Commodity Spot trading damage control techniques are a necessity to financially survive as a trader. Trading commodity Spot will cause you to encounter three powerful and destructive emotions: fear, greed and hope. Trading which is influenced by these emotions will almost always result in losing trades so you need to develop survival insurance in the form of commodity Spot trading damage control techniques.
Risk is the probability of an event occurring. In commodity Spot, risk is exposing your trading capital to loss. All traders deal with varying degrees of risk when they trade. The greatest risk in trading commodity Spot occurs from surprise events which moves price too fast (via Limit Moves) and prevents you from exiting at your pre-determined Stop-Loss point. In this situation, your losses accumulate rapidly, and there's nothing you can do about it until the market volatility subsides!
Although you will never entirely eliminate this risk, you can protect yourself against it by watching the news for those events which would result in a surprise market move. These events would include sudden weather changes (freezes, floods, drought) in different parts of the world, crop reports, changes in currency, wars, pestilence, etc.
Being aware of events which could influence a commodity's price gives you a warning signal to take immediate action. This can mean either getting out of a market to avoid financial loss, or getting into a market to profit from the anticipated change.
You need to control risk to survive in this business. The two ways to control risk are:
- Control equity risk (loss of capital is predetermined prior to the trade)
- Control trading risk (time is spent waiting for the right opportunity to develop)
Modern risk management techniques have their roots in gambling techniques and probability theory. Traders often don't know what risk confronts them. The trading profession is a business, not speculation or gambling. A trader's main goal is to avoid ruin. This means you should always have excess capital in reserve to cover obligations, to live on, and to make profitable trades when the right opportunity presents itself. Strategies for safety are important.
A. Money Management
Money Management is clearly the most important risk management technique that you must learn. It is a system of rules which you need to define to identify how much capital you will risk on any one trade. This discipline will remove fear and greed from your trading activities, and also provides you with staying power. Trading without equity control guarantees failure. Self discipline is the key to successful trading, and this discipline is attained by trusting the system that you have defined.
A sound Money Management Plan uses several rules to help you control equity risk.
Having a Money Management Plan gives you a trading advantage. Your personal homework assignment is to define the rules that establish how much money you will risk on a trade. You will religiously use this plan in all of your trading activities.
Establish the total Nepali amount which you will deposit into your commodity fund and give that total amount to your broker. Put a limit on total trading capital.
Commit the amount of money you are willing to lose on the trade based on the probability that the trade will be profitable. That's why you use a Stop-Loss Order.
Define a percentage (10-20%) Nepali amount available for all trades. This amount dictates how many trading instruments you can afford. As soon as you have invested that amount of your total funds – STOP Trading! Do not take on any new positions.
As you make money and your trading account amount grows, you increase your position with more contracts (or options) per trade. As you lose money, you decrease your position with fewer contracts (or options) per trade.
B. Trading Plan
You must have a clearly defined trading plan and religiously follow it or you will not be successful at profiting from the market. A trading plan is a predefined set of rules which you define and use to mechanically and unemotionally determine the conditions you will use to get in and out of the market. A sound trading plan will control losses better than you can. Rules which should be part of any trading plan include:
Have a Trading Plan (which uses charts, tools, and trading rules that tell you when to buy or sell) to give you a trading advantage. It is your homework assignment to define the rules for your personal trading plan. The rules for a trading plan may be different for each trader, but these rules should also include:
- How much money will you risk on the trade?
- What are the conditions which will signal when to enter the market?
- Will you stay in the trade until you achieve your objective or follow the market?
Use your trading plan as your religion. NEVER go against your trading plan. If it's flawed, identify the problem and modify your trading plan to eliminate the flaw. You should also continually try to improve your trading plan. You do this by changing the rules in your trading plan, and then paper trade the changes against your current trading plan. After several trades, you should have results that will help you determine if the changes were an improvement or not. Never use a changed trading plan until you have paper traded it sufficiently to be comfortable about its reliability.
Don't put on a trade and forget it. You must take a daily account of the profit or loss that has accumulated in each trade.
Limit your losses. Use real Stop-Loss Orders. Set them to limit your loss and give up no more than 5% per contract of the total capital in your trading account. Never expose yourself to excessive risk, and never invest too large a percent of your capital.
Do not be in more than 3-4 trades at one time. Don't overtrade!
Successful traders are very defensive of their capital. They exit quickly when they suspect they are wrong. The best trades work right away. Do not fight the market. If you make a mistake, exit the market immediately! Small losses hurt much less than large losses.
Never add to a losing position – ever.
Don't trade thin markets (i.e., markets that lack liquidity which is evidenced by low Open Interest and low Volume. You need liquidity to quickly get in and out of a market at a price close to your defined exit price.
Never put yourself in a position that can result in tragedy. If in doubt, stay out!
C. Stop-Loss Orders
You must use real Stop-Loss Orders with each trade to protect your trading capital. They are used to define the maximum amount of money that you can lose – if the market reverses and moves against you. Stop-Loss Orders are used to control risk and to avoid being financially wiped out. Always set your Stop-Loss Orders so you will lose no more than 5% of your trading account capital if the trade goes bad.
Note: The Stop-Loss Order does not give you a 100% guarantee that your loss will be limited to the amount you specify. Your Stop-Loss protection may not be effective if the market moves against you during a Limit Move. When this happens, nobody can get in or out until the market volatility subsides. By then, you could easily have sustained several thousands of Rupees in loss. Fortunately, many of the tools which have been described earlier may give you advance warning of an impending reversal. This is why it is important that you monitor your active trades and the news daily.
Beginning traders often wonder where their Stop-Loss Orders should be placed. You need them to protect your trading equity, but where do you put them?
Use Stop-Loss Orders to control loss in the following ways:
In Bull markets, the Stop-Loss Order will be about the same Rupee amount that would account for a 1½ limit move
In Bear markets, the Stop-Loss Order will be about the same Rupee amount that a 2 limit move would produce.
Once you have an active position, your Stop-Loss Order will also be used to get you out of the market. As price moves in your favor, the Stop-Loss Order will be used as a protective Trailing Stop. When price movement yields meaningful profit, you will instruct your broker to move the Stop-Loss Order in the direction of price movement.
Your Trailing Stop is used to minimize loss and lock in profit.Give your Stop-Loss Order a little room so that you are not stopped out of the trade. Continue this procedure until you're stopped out of the trade.
Alternatively, every time price makes a new high, you move the stop to the lowest low of the last n days (where: n = 3-12 days).
Use the last 12 days when you first enter, and tighten up to 3 days when market has moved close to the expected target.