Futures Trading Introduction:
A Beginner's Guide
Futures Trading is a form of investment
which involves speculating on the price of a commodity going up or down in the
future.
What is a commodity? Most
commodities you see and use every day of your life:
the corn in your morning
cereal which you have for breakfast,
the lumber that makes
your breakfast-table and chairs
the gold on your watch
and jewellery,
the cotton that makes
your clothes,
the steel which makes
your motor car and the crude oil which runs it and takes you to work,
the wheat that makes the
bread in your lunchtime sandwiches
the beef and potatoes
you eat for lunch,
the currency you use to
buy all these things...
... All these commodities (and dozens more)
are traded between hundreds-of-thousands of investors, every day, all over the world. They
are all trying to make a profit by buying a commodity at a low price and selling at a
higher price.
Futures trading is mainly speculative
'paper' investing, i.e. it is rare for the investors to actually hold the physical
commodity, just a piece of paper known as a futures contract.
To the uninitiated, the term contract
can be a little off-putting but it is mainly used because, like a contract, a futures
investment has an expiration date. You don't have to hold the contract
until it expires. You can cancel it anytime you like. In fact, many
short-term traders only hold their contracts for a few hours - or even minutes!
The expiration dates vary between
commodities, and you have to choose which contract fits your market objective.
For example, today is June 30th and you
think Gold will rise in price until mid-August. The Gold contracts available are February,
April, June, August, October and December. As it is the end of June and this contract has
already expired, you would probably choose the August or October Gold contract.
The nearer (to expiration) contracts are
usually more liquid, i.e. there are more traders trading them. Therefore, prices are more
true and less likely to jump from one extreme to the other. But if you thought the price
of gold would rise until September, you would choose a further-out contract (October in
this case) - a September contract doesn't exist.
Neither is their a limit on the number of
contracts you can trade (within reason - there must be enough buyers or sellers to trade
with you.) Many larger traders/investment companies/banks, etc. may trade thousands of
contracts at a time!
All futures contracts are standardised
in that they all hold a specified amount and quality of
a commodity. For example, a Pork Bellies futures contract (PB) holds 40,000lbs of pork
bellies of a certain size; a Gold futures contract (GC) holds 100 troy ounces of 24 carat
gold; and a Crude Oil futures contract holds 1000 barrels of crude oil of a certain
quality.
Before Futures Trading came about, any
producer of a commodity (e.g. a farmer growing wheat or corn) found himself at the mercy
of a dealer when it came to selling his product. The system needed to be legalised
in order that a specified amount and quality of product could be traded between producers
and dealers at a specified date.
Contracts were drawn up between the two
parties specifying a certain amount and quality of a
commodity that would be delivered in a particular month...
...Futures trading had begun!
In 1878, a central dealing facility was
opened in Chicago, USA where farmers and dealers could deal in ‘spot’ grain,
i.e., immediately deliver their wheat crop for a cash settlement. Futures trading evolved
as farmers and dealers committed to buying and selling future exchanges
of the commodity. For example, a dealer would agree to buy 5,000 bushels of a specified
quality of wheat from the farmer in June the following year, for a specified price. The
farmer knew how much he would be paid in advance, and the dealer knew his costs.
Until twenty years ago, futures markets
consisted of only a few farm products, but now they have been joined by a huge number of
tradable ‘commodities’. As well as metals like gold, silver and platinum;
livestock like pork bellies and cattle; energies like crude oil and natural gas;
foodstuffs like coffee and orange juice; and industrials like lumber and cotton, modern
futures markets include a wide range of interest-rate instruments, currencies, stocks and
other indices such as the Dow Jones, Nasdaq and S&P 500.
It didn't take long for businessmen to
realise the lucrative investment opportunities available in these
markets. They didn't have to buy or sell the ACTUAL commodity (wheat or corn, etc.), just
the paper-contract that held the commodity. As long as they exited the
contract before the delivery date, the investment would be purely a paper one. This was
the start of futures trading speculation and investment, and today, around 97% of futures
trading is done by speculators.
There are two main types of Futures trader: 'hedgers'
and 'speculators'.
A hedger is a producer of
the commodity (e.g. a farmer, an oil company, a mining company) who trades a futures
contract to protect himself from future price changes in his product.
For example, if a farmer thinks the price of
wheat is going to fall by harvest time, he can sell a futures
contract in wheat. (You can enter a trade by selling a futures contract first,
and then exit the trade later by buying it.) That way, if the cash price
of wheat does fall by harvest time, costing the farmer money, he will make back the
cash-loss by profiting on the short-sale of the futures contract. He ‘sold’
at a high price and exited the contract by ‘buying’ at a lower
price a few months later, therefore making a profit on the futures trade.
Other hedgers of futures contracts include
banks, insurance companies and pension fund companies who use futures to hedge against any
fluctuations in the cash price of their products at future dates.
Speculators include
independent floor traders and private investors. Usually, they don’t have any
connection with the cash commodity and simply try to (a) make a profit buying
a futures contract they expect to rise in price or (b) sell
a futures contract they expect to fall in price.
In other words, they invest in futures in
the same way they might invest in stocks and shares - by buying at a low price and
selling at a higher price.
Trading futures contracts have several
advantages over other investments:
1. Futures are highly leveraged
investments. To ‘own’ a futures contract an investor only has to put up a small
fraction of the value of the contract (usually around 10%) as ‘margin’. In other
words, the investor can trade a much larger amount of the commodity than
if he bought it outright, so if he has predicted the market movement correctly, his
profits will be multiplied (ten-fold on a 10% deposit). This is an excellent
return compared to buying a physical commodity like gold bars, coins or mining stocks.
The margin required to hold
a futures contract is not a down payment but a form of security bond. If
the market goes against the trader's position, he may lose some, all, or possibly more
than the margin he has put up. But if the market goes with the trader's position, he makes
a profit and he gets his margin back.
For example, say you believe gold in
undervalued and you think prices will rise. You have $3000 to invest - enough to purchase:
10 ounces of gold (at $300/ounce),
or 100 shares in a mining company (priced
at $30 each),
or enough margin to cover 2 futures
contracts. (Each Gold futures contract holds 100 ounces of gold, which is effectively what
you 'own' and are speculating with. One-hundred ounces multiplied by three-hundred dollars
equals a value of $30,000 per contract. You have enough to cover two contracts and
therefore speculate with $60,000 of gold!)
Two months later, gold has rocketed 20%.
Your 10 ounces of gold and your company shares would now be worth $3600 - a $600 profit;
20% of $3000. But your futures contracts are now worth a staggering $72,000 - 20% up on
$60,000.
Instead of a measly $600 profit,
you've made a massive $12,000 profit!
2. Speculating with futures contracts is
basically a paper investment. You don’t have to literally store 3
tons of gold in your garden shed, 15,000 litres of orange juice in your driveway, or have
500 live hogs running around your back garden!
The actual commodity being traded in
the contract is only exchanged on the rare occasions when delivery of the contract takes
place (i.e. between producers and dealers – the 'hedgers' mentioned earlier on). In
the case of a speculator (such as yourself), a futures trade is purely a paper
transaction and the term 'contract' is only used mainly because of the expiration
date being similar to a ‘contract’.
3. An investor can make money more
quickly on a futures trade. Firstly, because he is trading with around ten-times
as much of the commodity secured with his margin, and secondly, because futures markets
tend to move more quickly than cash markets. (Similarly, an investor can lose money more
quickly if his judgement is incorrect, although losses can be minimised with Stop-Loss
Orders. My trading method specialises in placing stop-loss orders to maximum effect.)
4. Futures trading markets are
usually fairer than other markets (like stocks and shares) because it is harder
to get ‘inside information’. The open out-cry trading pits --
lots of men in yellow jackets waving their hands in the air shouting "Buy! Buy!"
or "Sell! Sell!" -- offers a very public, efficient market place. Also, any
official market reports are released at the end of a trading session so everyone has a
chance to take them into account before trading begins again the following day.
5. Most futures markets are very
liquid, i.e. there are huge amounts of contracts traded every day. This ensures
that market orders can be placed very quickly as there are always buyers and sellers of a
commodity. For this reason, it is unusual for prices to suddenly jump to a completely
different level, especially on the nearer contracts (those which will
expire in the next few weeks or months).
6. Commission charges are small
compared to other investments and are paid after the position has ended.
Commissions vary widely depending on the
level of service given by the broker. Online trading commissions can be as low as $5 per
side. Full service brokers who can advise on positions can be around $40-$50 per trade.
Managed trading commissions, where a broker controls entering and exiting positions at his
discretion, can be up to $200 per trade.
In the next section,
you will learn:
Why Leverage is the
Biggest Advantage is also the biggest Disadvantage in Futures Trading
How to Protect
Profits with Stop-Loss Orders
Where to find Market
Information
