Investing or trading of futures contracts allows you to take a leveraged position on the future value of the underlying assets. Futures trade against a wide range of commodity and financial product values, including energy, currencies, precious metals, interest rates and stock indexes. The leveraged nature of a futures contract means you must have a plan to keep small losses from turning into very large losses.
Enter an Offsetting Order
An open futures contract position can be closed out by entering the opposite type of order for the same contract. If you long position the futures contract from a buy order that establishes your position, a sell order closes the trade and prevents any further losses, assuming the price is below your entry price. If you short position the futures -- open with a sell order -- a buy order closes the position and prevents any further losses.
Use a Stop Order
Use a stop order to keep your futures contract position open, and then close out the trade if the loss increases to a certain point. A stop order is a pending order that is triggered when the futures price hits a level you set. A buy stop order will close out a short futures position with the stop price set above the current futures price. A sell stop order is set below the current contract price to close a long futures position and limit the losses. Using a stop order limits your losses at a certain level, but allows you to keep your futures trade open and profit if the price moves in the right direction.
Hedge a Long-Term Futures Position
If your goal for the long-term futures position is focused on the long-term value of the underlying commodity, you may not want to close your position with a stop-loss order. An alternative is to hedge the long-term futures position with a short-term contract of the same futures. For example, if you long position a two-year oil futures, you could sell -- take a short position -- in a 3-month oil futures, protecting your long position against a short-term decline in the price of oil. While the short-term futures trade is on, the gains and losses of the two contracts -- long-term and short-term -- will offset each other.
Managing Pending Orders
An important consideration with pending orders, such as stop orders, is where the order is recorded and held. An order may be held on your broker's server to be filled when the target price is hit, or the order may only be tracked on the trading software on your computer. In the second case, if your computer is not connected to your broker's system, the stop order may not get triggered and filled. Check with your broker to find out where pending orders are held so you do not get the unpleasant surprise of a missed stop-loss order.
Tim Plaehn has been writing financial, investment and trading articles and blogs since 2007. His work has appeared online at Seeking Alpha, Marketwatch.com and various other websites. Plaehn has a bachelor's degree in mathematics from the U.S. Air Force Academy.