A Rookie Trader's Guide

What's here: (click on these headings to "jump" to the appropriate section) - How Futures Evolved
- Who Trades Futures, and Why?
- Setting up a Trading Account
- Margin Requirements
- Let's Walk Through a Typical Futures Trade
- Figuring your Profits and Losses
- Closing the Position

How futures evolved:
The futures contract as we know it today, evolved as farmers (sellers) and dealers (buyers) began to commit to future exchanges of grain for cash. As an example, the farmer would agree with the dealer on a price to deliver to him 5,000 bushels of wheat at the end of June. The bargain suited both parties, as the farmer knew how much he would be paid for his wheat, and the dealer knew his costs in advance. The two parties may have exchanged a written contract to this effect and even a small amount of money representing a "guarantee". Eventually, these contracts became common and were even used as collateral for bank loans. They also began to change hands before the delivery date. If the dealer decided he didn't want the wheat, he could sell the contract to someone who did. Or, the farmer who didn't want to deliver his wheat might pass his obligation to sell on to another farmer. The price would go up and down depending on what was happening in the wheat market. If there was bad weather, the people who had contracted to sell wheat would hold more valuable contracts because the supply would be lower; if the harvest was bigger than expected, the seller's contract would become less valuable. It wasn't long before people who had no intention of ever buying or selling wheat began trading the contracts. They were speculators, hoping to buy low and sell high - or sell high and buy low. Over time, more and more of these contracts were in the marketplace. But they presented problems. What if the farmer who contracted to deliver the grain, and/or the dealer who contracted to pay for it, defaulted? There was no way to guarantee that either or both of the parties would comply with the contract. What if the farmer delivered grain that the dealer thought was inferior? How could either side, or both, cancel the contract - whether it meant losing money or picking up profits because of price fluctuations?

The answer came in the form of an organized exchange with a clearing house and standardized futures contracts that could be canceled before scheduled delivery. The clearing operation meant that a legal entity stood between buyers and sellers to guarantee their trades. Standardization of the contract meant that instead of IOU's floating around for different amounts of grain and different delivery dates, everyone agreed that a wheat futures contract called the delivery of, for instance, 5,000 bushels of wheat, on one of five set delivery dates, and within a specific range of quality. Today, the same types of characteristics must be agreed upon for every new futures contract.

Today, futures contracts trade on commodities such as soybeans, corn, heating oil, gold, foreign currencies and T-bonds. All are ready to be used as they are or after they are processed; they can be stored in warehouses or deposited in bank accounts; they fluctuate in price from day to day - sometimes widely.

The futures industry has seen trading in some interesting contracts that have ultimately failed. Futures on frozen shrimp, tomato paste, eggs, cheddar cheese, commercial paper and 4-year Treasury notes have come and gone.

Who trades futures, and why?
There are two basic categories of futures participants: hedgers, and speculators.

In general, hedgers use futures for protection against adverse future price movements in the underlying cash commodity. The rationale of hedging is based upon the demonstrated tendency of cash prices and futures values to move in tandem.

Hedgers are very often businesses, or individuals, who at one point or another deal in the underlying cash commodity. Take, for instance, a major food processor who cans corn. If corn prices go up, he must pay the farmer or corn dealer more. For protection against higher corn prices, the processor can "hedge" his risk exposure by buying enough corn futures contracts to cover the amount of corn he expects to buy. Since cash and futures prices do tend to move in tandem, the futures position will profit if corn prices rise enough to offset cash corn losses.

Financial institutions also use futures for hedging. Pension funds, insurance companies and corporations holding well-diversified stock and/or interest-rate securities portfolios can protect themselves against market downturns by selling stock index futures, T-bond or T-bill futures.

Speculators are the second major group of futures players. These participants include independent floor traders and investors. Independent floor traders, also called "locals", trade for their own accounts. Floor brokers handle trades for their personal clients or brokerage firms.

Typically, speculators do not deal in the cash commodity underlying the futures they trade. Instead, they are in the market to profit by buying futures contracts they expect will rise in price or by selling futures contracts they expect will fall. Successful speculators are disciplined traders who study the market carefully. They know when to cut their losses and when to let their profits run. Some speculators take less risky positions called spreads or straddles.

For speculators, futures have important advantages over other investments:

a. If the trader's judgment is good, he can make more money in the futures market faster because futures prices tend, on average, to change more quickly than real estate or stock prices, for example. On the other hand, bad judgment in futures markets can cause greater losses than might be the case with other investments.
b. Futures are highly leveraged investments. The trader puts up a small fraction of the value of the underlying contract (usually 10% - 15%, and sometimes less) as margin, yet he can ride on the full value of the contract as it moves up and down. The money he puts up is not a down payment on the underlying contract, but a "performance bond". The actual value of the contract is only exchanged on those rare occasions when delivery takes place.
c. In general, futures are harder to trade on inside information. After all, who can have the inside scoop on the weather, or Greenspan's next proclamation on inflation?! The open outcry method of trading - as opposed to a specialist system - insures a very public, fair and efficient market.
d. Commission charges on futures trades are small compared to other investments.
e. Most commodity markets are very broad and liquid. Transactions can be completed quickly, lowering the risk of adverse market moves between the time of the decision to trade and the trade's execution.

Setting up a Trading Account
You go to a brokerage firm - or Futures Commission Merchant (FCM) - to set up a speculative or hedging account. The FCM must be a clearing member of the exchanges you wish to trade, or have an arrangement for clearing through an exchange member firm. The FCM will require that you deposit margin money. For some companies, this is an up-front initial deposit to open the account, which will be used to margin any subsequent trades. The amount of margin needed for most futures contracts is about 10% to 15% of their underlying dollar value.

Margin Requirements
Minimum margins are set by the exchanges and may be periodically adjusted. For instance, if a contract becomes more volatile, its price moving more frequently and sharply, the exchange may increase the margin requirement. Similarly, if the contract becomes less volatile, the exchange may decrease the margin.

Brokerage firms usually require more margin money than the exchange's minimum. No industry-wide policies dictate when you can withdraw excess funds (my company will issue you a cheque the same day), but there are set rules governing when you must replenish your account to the initial margin level after incurring losses. These are important questions to ask your broker (FCM).

Keep in mind, as I previously mentioned, that the average futures trader never makes (in the case of the seller) or takes (in the case of the buyer) delivery of the underlying cash commodity. Instead, he closes out his position before the contract expires. Some speculators, especially locals, buy and sell contracts within a few minutes, or even seconds, closing out one position and then opening another. This kind of floor trading is called scalping.

Remember also, that futures prices are marked-to-market daily. Your trading account will be debited or credited to reflect the price you paid for your contract (the transaction opening price) in relation to the price of that contract at the close of trading every day. Margin deposits are therefore required to cover normal daily price fluctuations of the contract you are trading.

Let's walk through a typical futures trade:
Suppose it is January 2. After a careful study of the market, you decide to buy a gold futures contract (take a long position), so that you can sell the contract later (offset it by liquidating the long position) at a profit.

You have told your FCM that you want the firm to buy an April gold contract for you as soon as the market opens on January 3. This is called a market order.

Prior to the gold pit at the COMEX opening on January 3, at 8:20 est, your FCM will have telephoned your market order to the firm's booth on the COMEX floor. As soon as the order arrives, it is time-stamped by a clerk, who then makes sure the floor broker has the order ready when trading begins. The clerk will wait in the pit for your order to be filled. Your floor broker finds a position on the steps of the gold pit along with a crowd of other floor brokers and independent traders.

Overhead screens in the gold pit show that April gold closed on January 2 at $335.00 per troy ounce. No major news has broken since yesterday's close and London cash gold is also trading steady. Therefore, trading should open around $335.00.

The bell rings. Trading begins. The noise level rises because every offer to sell and every bid to buy a futures contract must be cried out publicly and accompanied by hand signals. Trading by "open outcry" is one of the market rules on just about every futures exchange.

A trader across the pit from your floor broker yells, "April at 20." His palm is facing outward. This means he is willing to sell a gold contract at $335.20. Your broker is fast and yells back - before anyone else - "Bought you at 20."

Since the gold pit is crowded, there may be more than one transaction going on at a time. Your order may not be the first filled if many brokers in the pit are holding market orders. But the broker is obliged to do his best to fill your order quickly. The trader and your broker have signaled by voice and hands that they are in agreement. Each party completes a ticket with the number of contracts (in this case, one), month and price agreed upon and the other party's identification number or mnemonic, which appears on the badge he must always wear during trading.

A clerk from your broker's firm takes the filled order ticket from the broker, runs back to the booth, time stamps the ticket and calls your FCM (if he's not on hold already). Within seconds you can know the price at which you are "long one April gold contract." Your firm will send you a confirmation slip with details of the purchase.

Figuring your Profits and Losses
The underlying value of your long April gold futures position is $335.20 x 100 or $33,520.0. Recall that the $335.20 quoted is for one troy ounce of gold, but the contract calls for 100. Assume you have deposited 15% of the position's value or about $5,000 to cover the initial margin requirement and potential margin calls in case the price of April gold falls despite your prediction. Before the close of trading on January 3, the Chairman of the Fed. is quoted as fearing a possible revival of inflation. April gold futures jump up and trading closes that afternoon at $340.00. You have now made a paper profit. Here's how your account looks:

April futures price:

Opening trade price $335.20

Close on Jan. 3 $340.00

Change in your a/c (x100) $4.80

The gain in the futures price of $4.80 means a profit of $480.00 ($4.80 x 100) (4.80 x 100) in your account. A relatively small move in the underlying futures contract quickly became a gain of $480.00 on the small initial margin you deposited. This is what is meant by leverage.

But what if gold prices drop?
On January 4, April gold closes at $333.00 following a report that the U.S. dollar has strengthened against other currencies. (Gold and dollar values often move in opposite directions). You put on the long position at $335.20 and now it is $2.20 below that amount, so your account will show a loss of $220.00 ($2.20 per ounce x 100).

Closing the Position
Your April gold contract can be closed at any time up to four business days before the end of April. When you do so, your profit or loss is calculated using the price at which you close out your long position by selling an April gold contract.

Your account has remained fairly stable. You close out your position on March 1 at the market opening. Since all trades are ultimately transacted with the clearing house, you will not have to sell your contract to the party from whom you originally bought it.
On March 1, your firm's floor broker steps into the crowded gold pit and takes the first offer to buy. That bid is $340.30, so your final account will be: April

Opening trade price $335.20

Liquidation, March 1 $340.30

Change in your a/c (x100) +$5.10

So, your FCM will return your initial deposit, plus the $510.00 profit, minus the commission. You will also receive a "P and S" (purchase and sale) statement showing both sides of the transaction and the final profit or loss.

Commissions for commodity trades are negotiable. A typical commission on a futures transaction is about $75 for full service, although discount brokers may open accounts for around $20 per round turn if you simply need execution services.

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