Market Data Central

Introduction

Futures markets have been described as continuous auction markets and as clearing houses for the latest information about supply and demand. They are the meeting places of buyers and sellers of an ever-expanding list of commodities that today includes agricultural products, metals, petroleum, financial instruments, foreign currencies and stock indexes. Trading has also been initiated in options on futures contracts, enabling option buyers to participate in futures markets with known risks.

Notwithstanding the rapid growth and diversification of futures markets, their primary purpose remains the same as it has been for nearly a century and a half: to provide an efficient and effective mechanism for the management of price risks. By buying or selling futures contracts—contracts that establish a price level now for items to be delivered later—individuals and businesses seek to achieve what amounts to insurance against adverse price changes. This is called hedging.

Other futures market participants are speculative investors who accept the risks that hedgers wish to avoid. Most speculators have no intention of making or taking delivery of the commodity but, rather, seek to profit from a change in the price. The interaction of hedgers and speculators helps to provide active, liquid and competitive markets.

For those individuals who fully understand and can afford the risks which are involved, the allocation of some portion of their capital to futures trading can provide a means of achieving greater diversification and a potentially higher overall rate of return on their investments.

Intended to help provide you with the kinds of information you should first obtain—and the questions you should seek answers to—in regard to any investment you are considering:

• Information about the investment itself and the risks involved
• How readily your investment or position can be liquidated
• Who the other market participants are
• Alternate methods of participation
• How prices are arrived at
• The costs of trading
• How gains and losses are realized
• What forms of regulation and protection exist
• The experience, integrity and track record of your broker or advisor
• The financial stability of the firm with which you are dealing

Futures Markets: What, Why & Who

Prior to the establishment of central grain markets in the mid-nineteenth century, the nation's farmers carted their newly harvested crops over plank roads to major population and transportation centers each fall in search of buyers. The seasonal glut drove prices to giveaway levels and, indeed, to throwaway levels as grain often rotted in the streets or was dumped in rivers and lakes for lack of storage. Come spring, shortages frequently developed and foods made from corn and wheat became barely affordable luxuries.

The first central markets were formed to meet that need. Eventually, contracts were entered into for forward as well as for spot (immediate) delivery. So-called forwards were the forerunners of present day futures contracts.

Spurred by the need to manage price and interest rate risks that exist in virtually every type of modern business, today's futures markets have also become major financial markets. Participants include mortgage bankers as well as farmers, bond dealers as well as grain merchants, and multinational corporations as well as food processors.

Futures prices arrived at through competitive bidding are immediately and continuously relayed around the world by wire and satellite. A farmer in Nebraska, a merchant in Amsterdam, an importer in Tokyo and a speculator in Ohio thereby have simultaneous access to the latest market-derived price quotations.

Hedgers

Hedgers are individuals and firms that make purchases and sales in the futures market solely for the purpose of establishing a known price level—weeks or months in advance—for something they later intend to buy or sell in the cash market. In this way they attempt to protect themselves against the risk of an unfavorable price change in the interim.

The number and variety of hedging possibilities is practically limitless. A cattle feeder can hedge against a decline in livestock prices and a meat packer can hedge against an increase. Borrowers can hedge against higher interest rates, and lenders against lower rates. Investors can hedge against an overall decline in stock prices.

Whatever the hedging strategy, the common denominator is that hedgers willingly give up the opportunity to benefit from favorable price changes in order to achieve protection against unfavorable price changes.

Speculators

Speculators are individuals and firms who seek to profit from anticipated increases or decreases in futures prices. In so doing, they help provide the risk capital needed to facilitate hedging.

Someone who expects a futures price to increase would purchase futures contracts in the hope of later being able to sell them at a higher price. This is known as "going long." Conversely, someone who expects a futures price to decline would sell futures contracts in the hope of later being able to buy back identical contracts at a lower price. This is known as "going short."

One of the attractive features of futures trading is that it is equally easy to profit from declining prices (by selling) as it is to profit from rising prices (by buying).

Floor Traders

Persons known as floor traders or locals, who buy and sell for their own accounts on the trading floors of the exchanges, help to provide market liquidity. Like specialists and market makers at securities exchanges, they help to provide market liquidity. If there isn't a hedger or another speculator who is immediately willing to take the other side of your order, the chances are there will be an independent floor trader who will do so.

What is a Futures Contract?

There are two types of futures contracts: those that provide for physical delivery of a particular commodity or item and those which call for a cash settlement. The month during which delivery or settlement is to occur is specified.

Even in the case of delivery-type futures contracts, very few actually result in delivery. The vast majority of speculators choose to realize their gains or losses by buying or selling offsetting futures contracts prior to the delivery date. Selling a contract that was previously purchased liquidates a futures position in exactly the same way that selling 100 shares of IBM stock liquidates an earlier purchase of 100 shares of IBM stock.

Even hedgers generally don't make or take delivery. Most find it more convenient to liquidate their futures positions and use the gain to offset whatever adverse price change has occurred in the cash market.

Why Delivery?

Since delivery on futures contracts is the exception rather than the rule, why do most contracts even have a delivery provision? There are two reasons:

1. It offers buyers and sellers the opportunity to take or make delivery of the physical commodity if they so choose.
2. More importantly, the fact that buyers and sellers can take or make delivery helps to assure that futures prices will accurately reflect the cash market value of the commodity at the time the contract expires—i.e., that futures and cash prices will eventually converge.

It is convergence that makes hedging an effective way to obtain protection against an adverse change in the cash market price. Cash settlement futures contracts are settled in cash rather than by delivery at the time the contract expires. Stock index futures contracts, for example, are settled in cash on the basis of the index number at the close of the final day of trading.

The Process of Price Discovery

Futures prices increase and decrease largely because of the myriad factors that influence buyers' and sellers' judgments about what a particular commodity will be worth at a given time in the future.

As new supply and demand developments occur and as new and more current information becomes available, these judgments are reassessed and the price of a particular futures contract may be bid upward or downward. The process of reassessment—of price discovery—is continuous.

Competitive price discovery is a major economic function—and, indeed, a major economic benefit—of futures trading. The trading floor of a futures exchange is where available information about the future value of a commodity or item is translated into the language of price.

After the Closing Bell

Once a closing bell signals the end of a day's trading, the exchange's clearing organization matches each purchase made that day with its corresponding sale and tallies each member firm's gains or losses based on that day's price changes.

Gains and losses on futures contracts are not only calculated on a daily basis, they are credited and deducted on a daily basis. If a speculator has a $300 profit as a result of the day's price changes, that amount would be immediately credited to his brokerage account. If the day's price changes had resulted in a $300 loss, his account would be immediately debited.

This process is known as daily cash settlement and is an important feature of futures trading.

The Arithmetic of Futures Trading

The leverage of futures trading stems from the fact that only a relatively small amount of money (known as initial margin) is required to buy or sell a futures contract. On a particular day, a margin deposit of only $1,000 might enable you to buy or sell a futures contract covering $25,000 worth of soybeans.

If you speculate in futures contracts and the price moves in the direction you anticipated, high leverage can produce large profits in relation to your initial margin. Conversely, if prices move in the opposite direction, high leverage can produce large losses. Leverage is a two-edged sword.

Trading

An absolute requisite for anyone considering trading in futures contracts—whether it's sugar or stock indexes, pork bellies or petroleum—is to clearly understand the concept of leverage as well as the amount of gain or loss that will result from any given change in the futures price. If you cannot afford the risk, or even if you are uncomfortable with the risk, the only sound advice is don't trade. Futures trading is not for everyone.

Margins

Used in connection with futures trading, margin has an altogether different meaning than with securities. Rather than providing a down payment, the margin required to buy or sell a futures contract is solely a deposit of good faith money that can be drawn on by your brokerage firm to cover losses. It is much like money held in an escrow account.

There are two margin-related terms you should know:

• Initial margin — the sum of money that the customer must deposit for each futures contract to be bought or sold. Profits are added to and losses deducted from this balance daily.
• Maintenance margin — if losses reduce the funds in your account below this level, your broker will require additional funds to bring the account back to the initial margin. These requests are known as margin calls.

Basic Trading Strategies

Buying (Going Long) to Profit from an Expected Price Increase

Someone expecting the price of a particular commodity to increase can seek to profit by buying futures contracts. If correct in forecasting the direction and timing of the price change, the futures contract can later be sold for the higher price, yielding a profit. Because of leverage, the gain or loss may be greater than the initial margin deposit.

Selling (Going Short) to Profit from an Expected Price Decrease

Instead of first buying a futures contract, you first sell a futures contract. If, as expected, the price declines, a profit can be realized by later purchasing an offsetting futures contract at the lower price.

Spreads

A spread involves buying one futures contract and selling another futures contract. The purpose is to profit from an expected change in the relationship between the purchase price of one and the selling price of the other.

As an illustration, assume in November that the March wheat futures price is $3.10/bu and May wheat is $3.15/bu—a 5-cent difference. If you expect this spread to widen, you could sell March and buy May. If by February the spread has widened to 15 cents, you realize a net gain of 10 cents per bushel, or $500 on a 5,000 bushel contract.

Participating in Futures Trading

There are several ways to participate in futures trading:

• Trade Your Own Account — Open an individual trading account and make your own trading decisions. All brokerage firms conducting futures business must be registered with the CFTC and be Members of NFA.
• Managed Account — Give an account manager written power of attorney to make trades for you. You remain fully responsible for any losses and margin calls.
• Commodity Trading Advisor (CTA) — For a fee, provides advice including specific trading recommendations. CTAs must be registered with the CFTC.
• Commodity Pool — Similar to a mutual fund. Your money is combined with other participants and traded as a single account. Your risk is generally limited to your investment in the pool.

Regulation of Futures Trading

Firms and individuals that conduct futures trading business with the public are subject to regulation by the CFTC (Commodity Futures Trading Commission) and by NFA (National Futures Association). All futures exchanges are also regulated by the CFTC.

Firms and individuals that violate NFA rules can be permanently barred from engaging in any futures-related business with the public. The enforcement powers of the CFTC include the power to seek criminal prosecution by the Department of Justice.

Establishing an Account

When you apply to establish a futures trading account, you can expect to be asked for information including your income, net worth, and previous investment or futures trading experience. The person or firm handling your account is required to provide you with risk disclosure documents and obtain written acknowledgment that you have received and understood them.

Opening a futures account is a serious decision. Just as you wouldn't consider buying a house without carefully reading the contract, neither should you establish a trading account without reading and understanding the Account Agreement.

What to Look for in a Futures Contract

• The Contract Unit — Delivery-type contracts stipulate specifications (e.g., 5,000 bushels of grain, 40,000 pounds of livestock, 100 troy ounces of gold).
• How Prices are Quoted — Usually the same as the cash market: dollars, cents, and fractions per bushel, pound or ounce.
• Minimum Price Changes (Tick) — The minimum amount the price can fluctuate. For example, each tick for grain is 0.25 cents per bushel ($12.50 on a 5,000 bushel contract).
• Daily Price Limits — Exchanges establish limits stated in terms of the previous day's close. Once a limit is hit, no trading can occur beyond that price until the next day.
• Position Limits — Maximum speculative position any one person can have in any one contract, to prevent undue influence on price.

Understanding (and Managing) the Risks of Futures Trading

Choosing a Futures Contract

Different futures contracts involve different degrees of probable risk and reward. You should evaluate and choose contracts that appear most likely to meet your objectives and willingness to accept risk.

Liquidity

There can be no ironclad assurance that a liquid market will always exist for offsetting a futures contract. Two useful indicators of liquidity are the volume of trading and the open interest (the number of open futures positions still remaining).

Timing

Being right about the direction of prices isn't enough. It is also necessary to anticipate the timing of price changes, because an adverse price change may result in a greater loss than you are willing to accept before you are eventually proven right.

Stop Orders

A stop order is placed with your broker to buy or sell a particular futures contract at the market price if and when the price reaches a specified level. Stop orders are often used to limit losses. However, there can be no guarantee that it will be possible to execute at the specified price under all market conditions.

Options on Futures Contracts

The principal attraction of buying options is that they make it possible to speculate on increasing or decreasing futures prices with a known and limited risk. The most that the buyer of an option can lose is the cost of purchasing the option (the option "premium") plus transaction costs.

Buying Call Options

The buyer of a call option acquires the right but not the obligation to purchase (go long) a particular futures contract at a specified price (the "exercise" or "strike" price) at any time during the life of the option.

Buying Put Options

A put option conveys the right to sell (go short) a particular futures contract at a specified price. Put options can be purchased to profit from an anticipated price decrease.

How Option Premiums are Determined

Three major variables influence the premium:

1. Exercise price relationship — An "in-the-money" option commands a higher premium than an "out-of-the-money" option.
2. Time remaining — More time until expiration means higher premium. An option is an eroding asset.
3. Volatility — Greater volatility means higher premium, because the option stands a greater chance of becoming profitable.

Selling Options

In Closing

The foregoing is, at most, a brief and incomplete discussion of a complex topic. Options trading has its own vocabulary and its own arithmetic. If you wish to consider trading in options on futures contracts, you should discuss the possibility with your broker and read and thoroughly understand the Options Disclosure Document which he is required to provide.

In no way should anything discussed herein be considered trading advice or recommendations. That should be provided by your broker or advisor. Similarly, your broker or advisor—as well as the exchanges where futures contracts are traded—are your best sources for additional, more detailed information about futures trading.