Commodities and Futures Markets
The markets for commodities and financial and equity market index futures are time-based, zero-sum contract markets (just like options). I find these markets quite risky and believe trading them should involve only money that you can afford to lose (and I'm not referring to ‘play' money). Most important is that these markets can give the student of the market like me a huge amount of additional information to study when making decisions to buy or sell a stock.
Let me start by telling a sad but true story.
One of my associates was a successful commodity fund manager who also had a popular weekly radio show on the topic. One day over drinks at lunch, watching the ticker in the steakhouse frequented by market professionals, my friend noticed that commodity prices had gone against him, strongly. The more he fretted as seconds turned into minutes, the deeper it seemed the markets sunk, while to the rest of us it was no big deal. But that's the nature of leverage; it can turn quickly against you.
At first, he was anxious to return to his office. Then he dulled, grew disconsolate and sat back. Finally this proud guy -- one of Toronto's leading commodities and futures traders -- just gave up and said to us: "I've lost all my client's money. I'm finished. I guess I'll have to leave town."
All this over lunch!
This brief write-up is focused on complex markets such as commodities and financial futures, metals and gold futures, and "collectibles". As I say, I am interested in them mostly for information that I can glean to help me in my other investment programs. I do not trade these instruments, and the info I pass on here comes from other traders and from books.
Basically, professionals dominate futures markets. But I feel the investment techniques are easily grasped and can be utilized by anyone who will take time to learn the ground rules, understand what's happening, and do his or her homework. There is a higher-level risk going from options trading into futures, however, and you can never forget that.
With conservative investing in high-quality equities, patience is essential. You know the longer you wait, the more probable, and bountiful, your return on investment. With greater speculation, the gains should come faster because likely your money is not generating an income and is probably diminishing due to interest and commission costs and time decay involved with futures contracts.
But, while I personally never got into it, I do know that futures markets offer opportunities to build capital quickly and, under certain conditions, can be used conservatively to hedge and sell short positions in equity portfolios.
Advice to novice commodity traders:
The markets for commodities, financial and index futures, and currencies are where the biggest profits are made. Regardless, most speculators in these markets are losers, which concerns me.
If you are a novice trader who is newly acquainted to these expert markets, it will pay to apply the following advice:
(1) Read books about commodity trading. Then decide if you have the nerves and the funds to start speculating in these markets.
(2) If you can't afford to lose, you can't afford to win. If you are not in a position to accept losses, either psychologically or financially, you have no business speculating. Unlike stocks, remember, commodity trading is a zero-sum game. You either win or you lose.
(3) Choose an experienced broker. Deal only with a reputable company that (a) has extensive commodities trading services, and (b) has experienced staff you can trust and who know the markets that interest you.
(4) Get current information. All statistics are available in Government reports, business publications and newsletters so inside information is not a serious problem in commodities markets. Study the data and then review your conclusions with your Commodity Trading Advisor.
(5) Focus on a few commodities, preferably those in the news. Staples such as corn, wheat and hogs always have strong markets but the easier speculative profits can be made in the active groups, such as gold, metals and petroleum.
(6) Adopt the Zulu Principle. To succeed, you will have to become something of an expert in both the fundamental and technical aspects of at least one commodity or futures contract.
The Zulu Principle was described in the 1960s as being the expertise acquired rapidly in a single obscure subject, like Zulu's, by conducting an in-depth study of library books and magazine articles.
Actually, for a brief period leading up to the free elections in South Africa, I became the chief financial advisor to the Zulu nation, by appointment of Prince Buthelezi (current Home Minister of Republic of South Africa) and his associate at the time, Sipo Mzemela. It's true, but that's another story. Nonetheless, I still use the Zulu Principle concept in my discussions.
(7) Prepare a trading plan. Without a road map, you can't find your goal. Before you turn over cash to your broker, test your trading hypotheses on paper until you feel confident. Set up a game plan like this:
(i) Never meet a margin call. When your original margin is impaired by 25%, your broker will call for more money. Except in the most unusual circumstances, do not send in more money. Liquidate your position and accept your loss. This is a form of stop-loss safeguard. When a declining trend has been established, further losses can be expected.
(ii) Unless you are sure, don't. Don't get carried away by the unreal world of computer numbers and arrows. You are trading real money. If there is any doubt in your mind about the trend of the price of a commodity, do not buy or maintain a position. Better to miss a few profit opportunities through caution than throw money away recklessly.
(8) Be alert to "situations". Information is the key to profitable speculation in commodities and futures. As you become more knowledgeable, you will pick up pointers, such as:
(i) If there's heavy spring-summer rain in Maine, buy long on potatoes. They need ideal weather.
(ii) If there's a bad storm with multiple tornadoes over large portions of the Great Plains, buy wheat contracts. Chances are the wheat crop will be damaged, thus changing the supply/demand.
(iii) There are, of course, many other factors to analyze before reaching any final decision. As with everything involving the profit potential of money, knowledge plus luck are important. And be wary of the disinformation floating about.
(9) Look for a ratio of net profit to net loss of 2:1. Since most traders have more losing trades than winning trades, choose commodities where potential gains, based on trend studies, can be more than double the possible losses. When making such projections, include the cost of commissions because that can be a major factor when dealing in small units and small price shifts.
(10) Trade with the major trend, against the minor trend. With copper, for example, if you project a worldwide shortage of the metal and the market is in an up-trend, buy futures when the market suffers temporary weak spells. As long as prices keep moving up, you want to accumulate a meaningful position.
The corollary to this is never average down. Adding to your loss position increases the number of contracts that are returning a loss. By buying more, you put yourself in a stance where you can lose on more contracts if the price continues to drop.
Generally, if the trend is down, either sell short or stay out of the market. And never (well, hardly ever) buy a commodity after it has passed its seasonal high or sell a commodity after it has passed its seasonal low.
(11) Avoid thin markets. You can win big when a thinly traded commodity takes off but the swings can be too fast for you. Prices might plummet, or soar, and the amateur trader can get caught with no chance of closing positions.
(12) Watch the spreads between different delivery dates. In the strong summer market, the premium for January soybeans is 8¢ per bushel above the November contract. Buy November and sell January.
If the bull market persists, the premium should disappear and you will have a limited profit. Carrying charges on soybeans run about 6¢ per month, so it is not likely that the spread will widen to more than 13¢ per bushel. Thus, with that 8¢ spread, the real risk is not more than 5¢ per bushel.
(13) Deal in percentages. Don't take a position unless your profit goal is at least 10 times your commissions. I used to go to a casino with a player who had the idea that every day he would skilfully play 21 until he removing $2,500 from the casino owner. I've seen amateur commodity speculators take the same approach. They think they can dip into the market and automatically remove money. To do this, they must be right 60% of the time in order to cover the high commissions and loss trades. That means, unless you're very qualified, DO NOT DAY-TRADE commodity contracts.
(14) Margin requirements are irrelevant to profit and loss objectives. Margin is not a cost, a purchase price, a measure of value or a measure of available capital. It's a security deposit and nothing more.
(15) Remain a student of the market. Devote time to learning how markets inter-relate and why prices move as they do. You should know why economic recovery in Europe means higher soybean prices in Chicago and why higher soybean prices can pick up the price of silver in New York.
Some of these comments, many from a book by Colburn Hardy, are repetitive . . . on purpose. If you happen to read most any book on the subject, you will see lists of the same type of advice.
There is some excellent free educational material on the Internet. One source in particular that I recommend is TradingCharts.com Inc. TFC Commodity Charts are advertising supported services from the same company.
Commodity Trading Advisors
Professional traders of commodities and futures who receive compensation from investors and traders must be licensed as Commodity Trading Advisors (CTA). Some of the ones I've met are pretty sharp, but the best ones tend to manage their own capital or run pools/funds.
I also suspect there are a few who may be super salespersons, but couldn't trade their way out of a wet potato sack.
Most of these players use charts to locate support and resistance lines and/or time series analysis to project price trends and cycles. All of them consider fundamentals such as, for example, the outlook for crops, damage due to drought or storms, unusual demands for particular metals, shifts in government support policies, and changes in the interest rates.
And they all have very good info.
If you're going to invest here, you must be able to spot situations where the rewards are greater than the risks. Then with the odds in your favor, and the use of leverage, you could achieve excellent profits, usually quickly. Hopefully.
To manage your own portfolio successfully for the long-run in the commodities and collectibles markets, however, you are going to have to compete against professionals, or work with them, or both.
You must be aware that like a card game, these markets are zero-sum. There is a winner and a loser.
So you are competing against others, whereas in securities markets, you are competing only against yourself.
If you are going to venture into commodities and futures, I think it is important to keep aware of market dynamics and fundamental developments in all capital markets, and to act only in the few isolated instances where you truly believe the opportunities for gains are substantially greater than the possibility of losses.
And, if you are not doing well, it will pay to seek and heed expert counsel.
I am not that counsel; I lack the qualifications, or the time needed to oversee momentary changes in these markets.
To get started, you might wish to get your feet wet with a small position in a managed fund.
Commodities Mutual Funds:
Over the years I discovered a lot about the nature of the person by the type of managed fund they bought.
Maybe she was worried about those pork bellies? Do you think?
The point is that buyers of managed funds also have to be held to account.
Commodities funds, in my view, are a Wall Street pitch to let the small investor seek profits that they have been told were previously possible only for the wealthy.
For as little as $5,000, as the advertisement says, you can buy participations in a diversified portfolio managed by professionals...."Smart money goes where the profits are. In the past x years, a $100,000 portfolio in a conservatively managed commodities trading account has risen to over $500,000. Every active investor should have a portion of his assets in commodities. The rewards are high and, by tested techniques, losses are limited and profits can run."
Maybe so, but let's see how these funds operate.
These funds are an outgrowth of managed individual accounts for wealthy persons, where the trading advisor did not want to have to deal with small investors.
They are similar to mutual funds in that brokerage firms sell limited partnership interests to the public, generally in five $1,000 units. The proceeds are pooled to buy, or sell, futures contracts in some large number (say 18) of the most active, most potentially profitable contracts.
Management typically uses a market-proven system that is supposed to automatically trigger sales and signal buying points. They are speculations and, usually, the fund is structured so that it will be closed out when 50% of the original capital is wiped out.
Participations can be bought and sold, with short notice, at the end of each monthly or quarterly reporting period. If you need money in a hurry, you will have to sell at a loss if the market is down at the time.
There are no dividends, only capital gains or losses. These are short term and taxable, to the individual, at regular federal income tax rates.
Look at the requirements in the Fund's prospectus. While exact terms might vary, the proposals typically call for:
(1) Limitation of sales to individuals who have a net worth (excluding home, furnishings, and automobiles) of (a) $50,000 or (b) $20,000 plus an annual income of $20,000.
(2) No sales load. All of your dollars are used to trade in commodities.
(3) Commissions 20% to 25% below the regular rates charged to most individual customers.
(4) Payments to the registered representative of 15% to 25% of total commission on a proportionate basis e.g., for a $5 million fund, the broker who sells 5 units ($5,000) will get 1/10th of 1%, which sounds small but, over a year, will be substantial. An extreme example I read about is a fund that reported adjusted brokerage fees of $203,385 on fund assets of $7.2 million in three months!
In addition (and this is typical), the management group receives 20% of net profits plus 1% of net monthly assets if the net assets exceed 3.2% of fund assets plus interest on the investment of cash reserves in Treasury bills.
The single biggest advantage of commodities funds is that the best ones have staying power. They have sufficient resources to keep going despite interim losses . . usually. But even some good ones go broke too.
Never forget that these are speculations. There is no real wealth being created. The managers are trading against each other in a series of paper transactions. It is a zero-sum game.
Seeking Alpha in Commodity Trading Funds:
In studying a commodity fund, here is what you should be looking for in fund management:
Above all, a professionally managed commodities or currencies fund should be trying to accomplish what you presumably can't do for yourself.
(1) Track record.
This fund should have been working well for the long run, with a management track record based on 10 years' experience rather than ten times one years' experience.
(2) Limited losses.
Stopping losses is more important than making gains in the commodities business. To keep losses low, positions must have been closed out at definite points over the years. Look for proof a fund does that.
(3) Unlimited profits.
I'd be uncomfortable with a fund manager who is trying to pick bottoms and tops, or one who uses a system that supposedly picks tops and bottoms. The manager should not always be trying to make purchases at the very cycle bottom, nor sales at the very top. There is no need to, and, besides, that's where the risks are greatest.
Whenever there's a sustained move, a well-run fund should capture, as profit, a large slice of the middle of the move " same as in other capital markets. As long as the move continues without a valid crossing of the MA in the opposite direction, positions should be maintained.
(4) Caveat with commodity trading funds: Watch the tax angle. Commodity funds are limited partnerships, so your share of realized gains and losses will be passed along directly to your tax return.
For the individual, the important factor is the period of holding because most gains and losses in commodity funds are short-term so they are taxed at ordinary rates or with limited deductibility.
One fund finished the year with $ 1.8 million in unrealized profits (so no benefits), but they also had $1 million in realized losses. Even if the losses may have been tax deductible " and they're not always, -- ouch!
Insert table of futures contract specs here
Financial futures:
With financial futures, you are playing the interest rate game, so they are a little different than commodities. Some of us, even some economists and bankers, know a thing or two about interest rates.
In the past few years, the unprecedented swings in interest rates have exposed businesses and financial institutions to severe risks. To protect themselves from these hard-to-predict fluctuations, professional money managers have developed the financial futures market.
Its growth has been explosive. Financial futures contracts are now traded on about a dozen exchanges and are a major force in the financial world.
Financial futures include the following contract instruments:
Insert Table Here
Basically, financial futures are a form of the time-based commodities contracts widely used with wheat, corn, copper and other foods and metals. They are standardized packages of debt securities whose prices move with interest rates: up when the cost of money falls; down when it rises. In familiar terms, here's the situation:
A bank buys a 20-year, 8% bond at issue, for $1,000. If the market interest rate was to rise to 12%, the value of the bond drops to about 66 ($660). Similarly, if the cost of money should decline to 7%, that bond would sell at around 112 ($1,120). At maturity, the bond would be worth 100 ($1,000) again.
But, meantime, the banker has problems. If he needs extra funds in a hurry, he must sell at a loss.
Like any businessman, the banker would prefer to have stable, predictable assets. That's where the financial futures market, and hedging, comes in. It enables the money manager to take positions in the futures market to protect positions in the cash market. When the cost of money changes, the loss in the cash market is offset by a profit in the futures market. And vice versa.
In each position, someone has to take the opposite side of the contract. This may be a speculator seeking a quick profit by buying or selling short according to his view of the cost of money in the days or months ahead.
In the futures market, the profits can be big and fast but the losses can be bigger and faster. As a conscientious commodity trader warned, "You can make enough money in a morning to send your kids to college. But, in the afternoon, you can lose enough to have to sell your house."
All futures are a zero-sum game: for every winner there's a loser. In the stock market, at least, you will usually be moving with the majority. If the market goes up, nearly everyone wins. If it goes down, nearly everyone loses " but only for a while because stock prices eventually trade based on corporate value and the value of most of the quality corporations is constantly rising.
Using a case study, here are two examples of how financial futures were used in the past for hedging:
Long hedge. In the late winter, Mr. PM, a portfolio manager, expected an inflow of $1 million in the spring from client retirement fund savings. He planned to invest this money in 5-year 8% Treasury notes to yield 9.01% but he feared a drop in the rate of return before he actually received this cash.
To lock in his position, he bought 10 futures contracts at $100,000 each for 95 16/32nds ($95,500). He put up $10,000 in margin: $1,000 per contract.
Soon, interest rates dropped, as he expected, so the price of the notes rose to 99 16/32nds ($99,500). He chalked up a $40,000 profit ($4,000 per contract).
When the $1 million in cash came in, the price of the notes was up to 100. Now he had to pay $1 million but his actual cost was $960,000 since he had a $40,000 gain in the futures market. Thus, the yield on the 8% notes was the targeted 9.01%.
Short hedge. In mid fall, a bond dealer contracted to sell bonds held in his inventory to a buyer. The interest rates would later rise so that his holding would be worth less than their current 99 8/32nds for a yield of 8.18%. As a hedge, he sold 10 futures contracts at 98 24/32nds ($980,750).
Three weeks later, interest rates were up as expected so the dealer bought back the contracts at 93 24/32nds ($930,750) for a $50,000 profit, enough to offset the loss in the value of the sold bonds.
Mr. PM, the portfolio manager, could also profit. In the first example, if he bought in anticipation of a drop in the cost of money, he would make the $40,000 profit. In the second example, if he looked for a rise in interest rates, he sold short and covered his position for a $50,000 gain.
In both cases, if interest rates moved opposite to his guess, Mr. PM would have lost money. But he would not have waited until the expiration of the contracts. Knowing that 75% of all trades result in a loss, he would have taken a quick, small loss, probably by means of a stop order.
Commodities:
With commodities, you are playing the farmer's game, so they are a little different than financial futures. Some people know a lot more about these products that most of us.
Commodities include the following contract instruments:
Cattle/Hogs/Meat Commodity Futures Feeder Cattle (CME)
Lean Hogs (CME)
Live Cattle (CME)
Pork Bellies (CME)
Grains/Cereals/Oilseed Commodity Futures Barley (Alberta)
Canola (WCE)
Corn (CBOT)
Corn Mini (XC, CBOT)
Cotton (NCE)
Feed Wheat (WCE)
Flaxseed (WCE)
Hard Red Spring Wheat (MGE)
Oats (CBOT)
Rice (CBOT)
Soybean Meal (CBOT)
Soybean Oil (CBOT)
Soybeans (CBOT)
Soybeans Mini(XS, CBOT)
Wheat (CBOT)
Wheat (Kansas)
Wheat Mini (XW, CBOT)
Miscellaneous Commodities Futures
BFP Milk (DA, CME)
BUTTER (DB, CME)
Cocoa (CSCE)
Coffee (CSCE)
Lumber (CME)
Orange Juice (CEC)
Sugar #11 (CEC SU)
Sugar #14 (CEC SE)
Trading in commodities and futures is one of the few remaining areas where an individual with small capital working in legitimate ways can strike it rich, but, according to one study, 75% of commodities speculators lose money. Moreover, their aggregate losses were six times as great as their gains.
Even the best commodities speculators lose more often than they win, but by keeping losses small and allowing profits to run, they can do well. Profits can be quick and large.
One speculator I read about made a $12,500 profit on a $1,350 investment, in a few months, after the price of soybeans soared from $5.50 to $8.00 per bushel. That $1,350 was all that was needed to buy a 5,000-bushel contract for future delivery.
The cash requirements for all commodities trading are low: 5% to 10%, varying according to the commodity and to the broker's requirements. But when there is extreme speculation, those margins can be raised quickly. There are no interest payments on the balance. Roughly, commissions average about $35 per round trip to use a full-service broker but self-directed trading can be much cheaper, as per the Interactive Brokers rate sheet:
Insert IB commissions table here
The lures of fast action, minimal capital and high potential profits are enticing but before you start trading corn, wheat, soybeans, silver or any other commodity, heed these warnings from professionals:
(1) The odds are against making a profit on any one trade. You have to make a hit big enough to offset the losses. Only a handful of amateurs last more than three years. The rest are broke.
(2) Emotional stability is essential. You have to be able to control your sense of fear and greed and train yourself to accept losses without too great a strain. Until a few years ago, some brokerage companies even refused to accept female customers!
(3) Be ready to risk at least $10,000: $5,000 at once, the rest to back up margin calls.
Commodity trading is different from investing in stocks. When you buy a common stock, you own part of the corporation and share in its profits, if any. If you pick a profitable company, the price of your stock will eventually move up.
With commodities there is no equity. You buy only hope. Once the futures contract has expired, there's no tomorrow. If your trade turned out badly, you must take the full loss.
The economic reason for a futures market is hedging (that is, removing or reducing the risk of a commitment by taking an offsetting one).
A farmer who borrows money to plant a 10,000-bushel soybean crop may be asked by his banker to sell two futures contracts (5,000 bushels each) for November delivery. This contract calls for a fixed price, say $5.30 per bushel. If the November price is $5.00, the farmer loses 30¢ per bushel in the cash market, but makes up the loss by buying back his futures contracts for less than he paid. The opposite happens when the November price rises. Either way, the farmer is assured of a return of $5.30 per bushel so that he can repay his bank loan and probably turn a profit, too.
On the other hand, a food processor that sells products throughout the year wants a predetermined cost for his soybean purchases. He buys futures in the appropriate forward month.
If the price rises, he pays more in the cash market but profits when he sells the futures contract.
In both cases there must be someone to take the opposite side of the transaction. That's the role of the speculator. He assumes the risk because he thinks he can buy or sell the contract at a profit before the delivery date.
Here's what might happen.
To the hedger, who needs soybeans for processing in November, buys (goes long on) one 5,000-bushel soybean contract:
June 4: Buy one November soybean contract $5.30 $26,500
Dec. 6: Sell one November soybean contract $5.00 25,000
Loss $ 1,500 Commission 45
Total Loss $ 1,545
The farmer who owns soybeans will sell short
June 4: Sell one November soybean contract $5.30 $26,500
Dec. 6: Buy one November soybean contract $5.00 25,000
Profit $ 1,500 Commission 45
Total Profit $ 1,455
Note: In 2003, November soybeans moved from about $5.10 a bushel in late-July to $8.00 in twelve weeks. For some speculators this was very profitable because that $2.90 move was worth $14,500 per contract on a margin of about $1,350!
Because the buyers and sellers seldom match, the speculator moves in to take the opposite side of the contract. He holds the long contract as long as prices are rising (up to delivery date) and cuts his losses by selling fast when the market declines. Vice versa for the short sale. In almost every case, he takes action long before the contract becomes due. That's the profit opportunity of trading in commodities.
Market index and indicator futures:
With market index futures, you are playing the professional money manager's game. Most of us know a little about the cash markets but the futures market is something else again. This is not a market for novices.
Major Market Indexes & Indicators Futures involves trading in the following contract instruments:
Insert Table here
I'm not a futures trader. If I was, I'd probably stick to e-mini contracts and, for advice, go to Teresa Lo, founder and chief market strategist of the trendVUE.com educational financial website, or expert independent traders like Teresa.
Metal futures:
With metals futures, you are playing the professional counter-trade money manager's game. Most of us know a little about the metal markets but the futures market is something else again. This is not a market for novices.
Metals Futures involve trading in the following contract instruments:
Aluminum (AL, COMEX)
Copper High Grade (HG, Comex)
Gold (100 oz. GC, COMEX)
Gold NY Mini (YG, A/C/E)
Palladium (NYMEX)
Platinum (NYMEX)
Silver NY Mini (YI, A/C/E)
Silver, 5000 oz (SI, COMEX)
After reading AC Copetas' book ("Metal Men") about trader Marc Rich, as I did (and found fascinating), you might want to stay away from these markets.
About commodities trader Marc Rich, I found some other sources of info you might wish to read. (1) (2)
Marc Rich became rich, so maybe you too will see the immense potential for profit as did Mr. Rich, and you'll want to learn as much as possible.
Gold futures:
While it could be a good speculative investment, gold is usually a poor investment for conservative investors unless you are into writing puts or calls for additional income. The gold futures market is that much more dangerous.
Gold futures contracts give the gold speculator the biggest bang for the buck. Similar to contracts for commodities, they can be handled by most brokers and are actively traded on the New York Commodity Exchange and the International Monetary Market in Chicago.
You can buy and sell 100-ounce contracts with different future delivery dates on margins of 5% to 15%. Thus, with gold at $400 an ounce, each contract is worth $40,000, which you can leverage with about $4,000.
Be sure that you have ample collateral; gold prices can move fast, and when they go down, you must come up with more cash or securities or the broker sells out your position at the end of the day.
Most brokers ask for a minimum balance of $10,000.
It's wise to set target prices. You can let your profits run, but, to protect your holdings, give the broker a stop loss price: either at the price at which additional margin will be needed or at the average price of the last 30 trading days.
Thus, if you bought a contract when gold was $370 an ounce and used a 10% margin, the sell price would be $350 if you were conservative. As the price of the metal moves up, boost the stop-loss accordingly.
Even stops may not protect you. Commodity traders try to knock off those stops late in the afternoon--e.g., when the price of gold drops below $402, the professionals, knowing that amateurs have set stops at $400, will go short. This will drop the price again so that the trader may be able to buy back his contracts at about $395. He makes a quick profit and if you had put in a stop at 400 you're out of luck...and money...as the price moves higher to the 410-425 range.
In bull markets, trading in gold futures can be very profitable. A 5-point move is common. With a little patience, you can pick up a 10-point move.
The last secular bull market for gold was in the 1970s. The period from 1980 through to 2002 was a secular bear for gold (and a secular bull for paper assets). Of course, in any bear market there are several cyclical bullish phases, and for gold there were opportunities to make money on the upside for the past 20-some years. But not many.
The period from 2002 through to perhaps 2010, however, is likely to see a return of the secular bull to gold and other real assets. This will bring a return also to the number of professional futures traders in the gold market. I expect to see contract volumes increase.
Energy futures:
Petroleum futures have been around for some time but, with widespread fears of rising prices and temporary shortages, these contracts have become one of the most popular trading vehicles of speculators.
Energy Futures involve trading in the following contract instruments:
Brent Crude Oil (LO, IPE)
Crude Oil (light, NYMEX)
Gas-Oil (QS, IPE)
Heating Oil (NYMEX)
Natural Gas (NG, NYMEX)
Propane (NYMEX)
Unleaded Gas (NYMEX)
Oil futures meet an essential need by establishing a mechanism to be used by commercial sellers and buyers to be sure of firm future prices, which they assure through hedging.
I suppose to rest of us, who put gasoline into our cars and fuel up our homes with oil, we know a little about energy prices. But, crude oil contracts is not a market for amateur speculators.
Insert table here
The base contract for heating oil futures is 42,000 U.S. gallons (1,000 U.S. barrels) of No. 2 heating oil with delivery at the Port of New York.
As with all futures contracts, the original margins for heating oil futures are low: 10% with a $3,375 minimum margin. That means that if the price of the contract rises just 20%, the speculator (who takes the opposite side of what may be a professional's contract) will double his money.
But if the price falls 30%, the speculator would be wiped out. Trading is on the New York Mercantile Exchange (NYMEX).
To get the dollar equivalent, multiply 42 by the newspaper quote: at 82.34¢ per gallon (Oct 20, 2003), it's $34.58 per barrel. Contracts at this time were also sold on the N.Y. Mercantile Exchange for delivery in the months of Dec03 @83.31¢ per gallon, Jan04 @83.91¢ per gallon, Feb04 @ 83.41¢ per gallon, Mar04 @ 81.56¢ per gallon and monthly through to Aug04 @ 72.41¢ per gallon.
Under exchange rules, the minimum daily price fluctuation is .01¢ per gallon ($4.20 per contract) to a maximum of 1¢ per gallon ($420 per contract). The margin can be put up in cash or collateral such as a letter of credit or Treasury bills (up to 90% of market value).
When you use T-bills, you can apply the interest charges against the position cost.
In the market itself, the moving force is the professional. Let's say that, in October, the purchasing agent of Smith Manufacturing Co. (SMC) is asked to order 10,000 barrels of No. 2 heating oil for December delivery at the current market price of 82.34¢ per gallon.
If he buys now, he will have to put up $8,234 (the normal 10% margin), plus arrange for storage of the heating oil that was purchased and pay interest on the money.
Instead, SMC buys 10 December futures contracts at 83.68¢ per gallon (the .25¢ is added for all futures and the .12¢ reflects the costs of storage and financing). This requires a cash outlay of $8,368.
In early December, say there is another price boost by OPEC and the cash price of No. 2 oil is 88¢ per gallon. The purchasing agent buys 10,000 gallons for $8,800. This is $1,000 more than budgeted but he sells his futures contracts for the same price. The small loss, $2,250, represents his insurance premium.
Role of the speculator
The speculator, say, gets into the game in June when he thinks that, before December, there will be an oversupply so that the price of the oil will drop a bit. He sells short 10 Decembers futures contracts at $85.25 each. That means he does not own the oil but merely agrees to make delivery in December. That's no fee, no interest.
In this hypothetical case, the speculator is right. In November, the price of the oil dips, so he buys back his contracts at 80.25¢ per gallon and chalks up a $5,000 gross profit on a margin of $8,525-in two months.
If he guesses wrong and the price of oil goes up, he will have to cover his position at a loss and hope for a bigger profit on his next deal.
When he becomes experienced and has the aid of a knowledgeable broker, the venturesome speculator can use hedges of his own to protect some of his holdings. Or he can take advantage of unusual spreads between current and future prices: as much as 33¢ per gallon: 65¢ in the cash market and 98¢ in the six-months futures market.
If he sells the 98¢ contract short and the spread narrows, he can buy back at a lower price for a profit. Or when the spread is narrow, he can buy long on one contract and sell short on the other.
But he should always remember that 80% of all futures contracts end up with a loss. You must make a big hit to win.
Options on Commodities and Futures:
These are contracts to purchase the commodity at a specified price on a specified date. As with stock options, the buyer pays a premium to the party granting the option. There's no margin, so the most the buyer can lose is the premium. The seller accepts a modest gain rather than a possibly higher profit and takes the risk that the value of the contract will not drop too far.
If you trade commodities options in London, say on the London Metals Exchange, there is the issue of currency conversion and profit retrieval for anyone who doesn't hold a British Pound account. The broker must convert dollars into pounds, and back again into dollars if there's a profit to be repatriated. That's expensive, so you'll want to hold a British Pound account.
Recap:
Lack of safeguards
At the risk of being repetitive, I want to re-emphasize some of the dangers of trading financial futures (and, of course, all time-based contract markets). For the amateur, these markets lack many of the safeguards of plain old stocks and bonds:
(1) No ban on inside information. With stocks, executives and brokers who use inside information to anticipate or cause stock movements are subject to severe penalties and even jail. Futures traders have no such restraints.
(2) Limited public disclosure. Investors who own 5% or more of a company's stock must publicly disclose their holdings. Large commodity traders do have to inform the Commodity Futures Trading Commission and the exchanges but that's of little use to small speculators.
(3) Stock orders must be processed when received. Futures traders can place orders for their own accounts and the public at the same time. This can create a conflict of interest and, possibly, force amateurs to pay too much or receive too little.
(4) The pooled funds, sponsored by brokerage companies, can influence the market. For small investors, the big advantage is a negative one: that they can lose no more than the money actually put into the funds.
(5) No screening of customers. With the tiny margins, anyone can get into the game and, with minimal governmental regulation, can be persuaded by commission hungry brokers to get in over his/her head.
But not everything is stacked against the individual. The New York Futures Exchange offers a computer simulation that uses actual trading data and prices for a theoretical $250,000 paper account. Each day, it shows what your decisions would have netted or lost.
Individual brokers also offer similar computer simulation programs.
Competing with professionals in hedging
Too few amateurs understand all of the risks of speculating in financial futures. There are important variables that are utilized by professionals. Here are some cited in Forbes:
(1) Basis. This is the difference in price or yield between the closest delivery month of a Treasury bill or Treasury bond futures contract and the present cash market price of that same instrument.
Let's say that you want to hedge a position in T-bonds. What could happen is that the cash market drops 1½ points while the futures market falls only one point. That's a half a point against you. With a hedge where you bought $100,000 in bonds and sold a $100,000 futures contract, you would have lost $15,000 on the bonds you owned and earned back $10,000 on the short sale of the futures contract.
(2) Cheapest to deliver. All sellers have the right to deliver those securities that are "cheapest to deliver" from a pool of securities. For bonds, the maturity must be at least 15 years. Usually, the highest-interest-rate, longest-maturity Treasury bond is the cheapest to deliver.
(3) Cost of financing a cash position. When the annual cost of carrying an 5% Treasury note (assuming almost full value loan) is 4%, there's a positive carry of 1%. But at a 6% cost, there would be a negative carry of 1%. That can make a big difference in the ultimate profit. The professional understands these extra risks and trades accordingly: Too often, however, the amateur does not know, or understand, such important variables.
Strict guidelines to go by:
If you have money you can afford to lose, enough time to keep abreast of developments, strong nerves and a trustworthy, knowledgeable broker, trading in financial futures could be rewarding and exciting.
But beginners are urged to follow these guidelines:
(1) Make dry runs in computer simulations for several months. Pick different types of futures contracts each week and keep practicing until you get a feel of the market and risk and can chalk up more winners than losers.
(2) Buy long when you look for a drop in interest rates. With lower yields, the prices of the contracts will rise.
(3) Sell short when you expect a higher cost of money. This will force down the value of the contracts and you can cover your position at a profit.
(4) Set a strategy and stick to it. Don't try to mix contracts until you feel comfortable and are making money.
(5) Set stop and limits orders, not market orders. A market order is executed immediately at the best possible price. A stop order, to buy or sell at a given price, becomes a market order when that price is touched. A limit order is the maximum price at which to buy and the minimum at which to sell.
(6) Buy a lucky charm. Even pro traders guess wrong. No matter how intense your research, there will always be unexpected changes resulting from political or economic decisions or actions in the world.
One thing I learned from years in the market is that the unexpected will happen. You can prepare all you want to manage your risk but at the end of the day, some days, you just have to be lucky. There will be days when you are not.
Summary
This section took me a lot of time and effort, but I feel the topic is an important one for securities traders as well as aspiring commodities and futures traders. I'm going to add to it, if, as and when I ever get directly involved, but for sure, as I get better informed.
Should there be CTAs out there who are not overly put off by my simplistic approach and negative remarks and still want to help me with corrections, I'll make the necessary changes.
Posted by Bill Cara at January 30, 2005 7:49 PM
