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Attention First Time Traders
First Time Trader's Class
Welcome to The Research Exchange's First Time Traders Class. This is a free service that allows you to learn some of the basics of futures and options trading. We hope that it will help you get started in one of the most exciting investment arenas; The Futures and Options Markets. We'll start with the very basics and work our way towards more advanced topics. All you need is a notebook, pencils or pens and some patience. If you like this course, e-mail us and ask about our advanced classes. If you have any questions about the materials covered, feel free to e-mail me with your questions. I will personally answer each and every question myself. Good luck and I hope to hear from you soon. Hugh Thomas Patterson CEO, The Research Exchange e-mail: HThmPttrsn@aol.com Attention: H.T. Patterson
PART ONE: AN INTRODUCTION TO FUTURES AND OPTIONS
THE FUTURES CONTRACT
The definition of a futures contract really lies in the two words that make up this term. A futures contract is basically an agreement to buy or sell a commodity at a date sometime in the future. The underlying commodity can be anything from soybeans to pork bellies. It can even be a stock index. Since this is a contract, the terms of these contracts are established before they are actually traded. By establishing these terms prior to the contract being traded, the exchanges ensure an efficient marketplace. The only point that is not established prior to trading is the futures contract price. Price is determined in the trading pits of the various exchanges.
POINTS ESTABLISHED PRIOR TO TRADING:
(1) The underlying commodity
a. Some of the commodities that are traded include: Soybeans, corn, wheat, cattle, hogs, lumber, gold, silver, currencies, stocks, stock indexes, government bonds, coffee and a host of others.
(2) The quantity
a. In the case of soybeans, one futures contract equals 5,000 bushels of soybeans. In the case of unleaded gasoline, one contract equals 42,000 gallons.
(3) The quality
a. Some commodities have different grades or qualities. If the commodity delivered doesn't meet contracted standards, it may be sold to the buyer at a discount.
(4) The delivery date
a. Each futures contract has a delivery date attached to it. This date is when the futures contract matures and delivery must be made. In the case of lumber, there are six different lumber contracts traded each year, each with a specific delivery date. Lumber contracts have delivery dates in January, March, May, July, September and November.
(5) The delivery point or cash settlement
a. The delivery points for various futures contracts are known. If you purchase a futures contract on soybeans and you decide to accept delivery of the 5,000 bushels of soybeans that make up one contract, you'll know exactly where to pick up your soybeans when the delivery date arrives. For commodities like currencies, there's a cash settlement rather than delivery of the actual commodity. In other words, you receive dollars instead of the actual currency.
POINTS NOT ESTABLISHED PRIOR TO TRADING
(1) The future contract's price
a. Price is established in the trading pits located on the exchange's floor. This is done in a manner similar to an auction (more on this process later).
AN EXAMPLE OF A FUTURES CONTRACT
Let's look at a lumber contract. Random lumber contracts are traded on the Chicago Mercantile Exchange or CME. The contract's quantity in predetermined to be 110,000 board feet of lumber. The quality of this lumber is also established prior to sale. It is grade stamped Construction or Standard, Standard or Better, or #1 or #2 two by fours of random lengths from 8 feet to 20 feet. The quality of the lumber you get is dependent on the quality that you need. However, whatever grade you ask for is the grade that you'll get.
As we mentioned earlier, the delivery date is determined prior to selling contracts on the market. There are six different lumber futures contracts traded each year. As mentioned early, each lumber contract has a specific delivery date. The delivery dates are January, March, May, July, September and November. The date on which you accept delivery (if that is what you chose to do) is chosen by the buyer. In other words, if you buy a January lumber contract, you know that the contract matures or expires in January.
We made mention of delivery points earlier. This is an important feature. If you plan to accept delivery on 110,000 board feet of lumber, you need to know where to pick it up from. These delivery points, or actual warehouses where your trucks can pick up the lumber are determined prior to putting a contract up for sale in the futures markets.
Most people who buy and sell lumber futures don't actually deliver or pick up the lumber that makes up the contract when their contracts mature. They usually offset the trade (that is sell out their position to someone else) prior to the maturity date. Why do they do this? Because they trade these contracts as a form of price protection against rising or falling lumber prices or they're simply out to make a profit in the futures markets.
We've taken a brief look at the futures contract. Now it's time to look at the markets on which these contracts trade.
THE FUTURES EXCHANGE
Futures contracts can only be traded on futures exchanges. Exchanges such as the Chicago Board Of Trade (the CBOT), the New York Mercantile Exchange (the NYMEX) and the Chicago Mercantile Exchange (the CME) are US exchanges that provide a place in which to trade futures contracts. These exchanges also create rules for trading and oversee trading. When we talk about commodities and futures, most people think of Chicago. That's because Chicago is really the home of these markets or the place where they first started trading. The first thing we're going to look at is the clearing function.
THE CLEARING FUNCTION
One of the most important functions of these exchanges is to provide a clearing operation. Now, just what is a clearing operation? Simply put, the clearing operation is responsible for a couple of things. First it is responsible for clearing trades. This means that the clearing operation records all of the trades that happen in the trading pits each day. At the end of the trading day, the clearing operation matches or reconciles all of the contracts that are bought or sold for that day. The next function the clearing operation is responsible for is the day to day settlement of the various trader's accounts. Let's look at this in more detail. When you buy or sell a futures contract, the exchange that you purchased the contract on will require you to put up a performance bond. You can think of this as a good faith deposit or down payment, like you'd put on a new car. The reason for this performance bond is to cover any loss that your investment might incur. Now if you investment has lost money for the trading day, you'll be asked to deposit further funds to bring the balance back up. Now if your investment made money, the exchange will deposit funds into your account. The clearing operation calculates these gains and loses each and every day. We'll explore this subject in more depth later on.
EXCHANGES AND REGULATIONS
The federal government regulates all exchanges. This regulation of futures exchanges started in 1923. The Trade Commission Act of 1974 created the Commodity Futures Trading Commission or the CFTC. The CFTC is the federal body that oversees all futures trading. The National Futures Association or NFA, regulates the activities of all brokerage houses and their agents or brokers. It is these organizations that help maintain the integrity of the futures markets.
ECONOMICS 101: SUPPLY AND DEMAND
Most people go through life without giving much consideration to the underlying economics that are such an important part of our daily lives. If you are going to trade commodities with any level of success, you have to understand the most basic law of economics: Supply and demand. Without supply and demand, the world would come to a complete stop. The price we pay for gasoline at our local gas station or the price we pay for orange juice at the local supermarket are determined by the law of supply and demand. In fact, everything you buy are sell is completely tied into supply and demand.
Supply is the quantity (amount) of a product that sellers are willing to put into the market at a given price. When prices are high, the seller will put more of their product out into the market. When prices are low, sellers put less of their product out into the market. This relationship between product supply and its price is called the law of supply. Countless economists have written numerous books on the factors that cause supply to increase or decrease. We don't need to read them all to understand the key concepts: When hog prices are low, there isn't much financial incentive for hog producers to provide hogs for the market. Now if hog prices go up, then hog producers suddenly have the financial incentive they want and they put more hogs into the market. Now, what causes these price changes? People may suddenly have a craving for pork products. However, the variables that cause these price swings are more subtle. The price of hog feed may be very low making it cheaper or more cost effective to raise more hogs, thus providing more hogs to the market. On the other side of the coin, feed prices may be too high, causing hog producers to raise less hogs and thus bring less hogs into the market. Each commodity will have a different set of supply factors that contribute to there price on the market.
If supply is the quantity (number) of a product that sellers are willing to put into the market at a given price, then demand is the quantity of a product that buyers are willing to purchase from the market at a given price. When prices are high, buyers purchase less of the product. When prices are low, buyers are usually willing to purchase more of a product. Here's an example: You go to the gas station intending to purchase $10.00 worth of gasoline. Gas is suddenly half price. Are you going to buy $5.00 worth of gasoline or are you going to spend the $10.00 and get twice as much gasoline as you had planned to? You are more inclined to get twice as much. It's human nature. So the relationship between product demand and it's price is called the law of demand. Just as there are many factors that contribute to the increase or decrease of supply, there are an equal number of factors that contribute to increases and decreases in demand. Each commodity has it's own set of demand variables or factors.
SUPPLY AND DEMAND IN ACTION
Let's look at an example of supply and demand in action. Let's use wheat in our example. Wheat is used for cereal, bread, pasta and a number of other food stuffs. Let' say wheat is trading for $2.90 per bushel. Suddenly, a bad storm system comes in and destroys 40 percent of our countries wheat crops. What will happen to the price of wheat? Well, in this example, demand remains constant (the same). However, supply is suddenly cut almost in half. Therefore, there is less wheat available in the market. This will drive prices up. After all, producers of wheat (farmers) will charge more for their crop if they can. It's human nature. Prices could go up to $4.00 or $5.00 dollars.
Let's see what happens when demand drops. We'll again use wheat in our example. Let's say that the United States Department of Agriculture or the USDA, finds that wheat leads to weight gain. Most people would cut some of the wheat out of their diet. This would cause demand for wheat to go down. What would this do to wheat prices? Well, farmers would have to lower prices in an effort to sell their crop. By how much? If wheat is currently at
$2.90 per bushel it might drop down to $1.00 or $1.59 per bushel.
So the price of a commodity really depends on the relationship between supply and demand. There are numerous variables that make up the relationship between supply and demand. While we're on the subject of trying to figure our pricing let's look at market analysis, starting with fundamental analysis.
There are two kinds of market analysis, fundamental and technical. We're going to look at both, starting with fundamental analysis. Why? Fundamental analysis first? Because it is the study of factors that affect supply and demand. Fundamental analysis is fairly straight forward. You gather and interpret information and then act on that information before the market incorporates the information into the commodities price. This is where fundamental analysis can help you make money: If you can gather and interpret information on a commodity that will affect it's price before this information is factored into the market price, than you might be able to make a profitable trading decision.
In the case of wheat, corn or soybeans, the fundamental trader studies both supply and demand. The US Department of Agriculture releases monthly and quarterly reports that give supply statistics. Inflation, consumer tastes, consumption patterns and population numbers all affect the demand for these grains. Weather and crop conditions affect the supply of these grains. The fundamental trader puts these factors together, creating models that attempt to show where grain prices are going.
Why am I mentioning financial fundamentals? Because they are a little bit different in theory and since you'll come across them in the marketplace, you need to learn about them. Financial futures require studying a different set of supply and demand factors. The overall health of the economy is the first key factor we're going to watch. Economic reports such as the Leading Indicator Index, Consumer Price Index, Gross National Product and the Employment Situation are just a few of the reports that help shape the pricing of financial futures. Let's look at an example: Changes in the direction of our economy usually signal major interest rate turning points. Now, this becomes important to someone who is trading interest rate futures such as US Treasury Bills. Demand for money rises during economic expansion. This in turn causes interest rates to rise. On the flip side of the coin, demand for money falls during an economic recession, thus causing interest rates to fall. The fundamentalist can study the relationship of long term and short term interest rates to predict the direction of interest rate movement. You'll have to put some extra time into studying these relationships within the financial futures markets if you want to be able to confidently trade these markets.
You've probably seen charts that depict the market movements of various stocks and commodities. If you've never worked with a chart, they may look like a bunch of lines and numbers. However, in the hands of someone who studies charts, they can tell you a lot about the market. This approach to price prediction is simply based on the idea that price movements follow historical patterns. What you're looking for when examining a chart is repetitive patterns. These uptrends, downtrends and sideways trends create patterns on the chart. By seeing the patterns being repeated in past years, the technical analyst can make price predictions when he or she sees an identical pattern forming. The technical analyst also watches daily volume numbers (that is, the number of contracts traded each day) and open interest numbers (the number of contracts not yet offset). These number can be used to assess the strength of a trade.
What kind of patterns should you look for? As the days during the life of a futures contract pass, the technical analyst watches for price reversal patterns and price continuation patterns. In English, this means that if prices are going up, are they going to reverse themselves and head down? Or, if prices are heading down, are they going to start moving up? Or even, will prices keep heading in the same direction? Complex charting involves patterns such as the Head and Shoulders Pattern and the Symmetrical Triangle Pattern. For more information on technical analysis try our upcoming class on Fundamental and Technical Analysis (being offered as one of our on-line classes).
HEDGERS AND SPECULATORS
Now we're going to look at the two types of individuals that trade these markets; hedgers and speculators. We'll look at the speculator first:
Speculators are individuals who analyze and forecast futures price movement. They trade contracts with the intention of making a profit. Speculators are in the markets to make money and nothing more. They put their own cash reserves at risk and many times lose money on a trade. 70 percent of all trades lose money. If this is the case, then why would a speculator invest in futures at all? Because, when a trade is profitable, it can bring back huge returns in a very short period of time. In many case, speculators specialize in particular commodities. For example, a speculator may specialize in crude oil and you'll find him only following the crude oil markets day after day. Each speculator will trade according to their own individual style. If a trader is an exchange member, you'll find them in their favorite trading pits at the exchange. Some traders are scalpers. This means that they buy and sell futures contracts quickly when prices move only a fraction of a cent. Other are day traders who buy and sell throughout the day, closing their positions before the end of the trading day. Other traders are known as position traders who may hold their positions for days, week or even months at a time.
Speculators go into the futures markets when they think that prices are going to change. They may put their money at risk but you can be sure that they don't do so without first trying to anticipate whether prices are moving up or down. Speculators use a variety of techniques to analyze price movement. They study external events that affect price movement or they apply historical price movement patterns to the current market.
A speculator who thinks that the price of a commodity is going up will buy futures contracts. If the speculator is right, the contracts can be sold at a later date at a profit. If the speculator thinks that prices are going down, the speculator would sell futures contracts and, if the market does go down, buy them back later at a lower price, thus ensuring a profit.
Now let's look at the hedger. People who buy and sell the actual commodities can use the futures markets to protect themselves against commodity prices that move against them. For example, a maker of cereal uses wheat as their base ingredient. The cereal maker pays $2.50 per bushel of wheat. If he pays much more than this, he won't make a profit. The cereal maker anticipates that the price of wheat will go up over the next three months. He needs to lock in a price for the wheat he'll need in three months from now so he buys a futures contract that gives him the right to buy wheat at say $2.55 per bushel. This is how a hedger uses the price protection afforded by a futures contract.
There's a futures contract for a commodity because there are people who need and use those commodities. We call this approach, risk management. The need for risk management that futures can give the hedger holds true for all markets, including the financial markets. Internationally, companies hedge their foreign exchange and interest rate exposures.
The producers and users of commodities, such as our cereal maker, are know as hedgers. The act of buying and selling futures as a risk management tool is called hedging.
Commodity prices in the cash markets have a fundamental relationship to the futures prices. When the forces of supply and demand shift and drive prices up and down in the cash markets, futures prices tend to rise and fall in a parallel manner. If soybean prices in the cash markets start to rise, soybean futures will start to rise in roughly the same way. However, they don't move in exact amounts. Hedgers take advantage of this relationship between cash and futures prices.
TRADING AT THE EXCHANGES
We're now going to take a look at how futures contracts are traded on the various exchanges. We'll see how your order goes from your broker to the actual trading pits on the exchange floor.
First let's look at placing an order. When you place an order, you usually do it over the telephone or via your computer. When placing an order you specify the futures contract you want to buy or sell, including the contract month. Each commodity has more than one contract. Each of these contracts has a different maturity date. For example, there are four Eurodollar futures contracts with maturity dates of March, June, September and December. So if you want June Eurodollars, you have to make that clear to your broker. You also have to tell your broker whether or not your buying or selling and how many contracts you're buying or selling. With certain types of orders you even have to specify a price (we'll examine order types later on). First let's look at the most basic type of order, the market order.
A market order is one of many types of orders that can be placed with your broker. When you place a market order, you're asking your broker and the floor trader to get you the best price they can immediately after receiving your order. You could say, "Buy 2 January Soybeans at the market." After your broker writes up an order ticket, it is then rushed to the floor broker in the pit (via telephone) who executes it right away. Now let's look at another type of order, the limit order.
We've given you a few short lesson to help get your feet wet as they say. We will be adding to this series on a regular basis, so check in for further lessons. Coming next week: Options basics: What you need to know about options.
There is a risk of loss in commodities, futures and options trading