Hedging
The primary purpose of futures markets, is to provide an efficient and effective mechanism to manage price risk. By buying or selling futures contracts, these contracts establish a price level now for items to be delivered later. Individuals and businesses seek to achieve insurance against adverse price changes. This is done by buying or selling futures contracts, with a price level established now, for items to be delivered later.
The principles underlying hedging are quite basic. Hedgers are individuals and firms who wish to establish a known price level weeks and sometimes months or years in advance for products they want to buy or sell in the cash market. This futures position protects them against unfavorable price changes in the interim which might occur. Alternatively, a hedger may want to establish a guaranteed margin between their purchase cost and their selling price.
For example, a food manufacturer will need to buy additional corn from his supplier in three months. However, he feels that the price of corn is going to increase by the time he needs the corn in three months. Because of fierce competition, he needs to hold his price constant. He wants to make sure that he pays $3.55 per bushel. Therefore, to lock in the $3.55 per bushel price, he buys a contract for three months out at $3.55 per bushel. If three months later the price of corn has risen to $3.69 per bushel, he will pay his supplier $3.69. However, the 14 cent increase has been offset by the 14 cent increase in his futures contract. On the other hand, if the price of corn declines by an amount of 10 cents per bushel to $3.45 per bushel, the decline in the futures contract will be offset by the lesser amount the manufacturer has to pay his supplier. Irrespective of what happens in the spot market, the manufacturer has locked in a set price for the corn he needs to purchase in the future.
The need for hedging is present in all forms of commerce. Large borrowers can protect against higher interest rates. Lenders can protect themselves against lower interest rates. Investors can protect themselves against lower stock prices. Jewelry manufacturers can protect themselves against higher gold and silver prices. Hedgers use futures contracts to protect themselves against adverse price changes. The drawback is that the hedger is unable to participate in favorable price changes. He locks in known costs to prevent against the unknown. That's the hedgers tradeoff.
Speculators
The speculative investor is looking for the risks that hedgers wish to avoid. Speculators have no intention of making or taking delivery of the commodity Instead, they seek to profit from a change in the price. They buy when they believe prices will rise; and they sell when they believe prices will decline.
Buying a futures contract in anticipation of price increases is known as 'going long'. Selling a futures contract in anticipation of a price decrease is known as 'going short'. Interaction between hedgers and speculators helps to provide active, liquid and competitive markets. Speculative participation in futures trading has increased with the availability of alternative methods of participation.
One of the most frequently used alternative methods is the use of professional trading advisors. The speculator can avoid the day to day trading decisions which arise by using an advisor. The speculator doesn't have to manage a portfolio. And further, the speculator may have his money infused in a 'pool' of money which is similar to a mutual fund concept. However, many other people prefer to make the decisions themselves and manage their own portfolios. The correct determination of which method will serve the investor better is determined by the individual circumstances of each individual investor.
Futures trading is extremely risky business. And it shouldn't be attempted by the novice investor. Most experienced investors stay away from it. That should give the reader an idea as to how risky it is. However, some individuals do understand the futures markets and are able to manage their risk and portfolio. Those investors may seek to speculate in the futures markets.
My father in law called me up one day and told me that he heard an advertisement on the radio which said that if heating oil moved 20 cents on an investment of a few thousand dollars he could make a $20,000 profit. It sounded good enough for him to give me a call and see if there was a hitch. I asked him why he called me. He said because he wanted to know if it was true. I told him it was true. And then I told him that if he had to call me up to see if it was true and he didn't understand the market he should definitely stay out of that market. He agreed. But he also wanted to know why it only had to make such a small move to make so much money. I told him that on heating oil, the limit up and down was 2 cents. I told him that 20 cents was an enormous move. Now it was beginning to sink in. On its face, the advertisement told the truth. What they left out was how difficult it is to get a 20 cent move in heating oil. The moral to this story is that you should be very very careful before entering the futures markets.
Futures trading is highly leveraged trading. Large profits can be made in a short time. However, large losses can also be realized. Because it only takes a little money to make large profits, the profit factor is magnified when prices move in the direction the speculator bet on. This works to the speculators disadvantage when price moves in the opposite direction. Losses are magnified.
How Futures Markets Came About
Many people see pictures of the large crowd of traders standing in a crowd yelling and signaling with their hands, holding pieces of paper, and writing frantically. To the outsider, it looks like chaos. But do you really think that there is in fact chaos going on in the worlds futures pits? Not a chance. Actually, everyone in the crowd knows exactly what's going on. It is in fact, another language. Learn the language and you know what is going on.
How does this differ from the way things operated in the 'old days'? Before there were organized grain and commodity markets, farmers would bring their harvested crops to major population centers. There they would search for buyers. There were no storage facilities; and many times the harvest would rot before buyers were found. Also, because many farmers would bring their crops to market at the same time, the price of the crops or commodities would be driven down. There was tremendous supply in relation to demand. The reverse was true in the spring. Many times there would be a shortage of crops and commodities and the price would rise sharply. There was no organized or central marketplace where competitive bidding could take place.
Initially, the first organized and central marketplaces were created to provide spot prices for immediate delivery. Shortly thereafter, forward contracts were also established. These 'forwards' were forerunners to the present day futures contract.
Futures prices and the bid and asked price are continuously transmitted throughout the world electronically. Regardless of what geographic location the speculator or hedger is located in, he has the same access to price information as everyone else. Farmers, bankers, manufacturers, corporations, all have equal access. All they have to do is call their broker and arrange for the purchase or sale of a futures contract. The person who takes the opposite side of your trade may be a competitor who has a different outlook on the future price, it may be a floor broker, or it could be a speculator.
Floor Traders Also Known As 'Locals'
Floor traders or locals, buy and sell for their own account on the trading floor of the exchanges. These are independent traders. Many times, if there is no one else who is willing to take the opposite side of your trade, the chances are good that a local will take your trade. The locals objective is to then turn around and exit their position seconds or minutes later at a small profit. Thus, the locals help provide liquidity to the futures markets. Floor traders are not obligated to take any position. They don't have to take the opposite side of any trade. They are strictly independent traders.
Physical Delivery and Cash Settlement
Physical delivery and cash settlement are two different means of settling a futures contract. For the most part, futures contracts are generally not settled with physical delivery. And when they are, it is usually done in the form of a warehouse receipt indicating that the goods are stored somewhere else. The warehouse receipt is a negotiable instrument. Speculators usually close out their position by buying or selling an offsetting position. And even hedgers usually close out their positions to lock in their position by buying or selling offsetting positions. Cash delivery is exactly what it implies. Settlement is in the form of cash. Stock index futures are a good example of this.
Why Have A Delivery Option For Settlement
Delivery, or the threat of delivery, assures that the spot price and the futures price converge at expiration. It is this convergence that makes hedging a viable strategy. A minor reason is that the buyer or seller do have the option of taking delivery. However, it is important to note that the purpose of the futures market has evolved as a way to maintain price stability and competitive bidding rather than as a means of taking delivery of commodities, etc. Convergence must occur at expiration. Arbitrage assures us of this. What happens is that astute investors would buy at the lowest market and sell in the highest market. This happens until prices converge.
Price Discovery
Price discovery is a continuous process. Information pertaining to supply and demand is ubiquitous. It is always being disseminated. As new information is received, the assessment of the current price of a commodity is re-evaluated. Based on this new information the price of the futures contract may be bid either up or down. The current price of a contract reflects the consensus of what that contract is going to be worth at the expiration of that contract. It is the transformation of information into price which is at the crux of the importance of the futures markets.
Margin
At the end of each trading day, every customer's account is totaled. And every purchase and sale is matched. Gains and losses are credited and debited to each account each day. This is known as daily cash settlement. Too many debits and you will be hit with a margin call. Because futures contracts are highly leveraged, the trader must maintain a minimum amount of cash in his account. It only takes a small amount of money to purchase a futures contract. For $2,000 a trader might be able to purchase a futures contract worth $40,000 to $50,000.
To demonstrate the risk involved with this type of leverage, suppose you bought one S&P 500 futures contract at 600. Assume that your broker will let you position trade this contract for $6,000 margin. The contract is worth approximately $300,000 at the time of purchase (and this writing). If the contract moves to 612 you have just doubled your money on a 2% upward move in the price of the contract. However, the reverse is also true. If the contract moves down to 588 your loss is 100All your $6,000 initial margin is gone. And this was just a 2move down in the contract. If you own the stock instead, you still have a loss, however, you still own something. With a futures contract, you have to deposit more margin to continue owning the contract if it declines.
Margin as used in futures trading is a good faith deposit of cash which can be drawn on by your brokerage firm to cover any losses which may occur in your futures account. Minimum margin requirements are set by the exchange. However, your particular broker may increase the minimum margin requirements as he sees fit. Initial margin or original margin is the amount of money which must be deposited with the broker for him to buy or sell a particular futures contract. Maintenance margin is the money required by the brokerage firm that you must put into your account if your balance drops below the minimum margin required. It is required to bring your account up to the minimum margin requirements. Margin requirements are strictly enforced. Always understand the terms of the brokerage firms 'Margin Agreement'. Some firms require you to wire transfer funds the same day, other's require certified checks. It usually has to be done the same day or the next day. If margin calls are not met the brokerage firm can sell off your contracts and you may have unsecured losses for which you will be liable.
Basic Trading Strategies
Buying (Going Long) If Price Is Expected To Increase
An investor expecting a futures price to increase may decide to go long. That is, purchase a futures contract. If the price of the contract rises the investor will profit. If the price of the contract declines, the investor will lose money.
Selling (Going Short) If Price Is Expected To Decrease
An investor who believes that the price of a commodity will decline will sell a futures contract. The mechanics of selling short are that first a futures contract is sold and then the profit is realized by buying an offsetting contract at a lower price. If the commodity declines in price the investor profits. If the contract increases in price the investor will have losses. An example of a profitable short trade would be to sell 1 July $3.65 corn and then close the trade by buying 1 July $3.60 corn to close.
Spreads
A futures spread involves buying one contract and selling another contract. The investor hopes to profit by any price discrepancy which develops between the two contracts. Assume there is a 10 cent difference between the January and March contracts. Analysis indicates that the difference between the two contracts will widen. The investor might want to sell the January contract and buy the March contract.
About Firms Dealing In Futures
All brokerage firms conducting futures business with the public must be registered with the Commodity Futures Trading Commission (CFTC). This is an independent regulatory agency of the federal government. It administers the Commodity Exchange Act. All Futures Commission Merchants or Introducing Brokers must be Members of the National Futures Association (NFA) This is the industry wide self-regulatory association.
Customer's funds must be maintained by Futures Commission Merchants in segregated accounts, separate from the firm's own money. You should also be familiar with the transaction costs and commissions the brokerage firm is charging you. If you want to find out if a particular firm is properly registered with the CFTC and is a Member of NFA, you should contact NFA's Information Center at 800-621-3570.
Managed Accounts
Many investors choose to use managed futures accounts. With a managed futures account an account manager has a written power of attorney to execute trades on your behalf. He will have discretionary authority to buy and sell for your account. You will get confirmation slips for the trades he makes. However, you may or may not have to give permission for each trade. This will depend on the agreement you have with the advisor.
You still remain fully responsible for the trades. And the losses or profits are yours. Any shortages in the account will have to be made up by you should they occur. Generally, you will need to deposit a greater amount of funds in a managed account than an individual account.
If you are considering a managed account, make sure you understand the account manager's trading philosophy and strategies. Make sure that his objectives and strategies are consistent with yours. Also, make sure that you know exactly what the fees are for the managed accounts. All charges must be disclosed in advance. The account manager is compensated for his efforts. You should also see a track record of the account managers past performance. There is no assurance that past performance will be indicative of future performance. But you should know what that past performance is. Also, inquire about the experience of the account manager. Make sure you know what restrictions apply to withdrawals from the account. Also, know if there is a provision to liquidate any positions if a loss exceeds a certain amount.
Commodity Trading Advisors
A Commodity Trading Advisor is an individual, or firm, that provides advice on commodity trading. This usually includes specific trading recommendations such as when to establish a particular long or short position and when to liquidate that position. Commodity Trading Advisors may offer specific recommendations to match your specific goals. However, they also have their own individual trading philosophies and strategies. It is usually best to find an advisor who already is trading in a way which matches your goals and objectives. Commodity Trading Advisors communicate their recommendations by phone, fax, e-mail, pager, or recorded message. A Commodity Trading Advisor cannot manage an account for you unless he is also registered as a Futures Commission Merchant.
The CFTC Regulations require that Commodity Trading Advisors provide their customers, in advance, with a Disclosure Document. This is an important document. Contained in the document is the experience of the advisor, past and present performance records, and fees. Also, if the advisor is also managing the account for you, you must sign a document indicating that you have read and understand the Disclosure Document. Commodity Trading Advisors must be registered with the CFTC. Advisors who accept authority to manage customer accounts must also be Members of NFA. You can verify that these requirements have been met by calling NFA at 800-621-3570.
Commodity Pools
A commodity pool is similar to a common stock mutual fund. In a commodity pool you do not have your own individual trading account. Your money is combined with other people's money and traded as a single account. You share the profits and losses of the pool in direct proportion to your investment in the pool. There is greater diversification of risks than if you were trading your own account. Also, your risk of loss is generally limited to your investment in the pool. Most pools are formed as limited partnerships. Last, you are not subject to margin calls. The risks the pool takes in its trades are the same as any other future's trade. These are still highly leveraged and volatile trades. Commodity Trading Pools may or may not be affiliated with the brokerage firm. You should check this out first before signing up.
The Commodity Pool Operator must provide you with a Disclosure Document. The Disclosure Document contains information about the pool operator, the pool's principals and any outside persons who will be providing trading advice or making trading decisions. The Disclosure Document also discloses past and present performance records. The Disclosure Document must also advise you of the risks involved in the pool. If it is a new pool, it usually can't begin trading unless a certain amount of money is raised. If you are responsible for any trading losses above your investment in the pool, the Disclosure Document must state this at the beginning of the document. It will also state how the pool's operators are compensated, how the organizational and administrative expenses are apportioned, how your shares are redeemed, redemption restrictions, and provisions for liquidating the pool should the capital drop to a level below a certain percentage of the initial capital.
You should also know the pool operators philosophy and the type of contracts to be traded. Also, Commodity Pool Operators must be registered with the CFTC and be Members of NFA. You can check that the requirements have been met by calling the NFA at 800-621-3570.
Futures Regulation
Futures trading is subject to regulation by the CFTC and the NFA oversees firms and individuals that conduct futures trading business with the public. All futures exchanges are also regulated by the CFTC. NFA is a congressionally authorized self-regulatory organization subject to CFTC oversight. It exercises regulatory Authority with the CFTC over Futures Commission Merchants, Introducing Brokers, Commodity Trading Advisors, Commodity Pool Operators and Associated Persons (salespersons) of all of the foregoing. The NFA has field auditors and investigators. NFA also has the responsibility for registering persons and firms that are required to be registered with the CFTC.
Violators of NFA rules of professional ethics or conduct, or failure to comply with financial and record keeping requirements can be fined, barred from the industry, or referred to the Department of Justice for criminal prosecution. Futures Commission Merchants which are members of an exchange are subject to CFTC and NFA regulation and also regulation by the exchanges of which they are members. Exchange regulatory staffs are responsible for the business conduct and financial responsibility of their member firms. Violations of exchange rules can result in substantial fines, suspension or revocation of trading privileges, and loss of exchange membership.
Arbitration
The National Futures Association has an arbitration process for those complaints which can't be settled by the exchange or the firm. First, with this type of arbitration, you don't have to prove that a law or rule was broken. You only need to prove that you received unfair treatment. The arbitrators, if you chose, do not need to be from the futures industry. Some arbitration hearings can be dealt with entirely in writing. Attorney's are not required (but I recommend them). Hearings can be scheduled for the convenience of both parties. The NFA will send you a free copy of their booklet titled "Arbitration: A Way To Resolve Futures Related Disputes.
The Contract Unit
Futures contracts which are settled with delivery, stipulate the specifications of the commodity to be delivered. You might be buying 5,000 bushels of grain, or 100 troy ounces of gold. Foreign currency futures provide for delivery of a specified quantity of the currency. For example, it would stipulate the amount of yen, or marks, or pesos. U.S. Treasury futures have a stated face value. They might be for $100,000 or $1 million at maturity. Futures contracts that call for cash settlement rather than delivery are based on a given index number times a specified dollar multiple. Stock index futures are a good example of this. You should always know the contract size.
How Prices are Quoted
Futures prices are usually quoted the same way prices are quoted in the cash market. They are quoted in dollars, cents, and fractions of a cent, per bushel, pound or ounce. They are also quoted in dollars, cents and increments of a cent for foreign currencies. And they are quoted in points and percentages of a point for financial instruments. Cash settlement contract prices are quoted in terms of an index number. The quotes are usually stated to two decimal points.
Minimum Price Changes
The minimum amount that the price can fluctuate up or down is determined by the exchange. This minimum amount is known as the tick. Consider a gold futures contract The tick is 10 cents per ounce. This amounts to $10 on a 100 ounce contract.
Daily Price Limits
Futures contracts have maximum limits as to the amount (price) the contract can move during the day. The exchanges set these limits. The limits are stated in terms of the previous day's closing price plus and minus so many cents or dollars per trading unit. If a futures contract price has increased by its daily limit, there will be no trading at any higher price until the next day of trading. There is also daily limit down price. If a futures price has declined by its daily limit, there can be no trading at any lower price until the next day of trading.
If the daily limit on corn is 10 cents, and the opening price of corn is $3.65 per bushel, if corn rises to $3.75 or declines to $3.55, there will be no more trading that day. During the expiration month, on some contracts the daily limit is eliminated. This is a very volatile time for a futures contract. Keep in mind that the daily limit can also be altered by the exchange if they feel that it is necessary. It's also important to know that you may not be able to liquidate a futures position when the limits are hit. When the limit is hit it is known as 'limit up' or 'limit down'. It is also possible for the commodity to be limit up or down for more than one day. This is known as 'lock limit'.
Position Limits
The exchanges and the CFTC also set maximum amounts of contracts which can be owned by one person. The purpose of this is to prevent one individual from cornering the market or exerting undue influence on the market. Position limits are stated in number of contracts or total units of the commodity.
Options on Futures Contracts
Put and call options are being traded on an increasing number of futures contracts. Trading options on futures allows the speculator to participate in the futures market and know in advance what the maximum loss on his position will be. The purchase of a call entitles the option buyer the right, but not the obligation, to purchase a futures contract at a specified price at any time during the life of the option. The underlying futures contract and the price are specified. The purchase of a put option entitles the option buyer the right, not the obligation, to sell a specified futures contract at a specified price. Keep in mind that the profit realized with an option strategy is reduced by the option premium. The option's price is determined in the same fashion that an equity option is determined.
Selling Options
Options are sold by other market participants known as option writers, or grantors. The reason people write options is to earn the premium paid by the option buyer. The option writer hopes that the option expires worthless. When this happens the writer retains the full amount of the premium. If the option buyer exercises the option, however, the writer must pay the difference between the market value and the exercise price. The possible loss to the option writer is unlimited.
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