Futures in Your Future?
Futures in Your Future?
Trading in futures is yet another potential method for building your wealth tree as an independent investor, but unlike the other strategies we’ve discussed, futures trading is a whole new ballgame.
Futures Trade in a Foreign Sea by Experienced Navigators
If you’ve been trading for a while, you know that most securities are traded on the NASDAQ or the NYSE - not so with futures. Professional commodities traders live in a completely different world than regular securities brokers. The futures trades are initiated at and controlled by the Chicago Board of Trade.
These traders buy and sell futures contracts in virtually any kind of commodity you can imagine, but the more popular ones that you would recognize include stock indexes, oil, gold, silver, pork bellies, corn, wheat, etc. Each commodity represents a market in its own right and experienced traders usually stay within a market they fully understand.
For the most part, trading commodity futures is a high speculative endeavor and is influenced by many factors that are beyond the investor’s control. As one simple example, if you buy a futures contract in corn and the Midwest is hit by massive flooding, your contract becomes more valuable but if more farmers plant extra corn in anticipation of the shortage, your contract becomes less valuable.
Why Trade in Futures - Leverage
Since futures trading has so many moving parts, why do traders get involved in the first place? Remember the first lesson you learned about trading? What moves the market? Fear and Greed.
Nowhere is this more evident in the speculative nature of futures trading. Futures speculators can leverage a futures contract by buying a small position and then add to that positions as market conditions changes. This allows them to exercise tremendous leverage with a minimal initial investment.
What are Futures and How Does it all Work?
As usual, we’ll explore the reasons why you may want to venture into these waters and provide you the insights on how to maximize your efforts. The main reason people trade futures is the leverage they can exercise with a lower investment that controls large contracts.
There are two types of futures traders; hedgers and speculators. Hedgers are typically businesses or individuals who transact business in the commodity they trade. Alcoa, for example, may purchase futures contracts as a hedge against future price increases.
Speculators are essentially gambling on which direction the price of the underlying commodity may go. Unlike securities, however, the purchase of a futures contract has no intrinsic value. Traders are trading “derivatives” where the value of contract is derived from the changes in the valve of the contract over time.
We all know what kind of trouble we got into with financial derivatives in 2008 so futures trading is a serious business influenced by many factors. As some of the oldest forms of derivatives, futures were initially introduced to allow farmers to hedge changes in crop prices from planting to harvest. It then evolved into other agricultural products like pork bellies, livestock and has now expanded to include precious metals, energy products (the largest percentage of dollars is traded in energy products), stocks and bonds.
How to Get Started
Since we are entering a whole new sea, there are a whole different set of brokers engaged in futures trading. Many of the more popular discount brokers also provide the opportunity to trade in futures but there are margin requirements that futures traders must meet.
The Chicago Board of Exchange (CBOE) has a list of available brokers and just like setting up a stock brokerage account, you simply go the appropriate website, complete the paperwork and once the account is funded, you are in business.
Commodities are classified into different markets or categories that include:
- Agriculture (grains, livestock, dairy and forest)
- Energy (heating oil, crude oil, natural gas, coal)
- Equity Indices ( S&P 500, Nasdaq 100, Nikkei 225, E-mini S&P 500)
- Foreign Exchange ( Euro/$, GBP/$, Yen/$, Euro/Yen)
- Interest Rates ( Treasuries, Money Markets, Interest Rate Swaps, Barclays Aggregate Index)
- Metals (Gold, silver, platinum, base metals)
Choose a category where you have some practical experience and do the research to understand where you think that market will go in the next few quarters. Take a position in the commodity you choose and hold on for the ride of your life.
Advice from the Experts
Experts advise far more caution when trading in commodities than in more traditional securities. In addition to the derivative nature of the contracts, they point out:
- Futures contract have expiration dates and like trading in options, when the contract expires, it is worthless. Market direction and timing are critical elements in planning futures trades.
- There are many dependent relationships across various commodities. For example, when it is cold in the northeast, the cost of fuel oil goes up and since that has an impact on supply and demand, the price of oil contracts may go up across the board.
Beware the Risks
In their “Beginners Guide to Futures Trading,” Investopedia rates the risks associated with futures trading very high, so please make sure you know what you are doing before venturing into these new seas. They say, futures trading “carries the potential for large rewards due to leverage . . . but also carries commensurately outsized risks. Before beginning to trade futures, you should not only prepare as much as possible, but also make absolutely certain that you are able and willing to accept any financial losses you might incur.”
If trading in futures is in your future, we suggest you really do your homework this time because futures trades are a breed apart. They understand the in’s and out’s of their chosen markets and typically have decades of experience to help them gauge how world economic, political and climatic events impact their positions.
As always, start with paper trading to see how well you can forecast market moves and then put a toe in the water before diving in head first.