Basic Training: A Futures Primer
Picking up the phone and instructing your broker to buy or sell is relatively simple. Performing a few mouse clicks and transmitting your order to a handheld device in the pit or to a totally electronic marketplace isn't all that hard either. It's really not all that difficult to understand how the money works. What is difficult, however, is extracting profits from the markets (something we'll tackle later in this book), but you have to start somewhere. This chapter is for those of you who need to learn the basics. So here we begin, as good a place to start as any.
Commodities are not only essential to life, but they are absolutely necessary for quality of life. Every person eats. Billions of dollars of agricultural products are traded daily on the world's commodity exchangeseverything from soybeans to rice, corn, wheat, beef, pork, cocoa, coffee, sugar, and orange juice. Food is where the commodity exchanges began.
In the middle of the nineteenth century in the United States, businessmen started organizing market forums to facilitate the buying and selling of agricultural commodities. Over time, farmers and grain merchants met in central marketplaces to set quality and quantity standards and to establish rules of business. In the course of only a few decades, more than 1,600 Exchanges sprung up at major railheads, inland water ports, and seaports. In the early twentieth century, as communications and transportation became more efficient, centralized warehouses were constructed in major urban centers such as Chicago. Business became less regional, more national; many of the smaller Exchanges disappeared.
In today's global marketplace, approximately 30 major Exchanges remain, with 80% of the world's business conducted on about a dozen of them. Just about every major commodity vital to commerce, and therefore to life, is represented. Billions of dollars worth of energy productsfrom heating oil to gasoline to natural gas and electricityare traded every business day. How could we live without industrial metals (copper, aluminum, zinc, lead, palladium, nickel, and tin); precious metals such as gold; or platinum and silver, which are considered both industrial and precious metals? How could we live without wood products or textiles? It would be hard to imagine life without them, and yet few people are aware of just how the prices for these vital components of life are set. Unlike 100 years ago, today the world's futures Exchanges also trade financial products essential to the global economic function. From currencies to interest rate futures to stock market indices, more money changes hands on the world's commodity exchanges every day than on all the world's stock markets combined.
Governments allow commodity exchanges to exist so that producers and users of commodities can hedge their price risks. However, without the speculator, the system would not work. Anyone can be a speculator, and contrary to popular belief, I do not believe the odds need be stacked against the individual. In this book, I plan to share with you techniques designed to help you make money trading commodities. Actually, you as an individual have one distinct advantage over the big players, and that's flexibility. You can move quickly, like a cat, something a giant corporation can't do. Many times, several of the big commercial operators that utilize the Exchange for hedging literally hand you your profits on a silver platterthey're there for a different reason. So, let's start by looking at how the futures contract works and the various participants in the marketplace. We'll also look at what they are attempting to accomplish and how they interact with each other.
Futures markets and the futures contract
Futures markets, in their most basic form, are markets in which commodities (or financial products) to be delivered or purchased at some time in the future are bought and sold.
The futures contract is the basic unit of exchange in the futures markets. Each contract is for a set quantity of some commodity or financial asset and can be traded only in multiples of that amount. The futures contract is a legally binding agreement that provides for the delivery of various commodities or financial entities at a specific time period in the future. (Prior to the time I was in this business, I envisioned the parties sitting at a table and actually signing paper contracts. It's nothing like that.)
When you buy or sell a futures contract, you don't actually sign a contract drawn up by a lawyer. Instead, you're entering into a contractual obligation that can be met in only one of two ways. The first method is by making or taking delivery of the actual commodity. This is by far the exception, not the rule. Less than 2% of all futures contracts are concluded with an actual delivery. The other way to meet this obligation, which is the method you most likely will be using, is offset. Very simply, offset is making the opposite (or offsetting) sale or purchase of the same number of contracts bought or sold sometime prior to the expiration date of the contract. Because futures contracts are standardized, this is accomplished easily.
Every contract on a particular Exchange for a specific commodity is identical except for price. The specifications are different for each commodity, but the contract in each market is the same. In other words, every soybean contract traded on the Chicago Board of Trade is for 5,000 bushels. Every gold contract traded on the New York Mercantile is for 100 troy ounces. Each contract listed on an Exchange calls for a specific grade and quality. For example, the silver contract is for 5,000 troy ounces of 99.99% pure silver in ingot form. The rules state that the seller cannot deliver 99.95% pure. Therefore, the buyers and sellers know exactly what they are trading. Every contract is completely interchangeable. The only negotiable feature of a futures contract is price.
The size of the contract determines its value. To calculate how much money you could make or lose on a particular price movement of a specific commodity, you need to know the following:
How the price is quoted
Minimum price fluctuation
Value of the minimum price fluctuation
The contract size is standardized. The minimum unit tradable is one contract. For example, a New York coffee contract is for 37,500 pounds, a Chicago corn contract is for 5,000 bushels, and a British Pound contract calls for delivery of 62,500 Pounds Sterling. The contract size determines the value of a move in price.
You also need to know how prices are quoted. For example, grains are quoted in dollars and cents per bushel: $2.50 per bushel for corn, $5.50 per bushel for wheat, and so on. Copper is quoted in cents per pound in New York, and dollars per metric ton in London. Cattle and hogs are quoted in cents per pound, whereas gold is quoted in dollars and cents per troy ounce. Currencies are quoted in the United States in cents per unit of currency. As you begin trading, you will quickly become familiar with how this works. Your commodity broker can fill you in on how prices are quoted on any particular market you decide to trade.
The minimum price fluctuation, also known as a "tick," is a function of how prices are quoted and is set by the Exchange.
For example, prices of corn are quoted in dollars and cents per bushel, but the minimum price fluctuation corn can move is 1/4¢ per bushel. So if the price of corn is $3.00/bushel, the next price tick can either be $3.00 1/4 (if up) or $2.99 and 3/4 (if down). Prices can trade more than a tick at a time, so in a fast market, the price could jump from $3.00 to $3.00 1/2, but it could not jump from $3.00 1/2 to $3.00 and 5/8 because the minimum price fluctuation for corn is a quarter penny. Therefore, the next minimum price tick for corn from $3.00 1/2 up would be $3.00 3/4, or down would be $3.00 1/4. The minimum price fluctuation for a gold contract is 10¢/ounce, so if gold is trading for $425.50 per ounce, the minimum it can move in price would be $425.60 if up, or $425.40 if down. Once again, in a fast market, or if the bids and offers are wide, it might jump from $425.50 to $426, but in liquid and quiet markets, many times the market moves from one minimum tick fluctuation to the next.
The value of a minimum fluctuation is the dollars and cents equivalent of the minimum price fluctuation multiplied by the contract size of the commodity.
For example, the size of a copper contract traded in New York is 25,000 pounds. The minimum price fluctuation of a copper contract is 5/100 of one cent per pound (or 1/20 of one cent). By multiplying the minimum price fluctuation by the size of the contract, you obtain the value of the minimum price fluctuation, which in this case is $12.50 (1/20¢ per pound times 25,000 pounds). In the case of the grains and soybeans, a minimum price fluctuation is 1/4¢ and a contract is for 5,000 bushels, so the value of a minimum fluctuation is also $12.50 (1/4¢ per bushel times 5,000 bushels).
Except for grains, minimum fluctuations are generally quoted in points.
For example, sugar prices are quoted in cents and hundredths of a cent per pound. The minimum fluctuation is 1/100 of one cent, or one point. If the price is quoted at 15 1/2 cents per pound, your broker would say it is trading at 1550, and if it moves up by a quarter of a cent per pound, this would be a move of 25 points, to 1575.
In some cases, the value of a minimum move may be more than a point. In the copper example, the minimum move is 1/20¢ per pound. A penny move is 100 points (for example, if copper prices rise from $1 per pound to $1.02 per pound, the market has moved up 200 points), but because the minimum fluctuation is for 1/20¢, a minimum move is 5 points, or $12.50 per contract. A move of 1¢ is worth $250, which is 100 points. You must understand what the value of a move is for the commodity you are trading. For example, if you are trading soybeans, you should know that a move of 1¢ is worth $50 per contract (either up or down), and if you buy three contracts and the market closes up 10¢ that day, you would make $1,500, or $500 per contract. If the market closes down 10¢, you would lose the same amount. Although this might seem confusing at first, you'll quickly understand the value of a minimum fluctuation and the value of a point at the time you write that check for your first margin call. That reminds me of an amusing true story told to me by my favorite copper broker.
On the floor of the COMEX (the world's largest metals Exchange), where copper is traded, the pit brokers always talk in terms of points instead of dollar values. You might hear a trader saying, "I made 300 points today," or "I lost 150 points on that trade." A number of years ago, there was a big commission house broker (a floor broker who makes his living filling buy and sell orders from customers who call in from off the floor) who was pressured by his wife to hire his brother-in-law. The brother-in-law wasn't all that bright, but the broker felt his brother-in-law couldn't do that much damage if he were on the phone as a clerk. After all, the clerks just take the buy and sell orders over the phone and run them into the pit to be filled.
Well, everything went reasonably well for a few weeks, and then the first inevitable error occurred. Apparently, the brother-in-law took an order to buy five contracts, and he wrote "sell" on the order ticket. By the time the error was discovered, it had resulted in a loss of 370 points ($925) that the commission house broker had to make good. After the market closed, the broker took the brother-in-law aside and carefully spoke to him.
The broker said, "Look, mistakes happen and, fortunately, this error was for only 370 points. It could have been much worse, but you have to be more careful. We cannot afford to have any more errors like this one."
The brother-in-law replied, "What are you getting so hot under the collar for? Sure I made a mistake, but it's only points."
To this day, whenever anyone makes an error in the copper pit, the guys on the floor say, "Hey, what's your problem? It's only points!"
Some contracts have associated daily price limits, which measure the maximum amount that the market can move above or below the previous day's close in a single trading session. Each Exchange determines whether a particular commodity has a daily trading limit and for how much. The theory behind the limit-move rule is to allow markets to cool down during particularly dramatic, volatile, or violent price moves. For example, the rules for the soybean contract state that the market can move up or down 50¢ per bushel from the previous close if it did not close "limit" the previous day. (Limit moves result in expanded limits). So if the market closes at $8.10 per bushel on Tuesday, then on Wednesday it can trade as high as $8.60 or as low as $7.60. Contrary to popular belief, the market can trade at the limit price; it just cannot trade beyond it. At times of dramatic news or price movements, a market can move to the limit and "lock." A lock-limit move means that there is an overabundance of buyers (for "lock limit up") versus sellers at the limit-up price, or that there is an overabundance of sellers (for "lock limit down") at the limit-down price.
For example, suppose that in a drought market, the weather services are forecasting rain one weekend, thereby causing the market to trade lower on a Friday. However, the rain never materializes, and on Monday morning, the forecast is back to drought with record-high temperatures predicted for the week. Conceivably, the market could open "up the limit" as shorts scramble to buy back contracts previously sold, and buyers would be willing to "pay up" for what appears to be a dwindling future supply of soybeans. Let's say the market closed on Friday at $7.50 and that it opened at $8 on Monday. Now it could trade at that price, or it could trade even lower that day. But suppose 20 million bushels are wanted to buy at the limit-up price of $8, with only 10 million bushels to sell. The first 10 million would trade at $8, with the second 10 million bushels in the "pool" wanting and waiting to buy. If no additional sell orders surface, the market would remain limit up that day, with unsatisfied buying demand at the $8 level. However, there is nothing to say the market has to open higher on Tuesday (it could unexpectedly rain Monday evening), but all other factors remaining equal, this unsatisfied buying interest would most likely "gap the market" higher on Tuesday morning.
In fact, some markets have what are called variable limits, which is where the limits are raised if a market closes limit up or limit down during a trading session. Cattle is one of the markets with variable limits. If one or more contract months close at the 3¢ (300-point) limit for two successive days, the limit is raised to 5¢ on the next business day. (You can consult the Web sites of the various Exchanges for the daily price-limit rules for each market.) Limit moves are rare, but they do occur during shocks to a market. Pork bellies, for example, are notorious for moving multiple limit days after an unexpectedly bullish or bearish "Hogs and Pigs Report."
Here's a true story of how gutsy some of the floor traders at the Board can be at times.
Bill, who works our soybean orders, told me about one summer day when the soybean market was down the limit. It wasn't just down the limit; it was "locked down the limit," with five million bushels offered to sell down the limit and no buyers in sight. It was very quiet. Then, out of nowhere, one large "local" wanders into the pit and utters, "Take 'em.'' "How many?" they ask. "All of 'em!'"
The other brokers in the pit literally fell over themselves selling the entire five million to this guy. What could he be thinking? But then, as soon as the five million were bought, and the quote machines around the world tuned into soybeans showed this, the telephones around the pit started to ring. Off the floor, traders around the world assumed with such a big buyer at limit down that something was up, and they started to buy, too. The market immediately started to rally. When it moved 5¢ per bushel off the limit-down price, the large local stepped back in and sold his five million bushels. It was a quick $250,000 profit, and it took only 20 seconds!
Trading hours are set for each individual market by the Exchange. Cattle opens at 9:00 A.M. Chicago time on the Chicago Mercantile and closes at 1:00 P.M. sharp. (If your order to sell reaches the cattle pit at 1:01 P.M., you're out of luck, at least for that trading session.) As more and more markets become completely electronic, trading hours won't matter as much as they used to. Many markets, particularly the financials, trade on virtually a 24-hour basis. Most of the major markets have after-hours trading, but some don't. If you miss the Live Cattle close at 1:00 P.M. Chicago time, for example, you have no choice but to wait until the next trading day. If you miss coffee, however, you can trade it in London, but there is an eight-hour period where coffee futures are not traded anywhere in the world. If you miss corn, on the other hand, which closes at 1:15 P.M. central standard time (CST), you can trade it electronically at night from 5:30 P.M. until 4:00 A.M. the following morning.
To review thus far, before you trade in any market, you need to know, at minimum, the Exchange the market is traded on, the trading hours, the contract size, and the delivery months traded. You need to know how prices are quoted, so that you can put them in the right priced order, the minimum fluctuation, the dollar value of the minimum fluctuation, and if there are any daily trading limits. You also need to know the types of orders accepted at that particular marketplace. Finally, you want to know what the margin requirement is for the market you are trading, and what commission your broker will be charging. These topics are covered in the following sections.