THE ART OF FUTURES TRADING

Presented at the Financial Editors Seminar,
Chicago, Illinois,
November 10, 1969.

In the 1960s—long before financial futures, and even longer before these markets were an established arena of finance and received serious attention from academia—very little had been written about the art of futures trading. It was generally considered an arcane, esoteric and wild world for reckless speculators and gamblers.

It was a revelation to discover first-hand the truth about trading: to learn that the rules for good trading techniques were quite the opposite of conventional wisdom, that successful futures trading required a business approach, discipline and the ability to manage money, and that luck was of minimal value, the rules of chance did not apply, and a trader's psychological make-up the most critical component of success.

To many, futures trading is a blessing.

To many, it is a curse.

To the majority, it is an enigma.

Why this divergence of opinion?  Why this love-hate relationship? Perhaps because futures trading today represents one of the last adventuresome frontiers of the business world. A frontier where the frontiersman must rely solely upon his own ingenuity and common sense, where he must be brave and willing to meet formidable personal challenges, where the challenges demand intelligence, fortitude, character and adventuresome spirit, and where the reward justifies the risks.

Personal futures trading is one of the last remaining spheres where an individual can still pyramid a sizable fortune from a modest investment.  Little wonder so many try, though so many fail.  Little wonder many of those who fail blame the challenge rather than their own inadequacies. Little wonder those who succeed become obsessed with the adventure.  And little wonder so few know about it, for as with any frontier, the unknown is awesome, complicated, and frightening. And as with most things of consequence, the challenge is formidable and fraught with risk.

For these reasons, many myths have developed about trading futures: You must be on the in. You have to be lucky. It's only for the pros. You have to be a gambler. There's no rhyme or reason to it. These myths are false. Often, these myths are used as excuses and alibis by those who have failed at futures trading for a variety of reasons, some of them rather personal. Perhaps they lacked the ability to concentrate or did not possess sufficient analytical skills; perhaps they lacked a well-adjusted personality, a mature temperament or business discipline. Others fail because they lack adequate capital, but capital, although important, is not usually the central reason individuals fail at trading.

Take the element of luck. Futures trading is one of the few areas where luck is of minimal importance. While luck never hurts (and on occasion—as in all things—it can play an important role) in general, luck is not a factor. Luck can go both ways and usually evens out. And good luck can even have an adverse effect. For example, if a trader is lucky in his early trading experience, he either has learned nothing or has learned the opposite of what he should. In the long run, an early streak of good luck will do him in.

In the final analysis, success at trading futures is determined by one's ability to decipher and analyze salient facts and statistics in order reach a logical opinion about the intermediate or ultimate price of a given product. In short, it depends on the ability to correctly measure supply and demand.

If that sounds simple, it isn't!  It is a most difficult task. Implicit in the challenge are some exacting requirements: knowing the significant economic components that can affect the price of a given product; keeping abreast of current facts and statistics; correctly comprehending these facts and their effects on supply and demand; the ability to pro-rate the importance of the various components as they apply to a given price structure—a ratio that changes from year to year, sometimes from week to week, as well as from commodity to commodity; understanding the different price idiosyncracies of different commodities; adjusting for all unknown variables; and finally, the courage to apply your conclusions to the market.

It is this last requirement—the courage to apply your conclusions to the market—where most futures traders meet their Waterloo.  It is the point where your personality meets its most formidable challenge and you learn the type of trader you really are. Indeed, a trader's psychological make-up is the most critical component in his success in futures trading.

While special education and professional training will help, they are not mandatory. Tips or inside information are of small consequence. What is necessary is an orderly thought process, a business-like approach, a well-balanced personality, a willingness to study the significant factors, and a working knowledge of the past history. And, of course, patience.  One needs patience to learn from trading experiences, patience to learn from past mistakes, and patience for confidence and trading ability to grow. These are not simple requisites, and yet they are not impossible or so complicated as to warrant the taboos or prohibitions that so many have placed on this challenging field.

The rules of odds or probabilities—the normal tools of a good gambler—are not required for futures trading and can be a distinct disadvantage. Successful professional futures traders, as a rule, are not gamblers in the classic sense; most of the time, when gamblers try their skill at futures, they lose.  The reasons for this are quite simple. Futures prices are dictated by the laws of economics while successful gambling is a consequence of the rules of chance. These two regimes are light years apart. Rules of chance, over the long haul, cannot successfully be applied to trading.  A good bet based on odds in other areas of life may be the worst possible trade in futures. A bad chance based on probabilities may in fact be a terrific futures position. For instance, in a bear market of long duration, pure odds will favor a rally; unfortunately, if an oversupply continues to dictate lower prices, those who buy the market on the basis of probabilities will lose money. 

I have often heard the statement, "I had to liquidate my long position because the market was up ten days in a row."  Those traders are applying the rule of probabilities to trading.  While that may sometimes turn out to be a correct decision, it is far from the right reason. The long position may have been a better position on the eleventh day than it was on the first; maybe, on the eleventh day the world finally recognized what the trader's instincts told him ten days before. Thus, the rule of probabilities cannot be the controlling factor for a market decision.

Successful futures traders—unlike those who follow gambler's rules and instincts—are good businessmen and good money managers. Though traders risk their capital, those who are successful follow conservative and disciplined business practices. Thus, money management is every bit as important as being correct in the market. Unfortunately, this principle has somehow been lost by the public, and futures exchanges are instead often compared to gambling casinos.

I am often asked how much money is needed to begin trading.  It is not really a question about the amount of capital required; rather it is a question of the type of capital. While I would not recommend it, one can begin trading futures with as little as a couple of thousand dollars—the minimum margin requirement—if a brokerage firm will accept your account.(1) The amount of capital available to begin trading will determine one's latitude in the learning process.  With a small amount, one has little room for error. With a larger sum, one has more time to learn. More important than the amount of money is that it not be necessary money. One should not speculate with capital needed for daily subsistence; i.e., the money required for food and shelter, for school or clothing, or for any of the other normal demands of life. The capital recommended for futures trading is "risk capital": money that, if lost, would not materially affect one's living standards. While this pre-condition excludes a great many from futures trading, it still leaves the possibility open to a good many others.

Will a large sum of risk capital provide a better chance at success than a small sum?  Yes, to the degree that it will provide more room to learn. However, more capital may produce a false sense of security, which in the long run will impair one's ability to succeed. Whether you begin with a large or small pool of risk capital, you must adjust the size of your futures position accordingly: with a small sum, you should begin trading on a very small scale; conversely, with a large sum, you may want to begin with larger positions.  In either case you must pace yourself so that there will be some risk capital remaining after you have learned to trade.  It will do you little good to face all the dangers and learn all the lessons if, after you graduate, you have no cash left to put your knowledge to work. 

Since it takes years of study and first-hand application to become thoroughly familiar with all the principles, rules, variations and exceptions involved for successful futures trading, it would be impossible to discuss these in depth. However, allow me to set down three of the most salient principles.

One must spend time educating oneself about the product one plans to trade; i.e., the various statistics and other factors that affect the supply/demand equation and therefore the price of the product. Implicit in this requirement is the corollary that one cannot rely solely on another's opinion. For example, if you use a broker, never take his word as gospel. While you should listen to what he has to say because he is an expert, you would be foolish to rely solely upon his information or interpretation of the facts.  This will also require that you fully understand the broker's jargon and reasoning and this again requires some personal education.

The second most important principle is not to over-trade.  This cannot be defined in terms of money or in terms of the number of trades per week, month or year.  It will depend upon your proximity to the market—how closely you can monitor price movement, the amount of time spent studying the product, and the objectives of your trading plan.  Over-trading will overexpose you to risk and danger, as well as to unnecessary commissions. Consequently, you must accept the fact you cannot participate in every market move, nor should you want to.  The most successful trader who is not daily on the trading floor of the exchange will pick his spots carefully.  Futures prices have trends as well as seasonal movements.  Concentrate on these rather than the daily fluctuations which are best left to the professionals. A successful trader who chooses his moves judiciously needs to be correct only 30-40% of the time.  On the other hand, an outside trader attempting to trade daily must maintain a profitable track record 60-70% of the time in order to come out ahead.

The third principle is to follow a predetermined trading plan; a set of rules or established guidelines you believe are valid, that have withstood the test of time, and that will guide your decisions. There is not one special formula or one set of trading rules.  There are many.  It will require a great deal of study to determine which rules make the most sense to you and best fit your temperament and your primary vocation, if you are not a professional trader.  Whichever they are, once you choose your set of trading rules, adhere to them.  This will require discipline and will test your emotional qualities. Unless you abide by a set of sound trading practices, you will be subject to the whim of every market idiosyncracy and fall easy prey to the stresses of a given moment.  As an extension of this principle, I would caution you not to allow successful speculation to go to your head and cause you to discard your rules. Conversely, if at first you are unsuccessful or suffer a series of defeats, do not despair and discard a sound set of trading principles.

Futures markets represent financial democracy.  They offer an open marketplace for investment and speculation where everyone has a right to an opinion. Some opinions are more qualified than others.  How qualified you become depends upon you alone.  This frontier is still open to a multitude of Americans who have the heart and spirit to learn what it takes.  It is one field where the victorious have the satisfaction of knowing they have no one to thank for success except their own intellect, fortitude and capability.  And the reward can certainly justify the effort and risk involved.

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     (1) The rules pertaining to the amount of capital required for futures trading have changed considerably since this essay was written in 1969. Inflation, the type of products available, and volatility of prices have affected the amount of margin capital required.

Reprinted by permission. Excerpted from Melamed on the Markets, by Leo Melamed. John Wiley & Sons, 1993

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