EAR U.S. TREASURY BONDS—MARCH
Source: Charts provided courtesy of TradingCharts.com: http//futures.tradingcharts.com; created with SuperCharts by Omega Research 䉷 1997.
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So if you convert U.S. dollars into British pounds, you receiveabout 0.51 pounds per dollar. And if you convert British poundsback to U.S. dollars, each pound would get you about $1.95. Theserates change daily, which is where the currency futures contractcomes into play. In today’s global economy, international commerce has made currency exchange very important. For example,overseas currency exchange affects even those companies listed onthe U.S. stock exchanges, especially if those companies are multinational. Companies like Coca-Cola and MacDonald’s, for example, sell in many countries and generate most of their revenueoverseas. As a direct consequence of this, as the dollar’s value relative to other currencies falls, these multinationals are likely to seeincreased profits from their direct sales in those countries.Valuable Resource: To check exchange rates and conversion betweenany two currencies, go to www.x-rates.com.
There are many currencies on which futures are traded. Amongthese are the British pound (symbol £), which is denominated indecimal units of 100 pence. This decimalization became effectiveon February 15, 1971, replacing the previous pound-based systemof shillings (with 20 shillings to the pound) and pence (12 penceto the shilling, thus 240 pence to the pound). The pound representsabout one-third of global currency reserves, following the U.S. dollar and the euro. It is also the fourth most traded foreign exchangecurrency, after the U.S. dollar, euro and Japanese yen. Figure 142 summarizes the March 2008 futures contract for the Britishpound as of December 2007.The euro (symbol y) is the official European Union (EU) currency, and is used in 15 countries (Austria, Belgium, Cyprus, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg, Malta,The Netherlands, Portugal, Slovenia, and Spain). Among Europeancountries not using the euro are the UK, Denmark, and Sweden.Many other currencies are pegged to the euro, making it the currency for 500 million people around the world. As of the end of2006, there were 610 billion in circulation (about equal to US $802billion), giving it the highest circulation value of any currency.The euro trades in decimal values, with 100 cents to the euro.Coins include the y2, y1, y.50, y.20, y0.10, y0.05, y0.02, and
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FIGURE 14.2. BRITISH POUND—MARCH
Source: Charts provided courtesy of TradingCharts.com: http//futures.tradingcharts.com; created with SuperCharts by Omega Research 䉷 1997.
y0.01. Euro banknotes are issued in y500, y200, y100, y50, y20,y10, and y5 denominations. Low and high exchange rates from1999 to 2008 of euros in U.S. dollars, according to the EuropeanCentral Bank (www.ecb.int), were:Lowest
Highest
Year
Date
Rate
Date
Rate
1999200020012002200320042005200620072008
12-0310-2607-0601-2801-0805-1411-1501-0201-1201-21
$1.00150.82520.83840.85781.03771.18021.16671.18261.28931.4482
01-0501-0601-0512-3112-3112-2801-0312-0511-2701-14
$1.17901.03880.95451.04871.26301.36331.35071.33311.48741.4895
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This chart demonstrates a one-decade slide in the U.S. dollar versus the euro. While the original exchange rate was one to one, theeuro has risen ever since. Figure 14-3 shows the March 2008 futures contract for the euro as of December 2007.The Japanese yen (symbol ¥) is the official currency of Japan,and is the third most traded after the U.S. dollar and the euro. It isalso a popular reserve currency in many nations. Figure 14-4shows the March 2008 futures contract for the Japanese yen as ofDecember 2007.The U.S. Dollar Index (USDX) is a popular index of the nation’s currency as traded against a basket of foreign currencies(British pound, euro, Japanese yen, Canadian dollar, Swedishkrona, and the Swiss franc). This index was begun in March 1973soon after the Bretton Woods system was done away with. This wasa form of international monetary management entered into by theworld’s industrialized nations after World War II. The original purFIGURE 14.3. EURO—MARCH
Source: Charts provided courtesy of TradingCharts.com: http//futures.tradingcharts.com; created with SuperCharts by Omega Research 䉷 1997.
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Classifications of Futures
FIGURE 14.4. JAPANESE YEN—MARCH
Source: Charts provided courtesy of TradingCharts.com: http//futures.tradingcharts.com; created with SuperCharts by Omega Research 䉷 1997.
pose was to help nations rebuild from the war, and the agreementalso formed the International Bank for Reconstruction and Development (IBRD, now reformed as the World Bank), and the International Monetary Fund (IMF). The Bretton Woods systemattempted to regulate exchange rates pegged to gold valuation;however, when the United States went off the gold standard in1971, the system collapsed. The U.S. Dollar Index formed shortlyafter Bretton Woods failed, with the original value set at an indexof 100.00. By the end of 2007, the index was at about 76. Figure14-5 shows the March contract as of December 2007.
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Index FuturesIn February 1982, the first-ever stock index was created on theKansas City Board of Trade. That was the Value Line CompositeIndex, including the 1,700 stocks that Value Line tracked and ana-
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FIGURE 14.5. U.S. DOLLAR INDEX—MARCH
Source: Charts provided courtesy of TradingCharts.com: http//futures.tradingcharts.com; created with SuperCharts by Omega Research 䉷 1997.
lyzed. Shortly after this new idea, many other stock-based indiceswere introduced. Today, you can trade index futures on stocks aswell as on futures.The index itself tracks a specifically identified grouping ofstocks. So the New York Stock Exchange Composite Index or theS&P 500 Index are among the popular indices tracked in this manner. In addition to buying shares in these index groupings, you canalso trade futures on them. Futures on broad indices are not valuable as hedge instruments if your portfolio is small or limited inscope; however, for a diverse portfolio that involves broad marketparticipation, index futures can be valuable. For example, if yourportfolio includes long positions in a broad mutual fund account,shorting a stock index future is one way to hedge such a portfolio.In addition to using futures on stock-based indices, you canalso buy or sell futures on indices tracking the futures market. In
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other words, you can trade futures on the broad futures marketitself, which overcomes the problem of diversification. If you originally plan to buy or sell futures contracts, you face the problem ofa very extensive market with several subclassifications. In addition,direct trading is awkward and expensive; so as a result, many traders have been attracted to futures indices like the well-known Reuters/Jeffries CRB Index (CRB) or the Goldman Sachs CommodityIndex (GSCI). Both of these include a diversified portfolio of futures contracts.Going a step beyond buying or selling shares of the index is theconcept of trading in futures on those commodity-based indices.The CRB, for example, is comprised of more energy futures thanany other subclass. It also holds futures in agricultural, preciousmetals, livestock, and tropicals/imports. In the 2005–2007 periodwhen futures values were rising strongly across a broad front, theCRB performed quite well; and buying futures in that index is oneway to leverage capital and benefit from market trends.So when you believe futures prices are going to rise, you maybenefit from buying futures in the CRB. This achieves market-wideparticipation for far less money than would be required to buy actual shares. If you believe the market is going to decline, you cansell the same futures. Hedging and other forms of speculative trading are also possible. The use of futures on an index of commoditiesis probably the most practical way to diversify and to leverage capital.Figure 14-6 shows the March 2008 contract for the CRB futures contract as of December 2007.Futures on stock indices include the DJIA, which is comprisedof 30 industrial stocks. The futures contract tracks this index,which is the most popular index in the entire stock market. TheDJIA futures contract dollar value is equal to 10 times the indexvalue. So when the DJIA is at 13,000, the DJIA futures contract isassigned a value of $130,000. So a 100-point move creates achange in the futures contract of $1,000.This kind of leverage is very exciting to traders who follow‘‘The Dow,’’ as the DJIA is often called. You gain an interest in all30 of the DJIA stocks by trading in the futures contract. A comparison to direct purchase of stocks makes the point. In a typical stock-
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FIGURE 14.6. CRB FUTURES—MARCH
Source: Charts provided courtesy of TradingCharts.com: http//futures.tradingcharts.com; created with SuperCharts by Omega Research 䉷 1997.
based margin account, you can leverage up to 50%, so with a$50,000 deposit you could own up to $100,000 worth of stock.But if you buy DJIA futures, you can cover the same level of stockparticipation for much less money. The level required varies as theDJIA changes its level. Another advantage to trading DJIA futuresis that you can short the index far more easily than would be possible to short all 30 companies in the index.Futures on stock indices are valuable for pure speculation or tohedge portfolio positions involving a range of the market (such asequity mutual fund holdings). Given the volatility of the market inrecent years, the appeal of a futures contract on the DJIA is high.With the market often moving well in excess of 100 points ($1,000change in the futures contract), a form of swing trading with theDJIA makes a lot of sense. Swing traders like to move in and outof positions in a three- to five-day period, and they base the timingof their decisions on the scope of movement (in stocks or indices).
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Because of the multiplier of 10, the volatility of the DJIA makes thefutures contract a viable instrument for swing trading. It alsomakes it easy and convenient to play with long and short sides ofmarket movements.Figure 14-7 shows the March 2008 DJIA futures contract as ofDecember 2007.Many people who limit their investment range to a stock portfolio may benefit by following the DJIA futures contract. By watching overall volume, MACD, and RSI as well as the direct trackingof the futures contract, you can judge the market on a technicalbasis, and time stock-based decisions using the futures contracttrends.Another popular index is the New York Stock Exchange Composite Index. This is an index of all common stocks of companieslisted on the NYSE. On June 1, 2007, the index went above 10,000points for the first time, twice the 500-point level it was assignedFIGURE 14.7. DJIA FUTURES—MARCH
Source: Charts provided courtesy of TradingCharts.com: http//futures.tradingcharts.com; created with SuperCharts by Omega Research 䉷 1997.
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only four years earlier. The index itself trades as an ETF under thename iShares NYSE Composite Index Fund (NYC). The futurescontract enables you to trade long or short on the NYSE Composite, based on the ETF trend and level. Figure 14-8 summarizes theMarch 2008 contract as of December 2007.Another popular stock-based index is the S&P 500, which includes 500 large-cap corporations. These companies’ stock tradeson both the NYSE and NASDAQ exchanges and, following theDJIA, the S&P 500 is the second-most popular market index.While the DJIA 30 industrial stocks are viewed as reliable indicators of market trends, the S&P 500—which is far broader—isviewed by many as an indicator of the strength or weakness in theU.S. economy. The index is included as part of the Index of Leading Indicators tracked by the Conference Board (www.conferenceboard.org), which is used to predict economic trends. So the S&P500 is important not only for market trends, but also for broaderFIGURE 14.8. NYSE COMPOSITE INDEX—MARCH
Source: Charts provided courtesy of TradingCharts.com: http//futures.tradingcharts.com; created with SuperCharts by Omega Research 䉷 1997.
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Classifications of Futures
economic trends as well. The S&P 500 is also used as a comparative indicator to judge mutual fund performance.Rather than having to buy shares of all 500 companies in thisindex, investors can buy shares of an ETF that includes the entireindex. The iShares S&P 500 (IVV) is one of several ETFs trackingthis index. In addition, many mutual fund companies offer indexfunds tracking the S&P. The first among this group was VanguardGroup’s S&P tracking fund (VFINX). Futures on the S&P aretraded on the CME. Figure 14-9 shows the March 2008 contractas of December 2007.
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Individual Stock FuturesTrading in individual stock futures contracts normally refer to anunderlying value equal to 100 shares of stock. When you trade futures instead of stock, you do not earn dividends on those shares,and you do not have voting rights. However, the futures contract
FIGURE 14.9. S&P 500 INDEX—MARCH
Source: Charts provided courtesy of TradingCharts.com: http//futures.tradingcharts.com; created with SuperCharts by Omega Research 䉷 1997.
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can be purchased with smaller margin levels and for much lessmoney. For stocks bought on margin, a 50% cash requirement applies; futures on stocks require only 20% cash. This leverage increases your margin range. In addition, because futures cost lessthan stocks, you can control about 2 1/2 times more stock thanyou can through direct purchase.In addition, you can short a futures contract without needingto borrow shares of stock, as you do when you short stock throughyour brokerage account. Speculators interested in short sales orhedgers desiring protection of long positions benefit from sellingfutures on stock because, like other futures, the contract valuesdiminish as the delivery date approaches. So the original sales pricedeclines, meaning the position can be closed profitably.Futures act in many of the same ways as options; but thereare important differences. First of all, a futures contract requiresfulfillment of the contract, whereas option buyers have only theright and not the obligation to buy. However, actual delivery isavoided by closing out a contract or by rolling it forward, just likeany futures contract. Some traders prefer futures over options dueto potential profits and advantageous margin rules. While optionscan also be rolled forward to avoid exercise, the differential inbreakeven point can be slim. Many option rolls are done simply toavoid exercise, but involve little or no profit and, at times, a smallloss.In the past, single stock futures were not allowed in the UnitedStates, mainly because the Commodity Futures Trading Commission (CFTC) and the Securities and Exchange Commission (SEC)could not decide which agency would have regulatory oversight inthis market. It was not until 2002 that the two agencies sharingjurisdiction resolved the problem.This chapter concludes the discussion of financial types of futures and options on those futures. As you can see, the variety ofmethods available for playing the futures market enables you topick an appropriate risk level based on your knowledge, experience,and willingness to place capital at risk. These potential alternativesbroaden the methods for being involved in futures, diversifying andallocating your portfolio, and managing risk.
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CONCLUSION
A
ny form of investing or trading demands skill and knowledge. Thefutures market is among the most complex of all markets, andthis prevents many people from taking advantage of it in riskappropriate ways.When you consider the many avenues for futures investing, itbecomes clear that you may be able to match a strategic approachto your own requirements. For example, as this book has shown,you can trade futures contracts directly; trade shares of index fundsand exchange-traded funds (ETFs); and even buy options on futures contracts. You can also invest in commodity sectors by buyingshares of sector-based ETFs, rather than buying stocks in a sector’sleading corporation. Therefore, you are not limited to just tradingfutures contracts. In fact, many experienced investors and tradersare less than comfortable in this market, due to the high cost oftrading and, compared to stock trading, the complex methods ofentering and executing trades. The alternatives solve this problem.In addition to being able to match a method of going into thefutures market, you can also accomplish many goals in your investment program that may include the futures market. For example,concerns about the value of the U.S. dollar may lead you to cur237
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Classifications of Futures
rency futures or to focusing on sectors with international markets.If you are aware of high energy costs and future energy demands,the energy futures (the most actively traded) are quite popular, andfutures indices as well as ETFs and sector funds also address thisinterest.Futures are useful instruments in their many avenues for a widerange of investment and trading risk levels. The risk taker can certainly speculate in either long or short positions through commodity brokers. More conservative investors can hedge their stock ormutual fund portfolios with short positions in futures or in ETFsand indices spread throughout the subsectors of the futures market. And using a variety of these methods, futures serve as an effective way to hedge against economic changes, including the threatsof both inﬂation and recession. Even the most conservative investorcan use the futures market in its many forms to diversify beyondstocks, bonds, the money market, and real estate; and to broadenan asset allocation program.As the global economy expands and a growing number of U.S.based corporations become multinational, the complexities of commodity costs as well as currency exchange and interest rate levelsmake futures more essential than ever before, not only to institutional investors and large corporations, but also to individuals. Forexample, you cannot possibly know what markets are going to looklike in a few years, so buying stock is a high-risk venture on itsown. For example, you may buy shares in an energy company inthe hope that its future stock price will be higher. But if you arewrong, then your stock will lose value. By selling calls or buyingputs on an energy sector ETF or a commodity index fund focusingheavily in energy futures, you can hedge your long stock position.The limited risks of this market approach make the strategy prudent. At the same time, it eliminates the higher risk and cost oftrading energy futures directly.You can apply the same approach to any market sector, and theinteraction between stock market sectors and the futures market isinescapable. In addition, the subsectors of the futures market arealso interdependent. The example used in this book was that ofcorn futures. Food prices rose when the demand for ethanol fuelplaced additional demands on the corn crop. In this example, corn-
Conclusion
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based ethanol might affect energy prices in one direction, whileother industries would suffer higher prices. Corn is a basic foodsource and a major cattle feed base, as well as being used in numerous industrial applications. The point to remember is that everything is interdependent, and in the modern global community, thisreality will only expand as progress continues.In the not-so-distant past, it was possible to create an illusionof isolation from the rest of the world. Domestic production andconsumption, a focused futures market, and lack of interest in thesupply and demand of the international community has never beenabsolute, and international trade has always existed. However, themodern recognition that these dependencies are ever-present is amajor change from the past. Today, no one can really ignore thefact that all markets, especially the futures market, rely upon andare affected by events and economic change around the world.
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INDEXAAPG Bulletin, 158ACP Sugar Protocol, 215All Indian Radio, 98Altria, 19Aluminum, 206–208American Buffalo, 201American Gold Eagle, 201American Petroleum Institute, 158Annualized return, 17–18Appalachian basin, 155Aramco Oil, 157Arctic National Wildlife Refuge (ANWR),148–150Australian Gold Kangaroo, 201Balance of trade, 93Benchmarks, 29–30Bhutto, Benazir, 62, 152Biodiesel, 163Boiler room, 23Bollinger Bands, 119–121BP, 150, 157, 160Breakeven return, 56–57Brent crude oil, 42, 43, 45–46, 151, 164Brent goose, 42Bretton Woods system, 227–228British Gold Sovereign, 201British Thermal Units (BTUs), 42Brookings Institution, 98Bureau of Mines, 157Burger King, 65Campbell, C. J., 158–159Canadian Association of Petroleum Producers, 148Canadian Gold Maple Leaf, 201Candlestick chart, 48–50Canola, 188–189Card clockers, 85Carter, President Jimmy, 158Centre for Monitoring the Indian Economy, 98Charting basics, 104–109Chevron, 150, 157Chicago Board of Trade (CBOT), 7, 12,14, 81, 151
Chicago Mercantile Exchange (CME), 7,12, 40, 81–82, 234Chicago Produce Exchange, 12China Daily, 98China Perspectives, 98CIA World Factbook, 97Citigroup, 19CME Feeder Cattle Index, 194–195Coca-Cola, 225Cocoa Producers Alliance, 219Cocoa Protocol, 219Cocoa, 217–220Coffee, 91–92, 212–214Commodity Exchange Act of 1936, 15Commodity Exchange Authority (CEA), 15Commodity Futures Modernization Act,15, 35Commodity Futures Trading Act, 15Commodity Futures Trading Commission(CFTC), 15, 35, 82, 235Commodity Pool Operator (CPO), 35–36Commodity Trading Advisor (CTA), 35Component weighting method, 34Confederation of Indian Industry (CII), 98Consumer Price Index (CPI), 56, 93Copper, 206, 207Corn, 111–112, 171–173Cotton, 177–180Countrywide, 19Crude oil, 42, 153, 156–159Currency futures, 224–228, 229Data entry employees, 85Day trader, 8Department of Agriculture, 15Department of Energy (U.K.), 158Department of Energy, 94–95Department of the Interior, 158Deutsche Bank Liquid Commodity Index,28–29, 32Devonian-Missisippian shale, 155Dow Jones Industrial Average (DJIA), 29–30, 31, 96, 230–232Dow Jones newswire, 106Dow Jones-AIG Commodity Index, 27–28
241
242Economic data, 93–96Economist, 97–98Edwards, J. D., 158EIA Inventory Level, 94Elliott Wave, 119–121EnergyAmount of, 160–162Basics, 147–152Crude oil, 156–159Distillation, 153–154Fossil fuel, 152–154Futures, 5, 162–165Reserves, 161Shale and sand oil, 154–156Energy Information Administration, 94–95Energy Select Sector SPDR (XLE), 150Enron, 98Erie Canal, 13Escapability, 4Ethanol, 151, 163, 169, 238–239European Union (EU), 215, 225Exchange clerks, 84Exchange-Traded Fund (ETF)Basket of futures, 36, 237–238Diversiﬁcation, 59–60Energy-based, 150Flexibility, 32–33, 80Futures-based, 34–35, 123Options on, 143or Note (ETN), 75Precious-metal, 200Ranges, 4–5Replication, 30Shorting, 66, 72–77Exponential moving average (EMA), 114ExxonMobil, 19, 65, 150, 157Federal Funds Interest Rate, 94Federal Oil Conservation Board, 158Federal Open Market Committee (FOMC),223Federal Reserve, 223Feeder cattle, 194–196Fill or kill, 83Financial futuresCurrency, 224–228, 229Index, 228–234Individual stock, 234–235Interest rate, 222–224Types of, 221–222Floor brokers and traders, 7, 84–85Floor runners, 85Forastero cocoa, 217Forward contract, 12Front month contract, 33Frozen Concentrated Orange Juice(FCOJ), 218–219Fundamentals of other countries, 96–98FuturesContract, 3–4, 5–8Deﬁnition, 4–5Fundamental analysis, 89–90Hedging, 60–61History, 11–15Charts, 43–48
IndexIndices, 25–34Investment value, 8–11Merchants, advisors and operators,34–36Options on, 122–124Order speciﬁcations, 80–82Order tracking, 84–86Order types, 82–84Prices, 38–41Quotations, 38Return calculations, 16–18Risks, 53–55Short position, 6Technical analysis, 103–104Trades, 22–23, 79–80, 87Unit deﬁnitions, 42–43Versus stocks and bonds, 19–20Futures Commission Merchant (FCM), 35,86Futures Trading Act of 1982, 15fxstreet.com, 106Gas-oil, 152Geological Survey, 157–159Gold, 112, 113, 200–203, 204Goldman Sachs Commodity Index (GSCI),25, 26, 79, 124, 127–130, 151, 230Good till canceled (GTC), 83Government National Mortgage Association (GNMA), 223Grains and oilseedCanola, 188–189Corn, 171–173Cotton, 177–180Futures types, 5, 170Lumber, 189–191Oats, 181–182Rice, 175–177, 178Soybeans, 182–185, 186, 187Western barley, 185–188Wheat, 173–175Green River formation, 155Gross Domestic Product (GDP), 93, 97Heating oil, 152, 166Henry Hub natural gas, 107Hindustan Times, 98Hubbert’s Peak Theory, 158, 159–160Hurricane Katrina, 152Illinois-Michigan Canal, 14Imports and tropicalsCocoa, 217–220Coffee, 212–214Futures types, 5, 212Orange ju