Chapter 3
The Futures Markets
In This Chapter
Making the futures markets go ’round: Hedgers and speculators
Keeping risk manageable
Playing by the rules: Six criteria futures contracts must meet
Exploring exchanges and the ways and means of trading
Getting a grasp on margins
A futures contract is a security, similar conceptually to a stock or a bond, yet significantly different. When you buy a stock, you’re buying part of a company, while a bond makes you a lender to a government or a corporation. Whereas a stock gives you equity and a bond makes you a debt holder, a futures contract is a legally binding contract that sets the conditions for the delivery of commodities or financial instruments at a specific time period in the future.
Futures markets emerged and developed in fits and starts several hundred years ago as a mechanism through which merchants traded goods and services in the present based on their expectations for crops and harvest yields in the future. Today, futures markets are the hub of capitalism, because they provide the base for prices at wholesale and eventually retail markets for commodities ranging from gasoline and lumber to key items in the food chain, such as cattle, pork, corn, and soybeans.
Futures contracts are available for a variety of financial products and commodities. There are contracts for trading just about anything, starting with familiar securities such as stock index futures, interest rate products like bonds and treasury bills, to lesser known commodities like propane and ethanol. Some futures contracts are even designed to hedge against weather risk and to trade electricity. The latest introduction, as of late 2007, is that of real estate market contracts.
Now virtually all financial and commodity markets are linked, with futures and cash markets functioning as a single entity on a daily basis. Thus, as a successful trader, you need to understand the basics of all major markets — bonds, stocks, currencies, and commodities — and their relationships to each other and the economic cycle.
In this chapter, you gain an understanding of who the major players are, how the futures markets evolved to their prominent role in the global economy, and what basic rules and regulations keep the markets as fair and reasonable as possible.
Taking Big Risks and Guarding Against Them: Two Types of Traders
The futures markets serve two major constituencies: hedgers and speculators. Although these two groups have differing interests, the participation of both is necessary for the markets to function.
Hedgers, in general, are major companies that actually produce the commodities, or others (like farmers) who have an inherent interest in the market. Hedgers may employ professional traders to use futures contracts on commodities and related products to decrease the company’s risk of loss. Their goal is not to profit from futures trading, but rather to cover their risk of losses and keep company operations moving forward.
Speculators, the second constituency (including you and me), trade futures contracts with the goal of making money from market trends and special situations. In other words, the speculator’s job is to see where the big money is going and follow it there, regardless of whether prices are going up or down.
So although hedgers may actually take delivery of or receive products specified in a futures contract, speculators are trying to ride the price trend of those products as long as possible, while always intending to cash in before the delivery date.
Hedging bets to minimize risk
Farmers, producers, importers, and exporters are hedgers, because they trade not only in futures contracts but also in the commodity, equity, or product represented by the contract. They trade futures to secure the future price of the commodity of which they will take delivery and then sell later in the cash market.
People who buy commodities, or holders, are said to be long, because they’re looking to buy at the lowest possible price and sell at the highest possible price. Short sellers sell commodities in the hope that prices will fall. If they’re correct, they offset, or close, the position at a lower price than when they sold it. (For more on the long and short of trading, see “Talking the talk,” later in this chapter.)
Futures contracts are attractive to longs and shorts, because they provide price and time certainty, and they reduce the risk associated with volatility, or the speed at which prices change up or down. At the same time, hedging can help lock in an acceptable price margin, or difference between the futures price and the cash price for the commodity, and improve the risk between the cost of the raw material and the retail cost of the final product by covering for any market-related losses. Note: Hedge positions don’t always work, and in some cases, they make losses worse.
Exxon Mobil is a good example of a hedger in the oil markets, because the company must gauge the potential risk of weather, politics, and other external factors on future oil production. Warm winter weather, for example, reduces the demand for heating oil and therefore puts downward pressure on the price of oil. Exxon wants to protect itself from such a risk.
Another good current example of a hedger is an airline in the post-September 11, 2001, world, and its fuel costs. Aside from labor, airplane fuel is by far the most expensive component of an airline’s costs. A good airline also has expertise in the oil market.
Say that Duarte Air (I know, I know, it’s self-serving promotion) is projecting a need for large amounts of jet fuel for the summer season, based on the trends in travel during the past decade. As the airline’s CEO, I know that demand for gasoline tends to rise in the summer; thus, prices for the jet fuel I need are also likely to rise because of refinery usage issues — refineries switch a major portion of their summer production to gasoline.
In order to hedge its costs for crude oil in the summer, Duarte Air starts buying July crude oil and gasoline futures a few months ahead of time, hoping that as the prices rise, the profits from the trades can offset the costs of the expected rise in jet fuel. Say, for instance, that Duarte Air bought July crude futures at $50 per barrel in December, and by June they were trading at $60 per barrel. As the prices continued to rise, Duarte would start unloading the contracts, pocketing the $10-per-barrel profit and using it to offset the higher costs of its fuel in the spot market (during the summer travel season).
On the other hand, if Duarte’s hedging was wrong and the price of oil went down, the airline could always use options to hedge the futures contracts, or go short, by selling futures contracts high and making money by buying them back at lower prices if there was a sudden price drop.
Considering the effects of a crash
The stock market crash of 1987 had one positive result. It ushered in the era of the one market. After that fateful day, October 19, 1987, anyone who’d ever invested in any market understood that all markets are linked, regardless of the underlying securities traded on them, and that money can and does flow at the speed of light from one type of market to another. In fact, the futures markets, according to Mark Powers, in his book Starting out in Futures Trading (McGraw-Hill), are like “convenient laboratories” for conducting market analysis.
After the 1987 crash, the Brady Commission coined and defined the concept that all markets were linked, because the action in one or more of them had an influence on one or several others. But the commission did little to dissuade the media’s and the public’s perception that the futures markets were not to blame for the crash — something the Federal Reserve concluded in its post-crash study released in 1988.
Another positive of the post-crash environment was the implementation of circuit breakers, or intraday limits on trading that slow or stop trading in specific products when the markets for those products are moving too fast. The Board of Governors of the Federal Reserve System (the Fed), the Securities and Exchange Commission (SEC), and the various exchanges (see the section “Seeing Where the Magic Happens,” later in this chapter, for a list of exchanges) also developed better techniques for monitoring position sizes and overall market liquidity after the crash.
Speculating that there’s a profit to be had
Speculators, in contrast to hedgers, are betting on the price change potential for one reason only — profit. Speculators do the opposite of hedgers; they look to increase risk and increase the chances of making money.
A hedger tries to take the speculator’s money and vice versa. So a normal futures transaction is likely to include a member of each of these subgroups. A speculator is likely to be buying a contract from a hedger at a low price, while the hedger is expecting the price to decline farther, which is why he’s selling the contract.
Think of this dance in terms of risk. Hedgers are transferring the risk of price variability to others in exchange for the cost of the hedge. Speculators assume price variability risk, thus making the transfer possible in exchange for the potential to gain. A hedger and a speculator can both be very happy from the outcome of price variability in the same market.
This interaction between speculators and hedgers is what makes the futures markets efficient. This efficiency and the accuracy of the supply-and-demand equation (see the later “Talking the talk” section) increase as the underlying contract gets closer to expiration and more information about what the marketplace requires at the time of delivery becomes available.
Limiting Risk Exposure: Contract and Trading Rules
By design, futures contracts are meant to limit the amount of time and risk exposure experienced by speculators and hedgers, those traders who use them. As a result, futures contracts have several key characteristics that enable traders to trade them effectively. I list and briefly describe these characteristics in the sections that follow and use these explanations to expand on how the contracts work throughout the book.
Checking the expiration date
All futures contracts are time based; they expire, which means that at some point in the future they will no longer exist. From a trading standpoint, the expiration of a contract forces you to make one of the following decisions:
Sell the contract and roll it over by buying the contract for the next front month (the futures contract month nearest to expiration) or another that’s farther into the future.
Offset the contract (taking your profits or losses) and just stay out of the market.
Take delivery of the underlying commodity, equity, or product represented by the contract.
Chilling out: Daily price limits
Because of the volatility of futures contracts and the potential for catastrophic losses, limits are placed on futures contracts that freeze prices but do not freeze trading. Limits are meant to let markets cool down during periods of extremely active trading.
Sizing up your account
Most brokers require individuals to deposit a certain amount of money in a brokerage account before they can start trading. A fairly constant figure in the industry is $5,000.
Staying Up to Snuff: Criteria for Futures Contracts
Futures contracts are nothing like credit-card transactions. Buying something and promising to pay for it later, the way you do when you go shopping with a credit card, doesn’t make a futures contract. True futures contracts must meet the following six criteria, which have developed since the inception of the futures markets:
Trading must be conducted on an organized exchange.
This exchange is a physical place, where trading actually takes place either by open-cry trading in a trading pit, which is what you see on television when you turn on the business channels, or by electronic means, which is an increasing phenomenon, especially in Europe, where trading already is done nearly 100 percent electronically, as opposed to the U.S. where both electronic and open-cry trading take place.
Common rules govern all transactions. The two most important ones are as follows:
• Trading occurs in one designated place, the ring or pit of the exchange, by open outcry or electronically, during specific trading hours, with every participant having equal access to the bids and offers and the flow of trading.
• No exchange member can offer to fill or match an order without first offering it to the crowd. A member is a firm or an individual who buys a seat on the exchange, or the privilege to trade directly for his own account and to be an intermediary for other traders. When a floor broker fills an order, he is fulfilling your request from his own inventory of futures contracts. When a floor broker matches an order, he is fulfilling your request by finding a buyer or seller in the trading crowd and matching the buyer with the seller.
Contract sizes, delivery dates, mode of delivery, and procedure are standardized. That means that there is consistency as each contract of each individual commodity is equal to the other contracts in its class, and the important dates of each contract year are easy to follow.
Traders negotiate only the original transaction with each other. Beyond the original agreement, the exchange becomes a clearinghouse, and the obligation of the parties to a futures contract transaction is with the exchange.
Futures contracts are canceled, or closed out, by offset. When a trader sells a contract to deliver a specific amount of a marketable product for December delivery, he has an obligation to deliver that product to the exchange by December. If he buys a contract for the same amount of that product before December, then he has met his obligation; he has offset the original sale with an equivalent buy and is out of the market.
The exchange clearinghouse acts as a guarantor, or guardian, for each transaction. It accomplishes this by requiring its members to have minimum amounts of working capital and enough funds to meet their outstanding debts. Exchange members who are not clearinghouse members must associate with exchange members, who are to guarantee and verify all contracts.
Seeing Where the Magic Happens
Several active futures and options exchanges are open for business in the United States. Each has its own niche, but some overlaps occur in the types of contracts that are traded. In this section, I cover the basics of three of the more frequently used Chicago exchanges, along with a handful of exchanges based in other cities.
The names of the exchanges are as follows:
Chicago Board Options Exchange (
www.cboe.com
): The premier options exchange market in the world, the CBOE specializes in trading options on individual stocks, stock index futures, interest rate futures, and a broad array of specialized products such as exchange-traded mutual funds. The CBOE is not a futures exchange but is included here to be complete, because futures and options can be traded simultaneously, as part of a single strategy. I discuss this throughout the book where applicable, but go into in a bit more detail in Chapter 4.
Chicago Board of Trade (
www.cbot.com
): Trades are made in futures contracts for the agriculturals, interest rates, Dow Indexes, and metals. Specific contracts traded on the CBOT include
• Agricultural futures: Corn, the soybean complex, wheat, ethanol, oats, rough rice, and mini contracts in corn, soybeans, and wheat
• Interest rate–related futures: Treasury bonds, spreads, Fed funds, municipal bonds, swaps, and German debt
• Dow Jones Industrial Average: Dow Jones Industrial mini contracts
• Metals futures: Gold and silver and e-mini contracts for gold and silver
Chicago Mercantile Exchange (
www.cme.com
): The CME is the largest futures exchange in North America. CME Group merged with the CBOT, forming a formidable contender in the exchange industry. The merged entity, a publicly traded company, operates both exchanges and trades on the New York Stock Exchange under the ticker symbol CME. The two exchanges, although they are one company, have two separate trading floors, and between the two distinct areas offer the opportunity to trade a wide variety of instruments, including commodities, stock index futures, foreign currencies, interest rates, TRAKRS, and environmental futures. Among the contracts traded on the CME are
• Commodities: Live cattle, milk, lean hogs, feeder cattle, butter, pork bellies, lumber, the Goldman Sachs Commodities Index (and associated futures contracts), and fertilizer
• Stock index futures: S&P 500, S&P 500 Midcap, S&P Small Cap 600, NASDAQ Composite, NASDAQ 100, Russell 2000, and the corresponding e-mini contracts for all the major indexes traded
• Other important stock-related contracts: Single stock futures, futures on exchange-traded funds (ETFs), and futures on Japan’s Nikkei 225 index
• Options: Options on the futures contracts that are listed by the CME
Kansas City Board of Trade (KCBT,
www.kcbt.com
): The KCBT is a regional exchange that specializes in wheat futures and offers trading on stock index futures for the Value Line Index, a broad listing of 1,700 stocks.
Minneapolis Grain Exchange (MGEX,
www.mgex.com
): MGEX is a regional exchange that trades three kinds of seasonally different wheat futures, and offers futures and options on the National Corn Index and the National Soybeans Index.
New York Board of Trade (NYBOT,
www.nybot.com
): A major international exchange, the NYBOT offers a broad array of products, including
• Commodities: Sugar, cocoa, cotton, frozen orange juice, ethanol and pulp, and the Reuters/Jefferies CRB Index
• Currencies: U.S. dollar index and a wide variety of foreign currency pairs and cross rates
• Stock index futures: Russell Equity Indexes and NYSE Composite Index
New York Mercantile Exchange (NYMEX,
www.nymex.com
): The NYMEX is the hub for energy trading in
• Energy futures: Light sweet crude, natural gas, unleaded gasoline, heating oil, electricity, propane, and coal
• Metals: Gold, silver, platinum, copper, palladium, and aluminum
Futures contracts for the Goldman Sachs Commodity Index and options on the futures contracts that the CME lists also are traded on the CME.
Exploring How Trading Actually Takes Place
Around the world, most futures exchanges have converted from open-cry to electronic trading. The United States, however, still uses the open-cry system of futures trading, where traders on a trading floor or in a trading pit shout and use hand signals to make transactions or trades with each other. Futures contracts are traded in a clear, albeit nonlinear, order.
When you call your broker, he relays a message to the trading floor, where a runner relays the message to the floor broker, who then executes the trade. The runner then relays the trade confirmation back to your broker, who tells you how it went. The order is just about the same when you trade futures online, except that you receive a trade confirmation via an e-mail or other online communiqué.
Trade reporters on the floor of the exchange watch for executed trades, record them, and then transmit these transactions to the exchange, which, in turn, transmits the price to the entire world almost simultaneously.
Shifting sands: Twenty-four-hour trading
In the United States, physical commodities, such as agriculturals and oil, are still traded primarily by an open-cry system; however, most futures markets in the world also offer electronic models of trading because they provide
A more level playing field
More price transparency
Lower transaction costs
Globex, the electronic data and trading system founded in 1992, extends futures trading beyond the pits and into an electronic overnight session. Globex is active 23 hours per day, and contracts are traded on it for Eurodollars, S&P 500, NASDAQ-100, foreign exchange rates, and the CME e-mini futures. You can also trade options and spreads on Globex.
When you turn to the financial news on CNBC before the stock market opens, you see quotes for the S&P 500 futures and others taken from Globex as traders from around the world make electronic trades. Globex quotes are real, meaning that if you keep a position open overnight and you place a sell stop under it, or you place a buy order with instructions to execute in Globex, you may wake up the next morning with a new position, or out of a position altogether.
Globex trading overnight tends to be thinner than trading during regular market hours (usually from 8:30 a.m. to 4:15 p.m. eastern time), and it tends to be more volatile in some ways than trading during regular hours.
You can monitor Globex stock index futures, Eurodollars, and currency trades on a delayed basis overnight free of charge at www.cme.com/trading/dta/del/globex.html.
Here are a few good questions to ask your futures broker about trading via Globex:
Does the brokerage firm that you’re using provide access to Globex? If so, what kind of an interface, front-end system, or link to Globex does it supply? You want to know whether the system is compatible with Globex and how smoothly it works.
Are the commissions for Globex trading different than the commissions charged for using the firm’s regular trade routing?
Are there any other rule or requirement changes, such as limits on the number of contracts that you can trade, margin requirements, or other particulars?
You may want to put in an order by phone. Does the firm offer customer support in after-hours trading?
Talking the talk
If you’re going to trade futures, you have to know trader talk. Knowing several key terms helps you get the job done and helps you understand what reporters and advisors are talking about.
Some key terms that refer to your expectations of the market include
Going long: Being bullish, or positive on the market, and wanting to buy something. When I say I’m long oil, in the context of futures trading, it means that I own oil futures.
Being short: Being bearish, or negative on the market in which you are trading. Your goal is to make money when the price of the futures contract that you choose to short falls in price. If you deal in the stock market, you know that you have to borrow stocks before you can sell them short. In the futures market, you don’t have to borrow anything; you just post the appropriate margin and instruct your broker that you’re interested in selling short.
I know this can be confusing, so it is best looked upon from the point of view of reversing, or offsetting, your position. To illustrate the point, consider an example in a vacuum. If you sell a crude oil contract short at $59 and the price drops to $54, you have a $5 profit. At that point, if you decide that you’ve made enough of a profit, you then offset the position by buying back the contract to cover your short sale. In other words, what you’re selling short is the contract, and by offsetting the position, you are now finishing the trade.
Locals: The people in the trading pits. They’re usually among the first to react to news and other events that affect the markets.
Front month: The futures contract month nearest to expiration. This time frame may not always feature the most widely quoted futures contract. As one contract expires, the next contract in line becomes the front month.
Orders: Instructions that lead to the completion of a trade. They can be placed in a variety of ways, including
• A stop-loss order, which means that you want to limit your losses at or above a certain price.
A stop-loss order becomes a market order (see next entry) to buy or sell at the prevailing market price after the market touches the stop price, the price at which you’ve instructed the broker to sell. A buy stop is placed above the market. A sell stop is placed below the market. Stop orders can also be used to initiate a long or short position, not just close (offset) an open position.
• A market order, which means you’ll take the prevailing price that the market has to offer. (It has nothing to do with trying to get fresh fish.)
• A trailing stop, is an order to sell placed a certain number of ticks below the price of your contract if you’re long, and a certain number of ticks above your contract if you’re short. The purpose of a trailing stop is to lock in profits. Here’s how it works. Say you buy one S&P 500 futures contract at 1000 and you want to limit your loss to five points. You would place your stop at 995. If the contract moves up to 1005, you then change your trailing stop to 1000.75, to give yourself some breathing room. If the contract moves up another two points, then raise your stop to 1002.75, and so on. When the market turns and your stop is hit, you’re out of the market automatically.
Hedging: A trading technique that’s used to manage risk. It may mean that you’re setting up a trade that can go either way, and you want to be prepared for whichever way the market breaks. In the context of large producers of commodities, hedging means putting strategies in place in case the market does the opposite of what is expected, such as a major and sudden rise in oil prices caused by a hurricane.
The following terms can help you understand hedging:
• Putting on a hedge means that you’re setting up a trading situation that enables you to cover all the bases for whichever way the market decides to go. Hedgers often account for 20 to 40 percent of all the open, or active, futures contracts in a particular market. They’re usually companies or large entities that are protecting their investments against the risk of price fluctuation in the future by buying or shorting futures contracts.
• A cross hedge isn’t fancy shrubbery; it’s the act of using a different contract to manage the risk of another contract in which you’re primarily interested. For example, an oil company may use gasoline contracts to hedge the risk of their crude oil contracts.
The pit: This isn’t Hell, although if you’re on the wrong end of the trade, it can feel like it. The pit is where all futures contracts are traded during a regular-hours trading session in the futures markets.
Speculators: Traders (usually, but not always, small- to medium-sized) who are trying to make money only from the fluctuation of prices without intending to take delivery of the contract. Hedge funds are also speculators.
Floor brokers: Agents who receive a commission to buy and sell futures contracts for their clients. These clients generally are futures commission merchants. A floor broker may also trade for his own account, under certain restrictions. Floor traders rarely make agent trades. They use their exchange membership to buy and sell futures for their own accounts, taking advantage of very low commissions and immediate access to market information. Floor brokers, by exchange rules, cannot place their own orders ahead of yours. Your broker can trade for himself, but he cannot put his order in ahead of yours.
Bid: The price at which you want to buy something.
Offer: The price at which you are willing to sell something.
Taking delivery: Taking the product on which you were speculating.
Supply and demand equation: Trader talk referring to whether there are more buyers than sellers. When there are more sellers than buyers, the equation tilts toward supply, and vice versa.
Expiration: This isn’t a reference to death or breathing out. Expiration with regard to a contract means that the contract is no longer trading.
Delivery: What futures contracts are all about — someone actually delivering or handing something to someone else in exchange for money.
Making the Most of Margins
Margins are what make futures trading so attractive, because they add leverage to futures contract trades. The downside is that if you don’t understand how trading on margin works, you can take on some big losses in a hurry.
Trading on margin enables you to leverage your trading position. By that I mean that you can control a larger number of assets with a smaller amount of money. Margins in the futures market generally are low; they tend to be near the 10 percent range. Thus, you can control, or trade, $100,000 worth of commodities or financial indexes with only $10,000 or so in your account.
In the stock market, the Federal Reserve sets the allowable margin at 50 percent. So, in order to trade stocks on margin, you must put up 50 percent of the value of the trade. Futures margins are set by the futures exchanges and are different for each different futures contract. Margins in the futures market can be raised or lowered by the exchanges, depending on current market conditions and the volatility of the underlying contract.
Generally, when you deposit a margin on a stock purchase, you buy partial equity of the stock position and owe the balance as debt. In the futures market, a margin acts as a security deposit that protects the exchange from default by the customer or the brokerage house.
When you trade futures on margin, in most cases you buy the right to participate in the price changes of the contract. Your margin is a sign of good faith, or a sign that you’re willing to meet your contractual obligations with regard to the trade.
Trading contracts that are lower in volatility.
Using advanced trading techniques such as spreads, or positions in which you simultaneously buy and sell contracts in two different commodities or the same commodity for two different months, to reduce the risk. An example of an intramarket spread is buying March crude oil and selling April crude. An example of an intermarket spread is buying crude oil and selling gasoline.
For more detailed information about margins, turn to Chapter 4.