you only make 5 to 10 trades a year, that’s less than 1 per month.Additionally, 3 or 4 of these are routine rollovers. That’s when youtransfer your position from one contract that is expiring to one thatis still trading. For example, you could roll over from the June oatcontract to the September oat contract. You do this to stay in themost liquid or most heavily traded option. This is done so you canquickly fill an order if you need to when the trend changes againstyour position. You can then reverse your position and go from longto short or short to long. Of course, you could always choose to getout of the market by “standing aside.”CHOOSING A FULL PORTFOLIO
One of the keys to selecting a full portfolio is diversifying your riskover as wide a spectrum as possible. The theory is both offensiveand defensive. It’s offensive in that it is designed to put you in theright place at the right time. By taking a position in several markets,you have a greater possibility of catching a major market move. Noone can anticipate exactly when a given market will make its next
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big move up or down. Therefore, the more markets you are covering, the greater the chance you will be successful.From a defensive stance, by spreading your investment capitalover a wide variety of markets, you won’t always be caught in thewrong market at the wrong time or even the right market at thewrong time.Experience teaches that the different commodity groups arenormally negatively correlated. That means they do not move upand down in unison. When one group is bullish, another is bearishand a third may be moving sideways. For example, if the price ofgrains is high and going higher, it puts pressure on livestock producers because it cuts their profit margin. More livestock are subsequently sent to market sooner, and livestock prices become bearish,moving lower as the cash market is flooded with animals. Negativecorrelation can help you from getting caught with all your eggs inone basket.Therefore, a diversified portfolio would look like this:Grains:Meats:Food/fiber:Metals:Petroleum:Financials:
Corn, oats, soybean oilFeeder cattle, live hogsCoffee, cotton, sugarGoldCrude oil, heating oilJapanese yen, Dollar Index, Muni-Bond Index, S&P 500 Index
A 15-market portfolio, like the one outlined above, requires$40,000 to $50,000 in margin money under normal conditions. Intimes of extreme stress, such as the U.S.-Iraqi war (January 1991),some of the margins in these markets were out of reach. During thatconflict, crude oil and gold margins exceeded $20,000 each on a percontract basis. The exchanges and the FCMs raise margins duringthese periods of stress in an attempt to control volatility. The individual trader is often forced to stand aside certain markets becauseof the inflated margin requirements.
STOCK INDEX PORTFOLIOS
How do you select which markets you should trade? If you have adecent-size stock portfolio or a lot of experience trading stocks, you
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may decide to get involved in the futures market by trading thestock indexes.To begin with, you have several choices when you decide totrade the stock indexes. Additionally, some of them, such as the S&P500, have an option liquid enough for the average trader to utilize.Prior to the bull rally in stocks, traders only had three other indexes besides the S&P 500 to track—the Major Market Index (MMI), theNew York Stock Exchange (NYSE) Composite, and the Value Line.As the bull market has flourished and developed a strong technology sector, there has been a proliferation of indexes. It is very important to understand the composition of these indexes in order toattempt to predict how they will react to changing market conditions. Several indexes have a broad base of stocks, while one, theMMI, contains only 20 (see Figure 3.1).The Value Line is the broadest-based index. It includes bothblue-chip and smaller-capitalized stocks. About 80 percent are onthe NYSE, 14 percent are over the counter (OTC), and 6 percent arefrom the Amex. The Russell 2000 Index, which has become a leading measure of small-capitalization stocks, has also become popular during the past few years.On the opposite side of the spectrum is the MMI. It includesonly blue-chip stocks, 85 percent of which are also part of the DowJones Index. Therefore, it would be the futures stock index contractthat most closely tracks the Dow.Do the blue chippers perform differently from the smallercompany stocks? Yes, blue-chip stocks usually lead the rest of themarket in a bull move. Once a bull stampede starts, individual investors rush to buy “undervalued” secondary issues that are still affordable. This segment of the market then catches up with the bluechip segment, as institutional buyers seek out bargains among thelesser issues.As a major bull move exhausts itself, the prices of the bluechips are traditionally the first to level off. Unfortunately, the pricesof the less capitalized stocks often continue to surge. This is wheresmall investors are just getting into the market and are often theones hurt, as it is so late in the move. They end up holding inflatedstock while the market moves sideways or down.The activity of institutional buyers is usually an indicator ofwhat to expect. Just as the institutional buyers’ rush for the blue-
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3.1
Index CompositionS&P 500:S&P Midcap 400:NYSE Comp:Value Line:MMI:Russell 2000:Nasdaq 100:Indice de Precios y Cotizaciones (IPC):Nikkei 225:
500 stocks, mostly NYSE issues301 NYSE, 7 Amex, and 92 NasdaqAll NYSE common stocksApproximately 1,650 NYSE,Amex, and OTC stocks20 blue-chip stocks, all NYSE, ofwhich 19 are on DJIASmall-cap stocks, 858 NYSE, 84Amex, 1,022 NasdaqAll 100 listed on Nasdaq StockMarketMain index of the Bolsa Mexicande Valores (BMV); 35 stocks, alltraded on the BMVAll listed on the Tokyo StockExchange
chip stocks often foretells a bull move, their movement from stocksto cash instruments may warn of a bear market ahead. This lack ofconfidence in the overall stock market causes a flight to quality;thus, the blue-chip stocks tend to hold their price level longer in bearrallies.BULL, BEAR, SIDEWAYS MARKET
This strategy puts you in the position of deciding whether the nextmove of the Dow will be to 12,000 or 7,500. You must also accurately predict what stage of the current move you are in and what to useas an indicator.Since the MMI most resembles the Dow, it would make senseto go long the MMI at the early stages of a bull, or short it just before a bear move. Once the move is well under way, you might wantto trade one or more of the other more broadly based indexes.Since the S&P 500 has a liquid option, you could buy a call at thesame time you go long the MMI. Once the small stocks catch up withthe blue chips, you would exercise that option or take profits on it.
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A SPREADING STRATEGY
Another alternative would be to spread the MMI against one of theother indexes. A spread is when you simultaneously buy and sell inthe same or related markets. This strategy allows you to take advantage of expected changes without having to predict accuratelythe overall market direction. You are basing your decision on thestrength of one contract compared with another or the strength ofthe blue-chip stocks relative to that of the broader-based issues.This approach may give you more protection in very volatilemarkets than taking an outright long or short position. You sell theweaker contract and buy the stronger. Regardless of the overalltrend, you can win.RISK CONSIDERATION
There are no risk-free futures trading strategies, including spreads.If your analysis of which contract is stronger is incorrect, the spreadmoves against you. You can close out the unprofitable leg and holdthe profitable one. The move must be large enough for you to recover what you lose on the unprofitable side and pay your transaction costs. If the markets move only slightly or sideways and there’sno change in the spread between the two contracts, you still mustpay transaction costs.Also, keep in mind that the NYSE Composite and the S&P 500settle in cash at the opening value on the last trading day, while theMMI and Value Line settle in cash at the closing value. If you areholding an MMI-NYSE Composite spread until expiration, at theopening of the last trading day you would be holding an outrightposition in the MMI until closing. This might be risky consideringexpiration-day volatility.THE EVOLUTION OF PROGRAM TRADING
Program trading on the stock market can have a significant impacton the volatility of the stock indexes, although the exchanges havemoved to lessen the effect since the sharp fall in the markets in 1987.The New York Stock Exchange and the other exchanges that tradestock index futures have established circuit breakers, trading-collar
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levels, and price limits in an attempt to cool down volatility thatmight result from program trading.Program trading at present encompasses a wide range of portfolio-trading strategies, which involve the purchase or sale of a basket of at least 15 stocks with a total value of $1 million or more.By 1960, block trading of stocks had become common. Theseare characterized as trades of 10,000 or more shares at one time. Inthe beginning, only one security at a time was block-traded. Itwasn’t until the mid-1970s that block trading occurred in a varietyof stocks at one time.In 1974, the ERISA law was enacted requiring pension fundmanagers to use “skill, prudence and diligence” to minimize risk.This is sometimes referred to as the “prudent investor” or “prudentexpert” legislation. Like most regulations, it requires managers to“prove” they are being prudent, as well as actually being prudent.How do you prove prudence? You don’t put all your eggs in thesame basket! This led to the first highly diversified index funds thatattempt to mimic the performance of the S&P 500 or the NYSE Composite Index.Enormous amounts of money were flowing into mutual fundsat this time. Portfolio managers had to devise a method of movingquickly and efficiently from cash to equities and back, dependingon the daily influx of cash and redemptions.“MAY DAY”
May 1, 1975, brought the end to fixed brokerage fee schedules. Portfolio managers were now free to negotiate commissions. This led tothe trading of packages of stocks because the portfolio’s performance was now less affected by transaction costs. Brokers weremore than willing to provide volume discount packages.You could hardly move a block of 5,000 shares in 1965. Tradesof 10,000 shares later became commonplace. This had an impact onvolatility. The major brokerage firms developed five basic portfoliolevel trading packages. These are usually referred to as the agency,open-hand, blind-bid, blind-blind-bid, and incentive trade packages. The cost per share traded ranges from a few cents to a few dollars. The wide range reflects the amount of risk the broker assumesin the trade.
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The highest commissions are paid when a brokerage firm is required to guarantee the price in advance. This is done even whenthe individual stocks and timing of delivery are not identified to thebroker. The broker is given a general description of the types ofstocks to be traded.How does a brokerage firm handle the risk of a blind-bid package? This is where the futures and options on futures come into play.In 1982, index futures became available and a year later index options. This allows the brokerage firm to hedge the transaction. If thepackage or program trade resembles the S&P 500 and the client isselling, the brokerage firm goes long the S&P 500. Between them,they are neutral or flat the market. When the trade actually takesplace, both legs of the hedge are offset. The brokerage fee naturallyincludes the cost of the hedge.On the opposite end of the spectrum are portfolio-level tradeswhere the brokerage firm assumes no risk. It simply agrees to handle the transaction whenever the client decides to do it, offering noprice guarantee. This is the agency package. The three packages inbetween include various methods of sharing the risk and rewardsbetween broker and client.THE IMPACT
How does program trading affect you as a futures trader? The mostobvious answer is the volatility of the stock market and its relatedimpact on the futures index markets.A study conducted by the NYSE several years ago indicatedthat the impact of a typical program trading market order at thattime was 0.2 percent. This equates to a 6-point move when the DowJones is at 3,000. (At 10,000, the effect would be a 20-point move.)But these program trades usually hit the market in waves of two,three, four, or even ten at a time. If the average trade was nearly 200stocks worth $10 million, what’s the impact of four of these in a 10or 15-minute time period? And the typical trade can double in sizeif it is the result of some negative news.From a longer-range perspective, there was a pattern of increased volatility on the NYSE in the mid-1980s as program tradinggrew. Between 1983 and 1985, prior to the widespread use of indexarbitrage, or spreading, volatility exceeded 2 percent on 13 days. In
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the 1986 –1988 period, 2 percent volatility days were up to 87. During the same periods, 3 percent volatility days increased from 1 to26 and 4 percent volatility days went from 0 to 14.MANAGE THE VOLATILITY
Stock trading curbs were first put into effect after the near-catastrophic 500-point DJIA plunge in 1987. As the bull stock marketrampaged into higher and higher ground, stock and futures exchange officials established measures to control volatility. The NYSEsystem of circuit breakers and trading-collar levels is aimed at controlling program trading when the market is in a free fall or wildsurge upward. The futures exchanges put into effect their ownprice-limit rules.The circuit breakers and collars are reviewed each quarter andchanged if necessary. Circuit breaker points represent the thresholdsat which trading is halted marketwide for single-day declines in theDJIA. There are decline levels of 10, 20, and 30 percent. For example, the circuit-breaker points adopted for the fourth quarter of 1999would have worked in the following manner:A 1,050-point drop in the DJIA before 2 p.m. (Eastern Time)would halt trading for 1 hour; it would halt trading for 30minutes if it occurred between 2 p.m. and 2:30 p.m.; and itwould have no effect if it occurred at 2:30 p.m. or later.◆ A 2,150-point drop in the DJIA would halt trading for 2hours if it occurred before 1 p.m., for 1 hour if it occurredbetween 1 p.m. and 2 p.m., and for the remainder of theday if it happened at 2 p.m. or later.◆ A 3,200-point drop would halt trading for the remainder ofthe day, regardless of when the decline occurred.◆
Trading collars would be implemented as follows:When the DJIA declined 210 points or more. Such a dropwould require all index arbitrage sell orders of the S&P 500stocks to be stabilizing, or “sell plus.”◆ When an advance in the DJIA of 210 points occurred. Allindex arbitrage buy orders of the S&P 500 stocks are thenrequired to be stabilizing, or “buy minus.”◆
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The “buy plus” and “buy minus” order formulas are designedto reduce the possibility that index arbitrage orders would furtherdepress or inflate a market that is already falling or rising sharply.Exchange officials hope the delays will take some of the fervor outof the markets.If you plan to trade the stock index futures markets, you shouldbe familiar with the trading-curb rules of the stock exchanges andthe futures exchanges. Be aware that they may change each quarter.Even with the curbs, you must learn to protect yourself fromthe risk of increased volatility in the stock market and the index futures markets. The use of trading stops or options as stops can help.Holding an uncovered position, on the other hand, can entail majorrisk.
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Placing Trades andWorking with a Broker
Key Concepts◆ Selecting a Broker◆ Opening an Account and Types of Accounts◆ Understanding and Completing Account Papers◆ Knowing the Kinds of Orders◆ Recognizing the Role of the Clearinghouse
To implement your trading plan, you need to be able to communicate closely and clearly with your broker. To do this, you musthave a broker you can rely on and relate to. You must also educateyourself with the terminology of the markets in order to avoid misunderstandings.SELECTING A BROKER
It pays to find a knowledgeable broker backed by a strong orderdesk. This way you can explain in plain English exactly what youwish to do and let the broker convert it to the trade jargon. For example, you can place what amounts to good-till-canceled (GTC) orders, or out-of-range orders, with your broker. The broker and theorder desk track them for you and place them in the market eachday until you get a fill or they are within range. Your broker shouldalso constantly review your positions with you to be sure none get
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entered without your knowledge. This way you won’t lose track ofa GTC order or get an unexpected and unwanted fill.To begin with, there are professional commodity brokers andthere are futures order takers. You must decide which you need.This also determines whether you trade through a discount or fullservice brokerage company. In the past few years, the technologicalrevolution has made it possible to trade directly online from yourown computer. Both full-service firms and discounters now offeronline trading.The per-trade cost at a discounter ranges between $25 and $35,depending on how much you trade and how long you have beenwith the firm. In most cases, the trader places a toll-free telephonecall to the order desk at the discounter headquarters. An order clerktakes the order and relays it to the order desk at the appropriate exchange. You may also place the order online to some brokers, withthe cost likely to be about the same, $15 to $30.To utilize either a discount service or an online broker, youneed a lot of experience. The order clerk is not in a position to assistyou in choosing or evaluating a trade. The clerk’s function is strictly to execute orders. In most cases the clerk will not even providecurrent price quotes or other information you may want at the timeyou are placing your order, such as highs, lows, trading ranges,trends, or market news. As a general rule, the discount cost matchesthe service. Discounters serve full-time traders who have the timeand money to generate all the information they need to trade.Full-service firms are set up to work in tandem with both experienced and inexperienced traders who need assistance in gathering and interpreting information about the supply and demandsituation of the commodities being traded. Commissions with fullservice firms may run from $100 to $110 per trade, but this will likely include analytical advice and other services usually not availablefrom discount brokers.HOW DO YOU SPOT A GOOD BROKER?
First off, the key word is good. It means good for you, your tradingstyle, your personality, and your needs. If you require no assistancein selecting trades, tracking them, money management, technicaland fundamental information, order placement, exchange floor re-
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ports, and the like, you should seriously consider using a discounteror trading online.One of the best places to develop a list of what you want froma broker is to review your list of limitations. Your broker should become your partner; you make money together. The broker’s commission must be earned.There are at least four common limitations most individualtraders must overcome. The first is to follow the markets and to sortout the important information from the false rumors that clutter thepits. The second is the flow and cost of information available aboutthe markets. As fast moving as the futures markets are, you oftenneed tick-by-tick price quotation equipment. Additionally, you needimmediate access to the wire services and other forms of news.Therefore, you require some expensive and sophisticated equipment, which most individuals cannot justify as part-time traders.Third is the experience that only comes from trading the markets day after day, year after year, facing bull markets and bear rallies, spotting the major moves early, and avoiding getting whipsawed by false breakouts. Last of all, there is just an enormousamount of background information you need at your fingertips totrade and avoid making expensive errors. You need to know all thespecifications of the contracts you’re trading, the hours the marketsare open, the days they are closed, and if they are closing early forsome reason. You also need to know how to place orders, when important government reports that will impact markets are to be released, and what rumors are sweeping the exchanges. The list goeson and on.To look at it from another perspective, here are some seriouserrors that could happen if you get into the futures markets withoutenough knowledge or assistance.A farmer has hedged on corn. There were 100,000 bushels inthe bins, and 100,000 were sold on the Chicago Board of Trade.When going to offset the short futures position, the broker was toldto buy 20 at the market. Since each corn contract is 5,000 bushels, itwas thought 100,000 bushels were being offset—the quantity thefarmer was short. But grains are traded differently than all othercontracts are, as mentioned earlier. The number refers to each 1,000bushel unit. The farmer’s broker did as instructed and bought 20 atthe market, or 4 contracts. Since 100,000 actual bushels of corn were
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sold on the cash market, the farmer was still short 80,000 bushels.The farmer was at extreme risk. For every cent the corn market goesup, $800 is lost.Something as seemingly simple as placing an order to be filledwithin the closing range can prove expensive and risky. For example, there is the case of the trader waiting to place a market order inthe last 15 minutes of trading to fulfill a trading strategy. Because ofa clock running late, the order was received on the floor too late. Thecustomer had to take the risk of holding the position overnight andexiting in the morning. The broker could have used a market onclose (MOC) order, if the situation had been fully understood byboth parties.Therefore, develop your list of what you are going to look forin a broker before you begin to interview (usually by telephone) broker candidates. Use all the skills you learned over the years in hiring employees or vendors, selecting schools for yourself or yourchildren, and making other critical buying decisions. Make a “T” listof positives and negatives on all candidates after you talk with them(see Figure 4.1). If you do this for each broker you interview, the selection process becomes much easier. Review the Trading PlanChecklist as you develop your T list.Some characteristics common to “good” brokers include:Availability. Good brokers are available to their customerswhenever they are needed. This often equates to long hoursfrom covering the early grain markets to the evening Treasury bond sessions. When they aren’t personally available,they see to it that an assistant or associate is. You’re never outof touch. Ask prospective brokers about how “reachable”they are. Then, when you open an account, test them (callthem at 8:00 a.m. and again at 8:00 p.m.) before a marketemergency occurs.Responsiveness. You need a broker who’ll help you overcomeyour limitations and satisfy your needs. Therefore, this person must be responsive. In the interview process, requestsome obscure piece of information, such as when the FederalReserve is releasing the next beige book. Find out in advancehow the broker performs. Ask how fast you’ll get fills. Try todiscern how hard the broker will push to respond to yourneeds.
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4.1
Broker Selection “T” ListBroker’s Name:Firm:Phone Number:
——————————————————————————————————————————————————————————————————
My Needs and/or Limitations
Pros
1.2.3.4.5.6.7.8.9.10.11.12.
X10 years
Live time quotesMarket experienceReliable trading systemTrack recordPersonalityReliabilityCommissionReferenceFirmTrade presentationType of traderNew services
Cons
?UnclearExcellentGood$72/rtCheck outUnknownUnorganizedTechnicalLimited
My overall impression is:————————————————————————————————————————————————————————————————Note: It’s important to customize the T list to suit your needs and/or limitations. This list is for illustrative purposes only.
Honesty. Naturally, you must trust and have confidence inyour broker. You can often learn a lot about sincerity whenyou ask about the risk of futures trading or a specific trade. Ifthe broker evades or glosses over the high risk involved, beware. You should receive a serious, no-holds-barred discussion from prospective brokers about the unlimited nature ofthe losses that can be sustained in futures trading. Regardingthe buying of options, the risk is limited to the cost of the option (premium) and the transaction costs (brokerage commission and fee), but you can lose 100 percent of this amount.Most options expire worthless. Few traders make money inoptions. If you’re told this is a serious investment with highrisks, it’s a big plus.
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Dealing with losses. Under the stress of losing other people’smoney and the pressures of trading, many brokers comeapart. The first sign is often a lack of communication with thelosing client. This is almost impossible to detect in the earlyinterview stage of the selection process. However, when youstart to trade, you should become sensitive to it. If possible,ask for references from past customers. Ask them how thebroker performed when the account was in a drawdown. Thebest brokers don’t let it bother them, because losing money isa large part of futures trading.Trading. Find out how they trade. What system do they use?Are they fundamentalists, technicians, or a combination?Have them “sell you a trade.” Just ask them what their traderecommendation for today is. You want to learn how wellthey present an opportunity to you. Is it well thought out?Convincing? Have they done their homework?Discipline. Good traders and brokers are very disciplined.They spend hours studying the market and refining their system. Bad brokers will try to emotionally sell you the “hottrade of the day.” Probe to get a feel for the daily routine ofprospective brokers. Do they keep a trading journal? What dothey do each day that assures that your positions will be reviewed?Experience, knowledge, track record. If you know more or havetraded more than a prospective broker, who’s going to helpwhom? Find out what they have done, what they know, andhow that’s going to make you more successful.The question of a trading track record is tricky. Most brokersdo not have one. If they do not take total discretion in an account(power of attorney that permits them to actually trade the accountas if it were their own), the customer approves each trade. Therefore, the broker is merely a consultant and the customer is the trader. The broker cannot use these accounts to create a track record, asper CFTC regulations.Next, there are some very stringent regulations imposed by theCFTC regarding track records. These regulations make it difficultand expensive for a broker to prepare a track record. This is another reason most brokers do not have one. Personally, if a broker
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shows or offers a track record that is not part of a full-blown disclosure document that has been reviewed by the CFTC, you should bevery suspicious.These are just a few of the areas to which you must be sensitiveas you select and work with a broker. Always remember that it isyour money that is being invested in the market. You are the