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Energy
Futures |
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Crude
Oil, Propane,
Natural
Gasoline,
Unleaded Gasoline, Heating
Oil/Diesel, Unleaded Gas,
Natural
Gas |
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Industrial
Metals Futures |
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Copper,
Aluminum,
Cadmium,
Chromium,
Cobalt,
Magnesium,
Manganese,
Mercury,
Nickel,
Zinc,
Tin,
Steel/Iron,
Lead
, Tungsten,
Titanium,
Vanadium,
Uranium,
Palladium
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Precious
Metals Futures |
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Gold,
Silver,
Platinum |
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Grains
Futures |
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Corn,
Canola,
Soybeans,
Soybean Meal, Sunflowerseed,
Soybean
Oil, Azuki
Beans, Palm
Oil, Wheat, Barley,
Oats,
Rice
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Meats
Futures |
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Live
Hogs, Live
Cattle, Pork
Bellies
Feeder
cattle |
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Food/Fibre/Softs
Futures |
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Cocoa,
Coffee,
Milk,
Plastics,
Pepper,
Potatoes,
Paper,
Salt,
Sugar,
Silk,
Tobacco,
Tea,
Lumber,
Onions,
Wool,
Cotton,
Orange
Juice, Rubber |
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COMMODITY FUTURES TRADING
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| What
are commodities? |
Commodities
are not only essential to life, but they are absolutely necessary
for quality of life. Every person eats. Billions of dollars
of agricultural products are traded daily on the world's commodity
exchanges—everything from soybeans to rice, corn, wheat,
beef, pork, cocoa, coffee, sugar, and orange juice. Food is
where the commodity exchanges began. |
In the middle of the nineteenth century in the United States,
businessmen started organizing market forums to facilitate
the buying and selling of agricultural commodities. Over time,
farmers and grain merchants met in central marketplaces to
set quality and quantity standards and to establish rules
of business. In the course of only a few decades, more than
1,600 Exchanges sprung up at major railheads, inland water
ports, and seaports. In the early twentieth century, as communications
and transportation became more efficient, centralized warehouses
were constructed in major urban centers such as Chicago. Business
became less regional, more national; many of the smaller Exchanges
disappeared.
|
In today's global marketplace, approximately 30 major Exchanges
remain, with 80% of the world's business conducted on about
a dozen of them. Just about every major commodity vital to
commerce, and therefore to life, is represented. Billions
of dollars worth of energy products—from heating oil
to gasoline to natural gas and electricity—are traded
every business day. How could we live without industrial metals
(copper, aluminum, zinc, lead, palladium, nickel, and tin);
precious metals such as gold; or platinum and silver, which
are considered both industrial and precious metals? How could
we live without wood products or textiles? It would be hard
to imagine life without them, and yet few people are aware
of just how the prices for these vital components of life
are set. Unlike 100 years ago, today the world's futures Exchanges
also trade financial products essential to the global economic
function. From currencies to interest rate futures to stock
market indices, more money changes hands on the world's commodity
exchanges every day than on all the world's stock markets
combined.
|
Governments allow commodity exchanges to exist so that producers
and users of commodities can hedge their price risks. However,
without the speculator, the system would not work. Anyone
can be a speculator, and contrary to popular belief, I do
not believe the odds need be stacked against the individual.
In this book, I plan to share with you techniques designed
to help you make money trading commodities. Actually, you
as an individual have one distinct advantage over the big
players, and that's flexibility. You can move quickly, like
a cat, something a giant corporation can't do. Many times,
several of the big commercial operators that utilize the Exchange
for hedging literally hand you your profits on a silver platter—they're
there for a different reason. So, let's start by looking at
how the futures contract works and the various participants
in the marketplace. We'll also look at what they are attempting
to accomplish and how they interact with each other.
|
| |
| What
are futures markets and the futures contract? |
Futures
markets, in their most basic form, are markets in which commodities
(or financial products) to be delivered or purchased at some
time in the future are bought and sold.
The futures contract is the basic unit of exchange in the
futures markets. Each contract is for a set quantity of some
commodity or financial asset and can be traded only in multiples
of that amount. The futures contract is a legally binding
agreement that provides for the delivery of various commodities
or financial entities at a specific time period in the future.
(Prior to the time I was in this business, I envisioned the
parties sitting at a table and actually signing paper contracts.
It's nothing like that.) |
When you buy or sell a futures contract, you don't actually
sign a contract drawn up by a lawyer. Instead, you're entering
into a contractual obligation that can be met in only one
of two ways. The first method is by making or taking delivery
of the actual commodity. This is by far the exception, not
the rule. Less than 2% of all futures contracts are concluded
with an actual delivery. The other way to meet this obligation,
which is the method you most likely will be using, is offset.
Very simply, offset is making the opposite (or offsetting)
sale or purchase of the same number of contracts bought or
sold sometime prior to the expiration date of the contract.
Because futures contracts are standardized, this is accomplished
easily.
|
Every contract on a particular Exchange for a specific commodity
is identical except for price. The specifications are different
for each commodity, but the contract in each market is the
same. In other words, every soybean contract traded on the
Chicago Board of Trade is for 5,000 bushels. Every gold contract
traded on the New York Mercantile is for 100 troy ounces.
Each contract listed on an Exchange calls for a specific grade
and quality. For example, the silver contract is for 5,000
troy ounces of 99.99% pure silver in ingot form. The rules
state that the seller cannot deliver 99.95% pure. Therefore,
the buyers and sellers know exactly what they are trading.
Every contract is completely interchangeable. The only negotiable
feature of a futures contract is price.
|
The size of the contract determines its value. To calculate
how much money you could make or lose on a particular price
movement of a specific commodity, you need to know the following:
-
Contract size
- How
the price is quoted
- Minimum
price fluctuation
- Value
of the minimum price fluctuation
The contract size is standardized. The minimum unit tradable
is one contract. For example, a New York coffee contract is
for 37,500 pounds, a Chicago corn contract is for 5,000 bushels,
and a British Pound contract calls for delivery of 62,500
Pounds Sterling. The contract size determines the value of
a move in price. |
You
also need to know how prices are quoted. For example, grains
are quoted in dollars and cents per bushel: $2.50 per bushel
for corn, $5.50 per bushel for wheat, and so on. Copper is
quoted in cents per pound in New York, and dollars per metric
ton in London. Cattle and hogs are quoted in cents per pound,
whereas gold is quoted in dollars and cents per troy ounce.
Currencies are quoted in the United States in cents per unit
of currency. As you begin trading, you will quickly become
familiar with how this works. Your commodity broker can fill
you in on how prices are quoted on any particular market you
decide to trade. |
The minimum price fluctuation, also known as a "tick,"
is a function of how prices are quoted and is set by the Exchange.
The value of a minimum fluctuation is the dollars and cents
equivalent of the minimum price fluctuation multiplied by
the contract size of the commodity.
|
Except for grains, minimum fluctuations are generally quoted
in points.
In some cases, the value of a minimum move may be more than
a point. In the copper example, the minimum move is 1/20¢
per pound. A penny move is 100 points (for example, if copper
prices rise from $1 per pound to $1.02 per pound, the market
has moved up 200 points), but because the minimum fluctuation
is for 1/20¢, a minimum move is 5 points, or $12.50 per
contract. A move of 1¢ is worth $250, which is 100 points.
You must understand what the value of a move is for the commodity
you are trading. For example, if you are trading soybeans,
you should know that a move of 1¢ is worth $50 per contract
(either up or down), and if you buy three contracts and the
market closes up 10¢ that day, you would make $1,500,
or $500 per contract. If the market closes down 10¢,
you would lose the same amount. Although this might seem confusing
at first, you'll quickly understand the value of a minimum
fluctuation and the value of a point at the time you write
that check for your first margin call. That reminds me of
an amusing true story told to me by my favorite copper broker.
|
On the floor of the COMEX (the world's largest metals Exchange),
where copper is traded, the pit brokers always talk in terms
of points instead of dollar values. You might hear a trader
saying, "I made 300 points today," or "I lost
150 points on that trade." A number of years ago, there
was a big commission house broker (a floor broker who makes
his living filling buy and sell orders from customers who
call in from off the floor) who was pressured by his wife
to hire his brother-in-law. The brother-in-law wasn't all
that bright, but the broker felt his brother-in-law couldn't
do that much damage if he were on the phone as a clerk. After
all, the clerks just take the buy and sell orders over the
phone and run them into the pit to be filled.
|
Some contracts have associated daily price limits, which measure
the maximum amount that the market can move above or below
the previous day's close in a single trading session. Each
Exchange determines whether a particular commodity has a daily
trading limit and for how much. The theory behind the limit-move
rule is to allow markets to cool down during particularly
dramatic, volatile, or violent price moves. For example, the
rules for the soybean contract state that the market can move
up or down 50¢ per bushel from the previous close if
it did not close "limit" the previous day. (Limit
moves result in expanded limits). So if the market closes
at $8.10 per bushel on Tuesday, then on Wednesday it can trade
as high as $8.60 or as low as $7.60. Contrary to popular belief,
the market can trade at the limit price; it just cannot trade
beyond it. At times of dramatic news or price movements, a
market can move to the limit and "lock." A lock-limit
move means that there is an overabundance of buyers (for "lock
limit up") versus sellers at the limit-up price, or that
there is an overabundance of sellers (for "lock limit
down") at the limit-down price. |
In fact, some markets have what are called variable limits,
which is where the limits are raised if a market closes limit
up or limit down during a trading session. Cattle is one of
the markets with variable limits. If one or more contract
months close at the 3¢ (300-point) limit for two successive
days, the limit is raised to 5¢ on the next business
day. (You can consult the Web sites of the various Exchanges
for the daily price-limit rules for each market.) Limit moves
are rare, but they do occur during shocks to a market. Pork
bellies, for example, are notorious for moving multiple limit
days after an unexpectedly bullish or bearish "Hogs and
Pigs Report."
|
Trading hours are set for each individual market by the Exchange.
Cattle opens at 9:00 A.M. Chicago time on the Chicago Mercantile
and closes at 1:00 P.M. sharp. (If your order to sell reaches
the cattle pit at 1:01 P.M., you're out of luck, at least
for that trading session.) As more and more markets become
completely electronic, trading hours won't matter as much
as they used to. Many markets, particularly the financials,
trade on virtually a 24-hour basis. Most of the major markets
have after-hours trading, but some don't. If you miss the
Live Cattle close at 1:00 P.M. Chicago time, for example,
you have no choice but to wait until the next trading day.
If you miss coffee, however, you can trade it in London, but
there is an eight-hour period where coffee futures are not
traded anywhere in the world. If you miss corn, on the other
hand, which closes at 1:15 P.M. central standard time (CST),
you can trade it electronically at night from 5:30 P.M. until
4:00 A.M. the following morning.
|
Before you trade in any market, you need to know, at minimum,
the Exchange the market is traded on, the trading hours, the
contract size, and the delivery months traded. You need to
know how prices are quoted, so that you can put them in the
right priced order, the minimum fluctuation, the dollar value
of the minimum fluctuation, and if there are any daily trading
limits. You also need to know the types of orders accepted
at that particular marketplace. Finally, you want to know
what the margin requirement is for the market you are trading,
and what commission your broker will be charging
|
| |
| How
to sell short or buy long? |
Everyone
knows that if you buy something at one price and sell it for
a higher price, you make money. If you sell it at a lower
price than what you paid for it, you lose money. When you
trade futures, you can buy or sell in whatever order you like.
You can buy and then sell, or sell and then buy. Whichever
you choose, the idea is that the selling price should be higher
than the buying price. One question I've often heard is "How
can you sell what you don't own?" Well, here's how: A
buyer of a futures contract is obligated to take delivery
of a particular commodity or—and this is what happens
most of the time—sell back the contract prior to the
delivery date. The process of selling back, which can be done
anytime during normal market hours (assuming the market is
not "locked limit down" in those markets with limits,
which is a rare occurrence), in effect, wipes the slate clean.
People seem to have no trouble understanding that if you buy
200 shares of General Electric stock that you can sell back
200 shares of General Electric stock at the stock exchange.
Again, if you buy at one price and sell at a higher price,
you make money, and vice versa. |
When trading futures, because you are trading for future delivery,
it is just as easy to sell first and then buy back later.
Selling first is referred to as shorting or selling short.
To offset your obligation to deliver, all you need to do is
to buy back your contract(s) prior to the expiration of the
contract(s). This process of buying back is known as covering.
You "covered your short position" to wipe the slate
clean. The purpose of shorting is to profit from a fall in
prices. If you believe the price of a particular commodity
is going down, due to an oversupply or poor demand, you want
to go short. The objective is to cover at a lower price than
you sold.
|
| |
| How
to use margin and leverage? |
One
of the big attractions—and what makes futures exciting—is
leverage. Leverage is the ability to buy or sell $100,000
of a commodity with only a $5,000 security deposit so that
small price changes can result in huge profits or losses.
Leverage gives you the ability to either make a killing or
get killed. You need to understand how this important concept
works before you trade, and a thorough understanding of the
powers and pitfalls of leverage is imperative to sound money
management principals, which we'll discuss later in the book. |
Each contract bought or sold on a futures Exchange must be
backed by a good-faith deposit called margin. This is not
like buying on margin in the stock market. When a stock market
investor buys on margin, he is, in effect, borrowing half
of the purchase price of the stock from his broker. (Stock
exchange rules prohibit borrowing more than 50%.) The investor
is charged interest on the balance. This provides a degree
of leverage, but nothing like commodities.
|
To see how powerful leverage can be, let's compare a futures
purchase with a stock purchase for cash. If a stock investor
buys 200 shares of a stock trading at $10, his purchase cost
is $2,000. If the stock moves up by 10% to $11 per share,
the investor has made $200 on his $2,000 investment, or 10%.
Margin in commodity trading is like a good-faith deposit.
It is a small percentage, generally in the neighborhood of
2 to 10%, of the value of the underlying commodity represented
by the contract. Margin deposits are set by the Exchange,
and they can change with price movements and market volatility.
Because you are trading for future delivery and not borrowing
anything, no interest is charged on the balance. Margin is
not a partial payment or a down payment, and it's not even
considered a cost. If you make money on the trade, upon liquidation,
your total margin deposit is returned, along with your profits.
Commissions are deducted, and they are a cost. Margin is money
deposited in your brokerage account that serves to guarantee
the performance of your side of the contract. Margin is a
form of "earnest money" deposited by both the longs
and the shorts, and it serves to ensure the integrity of every
futures transaction. In effect, margin ensures that you are
paid when you win, and that whoever is on the other side of
your transaction is paid if you don't.
|
When you enter a position, you have deposited (or will deposit)
the margin money in your account, but your brokerage house
is required to post the margin with a central Exchange arm
called the clearinghouse. The clearinghouse is a non-profit
entity that, in effect, manages the daily process of debiting
the accounts of the losers and redistributing the money to
the accounts of the winners.
|
There are two types of margin: initial margin and maintenance
margin.
Initial margin is the amount that must be in the account before
you place a trade. If you do not have enough initial margin
in your account, you incur a margin call. Most brokerage firms
require the initial margin to be in the account before they
allow a trade to be placed. Some might issue credit for good
customers, but they generally require that the margin call
be met within one to three business days. Any firm has the
right to require same-day deposit by bank wire transfer at
any time and might request this during volatile markets. Maintenance
margin is the amount that must be maintained in your account
as long as the position is active. If the equity balance in
your account should fall below the maintenance margin level,
because of adverse market movements, you incur a margin call
as well. After the margin call is issued, you are required
to meet the call or liquidate the position. If you fail to
meet a margin call in a timely manner, the broker has the
right (and will use it) to liquidate the position for you
automatically. This is done to protect the broker from additional
adverse movements in the market, because he is responsible
for meeting your margin call, even if you're a deadbeat and
don't.
|
If you fail to meet a margin call, and the position is ultimately
liquidated at a loss that leaves a deficit in the account,
the broker is immediately responsible for the deficit, but
you are legally responsible. In other words, initial margin
might not be the extent of your liability. You are responsible
for all losses resulting from your trading activities. If
the market moves against you five, six, or seven days and
you do not get out, if the market moves limit against you
and eats up your margin, you are still responsible for any
and all losses. Later in the book you'll learn ways to manage
the risk, but at this point be aware that whenever you trade
futures, your risk is not limited to the initial margin or
your account balance. It can go further than that. (Options
work differently; they will be discussed later in the book.)
|
For illustrative purposes only, let's assume your account
balance is at $20,000 and that you buy 10 silver contracts.
Your maintenance level is at $15,000. If the market starts
to move your way immediately, you're OK. Because a silver
contract is for 5,000 ounces, a 1¢ move results in a
profit or loss per contract of $50. In this example, the 10
contracts give you a profit or loss of $500 per penny move.
Suppose you buy the 10 contracts at $6, and the market closes
that same day at $6.05. Your account balance is $22,500 on
the close of business that day. You have an unrealized profit
of $2,500. The profit is unrealized because the position is
still open. The increase in equity value of $2,500 is the
result of the 5¢ move in your favor (5¢ times $50
per contract times 10 contracts). Suppose the next day, the
price falls 10¢ to close at $5.95. Your account value
decreases by $5,000 to $17,500. You would not have a margin
call, because your value still would be above the maintenance
level. If on the next day prices rose 5¢ to $6, your
equity value would move back to $20,000.
|
Basically, the futures is the process of generating a credit
or debit daily against your initial position until you close
it out. If you make money on any particular day, the unrealized
credit balance is credited immediately to your account and
debited from the people on the other side of the transaction.
(You will never know who they are because it's completely
anonymous, but they are out there.) If the market closes against
your position on any particular day, the loss would be immediately
debited from your account.
|
Each market has its own margin requirement. This requirement
is based on the volatility of the particular market and also
the volatility of the markets as a whole. Greater volatility
equals greater risk and higher requirements. The S&P 500
index and the NASDAQ are two of the more volatile contracts,
and it is not uncommon to have a daily range of $5,000 per
contract or more in value. The margin requirement for the
S&P can be in a normal period from $7,000 per contract
on up. I have seen the NASDAQ in the high-priced days with
$20,000 range days and $30,000 margin for a single contract.
On the other hand, corn is traditionally less volatile, and
in a normal market, it might have a price range of $250 per
contract. The initial margin might be $400 in a quiet market,
but it could move up to $1,000 in a volatile environment for
corn prices.
|
Here's another important point on margins: Although the Exchange
sets a minimum margin requirement, individual brokerage houses
have the right to charge higher than "Exchange minimum."
This protects the brokerage house from over-traders who tend
to plunge (trade in excess of prudent speculation, even in
excess of their ability to pay), which would require the broker
to make good on his commitment to the clearinghouse.
|
The entire point of this margining system is that all positions
are "marked to the market" by the clearinghouse
daily and revalued to the current market price. As such, profits
and losses are paid daily.
One last point about margins: The Exchange allows initial
margins to be posted either in cash or (in the United States)
U.S. government obligations of less than 10 years to maturity.
If an investor wishes to post T-Bills for margin, he can do
so; most commodity brokers will pass the interest back to
the customer. So, in effect, the initial margin earns interest.
|
| |
| How
to place an order? |
| Market
order |
This
is an order to buy or sell at the prevailing price. By definition,
when a commodity is bought or sold "at the market,"
the floor broker has an order to fill immediately at "the
next best price," but in reality, it is the "next
price." I've seen advice in trading manuals that effectively
states that you should never use a market order. The reasoning
has to do with the bid/offer spread.
|
In an auction market, traders make bids and offers. The
bid is the price put out for immediate acceptance. The offer
(sometimes known as the "asked price") is the
price at which the seller is "offering" for immediate
sale. In most cases, unless the floor broker is able or
willing to pass along the edge to the customer, you buy
at the offer and sell at the bid. You potentially lose this
difference—it may be small—but you can lose
it by placing a market order.
|
| Limit
order |
When
you place this type of order, you know what you will get
in the worst-case scenario (you could get better), but there
are strings attached. With a limit order, the floor broker
is prevented from paying more than the limit on a buy order,
or less than the limit on a sell order. Unless the market
is willing to meet your terms, you will not get in. The
drawback of a limit order is that there is no guarantee
you will get in. You could miss some markets. You are not
even assured you will get in if your limit is hit. In the
preceding example, if you place a limit order to buy at
"50 or better" and the market touches 50, this
may be your trade, or it may be someone else's. You can
be only reasonably assured you are in if the market trades
lower than 50. Nothing is more frustrating than to place
an order to buy at 50, see the market trade there once,
and call the floor to see whether you are filled, only to
receive an "unable" just as the market's crossing
75. That's not to say there isn't a place for limit orders.
I like to use them in quiet, back-and-forth type markets
so as not to give up the slippage seen with a market order.
I also use them to take profits on a good position. I try
to let the market reach out to my limit price. After all,
if the market doesn't reach my limit, I can always revert
to a market order.
|
| Stop
orders |
Stop
orders, or stops, are used in two ways. The most common
method is to cut a loss on a trade that is not working (also
known as a stop loss order). A stop is an order that becomes
a market order to buy or sell at the prevailing price only
if and after the market touches the stop price. A sell stop
is placed under the market, a buy stop above the market.
|
A
stop also can be used to lock in a profit and cut a loss.
In the sugar example, let's say the market starts to move
in your favor, up to 1150. You might decide to cancel your
1050 stop and move it up to 1104, thereby assuring a worst-case
break even or a small loss after commissions. The market
continues to move up, reaching 1210. You move your stop
up to 1150, thereby assuring a profit on the trade, even
if it trades back down. This is, at times, termed a trailing
stop, which occurs when you move your stop with the market.
A buy stop is placed above the market to liquidate a losing
short position. You go short sugar at 1201 and place your
buy stop above the market at 1253 to limit your loss. You
can always cancel and move your buy stop lower, should the
market move in your favor.
|
Stops
also can be used to initiate positions. They're used by
momentum traders who want to enter a market moving in a
certain direction.
|
However,
when used correctly, these can be good orders to enter with.
A sell stop would be used under the market to initiate a
new short position if not in the market. There is, in addition,
a variation of a stop order called a stop limit. With a
stop limit order, if the stop price is touched, a trade
must be executed at the exact price (or better) or held
until the stated price is reached again. The risk with the
stop limit is the same as with a straight limit. In other
words, if the market fails to return to the stop limit level,
the order is not executed, so I normally do not recommend
its use. It can, in a fast moving market, defeat the purpose
of the stop (to stop your loss).
|
| Market
if touched orders |
Also
called MITs, these are the mirror image of stops. An MIT
is placed above the market to initiate a short position.
These are the major types of orders you will use. There
are other exotic orders I've not found useful in practice,
with the exception of the OCO. OCO stands for one cancels
the other. It is used on both sides of the market either
to take profits or cut losses; one cancels the other. For
example, you buy silver at 700, you want to take profits
at 750, or cut the loss if the market trades down to 675.
You could place an order with your broker to sell at 750
or 675 stop; one cancels the other. In this way, you are
assured that if one side is hit, the other side will be
canceled. This is significant in volatile markets. If you
placed two separate orders, and the market first runs up
to 750, takes out your position at a profit, then trades
down to 675, you could be sold into a new short position
you didn't want.
|
| ------------------------------ |
| The above information has
been provide by George Kleinman courtesy of Financial Times
Prentice Hall from his book titled Financial Future: A Step
by Step Guide to Mastering the Markets, 3rd Edition.
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