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Introduction
Before you begin futures trading, there’s a lot of information you’ll need to assimilate. You also need to set goals and determine how much money you’re reasonably able to risk above and beyond your initial investment. You also need to understand the obligations of entering into futures and option contracts before you enter into them. Otherwise, you could get a nasty surprise and find yourself owing thousands of dollars beyond your initial investment. Futures trading can be profitable, but it is also very risky, and very volatile, and you need to make sure you are educated about the potential pitfalls and weigh that against your financial knowledge and resources.
You’ll also need to know who to contact in case of problems or questions. There’s a lot written about futures trading, and you need to be careful where you get your information. Companies or individuals promising huge profits with minimal risk probably won’t be able to deliver that, and later on, we’ll discuss where you can go to find out all need to know about a company before you decide to put your money on the table.
Sit down with your broker before you decide to embark on a journey through the world of futures trading. Decide how much you want to be involved in the trade decisions and how much input you want from your broker.
The History of Futures Trading
The first modern futures trading markets began in the United States in the middle of the nineteenth century. Futures trading allowed farmers who lived far away from major metropolitan markets to be able to sell their grain or livestock at a profit.
What we know today as the Chicago Board of Trade started in 1848. For the first ten years of its existence, the Chicago Board of Trade served mostly as a meeting place for farmers. It wasn’t until 1863 that the Chicago Board of Trade adopted rules for forward contracts, which eventually turned into what we know now as futures.
What is Futures Trading?
A futures contract is an agreement between a buyer and a seller to exchange a certain amount of something at a specific price on a future date. The object of the transaction can be corn, coffee, precious metals, petroleum products, financial instruments like treasury bonds or foreign currencies, or most anything else that people wish to buy and sell, although agricultural and mineral commodities make up the bulk of most commodities trading. Traders buy and sell futures contracts on what is known as an exchange, which is a marketplace operated by a voluntary association of members. The exchange gives trader the infrastructure and tools to do their jobs. Exchange members are the only ones allowed to trade on the exchange. Nonmembers use commission merchants, who are exchange members who charge outsiders a fee to manage their trades and accounts. The futures market is designed to help participants manage risk. For instance, a soybean farmer is hoping the price for soybeans won’t drop low enough to make it more worthwhile for him not to plant at all. By selling a soybeans futures contract, the farmer can hedge his bet so that he will end up with a satisfactory outcome from his crop regardless of market conditions.
There are three main purposes for futures markets. First, they enable hedgers to shift price risk to speculators in return for basis risk. Price risk is asset price volatility—in other words, the price of the commodity can vary widely. Basis risk is the difference between the futures price and the cash price of the underlying asset or commodity being traded. Hedging generally means to take opposing positions in the futures and cash markets. Hedgers are usually, but by no means always, farmers, feedlot operators, merchants, millers, export and import firms, lenders and hedge fund mangers. Speculating means to take a position in the futures market with no counter-position in the cash market. Speculators only intend to profit from a change in price of the underlying asset—they don’t plan to take delivery of the commodity the way a feedlot operator or miller would. Here’s a simplified example of how a hedge might work:
The grain that went into this bread probably went through a dozen futures contracts before reaching the mill.
It’s May 1st. Farmer Brown is growing 5000 bushels of soybeans, which are currently worth $2.00 a bushel on the open market, or $10,000. Farmer Brown wants to preserve the value of his soybeans until he sells them on July 1st – even if the price of soybeans drops in the meantime. To do that, he takes a position in the futures market exactly opposite his position in the current cash market. So, Farmer Brown sells a July futures contract for 5000 bushels of soybeans at a price of $2.10 a bushel, or $10,500. Absent basis risk, Farmer Brown has preserved the value of his soybeans because a fall in the price of soybeans is matched penny for penny in the futures market. If the price of soybeans falls 10 cents a bushel by July 1st, the cash, or spot price, is $1.90 a bushel, and the futures price is $2.00 a bushel. Farmer Brown sells his 5000 bushels of soybeans for $9500 and loses $500 in value on his cash transaction. At the same time, he fulfills the July futures contract for 5000 bushels of soybeans and makes $500. Farmer Brown has now offset his position in the futures market because he has both bought and sold a July futures contract.
This example may be somewhat misleading because it doesn’t take into account basis risk: hedgers can decide to hedge more or less than 100 percent of their cash positions and may also trade futures contracts with underlying assets that are not the same as the assets the hedger owns. Hedging is not designed to avoid risk, but to manage it and perhaps profit from it.
The second purpose of futures trading is to allow the acquisition of operating capital. Operating capital derived from futures trading is a short-term loan that finance purchases of intermediate goods like inventories of grain or petroleum. Lenders are more likely to finance hedged inventories, because the futures contract serves as an efficient form of collateral which costs only a fraction of the inventory’s value. Speculators make hedging possible because they absorb the inventory’s price risk.
A futures market also makes it possible get an idea about future economic events. As long as the futures market forms expectations by taking into account all available information, the market’s forecast of future economic events is almost always more reliable than any particular individual forecast.
Futures contracts are traded on organized exchanges. Prior to 1970, most futures exchanges dealt primarily with farm products like corn, livestock, and wheat. There are now successful futures markets in copper, gold, silver, fossil fuels and financial instruments. Single-stock futures began trading in November 2002. Futures contracts are typically traded in what is known as an ‘open outcry’ environment, which means traders and brokers shout bids and offers in a trading pit or ring.
The trading floor – order from madness
Though open outcry is still the main method for trading commodity futures in the United States, financial futures have been moving to more sophisticated electronic trading platforms, where the market participants post their bids and offers on a computerized trading system. Almost all the futures trading that is conducted in countries other than the United States use electronic systems such as this.
One of the functions of the exchange is to standardize the terms of delivery for the various commodities; as opposed to peer to peer systems of trading, market participants cannot alter these terms easily. The standardized terms include the amount of the commodity to be delivered (contract size), the delivery months, the last trading day, where the commodity is to be delivered and the acceptable quality or grades of the commodity. Here’s an example of the soybeans futures settlement from the Chicago Board of Trade (CBOT) on September 16, 2005:
Price Unit: Cents and quarter-cents/bu (5,000 bu)
Expiration Opening High Low Closing Settle Net
Change
05 Nov 573'4 572'0 573'4 568'0 572'0 570'4 571'2 +2'4
06 Jan 582'4 582'0 582'4 577'2 580'4 579'4 580'0 +2'2
06 Mar 588'0 588'4 589'2 585'0 587'4 587'0 587'2 +1'6
06 May 595'0 595'0 590'0 590'0 592'4 591'2 +0'6
06 Jul 597'0 597'4 598'0 594'0 596'0 596'4 596'2 +1'2
06 Aug 598'4 598'4 594'0 594'0 594'0 Unch
06 Sep 597'0 597'0 593'0 594'0 594'0 Unch
06 Nov 598'0 600'0 596'0 597'0 596'0 596'4 +0'2
07 Nov 605'4 N 605'4 -0'4
Table generated September 16, 2005 17:00 CDT
The CBOT soybeans futures contract provides for delivery of 5000 bushels of soybeans during January, March, May, July, August, September, and November. That delivery could be made in Chicago or any of several other specified delivery locations. The exchange also specifies that different varieties and grades of the commodity (soybeans, in this case) can be delivered at various premiums or discounts to the contract price. This standardization enhances liquidity, because large numbers of market participants are able to trade the same instrument, which in turn makes the contract useful for hedging.
Let’s go back to Farmer Brown and his soybeans. If Farmer Brown lives in Iowa, then he wants to harvest his crop and deliver it locally, perhaps to a Des Moines dealer, rather than Chicago. So that he means the he does not want to make actual physical delivery on his futures contract, which would be expensive and inconvenient for him. Instead of trucking his crop all the way to Illinois, Farmer Brown will buy back the futures contract before the last trading day, sell his soybean crop locally and offset the contract. Most futures contracts are liquidated by offset and do not result in delivery. The physical delivery component is in place to make sure the futures price and the cash market price converge, and there are arbitrageurs whose livelihood consists of coordinating these deliveries and arranging the contracts appropriately.
Futures trades made on an exchange are cleared through an organization known as a clearinghouse that acts as the buyer to all sellers and the seller to all buyers. When you buy or sell a futures contract, technically, you are buying from or selling to the clearinghouse rather than the party you executed the transaction with on the trading floor or on an electronic trading platform. That way, when Farmer Brown buys a futures contract and subsequently resells it (almost certainly to someone other than the original seller), he has offset his obligation and the contract is extinguished. Otherwise, he would end up with 5000 bushels of soybeans due in Chicago, and no way to get them there.
Futures traders do not have to put up the entire amount of the contract. Instead, a futures trader has to post a margin, usually between 2 and 10 percent of the contract price. Margins in the futures market are in place to ensure traders can meet their financial obligations. When you trade futures, you are required to post the initial margin of the amount specified by the exchange or clearinghouse. Your margin account is used to make up the difference between the futures price and the cash, or spot, price. After you post your initial margin, your account is ‘marked to the market’ daily. If your futures position loses value, the money in your margin account declines accordingly. If that amount falls below a specified maintenance margin, you will have to post more money (called variation margin) to bring the account back up to the initial margin level. But, if your futures position gains value, the profits are added to the margin account.
For example, you buy a soybeans futures contract that calls for delivery in November. The contract calls for 5000 bushels to be delivered in November at a price of $2.00 a bushel. The initial margin for this contract is set at 2 percent. That means you have to put $200 in your margin account. If the futures price goes down to $1.90 a bushel, your account will be debited $500. That means you have to put $500 in your account: $300 to make up the loss and another $200 to get back to the initial margin level. Keep in mind futures commissions merchants often require customers to maintain funds in their margin accounts that exceed levels specified by the exchange.
There are also daily price limits for trading in futures contracts. The exchanges establish those limits, which are stated in terms of the previous day’s closing price plus and minus a given amount of cents or dollars per trading unit. This means once a futures price increases by its daily limit, it can not be traded at any higher price until the next trading day. And, once a futures price declines by its daily limit, it can not be traded at any lower price until the next trading day. These price limits are eliminated in some contracts during the month in which the contract is to be delivered. Prices during the so-called ‘delivery’ or ‘spot’ month can be particularly volatile, and you may want to liquidate your position before that month. These daily price limits could impact your ability to trade your futures contracts on a given day, so you need to have strategies in place to deal with that eventuality.
For example, the Chicago Board of Trade’s price limit on soybean oil is 2 cents per pound above or below the previous day’s settlement price. So, if the previous day’s settlement price was 22 cents per pound, the higher limit is 24 cents, the lower 20 cents. That means there cannot be any trading above the 24 cent limit or below the 20 cent limit. These daily price limits are subject to change—if the market has increased or decreased by the price limit for a number of successive days, the price limits could be increased.
Futures contracts also have a limit on the minimum amount its value can go up or down. This is known as the tick. It refers to the minimum change in price, up or down. Up-tick means the last trade was at a higher price than the one preceding it; downtick means the last price was lower than the one preceding it. On a soybean oil futures contract, for example, the tick is 1/100th of a cent.
How to Trade Futures Contracts
In the United States, futures contracts must be executed on or subject to the rules of a commodity exchange. You cannot trade directly on an exchange unless you are one of the relatively few members of that exchange; a person or firm with an exchange membership has to trade on your behalf. Anyone who trades on your behalf as a customer must be registered with the Commodity Futures Trading Commission.
There are two general categories of accounts you can use to trade. The first is an individual account, where trading is done only for you. There are discretionary and non-discretionary accounts. In a non-discretionary account, you make all the trading decisions and the broker may not execute any transactions without your prior approval. A discretionary account means you give permission for the firm trading on your behalf to make trading decisions for you. You can open an individual account through a registered Futures Commission Merchant, or through an Introducing Broker. You deposit funds directly with the Futures Commission Merchant, and grant power-of-attorney to them. An Introducing Broker is not allowed to accept funds from you, but may accept your orders and transmit them to a Futures Commission Merchant with whom the broker has a relationship. If you open a discretionary account, you would also grant power-of-attorney to the Introducing Broker, an associated person or commodity trading advisor to make trading decisions for you.
In an individual account, you will be required to maintain the margin account discussed earlier. This account is set up at a level smaller than the value of your market position, which gives you the ability to leverage your funds. Because trading futures is leveraged, small changes in price occur frequently and result in large gains or losses in a very short period of time. It is critical that you be aware of your maximum possible loss, and that you be in a position to make good that loss, before you begin trading. The privilege of having a smaller sum in a margin account is a convenience to allow you to make optimum use of your cash; it is not a forbearance of having to make good any loss. It is never wise to invest funds that you are not in a financial position to lose if things go entirely the wrong way.
Each day, your broker calculates the value of your futures contract in your account. If the money in the account declines in value to the maintenance margin level (usually about 75 percent of the amount you had to put up originally), you will have to come up with more money to restore the initial margin level. This is known as a margin call. If you fail to meet that margin call in a reasonable period of time (which could be as little as an hour), your broker could close out your positions to keep your losses to a minimum. If your position is liquidated at a loss, you are liable for the amount of the loss, which means you can lose substantially more than your initial investment.
Let us return once again to Farmer Brown and his soybeans. This time, he has purchased a futures contract for November soybeans at $2.00 for 5000 bushels. At the end of the day, the futures price for his contract has fallen all the way down to $1.95. This is a loss of $250. If his initial margin was $200, he would now owe $50, and have to put $250 in his margin account to bring it back up to the initial margin.
You can also trade commodities through a ‘commodity pool’. In this scenario, you would purchase a share or interest in the pool, and the trades are executed for the pool itself, rather than the individuals who have interests in it. Pool participants get to share in gains or losses on a pro rata basis (if your investment represents 10% of the size of the pool, you receive 10% of the profits and are liable for 10% of the losses). In a commodity pool, the pool itself makes the initial margin payments and margin calls. Your obligations as a participant and your liability for any losses to the pool have to be described in the pool’s disclosure document.
According to the United States Commodity Futures Trading Commission, that disclosure document has to include extensive information:
v Principal risk factors;
v The extent of your potential liability;
v The percentage return necessary for you to break even;
v Fees and expenses;
v Any material litigation during the last five years against the pool's operator, manager, trading advisors, principals, the pool's Futures Commission Merchants and Introducing Brokers;
v Actual or potential conflicts of interest of the pool's operator, manager or advisors;
v Past performance information;
v Information about the Commodity Trading Advisor or company and its principals;
v The business background of the pool's operator, manager, and advisors;
v The volatility of the market;
v Limits on your ability to withdraw funds;
v Management, advisory, and brokerage fees;
v Whether foreign futures and option transactions are involved;
v The investment program of the pool and use of proceeds;
v Whether those managing your money may trade for their own account;
v Information on any protection of your principal investment;
v Transferability and redemption;
v Liability of participants;
v Distribution of profits and taxation;
v When trading will begin;
v The ownership of the pool; and
v The nature of the reporting done to pool participants.
Before a Commodity Trading Advisor can solicit you concerning authority to direct or guide your trading, the Commodity Trading Advisor must provide you with a disclosure document containing similar information. Be immediately wary of any advisor or broker who is slow about providing these documents or who urges you not to pay them any attention; no reputable advisor has anything to hide.
There are certain types of orders that are designed to limit your losses to certain amounts, called stop-loss or stop limit orders. Followers of business news will recall that a stop-loss order was part of what got Martha Stewart into trouble. In the futures market, a stop-loss order becomes a market order (an order to buy or sell a futures contract) when a certain price level is reached. A stop limit order goes into force as soon as there is a trade at the specified price. But, the order can only be filled at the stop limit price or better. You need to know, however, that these orders may not effectively limit your losses because market conditions could make it impossible for your order to be executed at a reasonable price.
What kind of conditions would make it impossible to execute your stop order? Let’s say you want to limit your loss on a soybean oil contract to a penny a pound. You purchased a soybean oil futures contract at 22 cents a pound, so you would place a stop order to sell an offsetting contract should the price fall to 21 cents a pound. If the market reaches that 21 cents a pound price, the stop order would be converted to a market order to execute your trade at the best possible price. But, in an active and volatile market, there is no guarantee that your position can be liquidated at the price you want. It could be prices are declining or rising so rapidly, there’s no opportunity for that to happen. And, if the prices have risen or fallen by the maximum daily limit (2 cents a pound, in the case of soybean oil), there’s no trading in the contract at the moment, a condition known as a ‘lock limit’ market. And, though it is not common, it’s possible the markets could be lock limit for more than a day, which could mean substantial losses if you couldn’t liquidate your losing position.
Stop orders can also be used to protect your profits. If you bought soybean oil futures at 22 cents a pound, and the price is now 25 cents a pound, you could place a stop order to sell when the price declines to 24 cents a pound. This would protect 2 cents per pound of your 3 cents a pound profit. The advantage of this type of stop order is that you aren’t as likely to hit a lock limit market in such a way as to wipe out all of your gains.
It is extremely important that you read the disclosure document in its entirety before you make any investment or enter into any commitments. You need to be fully aware of your obligations and potential losses before investing. Any individual or company that tells you not read the documentation or fails to provide it to you is likely trying to scam you out of your money. Don’t be pressured into quick decisions—take your time and read the document thoroughly and ask if you have questions. If an investment firm doesn’t want to answer your questions, then find someone who will. There are a lot of investment firms out there, and you don’t have to put up with a company that only sees you as a wallet.
If you are going to participate in a commodity pool, the risk disclosure document must include information on past performance. The Commodity Pool Operator is required to provide you with this performance information. If you have a Commodity Trading Advisor handle your trading for you, that person must also provide you with past performance information in the disclosure document. The Commodity Trading Advisor also has to let you know whether the performance results are based on actual trading results or whether they are hypothetical scenarios. Your advisor must tell you about the inherent limitations of simulated results and the advisor is not allowed to represent to you that your results would be similar to the profits and losses shown. Again – look out for advisors who aren’t following the rules. That should be a huge red flag.
If you’re planning on having an individual account, get as much information about the firm or advisor’s track record with other clients as you can. They are not required to provide this information, but beware of a company or individual who does not want to. Your broker should also confirm all purchases and sales, give you a month-end summary of your transactions that shows gains, losses and your current account value as well as mark-to-market valuation of your open positions. You should also be able to get this information on a daily basis.
In a commodity pool, if the pool assets do not exceed half a million dollars at the beginning of the pool’s fiscal year, you will get a quarterly report. In the larger value pools, the operator should send you a monthly statement of net asset value.
If you want to take money out of your individual account, be aware that the money needed to meet initial margin requirements can only be withdrawn after your trades are settled, and sometimes, after all open positions are closed. If there’s money in your account beyond the required margin or account-opening requirements, you should be able to withdraw it. Accruals on futures contracts are paid out daily.
Commodity pools may or may not allow you to withdraw money at any given time. Some pools limit when funds may be withdrawn, perhaps as infrequently as quarterly or yearly. You’ll be able to read about the restrictions on money withdrawal in the commodity pool’s disclosure document. You should also ask about the money withdrawal policy before you invest in the pool.
The money you deposit in your individual account with your broker’s firm to trade on American commodity exchanges has to be held separately from any of the firm’s own funds. Your individual account will either increase or decrease in value as you make or lose money on your trading. Be aware that even though the firm is required to segregate your funds, you may not be able to recover the full amount of money in your account if the firm becomes insolvent and there are insufficient funds to cover obligations to all the customers. If you trade on commodity markets outside the United States, the firm sets up a trading account for you, in addition to the account you have for US market trading. The funds in the foreign account are kept separate only while you maintain an open position on a foreign market, and only to the extent of the margin required by that position, give or take the unrealized gain or loss.
In a commodity pool, the operator has to disclose to you the percentage of the pool’s assets that will be segregated.
Trading Futures Options
The option on a futures contract gives the buyer the right, but not the obligation, to exercise that option in a given time period. The buyer has to pay a predetermined price known as a premium for the option. Exercising the option means the person exercising it has entered into a futures contract at a specified price, also known as the strike price. Sometimes, the option can confer the right to buy or sell the underlying asset directly. This is known as an option on the physical asset.
There are two types of option contracts, call and put. A call is an option contract that allows, but does not require, the buyer to purchase a specified amount of a commodity or interest at the strike price prior to, or on, a future date. A put allows, but does not require, the buyer to sell the commodity or other interest. You’ll also need to know the terms ‘long’ and ‘short’. Simply stated, going ‘long’ is the purchasing side of a futures contract, ‘short’ is the selling side.
If you’re buying a call option, it will specify the futures contract that may be purchased, known as the underlying futures contract, and the price at which it can be purchased (the strike price). For instance, a March Treasury bond call option ‘84’ (meaning that it has a strike price of $84,000) gives you the right to buy one March U.S. Treasury bond futures contract at a price of $84,000 at any time during the life of the option. One reason you might do this is to profit from an anticipated increase in the price of the underlying futures contract. You can also make money on the deal if, upon exercising your option, the underlying futures price is above the price to exercise the option by more than the premium you paid.
Let’s assume you pay a $2000 premium for a June Treasury bond 82 call. This option expires in May. If you expect interest rates to go down, the bond price would go up, because interest rates and bond prices move inversely. If you are correct, and at the expiration of your option in May the June T-bond price is 90, you would make a gain of 8, or $8000. Since you paid $2000 for the premium, your profit is $6000, less transaction costs.
The most an option buyer can lose is the option premium plus transaction costs. Your liability in the previous example is limited to the $2000 premium plus the transaction costs, no matter how wrong you might have been. The advantage of buying an option is that it limits your risk, but it also limits your profits because the profit potential is reduced by the cost of the premium. You can, of course, lose the entire amount of the premium if you hold the option until its expiration and the market price makes the option not worth exercising.
The put option gives you the right to sell, or go short, a particular futures contract at the specified price. If you’re expecting a price decrease, you would purchase a put option. Let’s say you expect gold prices to decline, so you pay a premium of $1000 to purchase an October 320 gold put option. This gives you the right to sell a 100-ounce gold futures contract for $320 an ounce. If, at expiration, the October futures price goes down to $290 an ounce, on 100 ounces, that means you’d gain $3000. After you subtract the premium of $1000 you paid, that’s a net profit of $2000 less transaction costs. If you were wrong, and gold prices went up, the most you would have lost would have been the $1000 premium you paid.
Three main variables affect the price of an option premium.
1. The relationship between the option’s exercise price and the current price of the underlying futures contract
2. The length of time remaining until expiration
3. The volatility of the underlying futures contract.
Usually, an option that is already worthwhile to exercise, called an ‘in-the-money’ option will command a higher premium than one that is not yet worthwhile to exercise (an ‘out-of-the-money’ option). A ‘deep-out-of-the-money’ option is a call option with a strike price substantially above the underlying futures contract price, or a put option with a strike price substantially below the underlying futures contract price. Substantially above or below is often defined as more than one strike price above or below the current value of the underlying futures contract. For instance, if a soybean oil contract is currently selling at 22 cents a pound, a put option conveying the right to sell soybean oil at 25 cents a pound is more valuable than a put option conveying the right to sell soybean oil at 23 cents a pound. Thus, the premium for the 25 cents a pound put option would be higher.
With everything else being equal, an option with a long period of time remaining before it expires will have a higher premium than an option with a short period of time remaining. That’s because the longer time gives the underlying futures contract more time to be profitable. An option is known as an eroding asset, because its value declines as it approaches expiration.
The greater the volatility of the underlying futures contract, the higher the option premium. That’s because the option has a greater chance to become profitable to exercise in a volatile market.
Options are sold by market participants known as grantors or option writers. They make money by earning the premium paid by you, the option buyer. If your option expires without you exercising it, the option writer gets the full amount of the premium you paid. If, however, you exercise your option, the option writer has to pay you the difference between the market value and the strike price. And, unlike an option buyer who can only lose the option premium, the option writer has unlimited risk, because any gain realized by the option buyer is a loss for the option writer.
Things To Watch Out For
The best rule of thumb in figuring out whether a firm or individual is on the up and up is: “If it sounds too good to be true, it probably is.” As with all investment vehicles, beware of promises of high returns with little or no risk – something for nothing. You might be able to get a something for nothing deal from a relative who has your best interest at heart; your futures broker is not your kindly uncle. There is substantial risk in futures or options trading, and anyone who says otherwise is not being honest about it. The Commodity Futures Trading Commission says it has seen a huge increase in the number of scams that promise high returns with little or no risk. These scams have often been targeted at ethnic communities, presented in their native languages, all over the United States.
You should also watch out for any firm offering to sell commodities, commodity futures or options. They could be selling anything from gold or silver to foreign currency to agricultural products to heating oil or unleaded gasoline. A firm might offer to manage your money for you and trade on your behalf in commodity futures or options or give you the opportunity to pool your money with other customers. If a company makes these offers and claims incredible profits with low risks, or claims all their customers have made money, don’t believe it without proof. You can lose your entire investment and more very quickly, and anyone who says otherwise could be breaking the law. Be wary of investors who promote their track records of correct predictions with a newsletter or other informal vehicle; there is a well-known scam involving random predictions and a dwindling mailing list. A scammer will send an up-or-down prediction to 5,000 people, and the opposite prediction to another 5,000. He will discard the mailing list that got the wrong prediction, and make another two-way prediction, this time with 2,500 on each list. After six predictions, over six months, he’ll be down to 125 people on his list – but those 125 people will think he has the ability to predict the future, and he will be able to scam them very effectively. Don’t be one of those folks.
No matter what the commodity or financial instrument, there is a scammer waiting to take your money. Foreign currency trading scams are often advertised as high-return, low-risk investment opportunities. Get-rich-quick schemes like this should be greeted with a healthy dose of skepticism. Sometimes, commodity pool operators use their position in the community to solicit money from friends, co-workers, or neighbors. In many cases, these investment opportunities are fraudulent, and investors lose all their money. Sometimes, little or none of the money given them is actually invested as promised. There is also what’s known as ‘Ponzi’ scheme, so named after an Italian-born immigrant to the United States who got about 40 thousand people to invest the equivalent of 140 million dollars in today’s U.S. funds into a postage stamp scheme. The operator of a Ponzi scheme steals the invested money and uses some of the money put in by later investors to pay phony profits to the earlier investors, which makes it look like their investment is making money (thus generating word of mouth and a “track record” of successful returns). That, in turn, attracts more investors and perpetuates the scam. If you don’t fully understand where your profits are coming from, that’s a big red flag.
Remember, there is no such thing as a free lunch. Be especially cautious if you just inherited or won a large sum of money and are looking for a safe investment. Retirees are especially at risk for scammers, who can find them an easy target. Once your money is gone, it is often next to impossible to get it back.
Also beware of companies that promise huge profits, or promise high performance. Get all the information you can about the company, its track record and make sure you verify that information. Before investing with any company, check with someone you trust about the information the company has given you.
Companies that downplay risk, or tell you disclosure statements are mere government formalities you don’t need to read are companies to stay away from. If the company refuses to give you solid documentation about what you’re investing in, don’t give them your money.
Firms that claim to trade in the ‘interbank market’ or say they’ll do so for you are also good to avoid. Firms that do trade currencies in the interbank market are most likely large corporations, banks or investment banks. The term ‘interbank market’ simply means a loose network of currency transactions negotiated between financial institutions and other large companies.
The quicker a firm wants your cash, the quicker you should look somewhere else. High-pressure efforts to get money to a firm immediately likely means you won’t get what you pay for. Nobody trustworthy will ever rush you for money upfront (you may have to make margin calls promptly, of course, but that is a different story.)
If you get unsolicited phone calls about investing, beware. Watch out for companies you’ve never heard or are not located in your state. You should check with your state’s Attorney General’s office, the Better Business Bureau, the CFTC before you do any futures trading with a company or individual. You can also easily check to see if they are registered futures traders by calling the National Futures Association at 1-800-676-4632. Membership in the NFA is mandatory, which insures everyone conducting business with you in the American futures exchanges have to abide by the same high standards of professional conduct. The National Futures Association has more than 4200 firms and 55 thousand associates, and is an independent regulatory organization that has no ties to any specific marketplace. The NFA is financed exclusively from membership dues and assessment fees paid by those who use the futures market.
If you feel a company has violated commodities laws, you can report them to the CFTC Division of Enforcement at 1-866-366-2382.
Picking A Broker
There are a number of factors to consider in picking a broker. According to the vice president of futures at Smith Barney, Phil Tiger, the broker-customer relationship is fairly intimate, and people tend to be more concerned about the firm they’re trading with rather than the person placing the actual trades. Some of the things you need to consider are background and market knowledge. It’s good to work with someone who has been in the business five years or longer, because, says Tiger, if they’ve survived that long, you know they’ve learned something. Age and experience are crucial to selecting the best broker for you. Also, you should make a quick call to the National Futures Association to find out if the broker is registered with them and if there is any pending litigation against them.
Some of the questions you can ask to determine a broker’s experience include whether he or she appears to know about financial markets as well as agricultural commodities. Are they comfortable trading spreads? If you plan to trade in a variety of markets, is the broker familiar with what you wish to trade, and do they have access to multiple exchanges and markets, at home and abroad? If you want to pick one market and stick with it, make sure your broker knows the markets seasonal tendencies, volume and volatility.
Another thing to do is ask for a financial statement. The financial stability of the brokerage guarantees your account, and you need to know how capitalized the firm is. If they’re reluctant to give you that in writing, they may not be on the up and up with you.
You can opt for a discount broker or a full-service house. A discount broker will execute the orders you initiate, and you’re mostly on your own. They will generally only offer you an opinion when asked. If you use a discount broker, you’ll probably use your own trading system and methods, and have your own source for real-time quotes and subscribe to the necessary charting and news services you’ll need for market information.
A full-service broker will charge you a higher fee, but offer you more customized order entry and personalized service. A full-service broker will call you with trade recommendations and can also help you with all the things in your investment portfolio. They will also give you fundamental and technical information contained in government reports, news items, charts, and advisory newsletters.
Discount brokers sometimes have what’s known as a hybrid service, in which you are assigned to one person will discuss the market outlook based on reports and chart patterns. That comes at an extra charge. Some discount brokerages also offer on-line quote services, market information and toll-free hotlines with information, but the final trade decisions are still left up to you.
Don’t be afraid to ask the firm you’re considering questions. Some of things to check out include whether brokers are available 24 hours a day to place trades; how many desks the firm has on the floor of the exchange and where they are located; what does the daily statement look like and how easy is it to understand; if I get a margin call, will the firm accept only wire transfers; how much help do I get when calling in orders and what’s the average reporting time for fills in the market I want to trade.
Keep in mind, market demands continually set new standards. Because over half discount brokerage business comes from new customers, some have set up clerks who will take more time with you to explain how to place an order correctly.
No matter what kind of brokerage you choose, the more service you want, the more it’s going to cost you. Fees are usually based on which markets you trade (oats being cheaper than metals, for example), which exchanges you use (New York markets tend to be more expensive than Chicago) and the amount of business you generate (the more active your trading and the more you spend on it, the lower your fees). Discount brokerages typically charge between $20 and $35 per round turn, with special services adding to the bill. A full-service broker will cost $75 or more per round turn.
If you choose a full-service broker, and let the broker make trading decisions for you, make sure you understand his or her methods. If the broker has his or her own trading system, do you have to use it? What kind of technical and fundamental analysis does the broker use?
Whatever you decide, make sure you have your trading plan clearly in mind. Both you and your broker need to know how much money you are willing to risk on each trade, what your profit objective is and the plan you have for taking losses. Listen carefully to the broker during your initial conversation. If the focus is all on profits, you’re only getting half the story. The more questions you ask and the more questions the broker asks you about your trading goals and financial plan, the more successful the relationship will be.
How To Resolve Disputes
As with any dispute, try first to resolve the problem with your broker and the broker’s supervisor. If that fails, there are several options for you to consider. The Commodity Futures Trading Commission has a reparations program, there is industry sponsored arbitration, and as a final resort, you can go to litigation. Before you decide on your course of action, consider how long it will take, how much it will cost you and whether or not you will need an attorney.
The CFTC reparations program has three types of proceedings. With just a $50 filing fee, voluntary proceedings are the quickest and least expensive. No hearings or appeals are involved and the cases are decided only on the basis of written material and exhibits provided by the parties. Certain rights, including the right to appeal, are waived and all parties involved must consent before the case can be a voluntary proceeding. The result is a Final Decision that is non-appealable and contains no factual findings or a discussion on the basis for the Final Decision. The voluntary proceeding has no dollar limit.
The second type of proceeding is a summary proceeding, which has a $125 filing fee and resolves claims totaling $30,000 or less. If the judge decides it is necessary, an oral hearing will be held by conference call. The summary proceeding results in an Initial Decision which can be appealed and which does include facts and legal conclusions explaining why the decision was made. The losing party can appeal first to the full Commodity Futures Trading Commission and then to a federal Court of Appeals.
The third types of proceedings are formal proceedings, which have a $250 filing fee and are used to resolve claims over $30,000. Formal proceedings involve an in-person hearing held at a location convenient for the parties. Like the summary proceeding, the formal proceeding results in an Initial Decision that can be appealed, that includes the factual findings and legal conclusions. The decision can be appealed to the full Commission and from there to a federal Court of Appeals.
In all of these proceedings, you may seek actual damages, such as the amount of money you lost trading. If you win, you also recover your filing fee. You could also get prejudgment interest in the formal and summary proceedings, but not in the voluntary proceeding. You may choose to present your self in the reparation proceeding, or you can have an attorney. By law, the reparations complaint must be filed within two years of the date that your cause of action ‘accrues’. That means the date when you knew, or should have known, of the alleged wrongdoing. If you believed you were hurt by a commodities law violation, decide as quickly as you can whether you’re going to file a complaint.
To use the CFTC reparations program, your complaint has to involve a registered commodity futures trading professional whom you allege engaged in activities that violate the Commodity Exchange act or CFTC regulations. Examples of this kind of activity include: unauthorized trading of your account; misrepresentation; misappropriation of funds; non-disclosure or violations of fiduciary duty. The transactions involved can include futures contracts, options on futures contracts or physical commodities and leverage contracts.
The firm or individual you are claiming harmed you cannot be in bankruptcy or receivership proceedings. If that is the case, your claim will be dismissed and you’ll be referred to either the bankruptcy trustee or the court-appointed receiver to administer customer claims. The same claim also cannot be under consideration on arbitration or a civil court. Your complaint also has to include facts that show the losses you claim are the result of the activities you describe; that the person or firm you are making the claim against actually engaged in these activities and that these activities appear to violate either CFTC regulations or the Commodity Exchange Act.
The CFTC Market Surveillance Program
According to the Commodity Futures Trading Commission’s webpage, futures prices are widely quoted and disseminated throughout the United States and abroad. Business, agricultural, and financial enterprises use futures markets for pricing information and for hedging against price risk. The goals of the CFTC's market surveillance program are to preserve these economic functions of the futures and option markets under its jurisdiction by monitoring trading activity to detect and prevent manipulation or abusive practices, to keep the Commission informed of significant market developments, to enforce Commission and exchange speculative position limits, and to ensure compliance with Commission reporting requirements.
The primary mission of the market surveillance program is to identify situations that could pose a threat of manipulation and to initiate appropriate preventive actions. Each day, for all active futures and option contract markets, the Commission's market surveillance staff monitors the daily activities of large traders, key price relationships, and relevant supply and demand factors in a continuous review for potential market problems.
Despite the great diversity among the underlying commodities on which futures contracts are based, from a surveillance perspective markets can be grouped according to their settlement provisions.
Physical-delivery commodities. Futures contracts that require the delivery of a physical commodity are most susceptible to manipulation when the deliverable supply on such contracts is small relative to the size of positions held by traders, individually or in related groups, as the contract approaches expiration. The more difficult and costly it is to augment deliverable supplies within the time constraints of the expiring futures contract's delivery terms, the more susceptible to manipulation the contract becomes.
Pertinent surveillance questions for such markets include:
• Are the positions held by the largest long trader(s) greater in size than deliverable supplies not already owned by such trader(s)?
• Are the long traders likely to demand delivery?
• Is taking delivery the least costly means of acquiring the commodity?
• To what extent are the largest short traders capable of making delivery?
• Is making futures delivery a better alternative than selling the commodity in the cash market?
• Is the futures price, as the contract approaches expiration, reflecting the cash market value of the deliverable commodity?
• Is the price spread between the expiring future and the next delivery month reflective of underlying supply and demand conditions in the cash market?
An excellent barometer for potential liquidation problems is the basis relationship (i.e., the cash and futures price difference). When the price of the liquidating future is abnormally higher than underlying cash prices or both the futures and underlying cash price are abnormally higher than comparable cash prices, there is ample reason to examine the causes and to assess the motives of traders holding long futures positions.
Financial instruments. Futures contracts that require the delivery of a financial instrument generally are less likely than futures on physical commodities to be subject to manipulation in the form of squeezes. This assertion is based on the premise that the underlying cash markets for financial instruments tend to be deeper, more liquid, more transparent, and more readily arbitraged than physical commodity markets. Nonetheless, certain of the questions specified above still pertain, particularly when the above-stated assumptions do not hold. For example, when the particular financial futures contract provides for a deliverable supply that either is of finite size or is a narrow segment of the broader cash market for the underlying financial instrument, all the questions raised in the prior section on physical commodities would apply.
In addition, price aberrations in the cash market for the underlying financial instrument may provide an indication of (or an opportunity for) an attempted manipulation. Surveillance staff members monitor cash prices for the financial instrument specified for delivery on the futures contract in relation to cash prices for non-deliverable instruments that would be close, or identical, substitutes in the cash market. Relatively high prices for deliverable, as compared to nondeliverable, financial instruments may be an indication of an attempt to remove deliverable supplies from the futures market as part of an attempted manipulation. Also, to the extent participants in the markets take positions vastly beyond their financial means or capacity to take delivery or make settlement, this may be a sign of manipulative activity.
Several financial products involve U.S. Treasury or Agency instruments (for example, bonds or notes). The Commission surveillance staff, therefore, maintains open lines of communication with, among others, the U.S. Treasury Department, the Federal Reserve Bank of New York, and the Securities and Exchange Commission.
Cash-settled markets. The size of a trader's position at the expiration of a cash-settled futures contract cannot affect the price of that contract because the trader cannot demand or make delivery of the underlying commodity. The surveillance emphasis in cash-settled contracts, therefore, focuses on the integrity of the cash price series used to settle the futures contract. Since manipulation of the cash market can yield a profit in the futures contract, Commission staff members monitor futures positions of significant size and are alert for unusual cash market activities on the part of large futures traders, especially in the period of time that the final cash price for futures settlement is determined.
Pertinent surveillance questions for those markets are:
• As the futures contract expiration approaches, is the cash price moving in a manner consistent with supply and demand factors and/or with other comparable cash prices that are not used in the cash-settlement process?
• Do traders with large positions in the expiring future have the capacity to affect the cash price series used to settle the futures contract?
• What information can be obtained from the organization that compiles the cash price series regarding how the price is determined for the period in question? Is anyone reporting prices that appear to be out of line with prices reported by others, and can it be determined if the party reporting those prices holds a futures position that would be affected favorably by those prices?
Special concerns related to equity futures. Generally, equities and derivatives markets likely will be closely linked through intermarket arbitrage. Therefore, effective surveillance of equity futures markets requires coordination among the exchanges trading the underlying equities and equity options to address intermarket trading abuses, such as manipulation, frontrunning of customer orders and insider trading.
If the stock index underlying the futures and/or option contract is broad-based in terms of both the number and capitalization of the equities included in the index, intermarket price manipulation and insider trading (regarding information on individual stocks) concerns will be greatly reduced. Narrower indices and single-stock derivatives may require more aggressive surveillance and added protections with respect to misuse of information, especially to the extent that the market is, or acts like, a market in a single security. The Commission cooperates with the Securities and Exchange Commission and encourages intermarket cooperation on surveillance issues.
To accomplish its objectives, the Commission's market surveillance program uses many sources of daily market information. Some of this information is publicly available, including data on the overall supply, demand, and marketing of the underlying commodity; futures, option and cash prices; and data on trading volume and open contracts. Some of the information is highly confidential, including data from exchanges, intermediaries and large traders.
Futures exchanges report to the Commission the daily positions and transactions of each clearing member. These data are transmitted electronically during the morning after the “as of” date. They show the aggregate position and trading volume of each clearing member in each futures and option contract, separately for proprietary and customer accounts. These data are useful for quickly identifying the firms that clear the largest buy or sell volumes or hold the biggest positions in a particular market. The clearing member data, however, do not identify the beneficial owners of the positions.
To address this limitation, the Commission has at the heart of its market surveillance system a large-trader reporting system. Under this system, clearing members, futures commission merchants ("FCMs"), and foreign brokers (collectively called “reporting firms”) electronically file daily reports with the Commission. These reports contain the futures and option positions of traders that hold positions above specific reporting levels set by CFTC regulations. If, at the daily market close, a reporting firm has a trader with a position at or above the Commission's reporting level in any single futures month or option expiration, it reports that trader's entire position in all futures and options expiration months in that commodity, regardless of size.
Since traders frequently carry futures positions through more than one FCM and since individuals sometimes control or have a financial interest in more than one account, the Commission routinely collects information that enables its surveillance staff to aggregate related accounts. Reporting firms must file a CFTC Form 102 to identify each new account that acquires a reportable position. In addition, once an account reaches a reportable size, the account owner periodically is required to file a more detailed identification report, a CFTC Form 40, to further identify accounts and reveal any relationships that may exist with other accounts or traders. To obtain more detailed and targeted information, the Commission may issue a “special call,” to a reporting trader or firm. The special call is designed to gain additional information on a participant's trading and delivery activity, and may include the trader's positions and transactions in the underlying commodity.
Surveillance economists prepare weekly summary reports for futures and option contracts that are approaching their critical expiration periods. Regional surveillance supervisors immediately review these reports. Surveillance staff members advise the Commission and senior staff of potential problems and significant market developments at weekly surveillance meetings so that they will be prepared to take prompt action when necessary.
The market surveillance process is not conducted exclusively at the CFTC. Surveillance issues are usually handled jointly by the CFTC and the affected exchange. Relevant surveillance information is shared and, when appropriate, corrective actions are coordinated. Potential problem situations are jointly monitored and, if necessary, verbal contacts are made with the brokers or traders who are significant participants in the market in question. These contacts may be for the purpose of asking questions, confirming reported positions, alerting the brokers or traders as to the regulatory concern for the situation, or warning them to conduct their trading responsibly. This “jawboning” activity by the Commission and the exchanges has been quite effective in resolving most potential problems at an early stage.
The Commission customarily gives the exchange the first opportunity to resolve problems in its markets, either informally or through emergency action. If an exchange fails to take actions that the Commission deems appropriate, the Commission has broad emergency powers under which it can order the exchange to take actions specified by the Commission. Such actions could include limiting trading to liquidating transactions, imposing or reducing limits on positions, requiring the liquidation of positions, extending a delivery period, or closing a market. Fortunately, most issues are resolved without the need to use the CFTC's emergency powers. The fact that the CFTC has had to take emergency actions only four times in its history demonstrates its commitment to not intervene in markets unless all other efforts have been unsuccessful.
The surveillance staff also monitors compliance with Commission or exchange speculative-limit rules. These rules help prevent traders from accumulating concentrations of contracts of a size sufficient to possibly disrupt a market. To monitor those limits, the market surveillance staff reviews daily large-trader reports for potential violations. Although bona fide hedgers are exempt from speculative limits, Commission staff monitor hedgers' compliance with their exemption levels. Commercial traders that carry futures and option positions in excess of Commission speculative position limit levels are required to submit a monthly statement of cash positions. These statements show the total cash position of each trader, which reflects the amount of the trader's actual physical ownership of each commodity and the amount of the trader's fixed-price purchases and sales for which the trader has a legitimate cash risk. Commission staff compares each trader's cash position to the trader's futures and option positions.
In summary, the Commission has a comprehensive market surveillance program to detect and prevent corruption of the economic functions of the futures and option markets that it oversees.
Why The Ups And Downs In Futures?
Buyers’ and sellers’ decisions – opinions, really - about what a particular commodity will be worth at some given time in the future are what cause futures prices to go up and down. The time frame can be anywhere from a few days to more than two years. As conditions change, and more and new information becomes available, the prices for futures fluctuate up and down. This process is known as price discovery. If we’re in September, the price of a March futures contract reflects the opinions of buyers and sellers about what the commodity’s value will be when the contract expires in March. On any given day, those opinions change, with weather reports, economic indicators, federal government action and a host of other factors. The one certainty you have in the futures market is that prices will change.
Paper Trading
Now that you know more about futures and how they work, you may think you’re ready to open your account and get going. Most experts will tell you that’s NOT what you should do. First, you need to have a firm handle on your own financial situation. You need to set clear goals as to how much you can afford to risk on futures trading. If you’re worrying about how you’re going to feed your family and are depending on futures trading to buy groceries, it probably isn’t something you should be doing at the moment. Obviously, the more ‘risk capital’ you have, the more you can invest in the futures market. Make sure you write down your goals and stick to them. The basic rule of thumb in futures trading is to cut losses short and let profits run. That means, don’t stick with a losing position too long, hoping the market will turn around. Conversely, don’t pull all your profits out for fear of losing your investment. Most of your trades won’t succeed—that’s just the law of averages at work. Most successful traders have more losers than winners. But, if you stick with a strategy that gets you out of a losing position in time, and lets the winning position ride, you will find that you may be able to succeed in the futures trading game.
Paper trading means you watch the markets and figure out when you should have bought or sold, or gone long or short, without actually investing the money. You then decide when is the right time to exit the trade, and keep track of the profit or loss you would have incurred. The goal is to help you understand how your trading method will work when you’re doing it with real money and what you can do to improve your application of that method.
A lot of people don’t take this part of preparing to trade futures seriously. They ignore their bad trades and continuously add more money to their fake accounts. In order for paper trading to work properly, you have to be honest with yourself and not fake it just because you can.
It’s also important to right down the reasons you entered and exited your trades. This will help you later as you change your method and perhaps adjust your position when you are trading in the real world with real money.
Another key to productive paper trading is to use reasonable fills. When you’re your own broker, you can buy or sell at any time you choose – something that is not the case when you’re really trading. A broker can help you get those numbers, if they’re willing. Many are not, because it doesn’t make them any money. Try to find one who is willing to provide you with this valuable information.
Though it’s called paper trading, most people use software to do their trading. There are a number of free-to-try programs out there—the one we’ll use is called Track ‘n Trade Pro 4.0 by Gecko Software. This comes with a 30-day free trial of market information, so you can punch in your numbers and see what happens in the futures market for your commodity or financial market or instrument of your choice. The graphs in the coming pages are all produced by this software.
[This section uses some illustrations which are not available in the online free version.]
To give you a sense of how the program works, let’s say we deposit $2000 in our individual account on July 1st. The Track ‘n Trade screen will look something like this:
Now, because we believe soybean oil prices will be going down in the next 60 days, we decide to sell one September soybean oil futures contract on July 5th for $564, with a broker fee of $50 for the trade. That takes our margin account down to $1386. The margin requirement is $641, so that leaves us with $745 available in the account. The settlement price on July 5th for September soybean oil is 24.63 cents a pound. With each contract calling for 60 thousand pounds, that makes the contract worth $14778. But, remember, we only have to pay a percentage of that in our margin account, hence the $564 cost for the contract. We’re hoping in the next 60 days, the price for soybean oil will go down, and our target price we want it to get to is less than 23 cents. So, once the price goes below 23 cents, we will buy an offsetting contract, and make a profit. As you can see from the chart, on August 12th, that’s what happens, so we buy the offsetting contract.
And, on August 15th, our account looks like this:
Looking at the account total, you can see we made a profit of $1004 on our $2000 initial investment. Remember, this is just an example to give you an idea of how a futures trade CAN be profitable, and, as always, past performance is no guarantee of future results.
In addition to setting your investment goal, you also need to decide on how many contracts you want to buy. In our example, we just used one, but you can buy as many as you can afford. You can also diversify and invest in several kinds of futures contracts. Most experts will tell you, though, as a beginning futures trader, it is better to stick to only two or three commodities until you become more experienced.
Picking A Trading Strategy
Most trading strategies involve either fundamental or technical analysis. Fundamental analysis uses economic data like government reports (on production, consumption and consumer prices, to name a few) to forecast prices. Technical analysis looks at patterns in the price data itself. Both have their advantages and disadvantages.
According to well-known futures analyst Jack Schwager, there are three big pitfalls in fundamental analysis. The first is the unexpected development. Let’s consider the cotton market in 1972 and 1973. Before then, the United States did not export cotton to China. That changed dramatically in the 1972-73 season when the U.S. exported about 11 percent of its total shipments to China. The sudden emergence of this heretofore-untapped market was behind the bullish cotton market in those years.
Weather can also play a factor. A freeze in 1989 caused a huge increase in the futures price of frozen concentrated orange juice. A drought in 1988 caused a similar swing in corn prices. Surprises in government reports can also cause sharp changes in prices.
The second potential problem with a fundamental analysis is the missing variable. Schwager says a market that has been adequately described by a given set of variables for an extended period of time can suddenly be influenced by a totally new factor. The inflationary boom of the early 70’s resulted in different markets becoming more dependent on each other. Failing to take such factors into account can result in market predictions that are far out-of-whack.
The third pitfall is poor timing. Even if your strategy is correct and your assumptions are right, the market can still move against where you think it should in the short term.
So, does this mean a fundamental analysis doesn’t work? No, says Schwager. Fundamental information responsible for a price trend is often available well before the price trend actually develops. Let’s look at an example of a fundamental analysis of soybeans.
The U.S. soybean crop year runs from September 1st through August 31st. Soybeans are planted from May to June and harvested between September and November. Farmers begin to get an idea of how good their yields and crop quality will turn out starting in August and running through early September. The six largest producing states are Illinois, Iowa, Ohio, Missouri. Indiana and Minnesota. Japan has historically been the largest customer for American-grown soybeans.
Weather tends to be the key fundamental factor in forecasting soybean prices. Drought concerns typically fuel crop scares, and crop-scare rallies can start in the spring, especially if subsoil moisture is low going into the growing season. August is usually the most important yield-determining month, but since crop scare rallies tend to look forward, they typically peak in July. Only approximately a quarter of crop-scare rallies extend into August. That means prices have usually discounted the damage ahead of any official word from the government in its crop reports.
If old-crop supplies are tight, or new-crop acreage is thought to be low, the market will be a lot more sensitive to weather developments during the growing season.
How do you use this data to successfully negotiate the futures market? First, look at the key characteristics for the coming growing season. Using the 1992/1993 season as an example, the USDA March report said production was above the prior season’s usage and above the prior season’s crop; there was an increase in carryover stocks following a decline in the prior season. Second, check the highs and lows in prior contract years that have these same fundamental factors. Third, look closely at the price swings for similarities and relationships between those highs and lows. Fourth, project the price levels for the forecast period based on swings in the previous years. The resulting projections for the 1992/1993 spring high using this method would have been $6.09. The actual historical figure was $6.14.
To determine trends, a technical analysis is your best tool. There are two basic methods to conducting such an analysis. The breakout method relies on the theory that a bullish signal occurs whenever the current value of a variable is greater than any variable during the past ‘X’ periods. If X= 12, a bullish signal is generated when the current reading of the series is greater than any value for that series in the past 12 months. That means when a given commodity price or index hits a high point higher than any in the last 12 months, the trend will be for that price to go down.
The second method is called the crossover moving average method. Moving averages help smooth data. In a moving average, each point in the series is replaced with an ‘X’ period average, ending with the current point. In a six-period moving average of a weekly series, each point would equal the average of the past six weeks (ending in the given week). This makes it easier to figure out the trends in the data. A shorter moving average will turn up before a longer moving average when a declining series reverses trend. The crossovers of these two moving averages serve as a signal to buy or sell.
As you can tell, determining a trading strategy can be extremely complicated. The preceding discussion is by no means a complete representation of the complexities of trading strategies.
When developing a trading a plan, one important consideration is the amount of funds you are willing and able to devote to trading. A $5,000 account will have limitations that may not hinder a $100,000 account. Many books written about futures trading recommend not risking any more than three to ten percent of your equity on any one trade. The reason for this rule is to prevent one or two bad trades from destroying your account. Suppose you decide that you will not risk any more than ten percent of your equity on any one trade. If you have $10,000, your maximum risk will be $1,000 per trade, but if you have $5,000, your maximum risk is reduced to $500 per trade. The trading strategy that you choose should be dictated by the amount you are willing to risk. If the trading strategy you found to be successful in paper trading requires the risk to be an average of $1,500 a trade, and you choose to trade with an amount of $5,000, you must realize that you cannot afford to start off with a couple of bad trades.
For example, traders ABC and XYZ are friends and they devise a system that over a long period of time produces a winning trade 60% of the time, with the average winner being $540, and the average loser being $450, with a maximum risk of $700 per trade. ABC starts with $4,000 and XYZ starts with $7,000. Suppose the first six trades lose $1,400. ABC now only has $2,600 but XYZ has $5,600. The next two trades come along at the same time and have a required margin of $2,200. This situation already presents a dilemma for ABC. He knows that if the trades do not go in the right direction immediately, he could very easily find himself on a margin call. The margin call could lead to a decision to close out a trade prematurely, which in turn means he is unable to trade his plan. XYZ, on the other hand can still proceed with business as usual. This is one very simple example of one of the many ways and scenarios where undercapitalization hinders smart trading.
When setting up a trade, it is necessary to predetermine the amount of risk you are going to allow on the trade. That means coming up with a stop loss. Successful traders always talk about having a stop loss or at least a mental stop loss prior to initiating a trade. Trading without a stop loss can lead to disaster for an inexperienced trader because they can find themselves unable to pull the trigger to cut losses until it is too late. Another option, which may be psychologically easier for people who have a hard time cutting their losses, is to buy an option in the opposite direction of the trade to limit the potential risk. The downside of this, of course, is that it also limits the potential return, since your opposite option will lose money if your primary trade goes well.
Good record keeping is also a key element of managing risk. Record why you are entering and exiting a trade. This is important when you go back through your records to try to determine what is working or not working. It is very tempting to think “oh, I will remember” – and you might, for your first few trades. But when you’re looking back at three years’ worth of results to analyze what bad decisions you’ve made and want to avoid in the future, believe me, you’ll have no idea. Learning how to make observations and being able to grow and learn is very important to being a successful futures trader. Looking for patterns in your winning and losing trades may lead you to the conclusion that your system is at fault, or you may find out that trader error (not following the system) is the problem. It is also recommended that you keep track of your equity closely so if an abrupt deterioration in equity occurs, you will be able to reassess and scale back your trading before it is too late.
Diversification of the markets you trade is also a key issue. In other word, do not put all your eggs in one basket. A trader may be in five different markets, but if those five markets are all long positions in wheat, corn, soybeans, soymeal and oats, he may soon find himself alternately generating fantastic returns and getting slammed in every trade. Don't take that chance with your equity. Genuinely diversifying your positions spreads risk around.
Volatility can also make or break an account. If you have a $5,000 account, certain markets may not be appropriate. For example, the Japanese yen has been known to open up almost 300 points in one day, which could have been a loss of $3,750 for a short position. Coffee has jumped thirty cents ($11,250) in one day because of freezing overnight weather in Brazil's coffee growing area. Pork bellies can go limit up or down several days in a row without any apparent rhyme or reason. It may be that it is a "thin" market (one which lacks volume and open interest). Trade with your eyes wide open.
Trade a consistent number of contracts. If you are in a winning trade, don't add contracts at an increasing rate. Too many traders buy one position initially, buy one more, and because the trade is going so well, insist on buying two or even three more, until the market suddenly turns on them, turning what had been a modest winning trade into a huge loser. Another tendency to avoid is to become overconfident and start trading larger quantities after a string of winning trades. You do not want to give back your profits faster than it took to make them.
Picking What You Want To Trade
Deciding what kind of futures contracts you want to trade is not a simple process, and making a good decision here will go a long way toward determining your success or failure in the futures trading game. The best place to start is to correlate your trading goals with the rules in place for a given commodity - what the initial margin is, how volatile is it, does it tend to be traded in a fluid environment. These are just a few of the criteria to consider. Let’s look at initial margin requirements first.
The latest initial margin requirements (per contract, as of September 22, 2005) on the Chicago Board of Trade:
Corn $810
Oats $405
Rough Rice $574
Soybeans $2498
Soybean Oil $1080
Ethanol $2295
Wheat $945
As you can tell, there is a wide range of initial margin requirements to choose from. Obviously, you want to pick a commodity that has an initial margin you can afford. If you only have $2000 to invest, you won’t be able to buy ethanol futures, for instance.
There are also the mini futures contracts. These are futures contracts that have a smaller contract size (and thus a smaller initial margin requirement) but are otherwise identical to their big brothers. On the Chicago Board of Trade, here are the mini offerings (per contract, as of September 22, 2005):
Gold $317
Silver $324
Dow Jones Industrial Avg $2632
Eurodollars $338
Corn $162
Soybean $500
Wheat $189
Next, here is a discussion of how the various futures contracts work. Remember, these numbers can and do change, so check with a broker or the exchange you want to trade on for the most up to date information.
Contract size- One contract represents a specific number of units of the commodity. For example, one wheat contract represents 5000 bushels of wheat. Unleaded gasoline contracts are for 42000 gallons. There are 40000 pounds per live cattle contract.
Point value- A change in price will result in a change in value of the contract. The point value specifies the dollar change in value of the contract per change in the price. The point value is derived from the contract size. This is illustrated by several examples below.
Cocoa has ten tons per contract. The price is stated in dollars per ton. If the price of cocoa is at $985/ton, the total value of the contract is ($985)x(10)= $9850. Suppose the price rises to $986/ton, then the total value is ($986)x(10)= $9860. When the price went from 985 to 986, we refer to that as a one-point move. The change in value for the contract is $10. Therefore one point = $10.
Live cattle has 40000 pounds per contract and is quoted in cents per pound. Each cent in cattle is segmented into 100 points. For example, the price is quoted at 76.65 cents per pound which can also read as $.7665. The total value of the contract is (40000)x(.7665)=$30660. If the price rises to $.7675, that is a ten point move in the price, the contract value changed $40. Therefore in live cattle, one point equals $4.00.
Wheat has 5000 bushels per contract and is quoted in cents per bushel. It is common to see the price stated as $3.76 per bushel which is the same as saying 376 cents per bushel. The total value of the contract would be ($3.76)x(5000)=$18800. If the price moved one cent to $3.77, the total value would be ($3.77)x(5000)=$18850. Therefore, one cent = $50.00. In this example, if you were asked what the point value is for wheat, you would answer one cent equals $50, not one point equals $50.
Minimum tick- This term refers to the minimum amount the price can change as it is traded in the pit or electronically. For example, in Cocoa, the price can change from 985 to 986, so the minimum tick is one point. Wheat on the other hand can be divided into 1/4 cent increments, so you can see the price change from $3.76 to 3.76 1/4 to 3.76 1/2. Knowing the minimum tick is helpful in placing your orders properly.
GRAINS (Chicago Board of Trade)
**Soybeans (S), Wheat (W), Corn (C), and Oats (O)
5000 bushels $ 50/cent <1/4>
Quotes on grains are often presented in various ways. Suppose the soybeans are trading at $5.12 1/2 per bushel. That can be interpreted as 512 1/2 cents. Depending on your source of information, it may be listed as the following.
5124 The last digit "4" represents 1/2. The last digit can be a 0,2,4, or 6.
5122 Read the quotes as 512 1/4
5126 Read as 512 3/4
5120 Read as 512 even
512.50 Some quote sources convert the fractions to decimals. Get in the habit of thinking in fractions on these grains.
Example: Soybeans moves from 512 1/2 to 519 1/4. This is a change of 6 3/4 cents which is multiplied by the point value ($50) which equals $337.50.
**Soybean Meal (SM)
100 tons ($1.00/point) <10>
Soybean meal is quoted in dollars per ton. A quote of 19850 tells us that it is trading at $198.50 per ton. Be aware that on many websites, the last zero is dropped so you may see 1985. Be sure to add the extra zero. An order in soymeal has to end in a zero. If you say you want to buy soymeal at 19855, your order will be rejected.
Example: Soy meal moves from 19850 to 21620. That is a move of 770 points at one dollar per point which equals a $770 move. Many traders will also refer to this as a move of $7.70 per ton.
**Soybean Oil (BO)
60000 pounds ($6.00/point) <1>
Bean Oil is quoted in cents per pound, and each cent is divided into 100 points. A quote of 2520 is .2520 per pound.
Example: The price moves from 2520 to 2573. That is a 53 point move, multiplied by $6.00 which equals $318.00.
**Rough Rice (RR or NR)
2000 cwt. ($20.00/cent) <1/2>
Rough rice is quoted in cents per cwt. (100 pounds). So when you see a quote for 9105, interpret that as 910 ½ cents, or $9.10 ½ cents per cwt.
Example: The price moves from 9105 to 9175. That is a move of seven cents multiplied by $20/cent which equals $140.00.
MEATS (Chicago Mercantile Exchange)
**Live Cattle (LC), Lean Hogs (LH), Pork Bellies (PB)
40000 pounds ($4.00/point) <2>
The meats are quoted in cents per pound. Each cent is divided into 100 points. So if Live cattle is trading at 75 cents per pound, some quotes read as .7500, and others as 75.00. To make it more confusing, you may also come across $75.00 per cwt. (100 pounds). Dropping the decimals helps. Another twist is that the price of meat futures contracts move in minimum ticks of 2 ½ points so must end in a 0,2,5, or 7. if live cattle is trading at 7502, that actually means 7502 ½. For whatever reason, dropping the last digit has become standard practice. But on your trade statements you will see that half point show up.
Example: lean hogs moves from 5625 to 5687. That is a move of 62 ½ points, multiply by $4.00 per point which equals $250.00.
**Feeder Cattle (FC)
50000 pounds ($5.00/point) <2>
Feeder cattle is read like the other meats, with the only difference being the contract size and point value.
Example: Feeder cattle moves from 8965 to 9030. That is a move of 65 points, multiply by $5.00 per point, which equals $325.00.
SOFTS AND FIBERS (New York Board of Trade)
**Coffee (KC)
37500 pounds ($3.75/point) <5>
Coffee is quoted in cents per pound. Each cent is divided into 100 points. If coffee is trading at 70 cents per pound, you may see quotes listed as 7000, .7000 or 70.00.
Example: The price moves from 70.25 to 73.65. That is move of 340 points multiplied by $3.75/point which equals $1275.00. Regarding the five point minimum fluctuation; this market is notorious for the floor brokers restricting the orders they will accept when the market gets busy. They may require orders to be in increments of 10 points (7360 or 7370) or 25 points (7325 or 7350).
**Cocoa (CC or CO)
10 metric tons ($10/point) <1>
Cocoa is quoted in dollars per ton. There should not be any decimal points on the quote. If it reads as 1076, that means $1076 per ton.
Example: Cocoa moves from 925 to 1007. That is a move of 82 points ($82 per ton), multiplied by $10/point, which equals $820.
**Orange Juice (OJ or JO)
15000 Pounds ($11.20/point) <1>
Orange Juice is quoted in cents per pound. Each cent is divided into 100 points. If it is trading at 85 cents per pound, you may see 8500, .8500 or 85.00. Orders on orange juice have to end in a 0 or a 5 as this has been designated as the minimum tick.
Example: Orange juice moves from 9845 to 10135. That is a move of 290 points, multiplied by $1.50/point, which equals $435.00.
**Sugar (SB)
112000 pounds ($11.20/point) <1>
Sugar is quoted in cents per pound. Each cent is divided into 100 points. If it is trading at nine cents per pound, it may read as 900, 9.00 or .0900.
Example: If sugar is trading at 947 and moves to 1005, that is 58 points, multiplied by $11.20 per point, which equals to $649.60.
**Cotton (CT)
50000 pounds ($5.00/point) <1>
Cotton is quoted in cents per pound. Each cent is divided into 100 points. If cotton is at 67 cents per pound, you may see it as 6700, .6700, or 67.00. Be aware that most floor brokers want the orders to end in a 0 or a 5 (6705 or 6710), again indicating a minimum tick of 5 points.
Example: Cotton moves from 6630 to 6795. That is a 165 point move, multiplied by $5.00 per point, which equals $825.00.
**Lumber (LB) Chicago Mercantile Exchange
110000 board feet (1.10/point) <10>
Lumber is quoted in dollars per 1000 board feet. If lumber is trading at $234.50, it will read as 23450 or 234.50. Lumber must always end in a 0 because of the 10 point minimum tick.
Example: Lumber price changes from 23450 to 24120. That is a move of 670 points, multiplied by $1.10/point, which equals $737.00.
METALS (New York Mercantile Exchange, COMEX division)
**Silver (SI or SV)
5000 troy oz. ($50.00/cent) <1/2>
Silver is quoted in cents per troy oz. If silver is trading at $5.24 per ounce, you may see the quote stated as 5240, 52400, 5.240, or 5.2400. Although the price of silver fluctuates in half cent increments during trading, you will notice that the closing prices can end in different digits such as 5.247, 5.248 and so on.
Example: Silver price changes from 5245 to 5310. That is a move of 6.5 cents, multiplied by $50.00.cent, which equals $325.00.
**Gold (GC or GO) and Palladium (PA)
100 troy oz ($1.00/point) <10>
Gold is quoted in dollars per oz. If gold is trading at $289.50, the quote will be stated at 28950 or 289.50. What we refer to as one point is synonymous with one cent in the price of gold.
Example: Gold price changes from 28950 to 29470. That is a change of 520 points, multiplied by $1.00/point, which equals $520.00. Of course, many people will prefer to say that the price changed by $5.20.
**Platinum (PL)
50 troy oz ($.50/point) <10>
Platinum is quoted in dollars per troy oz. and is read the same way as the gold example above. But the contract size, thus the point value is different.
Example: Platinum moves from 52850 to 53940. That is a move of 1090 points, multiplied by 50 cents/point, which equals $545.00.
**Hi-Grade Copper (HG)
25000 pounds ($2.50/point) <5>
Copper is quoted in cents per pound, and each cent is divided into 100 points. If copper is trading at 83 cents per pound, the quote would read as 8300, 83.00, or .8300.
Example: Copper moves from 8250 to 8635. That is a move of 385 points, multiplied by $2.50 point, which equals $962.50.
ENERGIES (New York Mercantile Exchange)
**Crude Oil, Sweet light (CL)
1000 barrels ($10.00/point) <1>
Crude oil is quoted in dollars per barrel, and each dollar is broken into 100 cents. Many traders talk in terms of points, which means one cent equals one point. So if Crude oil is trading at $25 per barrel, the quote will be 2500 of 25.00.
Example: Crude oil moves from 2504 to 2577. That is a move of 73 points, multiplied by $10/point, which equals $730.
**Heating Oil (HO) and Unleaded ( HU)
42000 gallons ($4.20/point) <5>
Prices for these two products are quoted in cents per gallon, and each cent is divided into 100 points. If the Unleaded or Heating oil is trading at 70 cents a gallon, the price would read as 7000, 70.00 or .7000.
Example: If the price of Heating oil moves from 7025 to 7140, that is a move of 115 points, multiplied by $4.20 per point, which $483.00.
**Natural Gas (NG)
10000 million BTU ($10/point) <1>
Natural Gas is quoted in dollars per million BTU. So if the price is at $5.00, then the quote would read as 5.000 or 5000.
Example: If the price of Natural Gas moves from 5035 to 5186, that is a move of 151 points, multiplied by $10/point, which equals $1510.00.
FINANCIALS (Chicago Board of Trade and Chicago Mercantile Exchanges)
**30 Year U.S. Bonds (US)
$100,000 face value ($31.25 per 1/32) <1/32nd>
The price of a bond is based on a yield of 6%, at which the price is at par or 100 even. If the yield is less than 6%, the price of the bond is greater than 100 and if the yield is greater than 6%, the price of the bond is below 100. The difference between 99 and 100 called a basis point. Each point is divided into 32 ticks. To confuse the new trader, many people refer to 1/32 as a "point" when they make their calculations. When reading a quote, think in terms of fractions. For example, 9925 or 99~25 should be interpreted as 99 25/32. Some data vendors convert the fraction into a decimal number, giving us 99.78125.
Example: The bond price moves from 99~25 to 100~07. That is a change of 14 ticks, or 14/32. Multiply by $31.25 per tick, which equals $437.50.
**Ten Year Notes (TY)
$100,000 face value (31.25 per 1/32)
Ten year notes are similar to the 30 year bonds in reading the quote and making calculations. They used to be read the same way until recently when the tick size became one half of 1/32. One would logically consider that to be 1/64th, but it is not done that way. Just treat it like a bond and if there is a half involved, you have to do a little extra math. The quote for the Ten Year has an extra digit to account for the halves. 99250 or 99~250.
Example: The ten year moves from 99~255 to 100~04. That is a move of 10.5 /32nds. Multiply 10.5 by $31.25 and the value of the move is $328.125.
**Eurodollars (ED) and T-Bills (TB)
Principle $1 million ($25.00/point)
The Eurodollar and T-Bill futures are interest bearing time deposits with a three month maturity. So short term interest rates are tied to the price of these futures contracts. If the price is going up, that implies the interest rate or yield is going down. If the price is going down, the yield is going up. Over the years, the Eurodollar has become the most actively traded futures contract and the T-bill futures have declined in volume. Speculators of short term interest rates should trade the Eurodollar contract! The price of the contract is often shown as 94520 or .94520. The last digit is for halves. If the interest rate is equal to zero, the contract price should be 1.00000.
Example: The Eurodollar moves from 94520 to 94595. That is a move of 7.5 points, multiplied by $25, which equals $187.50.
**Libor (EM)
This contract is treated like the Eurodollar. It is a time deposit with a one month maturity and the principle amount is $3 million.
**Euroyen (EY)
100 million yen (2500 yen/point)
The Euroyen is a time deposit of yen with a three month maturity. This contract is denominated in Yen, hence the point value is stated in yen. the point value in terms of U.S. dollars fluctuates with the exchange rate between the yen and the dollar. Reading the Euroyen is similar to reading the Eurodollar.
Example: If the Euroyen moves from 99550 to 99600, that is a five point move. Multiply by 2500 yen, which equals 12500 yen. If the exchange rate is at 117 yen per dollar, divide the 12500 yen by 117, which equals $106.83.
STOCK INDEX FUTURES
A stock index takes the total value of a given collection of stocks. It gives the trader a measure of strength or weakness of prices for a certain group of stocks. For example, the S&P 500 contains 500 companies representing a wide variety of publicly traded companies. 80% of the companies are traded on the New York Stock Exchange. The NASDAQ 100, on the other hand primarily lists the top computer and communications related companies traded on the NASDAQ exchange. Also included on the list are some major biotech stocks and several non-technology stocks.
**S&P 500 (SP) and Emini S&P (ES)
250X Index ($2.50/point) <10> Regular size
50X Index ($0.50/point) <25> Emini
Examples: If the S&P moves from 1305.80 to 1316.30, that is a 1050 point move, multiplied by $2.50/point, which equals $2625.00.
If the Emini S&P moves from 1305.75 to 1316.25, that is a 1050 point move, multiplied by $0.50/point, which equals $525.00.
**Nasdaq 100 (NQ) and Emini Nasdaq (EN)
100X Index ($1.00/point) <50> Regular size
20X Index ($.20/point) <50> Emini
Examples: If the Nasdaq moves from 2227.50 to 2318.00, that is a move of 9050 points. For the regular contract multiply by $1.00/point which equals $9050.00. For the mini, multiply by $0.20/point, which equals $1810.00.
**Dow Jones (DJ)
10X Index ($10/point) <5>
If the Dow Jones moves from 10765 to 10540, that is a 225 point move, multiplied by $10.00/point, which equals $2250.00.
**Mini Value Line (MV)
100X Index ($1.00/point) <5>
Example: If the Mini Value Line moves from 1238.50 to 1246.20, that is a 770 point move, multiplied by $1.00/point equals $770.00.
CURRENCIES (Chicago Mercantile Exchange)
The currencies are stated in terms of how much that currency is worth in U.S. dollars. For example if the quote for the Swill Franc is at .6750 or 67.50, it means that one Swill Franc is worth 67 ½ cents in U.S. dollars.
**Japanese Yen (JY)
12,500,000 yen ($12.50/point) <.000001>
One Japanese Yen is often times worth less than a penny, so the quote has a couple zeroes in the beginning. Many quote sources drop these zeroes. For example .008950 would often times be quoted as 8950 or .8950.
Example: If the yen is trading at 8950 and rises to 8984, that is a move of 34 points, multiplied by $12.50/point which equals $425.00.
**Eurocurrency (EC)
125,000 units ($12.50/point) <1>
The Eurocurrency, commonly referred to as the Euro FX is a relatively new currency formed by a number of European countries. For example, Germany is one of the countries participating and the D-mark is slowly being phased out. If one Euro FX is worth 91 cents, the quote may read as .9100, 91.00 or 9100.
Example: If the Euro FX moves from 9167 to 9198, that is a 31 point move, multiply by $12.50, which equals $387.50.
**Canadian Dollar (CD) and Australian Dollar (AD)
100,000 dollars ($10.00/point) <1>
If the Canadian or Australian dollar exchange rate is at 65 cents, then the quote may read as .6500, 65.00 or 6500.
Example: If the Canadian or Australian dollar moves from 6523 to 6576, that is a 53 point move, multiply by $10.00/point which equals $530.00.
**British Pound (BP)
62500 pounds ($6.25/point) <2>
If one British pound, also called a sterling, is worth $1.50, then the quote would read as 1.5000, 150.00 or 15000. Since the minimum tick is 2 points, the number always ends with an even number.
Example: If the Pound moves from 15238 to 15416, that is a 178 point move which is multiplied by $6.25/point which equals $1112.50.
**Swiss Franc (SF) and German Mark (DM)
125000 units ($12.50/point) <1>
If the Franc or Mark exchange rate is at 52 cents, the quote will is presented as .5200, 52.00 or 5200.
Example: If the franc or mark moves from 5250 to 5275, that is a 25 point move multiplied by $12.50 which equals $312.50.
**Mexican Peso (ME)
500,000 Pesos ($5.00/point=.00001) <2.5>
Since the minimum fluctuation is 2.5 points, when you see a quote, there will be an extra digit to account for the halves. If the quote is .160125 or 16.0125, that means one peso is worth 16.0125 cents each.
Example: If the peso moves from 160000 to 163000, that would be a 300 point move, multiplied by $5.00/point, which equals $1500.00
**U.S. Dollar Index (DX) New York Board of Trade
1000X Index ($10.00/point) <1>
The Dollar index is a weighted average of six currencies which include the Euro FX, Yen, Pound, Canadian Dollar, Swiss Franc, and the Swedish Krona. The base price is 100 which would read as 10000 or 100.00. The higher the number, the stronger the U.S. Dollar against the is collection of currencies.
Example: If the Dollar moves from 101.75 to 102.35, that is a 60 point move, multiplied by $10/point, which equals $600.00.
The options on foreign currencies trade at the International Monetary Market (IMM) division of the Chicago Merc (CME). Trading hours are 7:20 to 2:00 PM CST.
There are currently three futures options contracts on US treasury futures traded at the Chicago Board of Trade. The 30 year T-Bond, and the 10 year and 5 year T-Note futures options. Trading hours are 7:20 to 2:00 PM CST and 5:20 to 8:05 PM.
The Eurodollar trades at the Chicago Merc IMM division like the currencies. It's extremely liquid and trades 7:20-2 PM CST.
The options on stock or commodity index futures are offered at the Chicago Merc Index and Option Market Division and the New York Futures Exchange. The stock index options trade from 8:30 to 3:15 PM CST. The CRB (Commodity Research Bureau) Index options trade from 8:40 to 3:45 PM. The mini S&P trades electronically on Globex and is very new. It trades 24 hours a day except on weekends.
The options on coffee sugar and cocoa futures are offered at the Coffee Sugar and Cocoa Exchange. Coffee trades from 8:15 to 12:35 PM CST. Sugar trades from 8:30 to 12:20 PM CST. Cocoa trades from 8:00 to 1:00 PM CST.
Lumber futures options are offered at the Chicago Merc. They trade from 9:00 to 1:05 PM CST.
The options on cotton and orange juice futures are offered at the New York Cotton Exchange. Cotton trades from 9:30 to 1:40 PM CST and OJ trades from 9:15 to 1:15 PM CST.
The options on crude oil, heating oil, unleaded gas and natural gas futures are offered at the New York Mercantile Exchange. Crude Oil trades from 8:45 to 2:10 PM. Heating Oil trades from 8:50 to 2:10 PM. Unleaded Gasoline trades from 8:50 to 2:10 PM. Natural gas trades from 9:00 to 2:10 PM. All times are central standard.
The options on agricultural futures are offered at the Chicago Board of Trade. Trading times are Soybeans: 9:30-1:45 PM; Wheat, Corn, Oats, Soybean Meal and Oil: 9:30-1:15 PM; Rough Rice: 9:15-1:30 PM.
The options on the metal futures are offered at the New York Commodity Exchange. Trading times are Gold: 7:20-1:30 PM; Silver: 7:25-1:25 PM; Copper: 7:10-1:00 PM and Platinum: 7:20-1:30 PM.
The options on meat futures are offered at the Chicago Mercantile. Trading times are Feeder Cattle: 9:05-1:00 PM, Lean hogs: 9:10-1:00 PM, Live Cattle: 9:05-1:15 PM, and Pork Bellies: 9:10-1:00 PM.
It’s very important that you familiarize yourself with the times the commodity, index or financial instrument trades. The preceding information will be invaluable if you decide you want to try scalping. This means profiting from small price changes on each transaction. Scalpers also limit their risk by moving quickly with a closely defined risk that could also limit the profit potential. The key to success using this method is to profit on volume rather than making it big on just one trade.
Conventional day trading basically means ending your trades at the end of the trading session to limit your exposure and avoid nasty overnight surprises. This is a more long-term focus than the scalper, because a day trader is looking for daily swings that may translate into longer market tendencies. The risks for a conventional day trader are well-defined and the approach is generally to look for entry points on perceived buying and selling climaxes, retracements (a change of direction in prices within a major price trend); trendline pull backs (in charting, a line drawn across the bottom or top of a price chart indicating the direction or trend of price movement is called a trendline; if it angles up, the trendline is called bullish; if down, it is called bearish) and similar strategies. The advantage to this method is that you do not expose yourself to overnight risk, but you lose the overnight opportunity as well.
Swing traders stay in the market for two to five days at a time. Swing trading is a great way to improve your investment while maintaining good risk management. This kind of trading is supported by a strategy based on price level, history or market economics that can be arrived through either technical or fundamental analysis, or a combination of the two. Usually, a swing trader sticks with their strategy until their target price is reached, the projection and market align measurably, or the fundamental conditions have changed. There is greater risk in swing trading because it does allow the opportunity of overnight positions. Profit potential is also greatly increased because of the expansion of the time frame to several days.
Spreading is a technique that can be used by scalpers, day traders or swing traders. Spreading means focusing on the difference in price between one futures contract month and another futures contract month, or the difference in prices between related markets (gold and silver, or corn and wheat). There are widely differing risk/reward ratios for spreading, but to be successful, good risk management is the key.
Make sure you choose a market you are comfortable in. If you don’t understand how something works, how it is sold, or even what it is, don’t trade it. High rewards mean high risk, and if you don’t have a lot of capital, you’ll want something that is lower risk.
One thing to look for is how the market overall is trending. That means look for something with an established trend, which could include corn, copper, soybeans, wheat or Eurodollars. Liqudity is also extremely important. A liquid market means there are enough traders to allow you to get into and out of a trade easily. In an illiquid market, you could lose all your profits getting out because nobody is trading. Once you find a market you’re happy with, then you need to find out all you can about your contract to figure how its risk/reward potential. You’ll need to know the exchange where the contract is traded and whether your broker executes trades there, as well as the contract’s trading hours and expiration date. You’ll also need to know the delivery months (when the contract matures); the size of the contract; how prices are quoted; the minimum tick; daily trading limits and the margin requirements we discussed earlier.
Another thing to consider is volatility. Many exchanges have historical volatility information available for you that shows you the average price fluctuation of a contract over time. Here’s an example of the soybeans volatility chart from the Chicago Board of Trade:
You can also look at this chart, which combines volatility, margin, contract size and tick value. This will give you a quick idea of how much a contract will deviate over a given time period, how much that will cost you if it does deviate, and if you can afford to hold the contract overnight. You may want to avoid extremely volatile contracts like coffee that can change in a hurry overnight.
Where To Find The Best Information
The government is a great source of information, and there are many ways to access that information that will cost you little or nothing. You can access weather information over the Internet from a variety of sources, including NOAA. Here’s an example of some of what you’ll find. One of the most used sources of weather information for people trading commodity futures is the Palmer Drought index, which NOAA explains as follows:
The Palmer Drought Severity Index
The Palmer Index was developed by Wayne Palmer in the 1960s and uses temperature and rainfall information in a formula to determine dryness. It has become the semi-official drought index.
The Palmer Index is most effective in determining long term drought—a matter of several months—and is not as good with short-term forecasts (a matter of weeks). It uses a 0 as normal, and drought is shown in terms of minus numbers; for example, minus 2 is moderate drought, minus 3 is severe drought, and minus 4 is extreme drought. At present, northern Virginia is at a minus 4.0 point; north central Maryland is at a minus 4.2 level, and southern Maryland is at least a minus 4 level.
The Palmer Index can also reflect excess rain using a corresponding level reflected by plus figures; i.e., 0 is normal, plus 2 is moderate rainfall, etc. At present, north central Iowa is at a plus 5.2 level, and parts of South Dakota are even higher.
The advantage of the Palmer Index is that it is standardized to local climate, so it can be applied to any part of the country to demonstrate relative drought or rainfall conditions. The negative is that it is not as good for short term forecasts, and is not particularly useful in calculating supplies of water locked up in snow, so it works best east of the Continental Divide.
The Crop Moisture Index (CMI) is also a formula that was also developed by Wayne Palmer subsequent to his development of the Palmer Drought Index.
The CMI responds more rapidly than the Palmer Index and can change considerably from week to week, so it is more effective in calculating short-term abnormal dryness or wetness affecting agriculture.
CMI is designed to indicate normal conditions at the beginning and end of the growing season; it uses the same levels as the Palmer Drought Index. It differs from the Palmer Index in that the formula places less weight on the data from previous weeks and more weight on the recent week.
You can also get maps letting you know about the vegetation health in the U.S. Here is such a map from NOAA:
Vegetation Health: Red - stressed, Green - fair, Blue - favorable, White - Cold
You can also get current information right from the exchange’s webpage. Here’s a sample from the Chicago Board of Trade:
Sharp increases in the USDA's 2005 corn and soybean crop estimates shook the CBOT Monday when the latest government update took production levels above pre-report trade expectations, despite marginal weather during August as well as heat and drought in the central U.S. this summer.
Of course, you can get real time information as well, but you will have to pay for that. There are numerous companies out there selling software and subscriptions that can deliver the latest market information right to your computer.
Speculating - Model and Back Testing
In order to be a successful speculator, you’ll need a lot of discipline—both mental and financial. If you plan on using a day trading strategy (getting out of the market by the end of the trading day), be prepared to spend a lot of time watching the markets and be ready to move as quickly as you can. As a day trader, you’ll be responsible for all market actions. You need to consider your motivation for trading before you start, to make sure you have your goals clearly in mind. Make sure your plan of action is clear and precise and that it’s automatic and effortless in its implementation. Also, be patient, practical (profit oriented) and consistent. Once you’ve made your plan, you need to stick to it and be prepared for losing trades. These will happen no matter what your strategy is.
The example strategy we will discuss here will be a relatively short-term one, based on just a couple of months of market action. This plan calls for starting with $2000 in our margin account, with a goal of increasing that investment by 50 percent in less than 60 days. To do this, we’ll return to our soybean oil model.
On July 1st, we put the $2000 in our initial margin account, and four days later, sell 1 soybean oil futures contract at $564 (at a price of 25.51 cents per pound, plus a $50 trade transaction fee.) The contract calls for delivery of 60 thousand pounds of soybean oil. Our margin account declines to $1386. We’re hoping a bumper crop of soybeans causes the market to go down in the next 60 days by at least two cents per contract. On July 6th, the market moves in our favor, to 25.18 cents per pound. That puts our margin account up to $1584, and we’ve made nearly 200 dollars in just one day. But, with our goal of a 50 percent profit firmly in mind, we stick with our position.
Moving forward to July 15th, we see the market moving against us, as the close on July 15th is at 25.62. This causes our margin account to decline to $1320.
Nonetheless, we stick with our position because we have yet to realize our 50 percent profit goal. On July 19th and 20th, the market again moves in our favor, with the close on the 20th at 24.82 cents. Our margin account is now back up to $1800, but we haven’t yet reached the goal—which would be $3000 in our margin account (a $1000 profit on our $2000 initial investment).
For the next few days, the market hangs around the 24.82 cent level, then takes a big dip on August 5th, where the closing price is 23.69. This puts our margin account at $2478, still about $500 away from our goal.
Though the market is getting close to where we want it to go, we’re still going to hang in there for our 50 percent profit goal. On August 9th, the price takes yet another dive, and closes at 22.89. This puts our margin account at $2958, just $42 from the goal. Letting the profits run until our trading goal is reached means we decide to risk our profits and continue.
Now, it’s August 15th, and the price has declined to 22.66. Our margin account balance is now at $3004, we’ve reached our goal, and it’s time to buy an offsetting soybean oil futures contract. We’ve made our 50 percent profit, and gotten out of the market and no longer have a futures position.
Note on the chart that if we’d have stayed in the market for just a little longer, our profits would have been even greater, since the close on August 15th was 22.30. But, because we’re disciplined and reached our goal, we got out of the market when we said we would.
Hedging—A Model And Example
Hedging is used by people who actually grow or manufacture the commodity to lock in a price to ensure they don’t wind up in a bad financial position. If you were a wheat farmer near Omaha, Nebraska and are expecting a yield of 50 thousand bushels during the spring, you would want to make sure it is worth your while to plant this year. The Chicago Board of Trade contract provides for delivery of 5000 bushels of wheat in Chicago and other locations during the contract month. The available months are July, September, December, March and May. The first new crop contract month for spring wheat is December, and right now it is trading at $3.50 a bushel. Though the price for wheat in the Omaha area might differ from the futures price, they are closely related. And, you know if you can sell the wheat at $3.50 a bushel, you’ll make a reasonable profit. By planting your wheat, you’re betting the price of wheat won’t go down between now and harvest time. This is where the hedging comes in.
Since farmers have no control over wheat prices, you can hedge your bet by selling 10 wheat futures contracts at $3.50 a bushel.
Since each contract provides for delivery of 5 thousand bushels, and the expected harvest is 50 thousand bushels, you would sell the ten futures contracts at $3.50 a bushel. As of September, 2005, the initial margin and the maintenance margin for a hedger are $700 a contract, so you would need to deposit at least $7000 to cover the margin for the 10 contracts. Each day, your position is marked to the market, so if the market moves in your favor (in this case, declining wheat prices), your margin account is credited with the accrued profit. When the futures prices rise, your margin account is debited with the accrued loss. If the margin account ever falls below $7000, you have to post the variation margin to bring the account back up to at least $7000.
Now, it’s time to harvest your wheat, and you do get your expected 50 thousand bushel yield. But, there’s been a bumper crop this year, and the futures contract has declined to $3.00 a bushel. You now have 50 thousand bushels of wheat and you’re short 50 thousand bushels of wheat of the futures market. This is called a hedged position. You need to unwind this hedged position, and you can do so in a couple of ways. You can decide to make delivery of your wheat according to the terms of the futures contract, and deliver it to one of the locations specified in the contract. But that would be expensive, because Omaha is a good distance from the specified locations. The second choice, and the way it usually works, is for you to buy ten wheat futures contracts at the current price of $3.00 a bushel to offset your futures position, since the ten you previously sold are now offset by these ten you are buying, which means you no longer have a futures position. Assuming you’ve made no deposits or withdrawals, you now have $25,000 more in your margin account (50 cents per bushel times 50 thousand bushels). This futures trade gives you a profit of 50 cents per bushel. You can now complete unwinding your hedged position by selling the wheat in your silo locally for $3.00 a bushel. Taking into consideration the 50 cent per bushel profit you made in the futures market, you, in effect, received $3.50 per bushel for your wheat, which was your original goal.
Bibliography
Abel, Howard The Day Trader’s Advantage: How to Move from One Winning Position to the Next Dearborn, 2000
Burden, Anne Anne Burden’s Futures Guide “Risk and Money Management” 2002
“Basics of Futures Trading” Commodities and Futures Association Commission, September, 2005
“CFTC Market Surveillance Program” ibid
“CFTC- “Broker Registration and Background Information” ibid
“CFTC- “The Economic Purpose of Futures Markets” ibid
Holter, James T. “Getting Your Wings.” Futures September 2004
Santos, Joseph A History of Futures Trading in the United States, August 10, 2004
Schuessler, Heidi “First Things First” Futures September, 2004
Schwager, Jack D. Schwager on Futures: Fundamental Analysis John Wiley and Sons, 1995
Thachuk, Rick “Setting Realistic Expectations” Futures September, 2004
Thachuk, Rick “Developing a Trading Plan” ibid
