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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:
  1. typically require smaller margin deposits;
  2. make money no matter which way a market moves; and
  3. 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.