near in-the-money as protection. This is nota sign of weakness. It is a sound business decision. Another suggestion is to continually take excess profits out of your account.Then, when you do have a drawdown, it is not as crushing. You stillhave profits to show. You don’t feel as threatened, and fear doesn’toverwhelm you.Futures trading is a very personal challenge. To check your preparedness, complete the Financial-Psychological Worksheet in Figure 1.1.F I G U R E
1.1
Financial Psychological Worksheet1. Never invest more than you can afford to lose in highly speculative investments such as futures and options trading. Don’t invest more than 10 percent of net liquid assets (those that are cash or can be converted to cash within 24 hours) in the futures market. And don’t put more than 10 percent of this10 percent amount in any one position.Net liquid assets (NLA)Cash-savings/checking accountsCDs and money market funds
$———————————————$ ———————————————(continued)
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Bonds–—Treasury, etc.$———————————————Publicly traded stocks$———————————————Other$———————————————Total$———————————————Risk capital*—10% of NLA$———————————————*If this is less than $5,000, consider trading options rather than futures.2.
Before opening a futures or options trading account, have the following:
————————
Adequate life insuranceA sufficient net worth to sustain your lifestyle in the event all orpart of the NLA is lost
3. Examine your attitude toward risk.————————————
Risk averse (avoid futures trading programs)Risk neutral (consider options or managed programs)Aggressive risk taker (consider futures and managed programs)
4. Determine the annual percentage rate of return you desire from the fundscommitted. The higher the expected return, the higher the risk will normallybe.————25%————50%————75%5.
————100%————150%————200% or higher
Qualify your past investment experience.
———— Minimal6.
———— Experienced
Access your personal knowledge of the futures market.
———— Very good7.
———— Adequate
———— Medium
———— None
Measure your reaction to pressure.
———— Checks for $10,000 or more for an investment increase heartrate.———— Losing money causes sleepless nights.———— Taking the good and bad in stride is no problem.———— Gambling and taking chances are enjoyable.———— Seriously describe behavior when under financial pressure:————————————————————————————————————————————————————————————————
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8. Rate your ability to accept the follwing negative facts of trading:———— Numerically, there are more losing trades than winning ones.———— Trading accounts will regularly experience drawdowns of equity.———— Occasional margin calls are inevitable.9. Check off what trading successfully means to you:———— Cutting losing trades short and letting winners run———— Controlling pride, greed, hope, and fear———— Writing a plan that includes goals———— Keeping a trading journal———— Developing a trading system———— Selecting a broker that complements my character and limitations———— Funding my account adequatelyThere are no right or wrong responses to these items. After answering themhonestly, review your answers with someone you trust. Then carefully andthoughtfully make your decision about whether you are ready to become a futures trader.
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C H A P T E R
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Understanding the Basicsfor Futures Trading
Key Concepts◆ The Development of the Futures Market◆ Forward Contracts versus Futures Contracts◆ Standardization of Contracts◆ Manage Up (Bull), Down (Bear), and Sideways MovingMarkets◆ Discovery of Price Trends
When you buy a futures contract, you agree to be contingentlyliable for accepting delivery of a specific amount of a specific commodity at a specific time in the future at a specific price. Every futures contract is carefully defined as to size, quality, quantity, delivery location, and delivery date. (See Figure 2.1 and the Appendix.)When you buy a contract, you are considered to be “long” the commodity. It “be-longs” to you. You own it at a given price.On a cash commodity basis, when you are long, you have physical possession of the commodity. For example, a farmer with 5,000bushels of No. 2 corn in a bin on the farm or at a grain elevator islong cash corn.When you sell a futures contract, you contingently agree to deliver a specific amount of a specific commodity at a specific time inthe future at a specific price and location. If you are a seller of a futures contract, you are short. You are currently “short” of the com-
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2.1
Basic Futures Trading StrategyOffset positions at a better price than you originally paid for them.Long the MarketObjective:Example:Initial position:Offsetting position:Results:
Buy low, sell high.You decide to go long the deutsche mark becauseyou believe it is going higher.Buy 1 June d-mark at 55 cents on the IMM ExchangeSold 1 June d-mark at 60 cents on the IMM ExchangeA 5-cent profit was realized. Since 1 cent equals$1,250, a total profit of $6,250 was earned. Fromthis, a brokerage commission and NFA, FCM, andexchange fees would be deducted, or approximately$100.
Short the MarketObjective:Example:Initial position:Offsetting position:Result:
Sell high, buy low.You decide to short gold because you believe it’s going to decline in value.Sell 1 August gold contract a $500 per ounce onCOMEX.Buy 1 August gold contract at $450 per ounce onCOMEX.A $50 per ounce profit was realized. Since eachCOMEX contract contains 100 troy ounces of gold, atotal profit of $5000 was earned. From this would bededucted the transaction costs (brokerage commission; NFA, FCM, and exchange fees), which could be$100 more or less.
Note: See the appendix, “Contract Specifications.” An offsetting futures position must be for the same commodity, delivery month, quantity, and exchange, but on the opposite side of the market, as the initial position.
modity. On a cash basis, a farmer would be short corn if it is currently not in the inventory. It has been agreed to accept delivery ofa specific number of bushels of corn of a specific grade (quality) ata specific location (grain elevator) at a specific time and price.A little historical perspective may help in explaining this basic
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concept. The modern futures markets began to develop in the early1800s. Chicago, because it was a strong financial center in the heartof the corn, cattle, and hog country, was one of the early centers. Itis still a leading center today.SURPLUS TO SHORTAGE PROBLEMS
At harvest each year, farmers hauled to town the grain they couldnot use as livestock feed. Chicago became a natural basin for this excess grain because of transportation routes. Harvest was a time ofsurpluses. Grain users (feed companies, stockyards, processors,etc.) pressed for low prices, often forcing farmers to accept ridiculously low offers.Grain merchants stockpiled as much grain as they could affordat the low harvest prices, but storage facilities were limited. As theyear progressed, the supply of stored grain shrank and users wereforced to bid aggressively for the remaining supply still stored onfarms. Thus began the annual cycle of surpluses to shortages. Violent price swings from harvest lows to late-season highs drove thegrain industry to search out an alternative marketing method. Forward contracts were born.FORWARD CONTRACTS—A USEFULMARKETING TOOL
It’s impossible to appreciate the development of the modern futurescontract without taking a close look at the forward contract—a stillpopular vehicle that allows users to manage risk. A forward contractis an agreement between two parties. The first party agrees to deliver a certain product to the second party at a specified time for aprice agreed upon in advance. The term forward refers to a date forward in time.Forward contracts have been around for ages, but they gainedparticular popularity in the Midwest in the early and middle nineteenth century as farmers began to cultivate the vast prairie. Finding themselves far from the market centers in the East, producersoften had little choice but to transport their excess grain long distances.
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Meanwhile, Chicago, located on the shore of Lake Michigan,was establishing itself as a center of trade in grain, livestock, andother physical commodities. As the city grew and roads, canals, and,eventually, railroads connected to it, Chicago cemented its positionas the supplier of grain to the more populous East, as well as tomuch of the rest of the world.While Chicago became a ready market for Midwestern grain,farmers had little to insulate themselves from cyclical price swings.Without much in the way of storage, producers usually had to taketheir crops to market soon after harvest. What’s more, the farmershad no choice but to take the price offered. Often, prices plummetedas the harvest progressed and the grain markets were flooded withsupply.Eventually, a small group of farmers sought a more efficientway to price their crops, striking agreements with buyers to delivergrain at a set price in the future. If nothing else, the arrangementguaranteed the farmer a set price for the grain. While facing the riskof missing out on added profit if the price fell before the grain wasdelivered, the farmer was seemingly guaranteed not to suffer shouldthe price plunge.Farmers benefited because price risk was being transferred inpart to the buyer. Millers benefited as well. While they would missout on a bargain if prices fell before the grain was delivered, theydidn’t have to worry that prices would rise sharply.It was a great idea in theory. The shortcomings of these earlyforward contracts, however, included the fact that they were difficult to enforce. Since the contracts were agreements jointly betweenthe buyer and seller, farmers were often tempted to wriggle out ifprices rose before they made delivery. Millers were also known torenege on their obligations if prices had fallen in the interim.INADEQUACIES OF FORWARD CONTRACTS
Forward contracts suffer from an inherent problem. They lack flexibility. To understand the limitations of forward contracts, considerthe following situation. On July 15, a farmer has 100 acres of landplanted to corn. The crop seems healthy, and the farmer expects 100bushels of corn per acre, or 10,000 bushels. On the same date, a corn
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oil refiner checks the inventory and decides 10,000 bushels areneeded at harvest time to meet the production schedule.The farmer feels confident that 10,000 bushels of corn will bedelivered at harvest, and a buyer needs to be found willing to setthe price. The corn oil refiner is sure that 10,000 bushels of corn atharvest time will be needed and wants to lock in a price.As the corn buyer and the seller bargain, they hammer out thespecifics of a forward contract. They agree upon:A price—$2.50Quality—No. 2 yellow cornQuantity—10,000 bushelsDelivery place—the refiner’s siteTime of delivery—October 10The seller of the grain signs the contract, obligating himself to deliver.If the price of corn declines during the contract period, the seller would be protected, but the buyer would have a loss of opportunity—the opportunity to buy at a cheaper price. If the price rose, thebuyer would enjoy the lower price, but the seller would lose the opportunity to sell at a higher price.Suppose that after signing the forward contract, the cornfarmer experiences a major crop failure that cuts production in half.The forward contract obligates the farmer to deliver 10,000 bushels,so the farmer would have to purchase corn in the cash (open) market, thus compounding the loss.A similar problem could arise for the refiner if a decline in thevalue of corn oil were to dictate a reduction in oil output. The refiner is contractually bound to accept delivery of and pay for 10,000bushels of corn. A portion of this corn would likely have to be soldin the open market at a lower price if it is not used for oil production.The forward contract was an improvement over producingand holding grain in the hopes of higher prices; however, it stillproved to be an inefficient and inflexible way to market crops whensupply or demand changed unexpectedly. Grain buyers and sellersneeded more flexibility.
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DEVELOPMENT OF CONTRACT STANDARDS
As forward contracts became more common, speculators appearedon the scene. They hoped to make a profit by assuming temporarybuy or sell positions in forward contracts. For example, a sellerwants to create a forward contract to price for future delivery ofgrain but lacks a commercial buyer. A speculator might step in andsign the buyer’s side of the contract with the objective of finding acommercial buyer at a later date. The speculator hopes to profit byreselling the forward contract at a higher price.Assume that a speculator takes the buy side of a wheat producer’s forward contract. Shortly afterward, prices of forward contracts begin to rise. The speculator realizes that the forward contractcan now be sold at a profit—say, 10 cents per bushel higher. The contract can be sold to a commercial grain buyer for a profit. In that case,the grain buyer must be willing to accept the specific details of theoriginal contract. The speculator’s profit is the 10-cent difference between the original contract price and the resale price. On a 10,000bushel contract, $1,000 has just been made.As you can see, trading or speculating in grain by forward contracts can be cumbersome, inefficient, and restrictive. The ChicagoBoard of Trade, established in 1848 with 82 members, was formedin large part to encourage a smoother transfer of forward contracts.The existence of a centralized marketplace highlighted the need forstreamlined trading procedures. Over time, these forward contractsacquired specific standards for quantity, quality, commodity, delivery place, and date. They, thus, became similar to modern futurescontracts—one of the most flexible, innovative pricing mechanismsin the history of commerce.Although the Chicago Board of Trade was charged initiallywith promoting commerce in general, one of its first accomplishments was to set standards for wheat, as well as to implement an inspection system. By 1865, following years of volatile global and local price action due to the Crimean War and, later, the U.S. Civil War,the exchange had adopted rules that defined the first real futurescontracts. While modifications and additions were to come, themodern futures contract had been born.Essentially, futures contracts differ from forward contracts inseveral key ways. First, futures contracts are traded on exchanges,
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while forward contracts are two-party agreements between a buyer and a seller. Second, futures contracts rely on standards that determine the product being delivered will be of uniform quality. Also,a futures contract sets a specific quantity to be traded, while the sizeof a forward contract is set by the buyer and the seller.Forward contracts require counterparty vigilance. Since futuresare traded on an exchange, buyers and sellers needn’t worry whetheror not the person they trade with will make good on the contract.That’s because the exchange clearinghouse guarantees that the other side of the trade will be fulfilled if either the buyer or seller defaults. There’s no clearinghouse to stand between a buyer and sellerin a forward contract. That means both parties in a forward mustkeep close track of their trading partner’s creditworthiness.Forward contracts don’t allow users to easily change marketing plans. Futures provide more flexibility. For example, a farmerwho sold, or went short, a November soybean futures contract inMarch, expecting the price to go down, could see a summer droughtpush the price of soybeans substantially higher. At that point, thefarmer could buy back the November contract, eliminating the shortposition—leaving the farmer long the cash soybean market basedon the crop that is in the fields. With a forward contract, the producer is locked into delivering the soybeans to the local elevator atthe price established in March.A forward contract’s value isn’t “marked to market” until itcomes due. Exchanges require that each futures account be markedto market at the end of each trading day. That means that each position in the market is assigned a value based on the day’s closingprice. A trader holding a losing position may be required to post additional margin or else close out the position. This keeps big losingpositions from accumulating and lowers the risk of default. Sinceforward markets aren’t marked to market, the risk that a tradingpartner could default in a volatile market is higher.Forward transactions are often more complex than futurestransactions. Complex financial transactions can often be executedmore easily in the futures market than in the forward market. Abank whose client wants to borrow money in September, and repayin December, would be exposed to interest rate risk if it quoted afixed rate. To offset the risk in the forward market, the institutionwould have to make two trades, lending to September and borrow-
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ing from December. Futures would allow the bank to execute a single trade, selling 3-month Eurodollar futures for settlement in September.If the bank wanted to unwind the position before September, itwould simply offset the futures position by buying back a September contract, eliminating the short position.FUTURES CONTRACTS
Futures contracts have only one buyer and one seller at any momentin time. The creation of a contract simply depends on one buyer andone seller agreeing on a price. This is accomplished by “open outcry” in the pits on the floors of the exchanges. All other specifications, except for the number of contracts to be bought or sold, arestandardized.You, as a trader, transmit your trading order (to buy or to sella futures contract) to your broker. Your broker in turn communicateswith the order desk on the floor of the exchange that trades the specific futures contract you want to trade. The floor order desk givesyour trade to the floor trader in the pits. Once your order is filled,the process is reversed and your broker calls you with your fill (theprice at which you bought or sold the contract).To offset your position in the futures market, you need only tofind a substitute seller or buyer. You do this by giving your brokeran equal but opposite order to your current futures position. Onlyabout 3 percent of futures contracts are actually delivered. Therefore, initiating and offsetting futures positions are carried out in thesame way.Because futures contracts are standardized, ownership, transfer, and substitutions are accomplished without endangering theoriginal purpose of the forward markets—which is to set price, facilitate delivery, and transfer risk. Futures contracts can changehands many times before their delivery date (expiration). Historically, the increased use of futures by speculators makes the marketmore efficient and actually reduces price fluctuations.Without active involvement of speculators, buyers’ and sellers’price differences (the bid and offer price spread) would widen andprices would fluctuate more dramatically. Furthermore, withoutthis speculative activity, the consumer would have to pay higher
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food prices to compensate grain dealers for the risk of violent priceswings resulting from temporary gluts and shortages.THE IMPORTANCE OF STANDARDIZATION
As stated previously, the Chicago Board of Trade’s adoption of standardized contracts for delivery of grain in 1865 marked the birth ofthe modern futures contract. While forward contracts can be written for any quantity of any commodity for delivery at any time thetwo parties desire, futures contracts are rigidly defined.Futures exchanges establish all the key parameters of a contract. They define its size, the specific grade and class (U.S. No. 2 yellow corn, 30-year U.S. T-bonds) of the underlying commodity orproduct, the month that delivery will take place, and the time period within that month when delivery can occur. The exchanges alsodetermine where delivery can take place.For example, a Chicago Board of Trade corn futures contractsets terms for delivery of 5,000 bushels of U.S. No. 2 yellow corn tobe delivered to an exchange-approved clearinghouse. Available delivery months are March, May, July, September, and December.STANDARDIZATION SIMPLIFIES AND EXPEDITESPRICE DISCOVERY
By defining all the key characteristics of the commodity or productto be delivered, buyers and sellers need only worry about howmany contracts they want to trade and at what price. When a customer phones the broker and places an order to buy two contractsof corn for December delivery, the broker needn’t worry what typeof corn is wanted or where it will be delivered. All orders flowinginto the corn pit are for the same commodity. There’s nothing left forthe traders to shout about other than the price.STANDARDIZATION PROMOTES LIQUIDITY
Standardized delivery grades mean virtually anyone with sufficientcapital can enter the market easily to hedge or speculate. Because thecontracts are standardized, there’s no confusion about what’s on theblock. A speculator who spots what is believed to be a trading op-
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portunity can move into the market quickly, without first hagglingto determine exactly what to buy or sell or when it will be delivered.Similarly, hedgers know whether or not the product beingtraded can be used to offset their own risk in the spot market. Bothspeculators and hedgers can move in or out of the market with ease.Increased participation by speculators and hedgers increasesliquidity, and increased liquidity means lower transaction costs. Ofcourse, for a contract to be a success, it’s crucial that the specifications meet the requirements of end users or liquidity will suffer. Acontract that doesn’t provide delivery of grain when mills most require it offers few advantages. Similarly, delivery of a class of commodity or product that doesn’t fit the commercial user’s hedgingneeds will also have difficulty attracting liquidity.Speculators must also be accommodated. While the terms of agrain contract should readily accommodate both farmers and millers,it must also be of a size that’s attractive to speculators. A contractthat is too big may force potential speculators to pony up a marginbeyond their means. Similarly, a contract too small may attract investors unsuited for the volatility of a particular contract.STANDARDIZATION PRODUCES MORE RELIABLEPRICE INFORMATION
Futures markets offer buyers and sellers more reliable price information than cash and forward markets. Forward markets often offer a number of delivery dates and locations. For most users, particularly nonprofessionals, it is often difficult to determine themarket price. That’s not the case with futures, which offer numerous products and designate a single delivery date for settlement.What’s more, futures quotations offer a combination of theprice for a spot commodity plus the “carrying cost” (interest, insurance, etc.) of holding the commodity until delivery—a feature usually not found in spot market quotations.ROLE OF INVENTORY MANAGER
To really get into the swing of what moves the markets, put yourself behind the desk of someone responsible for managing an inventory of a specific commodity, soybeans for example. Begin atharvest time when the bean supply is plentiful.
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One of the first insights an inventory manager needs is howthis commodity reacts to changes in supply and demand. The principle of elasticity can be defined as a characteristic of commoditieswhich describes the interaction of the supply of, demand for, andprice of a commodity. A commodity is said to be elastic in demandwhen a price change creates an increase or decrease in consumption.It is said to be elastic in supply when a change in price creates achange in the production of the commodity. Inelasticity of supply ordemand exists when either supply or demand is relatively unresponsive to changes in price.Most food and feed commodities respond to changes in price.If soybean prices shoot up, users look for a substitute or ration theirusage of soybeans. Livestock feeders use other sources of protein.Vegetable oil producers and users have a wide variety of substitutesavailable such as sunflower seeds, corn, palm, and coconuts.The professional inventory manager knows soybean prices areelastic. The price stretches and contracts (rises and falls) in relationship to supply and demand. It is known that supplies are usuallyplentiful and prices are relatively low at harvest because manyfarmers do not have or cannot afford storage.Studying the season price information indicates cash soybeanscan be expected to bottom approximately three out of four timesduring the October–November period each year. Therefore, the inventory manager looks at harvest as a buying opportunity. Then thequestion becomes how much to buy or whether to wait and buy asthe beans can be used. The next step is to make an evaluation of theoverall supply and demand (also known as fundamental) of the market. In late fall, the South American crop is planted. How manyhectares? What yields are expected? How aggressively are the governments of Brazil and Argentina promoting production and exportation?Most American farmers are on a cash basis accounting systemand often carry soybeans for sale into the next tax year as a way ofbalancing their income. Traditionally, farm real estate debt comesdue on March 1. This generates another buying opportunity for theinventory manager. Within the same time frame, the South American crop is being harvested and supplies are again plentiful if thecrop is good.In other words, the inventory manager must decide in Novem-
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ber how much to buy between then and spring. Technical analysiscan be a big help. What do the charts indicate? Are prices near longor short-term support areas? How much volatility is in the markets?This gives insight into how wide or narrow the trading range is expected to be. Keep in mind that beans are elastic. They will respondto changes—often widely.When you put yourself in the inventory manager’s seat, allknown and unknown variables come into sharper focus. This is truefor virtually any commodity traded. Suppose you wish to trade thefinancials. You can evaluate interest rates from the standpoint of abank officer inventorying money. What about the S&P 500? Putyourself in the shoes of a mutual fund manager. If you have a $20million stock portfolio to manage, what do you do?The object of this exercise is to gain an overview of the marketyou are interested in trading. Is the trend likely to be up, down, orsideways? If your analysis indicates it is up, you would go long onthe futures or buy call options. If it is down, go short or buy puts. Ifit is sideways, stand aside or learn to trade within the price range.Before trading, you must also gauge the strength of your conviction. Hold back when you get conflicting signals from the seasonals, fundamentals, and other technicals. Your confidence shouldincrease when everything is synchronized.Timing can make all the difference—even when your analysisis absolutely correct. You can be dead right and still lose in the futures market, especially in the short term. In the long term, you musthave the money and the patience to wait for the right time or to getin and out of the market with small, controlled losses until the timing is right for a big win.Also, you can never assume your analysis is infallible. Thereare always unknown factors—dock strikes, floods, droughts, governmental intervention, etc.—that can stampede the market againstyour position. That’s why you need to use special techniques suchas protective stop orders to cover your positions.The beauty and value of the futures market is that every contract eventually reverts to the cash market. When a contract expires,it is either deliverable in the commodity or settled on a cash basis.The cash and the futures markets become one!If you chart the cash price of a specific commodity at a givenlocation and its futures price, particularly in the nearby delivery
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month, you’ll find these two prices usually move together. One doesnot mirror the other, but the patterns are usually similar. Keep inmind that the cash price quote comes from a delivery point such asa grain terminal. This geographical point has specific local influences that explain minor discrepancies that distinguish the cash andfutures markets.Also, the futures price is just that—a price for the commodityat some chronological point in the future. News, crop reports, cycles, seasonals, and all the other influencers of price usually affectthe futures price first and with more impact than in the cash market. Then the price influencers trickle down into the cash market. Itis common to see a 2- or 3-week differential in the trend changes between the futures and the cash markets. Eventually, they becomeone price