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How old and how useful are the commodities markets?
The modern futures markets have been traded since
rice futures traded in the eighteenth century in
Osaka, Japan. However, historians have found some evidence of primitive futures
contracts for olive oil, spices and other goods were used by shipping merchants in
Persia before Christ. In the United States futures trading
began in the mid-nineteenth century with corn
contracts in Chicago and cotton contracts in New
York.
The industrial revolution brought a new technology
and the ability to produce more efficient tools and
consequently more food. Economic output not only
began to keep pace with the growing population but
also increased the standards of living. This new
productivity called for more agricultural storage,
transportation, and more efficient distribution of
goods.
At
first the cash markets could handle the growing
demand, but as quantities increased, the futures
markets with uniform commodity pricing, grading, and
delivery, became increasingly important. To cope
with the gluts that occur during harvest times and
with the shortages that occur before the harvest,
purchasers could now protect themselves from price
fluctuations by locking in a specific price for a
commodity before they actually needed it.
What is a futures contract?
The unit of exchange that trades in the exchanges is
the futures contract. Each contract 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.
Why
do people invest in commodities?
Leverage is very important to the commodities
markets. Unlike the stock market, where you might
have to invest 10,000 dollars to leverage 10,000
dollars of a particular stock. A commodities trader can leverage tens of
thousands of dollars worth of a commodity for
pennies on the dollar. Also unlike stocks, commodities have intrinsic value and
will not go bankrupt.
The futures markets are so crucial to the well being
of our nation, that the government established the
Commodity Futures Trading Commission (CFTC) to
oversee the industry. There is also a
self-regulatory body, the National Futures
Association (NFA), who monitor the activities of all
futures market professionals to ensure the integrity
of the futures markets.
Commodities
also give the investor the ability to
participate in virtually all sectors of the world economy and have the potential
to produce returns that tend to be independent of the stock, bond and real
estate markets. In fact portfolios that add commodity investments can actually
lower the overall portfolio risk by diversification.
What is the difference between hedging and
speculating?
Just about every product that you consume would
likely cost dramatically more without the
commodities futures markets. Because of the
intrinsic risks associated to being in business,
lacking the ability to shift risk, a
manufacturer/producer of goods or services would be
forced to charge higher prices, and the consumer
would have to pay higher prices. This shifting of
risk to someone willing to accept it is called
hedging. Manufacturers could effectively lock in a
sales price by going short an equivalent amount of
goods with futures contracts. If a mining company
knew that they were going to sell 1000 ounces of
gold in several months, they could protect
themselves for a future price decline by going short
10 gold futures contracts or 10 gold put option contracts today. If the price of
gold fell by $30 in the following months, they would
receive that much less in the cash marketplace for
their gold, but earn that much back when they offset
their short gold futures or gold options positions. The futures price
will eventually become the cash price. A user or
buyer of goods can use the futures market 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 cotton
in your shirt, the orange juice, cereal and coffee
you had for breakfast, the lumber, copper and mortgage for
your home, the gas or ethanol that you put in your car all
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.
What if I am not a large
producer or consumer of a commodity and I just want to hedge my stock and bond
portfolio?
The same thing applies to protecting your stock
and bond portfolios from adverse market moves. If you have exposure in Dow
Jones, S & P or NASDAQ stocks you can simply short the futures or buy puts on
the index. If you are worried about higher interest rates hurting your fixed
income investment prices, once again, you can short the futures or buy puts on
your Treasury Bills, Notes and Bonds.
What does going long and going short mean?
To make a profit on any investment requires
that something be bought and sold. 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. If you were bearish
you would sell, or go short. If you were bullish
you would want to buy, or go long.
How do you sell something that you don’t own?
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, your only goal is to buy
low and sell high or vice-versa. Before the contract
expires you will need to relieve your contractual
obligation to take or make delivery by offsetting
your initial position. Therefore, if you originally
entered a short position to exit you would buy, and
if you had originally entered a long position, to
exit you would sell.
What are options?
Many people are intimidated by the unlimited risk
potential when trading futures. Margin calls can and
do happen when trading futures. Options have limited
risk and many investors choose them to trade
commodities contracts. Your maximum risk when purchasing an option is loss of
the premium paid plus your commission and fees. An option is the right but
not the obligation to buy or sell a futures
contract, at a predetermined price (strike price) on
or before a predetermined expiration date. To go
long (buy) an option requires a buyer (holder) to
pay a premium. When going short on option, the
seller (writer or grantor) receives a premium but is liable for the entire
contract value.
What is a call option?
A
call option is the right but not the obligation to
buy an underlying futures contract. Purchasing a
call means that you are expecting higher prices for
the underlying commodity. Let’s assume you purchased
a December Crude Oil $60 call option. You bought the
right but not the obligation to buy 1000 barrels of
December crude oil for $60 per barrel.
What is a put option?
A
put option is the right but not the obligation to
sell an underlying futures contract. Purchasing a
put means that you are expecting lower prices for
the underlying commodity. Let’s assume that you
purchased a November Soybean $5 put option. You
bought the right but not the obligation to sell 5000
bushels of November soybeans at $5 per bushel.
How is the value of an
option figured out?
To understand option trading basics first you have to understand the meaning of
intrinsic and extrinsic. The option premium is made up of both of these values.
Intrinsic is the value of the option if you exercised it to the futures contract
and then offset it. For example if you have a Nov. $5 soybean call and the
futures price for that contract is $5.20 hence there is a .20 intrinsic value for that
option. Soybeans are a 5000 bushel contract so 20 cents multiplied by 5000=
$1000 intrinsic value for that option.
Now let's say that same $5 Nov. soybean call
costs $1600 in premium. $1000 of the cost is intrinsic value and the other $600
is extrinsic. Extrinsic value is made up of time value, volatility premium and
demand for that specific option. If the option has 60 days left until expiration
it has more time value than it would with 45 days left. If the market has large
price movements from low to high the volatility premium will be higher than a
small price movement market. If many people are buying that exact strike price,
that demand can artificially push up the premium as well.
How much will an option
premium move in relation to the underlying futures contract?
You can figure this out by finding out the
delta factor of your option. The delta factor tells you how much the change in
premium will occur in your option based on the underlying future contract's
movement. Let's say that you think Dec. gold will go up by $50/ounce or
$5000/contract by expiration. You bought an option with a .20 or 20% delta
factor. This option should gain approximately $1000 in premium value of the
$5000 expected gold futures price movement.
Can an option speculator
have a profit before the option has intrinsic value?
Yes, as long as the option premium increases
enough to cover your transaction costs such as commission and fees. For example,
you have a $3 Dec. corn call and Dec. corn is at $270/bushel and your
transaction costs were $50. Let's say your option has a 20% delta and the Dec.
corn future market moves up 10 cents/bushel to $2.80/bushel. Corn is a 5000
bushel contact so 1 cent multiplied by 5000= $50. Your option premium will increase by
approximately 2 cents = $100. Your break even was $50 so you have a $50 profit
without any intrinsic value because you are still out of the money by 20 cents.
What is a bull call spread?
A bull call spread is a bullish strategy to
take advantage of markets with high volatility option premiums. It involves the
purchase of a at or close to the money call option and the granting of a further
out of the money call option. The profit potential is the difference between the
strike prices minus your costs and your risks are the cost of the trade.
Example: buy 1 Dec. crude oil $70 call for $2500 and sell 1 Dec. crude oil $75
call for $1000. The cost of the trade is $1500 ($2500-$1000) and your profit
potential is $3500 ($70-$75=$5 and crude is 1000 barrel contract so $5
multiplied by 1000=$5000-$1500 cost=$3500).
What is a bear put spread?
A bear put spread is just like the bull call
spread above but it uses puts instead of calls and is for speculating on a
decline in prices. So you would buy an at or near the money put and grant a
further out of the money put.
Should I open a full
service account?
Many new commodity
traders erroneously believe that commission rates will have a greater impact on
their trading success than the markets themselves. Reasonable full
service rates are not usually the cause for losses. Bad trades are the cause for
most losses. Many new traders begin trading commodities with a discount account
and rationalize that their stock trading accounts are discount so why not do the
same for their commodity account. The futures markets not only have almost 10
times more money volume than the stock markets on any given day but other
nuances such as order placements, slippage in illiquid markets, varying trading hours,
varying contract months, varying expiration dates and many other factors are involved in future trading that differ from stocks and must be interpreted before
trading.
The most important
question to ask is, “Will a discount broker monitor your account to make sure
you don’t make a costly mistake?” Other important questions to ask
are: "Will a discount broker let you know that your sell order
you are trying to place will initiate another short future because you meant to
offset a short with a buy not a sell to exit your trade? Will they alert you to
the fact that there is a major USDA grain report coming out before you place
your grain order? Will they call you and let you know that your options have
just 1 week before they expire?" All of the examples above can be very costly to
the new trader. The answers to all of the questions above is no because
discount brokers
are not paid enough to do so.
The old analogy of the
discount heart surgeon vs. the best heart surgeon should be pondered. If a loved
one needed heart surgery would you go to the cheapest or the best and
most experienced surgeon? Why would you treat your finances any differently?
Visit commodity broker to learn more.
How do trades take place?
Chicago Mercantile Exchange and most other U.S.
futures exchanges offer two venues for trading:
the traditional floor-trading venue and electronic
trading. Broadly speaking, trading is essentially
the same in either format: Customers submit orders
that are executed – filled – by other traders who
take equal but opposite positions, selling at prices
at which other customers buy or buying at prices at
which other customers sell. This matching of buyers
and sellers occurs in both open outcry and
electronic trading, but there are some differences
between the two processes.
In open outcry trading, orders are communicated to
brokers in a trading pit, via requests that
customers make to their brokerages by phone or
computer. Customer bids and offers are presented by
pit brokers to other brokers standing in the pit,
and trades are “executed” – matches are made – when
prices that are mutually acceptable to buyers and
sellers are identified. Customers are notified of
their trades, information about each trade is sent
to the clearing house and brokerages, and prices are
disseminated immediately throughout the world. The
trade order is also time-stamped at both ends of the
process.
In electronic or screen-based trading, customers
send buy or sell orders directly from their
computers to an electronic marketplace offered by
the exchange. There is no need to have brokers
submit and execute orders for customers, because the
customers will have received brokerage approval to
trade electronically, and the exchange computer
system informs the brokerages of customer activity.
In a sense, the trading screen replaces the trading
pit, and the electronic market participants replace
the brokers standing in the pit. There is greatly
expanded price transparency because the top five
current bids and offers are posted on the trading
screen for all market participants to see – an
advantage that even brokers in a pit don’t have.
The exchange computer system keeps track of all
trading activity, and identifies matches of bids and
offers, with fills generally made according to a
first-in, first-out (FIFO) process, although some
alternate allocation processes are used in
particular markets. Trade information is sent to the
clearing house and brokerage, and prices are also
instantaneously broadcast to the public. Trades made
on CME Globex exchange, for instance, are typically
completed in a fraction of a second. In open outcry
trading, however, it can take from a few seconds to
minutes to execute a trade, according to the
complexity of the order.
How
does the
process of price discovery work?
Futures prices increase
and decrease largely because of the myriad factors that influence buyers' and
sellers' judgments about what a particular commodity will be worth at a given
time in the future (anywhere from less than a month to more than two years).
As new supply and demand
developments occur and as new and more current information becomes available,
these judgments are reassessed and the price of a particular futures contract
may be bid upward or downward. The process of reassessment--of price
discovery--is continuous.
Thus, in January, the
price of a July futures contract would reflect the consensus of buyers' and
sellers' opinions at that time as to what the value of a commodity or item will
be when the contract expires in July. On any given day, with the arrival of new
or more accurate information, the price of the July futures contract might
increase or decrease in response to changing expectations.
Competitive price
discovery is a major economic function--and, indeed, a major economic
benefit--of futures trading. The trading floor of a futures exchange is where
available information about the future value of a commodity or item is
translated into the language of price. In summary, futures prices are an ever
changing barometer of supply and demand and, in a dynamic market, the only
certainty is that prices will change.
What happens after the
closing bell?
Once a closing bell
signals the end of a day's trading, the exchange's clearing organization matches
each purchase made that day with its corresponding sale and tallies each member
firm's gains or losses based on that day's price changes--a massive undertaking
considering that nearly two-thirds of a million futures contracts are bought and
sold on an average day. Each firm, in turn, calculates the gains and losses for
each of its customers having futures contracts.
Gains and losses on
futures contracts are not only calculated on a daily basis, they are credited
and deducted on a daily basis. Thus, if a speculator were to have, say, a $300
profit as a result of the day's price changes, that amount would be immediately
credited to his brokerage account and, unless required for other purposes, could
be withdrawn. On the other hand, if the day's price changes had resulted in a
$300 loss, his account would be immediately debited for that amount.
The process just
described is known as a daily cash settlement and is an important feature of
futures trading. As will be seen when we discuss margin requirements, it is also
the reason a customer who incurs a loss on a futures position may be called on
to deposit additional funds to his account.
Is the
arithmetic of futures trading complicated?
To say that gains and
losses in futures trading are the result of price changes is an accurate
explanation but by no means a complete explanation. Perhaps more so than in any
other form of speculation or investment, gains and losses in futures trading are
highly leveraged. An understanding of leverage--and of how it can work to your
advantage or disadvantage--is crucial to an understanding of futures trading.
As mentioned in the
introduction, the leverage of futures trading stems from the fact that only a
relatively small amount of money (known as initial margin) is required to buy or
sell a futures contract. On a particular day, a margin deposit of only $1,000
might enable you to buy or sell a futures contract covering $25,000 worth of
soybeans. Or for $10,000, you might be able to purchase a futures contract
covering common stocks worth $260,000. The smaller the margin in relation to the
value of the futures contract, the greater the leverage.
If you speculate in
futures contracts and the price moves in the direction you anticipated, high
leverage can produce large profits in relation to your initial margin.
Conversely, if prices move in the opposite direction, high leverage can produce
large losses in relation to your initial margin. Leverage is a two-edged sword.
For example, assume that
in anticipation of rising stock prices you buy one June S&P 500 stock index
futures contract at a time when the June index is trading at 1000. And assume
your initial margin requirement is $10,000. Since the value of the futures
contract is $250 times the index, each 1 point change in the index represents a
$250 gain or loss.
Thus, an increase in the
index from 1000 to 1040 would double your $10,000 margin deposit and a decrease
from 1000 to 960 would wipe it out. That's a 100% gain or loss as the result of
only a 4% change in the stock index!
Said another way, while
buying (or selling) a futures contract provides exactly the same dollars and
cents profit potential as owning (or selling short) the actual commodities or
items covered by the contract, low margin requirements sharply increase the
percentage profit or loss potential. For example, it can be one thing to have
the value of your portfolio of common stocks decline from $100,000 to $96,000 (a
4% loss) but quite another (at least emotionally) to deposit $10,000 as margin
for a futures contract and end up losing that much or more as the result of only
a 4% price decline. Futures trading requires not only the necessary financial
resources but also the necessary financial and emotional temperament.
What
risks should I consider when trading?
An absolute requisite
for anyone considering trading in futures contracts--whether it's sugar or stock
indexes, pork bellies or petroleum--is to clearly understand the concept of
leverage as well as the amount of gain or loss that will result from any given
change in the futures price of the particular futures contract you would be
trading. If you cannot afford the risk, or even if you are uncomfortable with
the risk, the only sound advice is don't trade. Futures trading is not for
everyone.
What is margin?
As is apparent from the
preceding discussion, the arithmetic of leverage is the arithmetic of margins.
An understanding of margins--and of the several different kinds of margin--is
essential to an understanding of futures trading.
If your previous
investment experience has mainly involved common stocks, you know that the term
margin--as used in connection with securities--has to do with the cash down
payment and money borrowed from a broker to purchase stocks. But used in
connection with futures trading, margin has an altogether different meaning and
serves an altogether different purpose.
Rather than providing a
down payment, the margin required to buy or sell a futures contract is solely a
deposit of good faith money that can be drawn on by your brokerage firm to cover
losses that you may incur in the course of futures trading. It is much like
money held in an escrow account. Minimum margin requirements for a particular
futures contract at a particular time are set by the exchange on which the
contract is traded. They are typically about five percent of the current value
of the futures contract. Exchanges continuously monitor market conditions and
risks and, as necessary, raise or reduce their margin requirements. Individual
brokerage firms may require higher margin amounts from their customers than the
exchange-set minimums.
There are two
margin-related terms you should know: Initial margin and maintenance margin.
Initial margin
(sometimes called original margin) is the sum of money that the customer must
deposit with the brokerage firm for each futures contract to be bought or sold.
On any day that profits accrue on your open positions, the profits will be added
to the balance in your margin account. On any day losses accrue, the losses will
be deducted from the balance in your margin account.
If and when the funds
remaining available in your margin account are reduced by losses to below a
certain level--known as the maintenance margin requirement--your broker will
require that you deposit additional funds to bring the account back to the level
of the initial margin. Or, you may also be asked for additional margin if the
exchange or your brokerage firm raises its margin requirements. Requests for
additional margin are known as margin calls.
Assume, for example,
that the initial margin needed to buy or sell a particular futures contract is
$2,000 and that the maintenance margin requirement is $1,500. Should losses on
open positions reduce the funds remaining in your trading account to, say,
$1,400 (an amount less than the maintenance requirement), you will receive a
margin call for the $600 needed to restore your account to $2,000.
Before trading in futures contracts, be sure
you understand the brokerage firm's Margin Agreement and know how and when the
firm expects margin calls to be met. Some firms may require only that you mail a
personal check. Others may insist you wire transfer funds from your bank or
provide same-day or next-day delivery of a certified or cashier's check. If
margin calls are not met in the prescribed time and form, the firm can protect
itself by liquidating your open positions at the available market price
(possibly resulting in an unsecured loss for which you would be liable).
Who is safeguarding commodity investors’
money from insolvency issues?
T & K Futures and Options
Inc. is registered with the United States Commodity Future Trading Commission (CFTC)
and the National Futures Association (NFA). The financial integrity of the
United States Futures markets is of the utmost importance to both the CFTC and
the NFA. One of their main goals is to ensure the viability of the markets and
protect investor funds. Subsequently, investor losses caused by insolvency of
futures brokerage firms has been practically non existent. In the last 50 years
these types of losses have totaled less than the amount that happens, on average,
every year in the securities markets.
Where
does my money go when I open an account?
The
cornerstone of the U.S. futures trading system is that
no futures brokerage company is
permitted to hold customer funds in any of its corporate bank accounts.
According to strict regulations that are aggressively enforced by the CFTC and
NFA, futures brokerage companies are required to maintain customer funds in bank
accounts that are totally separate
from their own bank accounts. By law, funds deposited by customers may
never, under any circumstances, be commingled with the brokerage company's own
funds. Your trading funds will always be carefully and securely held in a
"customer segregated funds account."
How do I open an account?
Simply click
open an account to begin trading.
What is a futures exchange?
A futures exchange, legally known in the U.S. as a
“designated contract market,” is, at its core, an
auction market – highly regulated, technical and
complex – but an auction market nonetheless.
A futures exchange is the only place where futures
and options on futures (which offer the right, but
not the obligation, to buy or sell an underlying
futures contract at a particular price) can be
traded. Trading may take place either on the
exchange’s trading floor or via an electronic
trading platform. An exchange itself does not trade
futures. Instead, it:
-
Provides and maintains the facilities where
buyers and sellers meet, ranging from
traditional “trading pits” to global electronic
trading networks
-
Researches, develops and offers futures
contracts to be traded
-
Oversees the trading of its products and
enforces trading-related rules and regulations
-
Monitors and enforces financial and ethical
standards
-
Provides daily and historical data on the
contracts traded under its auspices
Futures exchanges in the U.S. are subject to a great
deal of regulation. They are monitored by the
Commodity Futures Trading Commission (CFTC) and the
National Futures Association (NFA). In addition,
most futures exchanges practice intense
self-regulation, monitoring their employees and the
trading practices that occur in their facilities.
These agencies look after the public interest,
ensure fair practice and monitor the process of
price discovery that occurs in futures trading.
Other governmental bodies, including the Securities
and Exchange Commission, the Federal Reserve Board,
and the U.S. Treasury Board also monitor some
futures exchange functions. Violations of exchange
rules can result in substantial fines, as well as
suspension or revocation of trading privileges.
How many futures
exchanges are there?
There are currently 13 futures exchanges registered
in the U.S. but not all are hosting active trading.
CME is the largest futures exchange in the U.S. by
volume, and the first U.S. futures exchange to
become a for-profit corporation, after revising its
original private membership structure and a becoming
publicly traded company in 2002. Most U.S. exchanges
remain not-for-profit, private membership
organizations, but a number of them are actively
weighing the advantages of changing to stock
corporations.
There are more than 50 futures exchanges worldwide,
and they are structured in a number of different
ways. Some futures exchanges are owned by groups of
banks or by a stock exchange holding company. Other
exchanges, or their holding companies, are publicly
listed on a stock exchange, similar to CME.
How Futures Exchanges Earn Income?
Since futures exchanges do not themselves engage in
trading, people sometimes wonder how they earn
money. Futures exchanges earn income primarily by:
-
Receiving a fee for every trade made through the
exchange.
-
Selling price data – current, streaming price
data in real time as well as historical price
data on trades made through the exchange. At CME,
data subscription services include CME E-quotes™
and CME E-history.
-
Charging for clearing services, if the futures
exchanges own their own clearing house, as is
the case with CME. Some exchanges outsource the
clearing function. The Chicago Board of Trade,
for example, has its contracts cleared through
the CME Clearing House.
To learn more visit future
trading strategy,
option trading strategy and
investment glossary.
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