Futures 101
Provided by: ALTAVEST Worldwide Trading, Inc
There is a risk of loss in trading futures & options.
The information provided here is strictly informational in nature.
Origin Of The Futures Markets
EXCHANGES: The U.S. futures markets were developed out of necessity in the middle
1800's. As our Country was expanding and spreading west, farmers were having a difficult
time reaching buyers efficiently. Farmers would carry tons of goods, hundreds of
miles, only to have a prospective buyer back out of a deal. Quarrels repeatedly
erupted relating to the quality, quantity, and price of the goods. A central marketplace
where many willing and able buyers and sellers transacted business was the answer.
Commodity exchanges were created to serve this function.
CONTRACTS: The unit of exchange that trades in the exchanges is the futures contract.
It provides for the future delivery of goods at a specified date, time, and place.
Each particular commodity is bought and sold in standardized contractual units,
which makes them completely interchangeable. For example, each sugar futures contract
for a particular month is the same size, is of the same quality and grade, and is
due for delivery at the same day and time.
Why Should I Be Interested In Commodities?
ADVANTAGES:
- Liquidity---The U.S. futures markets are the largest in the world, in terms
of trading volume and dollars, transacting hundreds of millions of dollars
daily.
- Government regulated---The futures markets are so crucial to the well being
of our nation, that the government established the Commodity Futures Trading Commission
to oversee the industry. There is also a self-regulatory body, the National Futures
Association, to further monitor the activity of all market professionals.
- Leverage---Unlike the stock market, where you have to actually spend up to
$100, 000 to buy $100,000 worth of a stock, through the use of margin deposits,
a commodities trader can control hundreds of thousands of dollars worth of a commodity
for pennies on the dollar. Leverage may generate significant profits or losses from
a small move in price.
- Low transaction costs---For example, if you thought the price of coffee was
going higher, you could attempt to locate a seller and buy 37,500 lbs. of coffee,
(the standardized size of one coffee futures contract). You could have the coffee
shipped to a warehouse, and insure it until the price hopefully rose. When you felt
the price wasn't going any higher, you would have to find a buyer, ship it to them,
and hopefully receive your money.
- By depositing margin, (approximately $4,200 in this example) from your trading
account, and going long on coffee futures contract, you could have traded coffee
(or any other commodity) without the hassle of locating a buyer and seller, and
without incurring the extra costs of transportation, storage and insurance.
- Options---Option buyers have virtually unlimited gain potential while the amount
at risk is limited to the premium paid. Option sellers assume nearly unlimited risk
in exchange for the premium received. Because option sellers assume such risks,
we do not recommend holding uncovered ('naked') short options.
HEDGING & SPECULATING:
- You should take an interest in the futures markets for several reasons. The futures
markets effect you daily. Virtually every product you consume would not only be
in scarce supply, but would cost dramatically more without the existence of the
commodity futures markets. Due to the intrinsic risks of being in business without
the ability to shift risk, a manufacturer/producer of goods would be forced to charge
higher prices, and a user of goods would incur the higher costs.
- Shifting risk to someone willing to accept it is known as hedging. A manufacturer
could effectively lock-in a sales price by shorting an equivalent amount
of his goods with futures contracts. If a mining company knew they were going to
sell 1000 oz of gold in several months, they could protect themselves from a future
price decline by shorting ten gold futures contracts today. If the price of gold
fell by $30 in the following months, they will receive that much less in the cash
marketplace for their gold, but earn that much back when they offset (liquidate)
their short gold futures position. A user or buyer of goods can use the futures
markets in the same manner. They would need to protect themselves from a future
price increase, and therefore go long futures contracts.
- The person willingly accepting a risk does so because of the opportunity to profit
from price movements, this is known as speculating. The lumber and mortgage
for your home, the cereal and coffee you had for breakfast and the gas in your car
would be priced many times higher without the participation of speculators (you)
in the futures markets. Through supply and demand market forces, equilibrium prices
are reached in an orderly and equitable manner within the exchanges, and world economies,
and you, benefit tremendously from futures trading.
-
While trading commodities provides for unique opportunities, it is imperative that
investors understand the risks before trading. The risk of loss in trading futures
and options is substantial. You could lose your entire balance and in the event
of a margin call, you may be required to deposit additional funds which means you
could lose more than you intended on investing. Because of the risks, prospective
investors should only invest 'risk capital' or money they can afford to lose.
How Do I Actually Make Money Trading Commodity Futures?
GOING LONG & SHORT:
Going
LONG &
SHORT.to make a profit on anything requires that
something be bought and sold, and that you sell at a higher price than you buy.
When trading a futures contract it doesn't matter if you initially sell or buy,
as long as you do both before the contract comes due. When you feel the price of
a commodity will fall, you would sell, or go
short. When you feel the price
of a commodity will rise, you would buy, or go
long.
You may be asking yourself."How do I sell something that I don't own, or why would
I buy something I don't need". The answer is simple. When trading futures, you never
actually buy or sell anything tangible; you are just contracting to do so at a future
date. You are merely taking a buying or selling position as a speculator, expecting
to profit from rising or falling prices. You have no intention of making or taking
delivery of the commodity you are trading. This is why you always relieve your contractual
obligation to take or make delivery by
offsetting (also known as
unwind,
or
liquidate) your initial position.
LEVERAGE:
The following contains mathematical examples of leverage in the commodity markets.
No representation is being made that any account has, or is likely to achieve profits
similar to those shown in these examples.
- If I buy a bushel of corn from a farmer for $2.65 per bushel, and it subsequently
rises to $2.95 per bushel, haven't I only made 30 cents?
- If you only purchased one bushel of corn, you would be correct. What if you had
purchased 50,000 bushels (the equivalent of 10 futures contracts) of corn? At $2.65/bushel
X 50,000 bushels you would need to have spent $132,500 to initially purchase the
corn. If you had a storage silo and the extra cash, and the price rose 30 cents,
you would have made $15,000 (30 cents X 50,000 bushels = $15,000) less storage,
insurance, transportation, and opportunity costs.
- What if you don't have an extra $132,500 in your pocket, or a grain silo to store
the corn? The good news is you don't need $132,000, or a grain silo in the backyard.
With only approximately $6,000 as a margin deposit, you could go long 10
corn futures contracts with your broker and reap the same dollar reward, earning
an incredible 250% on margin, (less fees & commissions). You would incur no
silo storage, delivery, or insurance costs.
- If you wanted to buy every stock listed in the S&P 500 index, it would
take hundreds of thousands of dollars. As a commodity speculator utilizing leverage,
you could control the equivalent value of our country's 500 largest stocks with
one futures contract, using approximately 90% less money, and with far less in transaction
costs.
Why Do I Need A Broker?
The vast majority of individuals need a broker to execute trades on their behalf.
If you are knowledgeable, wealthy, or experienced enough, it is possible to relay
your orders verbally or electronically to the floor of an exchange.
It takes large amounts of capital, staffing, knowledge, and experience to execute
and clear trades on the exchanges. As an
Introducing Broker, the Futures
Commission Merchant
(FCM), or
clearinghouse acts as a conduit to the
exchanges.
What Are Options?
There are many people who choose not to trade futures contracts because they feel
the potential gains do not outweigh the potential losses. For those people, options
are the primary investment vehicle of choice. An option is simply the
right,
but not the obligation to buy or sell a futures contract, at a pre-determined price,
(
strike price) on or before a pre-determined
expiration date. To go
long (buy) an option requires the buyer (
holder) to pay a
premium.
When going short an option, the seller (
writer or
grantor) receives
the premium.
The following contains mathematical examples of leverage in the commodity option
markets. No representation is being made that any account has, or is likely to achieve
profits similar to those shown in the examples.
CALLS:
A call option is simply the
right to buy, (go long). You can choose to be
either long or short a call. For example, If you felt crude prices were going to
rise, you could purchase (go long) calls, and pay the premiums to the seller (grantor
or writer). Lets look at what would happen if Crude was trading near $22/barrel,
and you purchased 10
at-the-money July $22 (strike price) Crude call options.
You would have paid a $600 premium (estimated example price for illustration use
only, plus fees and commissions) for each option. Each call option you now own represents
the
right to buy 1,000 barrels of July crude at $22 barrel. For $6,000 plus
fees and commissions, you would be controlling 10,000 barrels of crude oil.
Every dollar July Crude moved above your strike price, your call option position
would gain $10,000 of
intrinsic value. If the price rose just $3/barrel to
$25, each option would be $3
in-the-money, and your entire option position
would have an intrinsic value of $30,000! Depending on how much
time value
remains, and the
volatility of the market, the option position could actually
be worth much more. If prices didn't rise, your maximum risk would be limited to
your original investment, ($6,000) less fees and commissions.
It is also important to realize that at any time prior to the expiration date, you
could place an order with your broker to
liquidate all or part of your option
position. This would further limit your risk by allowing you to recover whatever
premium remained. For example, with a month of time value left, and Crude hovering
around $21/barrel, let's say each option is now worth only $200, the value having
fallen from our original purchase price of $600. You may tell your broker to sell
your July Crude options because you feel the
underlying market, and therefore
your options, will not increase in value within a month. By doing this, you would
be recovering $2,000 ($200 premium X 10 options) from your original investment,
and implementing
money-management.
If you thought the price of July Crude was going to fall, you could sell a July
Crude call option, and receive the premium from the buyer. You would do this because
if prices did fall, the value of the call to the owner (the person you sold the
call to, and who paid you the premium) would drop, because the option is less likely
to become in-the-money. If prices didn't rise before the option expired, the value
of the call would drop to zero, expire worthless in the owners' hands, and you would
keep the entire premium the buyer originally paid you.
As an example, if July Crude were trading near $22/barrel and you felt that prices
were going to drop, you could short a July $23
out-of-the-money call. To
do this would require the suitable margin deposit for a Crude futures contract because
you have unlimited risk, assuming the option is
uncovered, (
naked).
You would essentially be selling to the purchaser (holder) of the call, the
right
to go long July Crude at $23 per barrel, no matter where the July futures price
settles. You would receive a $600 premium (estimated example for illustration
purposes) from the purchaser to assume this risk.
If prices were to rise to $25 per barrel, and you had not
offset your short
call, (by placing an order with your broker to buy it back) the owner of the call
could
exercise his
right to buy (which you sold him) crude at $23.
Then he would be assigned a long position in a July Crude contract from $23, and
you would end up assigned a short position from $23. He would be sitting on a $2,000
gain (1000 barrels per contract X $2/barrel= $2,000), and you would be sitting on
a $2,000 loss.
PUTS:
A put option is simply the
right to sell, (go short). You can choose to be
either short or long a put option. For example, if you felt July Crude prices were
going to fall from $22, you could purchase (go long) puts, and pay the premiums
to the seller (grantor or writer). Imagine you purchased 10 July Crude $22 at-the-money
puts for a premium of $600 each, total cost of $6,000 less fees and commissions.
Each put option you now own represents the
right to sell 1,000 barrels of
July crude, at $22/barrel, regardless of where the futures price settles. Every
dollar the July Crude market falls below your strike price, your put option position
would gain $10,000 of intrinsic value. If the July Crude price fell to $19, your
option position would be worth a minimum of $30,000! If prices didn't rise, your
maximum risk would be limited to your original investment, less fees and commissions.
If you thought the price of July Crude was going to rise, you could go short a July
Crude put option, and receive the premium from the buyer. You would do this because,
if prices did rise, the value of the put to the owner (the person you sold the put
to, and who paid you the premium) would drop. If prices didn't fall before the option
expired, the value of the put option would drop to zero, expire worthless in the
owners' hands, and you would keep the entire premium the buyer originally paid you.
What Is A Spread?
FUTURES SPREAD:
A spread is the simultaneous purchase and sale of the same or similar commodity,
in different or the same contract months. Spread trading is usually considered to
be a lower risk strategy than an outright long or short futures position, and therefore
margin requirements are usually less. For example, if the price trend of soybeans
is currently up, and you are in a soybean spread, the gain on a long position would
offset the loss in a short position. If the trend is lower, the gains on the short
side will negate the loss of the long side.
You must be asking "How do I make money if I am both long and short the same commodity?"
The answer is you are hoping to profit from the difference in the two contract months,
not from a move higher or lower in soybeans. With a spread, you follow the relationship,
or difference between the contracts, without having to pick a market direction.
For example, if July Soybeans were trading at $8.50/bushel, and November Soybeans
were at $6.90, the spread would be $1.60 to the July side. If you bought a July/November
bean spread at this level, and July went to $9.00, while November went to $7.20,
the spread would now be $1.80. You could then sell the position, and make 20 cents/bushel
* 5000 bushels=$1,000. If July Soybeans went to $7.50, while November Soybeans went to
$6.10, the spread would shrink to $1.40. If you sold this position, you would lose
20 cents/bushel * 5000 bushels = $1,000. This example is known as an
intra-commodity spread, buying one month and selling another in the
same commodity. An
inter-commodity spread is buying a commodity month in one
market, and selling another related commodity in the same or similar month.
OPTION SPREADS:
Not only can spreads be utilized in futures markets, but options provide even more
opportunities for successful spread trading. Options can even be utilized in conjunction
with futures spreads to limit risk. With so many variables including strike prices,
trading months, and different markets available, the permutations and combinations
of option strategies are tremendous. The explanations are a bit more detailed, and
beyond the scope of this brief introductory course. We do invite you to call one
of our brokers for further explanations.
While spread trading offers many benefits, it is important to note that there is a
high degree of risk, so you should only trade with money you can afford to lose. Spread
trading is the simultaneous buying and selling of multiple contracts, therefore
commission costs may be higher for spread trades than for single contract trades.
Market forces may make the execution of spread trades more complicated as multiple
contracts must be traded simultaneously. This may cause a delay in entering/exiting
trades and may increase risk.
Some of the advantages of spreads are:
- typically require smaller margin deposits;
- make money no matter which way a market moves; and
- seasonal patterns exist among spread relationships.
Order Types & Placement
There are many methods of entering and exiting a market. Below are a few examples
of some of the most common order types, and examples on when to use them. This is
by no means an extensive listing, and it is important to realize that not all orders
can be used in every market.
Click here for more details
on order placement.
- Market Order---The most frequently used order, which in most cases, assures
you of getting in or out of a position. It is executed at the best possible price
obtainable at the time the order reaches the trading pit. An example might be telling
your broker, "sell 5 contracts of September Comex Silver at the Market."
- Limit Order---It is an order to buy or sell at designated price. A limit
(sometimes known as an "or better") order to buy must always be placed below the
current market price, and a sell limit above the current price. If the market price
touches a limit order, it does not necessarily mean the order is filled. A limit
order may never get reached, and you therefore could miss your entry or exit point.
An example of a properly placed limit order would be if the price of September Silver
is currently trading at $4.80/ounce, you could tell your broker to sell at $4.87,
or buy at $4.71. In either case, you are looking to obtain a fill price better than
the current trading price. In the case of your sell limit at $4.87, your fill price
could never be lower than $4.87, but could possibly be better (higher). In the buy
limit example, the fill price could never be higher than $4.71, but could possibly
be better (lower).
- Market-if-Touched (MIT)---They are used in the same manner as a limit order,
but can be filled if the market touches your order price. If so, then the order
instantly becomes a market order and can be filled above or below your initial order
price.
- Stop Order---This is nothing more than an order that once is touched, becomes
a market order. A buy stop must always be placed above the current market price,
and a sell stop below the market price. A stop order can be used to minimize a loss
on a short or long position, protect a profit, or initiate a new long or short position.
An example would be if September Silver were trading at $4.80, and you wanted to
buy, but only if the price reached $4.95, you could place an order to tell your
broker "I want to buy one September Silver at $4.95 stop."
- Market on Close (MOC)---An order to be filled during the period designated
by the exchange as the close, at whatever price is available. The floor broker does
reserve the right to refuse an MOC up to 15 minutes before the close.
- Stop Close Only (SCO)---The stop price on a stop close only will only be
triggered if the market touches or exceeds the stop during the period of time the
exchange has designated as the close of trading, (usually the last few seconds or
minutes).
What Is Technical Analysis?
It is another tool available to assist you in your quest for profits. Find out more
about Technical Analysis in
Technical Analysis 101.Introduction To Charts.