I recently received a brochure from Van K. Tharps International Institute of Trading Masterty called How to Make Bigger, Consistent Profits, without the stress. In the brochure they mention some text that was found in the book Trade Your Way to Financial Freedom. It goes:

Ed Seykota made the statement that anyone risking more than 3% of his or her equity on a given trade was probably a "gunslinger." Now your risk on a given trade is the amount of exposure you have on that trade-the difference between your entry price and your stop price. For example, if you enter a gold position at $400 with a stop at $390, then your $10 stop represents a risk of $1000. If you had an account of $25,000, then your risk for one contract would be 4%.

I don't follow the text I bolded. How is the $10 difference a risk of $1000?

Dave

A gold contract is 100 oz. So, a $10 move (if gold went from $335 to $345) would be $10/oz * 100 oz = $1000. Not fun if you're on the wrong side of that market.

...can you break this down a bit more? (sorry, I'm new to the gold thing.)

The contract is entered for $400. Did the buyer pay a total of $400 for it? If it goes down to $390 isn't that a $10 difference? I'm not seeing how the dollars per ounce plays into this.

Thanks

Dave

Dave,

The contract calls for 100 ounces of gold. If gold is $400 an ounce, the contract is worth $40,000 (100x$400).

In order to trade one contract you have to put up a margin requirement of about $2,000 (depending on the broker). However, you have entered into a contract to buy 100 ounces of gold for future delivery. So you are dealing with a tremendous amount of leverage. If you were to hold the contract until its expiration date and take delivery of the gold you would have to come up with $38,000 to pay for it ($40,000 minus the $2,000 margin). That is hardly ever done because the great majority of traders will sell their contract before the expiration date.

If gold drops from $400 and ounce to $390 an ounce, you lose $10 an ounce. But since the contract is 100 ounces, you have lost $1,000 (100x$10). Think of the margin requirement as like a deposit. You can lose much more than whatever you put up for margin.

Larry

Thanks Steve and Larry for breaking that down.

So in the above example a $395 stop would represent a 2% equity risk for the buyer. In that case (based on the current price volitility of gold) would that be too tight of a stop to make such a trade and stay within decent position sizing?

Dave

It's tight, but there's nothing necessarily wrong with tight stops. You just have to be willing to find another place to enter the market in case you get stopped out.

Rather than just entering a percentage stop, I would rather enter the market close to some key support level and put the stop underneath support. That way you could have a $5 stop that has a lower probablilty of stopping you out of the market only to trade higher. Also, there is no guarantee that $5 would be all you lose. A stop just means that it becomes a market order if it should hit your stop loss price. You could get filled considerably below your stop price. Also, the market could close at say, $396 one day and open at $386 the next. You wouldn't be out at $395. You would be out at $386. If you bought at $400, you just lost $14 an ounce even though your stop was at $395.

Dave, make sure you understand the futures markets before trade them.

Larry

Thanks Larry. Futures trading is a way down the road for me. In the meantime I'll just keep trying to learn a little more each day.

Dave