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C H A P T E R 1
WHAT IS A FUTURES CONTRACT?
If you could know the future value of anything, you would naturally be able to get rich. In all public markets, investors and traders share this common dream, and the anticipation of future price movement dictates how and where investment decisions get made. In fact, the futures market is a formalized version of this forward-looking pattern. But it involves commodities, indices, and financial instruments rather than stocks.
One famous writer spoke of the future as "That period of time in which our affairs prosper, our friends are true and our happiness is assured."1 This makes an important point about all forms of investing. Optimism is often a ruling force, and those investors who look optimistically to the future expect prices to rise, hopefully immediately after they take up a position in the stock, bond, or futures contract.
As a philosophy of investing, the futures market contains a never-ending series of price estimates for future goods: oil, grain, livestock, metals, coffee, currency exchange, and even stocks. Futures contracts set a price of future delivery. This does not mean that if you buy a futures contract, you expect to actually take delivery of the product involved; it does mean that if the actual price moves higher than the fixed price of the futures contract, you can sell that contract and take a profit.
This is only one basic explanation of how futures contracts work and are traded. The variations involve not only different positions (long or short) but different structures as well (direct trades, indices, or exchange-traded funds, for example).
A good starting point is to carefully define the futures contract. This is an agreement involving the purchase and sale of a specified amount of a commodity (or index, currency, or other asset of value). The contract sets the value as well as the delivery date; it is standardized, meaning that the expiration cycles are set ahead of time, monthly or quarterly. So delivery occurs every three months. The reason for standardizing futures contracts is to make them more easily exchanged in the market. When every futures contract is set by date and amount, traders have an efficient market and can easily find the value of every existing contract. The futures contract can only be bought or sold on the futures exchange, and only a member of that exchange can execute the transaction.
In a futures contract, a good-faith margin deposit is required at the time the contract is originated. The basic transaction is speculative, but it is based on anticipation of price movement. If you buy a futures contract and the value of the underlying commodity rises, then the value of that contract will rise as well. However, you can take out your profits or close out the contract whenever you want. This feature, escapability, makes futures speculation relatively easy, so that speculation in futures works very much like speculation in the options market.
Investors buy and sell futures contracts for several reasons, using contracts directly or other investments designed to pool money. For example, many exchange-traded funds (ETFs) are designed specifically to provide investors with a range of coverage in several assets. There are a number of ways to participate in the market. First is pure speculation, with a trade entered in the belief that value is going to move either up or down. Second is to hedge other positions; for example, if you bought shares in an oil company, you may also go short in an oil ETF; that is one example of a hedge, meaning that a loss in one position will be offset by a gain in another.
The third section of this book will explain specific futures. For now, to provide an overview of the entire futures market, the following is a list of the major commodities by type:
energy—crude oil, natural gas, coal, nuclear power, solar and wind power, electricity, ethanol
grains and oilseeds—corn, wheat, soybeans, soybean oil and meal, sugar, cotton
livestock—live cattle, feeder cattle, lean hogs, pork bellies, lumber
precious metals—gold, silver, platinum, aluminum, copper, palladium, nickel, zinc
imports and tropical products—frozen concentrated orange juice, coffee, cocoa, rice
financial futures—noncommodity contracts including those on single stocks, indices, and currencies
Another way to think about the futures market involves risk and risk transfer. The futures market not only helps anticipate the future prices of products, it also helps investors and those wanting to hedge positions transfer risks to speculators who are willing to accept those risks in exchange for profit potential. It is this risk exchange that makes futures contracts so interesting. As specific commodity prices rise and fall, corresponding action and price movement in futures contracts will react at once (when the market is open), and traders react by trading in those contracts.
The Contract and How It Works
Anyone who buys a futures contract, directly or through one of the pooled investment alternatives (like ETFs, for example) takes up a long position. Just as stockholders who buy shares of stock "go long," the same important definition applies to futures buyers as well. In a long position, the sequence of events is "buy, hold, sell," a well-known and common method of investing.
A short position is the opposite. This involves first selling a futures contract (or shares of stock) and then later closing the position with a closing purchase transaction. The sequence of events in a short position is "sell, hold, buy."
One of the most crucial elements of the contract is whether you take up a long or a short position. You can do either, and, because the market is facilitated by the futures exchanges, every short position is offset by a corresponding long position, and vice versa.
The decision to go long or short defines and distinguishes risk as well. The level of risk in short positions in futures or in any other market is usually much higher-risk than the better-known long position. Those traders who understand markets well and who are willing to accept the risk may want to sell short when they believe prices are going to move down.
Taking a short position is one way to hedge other investment positions. If you own shares of stock in a company whose price is sensitive to futures values, selling a futures contract short is one way to hedge the long stock position. Hedging can also be more complex and creative. For example, to offset a stock position, you can short an ETF for the market sector to which that company belongs.
Some traders who are involved in short positions on futures contracts (or on both long and short) are operating not as hedgers but as speculators. If they believe short-term prices are going to rise, they go long; and if they think prices will fall, they go short.
How much does a futures contract cost? The cash price of the commodity, for example, also known as the spot price, is defined as the current market value of the underlying commodity. The futures price is different. It is the price of a contract that anticipates future spot price levels. Futures prices tend to track spot prices, meaning that if the cost of a barrel of oil rises today, the various futures contracts for oil are going to rise too. The closest delivery month is going to be most sensitive to commodity value and how it changes, and delivery months further out will tend to change less responsively. The distinction is an important one. The spot price reflects supply and demand in the market today; futures prices are the sum of expectations about future price movement.
Another important aspect of the contract is the method by which a trade order moves through from initiation to completion. The futures exchanges are clearinghouses for execution of trades by both buyers and sellers, and supply and demand define price levels and price movements. So large exchanges, including the Chicago Board of Trade (CBOT), Chicago Mercantile Exchange (CME), and the New York Mercantile Exchange (NYMEX) contain brokers who match up each side of the transaction and ensure that the trades are made in a timely manner.
Valuable Resource: The three major futures exchanges can be found online, at:
Chicago Board of Trade: www.cbot.com
Chicago Mercantile Exchange: www.cme.com
New York Mercantile Exchange: www.nymex.com
All trades go through one of the exchanges. Several regional exchanges, including the Kansas City Board of Trade (www.kcbt.com) and the Minneapolis Grain Exchange (www.mgex.com), manage trades through their own brokers located on the floor of the larger national exchanges. Other, smaller futures exchanges make the trading world confusing; but it is likely that with improved Internet systems in the future, you will see mergers along the smaller exchanges or acquisitions by the larger ones. These exchanges facilitate international trading throughout the world.
When exchange members need to buy futures contracts, they present bids. Sellers present offers in the ask price. The net difference between bid and ask price is called the spread, and this is the profit brokers make for executing trades on the exchange floor. By definition, a bid is the highest price the buyer is willing to pay, and the ask is the lowest price a seller is willing to accept. The floor broker has the task of filling orders for anyone outside of the exchange, including commodity brokers, financial institutions, portfolio management companies, and the general public. Most floor brokers are excluded from trading on their own accounts.
Another type of trader is the local, those exchange members trading for their own accounts. These include day traders, position traders, and scalpers. A day trader is an individual who enters and exits positions within a single trading day, often many times. Typically, day traders limit their open positions to a few hours, and may complete their transactions within a matter of a few minutes. A position trader holds a futures contract open for several days or a few weeks. A scalper moves positions around very rapidly, often matching buyers and sellers to "scalp" the spread. Big volume equals small spreads, but a lot of small spreads can add up quickly. Scalpers provide a valuable function by matching long and short positions throughout the trading day.
Orders move from the customer, to the broker, and then to the exchange floor; from the trading floor desk, orders go directly to the trading pit to be executed. Then the process is confirmed, with information flowing back to the trading floor desk, to the exchange floor, then to the broker, and finally back to the customer. Most people tracking their trades are going to be aware of only one person, their broker, and may not realize how many steps are involved in the placement of the trade.
The Investment Value of Futures
It is a mistake to think of futures trading as an investment. By definition, investing usually involves buying a product and holding it until it grows in value, or earning current income (interest on debt securities or dividends on equities). But beyond investing is an activity known as speculation. Because futures are intangible contracts and not products, they are not investments but speculative plays. The entire futures market is a series of speculative trading decisions. The use of futures contracts as hedging strategies can certainly augment a long-term investment portfolio; but futures are not the same as tangible products like shares of stock.
Earning a profit from futures trading is more difficult than it might seem on paper. Many people have convinced themselves that by speculating on futures full time, they can retire from their jobs and make a living as traders, perhaps even get rich. The truth, however, is that this is a risky idea. You might make money on a series of consecutive trades, increasing your dollar positions each time. But it only takes one reversal to wipe out your profits. And reversals are inevitable.
Futures have to be viewed for what they are: speculative devices best used to hedge or to enter positions when you expect strong price movement in the desired direction. It also is prudent only if you limit your risks to an affordable level. Selling all your equities and mortgaging your home to begin a new venture as a futures trader is not a smart idea, even though some people in the business may promise you unimaginable riches.
A perspective on futures requires a complete appreciation of the risks involved. Those futures relating to noncommodity items, like stocks or currency exchange, can move quickly, and relative values may change in a short time. Even commodities are not intended to act as investments, but to be bought and sold on the open market. The futures contract is a method for speculating on the price of a commodity, based on changing supply and demand and based on scarcity. For example, in 2007 a movement began in the United States to develop ethanol as an alternative energy source. But as a direct consequence of farmers beginning to grow more corn, the prices of corn rose, affecting market-wide prices of many other foods as well. Corn is not held in anyone's account the way that shares of stock are held; it is grown specifically to address a demand for corn. If corn were merely to be used as feed for livestock or as a key ingredient in so many different foods, the supply and demand aspect of futures prices would be easily understood. Adding the competition between feed/food use and energy, supply and demand for corn takes on a new dimension.
This example demonstrates how a futures contract can change in value based on emerging market realities. Futures prices rise because demand also rises. For example, as China continues to grow into an industrial power, its energy demands are growing more rapidly than any other country. Oil is recognized as a finite resource, and alarming estimates are continually made about when we will run out. (Actually, since 1910, "experts" have been predicting that oil is going to run out within a decade, and these estimates are updated every decade. This topic is documented in Chapter 9 in more detail.) Demand, or at least the perception of future demand, is what most directly affects the price of oil futures contracts. This is sensitive. For example, if conflict is anticipated in the Middle East in a way that could disrupt the flow of oil, future scarcity becomes one possibility that will affect the value of an oil futures contract.
Some esoteric factors also affect futures prices. One is inflation. Many traders expect, at the very least, that commodity values should match inflation. In other words, demand for ethanol may increase the price of corn. But even without increased demand, traders may argue that corn values (and oil, livestock, or lumber) should at least match the rate of inflation. This argument may hold during times of moderate or low inflation, but what happens when inflation rises? No one can know the answer to this, any more than they can predict future rates of inflation. Another factor is currency exchange. What happens to prices of domestic commodities and to imports if the U.S. dollar declines against other currencies? Concern about this causes increased speculation in U.S. and other currency futures. However, it also affects futures contract values on commodities.
The expert estimates of long-term changes are not always right, any more than expert predictions about dwindling oil reserves have been wrong for at least 100 years. Many doom-and-gloom predictions have been made concerning shortages and famines. For example, the famous Paul R. Ehrlich predicted in 1967 that between 1970 and 1985, a series of ever-worsening famines due to population growth would result from many resources running out. Not only was Ehrlich wrong about the timing of these predictions; in fact, the agri-technology of food production has improved in recent years to the extent that the threat is to the profitability of farming rather than to the ability of the human race to survive. Ehrlich's ideas led to the founding of the zero population growth movement, and he later published his predictions in book form as well.2
It is impossible to predict future commodity prices with certainty, just as it is impossible to predict the market value of a particular stock. Rational arguments can be made supporting the contention that prices are going to change in a particular direction, but even the most compelling arguments may be wrong. When Ehrlich predicted worldwide famine in 1967, he could not imagine how populations would actually grow nor how agriculture would change so that those people could be fed without running out of resources. Today, shortages of oil are more likely than concerns about famine nearly a half century ago.
So the "investment value" of futures cannot be defined in the same terms as the investment value of stocks or real estate. Futures contracts are going to exist for a short period of time, and they have no specific value on their own. They are predictions anticipating future value. However, a speculative value can be identified, but this is elusive. Anyone offering predictions about the future is just as likely to be wrong as a rank amateur. This fact makes futures trading very interesting. Very few futurists have ever been right about the timing or extent of events. Those predicting serious bear markets, depressions, and famines are no more likely to be right. The "science" they use is not actually science, and use of the scientific method is not useful for estimating the future. Today's global warming advocates have no actual science to prove what will happen in the future either, although many are ready to predict that higher seas and warmer climates will definitely affect commodity prices. But these proponents of the belief rely on a consensus of opinion rather than on actual data. No one really knows. And in the futures market, that equals potential for profits. Because you cannot know the price of anything in three months, the speculative futures market is the place to go to put your money down in anticipation of price direction.
Pt. 1 Knowing Your Market
Ch. 1 What Is a Futures Contract? 3
Ch. 2 How Futures Trades Are Made 22
Ch. 3 Reading Futures Prices 38
Ch. 4 Risk Levels of Futures 53
Pt. 2 Reaching the Market
Ch. 5 Order Placement 79
Ch. 6 Fundamental Analysis of Futures 89
Ch. 7 Technical Analysis of Futures 103
Ch. 8 The Leveraged Approach: Options on Futures 122
Pt. 3 Classifications of Futures
Ch. 9 The Energy Market 147
Ch. 10 Agriculture 170
Ch. 11 Livestock 192
Ch. 12 Precious Metals 200