The Market Participants
Should you at some time decide to trade in futures contracts, either for speculation or in connection with a risk management strategy, your orders to buy or sell will be communicated from the brokerage office you use to the appropriate trading pit or electronic trading platform for execution.If you are a buyer, your order will seek a seller at the lowest available price. If you are a seller, your order will seek a buyer at the highest available price. Market fluctuation is a process of finding fair prices for both buyers and sellers. In either case, the person who takes the opposite side of your trade may be or may represent someone who is a commercial hedger or perhaps someone who is a public speculator. Or, quite possibly, the other party may be an independent trader. In becoming acquainted with futures markets, you should have at least a general understanding of who these various market participants are, what they are doing and why.
Hedgers
The details of hedging can be somewhat complex but the principle is simple. Hedgers are individuals and firms that make purchases and sales in the futures market for the purpose of establishing a known price level - weeks or months in advance - for something they later intend to buy or sell in the cash market (such as at a grain elevator or in the bond market). In this way they attempt to protect themselves against the risk of an unfavorable price change in the interim. Consider this example:
A jewelry manufacturer will need to buy additional gold from his supplier in six months. Between now and then, however, he fears the price of gold may increase. That could be a problem because he has already published his catalog for the year ahead.
To lock in the price level at which gold is presently being quoted for delivery in six months, he buys a futures contract at a price of $550 an ounce.
If, six months later, the cash market price of gold has risen, he will have to pay his supplier that increased amount to acquire gold. However, the extra cost may be offset by a corresponding profit when the futures contract bought at $550 is sold for $570. In effect, the hedge provided insurance against an increase in the price of gold. It locked in a net cost, regardless of what happened to the cash market price of gold. Had the price of gold declined instead of risen, he would have incurred a loss on his futures position, but this would have been offset by the lower cost of acquiring gold in the cash market.
The number and variety of hedging possibilities are practically limitless. A cattle feeder can hedge against a decline in livestock prices and a meat packer or supermarket chain can hedge against an increase in livestock prices. Borrowers can hedge against higher interest rates, and lenders against lower interest rates. In addition, investors can hedge against a decline in stock prices.
Whatever the hedging strategy, the common denominator is that hedgers willingly give up the opportunity to benefit from favorable price changes in order to achieve protection against unfavorable price changes.
Speculators
Were you to speculate in futures contracts, the person taking the opposite side of your trade on any given occasion could be a hedger or it might well be a speculator - someone whose opinion about the probable direction of prices may differ from your own.
The arithmetic of speculation in futures contracts - including the opportunities it offers and the risks it involves - will be discussed in detail later on. For now, just know that speculators are individuals and firms who seek to profit from anticipated increases or decreases in futures prices. In so doing, they help provide the risk capital needed to facilitate hedging.
Someone who expects a futures price to increase would purchase futures contracts in the hope of later being able to sell them at a higher price. This is known as "going long." Conversely, someone who expects a futures price to decline would sell futures contracts in the hope of later being able to buy back identical and offsetting contracts at a lower price. The practice of selling futures contracts in anticipation of lower prices is known as "going short." One of the unique features of futures trading is that one can initiate a transaction with a sale as well as with a purchase.
Should you at some time decide to trade in futures contracts, either for speculation or in connection with a risk management strategy, your orders to buy or sell will be communicated from the brokerage office you use to the appropriate trading pit or electronic trading platform for execution.If you are a buyer, your order will seek a seller at the lowest available price. If you are a seller, your order will seek a buyer at the highest available price. Market fluctuation is a process of finding fair prices for both buyers and sellers. In either case, the person who takes the opposite side of your trade may be or may represent someone who is a commercial hedger or perhaps someone who is a public speculator. Or, quite possibly, the other party may be an independent trader. In becoming acquainted with futures markets, you should have at least a general understanding of who these various market participants are, what they are doing and why.
Hedgers
The details of hedging can be somewhat complex but the principle is simple. Hedgers are individuals and firms that make purchases and sales in the futures market for the purpose of establishing a known price level - weeks or months in advance - for something they later intend to buy or sell in the cash market (such as at a grain elevator or in the bond market). In this way they attempt to protect themselves against the risk of an unfavorable price change in the interim. Consider this example:
A jewelry manufacturer will need to buy additional gold from his supplier in six months. Between now and then, however, he fears the price of gold may increase. That could be a problem because he has already published his catalog for the year ahead.
To lock in the price level at which gold is presently being quoted for delivery in six months, he buys a futures contract at a price of $550 an ounce.
If, six months later, the cash market price of gold has risen, he will have to pay his supplier that increased amount to acquire gold. However, the extra cost may be offset by a corresponding profit when the futures contract bought at $550 is sold for $570. In effect, the hedge provided insurance against an increase in the price of gold. It locked in a net cost, regardless of what happened to the cash market price of gold. Had the price of gold declined instead of risen, he would have incurred a loss on his futures position, but this would have been offset by the lower cost of acquiring gold in the cash market.
The number and variety of hedging possibilities are practically limitless. A cattle feeder can hedge against a decline in livestock prices and a meat packer or supermarket chain can hedge against an increase in livestock prices. Borrowers can hedge against higher interest rates, and lenders against lower interest rates. In addition, investors can hedge against a decline in stock prices.
Whatever the hedging strategy, the common denominator is that hedgers willingly give up the opportunity to benefit from favorable price changes in order to achieve protection against unfavorable price changes.
Speculators
Were you to speculate in futures contracts, the person taking the opposite side of your trade on any given occasion could be a hedger or it might well be a speculator - someone whose opinion about the probable direction of prices may differ from your own.
The arithmetic of speculation in futures contracts - including the opportunities it offers and the risks it involves - will be discussed in detail later on. For now, just know that speculators are individuals and firms who seek to profit from anticipated increases or decreases in futures prices. In so doing, they help provide the risk capital needed to facilitate hedging.
Someone who expects a futures price to increase would purchase futures contracts in the hope of later being able to sell them at a higher price. This is known as "going long." Conversely, someone who expects a futures price to decline would sell futures contracts in the hope of later being able to buy back identical and offsetting contracts at a lower price. The practice of selling futures contracts in anticipation of lower prices is known as "going short." One of the unique features of futures trading is that one can initiate a transaction with a sale as well as with a purchase.
The Process of Price Discovery
Futures prices increase and decrease largely because of the myriad factors that influence buyers'and sellers' judgments about what a particular product 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 (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. As the term indicates, futures markets "discover" - or reflect - cash market prices. They do not set them.
Competitive price discovery is a major economic function - and, indeed, a major economic benefit - of futures trading. 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.
Minimum Price Changes
Exchanges establish the minimum amount that the price can fluctuate upward or downward. This is known as the "tick." For example, each tick for grain is .0025¢ per bushel. On a 5,000 bushel futures contract, that's $12.50. On a gold futures contract, the tick is 10¢ per ounce, so one tick on a 100 ounce contract is $10. You'll want to familiarize yourself with the minimum price fluctuation - the tick size - for whatever futures contracts you plan to trade. You'll also need to know how a price change of any given amount will affect the value of the contract.
Daily Price Limits
Exchanges establish daily price limits for trading in some futures contracts. The limits are stated in terms of the previous day's closing price plus and minus so many cents or dollars per trading unit. Once a futures price has increased by its daily limit, there can be no trading at any higher price until the next trading session. Conversely, once a futures price has declined by its daily limit, there can be no trading at any lower price until the next session. Thus, if the daily limit for a particular grain is currently 10¢ a bushel and the previous day's settlement was $3.00, there cannot be trading during the current day at any price below 2.90 or above 3.10. The price is allowed to increase or decrease by the limit amount each day.
For some contracts, daily price limits are eliminated during the month in which the contract expires.Because prices can become particularly volatile during the expiration month (also called the "delivery" or "spot" month), persons lacking experience in futures trading may wish to liquidate their positions prior to that time. At the very least,they should trade cautiously and with an understanding of the risks which may be involved.
Daily price limits set by the exchanges are subject to change. They can, for example, be increased or decreased on successive days. Because of daily price limits, there may be occasions when it is not possible to liquidate an existing futures position at will. In this event, possible alternative strategies should be discussed with a broker.
Position Limits
Although the average trader is unlikely to ever approach them, exchanges and the CFTC establish limits on the maximum speculative position that any one person can have at one time in any one futures contract. The purpose is to prevent one buyer or seller from being able to exert undue influence on the price in either the establishment or liquidation of positions. Position limits are stated in number of contracts or total units of the commodity.
The easiest way to obtain the types of information just discussed is to ask your broker or other advisor to provide you with a copy of the contract specifications for the specific futures contracts you are thinking about trading.You can also obtain the information from the exchange where the contract is traded.
Daily Close
At the end of a day's trading, the exchange's clearing organization matches each clearing firm's purchases made that day with corresponding sales and tallies each clearing firm's gains or losses based on that session's price changes - a massive undertaking considering that several 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 by the clearing firm on a daily basis. For example, if a speculator were to have 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 (see page 27), 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.
The Arithmetic of Futures Trading
Leverage
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.
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 $20,000, you might be able to purchase a futures contract covering common stocks worth $200,000. The smaller the margin in relation to the value of the futures contract, the greater the leverage will be.
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 E-mini stock index futures contract at a time when the June index is trading at 1400. And assume your initial margin requirement is $4,000. Since the value of the futures contract is 50 times the index, each one point change in the index represents a $50 gain or loss. Thus, an increase in the index from 1400 to 1420 would produce a $1,000 profit (20 x $50) and a decrease from 1400 to 1380 would be a $1,000 loss on your $4,000 margin deposit. That's a 25 percent gain or loss as the result of less than a 2 percent 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.
Futures trading, therefore, requires not only the necessary financial resources but also the necessary emotional temperament. For example, it can be one thing to have the value of your portfolio of common stocks decline from $200,000 to $190,000 (a five percent loss) but quite another, at least emotionally, to deposit $20,000 as margin and end up losing half of it as the result of only a five percent decline.
It is essential for anyone considering trading in futures contracts - whether it's sugar or stock indexes, pork bellies or petroleum - 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.
Margins
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. 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 $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 a loss for which you would be liable
