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ALL ABOUT FUTURES
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O T H E R T I T L E S I N T H E“ A L L A B O U T . . .” F I N A N C E
S E R I E S
All About Options, 2nd Editionby Thomas McCafferty (0-07-045543-0)All About Stocks, 2nd Editionby Esmé Faerber (0-07-134508-6)All About Bonds and Bond Mutual Funds, 2nd Editionby Esmé Faerber (0-07-134507-8)
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ALL ABOUT FUTURESThe Easy Way to Get Started
RUSSELL R. WASENDORF
Second Edition
McGraw-HillNew York San Francisco Washington, D.C. Auckland BogotáCaracas Lisbon London Madrid Mexico City MilanMontreal New Delhi San Juan SingaporeSydney Tokyo Toronto
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McGraw-Hill
Copyright © 2001 by The McGraw-Hill Companies. All rights reserved. Manufactured in the United States of America. Except aspermitted under the United States Copyright Act of 1976, no part of this publication may be reproduced or distributed in any formor by any means, or stored in a database or retrieval system, without the prior written permission of the publisher.0-07-139575-XThe material in this eBook also appears in the print version of this title: 0-07-134170-6.All trademarks are trademarks of their respective owners. Rather than put a trademark symbol after every occurrence of a trademarked name, we use names in an editorial fashion only, and to the benefit of the trademark owner, with no intention ofinfringement of the trademark. Where such designations appear in this book, they have been printed with initial caps.McGraw-Hill eBooks are available at special quantity discounts to use as premiums and sales promotions, or for use in corporate training programs. For more information, please contact George Hoare, Special Sales, at george_hoare@mcgraw-hill.comor (212) 904-4069.
TERMS OF USEThis is a copyrighted work and The McGraw-Hill Companies, Inc. (“McGraw-Hill”) and its licensors reserve all rights in andto the work. Use of this work is subject to these terms. Except as permitted under the Copyright Act of 1976 and the right tostore and retrieve one copy of the work, you may not decompile, disassemble, reverse engineer, reproduce, modify, create derivative works based upon, transmit, distribute, disseminate, sell, publish or sublicense the work or any part of it without McGrawHill’s prior consent. You may use the work for your own noncommercial and personal use; any other use of the work is strictlyprohibited. Your right to use the work may be terminated if you fail to comply with these terms.THE WORK IS PROVIDED “AS IS”. McGRAW-HILL AND ITS LICENSORS MAKE NO GUARANTEES OR WARRANTIES AS TO THE ACCURACY, ADEQUACY OR COMPLETENESS OF OR RESULTS TO BE OBTAINED FROMUSING THE WORK, INCLUDING ANY INFORMATION THAT CAN BE ACCESSED THROUGH THE WORK VIAHYPERLINK OR OTHERWISE, AND EXPRESSLY DISCLAIM ANY WARRANTY, EXPRESS OR IMPLIED, INCLUDING BUT NOT LIMITED TO IMPLIED WARRANTIES OF MERCHANTABILITY OR FITNESS FOR A PARTICULARPURPOSE. McGraw-Hill and its licensors do not warrant or guarantee that the functions contained in the work will meet yourrequirements or that its operation will be uninterrupted or error free. Neither McGraw-Hill nor its licensors shall be liable to youor anyone else for any inaccuracy, error or omission, regardless of cause, in the work or for any damages resulting therefrom.McGraw-Hill has no responsibility for the content of any information accessed through the work. Under no circumstances shallMcGraw-Hill and/or its licensors be liable for any indirect, incidental, special, punitive, consequential or similar damages thatresult from the use of or inability to use the work, even if any of them has been advised of the possibility of such damages. Thislimitation of liability shall apply to any claim or cause whatsoever whether such claim or cause arises in contract, tort or otherwise.DOI: 10.1036/007139575X
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C O N T E N T S
Preface
The Nature of the Futures Market viiChapter 1
Is Futures Trading for You? 1Chapter 2
Understanding the Basics for Futures Trading 13Chapter 3
Setting Goals and Creating a Portfolio 35Chapter 4
Placing Trades and Working with a Broker 49Chapter 5
Overview of Some of the Active Markets 65Chapter 6
Understanding Analysis 123Chapter 7
Breaking into Futures Trading with Options 163Chapter 8
Developing Your Own Trading System 195Chapter 9
Using Advanced Trading Strategies 213Chapter 10
Giving Trading Discretion to Someone Else 227Chapter 11
Knowing Your Rights and Recourse as an Investorin the Futures Markets 253INDEX 269Copyright 2001 The McGraw-Hill Companies, Inc. Click Here for Terms of Use.
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P R E F A C E
The Nature of theFutures MarketPhilosophers throughout the centuries have said that if Goddidn’t exist, man would have invented Him. The creation of futuresmarkets may have been just about as inevitable a concept. Humanbeings have always had a love-hate relationship with the future:They can’t wait for things to get better, and they fear what will happen tomorrow.On a more mundane level, businesspeople have at least asmuch difficulty dealing with the unknown as the average person.How can they set firm prices for the products they sell or manufacture if they don’t know what they’ll have to pay for the raw materials they use? This question is at least 6,000 years old, dating back towhen a futures market in rice is thought to have developed in China. By the Middle Ages there was already a sophisticated futurespurchasing system for wheat and wool.A futures market solves the basic business problem of the needto control as much of the future as possible. For example, if you arean importer or processor of crude oil, could you have dealt with theuncontrollable pricing that took place following the 1990 invasionof Kuwait by Iraq—without the futures markets? If you are a sellerof capital equipment to the Japanese and are to be paid in yen 120to 180 days from now, would you want to hedge the risk of thechanging currency values of your payment? What’s one of the mostefficient methods for farmers to handle the price fluctuations theyface each year while their crops are still in the ground?The futures markets permit users of commodities—e.g., grains,meats, metals, financials, food, fiber, etc.—to set a price for their future requirements well in advance of when the commodities areneeded. Notice that today’s definition of commodities stretches wellbeyond the physicals and includes security market futures, currencies, interest rates, and more. Producers can likewise lock in acceptable price levels (or profit levels) before their product is ready to besold.However, if the futures markets were restricted to bona fidehedgers (producers or users of the commodities) only, the volume
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of many contracts and some entire markets would be so low that onsome days they would not be able to trade. Volume is an essentialkey to discovering price; it is one of the most fundamental functionsof all types of exchanges. The higher the volume is at any given timefor a given commodity, the higher the reliability that its price reflectsthe current supply-demand situation. This is where speculators fitin. Speculators create liquidity in the market. They buy and sellthousands of contracts in hundreds of markets, allowing hedgers toeasily transfer risk.Confidence in understanding where the price of a commodityshould be going—commonly referred to as the trend—inspires trading, thereby increasing volume. Additionally, high-volume marketsare safer to trade. When you place an order for a trade, you have abetter chance for it to be filled when trading volume is high. Therefore, the market function of the speculator is to create volume, sothat anyone who wants to trade has a market. The speculator’s personal objective, naturally, is to make money from the ever-changingebb and flow of prices.Who should be a speculator is a much more important question. The term speculate means to engage in risky business transactions on the chance of generating great profits. There are three keyterms: risky business, chance, and great profits.Risky business distinguishes futures speculation from gambling. Gambling generally involves sport and pure chance. Futuresspeculation is more intellectual, involves research, strategies, andplanning.Detractors of futures trading have always tied their argumentsto the second key term, chance. There is always the element of chancewhen you attempt to forecast what is expected to happen at sometime in the future. This is true for commercial real estate investors,insurance companies, bank officers who set interest rates, and evenindividuals who buy homes. The speed at which the futures markets fluctuates is what makes its detractors wrongly classify it as agame of chance.The last key term, great profits, is what attracts aggressive investors to this form of investing. A goodly percentage of individualspeculators wish to make a lot of money fast. They are greedy. Thismay be the single most important reason that most small traderslose. Success in the futures markets requires the patience to wait for
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high-quality trades, to manage money judiciously, to study themarkets and do the research required, to control emotional responses to fast-moving opportunities when they are moving for oragainst your positions, and to have a clear head when everyonearound you is losing theirs.There are rules to follow in the market that are designed to protect you against catastrophic losses, but you can’t teach someone totrade successfully. “Natural traders” are as rare as “natural shooters.”The purpose of this book is to teach you enough about the futures markets and its rules so you can protect yourself. However,this knowledge is not a guarantee that you won’t get wiped out. Themarket has a will of its own. Never forget that! If it moves violently against your position, you’ll get burned.The futures market is a zero-based market. At the end of eachday, the books are balanced. For every buyer, there is seller. Forevery seller, a buyer. That means one side wins and one side loses—every day. And every day, the losers must pay the winners in theform of margin money or reduced equity in their trading account.Some days you’ll win. More often you’ll lose. Your objective isto be a net winner in terms of dollars invested. The risk may beheavy, but the possibility of reaping very large profits over veryshort periods of time attracts the aggressive investor.Futures trading is not for everyone, but careful study will giveyou an excellent overview of futures and options on futures. Thiswill help you decide if futures trading will assist you to reach yourfinancial goals; and if so, how you go about entering the markets,what alternative approaches are available to you, and how you candevelop strategies to reduce or control risk.
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Is Futures Tradingfor You?
Key Concepts◆ Financial and Psychological Suitability for Trading◆ Five Personal Attributes of the Effective Trader◆ Four Major Obstacles to Success
The title of this chapter implies that you have some general insights into how the futures markets work. You likely know that futures prices and price trends reflect the composite response to thecurrent supply-demand equation of everyone who is in the market.If the overall attitude is bullish, the market moves higher. If tradersare bearish, it plunges. If nobody is sure or opinions are conflicting,it slides sideways.Next, you must determine if you are suitable to trade futures.This is a question your broker must also determine, as mandated bythe federal regulators that govern the industry. Your broker ischarged by the National Futures Association (NFA) and the Commodity Futures Trading Commission (CFTC) to find out if you areindeed suitable. That’s why you are asked a series of personal questions. What is your net worth? Profession? Age? Investment experience?With this information, your overall suitability is reviewed onseveral levels. Your broker makes the first screening. Your accountforms or account papers are then passed to the supervisor, who is
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usually at the introducing broker (IB) level. From here, it goes up theladder to the futures commission merchant (FCM). The FCM is theentity that actually does the trading in the pits. It is the clearing (asin clearing trades through the system) member of the exchanges. AnIB is the link between you (the general public) and the FCM. It introduces you to the market.WHO’S SUITABLE AND FOR WHAT?
There are a variety of ways of determining suitability for futures andoptions trading. One of the measures is the person’s net worth, annual income, and liquid assets.Before getting into specific evaluation methods, you shouldunderstand the difference between futures and options trading.That difference is simply the amount of risk. With futures, the riskis unlimited. The options trader can lose 100 percent of the amountinvested, but the amount is known in advance.If you are in a futures position and the market makes a limitmove against your positions, you must immediately meet the margin call if your account does not include excess equity. Also, therecould be more than 1 day in a row of limit moves. For example,once the live hogs contract limited down 6 days in a row. The limit move was $600 per day, or $3,600 for those 6 days. If you had 10positions, it would have been over $36,000 when you include commissions and fees. And this doesn’t account for days when the limit might have been extended. Margin calls can be in the millions ofdollars.Buying exchange-traded futures options involves a more defined risk. It equals the amount of the premium for the option andthe transaction costs. These latter costs are defined as the broker’scommission and fees. (There are NFA, exchange, and FCM fees tobe paid on both futures and options trades.) Here, buying optionsrefers to calls or puts. If you write options, you’ll have the same riskas a futures trader if the options are exercised. Basically, you are contracting to deliver a futures position.This analysis of the risk facing both types of traders explainswhy the net worth and liquid asset requirements differ for each typeof account. The FCM, which is the entity that holds the investor’s
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capital and executes (or arranges to execute) the trades, sets the standards.When approving an account for trading, the FCM comparesthe prospective customer resources with their anticipated tradingactivity. Are they financially suitable? For example, many FCMs willnot approve an account that plans to trade more than 10 percent ofthe customer’s liquid assets. When and if a margin call is made onthe account, the customer has 24 hours or less to meet it. Therefore,only liquid assets can be considered in the evaluation.If customers have a high annual income (in excess of $100,000per year), they may be approved even if their net worth is unremarkable. If they are not very wealthy, they may be approved totrade (buy) options since the risk is defined and the entire investment is usually made in advance.A customer’s financial position, however, is not the only consideration. Brokers are required by federal regulations to “knowtheir customers.” They have to know the customer’s true name, address, approximate age, principal occupation or business, and an indication of the customer’s previous investment and futures tradingexperience.Also, the FCM and the federal regulators (the NFA and theCFTC) want to get an insight into the experience and sophisticationof the investor. For example, very young or very elderly people mayrequire additional investigation by the FCM before they are accepted. Investors who have traded futures in the past or traded stockson margin would be considered reasonably experienced.RISK TOLERANCE
Besides learning about an investor’s financial background and previous investing experience, good futures brokers delve into the risktolerance of their customers. This is a critical consideration whendeveloping a trading plan designed to reach specific objectives. Theplan must be one the customer is comfortable trading.When doing this, a good broker attempts to classify the customer’s attitudes toward risk. Each customer is an individual, andeach one reacts differently to risk. If a broker doesn’t deal with this,a lasting bond of trust will not be created.
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When classifying attitudes to risk, economists use the term utility, which is a measure of personal satisfaction. If something provides a feeling of greater satisfaction than whatever it is comparedwith, it is said to have greater utility.As experienced brokers discuss trading strategies and risk-toreward ratios of specific trades with their clients, they learn to classify customers as averse, neutral, or aggressive risk takers. For example, a risk-averse person may not be interested in a trade thatwould be projected to return a dollar for every dollar at risk. Thesetraders want to take little or no risk and are satisfied with low, butdependable, returns. If you fit the risk-averse description, you probably should not be trading futures.The risk-neutral traders may consider trading options and/orwhat appears to be the most conservative of futures trades. The aggressive risk takers are the ones most commonly thought of as futures traders. These people are willing to take the risks required toget high utility (satisfaction) from making successful trades.When you consider your suitability to trading futures, lookclosely at all three of these areas—financial situation, investing experience, and risk tolerance—before you fill out the account papersand send in your check.PERSONAL ATTRIBUTES OF SUCCESS
Just because you are suitable doesn’t mean you’ll be successful.Studies of futures traders indicate most lose money. So who will besuccessful in the futures market? What is the most important element of a successful trading system?When active traders get together at a conference or seminar,there is often a heated discussion about trading systems. Which oneworks best? Can the fundamental trader know and evaluate all thepossible facts that influence the supply-demand equation? How reliable are technical signals and how should they be interpreted? Whenyou are using technical and fundamental analysis and you selectively override your system, which are you relying on—skill or luck?The answer lies in certain common characteristics found in successful people of every profession, namely the personal attributesof self-knowledge, persistence, discipline, patience, and independence.
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Self-knowledge in successful people is an innate understandingof themselves and their mission in life. They seem to have alittle secret that guides their lives. They have clearly definedgoals.Persistence in working hard each day to achieve these goals isessential. Objectives are usually reached in stages, with eachstep of the journey clearly defined. How does this apply tothe futures traders? Why do, as conventional wisdom tells us,95 percent of futures traders end up net losers?Discipline must be exercised in setting realistic goals. Somepeople get in the market on a whim. Someone gives them atip that corn is going to $4 or silver to $10 in the next 3 weeks.They call a broker and put on a futures position or buy an option. Conversely, a broker might have called them with the“trade of the century.” Their odds of winning are the same assomeone who purchases a lottery ticket. Very few win; manylose.Patience must be used by the serious futures trader. The trader is no different from the serious athlete. The professionalfootball player starts playing in grade school, going on to 8 or9 successful years at the high school and college levels. Andyet, after 10 to 12 years of hard work, the player is still arookie! More years of sweat and bruises and the player maybe taken seriously in the NFL, and make it eventually to thePro-Bowl or Super Bowl. Most commodity traders do notspend 10 years preparing for their first serious season in themarkets, but in the long run they must learn the regimen.Independence in knowing yourself and staying focused is important. It really doesn’t matter what type of trading systemis employed. Systems of all sorts have proven successful. It isimportant that you choose a system that fits your personalityand unique character so that you will be consistent with theelements of the systems that are profitable, but will maintainthe individuality to change the system when necessary.Here are a few oversimplified examples. If you look at a headand-shoulders topping chart formation that projects a 22-pointmove lower and feel “in your heart” it is all hocus-pocus, youshould not be a technical trader. Or if you feel totally overwhelmed
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by all the information processed by a fundamental trader, that’sprobably not your calling either. Any system must suit the individual or it will fail. Traders who develop sophisticated systems requiring 1 or 2 hours of daily updating may be frustrated to learnthey don’t have the time or inclination to service such a system.Your system must suit you, your psychological makeup, andthe time you have available to administer it. Additionally, you needto believe in your system, and trust it, work with it, and refine it until it makes money for you. Without the patience, persistence, anddiscipline mentioned earlier, you’ll never succeed as a futures trader.OBSTACLES TO SUCCESS
This brings us full circle to the secret of success. It’s not the “magic system” that reaps success in the markets. You need achievableobjectives, a plan to reach those objectives, and a system in whichyou have faith—a system that matches your personality and helpsyou withstand the setbacks you’ll experience on the way. Last of all,you must learn to conquer four major obstacles everyone faces—fear, pride, hope, and greed.The ancient Greeks would easily relate to how an intelligent,aggressive trader with a strong market position ends up taking amassive loss on that position. The Greeks coined a word for whatoften happens to otherwise skillful people: hubris. Its common definition is simply “overbearing pride.” Be wary of the trader whosays, “I know where the market is going!”You’ll often find the four witches of greed, pride, hope, and fearaccompanying hubris. This foursome has brought more people whocould have been successful in the market to their financial kneesthan just about anything else.Why are these emotions so prevalent among traders, and whymust they be minimized or reduced for the trader to be successful?The first part of the question is easy to answer. These emotions aresimply human nature, and it is hard to separate human nature fromany task.The trader on a roller coaster of emotion is not a pretty sight.Take the trader who establishes a long position in crude oil futures.There really isn’t a specific trading plan, other than just a feeling orhunch the market is going to rally.
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Indeed, the first week in the market, crude oil rises by 50 centsa barrel. The trader has realized a profit of $500 (not including broker commissions and other trading fees). The trader says, “I made$500 in one week. That’s pretty good, but I want to make a $1,000profit on this trade.”At the beginning of the second week, crude oil is continuing torally strongly and prices rally by another 50 cents. As prices rise,sentiment becomes more bullish. (Remember that sentiment is mostbullish at market tops.) The trader knows there is already a $1,000profit, but can’t resist the bullish news and the hope of gaining evenmore profits. Greed is setting in.Toward the end of the week, some negative fundamental newssurfaces that sends crude oil prices plummeting by 75 cents a barrel. In one day the trader has lost $750 in profits. “It’s just a correction; this market is still headed to new highs,” the trader thinks tohimself. “Besides, media reports are still being heard on all the bullish factors in the crude oil market. I had $1,000 in profits and I needto get back to that level, and then I’ll get out.”The next day the market drops another 75 cents a barrel—putting the trader at a loss of $500 on the trade. Now the fundamentals in crude oil are not quite as bullish as they were, accordingto the media reports. The trader says, “I’m not going to lose on thistrade. I had $1,000 in profits just last week and lost it. Now, I justwant to get back to even money. When I get to even money, I’ll exitmy position and try another market.” This trader is hoping to getback to even so as not to be a loser on this trade. Nobody likes tolose.The last day of the week the crude oil market falls sharply by$1 per barrel as bearish news hits the market. The downdraft in priceis so sudden and so late in the trading day that the trader is not ableto exit his position by the time the market closes.Now fear has set in. But hope is still at play—the unlikely hopethat prices will rocket higher just as fast Monday as they fell on Friday. A more realistic hope is that prices will stabilize enough to justget out of the trade without any further damage.Having a specific plan of action when initiating a trade willgreatly reduce, and—the hope is—eliminate, the emotions that canbe so damaging to the trader. Know your entry and exit points.Know how much profit you think you’ll realize—or how much loss
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you will tolerate. Then, when you’ve got your trading plan all laidout and you’ve entered the trade, don’t let emotions change yourstrategy. Don’t listen to what the “herd” is saying. The herd is usually wrong. Calm, cool, and collected traders stand a much betterchance at success than do traders who ride all their emotions during a trade. This is where that personal attribute of independencecomes in to play.The answer may also be hidden in the past. Just as the ancientsoffered an ox or a goat to the gods, you must make a sacrifice. Weoften refer to it as “swallowing one’s pride.” One way of doing thisis being brutally honest with yourself in your trading journal. Let’ssay your system flashes a sell signal while you are holding a longposition. You override it, only to watch your profits evaporate asprices head lower. In your journal, if it is to be of any real value toyou, you must state how you violated your system. Your journalmust force discipline upon your trading. If it does only this, it willbe well worth all the time and trouble it takes to maintain.One way to prove to the market that you have conquered or atleast can manage greed is to take windfall profits. Let’s say you’reshort silver. Your analysis indicates it should go down a quarter overthe next 30 to 90 days. Shortly after you get your order filled, silverdrops a half dollar, 25 cents more than you expected. Do you takeyour unexpected profit, wait for it to go down further, or place aclose stop to protect profits?If you selected take the profit, you profit $2,500 minus transaction costs. If you wait for it to go down, you are blinded by greed,and this could lead to a devastating loss. If you place a close stop,you are still fighting greed, but you have shown some management.You’re still in the market. You still have a profit, at least on paper. Ifall goes well, you’ll eventually be stopped out with a profit.If you trade multiple positions, you can demonstrate your mastery of greed by closing out part of your position when it becomesprofitable by disciplining yourself to trade in three lots. You’re longcorn. It moves up to within a range from one-half to two-thirds ofyour objective. You close out one position at this point. Then youclose your second when your objective is hit, and you speculate withthe third using a stop.Eternal hope can put you in the poorhouse. You may surviveon hope in your personal life, but it can be extremely damaging inthe markets. The usual scenario revolves around a position that is
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moving against all your best judgments. Just about everything indicates you are wrong, but you keep hoping the market will turn inyour favor. Hope is addictive, numbing your discipline. Open yourjournal and write down why you are staying in this market. If you’refrank with yourself and write “because I hope it will go my way tomorrow,” you are in trouble. Cut your losses short. If you still thinkthe market will turn, place a stop reversal order in the market. However, do it only after reevaluating the situation and entering it as acomplete new trade that meets all your criteria for a new trade.Where greed and hope abound, fear is close by. It is faced daily in the markets. Fear of losing money, fear of making a stupid error, fear of looking foolish in the eyes of peers. Probably the most effective way of controlling fear is by sacrificing a portion of profit.The old adage—bears win, bulls win, hogs lose—comes into play.You can limit some market fear by not trying to pick tops or bottoms.If you are riding a bull market to seventh heaven, get off at the sixthcloud. Take your profits and bank them. Or you can hedge your position. If you are into a large position on the long side, consider buying some puts that are