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Understanding
Opportunities and Risks in Futures Trading
Table of Contents:
- Introduction
- Futures
Markets: What, Why & Who
- The
Market Participants
- What
is a Futures Contract?
- The
Process of Price Discovery
- After
the Closing Bell
- The
Arithmetic of Futures
- Trading
- Margins
- Basic
Trading Strategies
- Buying
(Going Long) to Profit from an Expected Price Increase Selling
- (Going
Short) to Profit from an Expected Price Decrease Spreads
- Participating
in Futures Trading
- Deciding
How to Participate
- Regulation
of Futures Trading
- Establishing
an Account
- What
to Look for in a Futures Contract
- The
Contract Unit
- How
Prices are Quoted
- Minimum
Price Changes
- Daily
Price Limits
- Position
Limits
- Understanding
(and Managing) the Risks of Futures Trading
- Choosing
a Futures Contract
- Liquidity
- Timing
- Stop
Orders
- Spreads
- Options
on Futures Contracts
- Buying
Call Options
- Buying
Put Options
- How
Option Premiums are Determined
- Selling
Options
- In
Closing
Introduction
Futures
markets have been described as continuous auction markets and as clearing
houses for the latest information about supply and demand. They are the
meeting places of buyers and sellers of an ever-expanding list of commodities
that today includes agricultural products, metals, petroleum, financial
instruments, foreign currencies and stock indexes. Trading has also been
initiated in options on futures contracts, enabling option buyers to participate
in futures markets with known risks.
Notwithstanding
the rapid growth and diversification of futures markets, their primary
purpose remains the same as it has been for nearly a century and a half,
to provide an efficient and effective mechanism for the management of
price risks. By buying or selling futures contracts--contracts that establish
a price level now for items to be delivered later--individuals and businesses
seek to achieve what amounts to insurance against adverse price changes.
This is called hedging.
Volume
has increased from 14 million futures contracts traded in 1970 to 179
million futures and options on futures contracts traded in 1985.
Other
futures market participants are speculative investors who accept the risks
that hedgers wish to avoid. Most speculators have no intention of making
or taking delivery of the commodity but, rather, seek to profit from a
change in the price. That is, they buy when they anticipate rising prices
and sell when they anticipate declining prices. The interaction of hedgers
and speculators helps to provide active, liquid and competitive markets.
Speculative participation in futures trading has become increasingly attractive
with the availability of alternative methods of participation. Whereas
many futures traders continue to prefer to make their own trading decisions--such
as what to buy and sell and when to buy and sell--others choose to utilize
the services of a professional trading advisor, or to avoid day-to-day
trading responsibilities by establishing a fully managed trading account
or participating in a commodity pool which is similar in concept to a
mutual fund.
For
those individuals who fully understand and can afford the risks which
are involved, the allocation of some portion of their capital to futures
trading can provide a means of achieving greater diversification and a
potentially higher overall rate of return on their investments. There
are also a number of ways in which futures can be used in combination
with stocks, bonds and other investments.
Speculation
in futures contracts, however, is clearly not appropriate for everyone.
Just as it is possible to realize substantial profits in a short period
of time, it is also possible to incur substantial losses in a short period
of time. The possibility of large profits or losses in relation to the
initial commitment of capital stems principally from the fact that futures
trading is a highly leveraged form of speculation. Only a relatively small
amount of money is required to control assets having a much greater value.
As we will discuss and illustrate, the leverage of futures trading can
work for you when prices move in the direction you anticipate or against
you when prices move in the opposite direction.
It
is not the purpose of this material to suggest that you should--or should
not--participate in futures trading. That is a decision you should make
only after consultation with your broker or financial advisor and in light
of your own financial situation and objectives.
Intended
to help provide you with the kinds of information you should first obtain--and
the questions you should seek answers to--in regard to any investment
you are considering:
*
Information about the investment itself and the risks involved
*
How readily your investment or position can be liquidated when such action
is necessary or desired
*
Who the other market participants are
*
Alternate methods of participation
*
How prices are arrived at
*
The costs of trading
*
How gains and losses are realized
*
What forms of regulation and protection exist
*
The experience, integrity and track record of your broker or advisor
*
The financial stability of the firm with which you are dealing
In
sum, the information you need to be an informed investor.
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Futures
Market
The frantic shouting
and signaling of bids and offers on the trading floor of a futures exchange
undeniably convey an impression of chaos. The reality however, is that
chaos is what futures markets replaced. Prior to the establishment of
central grain markets in the mid-nineteenth century, the nation's farmers
carted their newly harvested crops over plank roads to major population
and transportation centers each fall in search of buyers. The seasonal
glut drove prices to giveaway levels and, indeed, to throwaway levels
as grain often rotted in the streets or was dumped in rivers and lakes
for lack of storage. Come spring, shortages frequently developed and foods
made from corn and wheat became barely affordable luxuries. Throughout
the year, it was each buyer and seller for himself with neither a place
nor a mechanism for organized, competitive bidding. The first central
markets were formed to meet that need. Eventually, contracts were entered
into for forward as well as for spot (immediate) delivery. So-called forwards
were the forerunners of present day futures contracts.
Spurred by the need
to manage price and interest rate risks that exist in virtually every
type of modern business, today's futures markets have also become major
financial markets. Participants include mortgage bankers as well as farmers,
bond dealers as well as grain merchants, and multinational corporations
as well as food processors, savings and loan associations, and individual
speculators.
Futures prices arrived
at through competitive bidding are immediately and continuously relayed
around the world by wire and satellite. A farmer in Nebraska, a merchant
in Amsterdam, an importer in Tokyo and a speculator in Ohio thereby have
simultaneous access to the latest market-derived price quotations. And,
should they choose, they can establish a price level for future delivery--or
for speculative purposes--simply by having their broker buy or sell the
appropriate contracts. Images created by the fast-paced activity of the
trading floor notwithstanding, regulated futures markets are a keystone
of one of the world's most orderly envied and intensely competitive marketing
systems. Should you at some time decide to trade in futures contracts,
either for speculation or in connection with a risk management strategy,
your orders to buy or sell would be communicated by phone from the brokerage
office you use and then to the trading pit or ring for execution by a
floor broker. If you are a buyer, the broker will seek a seller at the
lowest available price. If you are a seller, the broker will seek a buyer
at the highest available price. That's what the shouting and signaling
is about.
In either case, the
person who takes the opposite side of your trade may be or may represent
someone who is a commercial hedger or perhaps someone who is a public
speculator. Or, quite possibly, the other party may be an independent
floor trader. In becoming acquainted with futures markets, it is useful
to have at least a general understanding of who these various market participants
are, what they are doing and why.
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Hedgers
The details of hedging
can be somewhat complex but the principle is simple. Hedgers are individuals
and firms that make purchases and sales in the futures market solely for
the purpose of establishing a known price level--weeks or months in advance--for
something they later intend to buy or sell in the cash market (such as
at a grain elevator or in the bond market). In this way they attempt to
protect themselves against the risk of an unfavorable price change in
the interim. Or hedgers may use futures to lock in an acceptable margin
between their purchase cost and their selling price. Consider this example:
A jewelry manufacturer
will need to buy additional gold from his supplier in six months. Between
now and then, however, he fears the price of gold may increase. That could
be a problem because he has already published his catalog for a year ahead.
To lock in the price
level at which gold is presently being quoted for delivery in six months,
he buys a futures contract at a price of, say, $350 an ounce.
If, six months later,
the cash market price of gold has risen to $370, he will have to pay his
supplier that amount to acquire gold. However, the extra $20 an ounce
cost will be offset by a $20 an ounce profit when the futures contract
bought at $350 is sold for $370. In effect, the hedge provided insurance
against an increase in the price of gold. It locked in a net cost of $350,
regardless of what happened to the cash market price of gold. Had the
price of gold declined instead of risen, he would have incurred a loss
on his futures position but this would have been offset by the lower cost
of acquiring gold in the cash market.
The number and variety
of hedging possibilities is practically limitless. A cattle feeder can
hedge against a decline in livestock prices and a meat packer or supermarket
chain can hedge against an increase in livestock prices. Borrowers can
hedge against higher interest rates, and lenders against lower interest
rates. Investors can hedge against an overall decline in stock prices,
and those who anticipate having money to invest can hedge against an increase
in the over-all level of stock prices. And the list goes on.
Whatever the hedging
strategy, the common denominator is that hedgers willingly give up the
opportunity to benefit from favorable price changes in order to achieve
protection against unfavorable price changes.
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Speculators
Were you to speculate
in futures contracts, the person taking the opposite side of your trade
on any given occasion could be a hedger or it might well be another speculator--someone
whose opinion about the probable direction of prices differs from your
own.
The arithmetic of
speculation in futures contracts--including the opportunities it offers
and the risks it involves--will be discussed in detail later on. For now,
suffice it to say that speculators are individuals and firms who seek
to profit from anticipated increases or decreases in futures prices. In
so doing, they help provide the risk capital needed to facilitate hedging.
Someone who expects
a futures price to increase would purchase futures contracts in the hope
of later being able to sell them at a higher price. This is known as "going
long." Conversely, someone who expects a futures price to decline
would sell futures contracts in the hope of later being able to buy back
identical and offsetting contracts at a lower price. The practice of selling
futures contracts in anticipation of lower prices is known as "going
short." One of the attractive features of futures trading is that
it is equally easy to profit from declining prices (by selling) as it
is to profit from rising prices (by buying).
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Floor
Traders
Persons known as
floor traders or locals, who buy and sell for their own accounts on the
trading floors of the exchanges, are the least known and understood of
all futures market participants. Yet their role is an important one. Like
specialists and market makers at securities exchanges, they help to provide
market liquidity. If there isn't a hedger or another speculator who is
immediately willing to take the other side of your order at or near the
going price, the chances are there will be an independent floor trader
who will do so, in the hope of minutes or even seconds later being able
to make an offsetting trade at a small profit. In the grain markets, for
example, there is frequently only one-fourth of a cent a bushel difference
between the prices at which a floor trader buys and sells.
Floor traders, of
course, have no guarantee they will realize a profit. They may end up
losing money on any given trade. Their presence, however, makes for more
liquid and competitive markets. It should be pointed out, however, that
unlike market makers or specialists, floor traders are not obligated to
maintain a liquid market or to take the opposite side of customer orders.
|
|
Reasons
for Buying futures contracts |
Reasons
for Selling futures contracts |
| Hedgers |
To
lock in a price and thereby obtain protection against rising prices
|
To
lock in a price and thereby obtain protection against declining
prices |
| Speculators
and floor Traders |
To
profit from rising prices |
To
profit from declining prices |
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What
is a Futures Contract?
There are two types
of futures contracts, those that provide for physical delivery of a particular
commodity or item and those which call for a cash settlement. The month
during which delivery or settlement is to occur is specified. Thus, a
July futures contract is one providing for delivery or settlement in July.
It should be noted
that even in the case of delivery-type futures contracts,very few actually
result in delivery.* Not many speculators have the desire to take or make
delivery of, say, 5,000 bushels of wheat, or 112,000 pounds of sugar,
or a million dollars worth of U.S. Treasury bills for that matter. Rather,
the vast majority of speculators in futures markets choose to realize
their gains or losses by buying or selling offsetting futures contracts
prior to the delivery date. Selling a contract that was previously purchased
liquidates a futures position in exactly the same way, for example, that
selling 100 shares of IBM stock liquidates an earlier purchase of 100
shares of IBM stock. Similarly, a futures contract that was initially
sold can be liquidated by an offsetting purchase. In either case, gain
or loss is the difference between the buying price and the selling price.
Even hedgers generally
don't make or take delivery. Most, like the jewelry manufacturer illustrated
earlier, find it more convenient to liquidate their futures positions
and (if they realize a gain) use the money to offset whatever adverse
price change has occurred in the cash market.
* When delivery does
occur it is in the form of a negotiable instrument (such as a warehouse
receipt) that evidences the holder's ownership of the commodity, at some
designated location.
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Why
Delivery?
Since delivery on
futures contracts is the exception rather than the rule, why do most contracts
even have a delivery provision? There are two reasons. One is that it
offers buyers and sellers the opportunity to take or make delivery of
the physical commodity if they so choose. More importantly, however, the
fact that buyers and sellers can take or make delivery helps to assure
that futures prices will accurately reflect the cash market value of the
commodity at the time the contract expires--i.e., that futures and cash
prices will eventually converge. It is convergence that makes hedging
an effective way to obtain protection against an adverse change in the
cash market price.*
* Convergence occurs
at the expiration of the futures contract because any difference between
the cash and futures prices would quickly be negated by profit-minded
investors who would buy the commodity in the lowest-price market and sell
it in the highest-price market until the price difference disappeared.
This is known as arbitrage and is a form of trading generally best left
to professionals in the cash and futures markets.
Cash settlement futures
contracts are precisely that, contracts which are settled in cash rather
than by delivery at the time the contract expires. Stock index futures
contracts, for example, are settled in cash on the basis of the index
number at the close of the final day of trading. There is no provision
for delivery of the shares of stock that make up the various indexes.
That would be impractical. With a cash settlement contract, convergence
is automatic.
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The
Process of Price Discovery
Futures prices increase
and decrease largely because of the myriad factors that influence buyers'
and sellers' judgments about what a particular commodity will be worth
at a given time in the future (anywhere from less than a month to more
than two years).
As new supply and
demand developments occur and as new and more current information becomes
available, these judgments are reassessed and the price of a particular
futures contract may be bid upward or downward. The process of reassessment--of
price discovery--is continuous.
Thus, in January,
the price of a July futures contract would reflect the consensus of buyers'
and sellers' opinions at that time as to what the value of a commodity
or item will be when the contract expires in July. On any given day, with
the arrival of new or more accurate information, the price of the July
futures contract might increase or decrease in response to changing expectations.
Competitive price
discovery is a major economic function--and, indeed, a major economic
benefit--of futures trading. The trading floor of a futures exchange is
where available information about the future value of a commodity or item
is translated into the language of price. In summary, futures prices are
an ever changing barometer of supply and demand and, in a dynamic market,
the only certainty is that prices will change.
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After
the Closing Bell
Once a closing bell
signals the end of a day's trading, the exchange's clearing organization
matches each purchase made that day with its corresponding sale and tallies
each member firm's gains or losses based on that day's price changes--a
massive undertaking considering that nearly two-thirds of a million futures
contracts are bought and sold on an average day. Each firm, in turn, calculates
the gains and losses for each of its customers having futures contracts.
Gains and losses
on futures contracts are not only calculated on a daily basis, they are
credited and deducted on a daily basis. Thus, if a speculator were to
have, say, a $300 profit as a result of the day's price changes, that
amount would be immediately credited to his brokerage account and, unless
required for other purposes, could be withdrawn. On the other hand, if
the day's price changes had resulted in a $300 loss, his account would
be immediately debited for that amount.
The process just
described is known as a daily cash settlement and is an important feature
of futures trading. As will be seen when we discuss margin requirements,
it is also the reason a customer who incurs a loss on a futures position
may be called on to deposit additional funds to his account.
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The
Arithmetic of Futures Trading
To say that gains
and losses in futures trading are the result of price changes is an accurate
explanation but by no means a complete explanation. Perhaps more so than
in any other form of speculation or investment, gains and losses in futures
trading are highly leveraged. An understanding of leverage--and of how
it can work to your advantage or disadvantage--is crucial to an understanding
of futures trading.
As mentioned in the
introduction, the leverage of futures trading stems from the fact that
only a relatively small amount of money (known as initial margin) is required
to buy or sell a futures contract. On a particular day, a margin deposit
of only $1,000 might enable you to buy or sell a futures contract covering
$25,000 worth of soybeans. Or for $10,000, you might be able to purchase
a futures contract covering common stocks worth $260,000. The smaller
the margin in relation to the value of the futures contract, the greater
the leverage.
If you speculate
in futures contracts and the price moves in the direction you anticipated,
high leverage can produce large profits in relation to your initial margin.
Conversely, if prices move in the opposite direction, high leverage can
produce large losses in relation to your initial margin. Leverage is a
two-edged sword.
For example, assume
that in anticipation of rising stock prices you buy one June S&P 500
stock index futures contract at a time when the June index is trading
at 1000. And assume your initial margin requirement is $10,000. Since
the value of the futures contract is $250 times the index, each 1 point
change in the index represents a $250 gain or loss.
Thus, an increase
in the index from 1000 to 1040 would double your $10,000 margin deposit
and a decrease from 1000 to 960 would wipe it out. That's a 100% gain
or loss as the result of only a 4% change in the stock index!
Said another way,
while buying (or selling) a futures contract provides exactly the same
dollars and cents profit potential as owning (or selling short) the actual
commodities or items covered by the contract, low margin requirements
sharply increase the percentage profit or loss potential. For example,
it can be one thing to have the value of your portfolio of common stocks
decline from $100,000 to $96,000 (a 4% loss) but quite another (at least
emotionally) to deposit $10,000 as margin for a futures contract and end
up losing that much or more as the result of only a 4% price decline.
Futures trading thus requires not only the necessary financial resources
but also the necessary financial and emotional temperament.
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Trading
An absolute requisite
for anyone considering trading in futures contracts--whether it's sugar
or stock indexes, pork bellies or petroleum--is to clearly understand
the concept of leverage as well as the amount of gain or loss that will
result from any given change in the futures price of the particular futures
contract you would be trading. If you cannot afford the risk, or even
if you are uncomfortable with the risk, the only sound advice is don't
trade. Futures trading is not for everyone.
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Margins
As is apparent from
the preceding discussion, the arithmetic of leverage is the arithmetic
of margins. An understanding of margins--and of the several different
kinds of margin--is essential to an understanding of futures trading.
If your previous
investment experience has mainly involved common stocks, you know that
the term margin--as used in connection with securities--has to do with
the cash down payment and money borrowed from a broker to purchase stocks.
But used in connection with futures trading, margin has an altogether
different meaning and serves an altogether different purpose.
Rather than providing
a down payment, the margin required to buy or sell a futures contract
is solely a deposit of good faith money that can be drawn on by your brokerage
firm to cover losses that you may incur in the course of futures trading.
It is much like money held in an escrow account. Minimum margin requirements
for a particular futures contract at a particular time are set by the
exchange on which the contract is traded. They are typically about five
percent of the current value of the futures contract. Exchanges continuously
monitor market conditions and risks and, as necessary, raise or reduce
their margin requirements. Individual brokerage firms may require higher
margin amounts from their customers than the exchange-set minimums.
There are two margin-related
terms you should know: Initial margin and maintenance margin.
Initial margin (sometimes
called original margin) is the sum of money that the customer must deposit
with the brokerage firm for each futures contract to be bought or sold.
On any day that profits accrue on your open positions, the profits will
be added to the balance in your margin account. On any day losses accrue,
the losses will be deducted from the balance in your margin account.
If and when the funds
remaining available in your margin account are reduced by losses to below
a certain level--known as the maintenance margin requirement--your broker
will require that you deposit additional funds to bring the account back
to the level of the initial margin. Or, you may also be asked for additional
margin if the exchange or your brokerage firm raises its margin requirements.
Requests for additional margin are known as margin calls.
Assume, for example,
that the initial margin needed to buy or sell a particular futures contract
is $2,000 and that the maintenance margin requirement is $1,500. Should
losses on open positions reduce the funds remaining in your trading account
to, say, $1,400 (an amount less than the maintenance requirement), you
will receive a margin call for the $600 needed to restore your account
to $2,000.
Before trading in
futures contracts, be sure you understand the brokerage firm's Margin
Agreement and know how and when the firm expects margin calls to be met.
Some firms may require only that you mail a personal check. Others may
insist you wire transfer funds from your bank or provide same-day or next-day
delivery of a certified or cashier's check. If margin calls are not met
in the prescribed time and form, the firm can protect itself by liquidating
your open positions at the available market price (possibly resulting
in an unsecured loss for which you would be liable).
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Basic
Trading Strategies
Even if you should
decide to participate in futures trading in a way that doesn't involve
having to make day-to-day trading decisions (such as a managed account
or commodity pool), it is nonetheless useful to understand the dollars
and cents of how futures trading gains and losses are realized. And, of
course, if you intend to trade your own account, such an understanding
is essential.
Dozens of different
strategies and variations of strategies are employed by futures traders
in pursuit of speculative profits. Here is a brief description and illustration
of several basic strategies. Buying (Going Long) to Profit
from an Expected Price Increase
Someone
expecting the price of a particular commodity or item to increase over
from a given period of time can seek to profit by buying futures contracts.
If correct in forecasting the direction and timing of the price change,
the futures contract can later be sold for the higher price, thereby yielding
a profit.* If the price declines rather than increases, the trade will
result in a loss. Because of leverage, the gain or loss may be greater
than the initial margin deposit.
For
example, assume it's now January, the July soybean futures contract is
presently quoted at $6.00, and over the coming months you expect the price
to increase. You decide to deposit the required initial margin of, say,
$1,500 and buy one July soybean futures contract. Further assume that
by April the July soybean futures price has risen to $6.40 and you decide
to take your profit by selling. Since each contract is for 5,000 bushels,
your 40-cent a bushel profit would be 5,000 bushels x 40 cents or $2,000
less transaction costs.
* For simplicity examples do not take into account commissions
and other transaction costs. These costs are important, however, and you
should be sure you fully understand them. Suppose,
however, that rather than rising to $6.40, the July soybean futures price
had declined to $5.60 and that, in order to avoid the possibility of further
loss, you elect to sell the contract at that price. On 5,000 bushels your
40-cent a bushel loss would thus come to $2,000 plus transaction costs.
Note that the loss in this example exceeded your $1,500 initial margin.
Your broker would then call upon you, as needed, for additional margin funds
to cover the loss. (Going short) to profit from an expected
price decrease The only way going short to profit from an expected price
decrease differs from going long to profit from an expected price increase
is the sequence of the trades. Instead of first buying a futures contract,
you first sell a futures contract. If, as expected, the price declines,
a profit can be realized by later purchasing an offsetting futures contract
at the lower price. The gain per unit will be the amount by which the purchase
price is below the earlier selling price. For example,
assume that in January your research or other available information indicates
a probable decrease in cattle prices over the next several months. In the
hope of profiting, you deposit an initial margin of $2,000 and sell one
April live cattle futures contract at a price of, say, 65 cents a pound.
Each contract is for 40,000 pounds, meaning each 1 cent a pound change in
price will increase or decrease the value of the futures contract by $400.
If, by March, the price has declined to 60 cents a pound, an offsetting
futures contract can be purchased at 5 cents a pound below the original
selling price. On the 40,000 pound contract, that's a gain of 5 cents x
40,000 lbs. or $2,000 less transaction costs.
Assume you were wrong. Instead of decreasing, the April
live cattle futures price increases--to, say, 70 cents a pound by the time
in March when you eventually liquidate your short futures position through
an offsetting purchase. The outcome would be as follows:
In
this example, the loss of 5 cents a pound on the futures transaction resulted
in a total loss of the $2,000 you deposited as initial margin plus transaction
costs.
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Spreads
While most
speculative futures transactions involve a simple purchase of futures
contracts to profit from an expected price increase--or an equally simple
sale to profit from an expected price decrease--numerous other possible
strategies exist. Spreads are one example. A spread, at least in its simplest
form, involves buying one futures contract and selling another futures
contract. The purpose is to profit from an expected change in the relationship
between the purchase price of one and the selling price of the other.
As an illustration, assume it's now November, that the March wheat futures
price is presently $3.10 a bushel and the May wheat futures price is presently
$3.15 a bushel, a difference of 5 cents. Your analysis of market conditions
indicates that, over the next few months, the price difference between
the two contracts will widen to become greater than 5 cents. To profit
if you are right, you could sell the March futures contract (the lower
priced contract) and buy the May futures contract (the higher priced contract).
Assume time and events prove you right and that, by February, the March
futures price has risen to $3.20 and May futures price is $3.35, a difference
of 15 cents. By liquidating both contracts at this time, you can realize
a net gain of 10 cents a bushel. Since each contract is 5,000 bushels,
the total gain is $500.
| November
|
Sell
March wheat |
Buy
May wheat |
Spread |
| |
$3.10
Bu. |
$3.15
Bu. |
5
cents |
| February |
Buy
March wheat |
Sell
May wheat |
|
| |
$3.20
|
$3.35 |
15
cents |
| |
$
.10 loss |
$
.20 gain |
|
Net gain 10 cents
Bu. Gain on 5,000 Bu. contract $500 Had the spread (i.e. the price
difference) narrowed by 10 cents a bushel rather than widened by 10 cents
a bushel the transactions just illustrated would have resulted in a loss
of $500. Virtually unlimited numbers and types of spread possibilities
exist, as do many other, even more complex futures trading strategies.
These, however, are beyond the scope of an introductory booklet and should
be considered only by someone who well understands the risk/reward arithmetic
involved.
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Participating
in Futures Trading
Now that
you have an overview of what futures markets are, why they exist and how
they work, the next step is to consider various ways in which you may
be able to participate in futures trading. There are a number of alternatives
and the only best alternative--if you decide to participate at all--is
whichever one is best for you. Also discussed is the opening of a futures
trading account, the regulatory safeguards provided participants in futures
markets, and methods for resolving disputes, should they arise.
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Deciding
How to Participate
At
the risk of oversimplification, choosing a method of participation is
largely a matter of deciding how directly and extensively you, personally,
want to be involved in making trading decisions and managing your account.
Many futures traders prefer to do their own research and analysis and
make their own decisions about what and when to buy and sell. That is,
they manage their own futures trades in much the same way they would manage
their own stock portfolios. Others choose to rely on or at least consider
the recommendations of a brokerage firm or account executive. Some purchase
independent trading advice. Others would rather have someone else be responsible
for trading their account and therefore give trading authority to their
broker. Still others purchase an interest in a commodity trading pool.
There's no formula for deciding. Your decision should,
however, take into account such things as your knowledge of and any previous
experience in futures trading, how much time and attention you are able
to devote to trading, the amount of capital you can afford to commit to
futures, and, by no means least, your individual temperament and tolerance
for risk. The latter is important. Some individuals thrive on being directly
involved in the fast pace of futures trading, others are unable, reluctant,
or lack the time to make the immediate decisions that are frequently required.
Some recognize and accept the fact that futures trading all but inevitably
involves having some losing trades. Others lack the necessary disposition
or discipline to acknowledge that they were wrong on this particular occasion
and liquidate the position. Many experienced traders
thus suggest that, of all the things you need to know before trading in
futures contracts, one of the most important is to know yourself. This
can help you make the right decision about whether to participate at all
and, if so, in what way. In no event, it bears repeating,
should you participate in futures trading unless the capital you would
commit its risk capital. That is, capital which, in pursuit of larger
profits, you can afford to lose. It should be capital over and above that
needed for necessities, emergencies, savings and achieving your long-term
investment objectives. You should also understand that, because of the
leverage involved in futures, the profit and loss fluctuations may be
wider than in most types of investment activity and you may be required
to cover deficiencies due to losses over and above what you had expected
to commit to futures.
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Trade
Your Own Account
This
involves opening your individual trading account and--with or without
the recommendations of the brokerage firm--making your own trading decisions.
You will also be responsible for assuring that adequate funds are on deposit
with the brokerage firm for margin purposes, or that such funds are promptly
provided as needed. Practically all of the major
brokerage firms you are familiar with, and many you may not be familiar
with, have departments or even separate divisions to serve clients who
want to allocate some portion of their investment capital to futures trading.
All brokerage firms conducting futures business with the public must be
registered with the Commodity Futures Trading Commission (CFTC, the independent
regulatory agency of the federal government that administers the Commodity
Exchange Act) as Futures Commission Merchants or Introducing Brokers and
must be Members of National Futures Association (NFA, the industrywide
self-regulatory association). Different firms offer
different services. Some, for example, have extensive research departments
and can provide current information and analysis concerning market developments
as well as specific trading suggestions. Others tailor their services
to clients who prefer to make market judgments and arrive at trading decisions
on their own. Still others offer various combinations of these and other
services. An individual trading account can be opened
either directly with a Futures Commission Merchant or indirectly through
an Introducing Broker. Whichever course you choose, the account itself
will be carried by a Futures Commission Merchant, as will your money.
Introducing Brokers do not accept or handle customer funds but most offer
a variety of trading-related services. Futures Commission
Merchants are required to maintain the funds and property of their customers
in segregated accounts, separate from the firm's own money. Along
with the particular services a firm provides, discuss the commissions
and trading costs that will be involved. And, as mentioned, clearly understand
how the firm requires that any margin calls be met. If you have a question
about whether a firm is properly registered with the CFTC and is a Member
of NFA, you can (and should) contact NFA's Information Center toll-free
at 800-621-3570 (within Illinois call 800-572-9400).
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Have
Someone Manage Your Account
A
managed account is also your individual account. The major difference
is that you give someone else--an account manager--written power of attorney
to make and execute decisions about what and when to trade. He or she
will have discretionary authority to buy or sell for your account or will
contact you for approval to make trades he or she suggests. You, of course,
remain fully responsible for any losses which may be incurred and, as
necessary, for meeting margin calls, including making up any deficiencies
that exceed your margin deposits. Although an account
manager is likely to be managing the accounts of other persons at the
same time, there is no sharing of gains or losses of other customers.
Trading gains or losses in your account will result solely from trades
which were made for your account. Many Futures Commission
Merchants and Introducing Brokers accept managed accounts. In most instances,
the amount of money needed to open a managed account is larger than the
amount required to establish an account you intend to trade yourself.
Different firms and account managers, however, have different requirements
and the range can be quite wide. Be certain to read and understand all
of the literature and agreements you receive from the broker. Some
account managers have their own trading approaches and accept only clients
to whom that approach is acceptable. Others tailor their trading to a
client's objectives. In either case, obtain enough information and ask
enough questions to assure yourself that your money will be managed in
a way that's consistent with your goals. Discuss
fees. In addition to commissions on trades made for your account, it is
not uncommon for account managers to charge a management fee, and/or there
may be some arrangement for the manager to participate in the net profits
that his management produces. These charges are required to be fully disclosed
in advance. Make sure you know about every charge to be made to your account
and what each charge is for. While there can be no
assurance that past performance will be indicative of future performance,
it can be useful to inquire about the track record of an account manager
you are considering. Account managers associated with a Futures Commission
Merchant or Introducing Broker must generally meet certain experience
requirements if the account is to be traded on a discretionary basis.
Finally, take note of whether the account management
agreement includes a provision to automatically liquidate positions and
close out the account if and when losses exceed a certain amount. And,
of course, you should know and agree on what will be done with profits,
and what, if any, restrictions apply to withdrawals from the account.
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Use
a Commodity Trading Advisor
As
the term implies, a Commodity Trading Advisor is an individual (or firm)
that, for a fee, provides advice on commodity trading, including specific
trading recommendations such as when to establish a particular long or
short position and when to liquidate that position. Generally, to help
you choose trading strategies that match your trading objectives, advisors
offer analyses and judgments as to the prospective rewards and risks of
the trades they suggest. Trading recommendations may be communicated by
phone, wire or mail. Some offer the opportunity for you to phone when
you have questions and some provide a frequently updated hotline you can
call for a recording of current information and trading advice. Even
though you may trade on the basis of an advisor's recommendations, you
will need to open your own account with, and send your margin payments
directly to, a Futures Commission Merchant. Commodity Trading Advisors
cannot accept or handle their customers funds unless they are also registered
as Futures Commission Merchants. Some Commodity Trading
Advisors offer managed accounts. The account itself, however, must still
be with a Futures Commission Merchant and in your name, with the advisor
designated in writing to make and execute trading decisions on a discretionary
basis. CFTC Regulations require that Commodity Trading
Advisors provide their customers, in advance, with what is called a Disclosure
Document. Read it carefully and ask the Commodity Trading Advisor to explain
any points you don't understand. If your money is important to you, so
is the information contained in the Disclosure Document! The
prospectus-like document contains information about the advisor, his experience
and, by no means least, his current (and any previous) performance records.
If you use an advisor to manage your account, he must first obtain a signed
acknowledgment from you that you have received and understood the Disclosure
Document. As in any method of participating in futures trading, discuss
and understand the advisor's fee arrangements. And if he will be managing
your account, ask the same questions you would ask of any account manager
you are considering. Commodity Trading Advisors must
be registered as such with the CFTC, and those that accept authority to
manage customer accounts must also be Members of NFA. You can verify that
these requirements have been met by calling NFA toll-free at 800-621-3570
(within Illinois call 800-572-9400).
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Participate
in Commodity Pool
Another
alternative method of participating in futures trading is through a commodity
pool, which is similar in concept to a common stock mutual fund. It is
the only method of participation in which you will not have your own individual
trading account. Instead, your money will be combined with that of other
pool participants and, in effect, traded as a single account. You share
in the profits or losses of the pool in proportion to your investment
in the pool. One potential advantage is greater diversification of risks
than you might obtain if you were to establish your own trading account.
Another is that your risk of loss is generally limited to your investment
in the pool, because most pools are formed as limited partnerships. And
you won't be subject to margin calls. Bear in mind,
however, that the risks which a pool incurs in any given futures transaction
are no different than the risks incurred by an individual trader. The
pool still trades in futures contracts which are highly leveraged and
in markets which can be highly volatile. And like an individual trader,
the pool can suffer substantial losses as well as realize substantial
profits. A major consideration, therefore, is who will be managing the
pool in terms of directing its trading. While a pool
must execute all of its trades through a brokerage firm which is registered
with the CFTC as a Futures Commission Merchant, it may or may not have
any other affiliation with the brokerage firm. Some brokerage firms, to
serve those customers who prefer to participate in commodity trading through
a pool, either operate or have a relationship with one or more commodity
trading pools. Other pools operate independently. A
Commodity Pool Operator cannot accept your money until it has provided
you with a Disclosure Document that contains information about the pool
operator, the pool's principals and any outside persons who will be providing
trading advice or making trading decisions. It must also disclose the
previous performance records, if any, of all persons who will be operating
or advising the pool lot, if none, a statement to that effect). Disclosure
Documents contain important information and should be carefully read before
you invest your money. Another requirement is that the Disclosure Document
advise you of the risks involved. In the case of
a new pool, there is frequently a provision that the pool will not begin
trading until (and unless) a certain amount of money is raised. Normally,
a time deadline is set and the Commodity Pool Operator is required to
state in the Disclosure Document what that deadline is (or, if there is
none, that the time period for raising, funds is indefinite). Be sure
you understand the terms, including how your money will be invested in
the meantime, what interest you will earn (if any), and how and when your
investment will be returned in the event the pool does not commence trading.
Determine whether you will be responsible for any losses
in excess of your investment in the pool. If so, this must be indicated
prominently at the beginning of the pool's Disclosure Document. Ask
about fees and other costs, including what, if any, initial charges will
be made against your investment for organizational or administrative expenses.
Such information should be noted in the Disclosure Document. You should
also determine from the Disclosure Document how the pool's operator and
advisor are compensated. Understand, too, the procedure for redeeming
your shares in the pool, any restrictions that may exist, and provisions
for liquidating and dissolving the pool if more than a certain percentage
of the capital were to be lost, Ask about the pool
operator's general trading philosophy, what types of contracts will be
traded, whether they will be day-traded, etc. With
few exceptions, Commodity Pool Operators must be registered with the CFTC
and be Members of NFA. You can verify that these requirements have been
met by contacting NFA toll-free at 800-621-3570 (within Illinois call
800-572-9400).
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Regulation
of Futures Trading
Firms and individuals
that conduct futures trading business with the public are subject to regulation
by the CFTC and by NFA. All futures exchanges are also regulated by the
CFTC. NFA is a congressionally authorized self-regulatory organization
subject to CFTC oversight. It exercises regulatory authority with the
CFTC over Futures Commission Merchants, Introducing Brokers, Commodity
Trading Advisors, Commodity Pool Operators and Associated Persons (salespersons)
of all of the foregoing. The NFA staff consists of more than 140 field
auditors and investigators. In addition, NFA has the responsibility for
registering persons and firms that are required to be registered with
the CFTC. Firms and individuals that violate NFA rules of professional
ethics and conduct or that fail to comply with strictly enforced financial
and record-keeping requirements can, if circumstances warrant, be permanently
barred from engaging in any futures-related business with the public.
The enforcement powers of the CFTC are similar to those of other major
federal regulatory agencies, including the power to seek criminal prosecution
by the Department of Justice where circumstances warrant such action.
Futures Commission Merchants which are members of an exchange are subject
to not only CFTC and NFA regulation but to regulation by the exchanges
of which they are members. Exchange regulatory staffs are responsible,
subject to CFTC oversight, for the business conduct and financial responsibility
of their member firms. Violations of exchange rules can result in substantial
fines, suspension or revocation of trading privileges, and loss of exchange
membership.
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Words
of Caution
It is generally against
the law for any person or firm to offer futures contracts for purchase
or sale unless those contracts are traded on one of the nation's regulated
futures exchanges and unless the person or firm is registered with the
CFTC. Moreover, persons and firms conducting futures-related business
with the public must be Members of NFA. Thus, you should be extremely
cautious if approached by someone attempting to sell you a commodity-related
investment unless you are able to verify that the offeror is registered
with the CFTC and is a Member of NFA. In a number of cases, sellers of
illegal off-exchange futures contracts have labeled their investments
by different names--such as "deferred delivery," "forward"
or "partial payment" contracts--in an attempt to avoid the strict
laws applicable to regulated futures trading. Many operate out of telephone
boiler rooms, employ high-pressure and misleading sales tactics, and may
state that they are exempt from registration and regulatory requirements.
This, in itself, should be reason enough to conduct a check before you
write a check. You can quickly verify whether a particular firm or person
is currently registered with the CFTC and is an NFA Member by phoning
NFA toll-free at 800-621-3570 (within Illinois call 800-572-9400).
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Establishing
an Account
At the time you apply
to establish a futures trading account, you can expect to be asked for
certain information beyond simply your name, address and phone number.
The requested information will generally include (but not necessarily
be limited to) your income, net worth, what previous investment or futures
trading experience you have had, and any other information needed in order
to advise you of the risks involved in trading futures contracts. At a
minimum, the person or firm who will handle your account is required to
provide you with risk disclosure documents or statements specified by
the CFTC and obtain written acknowledgment that you have received and
understood them. Opening a futures account is a serious decision--no less
so than making any major financial investment--and should obviously be
approached as such. Just as you wouldn't consider buying a car or a house
without carefully reading and understanding the terms of the contract,
neither should you establish a trading account without first reading and
understanding the Account Agreement and all other documents supplied by
your broker. It is in your interest and the firm's interest that you clearly
know your rights and obligations as well as the rights and obligations
of the firm with which you are dealing before you enter into any futures
transaction. If you have questions about exactly what any provisions of
the Agreement mean, don't hesitate to ask. A good and continuing relationship
can exist only if both parties have, from the outset, a clear understanding
of the relationship. Nor should you be hesitant to ask, in advance, what
services you will be getting for the trading commissions the firm charges.
As indicated earlier, not all firms offer identical services. And not
all clients have identical needs. If it is important to you, for example,
you might inquire about the firm's research capability, and whatever reports
it makes available to clients. Other subjects of inquiry could be how
transaction and statement information will be provided, and how your orders
will be handled and executed.
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If
a Dispute Should Arise
All but a small percentage
of transactions involving regulated futures contracts take place without
problems or misunderstandings. However, in any business in which some
150 million or more contracts are traded each year, occasional disagreements
are inevitable. Obviously, the best way to resolve a disagreement is through
direct discussions by the parties involved. Failing this, however, participants
in futures markets have several alternatives (unless some particular method
has been agreed to in advance). Under certain circumstances, it may be
possible to seek resolution through the exchange where the futures contracts
were traded. Or a claim for reparations may be filed with the CFTC. However,
a newer, generally faster and less expensive alternative is to apply to
resolve the disagreement through the arbitration program conducted by
National Futures Association. There are several advantages:
- You can elect,
if you prefer, to have arbitrators who have no connection with the futures
industry.
- You do not have
to allege or prove that any law or rule was broken only that you were
dealt with improperly or unfairly.
- In some cases,
it may be possible to conduct arbitration entirely through written submissions.
If a hearing is required, it can generally be scheduled at a time and
place convenient for both parties.
- Unless you wish
to do so, you do not have to employ an attorney.
For a plain language
explanation of the arbitration program and how it works, write or phone
NFA for a copy of Arbitration: A Way to Resolve Futures-Related Disputes.
The booklet is available at no cost.
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What
to Look for in a Futures Contract?
Whatever
type of investment you are considering--including but not limited to futures
contracts--it makes sense to begin by obtaining as much information as
possible about that particular investment. The more you know in advance,
the less likely there will be surprises later on. Moreover, even among
futures contracts, there are important differences which--because they
can affect your investment results--should be taken into account in making
your investment decisions.
The
Contract Unit
Delivery-type
futures contracts stipulate the specifications of the commodity to be
delivered (such as 5,000 bushels of grain, 40,000 pounds of livestock,
or 100 troy ounces of gold). Foreign currency futures provide for delivery
of a specified number of marks, francs, yen, pounds or pesos. U.S. Treasury
obligation futures are in terms of instruments having a stated face value
(such as $100,000 or $1 million) at maturity. Futures contracts that call
for cash settlement rather than delivery are based on a given index number
times a specified dollar multiple. This is the case, for example, with
stock index futures. Whatever the yardstick, it's important to know precisely
what it is you would be buying or selling, and the quantity you would
be buying or selling.
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How
Prices are Quoted
Futures
prices are usually quoted the same way prices are quoted in the cash market
(where a cash market exists). That is, in dollars, cents, and sometimes
fractions of a cent, per bushel, pound or ounce; also in dollars, cents
and increments of a cent for foreign currencies; and in points and percentages
of a point for financial instruments. Cash settlement contract prices
are quoted in terms of an index number, usually stated to two decimal
points. Be certain you understand the price quotation system for the particular
futures contract you are considering.
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Minimum
Price Changes
Exchanges
establish the minimum amount that the price can fluctuate upward or downward.
This is known as the "tick" For example, each tick for grain
is 0.25 cents per bushel. On a 5,000 bushel futures contract, that's $12.50.
On a gold futures contract, the tick is 10 cents per ounce, which on a
100 ounce contract is $10. You'll want to familiarize yourself with the
minimum price fluctuation--the tick size--for whatever futures contracts
you plan to trade. And, of course, you'll need to know how a price change
of any given amount will affect the value of the contract.
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Daily
Price Limits
Exchanges
establish daily price limits for trading in futures contracts. The limits
are stated in terms of the previous day's closing price plus and minus
so many cents or dollars per trading unit. Once a futures price has increased
by its daily limit, there can be no trading at any higher price until
the next day of trading. Conversely, once a futures price has declined
by its daily limit, there can be no trading at any lower price until the
next day of trading. Thus, if the daily limit for a particular grain is
currently 10 cents a bushel and the previous day's settlement price was
$3.00, there can not be trading during the current day at any price below
$2.90 or above $3.10. The price is allowed to increase or decrease by
the limit amount each day. For some contracts, daily price limits are
eliminated during the month in which the contract expires. Because prices
can become particularly volatile during the expiration month (also called
the "delivery" or "spot" month), persons lacking experience
in futures trading may wish to liquidate their positions prior to that
time. Or, at the very least, trade cautiously and with an understanding
of the risks which may be involved. Daily price limits set by the exchanges
are subject to change. They can, for example, be increased once the market
price has increased or decreased by the existing limit for a given number
of successive days. Because of daily price limits, there may be occasions
when it is not possible to liquidate an existing futures position at will.
In this event, possible alternative strategies should be discussed with
a broker
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Position
Limits
Although
the average trader is unlikely to ever approach them, exchanges and the
CFTC establish limits on the maximum speculative position that any one
person can have at one time in any one futures contract. The purpose is
to prevent one buyer or seller from being able to exert undue influence
on the price in either the establishment or liquidation of positions.
Position limits are stated in number of contracts or total units of the
commodity. The easiest way to obtain the types of information just discussed
is to ask your broker or other advisor to provide you with a copy of the
contract specifications for the specific futures contracts you are thinking
about trading. Or you can obtain the information from the exchange where
the contract is traded.
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Understanding
(and Managing) the Risks of Futures Trading
Anyone buying
or selling futures contracts should clearly understand that the Risks
of any given transaction may result in a Futures Trading loss. The loss
may exceed not only the amount of the initial margin but also the entire
amount deposited in the account or more. Moreover, while there are a number
of steps which can be taken in an effort to limit the size of possible
losses, there can be no guarantees that these steps will prove effective.
Well-informed futures traders should, nonetheless, be familiar with available
risk management possibilities.
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Choosing
a Futures Contract
Just as
different common stocks or different bonds may involve different degrees
of probable risk. and reward at a particular time, so may different futures
contracts. The market for one commodity may, at present, be highly volatile,
perhaps because of supply-demand uncertainties which--depending on future
developments--could suddenly propel prices sharply higher or sharply lower.
The market for some other commodity may currently be less volatile, with
greater likelihood that prices will fluctuate in a narrower range. You
should be able to evaluate and choose the futures contracts that appear--based
on present information--most likely to meet your objectives and willingness
to accept risk. Keep in mind, however, that neither past nor even present
price behavior provides assurance of what will occur in the future. Prices
that have been relatively stable may become highly volatile (which is
why many individuals and firms choose to hedge against unforeseeable price
changes).
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Liquidity
There can
be no ironclad assurance that, at all times, a liquid market will exist
for offsetting a futures contract that you have previously bought or sold.
This could be the case if, for example, a futures price has increased
or decreased by the maximum allowable daily limit and there is no one
presently willing to buy the futures contract you want to sell or sell
the futures contract you want to buy. Even on a day-to-day basis, some
contracts and some delivery months tend to be more actively traded and
liquid than others. Two useful indicators of liquidity are the volume
of trading and the open interest (the number of open futures positions
still remaining to be liquidated by an offsetting trade or satisfied by
delivery). These figures are usually reported in newspapers that carry
futures quotations. The information is also available from your broker
or advisor and from the exchange where the contract is traded.
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Timing
In futures
trading, being right about the direction of prices isn't enough. It is
also necessary to anticipate the timing of price changes. The reason,
of course, is that an adverse price change may, in the short run, result
in a greater loss than you are willing to accept in the hope of eventually
being proven right in the long run. Example: In January, you deposit initial
margin of $1,500 to buy a May wheat futures contract at $3.30--anticipating
that, by spring, the price will climb to $3.50 or higher. No sooner than
you buy the contract, the price drops to $3.15, a loss of $750. To avoid
the risk of a further loss, you have your broker liquidate the position.
The possibility that the price may now recover--and even climb to $3.50
or above--is of no consolation. The lesson to be learned is that deciding
when to buy or sell a futures contract can be as important as deciding
what futures contract to buy or sell. In fact, it can be argued that timing
is the key to successful futures trading.
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Stop
Orders
A stop order
is an order, placed with your broker, to buy or sell a particular futures
contract at the market price if and when the price reaches a specified
level. Stop orders are often used by futures traders in an effort to limit
the amount they. might lose if the futures price moves against their position.
For example, were you to purchase a crude oil futures contract at $21.00
a barrel and wished to limit your loss to $1.00 a barrel, you might place
a stop order to sell an off-setting contract if the price should fall
to, say, $20.00 a barrel. If and when the market reaches whatever price
you specify, a stop order becomes an order to execute the desired trade
at the best price immediately obtainable. There can be no guarantee, however,
that it will be possible under all market conditions to execute the order
at the price specified. In an active, volatile market, the market price
may be declining (or rising) so rapidly that there is no opportunity to
liquidate your position at the stop price you have designated. Under these
circumstances, the broker's only obligation is to execute your order at
the best price that is available. In the event that prices have risen
or fallen by the maximum daily limit, and there is presently no trading
in the contract (known as a "lock limit" market), it may not
be possible to execute your order at any price. In addition, although
it happens infrequently, it is possible that markets may be lock limit
for more than one day, resulting in substantial losses to futures traders
who may find it impossible to liquidate losing futures positions. Subject
to the kinds of limitations just discussed, stop orders can nonetheless
provide a useful tool for the futures trader who seeks to limit his losses.
Far more often than not, it will be possible. for the broker to execute
a stop order at or near the specified price. In addition to providing
a way to limit losses, stop orders can also be employed to protect profits.
For instance, if you have bought crude oil futures at $21.00 a barrel
and the price is now at $24.00 a barrel, you might wish to place a stop
order to sell if and when the price declines to $23.00. This (again subject
to the described limitations of stop orders) could protect $2.00 of your
existing $3.00 profit while still allowing you to benefit from any continued
increase in price.
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Spreads
Spreads
involve the purchase of one futures contract and the sale of a different
futures contract in the hope of profiting from a widening or narrowing
of the price difference. Because gains and losses occur only as the result
of a change in the price difference--rather than as a result of a change
in the overall level of futures prices--spreads are often considered more
conservative and less risky than having an outright long or short futures
position. In general, this may be the case. It should be recognized, though,
that the loss from a spread can be as great as--or even greater than--that
which might be incurred in having an outright futures position. An adverse
widening or narrowing of the spread during a particular time period may
exceed the change in the overall level of futures prices, and it is possible
to experience losses on both of the futures contracts involved (that is,
on both legs of the spread).
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Options
on Futures Contracts
What are
known as put and call options are being traded on a growing number of
futures contracts. The principal attraction of buying options is that
they make it possible to speculate on increasing or decreasing futures
prices with a known and limited risk. The most that the buyer of an option
can lose is the cost of purchasing the option (known as the option "premium")
plus transaction costs. Options can be most easily understood when call
options and put options are considered separately, since, in fact, they
are totally separate and distinct. Buying or selling a call in no way
involves a put, and buying or selling a put in no way involves a call.
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Buying
Call Options
The buyer
of a call option acquires the right but not the obligation to purchase
(go long) a particular futures contract at a specified price at any time
during the life of the option. Each option specifies the futures contract
which may be purchased (known as the "underlying" futures contract)
and the price at which it can be purchased (known as the "exercise"
or "strike" price). A March Treasury bond 84 call option would
convey 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
for buying call options is to profit from an anticipated increase in the
underlying futures price. A call option buyer will realize a net profit
if, upon exercise, the underlying futures price is above the option exercise
price by more than the premium paid for the option. Or a profit can be
realized it, prior to expiration, the option rights can be sold for more
than they cost. Example: You expect lower interest rates to result in
higher bond prices (interest rates and bond prices move inversely). To
profit if you are right, you buy a June T-bond 82 call. Assume the premium
you pay is $2,000. If, at the expiration of the option (in May) the June
T-bond futures price is 88, you can realize a gain of 6 (that's $6,000)
by exercising or selling the option that was purchased at 82. Since you
paid $2,000 for the option, your net profit is $4,000 less transaction
costs. As mentioned, the most that an option buyer can lose is the option
premium plus transaction costs. Thus, in the preceding example, the most
you could have lost--no matter how wrong you might have been about the
direction and timing of interest rates and bond prices--would have been
the $2,000 premium you paid for the option plus transaction costs. In
contrast if you had an outright long position in the underlying futures
contract, your potential loss would be unlimited. It should be pointed
out, however, that while an option buyer has a limited risk (the loss
of the option premium), his profit potential is reduced by the amount
of the premium. In the example, the option buyer realized a net profit
of $4,000. For someone with an outright long position in the June T-bond
futures contract, an increase in the futures price from 82 to 88 would
have yielded a net profit of $6,000 less transaction costs. Although an
option buyer cannot lose more than the premium paid for the option, he
can lose the entire amount of the premium. This will be the case if an
option held until expiration is not worthwhile to exercise.
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Buying
Put Options
Whereas
a call option conveys the right to purchase (go long) a particular futures
contract at a specified price, a put option conveys the right to sell
(go short) a particular futures contract at a specified price. Put options
can be purchased to profit from an anticipated price decrease. As in the
case of call options, the most that a put option buyer can lose, if he
is wrong about the direction or timing of the price change, is the option
premium plus transaction costs. Example: Expecting a decline in the price
of gold, you pay a premium of $1,000 to purchase an October 320 gold put
option. The option gives you the right to sell a 100 ounce gold futures
contract for $320 an ounce. Assume that, at expiration, the October futures
price has--as you expected-declined to $290 an ounce. The option giving
you the right to sell at $320 can thus be sold or exercised at a gain
of $30 an ounce. On 100 ounces, that's $3,000. After subtracting $1,000
paid for the option, your net profit comes to $2,000. Had you been wrong
about the direction or timing of a change in the gold futures price, the
most you could have lost would have been the $1,000 premium paid for the
option plus transaction costs. However, you could have lost the entire
premium.
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How
Option Premiums are Determined
Option premiums
are determined the same way futures prices are determined, through active
competition between buyers and sellers. Three major variables influence
the premium for a given option: * The option's exercise price, or, more
specifically, the relationship between the exercise price and the current
price of the underlying futures contract. All else being equal, an option
that is already worthwhile to exercise (known as an "in-the-money"
option) commands a higher premium than an option that is not yet worthwhile
to exercise (an "out-of-the-money" option). For example, if
a gold contract is currently selling at $295 an ounce, a put option conveying
the right to sell gold at $320 an ounce is more valuable than a put option
that conveys the right to sell gold at only $300 an ounce. * The length
of time remaining until expiration. All else being equal, an option with
a long period of time remaining until expiration commands a higher premium
than an option with a short period of time remaining until expiration
because it has more time in which to become profitable. Said another way,
an option is an eroding asset. Its time value declines as it approaches
expiration. * The volatility of the underlying futures contract. All rise
being equal, the greater the volatility the higher the option premium.
In a volatile market, the option stands a greater chance of becoming profitable
to exercise.
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Selling
Options
At this
point, you might well ask, who sells the options that option buyers purchase?
The answer is that options are sold by other market participants known
as option writers, or grantors. Their sole reason for writing options
is to earn the premium paid by the option buyer. If the option expires
without being exercised (which is what the option writer hopes will happen),
the writer retains the full amount of the premium. If the option buyer
exercises the option, however, the writer must pay the difference between
the market value and the exercise price. It should be emphasized and clearly
recognized that unlike an option buyer who has a limited risk (the loss
of the option premium), the writer of an option has unlimited risk. This
is because any gain realized by the option buyer if and when he exercises
the option will become a loss for the option writer.
|
Reward
|
Risk
|
| Option
Buyer |
Except
for the premium, an option buyer has the same profit potential
as someone with an outright position in the underlying futures
contract. |
An
option maximum loss: is the premium paid for the option |
| Option
Writer |
An
option writer's maximum profit is premium received for writing
the option |
An
option writer's loss is unlimited. Except for the premium received,
risk is the same as having an outright position in the underlying
futures contract. |
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In
Closing
The foregoing
is, at most, a brief and incomplete discussion of a complex topic. Options
trading has its own vocabulary and its own arithmetic. If you wish to
consider trading in options on futures contracts, you should discuss the
possibility with your broker and read and thoroughly understand the Options
Disclosure Document which he is required to provide. In addition, have
your broker provide you with educational and other literature prepared
by the exchanges on which options are traded. Or contact the exchange
directly. A number of excellent publications are available. In no way,
it should be emphasized, should anything discussed herein be considered
trading advice or recommendations. That should be provided by your broker
or advisor. Similarly, your broker or advisor--as well as the exchanges
where futures contracts are traded--are your best sources for additional,
more detailed information about futures trading.
Source:
National Futures Association; published here with permission.
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