Intro
As a Floor Trader at the Chicago Board of Trade and registered Commodity Trading Advisor (CTA), I earn my living everyday by trading - Trading my clients' assets as well as my personal funds.   Undoubtedly, my most important job is preserving capital.  That is, preserving capital by managing trading risk and employing strict money management guidelines. 

In this short article, I will focus on one area of capital preservation - Reducing trading risk by utilizing the CBOT mini-sized Dow futures.

There is a saying in the futures trading business: "you can't be in the futures trading business if your account is out of business."  Managing trading risk is an area that many traders talk about but few follow on a consistent basis.  Theoretically, it is an easy subject to discuss it because traders have heard the rules many times.  Rules such as:

• risk "x" percent of capital per trade
• calculate downside risk before entering each trade
• utilize stop orders for protection
• slowly increase size when winning
• quickly decrease size when losing

These are only but a few areas that professional traders consistently focus their efforts on a daily basis.  Unfortunately, when fear and greed penetrates the mind of a new or undisciplined trader, the rules of risk and money management are the first to fall by the wayside. 

Many books that have been written on futures trading, focus 80% on price forecasting methodology & the trading system and ONLY 20% on risk and money management (preserving capital).   In reality, professional traders focus 80% of their time on risk and money management and 20% on their trading system. 

As a professional trader both on and off the trading floor, I have been fortunate to meet some of the best and brightest traders.  All of these professional traders came from a wide variety of professions.  Some of these traders had strong backgrounds in mathematics, statistics, and finance ? while others began as plumbers, electricians and grocery store clerks.  Interestingly enough, they all use different methods of price forecasting and employ a wide array of trading styles. A few examples:

My conclusion is that it does not necessarily matter what price forecasting method and trading style a trader utilizes (assuming it is "statistically sound") as long as risk and money management rules are defined, embedded and followed in his or her trading plan.   Professional traders understand and respect by managing their downside risk.  

Why I trade the CBOT mini-sized Dow?
The main advantage of trading the CBOT mini-sized Dow is its flexibility.  The electronically traded $5 mini-sized Dow is ? the size of the regular $10 contract traded in the pit (i.e. One (1) $10 full size contract is equal to two (2) $5 mini-sized contracts).  Also, both contracts are fungible with each other.  In other words, if a trader is long one (1) $10 contract, he/she can offset the position by selling two (2) $5 Dow contracts.  And if a trader is short ten (10) $5 contracts, he/she can offset the position by buying five (5) $10 contracts.  Notwithstanding its smaller tick size and lower margins for smaller traders, the mini-sized Dow allows all traders to reduce or minimize risk because of its size.  Let me explain.

I am short to intermediate-term swing trader.  I typically enter the market with the full-size, $10 pit traded contract and exit using the $5, electronically traded mini-sized Dow contract.  As a swing trader, I typically try to buy support and sell resistance.  I have defined a series of rules, which tell me whether a market is in a trend or in congestion (sideways trading).  My belief is that support and resistance levels will either hold or they will break.  It's that simple.  My trading algorithm defines a series of "events" which must happen both before a trade signal is generated and then while in the position.  The "real value" is once I am in a position and the market is not doing what I expect it should (i.e. support is breaking to the downside and resistance is breaking to the upside), then I have the flexibility of liquidating a portion of my position before the market really turns against me and stops out the entire position.   The three advantages are:

1. I am able to decrease my position size if the market is not trading as I expect it should, thereby reducing downside risk. 
2. I can offset a losing position long before my original stop loss is hit, thereby reducing downside risk.
3. If the market does begin to trade in my favor, I am still able to participate in profits because I will still have a position.   Now the position could be reduced from my original position size, and I will probably make less "profit", but I will have reduced my trading risk.

Ways to use the CBOT mini-sized Dow
There are as many ways to trade the mini-sized Dow as there are traders.   Whether you are scalping for a few ticks on each trade, arbitraging the temporary discrepancies between the trading pit and the electronic market, employ a short-term methodology to extract 50 to 100 points per trade, or are a long-term trend follower attempting hundreds of points per trade, the mini-sized Dow can add flexibility to your trading plan. 

It is not my place to tell you how to trade, but only to give you ideas and/or suggestions on how you may be able to reduce your trading risk.   The following examples are a few ways that professional traders both on and off the trading floor utilize the mini-sized Dow in their trading plans.

Reduce the Risk of Trading 1 Full-Sized Contract

By trading one (1) $10 Dow contract and two (2) $5 Dow contracts, you can reduce your trading risk in two ways. 

Example 1: If bullish, enter the market by going long with one (1) $10 Dow contract.  If the market begins to move against you, then you have the flexibility of selling one (1) $5 Dow.  If the market begins to turn in your favor you are still long the equivalent of one (1) $5 Dow.  If the market continues against you, then simply sell one more $5 Dow contract.

Example 2: If bearish, enter the market by selling one (1) $5 Dow contract.  If the market continues in your favor, then sell another $5 Dow contract.  You have the equivalent position of being short one (1) $10 Dow contract.  Now, you can continue to manage the position as stated above if the market begins to turn against you.

Reduce Risk Trading Multiple Contracts

This would follow the same format as above but the number of contracts increases.  I.e. First, entering the market with four (4) $10 Dow contracts and then offsetting with eight (8) $5 Dow contracts and vice versa.

Taking "Partial Profits" on a position

This is a great strategy to lock-in profits while still maintaining a position. If you first enter the market by buying one (1) $10 Dow and the market quickly begins to trade in your favor, then you can sell one (1) $5 contract and "lock-in" profits on ? of your position.  If the market continues to rally, then you are still long the equivalent of one (1) $5 Dow contract.  If the market begins to turn against you, you have ? the size of your original position and have taken profits so you should not get hurt too badly on the remainder or your position.

Pyramiding to a winning position

This is a great strategy for intermediate and longer-term traders who attempt to enter a trending market and staying with the trend until it terminates.  After establishing your initial position, you should be expecting the market to pullback many times over the course of a trend.  You can increase your original position by adding $5 Dow contracts on the pullbacks during the beginning of a trend.  By utilizing the $5 mini-sized Dow contract, you are able to take ? the risk than if you were using the $10 Dow contract.

Special attention must be given to pyramiding to a position.   Adding to positions can be very rewarding, but also dangerous if not managed properly.  REMEMBER: you must always, always, always use stops.  When trading multiple contracts, you must always know what your downside risk exposure is and make sure that you have stops placed.  A more conservative approach to pyramiding is to only add positions when all of your stop orders working on your current open positions are at least at breakeven or better.  That way your account is not taking on any additional risk.  If the market went completely against you, then you would lose on your current position, but would breakeven on all of your other positions. 

Want to know more? Submit a question to the author of this article (please include "Brandolino Strategy" in question).

Q: Do 2 of the Dow 5 contracts offset 1 of the Dow 10 contracts or do you have to close out each of the contracts, ie, using 2 Dow 5's to offset 1 Dow 10-- at the end of the day, do you have to close out all the contracts vs each other or will the 5's offset the 10.

A: The answer to your question is that you do NOT have to get out of all the positions - they will be automatically offset against each other.

Interested in other  trading strategies?

About James Brandolino
James Brandolino is a Floor Trader at the Chicago Board of Trade, an independent investment advisor and President of LLoyd Lewis Capital Management, a registered Commodity Trading Advisor www.lloyd-lewis.com.   Mr. Brandolino is a dynamic speaker and educator who routinely lectures on the subjects of Protecting Your Investments During Market Turmoil and The Importance of Utilizing Managed Futures to Achieve True Portfolio Diversification.  Mr. Brandolino is currently writing a book entitled The 12 Commandments of Successful Trading.

If you trade CBOT Dow futures and are interested in submitting a strategy for publication on the CBOT Web Site please contact us.

The information in this commentary is provided from sources believed to be reliable, but the Chicago Board of Trade does not guarantee its completeness or accuracy. The opinions expressed within the commentary may change without notice. The commentary was prepared for general circulation and does not have regard for the particular circumstances or needs of any specific person who may read it. Neither the information nor any opinion expressed in the Commentary constitutes a solicitation for the purchase or sale of any futures or options contracts.