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Monday, November 5, 2007

Ok, so what ARE Futures??!

Futures? Ok, I still haven't answered that question. We got through Commodities, but what are 'Futures'?

First of all, when you deal with Futures on commodities, you are dealing in contracts. Not shares. That's the first difference. There are no 'shares' of anything when dealing with futures. Only contracts.

Ok, a contract to do what?

You are entering a contract that states you will take delivery of a specific commodity, at a certain time. It is said that you are entering a contract that gives you the right to take delivery of a specific commodity at a certain time. A commodity, say, like Sugar. Or Live Cattle. Or Wheat. Whatever it is that you are trading in. But there are no 'shares' of Sugar #11. There are no 'shares' of Live Cattle. You enter into a contract of Live Cattle, or of Sugar.

In other words, the contract comes 'due' at a specific time. This is the second major difference from stocks. A company's stock can't 'expire'. The company can go out of business. The company can buyback shares. But it can't 'expire'. A Futures contract expires. You put down a small amount of money (your Margin requirement) that states that you are undergoing the obligation to buy or sell a commodity at a specific price to be delivered to you at a specific time. This is why the Futures / Commodity markets are purely speculative vehicles. You cannot 'invest' in sugar. You're speculating for price difference in the Future. Thus, the term, futures contract.

Of course, you have no interest in taking delivery of a commodity. A commodity contract of, say, Sugar #11, means that you'd be placing a margin amount down, to control a Sugar #11 Contract for delivery of 112,000 pounds of Sugar. Are you actually interested in having 112,000 pounds of Sugar delivered to you? Of course not. You want to profit from the trade difference in the price of Sugar, that's all. So you enter and exit your position, usually, within the time span of a few weeks, and exit that position. Wala. Thus we enter the realm of speculation. Thus, it's time to discuss the risks. Which are very, very real.

Generally, one tick on Sugar #11, translates into $11.20 worth of profit. Think about that for one second. One tick = $11.20. You move 10 ticks? You're looking at $112.00. That's pretty fast movement and return. This is because the size of the contract is so large, and therefore valuable. The current margin requirement for one contract is sugar, is $910.00. When you initiate a position, $910 of your account is set aside, so as to control one contract in the market, at the price you buy in at. So let's say you buy the March Contract of Sugar #11, when the market is trading at $9.91. It goes to $10.50. That's how many ticks? 59 right? (10.50 - 9.91). So 59 * 11.20 = $660.00 that you just made, minus commissions. Congratulations. You have discovered the positive power of leverage. Leverage is taking a small amount of money (That $910 of your initial margin), and controlling an extremely valuable commodity like Sugar. If the market goes your way? Great. You're making money. But this sort of margin leverage is a two edged sword. What happens if the market moves against you?

You just used a small amount of money, to control a large asset. If the market moves against you too much, you need more money to control your position, as the market just ate your initial margin. You must maintain at least $850.00 in your account, free and clear. This is called the 'maintenance margin'. What happens if the market moves against you to the point that you are below the $850.00? You will be asked to place another $910.00 in your account. Immediately. This is called a 'Margin Call'.

Now let me let you in on a little secret with Futures on commodities.

You can be locked out of exiting your position.

When a particular market moves so fast, and reach a certain price, it is said to be 'lock limit'. This means that the market is not accepting any more buy or sell orders. This is usually because some piece of news has hit the market, and the market reacts quickly.

So let's say you are in, oh Soybean Meal last July. And you bought. Whoops, Soybean Meal has a down day. A really down day. It hit lock limit last summer (Meaning it moved 200 ticks away from the opening price, or $2000 since 1 tick = $10). You cannot exit your position. You are stuck. And if you do not have enough money in your account to meet your maintenance margin, you will be asked for a Margin Call. You must place this in your account, because the market has moved so fast, that it's locked. Your position cannot be liquidated.

The extremely famous Futures trader Larry Williams tells the story of being stuck in a lock limit situation for days on end. I believe in the end, he lost over $60,000.00. In one trade.

Now, you know why it is that I do not deal with Futures Contracts. Ever. I have 200 million dollars in my Futures Brokerage account, I might think about it. I deal in Futures Options. Big. Big difference. Futures Options do carry their own risk which I will get into a little later. But you can completely avoid those sort of lock-limit situations with a Futures Options. I will discuss this more tomorrow. I suggest anyone following this blog do more research into Futures and Commodities. Learn the very real risks.

Again, tomorrow, I will discuss the advantages of Futures Options.

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This is not an investment or trading recommendation. The losses in trading can be very real, and depending on the investment vehicle, can exceed your initial investment. I am not a licensed trading or investment advisor, or financial planner. But I do have 12 years of experience in trading and investing in these markets. The $500.00 challenge account is run for the education of other traders.

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