STOCK MARKET FOR BEGINNER | Stock & Option Guide

FUTURE TRADING (1 OF 2)

Welcome to the futures market – and relax – it’s not as complicated as you might think!

The futures market can provide opportunities that other financial markets simply cannot offer. If you were to write down the perfect investment, it would probably go something like this. I wish I could invest in:

• A product that would always be in high demand.
• Something that can’t be ruined by a greedy CEO and Board of Directors.
• Something that would move enough to make lots of money every day.
• Something where I didn’t have to put very much money down but could still make a huge return!
• Something I could buy or sell whenever I wanted – not just 9-5pm!
• Something that would always go up in value.

Yes, we have seen this wish list before, and we have some good news for you and some bad. The bad first. Unfortunately, such an investment does not exist – it’s the always going up part that ruins it every time. The good news is that there is an investment that comes pretty close: futures!

The futures market provides unparalleled access to the most basic and in-demand products in the world. Among the many investment opportunities in the futures market are commodities such as gold, oil, wheat, and orange juice (these are the kinds of products that are always in demand!). It also includes currencies such as the US Dollar, British Pound, and Japanese Yen (also high demand!). It also includes financial market indexes such as the Dow Jones Industrial Average, Nasdaq Composite, and the S&P 500 (again high demand!).

When you trade the stock market, you have a lot to consider in terms of who is running a company, what the company offers, whether the product or service has longevity, how the company performs in different economic cycles, etc.

In the futures market, you deal with the world’s most basic and fundamental products. Rather than worrying about who is running a particular aluminum company or whether they will be in business next year, you can just buy aluminum – with a level of comfort knowing there is always a market and use for aluminum.

Every day, banks deposit and lend money to customers. Instead of finding a bank with a strong fundamental balance sheet and solid management, why not invest in the product a bank makes its living from – currency. As you may be aware from recent world events, the values of currencies are constantly fluctuating, creating the opportunity to make money from the ever-changing value of money.

When it comes to success, mutual fund managers have one major challenge in life – to provide a better return than the market index. Some are successful, while others fail. Market indexes provide a baseline or fundamental benchmark for performance in the financial world. You could give your money to a money manager and give them a crack at outperforming the markets – or you could just invest in the over 25 different index futures! Chances are good that these indexes will still be ticking when your money manager has come and gone!

In addition to these advantages, futures have many other benefits over other financial instruments, including:

Leverage

Futures are one of the most efficient investment vehicles in existence. What do we mean? Simply stated, with futures you can make a large investment with a small amount of money. This concept is known as “leverage.” Leverage can be a boon to investors on the winning side of the market, as gains can be greater with futures than with other investments (this is how you invest in something that doesn’t require a lot of money but still has upside potential). However, leverage can be a double-edged sword, inflicting a lot of pain if you are on the losing side of the trade.

Diversification

With leverage, a little bit of money goes a long way. This means that excess funds in your account could be used for other purposes, including investing in other assets. Diversification is a good thing when it comes to investing since it helps to average things out! Portfolio diversification is something we will cover in detail later in the course.

Volatility

Futures are known for their considerable price movement, which is another key benefit. Like leverage, volatility can work for or against you. However, most traders want markets that move – and futures move! Just take a look at where the price of crude oil has gone over the last year, and you’ll see what we mean (didn’t you want an investment that moves enough to make lots of money every day?).

Trading Hours

Most futures markets today trade around the clock. It’s easy to get in and out of positions in popular and liquid futures markets, and you can do so at the click of a button, with lightning-fast speed. Futures markets are investor-friendly, and that has helped drive the incredible growth these markets have experienced in recent years.

Tax Benefits

Not only do investors like futures, the IRS smiles favorably on this market as well. Futures enjoy unique tax treatment not available to the equities market. Generally, securities transactions are taxed as either short-term capital gains, or more favorably as long-term capital gains. Futures transactions, however, are simply lumped together and reported on a single Form 1099 at year-end. Profits are then taxed at the “60/40″ rate – 60 percent taxed at the favorable long-term rate and 40 percent taxed at the short-term rate. We’re not tax advisors, so please consult your tax specialist about your individual circumstances.

Information

In the futures market, supply and demand form the basis of price direction – not quarterly earnings, corporate filings or management changes. Instead, the data that moves futures markets often comes from government reports that are found in the public domain. For example, the U.S. Department of Agriculture estimates crop sizes and international demand for wheat, corn and soybeans. The economy also plays an important role in futures pricing, and most economic reports are also public domain and come from central banks and various government agencies.

Not a Whole New World

Unfortunately, many people have never heard of futures trading or, worse, they have heard of futures and the stories have not been pretty. Put the horror stories aside for a moment and consider this: every time you invest you assume some level of risk. Futures are no exception. You can and many people do lose money investing in futures. However, just like any risky venture, there are steps you can take to minimize your risk.

First and foremost, if you have ever traded stocks or options, you’ll want to keep in mind what you have learned related to risk, portfolio management, discipline and emotional control. In fact, many of the concepts and knowledge you have gained trading stocks and options will translate nicely to futures. Concepts such as long and short, order types, margin, etc. all have similarities to futures trading.

Another similarity between equities and futures trading is the fundamental objective. When buying stocks or options, your objective is to buy when prices are low and sell when prices are high. This is the same objective in the futures market. There are some twists in “how” to buy low and sell high, but the objective is the same (the twists will be explained in greater detail in Module 3).

Futures traders are also able to build on the skills they have learned trading stocks and options. Concepts such as discipline, trading plan, psychology, etc. all play a role in your success as a futures trader.

A review of the characteristics of successful futures traders reveals three common factors that have more influence on their success than any other:

• Financial Resources
• Knowledge
• Discipline

The futures market can be risky, but people just like you are able to manage the risk and find success trading futures. How do they do it?

The futures market can be risky, but people just like you are able to manage the risk and find success trading futures. How do they do it?

Financial Resources

First, they have money. More specifically, they have enough money to stay in the markets long enough to make money. Experienced traders will try to get specific and tell you that you need $10,000 to $30,000 to get started. Rather than giving a specific dollar figure, it is important to understand why futures traders need significant financial resources to be successful.

Most futures traders will experience a drawdown – a streak of losing trades that reduces the capital in one’s trading account. Your account must be large enough to withstand the inevitable drawdown. Drawdowns are perfectly correlated to the amount of risk you take on each trade. If you are swinging for the fences, you’ll have larger drawdowns. If you are looking for small but consistent profits, you will have smaller drawdowns.

Knowledge

The second characteristic of successful futures traders is their trading plan. Rooted in sound financial principles, your trading plan should be simple to follow, simple to understand and simple to implement. If you were to survey the country’s most successful futures traders, you would discover that they all use different strategies; in other words each trader has his or her own unique trading plan. A successful trading plan helps you identify a competitive edge in the markets. You will also notice that each trading plan has its own set of flaws. A successful trader’s plan should include detailed instructions to compensate for these shortfalls.

Unfortunately, this type of trading plan is not created overnight. There are ample resources available to help you get started creating a simple trading plan (optionsXpress has a repository of professional lectures, forums, and discussions with ideas that will help you). However, the success of your plan depends on refinement. It is refined with time. It is refined with experience. It is refined with knowledge. When you first delve into the futures market, your trading plan must make accommodations for the acquisition of experience and knowledge over time. Time is needed to get over the learning curve. Experience is needed to learn the intricacies of the futures market. Knowledge is needed to understand the definitions, structure and boundaries of the futures market.

Discipline

Finally, if you don’t have the discipline to manage your trades according to plan, you won’t last very long in the futures market. They say that pride precedes the fall and nowhere is that more true than in the futures market. Your trading plan helps you keep your trading objective. When you fail to use discipline, your trading becomes subjective without rhyme or reason. It will be difficult for you to improve your trading success if every decision you make is according to your whims, passion and emotion. Historically, people who experience large drawdowns in futures do so because of feelings, opinions and not admitting or believing they might be wrong.

Disciplined traders are aware of the following emotional pitfalls and seek to avoid them:

• Trading for the thrill of it
• Trading to make back lost money
• Lack of money management
• Lack of a defined trading plan
• Inability to admit mistakes

Your success in the futures markets has as much to do with your financial, intellectual and emotional preparation as it does with your execution. This course will help you prepare to trade futures, but you will also need to work on preparing yourself in these other ways as well.

Your success in the futures markets has as much to do with your financial, intellectual and emotional preparation as it does with your execution. This course will help you prepare to trade futures, but you will also need to work on preparing yourself in these other ways as well.

The Investor Life Cycle

For many of the reasons we have already mentioned, over time, traders naturally gravitate to the futures market. In fact there is a growth cycle most investors go through as they develop knowledge and understanding of the financial markets.

First investors look toward mutual funds to provide growth and financial independence. For the daring few who choose to progress beyond the mutual funds, they seek the financial returns of the stock market. Traders will generally cut their teeth in this exciting financial market for 2-3 years when they naturally gravitate to the derivatives or options market. Those traders who endure the learning curve of the options market tend find a home in the futures market some 5-7 years into their trading career.

Today, however, investors are trumping the learning curve and short-circuiting the time curve to discover the wonderful opportunities that are available in the futures market much sooner – and for good reason, too.

Today’s futures markets have grown beyond the traditional commodities market of yesterday. Today, grains, gold and oil have yielded ground to a broader range of instruments including stocks, indexes, currencies and even carbon emissions futures! Today’s futures markets have grown beyond the boundaries of American borders to include a global financial market; futures trading in England, Germany, Japan and Australia has exploded as new global trading networks have evolved.

But what does this mean for you? Traditionally, the futures market was for that elite class of traders with RISK tattooed across the bicep. To set your stress at ease, today’s futures trading has made huge strides away from that stigma. Today, new products are being released with variable definitions, sizes, multipliers, etc. You can purchase “mini” futures that reduce your exposure to risk and make investing more palatable.

Who’s in charge of the Futures Market?

Like the stock market, the futures market is a highly regulated industry offering excellent protection to individual investors like yourself. Companies or individuals who handle futures money or give futures trading advice must apply for registration through the National Futures Association, a self-regulatory organization approved by the U.S. Commodity Futures Trading Commission, or CFTC.

In 1974, Congress created the CFTC as an independent pseudo-governmental agency with the mandate to regulate commodity futures and options markets in the United States.

When the CFTC was created, the majority of futures trading took place in the agricultural sector, which is why this industry is often referred to as the “commodities” industry. Today, the futures industry has become increasingly varied to encompass a vast array of highly diverse specialties including agriculture, metals, consumer staples, currencies, financial indexes, stock equities, and more.

The CFTC assures the economic utility of the futures markets by encouraging competitiveness and efficiency, protecting market participants against fraud, manipulation, abusive trading practices, and by ensuring the financial integrity of the clearing process. Through effective oversight, the CFTC enables the futures markets to serve the important function of providing a means for price discovery and offsetting price risk.

The CFTC’s mission is to protect market users and the public from fraud, manipulation, and abusive practices related to the purchase and sale of commodity and financial futures and options, and to foster open, competitive, and financially sound futures and futures options markets.

The CFTC seeks to protect customers by:

• requiring companies and individuals to disclose market risks and past performance information to prospective customers,
• requiring that customer funds be kept in accounts separate from those maintained by the firm for its own use, and
• requiring customer accounts to be adjusted to reflect the current market value at the close of trading each day.

The CFTC also monitors registrant supervision systems, internal controls, and sales practice compliance programs.

In addition to federally mandated regulation offered by the CFTC, the futures industry also self-regulates through the National Futures Association, or NFA. The NFA develops rules, programs and services that safeguard market integrity, protect investors and help firms and representatives meet the CFTC’s regulatory standards.

In today’s global financial markets, it is important to identify companies that are registered with the NFA and instruments that are created and managed under the CFTC’s jurisdiction. The global financial markets have literally opened access to a whole new set of challenges related to regulating the global futures market.

Dispute Resolution

If you have a dispute arising out of your commodity futures or options account, first try to resolve the problem with your broker and his or her supervisor at the firm that employs or guarantees the broker.

If that fails, commodity futures customers have several options for resolving disputes:

• The CFTC Reparations program
• NFA sponsored arbitration
• Civil court litigation

In selecting a particular approach, you may want to consider the cost, length of time involved, and whether or not the assistance of an attorney is required.

Where are futures traded?

Futures, like stocks, are traded on exchanges. A commodity exchange is an organized market where traders meet to buy or sell various futures contracts. The exchange may be a physical location, like the Chicago Mercantile Exchange, or it may be an electronic gathering place such as GLOBEX. Either way, the exchange acts as an important part of the futures industry by:

• Providing an organized location (physical or electronic) for trading futures
• Regulating the trading practices of their members
• Gathering and transmitting price information
• Gathering and governing commodities traded on the exchange
• Supervising warehouses that store the underlying commodities
• Providing a means for settling disputes between members

History of the Futures Market

It is helpful to begin a discussion on the futures market with a historical sketch. Commodity markets have existed for centuries around the world because producers and buyers of commodities, such as rice, wheat, oil and other items have needed a centralized place to trade. In those days, cash transactions were most common, but occasionally a “forward” type arrangement was also made – deals to deliver and pay for something in the future at a price agreed upon in the present. There are records, for example, of “forward” agreements related to the rice markets in seventeenth century Japan; most scholars agree that forward arrangements actually date back much farther in time.

he immediate predecessors of futures contracts were “to arrive” contracts. These were simple agreements to purchase designated goods when they arrived by ship, and they were used for centuries when shipping was the primary mode of international trade.

The first organized grain futures trading in the U.S. began in places such as New York City and Buffalo, but the development of “modern” futures, which are a unique type of forward agreement, began in Chicago in the 1840s. With the construction of the railroads, Chicago began to emerge as a center for transportation between Midwestern producers and East Coast population centers. The city was a natural hub for trade, but the trading that took place was inefficient and unorganized until a group of Chicago-based businessmen formed the Board of Trade of the City of Chicago in 1848. The Board was a member-owned organization that offered a centralized location for cash trading a variety of goods, as well as trading of forward contracts. Members served as brokers who facilitated trading in return for commissions.

As future trading of forward contracts increased, the Board decided that standardizing those contracts would streamline the trading and delivery processes. Instead of individualized contracts, which took a great deal of time to negotiate and fulfill, people interested in the forward trading of corn at the Board, for example, were asked to trade contracts that were identical in terms of quantity, quality, delivery month and terms, all as established by the exchange. The only thing left for traders to negotiate was price and the number of contracts.

These standardized forwards were essentially the first modern futures contracts. They were unlike other forwards in that they could only be traded at the exchange that created them, and only at certain designated times. They were also different from other forwards in that the bids, offers and negotiated prices of the trades were made public by the exchange. This practice established futures exchanges as venues for “price discovery” in U.S. markets.

In contrast to customized contracts, standardized futures contracts were easy to trade since all trades were simply re-negotiations of price, and they usually changed hands many times before expiration. People who wanted to make a profit based on a fortuitous price change, or alternatively, who wished to cut mounting losses as quickly as possible, could “offset” a futures contract before expiration by engaging in an opposite trade: buying a contract which they had previously sold (or “gone short”), or selling a contract which they had previously bought (or “gone long”).

The usefulness of futures trading became apparent, and a number of other futures exchanges were established throughout the country in the decades that followed. The Chicago Butter and Egg Board was founded in 1898 and evolved into the Chicago Mercantile Exchange (CME) in 1919. Futures exchanges also opened in Milwaukee, New York, St. Louis, Kansas City, Minneapolis, San Francisco, Memphis, New Orleans and elsewhere. Chicago, however, became the most influential and predominant location for futures trading in the U.S.

In recent years, the commodities exchanges have experienced tremendous change by way of mergers and acquisitions. Most notably, the Chicago Mercantile Exchange has redefined itself as the Chicago Mercantile Exchange Group – a conglomeration of the Chicago Mercantile Exchange, the Chicago Board of Trade, and the New York Mercantile Exchange. Otherwise know as the “Merc,” the Chicago Mercantile Exchange Group also controls the world’s largest electronic futures exchange: Globex.

In addition to the Merc, there are many other commodity exchanges both domestically and around the globe. The industry is in a state of significant growth, and change is announced almost daily. As of this writing here are some other exchanges you may come across:

Kansas City Board of Trade

A commodity futures and options exchange that specializes in hard red winter wheat – the principal ingredient of bread.

Chicago Climate Exchange

A relative newcomer to the futures industry, the Chicago Climate Exchange is North America’s only voluntary, legally binding greenhouse gas (GHG) reduction and future trading system for emission sources and offset projects.

Intercontinental Exchange

An electronic based marketplace which trades futures and over-the-counter (OTC) energy and commodity contracts as well as derivative financial products. While the company’s original focus was energy products, recent acquisitions have expanded its activity into the “soft” commodities, foreign exchange and equity index futures.

One Chicago

A subsidiary of the Chicago Mercantile Exchange, One Chicago is the home of single stock futures (SSF’s), which are futures contracts with the underlying asset being stock.

Futures trading is also growing around the world with many notable exchanges including Canada’s Montreal Exchange, Britain’s London Metal Exchange, Eurex, and many more.

How futures are traded on exchanges

Trading at the futures exchange is conducted in two ways: an open outcry format and the electronic trading platform.

Open Outcry

The open outcry method consists of floor traders standing in a trading pit to call out orders, prices, and quantities of a particular commodity. Traders on the floor of the exchange wear different color jackets to indicate their position and affiliation. In addition, complex hand signals (called Arb) are used. These hand signals were first used in the 1970s. The pits are areas of the floor that are lowered to facilitate communication, sort of like a miniature amphitheater. The pits can be raised and lowered depending on trading volume. To an onlooker, the open outcry system can look chaotic and confusing, but in reality the system is a tried and true method of accurate and efficient trading.

Electronic Future Trading

Approximately 70 percent of total futures volume is conducted via electronic trading platforms. Fully electronic trading systems allow market participants to trade from booths at the exchange or while sitting in a home or office thousands of miles away.

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