complex marketplace,a farmer in the Midwest was able to obtain payment for grains that
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Knowing Your Market
might not be delivered in New York for many months later, allbased on futures contracts and an agricultural money market.The problem with this system was that all the companies andpeople involved in the transaction had to live with a lot of risk. Aslong as market prices remained at about the same levels, these riskswere minimal. But a drought, infestation, or severe changes in demand could all spell disaster for the system; and on the financialend, a monetary panic of the type that did occur every few yearsalso brought the interdependent system to a grinding halt.Commercial volume increased quite a lot after 1848, the yearthat the Illinois-Michigan Canal was completed. This connector between the Illinois River and Lake Michigan expanded the grainmarket, and storage and handling technology made growth evenmore profitable. In the 1840s, the use of grain elevators and expanded rail lines improved the whole system, and this higher volume placed pressure on the financial side to provide a morelucrative system as well. By the 1850s, an efficient system for collecting various products, weighing, inspecting, and classifyingthem by quality levels emerged, making the commodities marketsmore efficient. The CBOT was dominant in both the shipment andfinancing of commodities, where merchants, bankers, and dealersalso came together to resolve disputes and to form agreements.Continued growth and expansion ultimately made it obviousthat the commodities market needed a secondary market to financethe production, shipment, and sale of goods. In 1863, the CBOTformalized this market with its forward contracts and two yearslater, began trading futures contracts, which proved to be moreefficient, more reliable, and added certainty into the markets. Giventhe technological limitations of railroads, telegraph communications, and hand-generated order placement, it was not until 1925that an efficient and working clearinghouse system was in place.The original clearing procedures can be traced back to systemsused at the Minneapolis Grain Exchange in 1891, but technologylimited even the most efficient of systems before widespread use oftelephones, not to mention air travel, automobiles, and trucks, andultimately, computer-based order placement over the Internet.As markets developed and expanded, so did the regulatory
What Is a Futures Contract?
15
structure of the industry. Up until 1920, the markets regulatedthemselves and the only attempted legislation was designed at shutting down these markets rather than ensuring that they operatedefficiently and fairly. In 1922, the U.S. Congress passed the GrainFutures Act in response to falling grain prices after World War I.This new law required exchanges to become licensed and also setdown rules for disclosures to the public.The Commodity Exchange Act of 1936 followed a period ofmarket reforms in the FDR era, when the Securities and ExchangeCommission (SEC) was formed as part of sweeping new regulations in the stock market. The commodity law, passed in the spiritof the times and in the belief that federal oversight would preventany future abuses, set up the Commodity Exchange Authority(CEA) as part of the Department of Agriculture. This organizationmonitored trading activity and was authorized to bring federalcharges for price manipulation. It also limited speculation in futures by limiting positions and also regulated futures merchants.Options trading was banned on any agricultural commodities andrestricted most forms of futures trading. However, the growth incommodities trading during the 1960s and 1970s made the lawineffective. It was replaced in 1974 by the Commodity FuturesTrading Act, which enabled formation of the Commodity FuturesTrading Commission (CFTC), which continues to act as the primary federal regulatory body to this day.Valuable Resource: The CFTC’s Web site is www.cftc.gov.
The 1974 act was modified by the Futures Trading Act of 1982.This made options legal on agricultural commodities, and clarifiedthe jurisdictions of both the CFTC and the SEC. Most recently,Congress enacted the Commodity Futures Modernization Act in2000, reauthorizing the CFTC for five more years and also repealing an 18-year restriction on single stock futures trading. This hasopened up many permutations on the futures market, which todaycovers not only commodities, but precious metals, natural resources, imports, and a wide range of stock market indices, currency exchange, and interest rates.
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Knowing Your Market
Calculating Futures ReturnsAny form of investment has to be quantified in two specific aspects:return and risk. Chapter 4 explores in detail the specific risk levelof futures; for now, it is important to understand the kinds of returns you should be able to expect.If you listen to the hype online or from telephone calls (fromso-called ‘‘boiler rooms’’), you can make hundreds of percent returns, but only if you act immediately. It is perplexing that anyonewould agree to send a stranger $5,000 just because they werepromised a $25,000 return within a matter of a few days. But ithappens. You should ignore unsolicited contacts from futures dealers. As with any investment, you cannot expect to simply be givena profit just for turning over your money. That’s not how profitsare generated. It takes work, research, and the willingness to acceptrisk.One difficulty in evaluating returns on futures contracts is thatat the time a transaction is initiated, money is not exchanged. Youwill be required to make a deposit on margin just to ensure thatyou intend to either see the trade through, or close it later. Themargin varies, but it may be as small as 5% of the value of thecommodity. But the majority of futures business is done withoutcash exchange at the time you enter the contract. When you buy orsell other instruments, such as stocks, real estate, or bonds, youeither pay for the entire transaction or make an arrangement formargin coverage or, in the case of real estate, for a mortgage loanfor the majority of your purchase. But if you do not have to put upthe money, how do you calculate your return?This is confusing, but it works the same way as the optionsmarket in some respects. The current value of a futures contract isthe agreed-upon cost of the contract, but not the future value ofthe underlying commodity or product. By the same rule, you canbuy a stock option for a small fraction of the exercise value of stock,and later exercise or sell the option. But you are not required toexercise, so you could trade the option value of stocks worth thousands of dollars using options, and remain obligated for only a fewhundred on the basis of ‘‘if and when exercised’’ only. The changing value of the option relies on the changing price of the stock.
What Is a Futures Contract?
17
The futures market is very similar. If you buy a futures contractin coffee, and the price of coffee later rises, your futures contractwill be worth more as well. If coffee prices fall, so will the value ofyour coffee futures contract. In this contract, both buyer and sellerhave agreed to trade the commodity at a fixed future price, and thedelivery date is well known to both sides in the transaction.The return on a futures contract is computed in one of manyways, as it is for options. It is not realistic to base the return on thefull value of a commodity as long as you are required to depositonly 5% of its future value. If you were to deposit the entire 100%value of the commodity, which is called fully collateralized, youwould base a return on the difference in cash paid, versus cashreceived later when the contract was sold. But few futures tradersdo this, so it is not relevant to base return calculations on the fullvalue.One approach, which is also unrealistic for most people, is toassume an investment value you would have earned if the entirevalue were invested elsewhere. For example, you may use currentTreasury bill yield as a comparative return, and then compare theinvestment value of the T-bills, versus the potential profit from buying a futures contract. This approach is valid only if you have thefull amount available, and your choice is actually to fully collateralize the futures contract, or buy on margin and invest the difference.This is an academic calculation if you don’t have the cash.It is far more realistic and accurate to calculate returns fromfutures contracts based on the total amount placed on margin—cash at risk—plus interest, versus cash out when the position islater closed. This cash-on-cash return is going to reflect your actualreturn in your portfolio and, for comparative purposes, returnsshould always be annualized. Figure 1-1 shows the formula for annualizing returns.For example, if you invest $450 and four months later sell for$500, your profit is $250, or 11.1%. You annualize to calculatewhat your return would have been if you had held the position forexactly one year. The formula:11.1%ⴒ 12 ⴔ 33.3%4
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Knowing Your Market
FIGURE 1.1. ANNUALIZED RETURN
(
returnholding period
)
x 12
= annualized return
Annualizing should not be considered as a reflection of the overallreturn you expect to earn from any investment program. However,it is valuable as a means of comparison. When you consider potential return with risk levels in mind, an annualized basis of returncalculation for several different futures strategies provides an answer. It is based on levels of risk, so the conclusion is that a givenannualized return is possible, given the level of risk calculated toapply to a specific strategy. That is the important distinction. Ofcourse, higher annualized returns are always possible if you arewilling to accept very high risks, but you cannot compare thosepotential returns to lower profits on much safer strategies. So youcannot compare a 33.3% return on a long futures position to a 5%dividend on a blue chip stock, or to a 3.5% return on an insuredcertificate of deposit. As long as risk levels are different, you cannotfairly compare the returns.Annualizing return is a useful tool for comparing likely outcomes for a range of futures positions, or for evaluating historicalreturns within your portfolio, given a series of different positionsyou have opened and closed. It is not reasonable to focus only onthe double-digit returns and to then proclaim your genius as a futures trader (while ignoring the smaller returns and the occasionallosses). That is self-deceptive, and can lead you into a false sense ofsuccess. Realistically, the real bottom line of portfolio managementinvolves an annual assessment of outcomes. What was your beginning balance, and what was your ending balance? The differenceis your annual return (adjusted for any additional deposits madethroughout the year, of course). So annualized your overall portfolio provides you with a reality check each year, but granting toomuch weight to annualized return for a short-term position is misleading.
What Is a Futures Contract?
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Futures Versus Stocks and BondsAnother way to evaluate the performance of futures contracts is bycomparing overall returns to those for stocks or bonds. You arelikely to base your portfolio on a foundation of equities, includingdirectly owned stocks and shares of mutual funds. If you also ownshares of income funds or balanced funds, you also own debt securities. Or if you have a savings account or a CD, those also countas debt securities.The historical equity return is normally based on the S&P 500.For debt, Treasury bonds and bills are often used as a means ofcomparison. Depending on the period you study, you are likely todiscover a range of different outcomes between commodities,stocks, and bonds. Depending on how stocks have performed inspecific time frames, commodities will either come out with betteror worse returns. For this reason, long-term comparisons are reallyof no value as indicators of what you can expect to experience inyour portfolio. The actual outcome is also going to rely on howmuch allocation you give to futures speculation, versus holdings ofstocks and bonds. It also depends on your strategic approach. Areyou simply speculating for the short term, or are you using futurescontracts to hedge long positions in your portfolio?The specific strategy you use will affect the return you shouldexpect. If you use futures as a hedge, your intention is to reduceoverall risk, so a relatively low return on futures compared to abetter than average return on stocks is also deceptive. Again, if youare only speculating, the weighting factor also matters. For example, if you dedicate only 10% of your capital to futures speculation,how can you compare outcome to the 90% you leave in equity anddebt? Additionally, the balance between stocks and bonds, and thebalance between directly owned stocks and mutual funds, also impact your overall return.For example, if you had bought shares in Altria, McDonald’s,and ExxonMobil at the beginning of 2007 and sold all of them atthe end of 2007, you would have shown impressive returns in yourequity portfolio. But if you had put all your money into Citigroupand Countrywide, you would have lost more than half. So the stockportfolio return is going to be based on the decisions you made.
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Knowing Your Market
How can you compare this to returns from futures speculation withany degree of reliability?The reality is that long-term historical returns are easily manipulated. Making valid comparisons of past performance is inaccurate, and depending on the date you pick, you can make theoutcome look good or bad, depending on which strategy you favor.It makes more sense to acknowledge that these markets all offerpotential returns, and all contain specific risks. Diversifying yourportfolio to include futures contracts as speculative moves or tohedge long stock positions, is one strategy. Its outcome will relyboth on timing and the degree of risk you are willing to accept.An example of how picking the time of a comparison affects theoutcome: If you compare futures to stocks between 1962 and2006, a portfolio of futures would have outperformed the S&P500. However, most of that positive growth took place in the1970s. If you look instead at a range of portfolios from 1983 to2006, stocks outperformed futures. It is impossible to believe thatin the future you can somehow know when to switch from oneinvestment to another. Just as it is impossible to time perfectly theselection of one stock over another, it is equally impossible to knowwhen to switch in and out of stocks or futures. Looking at the pastdoes not help, because it provides no clues about when or howsimilar comparisons will play out in the future.One hint worth remembering: In times of high inflation, futuresmarkets have historically performed better than the stock market.But looking again to the future, it is impossible to know when inflation is going to occur, how long it will last, and how severe it isgoing to be. The best approach is to study markets and economictrends, and attempt to hedge overall positions by anticipating inflationary times. Then futures contracts can be strategically used tohedge a stock portfolio or to speculate, selecting those futuresproducts most likely to experience price rises if and when inflationdoes occur.The next chapter moves beyond the generalized discussion offutures contracts, to describe how a trade takes place. Knowing themechanics of trade execution is important for anyone concernedwith timing in a fast-moving market.
What Is a Futures Contract?
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Notes1. Ambrose Bierce, The Devil’s Dictionary, 1911.2. Paul R. Ehrlich, ‘‘The Population Bomb,’’ The New York Times, November 4,1970.3. Randall Dodd, ‘‘Developing Countries Lead Growth in Global DerivativesMarkets,’’ Special Policy Brief 15, Financial Policy Forum, April 6, 2004(www.Financialpolicy.org).
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HOW FUTURESTRADES ARE MADE
I
n the pre-Internet days, trading in all markets was quite primitive.The majority of people who did not have direct access to the ﬂoorof an exchange had to work with brokers. For stocks, people telephoned their stockbroker, and fees were exorbitant. For futures,people had to work with commodities brokers, and, once again,fees made this market inaccessible for most individuals.This all began to change when stock-based discount brokerscame onto the scene. In 1963, Charles Schwab began circulating anewsletter for investors, and that led to development of a new concept: low-cost brokerage services. In 1975, as the business was deregulated, it became possible for ﬁrms to compete; Schwab alsowas the ﬁrst company to offer online brokerage services in 1996.Before that, even with discounting, investors relied on the telephone or ofﬁce visits to place trades. Prices of all trading have comedown substantially since the Internet became the dominant investment venue in the stock market. Prices reﬂect high levels of competition. In 1998, Schwab’s average fee per trade was $60; by 2006, ithad dropped to $14 (online trades are cheaper, but some investorscontinue to use the telephone to place trades, and the cost of thisservice is much higher).22
How Futures Trades Are Made
23
A similar revolution has been experienced in the futures market. Before the Internet took over as a dominant market force, investors had to rely on very expensive commodities brokers, whonot only charged high fees but very often provided questionableadvice as well. The infamous boiler room was a favorite highpressure sales organization known to telephone people and try tocoerce money from them. They often targeted the elderly, and resorted to techniques such as shouting at people, making demands,and even sending couriers to their homes to pick up checks. Boilerrooms continue to exist today, but the Internet and e-mail haveprovided a more convenient place for boiler rooms to operate.Another major change in the futures market—further madepossible with the Internet—is the advent of indexing, in both stocksand futures. Investing in indices rather than single products hasbecome popular with pension plans, and many people who used toinvest in stocks through mutual funds and variable annuities havediscovered that futures are also accessible in this way. Costs arelower than buying directly, and by relying on professional management, the risks of the futures market are of less concern. Between2003 and 2006, investing in futures indices rose from $15 billionto $100 billion per year. During this same period, the range andspecialization of indices have also expanded.
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Market DiversificationWhy is there a need for variation in the way you enter markets? Infact, why diversify at all? Isn’t it enough to hold on to a portfolioof well-picked stocks?The answer involves many considerations. First of all, stocksare tangible and potentially permanent, meaning you can invest andhold for many years. Futures, in comparison, are short-lived andintangible. They are speculative, and do not have any value on theirown. In fact, futures contracts will rise and fall based on prices inthe underlying commodity, and that is the sole driver of value inthis market. However, these kinds of trades, very much like options, can enrich a stock portfolio through indices, mutual funds,and other futures-based approaches to the market.Second, diversification spreads risk, and this aspect is a key to
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Knowing Your Market
a well-managed portfolio. Risk is going to exist on many levels. Thebest known is the market risk in owning a single stock. If all yourmoney is placed in that stock, a big decline affects your entire portfolio. However, risk also may apply to an entire sector like energyor banking, so even a stock portfolio should spread out amongmany sectors. But there is also a market-wide risk. If the stockmarket undergoes a long-term bear trend, a majority of stocks aregoing to fall with market averages.A solution to this risk is diversification between dissimilar markets, and this is where futures can provide a valuable form of protection. You have probably realized the value in diversifyingbetween equity (stocks or real estate) and debt (bonds or incomemutual funds). A problem with diversifying with real estate is theilliquidity of direct ownership, which accounts for the popularity ofmortgage pools, real estate sector mutual funds, and real estateinvestment trusts. A similar convenience is found in futures indexinvesting, which enables you to diversify broadly into marketsrather than buying an entire range of a product, or all of the stocksin a stock market index. For example, you can easily buy shares inthe S&P 500 as an alternative to buying small portions of each ofthe 500 companies in that index.Comparing today’s futures market to that of the past points outhow much more flexibility you have today. In fact, the traditionalrisks of owning commodities have been virtually eliminatedthrough the use of indices and mutual funds. The most obvious isprice risk, or the risk that price will change in a direction creatinga loss instead of a profit. But futures are also sensitive to risk fromoutside influences. Political unrest in the Middle East affects theprice of oil in the United States and elsewhere. The increased demand for ethanol makes the price of corn rise, which further affectsfeed costs for livestock. So isolated and singular events can have arippling affect in the futures market. The importance of diversification in its obvious forms is fairly well understood. In the futuresmarket, it is equally important to be aware of how events—political, economic, and market—affect prices of seemingly unrelated commodities and economic futures (interest rates andcurrency values, for example).Before the development of practical and convenient vehicles
How Futures Trades Are Made
25
like indices and futures mutual funds, hapless individual investorssimply were left out of the market. Diversification was limited orhad to be achieved via traditional vehicles (savings accounts,stocks, directly owned real estate, and mutual funds). Hedging asa strategic move was not generally available for individual investors.The options market, in which hedging is today both practical andaffordable, also was expensive when you had to rely on a broker.The commission costs were so high that you needed substantialmovement in option premium just to break even, so any diversification involving options was limited to pure speculation or coveredcall writing.These forms of diversification are valuable and workable, andeven before low-cost transactions were available, often made sense.But the point is diversification was a very restricted activity. PreInternet systems were not only slow and expensive, they also lackedthe ‘‘internal diversification’’ that makes indices and funds so attractive. This concept—internal diversification—refers to thespreading of risk within an index or fund itself. Today, you do nothave to trade directly in commodities, even though some traders dojust that. This activity should be reserved only for the most experienced speculator or hedger, whereas most individual investors willbe content with a more passive approach.‘‘Risk’’ in commodity investing used to include price risk,meaning that even if a trade were profitable, the transaction costgoing in and coming out made it impractical, or resulted in a netloss. By investing through pooled vehicles, you avoid this price riskwhile also achieving very effective levels of internal diversification.
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Commodities IndicesPopular commodity indices include several major selections. TheGoldman Sachs Commodity Index (GSCI) contains over $50 billion in investor dollars. As of December 18, 2007, weighting included 73% in energy, 7% industrial metals, 2% precious metals,14% agriculture, and 4% livestock. Figure 2.1 shows this breakdown.Valuable Resource: To find the current weighting of the GSCI, go to www2.goldmansachs.com/gsci/insert.html.
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Knowing Your Market
FIGURE 2.1. GSCI WEIGHTING
livestock4%
preciousmetals 2%
agricultural14%
industrialmetals 7%
energy73%
Another commodity index is the Reuters/Jeffries CommodityResearch Bureau Index, more commonly referred to as the Reuters/CRB Index. This index includes energy 17.6%, grains and oilseeds 17.6%, copper and cotton 17.6%, livestock 12%, preciousmetals 17.6%, and imports 17.6%. Figure 2.2 shows this breakdown.A third choice is the Rogers International Commodities Index(RICI). This index includes only commodities that are involved ininternational trade, and excludes those used primarily for nationalconsumption. Table 2.1 summarizes the initial weighting of components as reported in the 2007 RCI Handbook.Also check Figure 2.3 for a visual breakdown of these majorcomponents.
27
How Futures Trades Are MadeFIGURE 2.2. REUTERS/JEFFRIES WEIGHTING
imports17.6%
preciousmetals 17.6%
livestock12.0%
energy17.6%
grains andoilseeds 17.6%
copper andcotton 17.6%
Valuable Resource: For more details on RICI or to view the latest handbook, go to www.diapasoncm.com/indices/pdf/RICI_Index_Manual.pdf.
Another is the S&P Commodity Index, which was first introduced in 2000. This is called the ‘‘Geometric Series’’ and measuresa cross-section of commodities offering active U.S. futures contracts. The index includes five sectors—energy, metals, grains,livestock, and fibers or imports.As of 2006, the index included natural gas 18%, unleaded gas12%, heating oil 12%, crude oil 11%, wheat 5%, live cattle 5%, andthe remaining 37% spread among futures with less than 5% of thetotal. Figure 2.4 provides a visual breakdown.Valuable Resource: Find out more about the S&P Commodity Index atwww2.standardandpoors.com.
The Dow Jones-AIG Commodity Index is one of the most popular indices in the futures market. No component class is allowed
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Knowing Your Market
TA BLE 2.1. RICI INITIAL WEIGHTING
Commodity
Weight
Commodity
Weight
Crude OilBrent Crude OilWheatCornAluminumCopperCottonHeating OilGas OilRBOB GasolineNatural GasSoybeansGoldLive CattleCoffeeZincSilverLead
21.00%14.007.004.754.004.004.051.801.203.003.003.003.002.002.002.002.002.00
Soybean OilSugarPlatinumLean HogsCocoaNickelTinRubberLumberSoybean MealCanolaOrange JuiceRiceOatsAzuki BeansPalladiumBarleyGreasy WoolTotal
2.00%2.001.801.001.001.001.001.001.000.750.670.660.500.500.500.300.270.25100.00%
Source: 2007 RICI Handbook.
to account for more than 33% of the total weighting in the index,and no single commodity is allowed to make up more than 2% ofthe overall index. As of January 2007, the index included petroleum20%, natural gas 13%, grains 18%, vegetable oils 3%, livestock 9%,precious metals 9%, industrial metals 19%, and imports (these arecalled ‘‘softs’’) 9%. See Figure 2.5.Valuable Resource: For more about the Dow Jones-AIG CommodityIndex, go to www.djindexes.com/mdsidx/index.cfm?event⳱showAigIntro.
The Deutsche Bank Liquid Commodity Index, originated in2003, follows only six commodity contracts: two each among energy, metals, and agricultural sectors. These are light sweet crudeoil 35%, heating oil 20%, gold 10%, aluminum 12.5%, corn11.25%, and wheat 11.25%. See Figure 2.6.
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How Futures Trades Are MadeFIGURE 2.3. RICI WEIGHTING
crudeoil 21%
all otherunder 5%58%
Brent crudeoil 14%
wheat7%
Valuable Resource: Deutsche Bank’s Web page is dbfunds.db.com.
These are tracking funds, which are designed not to own thecommodities or even the futures contracts. Investors can use theindices in several ways:1. Benchmarks. Institutions often use tracking indices to comparethe performance of their own portfolios. As a measurement fora diversified portfolio of stocks and bonds, these portfolio managers want to ensure that their holdings match or perform betterthan the tracking index. As an individual, you can use a commodity index in the same way, comparing your portfolio’s performance to the separate index outcome. Many people use stockindices in the same way, although this is not really accurate. Forexample, you might observe that today, the Dow Jones Industrial Average (DJIA) rose 45 points, but your portfolio rose $75net. This is not accurate, because the index is point-based and
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Knowing Your Market
FIGURE 2.4. S&P COMMODITY INDEX WEIGHTING
naturalgas 18%all otherunder 5% each37%
unleadedgas 12%
heatingoil 12%livecattle5% wheat5%
crudeoil 11%
weighted; and your portfolio’s performance depends on the mixof holdings. So while the DJIA may provide a directional indicator, it is not accurate to compare points to dollars. In comparison, the year-to-year performance of a commodity trackingindex does indicate the relative strength or weakness of theeconomy.2. Investment via replication. You may also refer to a tracking fundand replicate its commodity breakdown (or parts of it) by investing in the same contracts. For example, if you note that mostof the large indices emphasize energy over most other commodities, you may decide to also buy energy futures contracts foryour portfolio; or to enter into the energy market through another method (such as buying stocks or shares of an ETF).3. Indicator only. As a method for deciding whether or not to invest in stocks or other market segments, you can use commodity indices as economic indicators. Some analysts believe that
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How Futures Trades Are MadeFIGURE 2.5. DOW JONES-AIG COMMODITY INDEX WEIGHTING
imports9%
petroleum20%
industrialmetals 19%naturalgas 13%preciousmetals 9%livestock9%
grains18%
vegetableoils 3%
commodity prices anticipate the direction of the economy atlarge, and that economic trends anticipate stock market trendsas well. In times when prices are rising, analysts expect stocksto follow; and vice versa, when commodity prices fall, the beliefis that stocks will also fall.4. Direct ownership of the futures contract. You can open a futuresaccount directly and purchase futures contracts based on commodity tracking index breakdowns or for part of the commoditybreakdown. This is going to be difficult if you plan to duplicatethe entire tracking range of commodities, however, and alternative methods are more practical.
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Knowing Your Market
FIGURE 2.6. DEUTSCHE BANK COMMODITY INDEX WEIGHTING
wheat11.25%corn11.25%
light sweetcrude oil35%
aluminum1