Last Updated on 11 September, 2023 by Samuelsson
Although the futures market is was initially meant for producers and suppliers of commodities to hedge their investments against fluctuations in price, a great majority of the market participants are retail traders who are in the market just to make profits because the market is highly liquid and the margin requirement is quite low. But is trading futures profitable?
Trading futures is as profitable as the trading strategy used. For the most part, a trader’s success is determined by his trading strategy and how well he executes the strategy.
There are many different strategies used in trading futures. Keep reading to find out more.
Common Trading Strategies for Futures
A trading strategy is what guides a trader to find an edge in the market. Every future trader has a personal trading strategy, which he must have adapted to suit his trading style. A well-formulated strategy should have clear criteria for identifying a trade setup.
While the strategy a trader is using can play a huge role in his trading success, proper execution of the strategy determines, to a great extent, the amount of profit he can make from each trade. Many futures traders, especially the beginner traders, might even lose money with a good strategy, since they cannot execute it correctly
Having said that, most of the strategies used in futures trading fall under the following categories:
- Trend following trading strategies
- Mean reversion trading strategies
- Momentum trading strategies
Let’s have a look at them in greater detail!
Trend following is a very popular trading strategy type, and many futures traders make use of it. Basically, a trend-following strategy tries to identify the direction of the trend as early as possible. With this strategy, a trader places a trade in the direction of the trend and rides the trend for as long as it lasts.
There are many ways to identify their trade entry points with this strategy, but the most common ones are the following:
Breakout: With a breakout strategy, a trader waits for the price to break above a resistance level or break below a support level before entering a trade. When trading this strategy, the first thing the trader does is to identify the direction of the trend. If the trend is up, he will look to take a long position when the price breaks above a major resistance level or the previous swing high. If the trend is down, the trader will look to take a short position when the price breaks below a support level or the previous swing low.
Moving average crossover: Traders do use moving average crossover as a signal for trade entry. A moving average crossover occurs when two moving average indicators cross each other. The two indicators are of different periods — one moves faster than the other. When the faster one crosses above the slower one, it is an indication to buy. Conversely, when the fast-moving average crosses below the slow moving average, it is an indication to sell.
Even though this is a quite popular strategy, it’s one that doesn’t work that well anymore.
Price action: Some traders base their trading decisions solely on price action. They use certain price patterns to identify the direction of the trend and trade setups. For example, if the price is making higher swing highs and higher swing lows, the trend is upwards, and if it is making lower swing lows and lower swing highs, the trend is downwards. Candlestick patterns are commonly used here as well.
This a contrarian trading strategy, and it can mean going against the trend on some occasions. Traders who make use of this strategy believe that the price has a tendency to revert to its mean value anytime it overshoots it by some huge points.
So, if the price moves significantly above the mean, they take a short position, with the hope that the price will move down to its mean value. And if the price moves significantly below the mean, they take a long position and ride the price up to the mean.
Some mean-reversion traders use Bollinger band to identify their entry and exit points. When the price rises above the upper Bollinger band, they go short and place their profit target at the middle band. A break below the lower band triggers a long position with a profit target at the middle band.
Other common indicators that are used for this strategy are standard deviation and price channels. Some traders also use oscillators, such as RSI, commodity price index (CCI), and stochastic, for mean-reversion trading.
A momentum strategy is similar to trend-following strategies, in that it looks for trade setups only in the direction of the trend. But unlike trend followers, a momentum trader doesn’t keep his trade when there is a pullback. He bails out at the slightest sign of weakness and may enter again when momentum picks in the direction of the trend.
Some traders implement this strategy with trendlines and candlestick patterns only, but others add one or two momentum indicators. Traders who use only price action enter their trades when a reversal candlestick pattern appears after a pullback to the trendline.
Those who use indicators for this strategy mostly use momentum indicators, like the RSI, CCI, William’s %R, MACD, and OsMA. They try to use the indicators to identify when a pullback is over. Once the momentum has turned to the direction of the trend, they place a trade in the direction of the trend.
How to Become a Profitable Futures Trader
Now that we have covered some different trading strategy types, it might in fit well to have a look at the type of trading that gives you the highest odds of success. We’re talking about algorithmic trading, which is a trading form where you program strategies that the computer trades for you.
The markets today are much more efficient than they ever have been, and in order to find an edge, we need to adopt quantitative methods. We need to use backtesting to determine whether there is an edge or not, and then make the computer trade those strategies for us to minimize our own mistakes.
Discretionary approaches like those outlined above don’t work that well anymore. And going forward, discretionary trading is only going to get harder, as the markets become more efficient.
If you want to learn more about algorithmic trading, then we recommend that you have a look at our complete guide to algorithmic trading!
What You Need to Know About Leverage and Futures
Futures contracts are highly leveraged instruments, so there is a need for caution when trading futures. With a little amount, you can carry a large contract. While this may help you make money faster, you can also lose all your money.
Leverage is the factor by which a trade is amplified, and it is based on the initial margin used for the trade. The initial margin is the minimum amount a trader must provide to be able to carry a trade. Leverage is gotten by dividing the total worth of a trade by the required margin.
For example, if a futures contract is worth $100,000 and the margin required to buy the contract is $5,000, the leverage will be given as $100,000/$5,000 = 20. In this case, the trade is worth 20x the trader’s money, so any profit made is multiplied by 20, likewise any loss.
As you can see, leverage is a double-edged sword — it can help you make huge profits if a trade moves in your favor, but when a trade is moving against you, it can run down your trading account. With a 20x leverage, a 5% decline in the price of the contract effectively blows your account.
How to Calculate the Dollar Risk of a Position
As a futures trader, it is important you know how to calculate the dollar risk of a position. To calculate how much you are risking in a position, you will need these three things:
1. The point size of the contract: This refers to the dollar amount per point movement in the price of the asset. The value varies for different assets. Since the tick is the minimum move a price can make and most traders calculate their stop loss in ticks, it is better to use the tick value. The tick value of the E-mini S&P 500 (ES) futures contract is $12.50.
2. The number of contracts you are trading: The higher the contract size, the higher the risk.
3. The number of ticks you are risking: This refers to the size of the stop loss. When the stop loss is larger, the dollar risk is larger too.
The dollar risk of a position is given as:
Dollar risk = Tick value x Contract size x Number of ticks at risk
For example, if you are trading two contracts of the E-mini S&P 500 (ES) futures and your stop loss is 10 ticks, the dollar risk of your position will be:
$12.50 x 2 x 10 = $250.00
Trading futures is as profitable as the trading strategy used. For the most part, a trader’s success is determined by his trading strategy and how well he executes the strategy. With a good strategy and proper execution, you can become a profitable futures trader. Most often, that means switching over to algorithmic trading.