2.5%
gold10%
heatingoil 20%
5. Buying futures contracts of the index itself. Some indices markettracking contracts, which enable you to trade in the entire portfolio of the index. This is a very practical method for duplicatingthe range of contracts, but without needing to trade each andevery one directly.6. Exchange-traded funds (ETFs). The relatively new ETF marketprovides great flexibility for investors, letting you enter a rangeof markets with instant diversification. You can own shares ofan ETF without the cost or risk of buying commodities directly;in fact, you can even sell short shares of an ETF, and many evenallow you to write options. Thus, you can write options on abasket of futures contracts, an idea that is appealing to thoserecognizing the potential but unwilling to take the risk of goingshort on individual futures contracts. You can also trade commodity ETF shares the same way you trade stocks, for very lowcost, using your online brokerage account. Deutsche Bank,which trades on the American Stock Exchange (symbol DBC),
How Futures Trades Are Made
33
offered the first commodity ETF in 2006. In the 12-month period through December 2007, this ETF earned more than a20% return. You can trade this fund through your online brokerage account, and it replicates the Deutsche Bank LiquidCommodity Index described previously.Expect the range of commodity-based ETFs to continuegrowing in the future. As of the end of 2007, other commodityETFs include:U.S. Oil Fund (AMEX: USO)streetTRACKS Gold Shares (AMEX: GLD)iShares Silver Trust (AMEX: SLV)JPMorgan Commodity Curve Index (NYSE: JPMCCI)PowerShares Agriculture Fund (AMEX: DBA)PowerShares DB Oil Fund (AMEX: DBO)PowerShares Silver Fund (AMEX: DBS)There is a lot to choose from; but how do you know whichindices are appropriate for you, and which are not? Regardless ofhow you use these indices or decide to enter the market, you needto be able to compare and analyze the index. You can find pertinentinformation in the literature provided by each index. You shouldinclude the following four areas of testing in your comparativeanalysis:1. Rolling method employed. The commodity indices merely trackperformance of futures contracts, and are not set up to takedelivery. So as a delivery date approaches, the index rolls itscontracts, replacing the current one with the next, known as thefront month contract. The roll generates a yield, based on pricedifferences between current contract and the one rolled, whichis going to be worth more (due to the greater amount of time todelivery date). Policies on frequency of rolling vary, and thesepolicies affect yield.2. Weighting calculations. The method an index uses to weight the
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Knowing Your Market
futures it tracks varies as well. Some indices use a productionweighted method, providing greater weight to those commodities based on its level of worldwide production. Others follow acomponent weighting method, calculated on the liquidity level infutures trading. In addition, some indices adjust their weightingperiodically, while others make changes on a continuing basis.3. Components of the index. How does the index determine whatto include? This varies, with some basing their tracking on production value and others on liquidity or volume of trading activity.4. Rebalancing frequency. The components are rarely left intact inone configuration indefinitely. The actual components and theirweighting levels are subject to adjustment, so that the index remains representative of the mix of futures contracts that ittracks. The frequency of this review can determine how out ofdate an index might be, and how long it will be before rebalancing occurs.
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Futures Merchants, Advisors, OperatorsPerhaps the easiest, most flexible, and most affordable method forentering the futures market is through one of the ETFs based on atracking index. This method, accomplished through an online broker in the same manner as buying and selling stocks, is instant,cheap, and relatively safe (at least as safe as trading in stocks, andcertainly far safer than buying futures contracts directly). In itsbrief history, the commodity ETF market, as a whole, has beenmore volatile than the stock market. However, this may reflect actual movement in commodity values more than any inherent tendency toward volatility.One drawback to the ETF approach is that you need to find avenue that closely matches what you are seeking. You may not beable to get an exact match. A recurring criticism of ETFs for notonly commodities, but stocks and sectors as well, is that the netreturn tends to be an average of all the components in the basket.The question is raised, Why not buy the best-performing membersof the basket rather than the whole thing? This is a good idea,
How Futures Trades Are Made
35
as long as you can be assured that you pick the best-performingcomponent in the future. For many traders, the ETF route limitsrisk, but it also limits the opportunity to outperform the market.For these less risk-averse traders, there are three designations forbuying or selling futures contracts directly; the Commodity FuturesTrading Commission, which was formed in 1974 and operatesunder the Futures Modernization Act of 2000, regulates all of thesedesignations.Valuable Resource: For more information about the CFTC, go to theagency’s Web site at www.cftc.gov.
The three regulated commodities designations are:1. The Commodity Trading Advisor (CTA) manages traders’ accounts and maintains detailed records. Disclosure reports haveto be filed periodically with the National Futures Association(NFA), which is the industry’s regulatory body. The CTA actsas a combination of facilitator and advisor to those wanting totrade individually in futures contracts.Valuable Resource: To find out more about the NFA, go to www.nfa.futures.org.
2. A Futures Commission Merchant (FCM) is licensed to acceptand to solicit orders for futures trades, and may also grant creditto customers, including individuals and brokerage housesthrough which investors enter transaction orders. The FCM isrequired to file monthly financial reports with the Division ofClearing and Intermediary Oversight, part of the CFTC.3. A Commodity Pool Operator (CPO) acts as a trading pool formany individuals or companies. The CPO does not have to register directly, but must distribute a disclosure document to clients, send out account statements, and present audited financialstatements. The CPO also must maintain detailed records oftransactions and pool operations, including any transactionsmade by pool officers. The disclosure documents and annualfinancial statements are filed with the NFA. In many respects,
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Knowing Your Market
the CPO operates like stock-based mutual funds, while it is alsopossible for investors to trade in commodities through traditional funds and ETFs. The traditional mutual funds involvedwith commodities rely on professional management to select futures contracts, so they differ from the commodity indices andtheir tracking funds, as well as ETFs, which identify a basket offutures in advance. The traditional mutual funds specializingin commodities include Pimco’s Commodity Real Return Fund(www.pimco.com) and the Oppenheimer Real Asset Fund(www.oppenheimerfunds.com). Because these are traditionalfunds, shares have to be bought directly from management andcannot be traded through brokerage accounts.
■
Publicly Traded Companies and PartnershipsOne way to view the entire futures business is to take a broadereconomic view. The futures market does represent the health andtrend of the U.S. economy in many respects. Because it involvescommodities of all kinds as well as major financial futures (including futures on stocks and stock market indices), virtually every aspect of economic growth and commerce is represented in futurestrading.Even so, this does not mean it is necessary to use futures contracts to take part in this broader economic trend. You can verynarrowly focus your attention through the stock market as well,using futures trends as a benchmark. For example, if you concludethat the energy sector is going to grow substantially over the nextfew months or years, you can invest in the commodity itself, including many variations of energy; or you could buy individual energysector stocks or even a stock market ETF or energy sector index.You can also buy futures on individual stocks, an idea explained ina later chapter; or use options to leverage capital and control blocksof energy company stocks.When you buy publicly traded company stock, you earn dividends as long as you own shares; and capital gains when you sell.You can further use options to create additional cash incomethrough covered call writing, and you can offset stock positions byhedging in the futures market for the sector. Most analysts studying
How Futures Trades Are Made
37
both stocks and futures trading have noticed the relationship between the two. The trends do appear to cross market lines, meaning, for example, that as energy prices rise and futures contractsalso follow the price trend, the stock energy sector also tends tobenefit in the same direction. As a result, buying energy stocks orsector index shares is yet another way to invest in the energy commodity. If you are bearish on a particular futures contract, you mayhesitate to go short in the contract itself, and you might be equallyworried about selling short energy stocks. An alternative is to golong on put options. Although this is a low-risk move as a longposition, it is also a bearish position on the stock or sector.There are many ways to play the futures market other than taking risks directly. The combination of mutual funds, ETFs, commodity indices, and even stock or sector plays including optionspresent you with a vast array of choices.Chapter 3 moves the discussion forward by explaining how toread and interpret the listings you find in the financial press oronline. Futures listings are difficult to read for novices, especially ifyou are accustomed to the relatively simple and straightforwardlistings for stocks.
C
H
A
P
T
E
R
3
READING FUTURESPRICES
F
utures prices are difﬁcult to read for one primary reason: Not all ofthem are in the same unit increments. On the stock market, youare accustomed to seeing share prices quoted in dollars and centsfor virtually every stock available; but in the futures market, thereare many different value increments, as well as varying minimumcontract sizes.
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The Basic Futures QuotationContracts trade under a two-part alphabetical system. First is theone- or two-digit designation for each type of futures contract; second is the delivery month. The symbols for each type of commodityused in this book are:light sweet crude oilunleaded gasheating oilnatural gascocoacoffeecotton
CLHUHONGCCKCCT
frozen concentratedorange juice (FCOJ)sugarcornwheatoatssoybeans
OJSBCWOS38
39
Reading Futures Prices
soybean mealsoybean oilcopperaluminumlumbergold
SMBOHGALLBGC
silverplatinumlive cattlefeeder cattlefrozen pork bellieslean hogs
SIPLLCFCPBLH
Delivery months used in contract quotations are:JanuaryFebruaryMarchAprilMayJune
FGHJKM
JulyAugustSeptemberOctoberNovemberDecember
NQUVXZ
So the February contract for light sweet crude is reported asCLG, for example. When a commodity trades on more than oneexchange, the symbol will be different as well. So it is important toensure that the symbol you refer to matches with the exchangewhere you expect it to trade.There are two popular methods for reporting current futuresprices. First is limited to the contract that is of greatest tradinginterest. This is usually the contract whose delivery date is secondin line. For example, in the month of December, the Decembercontract is about to expire, so most of the ‘‘action’’ is going to beon the March contract. If you see a listing with a single futurescontract, it is usually this second-in-line delivery date.Another method, which more accurately portrays the range ofmarket pricing for a particular grouping of futures, shows all thecontracts over the coming year and, often, over a longer period.You may see as many as 10 or 12 different delivery dates, but volume is going to focus on the second and third in line. Thus, inDecember, the March and June (or April and July) contracts willhave the highest trading volume. Actual delivery months vary bycommodity, so this adds to the confusion, much as the optionsmarket, which also trades on three separate calendar cycles. Unlikeoptions, which always adhere to a three-month expiration cycle,some commodities trade on a monthly series, such as 12 consecutive months and 12 delivery dates.
40
Knowing Your Market
The single-delivery date quotation may vary from one financialnewspaper or online site to another, but at the very least, it willcontain:• The type of commodity, its exchange, and trading increment• Delivery month• Opening price for the latest day• High price for the latest day• Low price for the latest day• Closing price• Change from previous close• Trading volume• Prior settlement price• Open interest (number of contracts)Figure 3-1 summarizes a typical futures quotation for livecattle.This listing reflects prices on the CME, an important distinction. Many commodities trade on more than one exchange. Also inthe heading is the definition of contract size and denomination ofFIGURE 3.1. FUTURES LISTING, SINGLE LINE REPORTcommodity, tradingincrement, and unit
date andtime
12/24/07 11:24 a.m. (EST)CATTLE - LIVE (CME) 40,000 lbs; cents per lb.MTH/STRIKE
OPEN
DEC07
deliverymonth
SESSIONHIGH LOW
CHANGE
VOLUME
PRIORSETTLE
PRIOR OPENVOLUME INT
91.975 92.150 91.300 91.350
-750
1253
92.100
1393
lowestprice
lastprice
openingprice
highestprice
LAST
tradingvolumepricechange
priorprice
priorvolume
3280
contractsopen
41
Reading Futures Prices
the prices that follow. In the case of live cattle futures, the futurescontract size is 40,000 pounds and the prices are shown in centsper pound.The second way that futures contracts are reported is with alisting of all current contracts available. While the information isidentical as that for a single delivery date, it is more revealing whenyou can view all the contracts together. Figure 3-2 gives an example.Notice how the volume and open interest change from one delivery date to another. The greatest volume is normally found inthe second delivery date; in this case, December remains open, butFebruary—the second delivery date—reports the greatest level ofopen interest and volume of trading. This is because commodityindices and ETFs (as well as individual traders) roll out of currentcontracts to avoid the delivery strike, and into the next contract.Because of the continual rolling effect, the tendency is for volumeand open interest to jump between the soonest and next dates; andto then taper off throughout the remaining delivery dates.Each futures contract trades in increments unique to its nature.Live cattle has a trading schedule every other month: February,April, June, August, October, and December. Some trade quarterlyor over 12 consecutive months.FIGURE 3.2. FUTURES LISTING, MULTIPLE LINE REPORT
12/24/07 11:24 a.m. (EST)CATTLE - LIVE (CME) 40,000 lbs; cents per lb.MTH/ SESSIONSTRIKE OPEN
HIGH
LOW
DEC07 91.975FEB08 95.200APR08 97.100JUN08 93.600AUG08 94.900OCT08 99.100DEC08 99.650FEB09 100.500APR09 100.000
92.15095.35097.20094.00095.35099.20099.650100.800100.000
91.30094.92596.82593.40094.80098.90099.200100.500100.000
PRIOR PRIOR OPENLAST CHANGE VOLUME SETTLE VOLUME INT91.350 –75094.975 –55096.900 –70093.550 –82595.000 –72599.050 –57599.500 –125100.500 UNCH100.000 UNCH
12535124351711836861741861
92.10095.52597.60094.37595.72599.62599.625100.500100.000
139332806492 1227604707 634703525 228871520 15524492602512941926015228235
42
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Knowing Your Market
Futures Contract Unit DefinitionsThe volume or weight of a commodity is going to vary by the commodity itself, and the unit of cost used is not the same for all. Youneed to know some important definitions before getting into thespecific unit distinctions. In addition, it is important to recognizethat with a variety of different commodities on the market, the unitsize varies because of some very basic differences. Some are solid,others liquid or gas in form; some are going to be valued by weight,others by volume. And volume valuation means that different agricultural commodities are not going to have the same weight either, so a volume unit size may involve different weight. Preciousmetals are valued in price per ounce, whereas other commoditiescome in price per pound or ton.In the energy market, you will hear about various kinds of oilor gas. Crude oil is highly explosive and flammable and is not commonly used in the form in which it comes out of the ground. Refining is the process by which crude oil is turned into gas, diesel gas,asphalt, heating oil, kerosene, and liquid petroleum gas. This isdone by distillation, based on different boiling points for each product. By-products also are used to manufacture plastics, solvents,detergent, and some fibers (nylon and polyesters). Because thereare many varieties of crude oil, specific and popularly cited typesshow up as separate commodities listings.Reformulated Blendstock for Oxygenate Blending (RBOB) isunleaded gasoline futures, which sell in increments of 42,000 gallons (1,000 barrels). Light sweet crude (containing low viscosityand low sulfur) is the most liquid form of crude oil, which is refinedand processed into many different grades. Brent crude comes fromShell UK Exploration’s North Sea oil fields. Exploration companieshave followed the practice of naming oil fields after birds, and inthis case, the field is named for the brent goose. Natural gas ismeasured in MMBTUs. The MM is Roman numeral for ‘‘a thousand thousand,’’ or one million; BTUs are for British ThermalUnits. One BTU represents the amount of energy needed to increase the temperature of one pint of water by one degree Fahrenheit.In other types of commodities, weights and measurements vary
Reading Futures Prices
43
by name and type. Industrial metals futures are reported in metrictons (MT), which are 1,000 kilograms or about 2,205 pounds. Atroy ounce, used for precious metals futures, is equal to 1/12pound. In comparison, most people who cook are more familiarwith the avoirdupois ounce, which is 1/16 pound.Lumber is measured in board feet. One board foot is equal to apiece of wood measuring one foot long, by one foot across, by oneinch of depth (1⬘ ⳯ 1⬘ ⳯ 1⬙).Many agricultural and livestock futures are measured inpounds. A pound is denoted as lb., which is derived from the Latinlibra, the zodiacal sign shown with scales representing balance.Other agricultural futures are reported in bushels. A bushel is adry measurement of mass, and depending on the commodity,weight is going to vary. One bushel is equal to 2,150.42 cubicinches, and there are four pecks per bushel.Futures for financial instruments are measured in percentages(interest rates), or currency units (dollars, Euros, pounds); andfinancial futures for stocks or indices are reported in dollar valueor index point values.Table 3-1 provides a summary of the most common commodities and their units of measurement in futures contracts.
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Reading Futures ChartsPrice charts for futures contracts are similar to stock price chartsin many important respects. Both show price movement over timeand both use a charting format familiar to most stock market investors or analysts.Figure 3-3 shows a four-month daily chart for live cattle futures that expired in December 2007. The chart shows price trendsas of December 24, 2007. Volume of trades is shown at the bottom.Note how volume falls off to nearly zero as the delivery date approaches.Prices fell over this period. In comparison, prices for Brentcrude oil futures rose, as Figure 3-4 shows. This is a December2007 chart for the contract expiring in February 2008. In this instance, volume remained high because the December contract
44
Knowing Your Market
TA BLE 3.1. COMMODITY UNITS
Commodity
Unit
Commodity
Unit
Light Sweet Crude OilUnleaded GasHeating OilNatural Gas
barrelsgallonsgallonsMMBTUs
Lumber
b.f.
CocoaCoffeeCottonFrozen ConcentratedOrange Juice (FCOJ)SugarCornWheatOatsSoybeansSoybean MealSoybean Oil
MTslbs.lbs.
CopperLeadNickelZincAluminum
MTsMTsMTsMTsMTs
SilverPlatinumGold
t.oz.t.oz.t.oz.
Lean HogsLive CattleFeeder CattleFrozen Pork Bellies
lbs.lbs.lbs.lbs.
lbs.lbs.bushelsbushelsbushelsbushelstonslbs.
lbs.poundsMMBTUs million British Thermal UnitsMTsmetric tonst.oz.troy ouncesb.f.board feet
rolled over to February. This contract was where most of the trading action and open interest were focused at the time.For the live cattle contract, the price and volume trend waspredictable because delivery date was so close. Volume and openinterest also fell as the December delivery date approached. In virtually all futures contracts, proximity of delivery date causes this tooccur, because those with positions roll them forward. So the activity in December contracts declines as those positions are closedand replaced with the next-occurring delivery date.On both of these charts, the section immediately below priceshows trends in the oscillator known as ‘‘moving average convergence/divergence,’’ or MACD. This is a popular measurement ofbuy and sell trends, intended to anticipate momentum in either direction. Two moving averages are calculated (in futures, these are
Reading Futures Prices
45
FIGURE 3.3. LIVE CATTLE—DECEMBER 7 CONTRACT
Source: Charts provided courtesy of TradingCharts.com: http://futures.tradingcharts.com; created with SuperCharts by Omega Research 䉷 1997.
usually 26-day and 12-day averages). MACD is the difference between the two, and the trend itself is measurement of convergence(the two averages moving closer together) or divergence (movingapart).Technicians contend that when MACD falls below a signal line(0.00), it creates a sell signal; and when it moves above, that createsa buy signal. As the trend moves across the signal line, it is called acrossover point. In the first chart for live cattle, MACD was wellabove the signal line in August, but it approached the line at theOctober price peak and then declined below. Prices did fall afterthat point, partially reacting to the MACD trend, and partly due torolling as the delivery date approached. The Brent crude oil futurescontract showed MACD trends well above the line beginning inOctober and continuing into the delivery month.MACD also implies when a futures contract is overbought oroversold. When the shorter-term moving average diverges from thelonger-term (when MACD rises), it becomes likely that the price
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Knowing Your Market
FIGURE 3.4. BRENT CRUDE OIL—FEBRUARY 2008 CONTRACT
Source: Charts provided courtesy of TradingCharts.com: http://futures.tradingcharts.com; created with SuperCharts by Omega Research 䉷 1997.
is overbought and will retreat. On declines, the oversold indicatorpresents the opposite scenario.When MACD moves significantly above or below the futurescontract price (when it diverges), it anticipates a price reversal.Thus, if the MACD is below the daily price line, that implies thatprices are going to fall in the short term. This bearish divergence isequivalent to an oversold condition, but is more likely to be spottedin the moving average lines overlaying daily price trends, than inthe MACD line itself.Beneath the MACD is a second technical indicator, labeled RSI.This is the Relative Strength Index, a momentum indicator basedon price trends. It measures the strength of the current price trend,in comparison to the former trend itself. The line is calculated bycomparing differences in daily closing prices and then calculating
Reading Futures Prices
47
an average. Thanks to the speed and convenience of online freecharts, you do not need to perform the calculation by hand. Likemoving averages, you can avoid the complexities of the math bysimply going to one of the sites that provide free charting.Valuable Resource: One of the many sites offering free futures contractcharts is www.futures.tradingcharts.com.
When you see RSI above 70, it suggests that current price levelsare overbought. The live cattle chart only went above 70 in its earlier period, August 2007. The Brent crude oil also went above thislevel briefly, in September and October. As you can see, the indicator did seem to anticipate downward price movements for the livecattle contract; but in the case of Brent crude oil, the trend wasshort-lived and preceded upward price movement. This inconsistency points out an important aspect of technical analysis: All indicators imply trends but don’t prove them, and any interpretationshould be done in conjunction with a range of different attributes.The RSI is expected to remain between 40 and 80 in most conditions. When it falls below 40, it indicates an oversold condition.The cattle futures contract did not fall below that level until deliverydate was quite close. The Brent contract briefly touched that levelearly on but, like its later trend, the level held too briefly to serve asa strong indicator. RIS is a measure of the strength in a trend, andshould not be used as a specific buy or sell signal by itself.RSI can also be used as a way to measure a form of divergence.For example, when prices move higher but RSI does not move asyou would expect, it could indicate weakness in the price trend.Generally, as prices rise, you would expect RSI to track. When itdoes not track over 20 or more days, it anticipates a pending pricereversal. The same works in reverse. When prices fall, RSI shouldfollow as well, at least until price becomes oversold. But if RSIremains steady or rises, it indicates that the apparent price trend isweak and will not continue.Both MACD and RSI are technical indicators, and some traders place more importance on them than others. Some highly detailed analysis may be involved for the true believer in technicalanalysis; but in practice, it makes sense to use indicators such as
48
Knowing Your Market
these as part of a broader program of analysis. That should involvemoving average and price comparisons and some strong fundamentals, such as worldwide and domestic supply and demand indicators. For example, if political tensions in the Middle East arebecoming worse, that could easily cause oil prices to rise. If a new,massive oil field is discovered in the United States, or refinery capacity increases, that may cause oil futures prices to fall. The pointis you can use many different indicators to track future prices andto anticipate upcoming price direction. The technical and chartbased patterns of price are valuable, but they are only aspects to abroader trend.
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Types of ChartsThe charts in the previous section show the range of trading in eachday, represented by the daily vertical bar. The high side is the highest price reached on that day, and the low side is the lowest. Thesmaller vertical bars for each day, called ticks, show the day’s opening price (on the left) and closing price (on the right). This formatis called the OHLC (‘‘open, high, low, close’’) chart. If movingaverages are also used on the chart, it is seen as a line movingthrough the series of daily bars. Figure 3-5 summarizes the featuresof the OHLC chart.Another way that price reporting occurs is with the candlestickchart. On this version, the open, high, low, and close prices are alsoshown; but the direction of price movement is also shown, using arectangular bar. A black bar indicates a downward price movementfor the day, and a white bar is used for upward-moving pricetrends. Figure 3-6 shows the features of a candlestick bar.The candlestick chart looks somewhat different than the morefamiliar OHLC. Referring back to Figure 3-5, which was an OHLCchart, the same chart using candlesticks looks like the versionshown in Figure 3-7.You can tell at a glance where trends have evolved with thecandlestick chart. A series of black rectangles represents a downtrend, and a series of white or clear rectangles points the way to anuptrend. For this visual advantage, candlestick charts are popularfor futures charting as well as for stocks. Figure 3-8 shows the
49
Reading Futures PricesFIGURE 3.5. OHLC CHART
movingaverage
PRICE
LEVEL
highestprice
lowestprice
openingprice
closingprice
T I M E
FIGURE 3.6. CANDLESTICK FORMATIONS
highestrangeclosingprice
openingpriceup daydown day
openingpriceclosingpricelowestrange
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Knowing Your Market
FIGURE 3.7. CANDLESTICK CHART
PRICE
LEVEL
T I M E
wheat futures contract for March 2008 as of late December 2007in OHCL format, and Figure 3-9 shows it in candlestick format.The next chapter moves beyond the methods for accessingprice, and explores the broader question of risk. Every investor andtrader should be interested in defining various kinds of risk beforeplacing money into a market. Futures risk is not the same as therisks in stocks or other markets.
Reading Futures Prices
51
FIGURE 3.8. WHEAT—MARCH 2008 CONTRACT
Source: Charts provided courtesy of TradingCharts.com: http://f