<s> The CompleteGuide toFutures TradingWhat You Need to Know aboutthe Risks and Rewards
LIND-WALDOCK
John Wiley & Sons, Inc.
The CompleteGuide toFutures Trading
The CompleteGuide toFutures TradingWhat You Need to Know aboutthe Risks and Rewards
LIND-WALDOCK
John Wiley & Sons, Inc.
Copyright © 2005 by Lind-Waldock, a division of Man Financial Inc. All rights reserved.Published by John Wiley & Sons, Inc., Hoboken, New Jersey.Published simultaneously in Canada.No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any formor by any means, electronic, mechanical, photocopying, recording, scanning, or otherwise, except aspermitted under Section 107 or 108 of the 1976 United States Copyright Act, without either the priorwritten permission of the Publisher, or authorization through payment of the appropriate per-copyfee to the Copyright Clearance Center, 222 Rosewood Drive, Danvers, MA 01923, 978-750-8400,fax 978-646-8600, or on the web at www.copyright.com. Requests to the Publisher for permissionshould be addressed to the Permissions Department, John Wiley & Sons, Inc., 111 River Street,Hoboken, NJ 07030, 201-748-6011, fax 201-748-6008, or online at www.wiley.com/go/permissions.Limit of Liability/Disclaimer of Warranty: While the publisher and the author have used their bestefforts in preparing this book, they make no representations or warranties with respect to theaccuracy or completeness of the contents of this book and specifically disclaim any impliedwarranties of merchantability or fitness for a particular purpose. No warranty may be created orextended by sales representatives or written sales materials. The advice and strategies containedherein may not be suitable for your situation. You should consult with a professional whereappropriate. Neither the publisher nor the author shall be liable for any loss of profit or any othercommercial damages, including but not limited to special, incidental, consequential, or other damages.FUTURES TRADING INVOLVES THE SUBSTANTIAL RISK OF LOSS AND IS NOT SUITABLE FORALL INVESTORS.Designations used by companies to distinguish their products are often claimed by trademarks. In allinstances where the author or publisher is aware of a claim, the product names appear in InitialCapital letters. Readers, however, should contact the appropriate companies for more completeinformation regarding trademarks and registration.For general information about our other products and services, please contact our Customer CareDepartment within the United States at 800-762-2974, outside the United States at 317-572-3993 orfax 317-572-4002.Wiley also publishes its books in a variety of electronic formats. Some content that appears in printmay not be available in electronic books. For more information about Wiley products, visit our website at www.wiley.com.ISBN-13 978-0-470-05559-5 (pbk.)ISBN-10 0-470-05559-6 (pbk.)Printed in the United States of America.10
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ContentsForeword
ix
Preface
xi
About the ContributorsCHAPTER 1
Futures: The Investment for the Twenty-First Century
Historical Roots
xiii12
What Futures Are
2
What Futures Are Not
4
Who Trades Futures?
9
Making Your Choice
11
CHAPTER 2
13
Becoming a Futures Trader
Trading Decision Issues
14
Fundamental Analysis Highlights
18
Technical Analysis Highlights
25
Putting It All Together
56
CHAPTER 3
59
Trading with a Broker as a Partner
What a Broker Can Offer
59
Options versus Futures
65
Market Should Fit Strategy
66
Paper Trading, Back-Testing
67
CHAPTER 4
69
Letting the Pros Trade Your Account
Why Managed Futures?
70
Where Do You Start?
74
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CONTENTS
Evaluating Trading Programs
76
Investing in Managed Futures
80
CHAPTER 5
83
Using an Auto-Executing Trading System
Why an Auto-Executing Trading System?
83
Look at Yourself First
85
What to Look for in a Trading System
86
Why “Successful” Systems May Fail
88
Summing up Systems
89
CHAPTER 6
91
Resources for the Self-Directed Trader
Brokerage Firm Choice
91
Trading Platform
93
Trading Support Tools
95
Match Resources to Your Needs
98
CHAPTER 7
99
Knowing Your Margins and Marching Orders
Trading on Margin
99
Order Types
101
Placing Orders
108
Tips about Trading Mechanics
110
Connectivity Issues and Questions
113
CHAPTER 8
115
Futures: Diverse Markets You Can Trade
Equity-Based Futures
117
Financial Instruments
122
Commodities
127
CHAPTER 9
Options on Futures: A Flexible Trading Tool
Issues to Consider When Investing in Futures Options
139140
Mechanics of Futures Options
144
Basic Futures Options Strategies
151
Contents
CHAPTER 10 Forex: Another Opportunity for Traders
vii167
What Is the Forex Market?
167
Exchange Rates and Central Banks
171
The Trading Instrument
172
Spot Market versus Futures Market
176
Electronic Trading
177
Costs of Trading
178
CHAPTER 11 Deciding to Trade
181
The Money Factor
181
Time for Trading
183
Knowing the Market
183
Who Are You?
183
Your Trading Plan
184
Picking a Brokerage Firm
186
CHAPTER 12 Opening an Account
189
Opening Account Information
190
Risk Disclosures
190
Type of Account
192
Power of Attorney
193
Customer Identiﬁcation (Patriot Act Requirements)
193
Single-Stock Futures
193
Account Funding Requirements
194
Margin Calls
194
Resolving Disputes
195
CHAPTER 13 The Tax Factor for Traders
197
Section 1256 Contracts
197
How to Report Gains or Losses
199
Special Considerations
201
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CONTENTS
CHAPTER 14 The Business of Futures: Who Does What
203
Regulatory Structure
203
Futures Exchanges
205
Clearinghouses
205
Futures Industry Professionals
207
APPENDIX A Domestic and International FuturesContract Volume
211
APPENDIX B Futures Contract Specifications
251
APPENDIX C Speculative Margins
269
Glossary
273
Index
289
Foreword
As its title suggests, this landmark book makes futures trading accessible to mainstream individual investors. The determination of whether futures are right foryour portfolio remains with each individual, but The Complete Guide to FuturesTrading can serve as an expert advisor to help you make informed decisionsabout how to participate in the exciting derivatives markets.Written by experienced industry practitioners, the book answers the questionsa newcomer to futures and commodities trading might have about what it takes toestablish an account and make a commitment to trading.This is not a book about trading futures, however. It does not offer tips abouta particular technical or fundamental approach to the markets. Instead, it servesas a bridge between having an interest in futures—yet knowing little about how togo about acting on that interest—and placing a trading order in your futures account. After reading it, you will know what questions to ask yourself and your brokers and other industry professionals when getting ready to establish a futurestrading account.Readers who are new to futures trading will be interested in the range of topics covered, because it will answer questions about how to get started tradingcommodity futures:• Which type of account is best for me?• What should I know about risk, leverage, and margin?• Is my comfort level with risk in line with what futures trading provides?• What questions should I ask when looking for a brokerage relationship?• How are futures taxed?• What resources do I need as a futures trader?• What are the different ways to approach making a trading decision?• What are the various types of orders I can use?• What markets can I trade?Clearly written by contributors with a depth of practical understanding thatcomes from years in the futures industry, The Complete Guide to Futures Trading
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addresses these issues and others in a well-organized, easy-to-follow style. Aschief executive officer of the largest financial exchange in the world for trading futures and options, I can wholeheartedly recommend this volume for the readerwho wants to learn the fundamentals of investing in futures.CRAIG S. DONOHUEChief Executive OfficerChicago Mercantile ExchangeMay 2005
CME is the largest financial exchange in the world for trading futures and options on futures—serving risk-management needs globally through a diverserange of derivatives products on its CME® Globex® electronic trading platformas well as on its trading floors. Today the company is in 27 countries, withmore than 740 direct customer connections, annual sales in excess of $735 million, and 1,300 employees. In 2004, CME handled nearly 800 million contractswith an underlying value of $463 trillion. The first financial exchange in theUnited States to go public, CME is traded on the New York Stock Exchange andNasdaq under the symbol “CME” and has a market value of nearly $7 billion.
Preface
F
utures are the investment of the twenty-first century.At the beginning of the twentieth century, investing in stocks was considered a risky proposition for individuals, who were advised to stick to buyingbonds. Now, over 50 percent of U.S. households invest in the stock market directlyor indirectly through mutual fund holdings—even in retirement accounts. At LindWaldock, we believe writers of the twenty-second century looking back on thetwenty-first will say the same about investment in futures.Although U.S. futures markets began in the mid-1800s, they didn’t haveglobal significance until the 1980s, when companies and governments worldwideembraced the instruments as financial management tools. Futures markets havealways been about price discovery and transfer of risk, so are ideally suited toenvironments of uncertainty and high volatility—an apt description of the past30 years.The collapse of the gold standard in 1972 led to free-floating currency exchange rates—and the first financial futures contracts, foreign exchange, at theChicago Mercantile Exchange. Inflation throughout the 1970s and early 1980s ledto record-high interest rates—and new futures contracts in U.S. Treasuries andEurodollars. Stock index futures came into their own during the bull market of the1980s, and were an inextricable part of the institutional investor’s playbook withinless than five years.Now, futures are part of a savvy individual investor’s playbook, too.Technological advances—most significantly, the Internet—have transformedthe futures trading landscape. Today, individual investors are on a level playingfield with professional traders and institutional investors, particularly in electronically traded futures contracts, with online order entry and execution. What’s more,“mini” products created specifically to appeal to individual investors are now standard among exchange offerings.This book reveals the many ways that individuals can use futures for tradingand portfolio diversification. Our aim is to remove the mystique about tradingfutures, clear up common misperceptions, and prepare individuals to begin usingfutures as a trading or investment tool in a responsible manner. The productsare highly leveraged and marked to the market daily. Thus, the industry is wellregulated and has superior financial safeguards in place to ensure trading integrity.xi
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PREFACE
So, if you understand the risks and are able and willing to accept them, there’s noreason you shouldn’t take advantage of the benefits inherent in futures. As wepoint out many times throughout this book though, futures trading is not suitablefor all investors.The first few chapters introduce you to the futures markets, explain their history and purpose, and provide an overview of how individuals participate in themarkets. Specifically, you’ll learn about the choices you have in trading or investing in futures—from working with a broker to investing in a professionally managed product or trading on your own. This will help you decide which path isright for you.Later on, we introduce you to the myriad of futures products available totrade—from the Dow Jones Industrial Average to gold to soybeans—and provide abrief background on the factors important to price movement in each market. Yetanother chapter delves into the way many traders use technical analysis as a decision-making tool. In addition, you’ll learn about options on futures and cash foreign exchange trading in two chapters devoted specifically to those topics.Our book helps you understand the “hows and whats” involved in futures trading—including opening an account, types of orders, margins, tax treatment, andresolution of disputes.The Complete Guide to Futures Trading is your futures trading handbook. Theprofessionals who have contributed to this effort bring decades of devotion and experience in the futures industry to the subject matter. We challenge you to learnfrom their experience, and as a result, make an informed decision about whetherfutures are right for you and your investment portfolio. We sincerely hope that thisbook convinces you that there may be a place for futures in your investment playbook, and guides you in making appropriate decisions about how you trade.A twenty-first–century investor needs to know about the investment of thetwenty-first century. That investor is you, and that investment is futures.MARK B. SACHSPresidentLind-WaldockApril 2005
About the Contributors
Carol Dannenhauer is Director of both the Managed Accounts and Auto-Executedivisions at Lind-Waldock. Carol began her industry career in the late 1970s. Shespent a number of years working on the floor of the Chicago Mercantile Exchangebefore beginning her association with Lind-Waldock in 1986, the year she receivedher futures license. Carol devotes her time to Lind-Waldock’s Managed Accountsdivision, which serves as the liaison between the client and the commodity tradingadvisor community, and to the Auto-Execute division, which caters to clients whowant to trade using platforms or auto-executing systems in their trading.Phillip Fondren directs retail foreign exchange trading for Man Financial Inc,Lind-Waldock’s parent company. Phil began his career as a bullion trader andshifted to foreign exchange in the early 1980s when international money flowsspurred a huge demand for investment services in foreign exchange. He receivedhis futures license in 1981. Phil has run foreign exchange trading and sales operations for several firms, having joined Man Financial Inc in 2005.Susan Abbott Gidel is Director of Marketing at Lind-Waldock. Susan began her career in the futures industry as an editor at Futures Magazine, covering the industry’sdevelopment during its explosive expansion into financial futures, options, andstock indexes worldwide. She is also the author of Stock Index Futures & Options:The Ins and Outs of Trading Any Index, Anywhere (John Wiley & Sons, 1999).Jim Gombas is Director of Lind Plus, Lind-Waldock’s Broker-Assisted division.Jim began his career with Lind-Waldock on the floors of the Chicago Board ofTrade and the Chicago Mercantile Exchange in 1984. He received his license in1985 and moved into the Retail Sales division of Lind-Waldock, which he thenmanaged until 1994 when he started the Lind Plus division. Jim’s team of marketstrategists offers a myriad of services to clients who choose to have a futures professional work with them as they trade.Greg Gulotta is Vice President of Trade Center Operations at Lind-Waldock. Gregreceived his license in 1983 and began his career with Lind-Waldock in 1985 in theTrade Center. In the ensuing years, Greg assumed positions of increasing operational responsibility and assumed the position of vice president in 2001.xiii
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Dave Howe is Director of Sales at Lind-Waldock, a position he assumed in 2005.Dave received his futures license in 1987 and joined Lind-Waldock as an accountexecutive in 1988. He was promoted to Sales Manager in 1999 after moving upthrough the ranks within the sales department. His staff is the first point of contactfor most investors interested in establishing a relationship with Lind-Waldock.Dan McMullin is the former Director of Business Development at Lind-Waldock.Dan, who is now an independent trader, has more than 16 years of industry experience, having traded futures for his own account both on the exchange floor andfrom the back office. He received his license in 1988. He was a principal of a smallbrokerage firm and has worked with and advised hundreds of professional and retail investors. Dan devoted a significant amount of his time to developing and delivering educational programming to investors.Laura Oatney is Content Manager in the Marketing Department at Lind-Waldock.Laura began her futures industry association at the Chicago Board of Trade in thelate 1970s. In 1982, she moved to the then-fledgling National Futures Association,the industrywide self-regulatory organization for the futures industry, where sheserved ultimately as Director of Communications and Education. She joined LindWaldock in 2003 and received her futures license in 2005.Mark Sachs is President of Lind-Waldock. Mark has spent almost 20 years in thefutures industry, 18 of which have involved increasing levels of operational responsibility within Lind-Waldock. He started with Lind-Waldock as an account executive in 1986, the year he received his license. In the early 1990s, he wasresponsible for opening and managing Lind-Waldock’s London and Hong Kong offices. When he returned to the States, he managed both the firm’s corporate relationships and its 24-hour global trade operations. In 2002, he was promoted to theposition of president. He has served on various committees for the Futures Industry Association and on the Chicago Board of Trade’s Futures Commission Merchant Committee.Nancy Westwick serves as Counsel to Lind-Waldock. After receiving her JurisDoctor degree in 1996, she completed her Master’s in Financial Services Law in2000, the same year she joined the firm. Previously, she had worked for various equity option traders and security brokerage firms for almost two decades. Nancycurrently serves as chairperson of the Futures & Derivatives Law Committee ofthe Chicago Bar Association.
The CompleteGuide toFutures Trading
CHAPTER 1
FuturesThe Investment for theTwenty-First Century
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nvestors have many choices today for investing their money. The first onethat often comes to mind is the stock market. It has been estimated that morethan 50 million U.S. citizens have some stake in the performance of the stockmarket, either through investments in individual stocks or mutual funds or viaparticipation in 401(k) or other company plans, individual retirement accounts,government pension plans, or some other program that gives Main Street residents a piece of Wall Street action.Then there are the bank certificates of deposit and numerous types of bondsthat have long been familiar investment vehicles—passive instruments that arebased on interest rates and don’t require much attention.So you may be wondering why you should be interested in a more active trading style featuring futures, options on futures, or cash foreign exchange markets,traditionally perceived as more risky places to put your money.Futures markets have benefits that the stock market simply can’t provide, andtraders are just beginning to discover what brilliant tools they are for participatingin a wide variety of markets. Long known, used, and understood by producers andusers of commodities such as grain, gold, and crude oil, futures markets today alsoencompass such financial products as stocks, stock indexes, and interest rates.What’s more, futures markets are not just a U.S. phenomenon—they exist theworld over, on every continent but Antarctica. Just take a look at Appendix A, “Domestic and International Futures Contract Volume,” and you’ll see how diverse theproduct offerings are and how global today’s marketplace really is.When it gets right down to it, futures aren’t hard to understand. In fact, theyare fairly straightforward. Like stocks, “buy low, sell high” is the basic premise.What’s different is that you can trade futures with leverage, and on either a longor a short position. That introduces an additional element of risk not present in1
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THE COMPLETE GUIDE TO FUTURES TRADING
the stock market. Another significant difference is that there is no uptick rule infutures. Thus, it is just as easy to sell short as it is to buy, thus easing entry into aposition to capture a downward move in prices.
HISTORICAL ROOTSSome people say that the concept of futures trading began in China nearly 1,400years ago and that it was also used in the Japanese rice market centuries ago. Butfutures trading as U.S. traders know it today has its roots in the mid-1800s when itall started in Chicago, the city that works.Mother Nature blessed Chicago with a location that lent itself to becoming acenter of commerce—at the south end of Lake Michigan and at the mouth of ariver system that reached all the way to the Gulf of Mexico. From Chicago, distributors and suppliers could reach the East Coast via the Great Lakes and the midsection of the country by river. This location in the middle of the United Statesalso helped Chicago become a railroad hub.This was good news for producers and users of commodities, such as wheatand corn. Farmers brought their harvest to Chicago to sell it to the companies thatwould turn it into bread and other foodstuffs. Chicago provided one central location for buying and selling. It was a great idea but still needed improvement.At harvest time, the supply of grain overwhelmed the demand, so prices werelow. Months later, prices would rise as supplies dwindled. Farmers wanted a wayto cash in on the higher prices. Users wanted a way to ensure steady supplies aswell as smooth out and better predict how much their raw ingredients would cost.So they started making deals that established the price of grain for a delivery datein the future.But there still was the matter of what we call today “counterparty risk.” TheChicago Board of Trade (CBOT), founded in 1848, solved the problem by creatingstandardized contracts for the future sale of grain. The contracts were interchangeable, so the buyer or seller of a contract could get out of the obligationwithout any harm to the original counterparty. In the 1920s, the CBOT added aclearinghouse to become the ultimate counterparty to everyone who trades a futures contract. To date, this clearinghouse system has never had a default.Economic necessity gave birth to futures markets. And good old American ingenuity has kept redefining the futures markets ever since.
WHAT FUTURES AREA futures contract is an obligation to buy or sell an underlying product at a specific price at a specific time in the future. We’ll explain each key phrase in thatsentence, so you can understand the elements that define a futures contract.
Futures: The Investment for the Twenty-First Century
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“Obligation to Buy or Sell”The key word is obligation. Unless you offset your original position before thecontract expires—and nearly 100 percent of speculators do just that—you musteventually buy or sell at the agreed-upon price when the contract expires. Hereis a brief explanation of how buying and offsetting a position might work with anE-mini Standard & Poor’s 500 stock index futures contract. All futures contractsfollow this same scenario, differing only in the total contract size and value ofthe contract.Long Position Example You buy a June E-mini S&P 500 index futures contract when it is trading at 1000. The contract size is $50 times the index level, soyour position equals a $50,000 ($50 × 1000) stake in the S&P 500 index. If the indexgoes up 10 points before the futures contract expires, you would receive $500, lesscommission and fees.If the index declines 10 points to 990, the value of the contract drops to$49,500. Unless you offset your position by selling a June E-mini futures contractbefore it expires in the third week of June, you will be obligated to pay the difference in contract value of the price at which you bought versus the final expirationprice to fulfill your side of the deal. This cash payment occurs because the E-miniS&P 500 is “cash-settled.” In futures contracts that require physical delivery, youwould be required to buy the underlying product. (Most futures positions are offset before expiration, however.)Short Position Example You sell a June E-mini S&P 500 futures contractwhen it is trading at 1000. Just as when buying to initiate a position, the contractsize is $50 times the index level, so your position equals a $50,000 ($50 × 1000)stake in the S&P 500 index. If the index rises 10 points to 1010 when the futurescontract expires, the value of the contract increases to $50,500.Unlike shorting in stocks, the next part in futures trading is just like the longposition example. Unless you offset your position by buying a June E-mini contractbefore it expires, you will be obligated to pay the difference in contract value of theprice at which you sold versus the final expiration price to fulfill your side of thedeal. Once again, this cash payment occurs because the E-mini S&P 500 is cashsettled. In futures contracts that require physical delivery, the seller is required tosupply the underlying product to a buyer to fulfill the contract obligation if the position is not offset. (But you don’t have to worry about that with stock index futures.)If you sell and the index declines by 10 points, you would receive the $500,less commission and fees.
“Underlying Product”Futures contracts originally were created for agricultural products such as cornand cotton. In the 1970s and 1980s, futures contracts on financial instruments such
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THE COMPLETE GUIDE TO FUTURES TRADING
as U.S. Treasury bonds and stock indexes became popular. Futures contracts onindividual stocks, called “single-stock futures,” are the latest innovation in this financial arena.Each futures contract specifies a certain amount (and sometimes quality) ofthe underlying product, so that the contract terms are standardized for all participants. For example, one E-mini S&P 500 futures contract represents exposure toall 500 stocks in the S&P 500 index. Contract standardization means that investorsdon’t have to worry about anything but the business at hand—changes in price.
“Specific Price”Futures contracts are traded in public, government-regulated forums—exchangeswhere business is conducted either electronically or in traditional open-outcrypits on a trading floor. Prices are determined by the orders that come into themarket from buyers and sellers. When an order from a buyer at $100 meets an order from a seller at $100, a trade occurs and a futures price of $100 is broadcast tothe world.
“Specific Time in the Future”Futures contracts expire at a certain time in the future. For example, a December2005 futures contract will cease to exist sometime during the month of Decemberin 2005 (depending on rules set by the exchange). Specifically, E-mini S&P 500 futures expire on the morning of the third Friday of March, June, September, and December. As with other elements of the contract, a standardized expiration datemakes it easier for investors to focus on pricing decisions.
WHAT FUTURES ARE NOTNow that you have been introduced to what futures contracts are, let’s explorehow they differ from other financial instruments you may be more familiar with,like stocks, options, and exchange-traded funds.
Futures Are Not StocksIt may be too obvious to say that futures are not stocks, but it is essential to understand the important differences between these two investment vehicles, summarized in Table 1.1.Agreements, Not Ownership A futures contract is an obligation to buy orsell at some time in the future, at a price agreed upon today. A futures contractdoes not convey ownership, as buying a share of stock does; it is only the promise
TABLE 1.1 Comparing InstrumentsFutures
Stocks
Exchange-Traded Funds
Options
Contract terms
Agreement to perform
Conveys ownership
Conveys ownership
Gives buyer a right,not an obligation
Type of contract
Standardized units, nolimit on number
Shares in a company,limited to numberissued
Standardized, nolimit on number
Standardized, nolimit on number
Time factor
Contracts expire
Continue perpetually
Continue perpetually
Contracts expire
Margin
Good-faith deposit toensure contractperformance
Down payment onownership
Down payment onownership
Buyer pays premium;seller posts margin
Leverage
High with minimummargins required generallyonly 2% –15% of contractvalue
Limited withminimum margin at50% of share price
Limited with currentminimum margin at50% of contract value
Varies with differentpositions
Short selling
Simple, involving sameprocess with same marginrequirements as goinglong
Complex, requiringuptick in share priceand borrowingshares to sell
As easy to sell as tobuy
More complex todetermine whichoption to use
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THE COMPLETE GUIDE TO FUTURES TRADING
that a buyer and seller will agree to exchange ownership in the future. Like stocks,futures contracts are usually traded on an organized and regulated exchange sothe buyers and sellers can find each other easily. Because futures contracts arestandardized and interchangeable, they can be traded anonymously among peopleon an exchange, where all that remains to be negotiated is the price.All futures contracts are settled daily (assigned a final value price). Based onthis settlement price, the values of all positions are marked to the market each dayafter the official close. Your account is then either debited or credited based onhow well your positions fared in that day’s trading session. In other words, as longas your positions remain open, cash will either come into your account or leaveyour account based on the change in the settlement price from day to day.This system gives futures trading a rock-solid reputation for creditworthinessbecause losses are not allowed to accumulate without some response being required. It is this mechanism that brings integrity to the marketplace. Or, considered another way, every trader can have confidence knowing that the other side ofthe trade will be made good. In fact, the clearing member firms—and, ultimately,the exchanges themselves—gu