The Mechanics of Futures Contracts
So far, we have learned that futures contracts are standardized and are guaranteed by the exchange. However, there is a lot more to be learned, and you must fully understand the basics before you can expect to be a successful futures trader.
The Long and Short of It
Commodity trading is a world full of insider lingo; it is almost as if the industry created a language of its own. If you want to be a participant, you must become familiar with commonly used terms and phrases. Doing so avoids miscommunication between yourself and your broker.
I cover several commonly used phrases and terms in a later chapter; however, the two most critical terms to be aware of are long and short. In essence, the term long is synonymous with buy, and the term short is synonymous with sell. This is the case whether the instrument in question is a futures contract or an option. Specifically, if a trader buys a futures or option contract, he is going long. If a trader sells a futures or option contract, he is going short.
It is important to realize that you will sometimes hear industry insiders say that they are long the market with options, futures spreads, and such. Although in strict context of the phrase long implies that something has been purchased, in loosely used lingo, being long a market might simply mean having a bullish stance. This can mean long futures, long call options, short put options, bullish option or futures spreads, or any other speculative play that profits from an increase in the price of the underlying asset. Consequently, you might hear a trader mention that she is short the market; this might mean that she is short futures, short call options, long puts, or engaged in a bearish option or futures spread. Despite the alternative uses, however, beginning traders should first be comfortable using long in the context of buying and short in the context of selling.
Buy or Sell in Any Order
One of the most difficult concepts for beginning commodity traders to grasp is the fact that a futures contract can be bought and sold in any order. The common thinking is that you can’t possibly sell something before you own it, and even if you could, some interest likely would be charged for borrowing the asset that you intend to sell. Although that might be true in stock trading, that logic doesn’t apply to the futures markets. Let’s take a look at why this is the case.
Unlike stocks, futures contracts are not assets; they are liabilities. The purchase of a futures contract does not represent ownership of the underlying commodity; instead, it represents an obligation to take delivery of the underlying commodity at a specified date. Likewise, the seller of a futures contract isn’t selling an asset; he is simply agreeing to make delivery of the stated asset on the appropriate date.
Because there is no ownership or exchange of the asset at the time the futures trade is made, it isn’t necessary to own the underlying commodity or even be prepared to take ownership. Thus, buying or selling in any order isn’t an issue for futures traders.
Offsetting and Rolling Over Trades
As mentioned, most investors who participate in the futures markets are simply attempting to profit from variations in price movement and are not interested in taking or making delivery of the underlying commodity. Again, to avoid the delivery process, it is necessary to offset holdings prior to expiration—or, more specifically, the first notice day.
The notion of offsetting is simple: To offset a trade, it is necessary to execute a position opposite the one that you originally entered the market with. To illustrate, if you bought a December corn futures, you would need to sell a December corn futures to get out of the position. When you are out of the market, you are said to be flat. This means that you do not have any open trades and are no longer exposed to price risk or margin. Of course, being flat the market doesn’t necessarily mean that the risk of emotional turmoil is eliminated. Unfortunately, many beginning traders have incorrectly looked at missed opportunities as monetary losses. We look at the psychological impact of such emotions in Chapter 11, “The Only Magic in Trading—Emotional Stability.”
The concept of offsetting can be best explained by an example. In September 2012, the corn futures contract expiring in December 2012 experienced a minor correction and seemed to be approaching trend line support. A trader who believed that prices would appreciate might purchase a futures contract in hopes of a rally. At that point, the trader has an open long position with the exchange and continues to have an open position until it is offset. As mentioned, the only way to offset an open position is to execute a transaction opposite the one used to enter the market. Looking at Figure 1.3, you can see that the trader purchased a December 2012 corn futures contract at $7.34. In Chapter 8, “Making Cents of Commodity Quotes,” I explain the details in quoting and calculating grain futures.
Figure 1.3. Futures traders can buy and sell in any order but must take the opposite action to exit. This trader is going long December corn and will later have to sell it to offset the position.
(Chart courtesy of QST.)
To get out of the market, the trader must sell a December 2012 corn futures contract, hopefully at a higher price. Naturally, if a trader can buy low and sell high, regardless of the order, he will be profitable (see Figure 1.4). As simple as this premise is, execution can be challenging. In fact, a majority of speculators walk away from the game with less money than they started with merely because they couldn’t find a way to consistently buy low and sell high.
Figure 1.4. When a trader no longer has an open position, he is said to be “flat” the market. This trader is hoping to sell his contract, and his obligation with the exchange, near $8.10.
(Chart courtesy of QST.)
The same concept would be true for someone who sold a December corn futures contract to enter the position rather than bought one. Aside from holding the futures into expiration and actually making delivery of the underlying asset, the only way to get out of a short December futures trade would be to buy a December futures contract to offset the position.
The term rolling, or rolling over, is commonly used to describe the practice of offsetting a trade in a contract that is facing expiration and entering a similar position in a contract with a distant expiration date. Rolling over is simply offsetting one position and getting into another. Many beginning traders make the mistake of assuming that rolling into a new contract somehow avoids exiting the original position and simply changes the contract month. Perhaps it is wishful thinking for those who would prefer not to lock in a loss on an open position; unfortunately, in doing so is a necessary evil if the goal is to move into an alternative contract month.
To illustrate, a trader who is long a June T-note futures contract with the first notice day quickly approaching might choose to roll into the September contract to avoid delivery while still maintaining a bullish speculative position in the market. In this case, rolling would include selling the June contract and buying September.
The notion of a bid/ask spread can be confusing. This is especially true given the differing perspectives of written literature available for beginning traders. Some articles and books seem to insist on explaining the bid/ask spread from both a market maker’s point of view and a retail trader’s perspective. However, in my opinion, providing details of both sides of the story simply creates more confusion than is necessary to get a good grasp of what a bid/ask spread is and how to cope with it as a trader.
The easiest way to understand the spread between the bid and the ask is to come to peace with the fact that there are essentially two market prices at any given time. There is a price at which you can buy the contract (the ask) and a price at which you can sell it (the bid). As a retail trader, you will always be paying the higher price and selling the lower price. It takes money to make money, and if you want to participate in a market, you must pay the bid/ask spread. For instance, a corn trader might buy corn at $6.21 and sell corn at $6.21[1/2]. The difference of a half a cent is the bid/ask spread, and it translates into a component of the transaction cost associated with executing a trade in this market.
Keep in mind that the bid/ask spread is how floor brokers, or market makers, are compensated for executing your trade and providing liquidity to the markets. Just as you pay a commission to the retail broker who took your order, the executing broker or market maker, must be paid in the form of the bid/ask spread. Think about it: If as a retail trader you are always paying the ask and buying the bid, you are a net loser even if the price of the futures contract remains unchanged. The beneficiary of the difference between the bid and the ask is the executing broker or market maker making fluidity of trade possible.
The spread between the bid and the ask isn’t something that investors should resent—in liquid markets, anyway. After all, the executing broker must be compensated for accepting the risk involved with taking the other side of your trade. In general, he wants to offset his position and risk as soon as possible; his intention is to “make a market” and profit from the difference in the bid/ask spread, not to speculate on price movement. In highly liquid markets, there are often no market makers but there is still a natural bid/ask spread of a tick.
As a trader, it is important to be aware of the bid/ask spread and the implications that its size will have on your trading results. A couple prominent factors that affect the size of the spread are market liquidity and volatility. As market liquidity decreases, the size of the bid/ask spread widens, and thus the costs associated with participating in such a market increases. This makes sense. If the executing broker is anticipating a lack of volume and the corresponding difficulty offsetting his trade, he will require more compensation for taking the other side of your trade.
Likewise, if volatility is high, the executing broker faces more price risk during the time in which he takes the other side of your trade and can subsequently offset the position. Thus, he requires higher compensation for his efforts, which creates a relatively wide bid/ask spread.
One of the biggest mistakes I have witnessed beginning traders make is to ignore the repercussions of large bid/ask spreads. Most futures contracts are fluidly traded enough for this to be a nonissue. However, in the option trading arena, this is a big concern. It is extremely important that you understand that bid/ask spreads are a part of doing business and know how to adjust your trading strategy accordingly.
Bid/ask spreads hinder a trader’s ability to make money; the wider the spreads, the more difficult it is to be profitable. In fact, certain markets have bid/ask spreads so wide that I believe investors have no incentive to trade them. This avoidance stems from the idea that excessively wide spreads create a scenario in which the trader must not only be right in the direction of the market, but must also be extremely right to overcome the hefty transaction cost. Imagine trading copper options that often have bid/ask spreads in excess of 1 cent in premium, or $250. Immediately after initiating the trade, it is a loser in the amount of $250, regardless of movement in the futures price. As you can see, this can make trading even more challenging.
Round Turns and Transaction Costs
Unlike the world of stocks, in which transaction costs are often quoted on a per-side basis and in the form of a ticket charge, commodity trades are typically charged on a round-turn basis. However, as the nature of the industry shifts from broker-assisted trading to discount online, futures brokers are beginning to quote commissions per side in an effort to make the transaction costs seem cheaper than they actually are. A single round turn consists of the purchase and sale of the same futures or option contract. Simply put, it is getting in and getting out of a market.
Many beginning traders mistakenly assume that the commission and fees charged to them depend on the number of order tickets rather than the number of contracts, but this is not the case. If a trader buys 10 e-mini crude oil contracts at $91.00 and later sells all 10 at $92.00, he has executed 10 round-turns and will be charged 10 commissions. This is true regardless of whether the 10 contracts were purchased and sold on single tickets or whether there were 10 separate orders to buy 1 contract at $91.00 and then 10 separate orders to sell 1 contract at $92.00.
Of course, not all traders are day-trading, and it is common for positions to be entered on one day and exited at some date in the future. In this case, a futures trader is charged a half of a round-turn commission on the day the trade is initiated and is then charged the other half the day that the trade is offset. Notice that I specifically noted futures traders; option traders normally are charged the entire round-turn commission when they enter the trade. Therefore, a trader who buys a soybean $12.00 put would be charged a commission to enter the position but would be able to exit the trade without being charged.
Keep in mind that I have been referring strictly to commissions, which your brokerage firm charges. Each round-turn is accompanied by exchange fees, minimal National Futures Association (NFA) fees, and possible transaction fees charged by the clearing firm. Transaction fees are charged on a per-side basis, regardless of whether the instrument being traded is an option or a futures contract.
When negotiating a commission rate with your brokerage firm, be sure to confirm that the quoted rates are per round-turn. You should also be aware of whether they include the additional fees. Because exchange fees vary from product to product, most firms state commission rates on a round-turn-plus-fees basis. This means that you have to account for any exchange, NFA, and clearing fees in addition to the commission. Some firms, typically deep discount brokerages, quote rates as “all inclusive,” which already account for incremental fees. Many of these firms also quote rates on a per-side basis simply because it “sounds” cheaper and can be an effective marketing tool.
As easy as it is to have the freedom to buy or sell in any order, sticking to the overall goal of buying low and selling high can be challenging. The price of a given asset, whether it be grains, metals, energies, or Treasury bonds, depends on a seemingly unlimited number of factors. Even as a market is making a large price move, it is nearly impossible to determine the driving force behind the change in valuation and whether it will last.
Not only are prices the result of supply and demand fundamentals, but they can also be swayed by logistical issues such as light volume, option expiration, and excessive margin calls. A primary catalyst for some of the largest commodity plunges in history was the sweeping number of forced liquidations due to insufficient margin in speculative trading accounts.
In addition, a seemingly unlimited number of intermarket relationships can be used as a guide but not a guarantee. For instance, a strong dollar often works against commodity prices, but that doesn’t mean that if the dollar is down, commodities will always rally. Another example is the negative correlation between Treasuries and stocks. In theory, investors have two major asset classes to choose from, stocks and bonds. If money is flowing into one, it is likely flowing out of the other. This is a useful but simplistic bit of information. Although this relationship tends to exist over time, in many cases, both markets travel together, and stubbornly trading according to the historical relationship could lead to large losses.
This discussion isn’t intended to discourage you from attempting to speculate on the price of commodities or to insinuate that it can’t be done; it can. However, I want you to recognize that analyses should be done with an open mind and a willingness to adapt to changes in what you consider to be the norm.