5 pips. If the rollover were done at this differential and the originalvalue date of the trade were July 5, the rollover transaction would be:Customer sells 100,000 EUR/USD for value date July 5 at 1.2600.Customer buys 100,000 EUR/USD for value date July 6 at 1.259965.Therefore, the customer has liquidated and then reinstated a position at amore favorable price. If the customer had been short EUR/USD, the rolloverwould have resulted in a reinstatement of the position at a less favorable price.Alternative Method Traditional rollovers are done based on exchange ratesthat exist on the date of the rollover. This means that, if the customer holds the position for any length of time, the original trade price is lost in the midst of all therollover transactions that flow through the account. The overall economic effectof the transaction does not change, but it is difficult to track the actual profit andloss of a given position that may be on the books today but was initiated sometime in the past.However, another way to handle this position maintenance necessity is particularly attractive to retail investors. The positive or negative effect of the rollovertransaction can be calculated automatically and simply credited or debited to the
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customer’s account. If we use the previous example, the credit to the customer’saccount would be calculated as follows:100,000 × 1.2600 = 126,000.00100,000 × 1.259965 = 125,996.50126,000 – 125,996.50 = 3.50So, in this example, the customer’s account would simply be credited $3.50.When this procedure is followed, the original trade price remains on the position that is carried in the customer’s account. This will then allow the customer’saccount statement to reflect the gross profit or loss of the trade, comparing theoriginal trade price against current market valuations. Of course, in calculating thenet profit or loss of the trade, debits or credits from rollovers would need to beconsidered as well.Because of the nature of what is actually being traded (currencies on deposit),the foreign exchange market is inextricably tied to the fixed-income markets.These rollover transactions are the equivalent of overnight repurchase agreementscommonly done in the world’s money markets. These trades are done by banks allover the world, and the actual rates (differentials) are determined within theframework of a highly competitive marketplace. There is a bid and an offer for anytwo value dates in all currency pairs. So it is relatively easy for a dealer to pricethese rollovers every day.
SPOT MARKET VERSUS FUTURES MARKETAlthough there are similarities in some functions, spot forex trading and futuresforex trading have some differences. Here are some of the main issues.
Principal versus ExchangeSpot forex trades are contractual obligations between two counterparties. A trade between a dealer and a customer is a principal transaction between those two parties.No other entity is involved in clearing or guaranteeing the performance of the parties.Futures market trades are executed on a centralized exchange through a futures broker who also performs the role of the customer’s clearing firm. The otherparty to the transaction is anonymous, and the trades are guaranteed by the exchange’s clearing organization.
Contract TermsSpot forex trades can be done in any size and are usually for value two businessdays after the trade date. Either currency can be the base currency.
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Futures market trades must be done in standardized units for specific valuedates in the future. The base currency is fixed.
Price Quote ConventionsSpot forex trades are quoted in European terms. This traditionally means that mostcurrencies, when traded against the U.S. dollar, are quoted as the number of currencyunits per one U.S. dollar. For example, “USD/CHF at 1.2150” means it takes 1.2150Swiss francs to buy one U.S. dollar. Exceptions are the euro, British pound, Australian dollar, and New Zealand dollar. For example, EUR/USD at 1.2510 means ittakes 1.2510 U.S. dollars to buy one euro. Trading terms and conventions in the spotforex market have historically been geared to the sophisticated institutional or commercial user. In recent years, however, some dealers have created account structuresand electronic trading platforms that simplify the process and make it more convenient and less confusing to retail investors. For example, some of the trading platforms feature a standardized contract size and specific currency pair conventions.Many futures market contracts are quoted in American terms. A currency isquoted in the quantity of U.S. dollars per unit of foreign currency. For example, aSwiss franc futures contract at .8283 means it takes .8283 U.S. dollars to purchaseone Swiss franc.
Dealer versus BrokerFutures market customers often refer to their account representatives as theirbrokers. The firm that carries the futures customer’s account is called a brokeragefirm because it charges fees for brokerage and clearing services. Those fees payfor facilitating the customer’s trading activity on futures exchanges and for thefiduciary services of carrying the customer’s account.A forex dealer is not a brokerage firm; it is a market maker and a principal toall transactions. Sometimes a forex dealer will offer services similar to a brokerage firm’s services, but the key difference is that the dealer is a direct trading counterparty to the customer. A dealer may have relationships with brokers for thepurpose of introducing customers. Mostly, this occurs when a broker has a valueadded service to offer the customer. This could be in the form of investment planning, trade recommendations, or even the introduction of professional tradingcompanies to act as third-party traders for customers. In these cases, a commission fee is usually added to the customer’s trading activity and paid to the introducing broker. Typically, though, these brokers are not employees of the dealer.
ELECTRONIC TRADINGUntil about 1992, “electronic trading” was a description of any trading activity bytwo counterparties conducted via a mechanism other than the telephone—in
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essence, electronic messages between two counterparties. Then the marketplace saw the development of several “electronic broking” systems—the Globexsystem at the CME, the Reuters Matching system, and Electronic Brokerage Systems (EBS).Futures brokerage firms and their clients use the Globex system to trade futures contracts on currencies. The other two systems are used by forex dealers totrade among themselves. These systems allow for the continuous posting of bidsand offers available to participants on the system. Counterparties are anonymousuntil after transactions are made.As this technology has advanced, it has also become more practical for individual dealers to provide electronic trading capabilities to their customers. In thelate 1990s and early 2000s, several dealers developed their own systems to providethis service to their customers. By early 2004, any forex dealer serious about serving its customers’ best interests had developed and implemented systems to enable customers to enjoy the ease and convenience of trading electronically,utilizing the Internet.These systems, or trading platforms, provide the customer a constant streamof bid/offer quotes. Some of these platforms allow transactions to be executedwith only a couple of mouse clicks. Others use a process known as “request forquote,” which means that the rates quoted are only indications, and a specific request has to be made to get a bid and offer for any deal. Some platforms are moresophisticated than others and provide for straight-through processing, charts,news, and online, real-time account statements. Trades done on these platformsare principal transactions between the customer and the dealer.
COSTS OF TRADINGThe first thing a trader should consider when assessing the costs of trading forexis the spread between the bid and offer. This is because the spread is the first thingthat needs to be overcome for a position to be profitable. Large institutional customers, such as investment and hedge funds, demand and get the narrowestspreads. These are typically three to four pips wide in the major currency pairs. Individual investors generally see bid/offer spreads of five pips or more.The dealer provides liquidity to customers by maintaining a constant streamof bid/offer prices. The dealer makes money when a customer hits the dealer’sprice and the dealer is able to lay off that position somewhere else (usually another dealer) at a more favorable price.
Brokerage FeesA commission is usually charged as a dollar amount per standard quantity ofcurrency traded. This standard quantity can be $100,000, $1,000,000, or any
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other quantity that makes sense to the client and the broker. For instance, futures brokers often like to have the commission be the same as it would be on afutures contract.However, a markup, which is another form of transaction fee, is not discernible to a client once the trade has hit the account statement. The bid/offerspread may be widened to accommodate the markup. Alternatively, the markupcould be applied to the price at the time the trade hits the back-office processingsystem. In either case, the markup is done in pips.In general, the dealer does not participate in commissions or markups unlessit performs regulatory oversight of the broker.
RegulationFor many years, U.S. regulators hotly debated who should have jurisdiction overthe forex market. The CFTC and the SEC were primarily concerned about protecting the public, while the Federal Reserve fought against any attempt to implementregulations that might affect the way commercial banks do business. The core ofthe issue was how to provide adequate customer protection while maintaining abasic framework allowing banks to conduct their normal banking activity unfettered by unnecessary constraints.While this debate was going on, unscrupulous forex investment schemes werebeing chased down by local and state law enforcement agencies that got no helpfrom federal guidelines and business practice regulations.The Commodity Modernization Act of 2000 clarified much of the uncertaintythat had existed in the U.S. forex markets. It provided a definition of a “retail investor” in the forex marketplace and specifically identified what type of institutions can deal with those retail investors. It also appointed the CFTC as thegovernment agency with regulatory oversight of the retail forex markets in theUnited States.Today, specific rules and business practice guidelines that are similar to thosethat exist in the commodities and securities markets are being applied to forexfirms that deal with retail investors. Any investor can review these rules and guidelines as well as check up on investment firms, dealers, and brokers at the NationalFutures Association web site at www.nfa.futures.org.
C H A P T E R 11
Decidingto Trade
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y now you probably have formed some opinions about whether trading futures, options on futures, or forex should be part of your overall investmentportfolio as an alternative asset class. You have read about the advantagesthat these trading instruments offer, how and where they are traded, what you cantrade, and whether it is feasible with the size of trading account you can fund.If you do decide to add futures to your portfolio, here are some of the criticalmatters that you need to consider:• How much money will you be trading in your futures account?• How much time do you have to devote to futures trading?• How much knowledge do you have about futures, about trading, and about themarketplace in general?• What is your trading personality?Answers to these interrelated questions will go a long way in determiningwhat futures markets you trade and how you may want to trade them.
THE MONEY FACTORMoney is a primary prerequisite for any trading program. The first money issue, ofcourse, is the amount you put into your trading account. The second involves covering your expenses to conduct trading.An overriding money issue, whether for your account or for trading expenses, is the source of your trading funds. The money you use to trade should bemoney you can afford to lose without having it affect your lifestyle. You should181
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not be tapping into your retirement or college fund or your household budget tofund your trading experience. The money you put into your trading accountshould be considered money at risk, and it should not be a factor in how you liveif you lose it.
Your Trading AccountBrokerage firms typically require a minimum of at least $5,000 to open a futurestrading account, but both you and the firm will probably be more comfortable ifyou start trading with at least $10,000 or $20,000. The larger your account, themore diversified your positions can be and the more staying power you have, increasing your chances for trading success.Starting with $5,000 may preclude you from trading markets you would liketo trade or know best. For example, you might like to trade S&P 500 index futures, but the full-size contract has a margin requirement that is about fourtimes the size of your starting amount, making it impossible to trade that contract, no matter how well you think you might be able to master trading. Eventrading the E-mini S&P, your initial $5,000 will limit your trading to one contractwhereas trading multiple contracts might be more suitable to your trading program—in effect, all of your eggs are in one basket and you have no possibilityfor diversification.Of course, most futures contracts do not have such large margin requirements, and it is possible to begin trading with as little as $5,000. But the main pointis that you should have a realistic view of what you can accomplish with theamount of money you do have available for trading. The discussions about leverage, risk, and margins in earlier chapters should provide some guidelines for theamount of money your trading plan requires.
Your Trading ExpensesThe amount of money you need to cover your trading expenses can vary widely,depending on how simple or sophisticated you want your trading setup to be.More than likely, your initial expenses will include some or all of these items:• Computer to receive quotes, analyze prices, and convey orders to a broker.• Internet connection through an Internet service provider, preferably a highspeed alternative.• Information sources, such as news, charts, research, or advisory services.• Price quotes. You may need only end-of-day, snapshot, or delayed quotes,but many active traders prefer real-time quotes, which not only involve datavendor fees but also exchange fees for each exchange providing a real-timedata feed.• Commissions. Compared to some of the other costs of trading, this may beone of your least concerns.
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The brokerage firm you choose may provide a number of these resources (seeChapter 6), but you should be aware that getting set up to trade may requirespending an amount of money over and above the amount you actually need forfunding your trading account.
TIME FOR TRADINGIf you have a $5,000 or a $20,000 account, trading may be a sideline for you whileyou maintain your day job. Even if you have a substantially larger account, youmay have a business that requires much of your time. Or you may prefer to spendmuch of your time with family, hobbies, or some other activities that are important to you.How much time do you plan to devote to: (1) learning how to trade futures,(2) monitoring prices and analyzing markets to find trading opportunities, and(3) actually making the trades? In your initial enthusiasm for trading, you may believe you have enough time to handle everything associated with trading, but timeis a critical element of trading that should not be overlooked any more than theamount of money you need.
KNOWING THE MARKETWhat you already know about futures, market analysis, and the trading processmay determine how much time you need if you hope to trade successfully. Or itmay determine how much money you decide to put into your trading account, depending on the confidence you have in your trading skills based on your knowledge of the market.Is this your initial exposure to the futures market? Are you familiar with thefundamentals of the market you want to trade? How much do you know abouttechnical analysis? What type of education do you think you need so that you feelcomfortable that you are prepared to begin trading? How much trading experiencedo you have? Do you know when and how to use various orders or when to exit abad position?
WHO ARE YOU?You can probably give pretty definite answers to the questions about how muchmoney you want to put into a trading account, how much time you want to devote
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to trading, and how well you know the markets and trading. But the most difficultquestion of all involves the personal traits you bring to trading.How suited are you to deal with the stresses of trading? What is your tolerancefor risk? How would you react if you had a big losing trade—or, almost as important, a big winning trade? What is behind your decision to trade futures? Whatmakes you think you can succeed as a trader?You may think you have the answers to these questions, but how you thinkand how you actually react in the heat of a trade may be totally different. That iswhy it is very important to analyze yourself as carefully as you would analyzeany trade and to find a trading style and situation that are most compatible withyour personality.
YOUR TRADING PLANMoney, time, knowledge, and personality are all interrelated issues that have abearing on what you can trade and how you will trade. You can’t really deal withone of those matters without considering them all.The next decision is where you will implement your trading program. Perhapsyou are unsure as to whether you should trade yourself, work with a broker to assist in the trade selection process, or have your money managed by a professionaltrader. This question is very important, and you need to determine what worksbest for you. Let’s examine each scenario.
Do It YourselfIf you are thinking about becoming a self-directed trader, ask yourself the following questions:• Do you have a trading plan? This plan starts with your motive for trading inthe first place and encompasses your whole trading approach—the time frameyou will trade, what markets you will trade, your criteria for entering a position, how much money you will risk on each trade, what factors will determine when you exit a trade, and so on.• Do you have time to devote to the markets to execute the trading plan youhave formulated? This includes acquiring knowledge about trading and doingthe research you need to make each trading decision as well as to do the actual trading itself.• Do you have the personal risk tolerance to sit with a position when you haveto make the decision to exit a trade? You can train your brain, but controllingyour heart may be another matter. Simulated trading is an excellent way tolearn the mechanics to prepare yourself for trading, but your emotions may
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react differently when real money—your money—is on the line. Will you beable to make a rational decision when you have to make the call to take a lossor a profit?If you answered yes to all of these, then you may just have what it takes totrade futures on your own in a self-directed account. If you answered no to any ofthese, then other alternatives may be more suitable for you.
Work with a BrokerIf you like everything about futures but have some shortcomings when it comes totime or knowledge, you may want to seek some help from a full-service broker.There is nothing like experience to help avoid some of the most common pitfallsand mistakes in trading, and that, among other things, is what a seasoned brokercan bring to the table.If you have some basic ideas about what you want to trade or how you want totrade or you want to make the call on what positions to take but aren’t sure how toexecute the order, the help of a broker can be invaluable. He or she can help you intiming your trade entry, controlling your risk by assessing your risk management,or producing ideas about refining your entry and exit points. In short, the experienced broker can enhance any trading program you may have by explaining howto put it into action in a variety of ways.In addition, a broker can offer some creative strategies you may not even beaware of or provide you with trading recommendations, backed up by the information and research capabilities of a large firm. With a broker-assisted account,you may be able to receive a complete course on trading or trading tips via a website, e-mail, newsletter, or some other means. The broker can be your trading mentor and can tailor his/her input to exactly what you need.
Have a Professional Trade Your AccountYou may have decided that you want futures to form part of your portfolio butthat it might best be left to someone else to make all of the trading decisions foryou. Many investors lack the time, knowledge, or personality to trade an account themselves, so turning their futures account over to a professional mayindeed be the best route to go for those who are more comfortable investingrather than trading.You may also decide to trade your own futures account but to place some ofyour funds with a professional futures trader as a way to spread your risk orachieve diversification. Even professional traders sometimes have other professionals manage a portion of their trading funds because that gives them exposureto a different trading method or removes their emotional involvement from making trading decisions with that money.
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There are several ways to get professional trading help, depending on theamount of money you have to commit. Your brokerage firm can introduce youto many commodity trading advisors or to a trading method that can be tradedautomatically by a broker. In either case, all of the trading is done on yourbehalf. Instead of making a trading decision, your decision is which professional program to choose after evaluating a variety of trading styles and trackrecords. Then you simply monitor the performance of the professionally tradedprogram.
PICKING A BROKERAGE FIRMWhether you decide to put your money into a self-directed account, trade with afull-service broker, or place your futures account in the hands of a professional,you will need to find a brokerage firm to execute your trades. The brokerage firmis your link to the exchanges where the trading actually takes place, and youshould find a firm that can handle all the things you need to trade in the manneryou have determined.I can’t think of the last time I went an entire day without seeing an ad in thenewspapers, on television, or on the Internet from one of the hundreds of brokerage firms offering “the best service possible,” “commission-free trading,” “freeeverything,” or some similar enticement. Although you can choose from amongnumerous firms, many of which do provide excellent service, you still need tomake the important decision about where to open your trading account based onwhich one best meets your needs and not which one is cheapest.My philosophy in selecting a futures broker is the same philosophy I use ineveryday life: You get what you pay for. When I pay top dollar for something that Iknow is important to me, I get the best product or the best service. If there is aproblem, I know the company will stand behind its product. But when I try to cutcorners and save a few bucks, I am invariably sorry.While saving money is a worthy goal in general, when it comes to somethingimportant (and I believe your brokerage service is), I recommend finding the bestthere is and worrying about price later. Saving a few dollars in commissions is notrelevant when you are talking about the type of trade support you need from yourbrokerage firm when navigating these markets.In making that selection, you need to make some basic decisions aboutyour own trading situation first and then do a little research to find the rightbrokerage firm and perhaps the right broker within that firm. You need to lookat the trading support tools the firm provides, the trading platform, the marketsand products you can trade, and the help you can expect to get if trading becomes hectic or disrupted.The history and stability of a firm can be quite telling. There’s a reason thatsome firms are larger than others and have been in the business longer. It’s gener-
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ally because the firm has found a way to provide the best possible service. Findout how long a firm has been in business, how many clients it has, and the amountof customer-segregated funds it has on deposit.The previous chapters should have given you more insights into what to expect and what you need, whether your account is self-directed, broker-assisted, orprofessionally managed. Refer to them for help in determining what type of brokerand brokerage firm is best suited to you.
CHAPTER 12
Openingan Account
I
f you have ever purchased any real estate or a new vehicle or applied for a loan,you may have been overwhelmed by the paperwork and wondered how allthose forms could possibly be necessary for what seems to be a relativelystraightforward transaction. When you open a futures account, be prepared formore of the same. All of the paperwork does have a purpose for both the clientand the brokerage firm, also known as a futures commission merchant (FCM).For the client:• Discloses the risks associated with futures trading.• Describes the rights and responsibilities of each party to the transaction.• Educates the client about the process of futures trading.For the FCM:• Provides information regarding the client’s finances.• Discloses the client’s level of knowledge and experience in markets the clientintends to trade.• Describes the rights and responsibilities of each party to the transactions.When you trade, you want to know that every person on the other side ofyour positions will fulfill the terms of the transactions into which you have entered. Other traders expect the same thing of you and deserve to know that youhave been screened and found acceptable to participate in trading. The Commodity Futures Trading Commission (CFTC) and National Futures Association (NFA)require FCMs to have complete information on file prior to opening an account aspart of their due diligence. This paperwork also serves to protect both you andthe FCM.189
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OPENING ACCOUNT INFORMATIONFCMs have standard opening account documentation that must be filled out before an account can be opened. The forms are different, depending on the type ofaccount—for example, individual versus corporate. The CFTC also specifies whatinformation needs to be obtained from customers and what risk disclosures haveto be provided to clients.Forms include a customer account application, which asks for basic identifying information (name, address, telephone number) and, for an individual, employment status (see Figure 12.1). Customers also need to provide financialinformation such as annual income, net worth and estimated liquid net worth,amount of capital available, banking information, and trading experience. Customers will need to disclose if they have any affiliations or employment with anycompany associated with the futures or securities industries.The customer agreement is the contract between an FCM and its customer.The customer agreement:• Authorizes the FCM to purchase and sell futures contracts upon the customer’s oral or written instructions, subject to the rules and regulations of theexchanges and other markets.• Requires the customer to provide and maintain margin requirements.• Authorizes the FCM to liquidate the customer’s positions in certain circumstances.• Obligates the customer to pay specified charges and fees.• Requires the customer to report discrepancies in statements.• Requires the customer to acknowledge that investment in futures contracts isspeculative and involves a high degree of risk.There may also be one or more agreements about the customer’s anticipateduse of an electronic trading platform. Other provisions in a customer agreementmay limit the customer’s ability to file a lawsuit to a certain jurisdiction or venue,shorten the time allowed for filing claims, or require the customer to waive theright to a jury trial.
RISK DISCLOSURESFutures trading involves a substantial risk of loss, and customers must acknowledge that they are aware of this risk and will accept responsibility for any lossesthat result from taking this risk. Customers also must acknowledge that they understand that, because of the low margins normally required in futures trading,price changes in futures contracts may result in significant losses, which may
Opening an Account
FIGURE 12.1 Account Application Form Book 2, page 1. (Source: Lind-Waldock)
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substantially exceed the margin deposits that the customer has made. Finally,customers must indicate that they have read and understood the risk disclosuredocument that the FCM sends to each customer.If a customer is a novice to futures trading, is retired, or is over the age of 65,the FCM will require the customer to sign an additional risk disclosure. The customer must acknowledge that the funds in the trading account are pure risk capital and that the loss of those funds will not jeopardize the lifestyle or retirementprogram of the customer.Many FCMs use online trading platforms, and many customers prefer to usethem to enter their own orders online. Consequently, electronic trading agreements are often included in an FCM’s opening account documents. These outlinemany of the risks associated with online trading such as technical problems, system capacity issues, Internet-related problems, security breaches, theft, and unauthorized access.If the customer decides to have a broker at the FCM trade the account with atrading system or wants to open a managed account, the customer will also be required to sign a document acknowledging receipt of a disclosure document containing the system or broker’s performance data, as well as some additionaldisclaimers and risk disclosures.If a customer intends to trade single-stock futures, an additional risk disclosure document will be provided. Trading in security futures contracts requiresknowledge of both the securities and the futures markets. In addition to the substantial risk involved in trading futures products, the customer may be unable toliquidate if trading is halted due to unusual trading activity in either the securityfutures contract or the underlying security, if a system failure occurs on an exchange or at the firm carrying the position, or if the position is in an illiquid market. If a customer holds a position in a physically settled security futures contractuntil the end of the last trading day prior to expiration, the customer will be obligated to make or take delivery of the underlying security, which could involve additional costs.
TYPE OF ACCOUNTCustomers are categorized according to the type of account to be opened. MostFCMs accept individual accounts in the name of one person, joint accounts in thename of two individuals, as well as corporate, trust, limited liability company, andretirement accounts. The last-named accounts require the submission of additional paperwork, as the FCM will want to assure itself that these entities are authorized to trade in commodity futures. The FCM will request corporateresolutions, copies of trust documents, or documents relating to the organizationand operation of the entity or retirement plan demonstrating that trading in futures is authorized.
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POWER OF ATTORNEYA customer may decide to leave the trading decisions in their account to anotherperson or entity, giving authority to trade to a friend or relative, a broker, or a commodity trading advisor. If so, the customer must give written power of attorney tothat person to allow him or her to trade the account. The FCM will want writtenassurance that the customer accepts full responsibility for all trading decisions inthe account and agrees to hold the FCM harmless from any loss that the managerincurs trading the customer’s account. For more information, see Chapters 4 and 5on managed futures and auto-executing trading systems.
CUSTOMER IDENTIFICATION (PATRIOT ACT REQUIREMENTS)Prior to September 11, 2001, many FCMs performed a preliminary credit check,making sure that the forms were completely filled out and that the name on the account was the same as the name on the check or bank account that was fundingthe account. Their compliance departments made sure that any third persons trading the account were registered, if so required. The accounts were also screenedto make sure that a corporation or a trust, for example, had authorized the opening of an account on its behalf and that the trader was authorized to place thetrades. Finally, the accounts were screened to identify persons with either a criminal or regulatory history.Since September 11, 2001, and the passage of the Patriot Act, the new accounts department, in conjunction with the compliance department, mustscreen accounts more closely. FCMs require customers to furnish proof of identity and address, so customers must now provide a picture ID and proof of address. FCMs are also now required