Order Types for Futures and Options
• Order Qualifiers
• Order Management
• Matching Algorithms