by: Thomas Cathey

“Survival” is possibly the most important aspect to get right in trading. This is number one. Without surviving the bad times we are gone, with no hope. Money management and risk may sound like boring subjects, but read on to see how exciting they can be once you learn the concrete reasons and logic for their use. You may never trade the same way again!

Let’s talk more about the most important subject in commodity futures contract and option trading; money management, probability and risk.

First of all, we need three things to be successful in commodity trading. With all three working well, we are like a three-legged tripod standing firm. Take one away and the whole commodity trading program falls apart. First, we need good market analysis to tell us when and where to buy and sell. Next, we need the right psychological frame of mind to effectively carry out the plan with minimum errors. And last, we need prudent money management techniques to stay in the game.

We can have the best buy and sell points in the world giving us 90% accuracy, but if we put all our money on each commodity trade, we will soon be wiped out. Or we can have the best money management, but if our buying and selling timing is bad, we will fail. And we can have great buy and sell points and good money management, but if we are not following our rules and doing self-destructive things to our trading, we will fail. All three must be running well and in sync. They are ALL equally important. The same applies to stock trading.

Let’s focus on money management. I have witnessed this area being the most abused of all. Many commodity futures traders spend a lifetime on market analysis but little time on money and risk management. I think it’s because many futures traders do not understand the survival mathematics of the game. It’s so easy to see once explained.

Let’s take a few examples. Say we are trading at 50% accuracy – that is, half of our trades are profitable and half are losers. Fifty percent accuracy is superstar status for way-out-of-the-money option buyers, a great average for long term traders, reasonable for day traders and very poor for way-out-of-the-money option sellers.

As you can see, percentage of accuracy (win/loss ratio) can be anywhere from 10% to 90% for a profitable commodity trader; it all depends on the trading method used and the person’s trading skills. Of these two, the biggest effect on the win/loss ratio is the TYPE of trading method used.

To analyze your own trading accuracy, start by discovering the ballpark percentage for your general trading method. This is a rough figure based on simple computer back-testing performance. Then figure your real-world accuracy over a long period of time through actual commodity trading. To break even at 50% win/loss accuracy, we must have a 1:1 profit to loss ratio. For example, our average loss must be $500 and the average gain must be $500 when trading at 50% accuracy to break even. This does not account for commissions and human execution errors and slippage. When counted, the accuracy (win/loss ratio) would have to be BETTER than 50% to break even.

More examples:

If we are completing three out of four commodity trades successfully, (75% accuracy) then we can break even with $750 losers and $250 gains. And if we are trading 25% accurate, then we must see $750 gains and $250 losses to break even.(not including expenses) See the point? Read this again until it makes sense. It is important.

Part Two of Five Parts - Next!

There is substantial risk of loss trading futures and options and may not be suitable for all types of investors. Only risk capital should be used.

Thomas Cathey - 27-year trading veteran heads the managed futures division of Thomas Capital Management, LLC. View his market forecast TimeLine Trading charts and get his complete 44+ lesson, “Thomas Commodity Trading Course - all free.” http://www.thomascapitalmanagement.com/commodity/welcome.htm Main site: http://www.ThomasCapitalManagement.com

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