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Trader's Center > Commodities Primer  Primer Intro Futures Options on Futures The Broker The Exchange All material presented from George Kleinman's book, "Commodity Futures & Options". Primer Intro A floor broker friend of mine told me the following story. He swears it's true. In the sixties, there was a corn speculator who traded in "the pit" at the Chicago Board of Trade. He was known for "plunging" (taking big positions). Early one summer, he put on a large short corn position for his own account (this is a position which will make money if prices fall, but is costly if prices rise). Soon after, the weather began to heat up in the Midwestern United States where the corn is grown. The corn crop needed rain and prices started to rise. Day after day, the sun shone, not a cloud in the sky, and the corn was starting to burn up. The market continued to rally against this guy. He knew if this continued, he would go broke. Late one trading session, the big trader started a rumor around the corn pit. His rumor was that it was going to start to rain the next morning at 10:30 A.M. The next morning the sun shone, not a cloud in the sky, and the market opened higher. Then, almost miraculously, at just about 10:30 A.M., rain started pouring down the windows that look onto the grain trading floor. (The old grain room, located on the fourth floor of the Board of Trade Building, had tall windows that you could see from La Salle Street.) Inside, in the corn pit, a selling panic developed as the traders scrambled to sell out their corn futures. The market went down the limit! The speculator covered his entire short position on this break and was saved from bankruptcy. How did he know it would rain at 10:30 that morning? It seems he was owed a favor from his Irish drinking buddy, the Chief of the Chicago Fire Department. The Chief brought out the hook & ladders and decided it was a very good day to wash those tall windows that looked out onto La Salle Street! So, you're thinking of trading, but you don't know the Chief? In fact, you're thinking of trading cocoa. You've just finished reading a private newsletter, hot off the presses, a first hand report of how the witch's tail disease is devastating the Ivory Coast cocoa crop. You have no way of knowing for sure how true this is. You do like chocolate, but you had no idea it all started with a bean called the cocoa bean. (You thought it came out of a can.) Hey, you don't even know where the Ivory Coast is. Yet, you're still thinking of trading this bean against the likes of Hershey's, Nestlé's and whoever else that really knows what's going on. Why would you do something like this? Why? To make money, why else? You do know one thing--the cocoa market is moving. It's moving up and it's moving fast. While you aren't exactly losing money by doing nothing, it's starting to feel that way. Do you have the guts to act? Do you have the money? Is now the time? You assume the shorts [those betting on lower cocoa prices] are beginning to experience financial pain. The longs [those betting on higher cocoa prices] are experiencing the opposite emotions--elation, happiness, the satisfaction that comes from being right. The accounts of the longs are growing--money from nothing. The shorts are watching their money disappear. Let's stop this commentary for a moment, because it's now time for your first lesson; trading is a human game. As a result, emotions affect price as much, perhaps more, than the news. You will learn that price movements themselves are a fundamental, and in turn, affect future price movements. It's all a function of who is being hurt, and who is benefiting. It's a function of which side of the market is being 'sponsored' by the 'strong hands'. Shorts and longs will act differently based on price movements which will affect their emotions as much as their pocketbooks. Your job, as a trader, is to identify what happens next. To do that, I will want you to start thinking about how others feel, because feelings affect actions. People who are generally right tend to do certain things (on balance). People who are generally wrong tend to act differently. The majority will act a certain way, but be warned, the majority are usually wrong at major turning points (although they can be right in the beginning). So, are the majority now long or short cocoa? The shorts are in pain, the longs are not, but then again this can change just as fast as the market's tone changes. Futures It's not that hard to pick up the phone or log onto the Internet and instruct your commodity broker to buy or to sell. It's really not that difficult to learn the math either, or to learn how the money works. The hard part comes later. Yet, some of you will want to start at the beginning and learn the basics. After all, if you haven't been exposed to futures or options before, you have to start somewhere. So we'll start here, it's as good a place as any. Commodities are not only essential to life, they are absolutely necessary for quality of life. Every person in the world eats. Billions of dollars of agricultural products are traded daily on the world's commodity exchanges, everything from soybeans, to rice, to corn and wheat, to beef, pork, cocoa, coffee, sugar and orange juice. This is how commodity exchanges began. In the middle of the 19th century in the United States, businessmen started to organize market forums to make the buying and selling of agricultural commodities easier. Farmers and grain merchants met in central marketplaces to set quality and quantity standards and to establish rules of business. Over 1600 Exchanges sprung up, mostly at major railheads, inland water ports and seaports. Around the early 20th century, communication and transportation became more efficient. This allowed for the building of centralized warehouses in major urban centers such as Chicago. Business became more national and less regional, and many of the smaller Exchanges disappeared. Today, business is global. Approximately 20 major Exchanges remain with 80% of the world's business conducted on about a dozen of them. Just about every major commodity vital to life, commerce and trade is represented. Billions of dollars worth of energy products, from heating oil to gasoline to natural gas are traded every business day. Metals, industrial (copper, aluminum, zinc, lead, palladium, nickel and tin), precious (gold) and some of which are both (platinum & silver). Wood products, textiles--how could we live without these? Yet, few of us are aware of how the prices for these vital components of life are set. Plus, today the world's futures exchanges trade financial products essential to the economic function of the world as well as physical commodities. 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. Yet, without the speculator, the system would not work. Anyone can be a speculator, and contrary to popular belief, I do not believe the odds are stacked against the individual. In fact, you the individual have one distinct advantage, and that's flexibility. You can move quickly, like a cat, something a giant corporation cannot do. There are times in which many of the big commercials who hedge on the Exchange literally hand you your profits on a silver platter, since they are there for a different reason. So, let's start by looking at the how the futures contract works: Futures markets are in their most basic form, 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. The basic unit of exchange in the futures markets is the futures contract. Each contract is for a set quantity of some commodity or financial asset, and can only be traded in multiples of that amount. A futures contract is a legally binding agreement providing for the delivery of various commodities or financial entities at a specific date in the future. Before I was in the business, I used to have a vision of the parties involved sitting down at a table and actually signing contracts. It's nothing like that. When you buy or sell a futures contract, you are not actually signing a written piece of paper drawn up by a lawyer; you are entering into a contractual obligation which can be met in one of two ways. The first is by making or taking delivery of the actual commodity. This is the exception, not the rule however, as less than 2% of all futures contracts are met by actual delivery. The other way to meet your obligation, the method you most likely will use, is by 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. This can be easily done because futures contracts are standardized. Every contract on a particular Exchange for a specific commodity is identical. 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 5000 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 5000 troy ounces of 99.99% pure silver in ingot form. The rules state 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 determine how much you will make or lose on a particular price movement of a specific commodity, you will need to know the following: the contract size, how the price is quoted, the minimum price fluctuation, and the value of the minimum price fluctuation. The contract size is standardized. The minimum unit tradable is one contract. For example, a coffee contract is for 37,500 pounds, a corn contract is for 5000 bushels, a Euro contract calls for delivery of 125,000 Euros. The contract size determines the value of a move in price. Options on Futures Options have been touted as 'the best of both worlds'. 'UNLIMITED profit potential with TOTALLY LIMITED risk', the radio ads shout. Sounds wonderful, doesn't it? Why would anyone trade anything else? The reality is, as in every other financial instrument, there are advantages to trading options, but there certainly is no free lunch. There are probably more ways to lose money when trading options than with any other financial instrument. You give something up for the limited risk feature, but it just may be worth it to you to give this something up. Then again it may not. I know traders who trade only options and wouldn't think of touching futures. Many do quite well. I know others who tell me options have never worked for them; they despise the added costs. Like anything else in the speculative world, options require good judgment, a sound game plan, and a bit of luck wouldn't hurt either. Definition: An option gives the buyer the right, but NO obligation, to buy or sell a stated quantity of a commodity at a specified price on or before a specific date in the future. Options are often compared to insurance. When you buy insurance, let's say house insurance, you pay a premium for certain rights. These rights are yours, but there are limits to the payoff according to the policy. This analogy works to some extent for a hedger [to be discussed later], but there are major differences when speculating. For one, the option buyer theoretically has no limit to his profit potential. Insurance policies have a stated limit. Insurance is not transferable between parties, and is usually specific to a person or property. Options are standardized and can be sold in the marketplace, most cases. Actually, while we plan to spend some time here discussing options, how they operate and the jargon of the trade, they are actually quite simple. There are just two types, and the features are fairly straightforward. They offer the speculator and the hedger ammo, which should be considered for any arsenal. The cost of an option is also called the premium. The premium is a one-time cost and the maximum exposure the buyer has. No matter how far prices of the underlying asset rise or fall, the option buyer knows what his maximum exposure is and therefore, what his maximum risk will be. Yet, the profit potential is not fixed. Just as in futures, the profits are only limited by how far the market moves in the stated time period. Options are now available for just about every futures market, from orange juice [an old adage says "never sell call options during freeze season"], to pork bellies, to gold, copper, heating oil, Eurodollars--you name it. The more liquid and active futures markets, you guessed it, generally have the most liquid option markets. Just like futures, options trade in designated contract months. Check the expiration dates, since in many cases the options expire in the month preceding the futures they correspond to. March grain options expire the 3rd Friday of February, for example. For cash settled futures contracts, such as the S&P 500 and Feeder Cattle, the options and futures expire the same day. You may have heard the term "triple witching hour" which refers to the simultaneous expiration of futures, stocks options and futures options the 3rd Friday of March, June, September, and December. All this activity is supposed to cause wild and crazy fluctuations, but in many cases this has been a non-event in my experience. In many of the active markets, there are options traded every month of the year. For currencies, as an example, the January, February, and March options are based on the March contract. There are also weekly and bi-weekly options during each month for currencies. Consult the Exchange tables or call us for the specifics on option months and expiration dates by market. An option for what? Options can be converted into the underlying futures contract at the discretion of the buyer, this is the right to exercise. This is why the size of every option is the same as the contract it represents. By exercising an option, the buyer receives either a long or short position at the option's strike price. An owner of a call option who exercises his option receives a long futures position. An exercise of a put receives a short futures position. Two types of options: Calls and Puts Call options are bought by bullish traders. A call option gives the buyer the right, but no obligation, to purchase the underlying asset at an agreed upon price (known as the strike price) within a specified time. Put options are the mirror image of the calls. A put option gives the buyer the right, but no obligation, to sell the underlying asset at an agreed upon price (the strike price) within a specified time. They are bought by bearish traders who anticipate a weaker market. What is the underlying asset? It is, for Exchange traded options, the corresponding futures contract. Call buyers have the right to exercise into a long futures position and put buyers into a short at the corresponding strike price. The Broker Margin may not be a true cost (you get back your margin deposit at the end of the trade, plus any profits, or minus any losses), but commissions are. Unlike stock transactions, most commodity brokers charge on the round turn. This is your broker's fee for his or her services. Commissions range across the board and by broker. There are two major types of 'commission firms', the discounter and full service. Commissions, while important, should not be your main consideration when choosing a broker. Low commissions do not mean the best service. I am not trying to say there isn't a place for discount brokers. If you are relatively sophisticated, know exactly what you want to do in the marketplace, do not require advice or additional services, only need basic order execution, then you should certainly consider using our discounted self-directed online services. However, you need to evaluate what you're receiving. With some firms, discount commissions =cheaper service. All firms use brokers on the floor to execute trades. Some use company brokers, but most use independent members of the Exchange who fill 'paper' or public orders. Not all independents are created equal. Bigger firms, with larger orders, can tend to attract the bigger (and better) floor brokers. This is because the floor brokers are paid a small fee per contract executed (the floor brokers, unlike the off-the-floor brokers, are paid on both the buy and the sell). If a floor broker can be a bit louder, a bit more aggressive, or is known to hold a large 'deck' of orders, he will tend to do a better job than the novice or floor broker with a small deck. The better floor brokers attract the bigger decks. At our firm, we pay some floor brokers who do an outstanding job, an additional or higher fee per contract executed. This fee is NOT passed on to our clients. We do this because an exceptional floor broker can often times buy the bid or sell the offer, which equals a better price fill. This means money in our customer's pocket and is more important than a low commission. Bottom line, whichever broker you ultimately choose you must evaluate how timely and accurate your price fills are. You also will need to see how fast your broker can get back to you with price fills. Additionally, you need to evaluate how much help your broker is providing you with, and how much help you require. A knowledgeable full service broker who can provide you with profitable recommendations is worth many times the commissions charged. Just as important, is your broker helping you to control your risks properly on the bad trades. Is he helping you to avoid the classic mistakes, such as overtrading? These are factors you will need to evaluate. A brokerage relationship is very personal so remember "who you trade with can mean the difference between profit and loss". One last thought about commissions; when talking about commodity futures, the fee per contract traded is generally quite low when compared with other types of investments. It can be one half of a percentage point of the total account value. It is a higher percentage when compared to the margin deposit, but still quite small. The other side of the coin is futures traders are much more active than more traditional investors, and total commission costs for an active trader can run up substantially over time. One last thought about brokers. There are brokers who do both securities (stock) and commodities business. I'm sure there must be some of these dual types who excel at both, but I've not met one. Many of our clients who previously had troubles in commodities seem to have come to us from a broker, in many cases from a major "wire house", who was one of these "Jack of all trades". Commodity trading is a full time business, very intense, and you should go with a specialist. The Exchange The first level of regulation is the exchange. The exchange does not take positions in the market, instead it has the responsibility to ensure that the market is fair and orderly. It does this by setting and enforcing rules regarding margin deposits, trading procedures, delivery procedures, and membership qualifications. Members who violate the rules can be fined and/or expelled. A sophisticated, intricate system of safeguards virtually guarantees against counter party credit risk and default. An individual member may default, but the party on the other side of the transaction has always been paid. This statement cannot be made of over-the-counter or non-exchange markets. Each exchange is composed of non-clearing members and clearing members. All members need to meet business integrity and financial solvency standards, and all members can trade on the exchange, but the standards are higher for clearing members. Each clearing member (there are over 60 on the NYMEX alone) must show a minimum working capital of $2 million plus own two seats on the exchange. They must also deposit 10 percent of the firm's capital (up to $2 million) into the guarantee fund, which is $160 million for the NYMEX alone. Yet, even if one clearing member goes under, and the guarantee fund cannot cover it (has never happened), every clearing member has agreed to cover a loss on a prorated basis. The clearing members represent some of the largest firms in the world, from Merrill Lynch to Citibank to Exxon/Mobil. As a result, the financial strength of the exchange is based on the combined financial capability of all its clearing members. The main job of the exchange is to guarantee each trade. Each player in the marketplace, whether he be a farmer in Des Moines or an automobile manufacturer in Stuttgart, must deal through a clearing member. Each participant must post a good-faith deposit (margin). If a doctor in Los Angeles buys ten gold contracts, he is required to have on account, or to quickly send in to his broker, the margin money required. His broker is either a clearing member or dealing through one. Whether he sends the money or not, the clearing member is still obligated to post this margin money at the exchange. The seller of the ten gold contracts, whoever that is (it could be a mine which is hedging, or another speculator who believes prices will fall), is also required to post the margin and so is his clearing firm. The exchange must know that participants have sufficient funds to handle losses they could potentially experience in the markets. While a trade may be conducted between two parties on the floor, it is ultimately the exchange's responsibility to act as the seller to every buyer and the buyer to every seller. The existence of the exchange provides assurances to participants of the marketplace. Market participants can enter into contracts with the utmost confidence that, whatever the outcome may be, they can be sure that their final position will be honored. ^ Back to Top All material presented here was reprinted with permission from Commodity Futures & Options; A Step by Step Guide to Successful Trading by George Kleinman -- Financial Times. |
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COMMODITY & FINANCIAL FUTURES AND OPTIONS; OUR ONLY BUSINESS SINCE 1983. COMMODITY RESOURCE IS A MEMBER OF THE NATIONAL FUTURES ASSOCIATION (NFA) AND REGULATED BY THE COMMODITY FUTURES TRADING COMMISSION (CFTC). CLIENT FUNDS ARE HELD ON THE BOOKS OF R.J. O'BRIEN (EST. 1914). R.J. O'BRIEN IS THE LARGEST, FULLY DIVERSIFIED, INDEPENDENT FCM IN THE INDUSTRY AND A MEMBER OF ALL MAJOR COMMODITY AND FUTURES EXCHANGES. FUTURES TRADING CAN INVOLVE SIGNIFICANT RISK OF LOSS AND IS NOT APPROPRIATE FOR ALL INVESTORS. PAST PERFORMANCE IS NOT INDICATIVE OF FUTURE RESULTS. © 2003-2010 Commodity Resource Corp. | Privacy Policy |
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