. Somestudies have shown that the probabilities are quite high that after a customer payshis commissions and calculates the interest income lost on money deposited withhis broker, he will not make money.You should not trade unless you are psychologically suited to taking largerisks. Most commodity futures transactions involve a great deal of risk. Unlessyou are certain that you can accept that risk and still sleep at night without worry,do not trade.You should not trade unless you are certain that you can control your ego andyour greed. High risk and high profit potential go together. If you cannot disciplineyourself well enough to admit a mistake on a trade and close it out at a small lossor to be satisfied with a moderate gain on a winning trade, do not trade.If you tend to live on hopes and dreams instead of on the realities of hard facts,do not trade.If you think you can make money trading futures without doing some hardwork, do not trade. Making money consistently is not easy in any line of work. Andit is especially hard in futures trading.If after reading the above you have already concluded that trading is not foryou, don’t give up. Read on. Investing in a professionally managed futures prod-
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Introduction
uct, in which you don’t have to do the work, may suit you fine. In that case, whenyou have finished with this chapter, go directly to Chapter 4, “Managed Futures—A Good Alternative.”As you read the rest of this book, keep these points in mind and try to determine your suitability for trading.
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Chapter 1
Trading Stocks versus TradingCommodity Futures
Most of you have probably invested in stocks so you understand something aboutexchange markets and how exchanges operate. Stock exchanges and commodityexchanges are similar in many ways. For example, they are both membershiporganizations established as a means of facilitating the investment decisions oflarge and diverse groups of people.The stock exchanges act to bring people with extra capital together withthose who need capital to develop a business. They facilitate the transfer of ownership of corporations which are engaged in various productive activities such assteel making, auto manufacturing, banking, etc. Property rights change hands.The commodity futures markets act to bring people together to transfer theprice risk associated with the ownership of some commodity, such as wheat, or aservice, such as an interest rate. No property rights to a physical commodity changehands at the time the futures contract is entered into. The transaction is a legallybinding promise that at a later date a transaction will occur involving the property rights to the actual commodity.1Copyright 2001 The McGraw-Hill Companies. Click Here for Terms of Use.
Chapter 1
One can “invest” in commodities in the same way one can in stocks: e.g., buya share in a commodity limited partnership. In that sense, according to the dictionary, investment is the “committing of resources with the expectation of making a profit.” On the basis of that definition, it seems apparent that one also “invests”in oil wells, real estate, and a whole array of other things.It would not be accurate to leave the impression that investing in blue chipstocks and investing in commodity futures contracts are exactly the same thing. Thetwo activities can often reside on different levels of the risk spectrum.
MARGIN AND LEVERAGECommodity futures contracts, when traded with high leverage, fall in the highrisk area of the spectrum near speculative stocks, rights, puts and calls, new issues,and “penny” stocks. But if you trade them using low leverage and carefully selecttrades that provide favorable probability payoffs, then futures trading can be atthe low-risk end of the spectrum.Just as there is a risk spectrum for all investments, one could set up the samesort of spectrum for commodity futures contracts. That is, you can select commodities for trading that have less risk associated with them because of highermargins (less leverage) or more stable prices. For example, trading futures in acommodity like pork bellies is normally more risky than an equally leveragedposition in lumber. Lumber prices are usually less volatile. Equal leverage withlower volatility means lower risk.Further, the method of trading you select can affect the risk you assume. Forexample, you could use a “spreading” technique, which refers to the simultaneouspurchase and sale of contracts in two different markets or for two different months.This usually, though not always, has less risk associated with it than an outright longor short position. We will discuss spreads in depth in a later chapter.Why do commodity futures end up so far out on most people’s risk spectrum? Is it because the prices of beef cattle or pork bellies fluctuate so much morethan the price of blue-chip stocks? Not at all. In fact, the prices of many commodities fluctuate less than many stock prices. During one six-month period of 1992,IBM’s stock moved down 20 percent, up 20 percent, and back down 50 percent.That’s real volatility. Meanwhile, no commodity changed that much. The important difference is in the leverage of margin—the amount of money needed to control a given amount of resources.When an investor buys a stock on margin, the margin represents an equityinterest in the security and the investor owes the unpaid balance as debt. In futurescontract trading, the trader is not buying or selling the commodity but only agreeing to buy or sell it at a later date. In one sense, you could look at the purchase orsale of a futures contract as the purchase or sale of the right to participate in the2
Trading Stocks versus Trading Commodity Futures
price change. The margin payment is considered a “sign of good faith” or earnestmoney such as might be used in acquiring a piece of property. In other words, thepurchaser promises to fulfill his contract during the delivery month.Use of the term “margin” to describe the security deposit posted when trading commodity contracts is somewhat unfortunate, because it suggests that “margin” in the securities market and “margin” for commodity futures contracts areidentical. In fact, they are quite different in concept and in practice.The purpose of margin in commodity trading is to act as a security deposit,thus providing the broker and the exchange clearinghouse with protection fromdefault by the customer or the brokerage firm. The level of these security depositsis set by the exchange on which the commodity is traded.Margins on securities are set by the Federal Reserve Board, and their purpose,as stated in the Securities Exchange Act, is to prevent the excessive use of creditfor the purchase or carrying of securities. Recent federal legislation gives the Fedauthority to review margins on certain financial futures.New purchases of stock on margin generate credit in a way that adds to thenational money supply. When stock is bought, the entire purchase price is paid tothe seller a few days after the transaction. If the purchaser is buying the stock onmargin, the balance of the purchase price must be borrowed in order to make hisfull payment. Ordinarily, this balance is borrowed from the broker or from a bankand, in either case, the effect is to expand the national total of bank credit, leadingto an expansion of the national money supply by the amount borrowed. This pointsup a major distinction between margin in commodities and margin in the stockmarket. Margin in commodities does not, in and of itself, involve the borrowingof money nor does it affect the money supply.Leverage is high in commodity futures trading because, as a percent of contract value, margins are low. In commodities markets, margins are usually lessthan 10 percent and in some instances less than 1 percent of market value. In thestock market, margins are much higher. Because of the low margins in commodities, one can control large amounts of resources with small amounts of capital.Hence, a slight change in the value of the total contract results in a substantialchange in the amount of money in your account. For example, a 1 percent changein $10,000 invested in the stock market via a non-margined account will equal a1 percent change in equity or $100. A 1 percent change in a futures contract valued at $10,000 is equal to a $100 change in account equity also, but in order to control that $10,000 futures contract, you probably needed to put down $750 as yourinitial margin. And a $100 change in $750 is equal to a 13 percent change in yourequity (see Figure 1.1).It is this leverage factor that causes commodity futures to be considered a highrisk investment. Of course, there is nothing that says you must use all of that leverage. You could arbitrarily set your personal margin higher, say at 30 percent andtrade more conservatively. In other words, the riskiness of futures trading is a self3
Chapter 1
Figure 1.1 Leverage Illustrated
selected risk. The institution of futures trading does not necessarily mean morerisk by design.
RELATIVE SIZEA very basic difference between the stock market and the commodity futures market, however, is the relative size of the two markets. The stock markets are overwhelmingly larger than the commodity futures markets, and the number of peoplewho own and trade stocks far outnumber those who trade commodity futures contracts. Although newspaper stories frequently portray the commodity markets asbeing “vast” with “millions of people playing the markets” where the dollar valueof trading frequently “exceeds the value of stocks traded on the New York StockExchange,” such statements are misleading.In the case of the value of securities traded on the New York Stock Exchange(NYSE), most of those securities were paid for in full and delivered to their new owners: Thus, something approaching the trillions of dollars in value of stock traded wasactually exchanged in cash through the exchange. On the other hand, futures con4
Trading Stocks versus Trading Commodity Futures
tracts are traded on margin and normally less than 5 percent of the value of the contract is deposited with the broker in cash. Hence, only a fraction of the trillions inthe dollar value of futures contracts traded annually actually changed hands.Over the years, a number of market profile studies have been completed bythe Commodity Futures Trading Commission (CFTC) in Washington, D.C., bythe exchanges and by various brokerage firms. All of them have concluded that thetotal number of futures accounts in the industry is quite small when compared tothe 60 million or so securities accounts. Because many futures traders carry morethan one account (one trader was known to carry 17 different accounts), it generally has been estimated that there are at any one time about 150,000 individualsand business firms who trade commodity futures contracts. These estimates includemembers of exchanges and brokers. On the other hand, in mid-1990, the NYSE survey showed that about 51 million people own securities, or about 21 percent of thepopulation, and 10,000-plus U.S. institutions (banks, universities, investment companies, pensions, etc.).
THE TIME FACTORBesides leverage, another difference between trading stocks and commodities isthat time is more important in commodities. You can buy a stock and put it awayfor years. Not so with commodities. Generally, you have to get out of a commodity position within a matter of months after you first make the commitment, oryou are legally bound to accept or give delivery. However, at the time a futures contract is created, you know the exact date on which it will mature, so there is littleexcuse for being “caught” inadvertently.
DAILY PRICE LIMITSUnlike stocks, some commodity futures contracts usually have daily price limitswhich prohibit prices from changing by more than a certain amount on any givenday. These daily price limits are instituted first, and most importantly, to limit thefinancial risk to the clearinghouse. Clearinghouse members must settle with eachother each day, paying in or receiving the amount by which the value of each contract they owned changed that day. Second, price limits act to constrain hysteria inthe marketplace and let all parties have a breather when prices are changing by substantial amounts. Some futures have no price limits while others have formulae thatdictate the imposition of price limits and the suspension of trading when marketsget too volatile. Perhaps the best known example of this is the cooperative effort ofthe various commodity exchanges, the NYSE or the NASDAQ market, regardingprice limits in the stock index contracts and the trading of the underlying stocks at5
Chapter 1
the stock exchanges. When the stock market gets volatile and the S&P futures indexadvances or declines by a certain percentage or a certain number of “points,” trading is halted for a half-hour. If the Dow Jones declines by another set amount, thereis a trading halt. In short, the two markets have coordinated their limits.
MARKET ANALYSISMarket and price analysis of commodity futures is similar to and yet simpler than itis for stocks. For those who are chartists, the techniques of charting and chart interpretation are nearly the same for commodities as for stocks. On the other hand, fundamental analysis of many commodities is much simpler, because there are far fewercommodity contracts than there are stocks, and some of the best fundamental researchorganizations in the world provide free data. For example, in agricultural commodity futures, there is the U.S. Department of Agriculture; in interest rates and currency, there are the Federal Reserve, U.S. Treasury, and Department of Commerce.
SELLING SHORTYou can sell short as easily in commodities as you can buy long. A short sale incommodities can be a speculation or a hedge. It is not necessary to borrow thecommodity in order to go short in the futures market, because it is not a sale of theactual commodity, but only a promise to sell and deliver the commodity at somefuture time. If you close out your position prior to the close of trading in that contract, no delivery is required. In the case of a short sale in securities, you must borrow the securities sold. Ultimately, you would have to obtain a similar amount ofsecurities and return them to the party from whom they were borrowed.Another difference: Contrary to the securities market, going short in futuresdoes not normally require an uptick before initiating the position; nor does itinvolve dividend payments.
METHOD OF TRADINGIn commodity trading there is no receipt or delivery of certificates with which you haveto be concerned each time you trade. That happens only if you decide to make or takedelivery at the consummation of the contract, in which case you will receive the physical commodity, not on your front lawn but rather in an exchange-approved warehouse or depository. Many futures contracts now have cash settlement, meaning theproduct is never delivered. Instead, at maturity, the two parties simply settle byexchanging cash, the same way as daily mark-to-market settlements are conducted.6
Trading Stocks versus Trading Commodity Futures
SIZE OF ACCOUNTMost commodity accounts are small. From surveys conducted by the CommodityFutures Trading Commission, the exchanges, and brokerage houses, it is clear thata majority of all accounts contain less than $25,000 in equity.Nearly 90 percent of them have less than $25,000 in equity, and only a fewhave equity in excess of $100,000. About three-quarters of all accounts are categorized as speculative.It seems apparent that most people risk very small absolute amounts in trading commodities. Less than one in four accounts is a hedge account, and even thelarge accounts (those in excess of $100,000) are small compared to accounts in thesecurities industry where $100,000 or less is considered a small account.
WHO TRADES COMMODITIES AND WHY?Some people trade commodity futures as a normal adjunct to their business of producing and marketing a product. For example, if a meat packer wishes to establishthe prices he will pay for cattle to slaughter in his plant during the next six months,he may buy futures. Traders who fall in this category are called hedgers. They buyand sell contracts as substitutes for merchandising transactions they will make at alater time. We will deal with this topic at length in subsequent chapters.Other people trade commodities not as a normal part of producing or marketing a product but only in the hopes of making a profit on their transactions bycorrectly anticipating price movements. These people are generally categorizedas speculators.1There are different types of speculators. Among them are the “scalpers” atthe exchanges. They buy and sell contracts continuously, minute by minute, inlarge and small amounts, hoping to make a small amount on each transaction.They seldom carry a position for more than a few hours.Another type of trader is the individual “position trader.” He takes a positionin the market and holds it for at least a day and frequently longer. He tries to takeadvantage of short- and long-term trends.One of the questions frequently asked is, “What sort of person is this speculator?”
1.
The terms “speculator” and “hedger” are unfortunate choices as they have strong emotional connotations for many people and do not always convey an accurate sense of an individual’s activities in the market. A more accurate and useful classification of participants would be on the basisof “commercial” and “non-commercial” users of the market.
7
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In a Chicago Mercantile Exchange study conducted a few years back (the onlymodern-day, full study done on this topic), some 4,000 individual customers weresurveyed. These customers were trading in all types of commodity futures listedon any exchange in the United States. It was found that the typical trader lookedsomething like this:➥ Male.➥ About 45 years old (56 percent of the sample were males between 35 and55 years of age).➥ Middle- to upper-middle income class.➥ Good job (54 percent were professionals such as doctors, lawyers, dentists, top management people, or white-collar workers).➥ Well-educated (68 percent had gone to college; 60 percent of them hadgraduated with a bachelor’s degree; 18 percent had graduate degrees).➥ Tended to be a short-term trader (85 percent were holding their positionsfor less than one month and 55 percent of them for less than 10 days).This could be interpreted in any number of ways. It might indicate thatmany of them were trading without a plan.➥ Tended to be a small trader (55 percent were trading one contract each timethey traded; 75 percent were trading less than five contracts each timethey traded).➥ The individual trading commodities generally had a securities accountalso (70 percent had securities accounts).This does not mean that these characteristics are required in order to be asuccessful commodity trader, because it takes a special emotional and psychological makeup to trade commodities. But it does help to remove some of the mystery about the type of individual who trades commodity futures. He is probably yournext-door neighbor.
SOCIAL AND ECONOMIC BENEFITS OFFUTURES TRADINGAlthough economists have not yet found a way to accurately quantify all the social andeconomic benefits that flow from futures markets, a number of them can be identified.The basic economic functions performed by futures markets relate to competitive price discovery, hedging (offsetting) of commercial price risks, facilitatingfinancing, and allocating resources.8
Trading Stocks versus Trading Commodity Futures
Prices on an organized futures market reflect the combined views of a largenumber of buyers and sellers, not only of current supply and demand but also ofthe relationships up to 12 or 18 months or longer in advance. This does not meanthat a futures price is a prediction that will hold true. Instead, it is an expressionof opinions concerning future supply and demand at a single point in time. As conditions change, opinions change—and, of course, so will the prices. These changesdo not make the market’s pricing function less useful. On the contrary, keeping thesupply/demand equation current makes the system more useful than a one-timeprediction.Information generated by futures trading through the price discovery processis invaluable for planning at every stage of commodity production, distribution, andprocessing. Planning is a normal part of every commercial business. It is necessaryto achieve maximum efficiency and to minimize operating costs. To the extentthat futures markets improve planning and efficiency and reduce operating costs,the benefits should accrue to the consumer and the economy.The second major function of the futures exchange is risk shifting. A futuresmarket is a market in risk. It is the risk of price change, not the physical commodity, that is being traded on futures contracts. The futures market allows risk tobe “packaged” in special ways and transferred from those who have it but maynot want it (commercial businesses) to those who do (speculators).The risk of price change is ever present. This risk represents a cost that mustbe borne by someone. If the merchants or middlemen have to assume the risk,they will pay the producer less, charge the processor more, or a combination of thetwo. If the risk is assumed directly by the producer or processor, they will need tobe compensated for bearing the risk, and they will pass the cost of that along. Inany event, the cost of risk assumption will become a charge on the economy.Numerous general economic benefits flow from the hedging function. Theseinclude reduced finance charges in carrying inventory. The larger banks that financeproducers, distributors, and processors give their best terms for the value of theinventory that is fully protected by an adequate hedge. Most merchants, for instance,finance their operations on borrowed money. A fully hedged merchant with a goodcredit rating may obtain a loan on 90 percent of the market value of his inventoryat a given interest rate. Such a merchant has a great advantage over a competitorwho obtains a loan of only 75 percent to 80 percent on unhedged inventory at a higher interest rate. If this latter merchant is to survive in the business, this added costhas to become a charge to someone in the economy.Market participants who do not reduce the risks through hedging are speculating.In assuming these extra risks, they may be increasing the costs to the consumer.A futures market acts as a focal point where buyers and sellers can meetreadily. This improves overall market efficiency by reducing “search” costs. Buyersautomatically know where the sellers are and vice versa. They do not need tosearch each other out.9
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A futures market in a commodity should lead to less segmentation in themarket or, to put it another way, it should foster competition by unifying diverseand scattered local markets. Local monopolists will have a difficult time maintaining their position when national markets easily accessible to all people offertheir customers other alternatives.Futures markets help to tie all local markets together into a national or international market. An integrated national market means that prices in all local marketswill tend to move more closely in unison with the national market. Price relationships(basis patterns) for a larger number of locations and a larger number of related products will become more stable. This makes for more effective and efficient hedgingof a wider number of risks. We will talk more about this in a later chapter.How much is the service of the futures market worth to the consumer? That ishard to say precisely. Some studies of the use of futures markets have shown that thosewho use futures for hedging purposes over several seasons have a more stable incomepattern than those who do not. They do not get the peak prices, but they do not getthe bottom ones either. The futures market provides them with the opportunity to stabilize their incomes and allows them to obtain a competitive advantage.Of course, a futures market can’t do all things. Some people have the mistaken notion that futures markets cause higher or lower prices. This is incorrect.A futures market does not cause either high prices or low prices. In an open market, prices are established by supply and demand. The futures market reflects thesupply and demand factors and their interaction.If a consumer boycott of a product becomes operative, if a foreign nationraises its export tax, if the foreign policy of a nation is intended in some way to affectworld commodity prices, the futures market should reflect those influences, if itis working correctly. A futures market cannot guarantee a businessperson a profit. If the businessperson cannot control costs or is inefficient, the futures marketwill not magically make his operation profitable.
STOCKS, BONDS, CURRENCIES, AND COMMODITIES—IT’S ALL ONE MARKET NOWAll markets are linked. One really cannot do a through job of analysis in one market without studying what is happening in related markets. Hence, if you really wantto understand the bond market, you need to analyze commodity markets, stockmarkets, currency markets, and interest rate markets. And if you really want tounderstand stock markets, you have to analyze bond markets, currency markets,and commodity markets, etc. Since the futures market covers, worldwide, all fourof these major groups—commodities, currencies, stocks, and interest rates—thefutures are convenient laboratories for conducting robust investment analyses.To illustrate, consider each of the four groups in turn.10
Trading Stocks versus Trading Commodity Futures
Commodities versus BondsBasic commodity price functions as a leading indicator and so do bonds. These twomarkets are linked and should be studied together. As you will see in Figure 1.2,bond prices and commodity prices usually trend in opposite directions. Commodityprices are reflective of low inflation and when people expect low inflation, bondprices rise (interest rates fall). John Murphy, in his excellent book entitled TechnicalAnalysis of the Futures Markets, provides a very readable explanation of theCommodity Research Bureau’s Futures Price Index (CRB Index) and its close(inverse) correlation to bond yields (prices). He demonstrates that the CRB Indexis a leading indicator on changes in long-term interest rate trends. When yieldsfall (bond prices rise), the CRB price tends to begin rising (see Figure 1.2). Asbond yields (prices) broke out to downside (upside) without a similar breakout inthe CRB Index, Murphy would argue that, given the close historic link between thesetwo markets, such a divergence suggests that either the bond market’s fears ofinflation are overstated or the commodity markets should begin to move higher.
Bonds versus StocksAs noted above, commodities have an impact on bonds. Bonds, in turn, impactthe stock market. The bond market is often viewed as a leading indicator for stocks:i.e., a rising bond market has generally indicated a rising stock market in the coming months, and a falling bond market (rising interest rates) generally indicatesthat the stock market will soon follow. Due to lags in the economic system, ofcourse, these things don’t happen simultaneously. At the end of an economic expansion, bonds and high-dividend stocks usually turn down well before the broaderindex, and during recessions, when inflation is dropping, bonds and interest-sensitive stocks rally well before the broader stock market (see Figure 1.3).Figure 1.2 T-Bond Futures versus CRB Index (weekly data)110.00108.00106.00104.00102.00100.0098.0096.0094.0092.0090.00
225.00220.00215.00210.00205.00200.00195.00190.00185.00
TimeU.S. T-Bond Futures
CRB Index11
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Figure 1.3 S&P 500 versus Bond Futures (weekly data)1600
140–00130–00
1400
120–00110–00
1200
100–00
1000
90–0080–00
MonthsU.S. T-Bond Futures
S&P 500 Futures
CurrencyThe third inter-market relationship can be seen in the comparison of currencies tointerest rate futures. As noted elsewhere in this book, the value of a currency obviously is influenced by the direction of interest rates in a country. For example,falling U.S. interest rates have a negative impact on the dollar, while rising ratesraise the value of the dollar. Thus an inverse relationship exists between the values of currencies and those of interest rates. Figure 1.4 shows how T-bill futureshave trended in the opposite direction of the U.S. dollar. As T-bill futures pricesrise, short-term U.S. interest rates drop. (See also Figure 1.5 for the relationshipbetween bond prices and the dollar.)Figure 1.4 Dollar Index versus T-Bills Futures (weekly data)94.10
109
94.00
108
93.90
107
93.80
106
93.70
105MonthsT-Bill Futures
U.S. Dollar Index Futures12
Trading Stocks versus Trading Commodity Futures
Figure 1.5 Dollar versus Bonds (weekly data)100–00
115
95–00
110
90–00
105
85–00MonthsBond Futures
U.S. Dollar Index Futures
Thus when you see the dollar going up, it may be a bullish signal about theeconomy, but it also may be bad news about interest rates. They are probablyincreasing.
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Chapter 2
The Electronic Exchange
THE ADVENT OF ELECTRONIC TRADINGThe most visible and exciting part of the traditional futures exchange is the trading floor with its pits and hundreds of people milling around, shouting, waving theirhands, and talking on telephones.The electronic exchange replaces all of that physical hurly-burly with a computer screen and a keyboard. Electronic trading is conducted by video display terminals tied to a central data processor where the bids and offers are matched. Theorder goes through a series of split-second computer and account checks and getsautomatically executed, or denied execution, cleared, and settled electronicallyinstead of going through the slower process of human hands. Thus, the world offutures trading has changed dramatically.The European exchanges have swiftly moved to the forefront with electronics trading. The Germans’ Deutsche Termine Bourse (DTB), one of the largest inthe world, is a completely electronic exchange and has had phenomenal growth.15Copyright 2001 The McGraw-Hill Companies. Click Here for Terms of Use.
Chapter 2
LIFFE (London International Finance Futures Exchange) started in the early 1980sand has grown rapidly. On September 16, 1992, when the currency turmoil hitEurope and both sterling and lira fell out of the European exchange mechanism,the volume of trading on LIFFE exceeded the volume on the CME and the CBOT.LIFFE has been completely electronic for about two years. In France, Marche àTerme de France (MATIF), the French futures exchange is completely electronic.Europe’s smaller exchanges—Stockholm’s SOM, Amsterdam’s EOE, Zurich’sSOFFEX, et al.—are also completely electronic and many of them are tied together in a way that allows their products to be traded on each other’s exchanges.The growth in futures and options business in European markets is mainlythe result of increased business from European banks and institutional investors thatare using futures and options, as well as other derivatives, to manage risk associated with their balance sheets and investments. These institutions are big hedgers.All of them are comfortable with electronic trading.
THE CRASH OF ’87, THE CHICAGO STING, AND THEGROWTH OF ELECTRONIC TRADINGAlthough electronic trading was put forth and fostered by various people in the U.S.since the late ’60s and early ’70s, it did not catch on in the U.S. largely becausethe U.S. exchanges had too much invested in the buildings, hardware, and methodof trading associated with “floor trading.” It took a stock market crash and a trading scandal in Chicago to change things.The crash of October 19, 1987, was a major public relations disaster for theChicago futures exchanges. On that day, the Dow Jones Industrial Average dropped23 percent