Previous Entry: 8 Advantages of Trading Emini S&P 500 Futures
If you're new to futures trading you most likely have some questions about how money is actually made in the markets. In Part 3 of the Emini Day Trading Series, we will cover margin requirements, the different trade types, and the commissions a trader pays. We will then take a closer look at potential day trader income over the course of a month and year when trading with various contract sizes.
Account Size, Leverage, and Margin
One of the great advantages of the futures market is the excellent leverage available to traders. This high leverage allows even those with smaller accounts to get started with trading a single Emini contract while still not taking on too much overall risk. It's true that leverage can be a double-edged sword for traders, both increasing potential profits and potential risk of loss, but with a good plan and a defined maximum risk this increased leverage is a very useful tool.
What the high leverage available in futures allows us to do is to trade intra-day (meaning that no trades remain open at the end each trading day) with as little as $500 per contract on margin. Essentially margin is what your broker uses as collateral for you to take control of a futures contract. Theoretically, a trader could trade as many as 5 contracts ($500 margin each) at once with a $2,500 account, though this would introduce a trader to an enormous amount of risk. In order to use leverage to our advantage, we need to understand our total risk on any given trade and plan our positions accordingly.
At Samurai Trading Academy we recommend an account size of at least $5,000 for a new day trader who is just getting their start in the live market. Using our trading approach we maintain an average loss of about 4 ticks (or 1 point), which at $12.50 per tick for 1 contract comes out to $50 of average risk. This means that with an account size of $5,000 a trader is only risking about 1% of their account on any one trade. This is ideal, especially for a newer trader, as it allows occasional losses without decimating the health of our overall account.
More experienced traders may increase their risk beyond these levels, but very rarely would a trader want to increase their total risk of loss on any given trade beyond 2%. Novice traders often focus on how much profit can be made, but experienced traders will tell you that risk management is a crucial part of their trading approach. Keep your risk low through appropriate position sizing relative to your account size and you will be able to fully enjoy the benefits of leverage available to futures traders.
Trading Long (Buy) and Short (Sell)
In the futures market we are able to trade and make money when the market is going up or going down. Compared to some markets and many individual stocks, the flexibility we have to trade in either direction with futures is a major advantage. We don't need any special account permissions from our broker or minimum account sizes to sell the market, as there is no practical difference in the futures market between going long and short.
In case the terms long and short are unfamiliar to you, let's quickly define them. When a day trader enters a long trade, they are buying a contract in expectation of the price going up so they can exit at the higher price for a profit. Many traders will use the terms "buy" and "long" interchangeably. On the other hand, when a trader takes a short trade, they are selling a contract with the expectation that price will go down. So how does a trader make a profit on a contract they don't already own when price drops and the contract becomes worth less?
When short selling, we are essentially "borrowing" a futures contract we don't own from our broker with the intention to buy it later (called "covering"), effectively returning the contract to the broker. Doing this allows us to profit from the difference between the original short price where we borrowed the contract and the cheaper price where we eventually bought the contract. We return the contract to the broker at the original borrowing price and get to profit from the difference on the sale.
While it's useful to understand the difference between buying or selling a contract, it's important to realize that in the futures market it makes little difference in terms of our activities as day traders. During actual trading, both trade types act similarly when executed and there is no difference in trading costs between them.
Profits and Losses
Now that we understand margin and know that we can trade long or short with equal ease, we can look at some specific examples of how we make money (or sometimes lose money) on our trades. These examples are very basic in execution and in terms of trade management, but they should give you a good idea of how trades are taken and how we exit them. We will also explore the commissions and exchange fees we need to pay to take part in the futures market, as this is part of our cost of doing business as day traders.
Example of a Profitable Long
In this example we will take a look at a typical trade we do here at Samurai Trading Academy. In most cases, we enter all trades with an initial profit target of 8 ticks and a maximum potential loss of 5 ticks. We always make sure to have a Stop Loss order on our trades, to ensure that we never take a larger loss than planned. This is absolutely crucial as you never know what may happen in the market, so setting a maximum potential risk on a trade right from the start is an important trading practice.
Here we go long (buy) at 1536.75. Our initial stop is set 5 ticks (1.25 points) lower at 1535.50 and our Take Profit order is set 8 ticks above our entry at 1538.75. As you can see, price makes a leg higher and we are able to sell the contract at our Take Profit target for an 8 tick (2 point) profit on the trade.
Let's assume we only bought 1 contract on this trade using $500 in margin with our broker as collateral. As we already know from Part 1 of the Emini Day Trading Series, each tick is worth $12.50 per contract, so once we sell our contract at the higher price and close the trade we will see a profit of $100 (8 x $12.50) added to our account (less commissions which we will cover next).
Although novice traders should always be trading the minimum amount of just 1 contract, experienced traders can increase their size substantially if they desire. In the Emini S&P 500 (ES) futures market, a trader can easily get filled for even hundreds of contracts at a time due to the large amount of liquidity in the market. So assuming that a professional trader took the same trade but with 10 contracts, their profit would be $100 for each contract, so $1000 on the trade. Many trades in ES can reach their profit targets within just a few minutes, which potentially makes even smaller movements hugely lucrative over the course of the trading day for those traders taking larger positions.
Example of a Losing Short
In this case we take a short position that eventually ends up being a losing trade. When we initially enter our trade, we start with the same 5 tick (1.25 points) Stop Loss and 8 tick (2 points) Profit Target as in the previous example. What's important in this example is that we got an opportunity to reduce our risk and take a smaller loss when the trading opportunity wasn't working out. We don't always get a chance to do this but when the rules allow us to use bring in our stops it greatly reduces the impact to our bottom line that any losses might have and increases our overall reward to risk ratio.
After a good run down, we find an opportunity to short the market at 1538.75. Price does make another attempt to the downside but is still 2 ticks short of our Take Profit area at 1536.75. Although we began this trade with a 5 tick stop, we do have an opportunity to minimize our risk.
A huge part of seeing long term results with your trading is to know when you can minimize your risk on a trade. According to the rules we use here at Samurai Trading Academy, in this trading situation we are able to bring in our Stop Loss order 3 ticks, making our maximum potential loss on the trade just 2 ticks. Basically, we've identified a situation in the market where our trade has become slightly lower probability, so we follow our stop management rules in order to reduce our overall risk while still maintaining a large profit potential on the trade if it does resume the prior move down.
In this case we don't have another move to the downside and our Take Profit, so we end up getting stopped out for a 2 tick (0.5 point) loss. Because we had initially "borrowed" our contract for this short in hopes of buying it at a lower price later, we end up taking an overall loss on this trade when we have to buy it back at a higher price. If trading with one contract, this loss will remove $25 (plus commissions) from our account.
Commissions and Exchange Fees
Another important consideration when transitioning into day trading is the commissions and fees you will need to pay to place trades. There are two primary costs you will need to pay: a commission to your broker, and a fee to the central exchange to place your trades. Your broker will take care of this for you automatically each time you fill a trade order.
Since each trade has two parts, one to enter and then one to exit, you will be charged fees for each side of the trade. Most people look at their fees in terms of a "round-trip", where both the entry and the exit fees are lumped together.
Typically these fees for a new trader are around $4 for a round-trip trade with 1 contract in ES. The split is usually near 50/50 in terms of what goes to your broker for the service they've provided, and what goes to the central exchange. As a trader begins to trade with larger size (more contracts) and has more round-trip trades per month they can usually get greatly discounted commissions from their broker. Similarly, there are options for reduced exchange fees for larger traders as well, like buying a seat on the exchange itself.
Because there are fees involved in taking trades, it's important that we don't just take trades constantly throughout the day without a good reason to do so. Although the fees are relatively small (about 3-4 trades are worth the same as 1 tick of movement in the market) they do add up over time. Trading is a business like any other, so we want to make sure we are only paying money for something worthwhile, which in our case would be high quality trading opportunities.
Potential Day Trader Income
For obvious reasons, the potential day trader income varies widely. The system traded, the size of their positions, the risk management, and their experience level all come into play. For the purpose of this example we will take a look at a developing trader using our approach at Samurai Trading Academy.
Our goal here at Samurai Trading Academy is to bring traders to a level of consistency where they can make 10-15 points of profit per week.
To do this with consistency requires a few things from a trading approach:
- A tested, winning trading strategy that is adaptable to the market and works in a variety of conditions
- A system that has more winning trades than losing trades
- A system that has bigger wins than losses (we aim for average wins twice as large as our average losses)
The STA trading approach allows our fully trained traders to reach these goals with remarkable consistency, and that's what trading is really all about. The best traders rarely focus on the short-term by aggressively trying to make hundreds of points in a few days. Rather, the greatest traders are the ones who are able to remain consistently profitable week to week and month after month for an extended period of time. This outcome is what we aim for with our students here at Samurai Trading Academy.
If a trader develops consistency, then the possibilities are almost limitless in terms of their potential income as a day trader. Most traders who reach a level of consistency in their trading then increase their number of contracts until they find their ideal psychological comfort zone, where they usually settle for the long-term. For some traders that might be 5 contracts, for others 10 contracts, and for some it may be hundreds. Let's take a look at some of the long-term day trader income potential at various trading sizes:
It's important to keep in mind that these would be gross trading profits and that there would still be commissions and fees to be paid. These costs would vary week to week depending on how active the market has been but as our strategy doesn't have us entering and exiting the market repeatedly its allows us to keep these costs of trading relatively low.
After reading this article, you should now have a good idea of how we take trades using leverage and margin, and how we can make (or lose) money on the outcomes of our individual trades. There is a great deal more to trading than this, of course, but this overview should give you an idea of how a day trader makes their money and what is possible by trading in the markets.
The next step in the progression is fully understanding what a person needs to actually begin day trading. In the next article of the Emini Day Trading Series, we will talk about brokers, charting platforms, trading computers, and other steps you will need to take to make your transition into a profitable and consistent trader.
Emini Day Trading Series
Part 1: What Are Emini S&P 500 Futures?