Futures Trading Introduction (Part 2)
Why Leverage is
the Biggest Advantage and the Biggest Disadvantage
How to Protect Profits with
Where to Get Market Information
Why Leverage is
the Biggest Advantage and the Biggest Disadvantage
The main advantage and disadvantage in
futures trading is the leverage involved. (You can hold a very large amount of a commodity
for a small deposit so any gains and losses are multiplied.) This is the main difference
between futures trading and, say, speculating with stocks and shares.
For example, you have $3000 to invest. You
could buy $3000 of shares in an Oil Mining Company, buying them outright. Or this $3000
may be sufficient margin (a goodwill "security bond") to buy a couple of Crude
Oil futures contracts worth $30,000.
The price of Crude Oil drops 10%. If this
effects the price of your mining stocks by 10%, you would lose $300 (10% of $3000). But
this 10% fall on the value of your Crude Oil futures contracts would lose $3000 (10% of
$30,000). In other words, all of your initial stake would be lost trading the futures
rather than only 10% of your capital trading the shares.
But, with Stop-Loss Orders you will
always know how much money you are risking in any trade.
A Stop Loss Order is a pre-determined
exiting point which automatically exits your position should the market go against you. In
the above example, you may only decide to risk $1000 on the Crude Oil futures contracts.
You would place a stop loss just under the market price and if the market dropped
slightly, your position would be exited for the $1000 loss.
So Leverage is great if the
market goes in your predicted direction - you could quickly double, treble or quadruple
your initial stake. But if the market goes against you, you could lose a lot of money just
as quickly. All of your initial stake (your margin) could be wiped out in a few days. And
in some cases, you may have to pay more money to your broker if the margin you have put up
is less than the loss of your trade.
How to Protect Profits with Stop-Loss
As mentioned above, losses can accumulate
just as quickly as profits in futures trading. Nearly every successful
trader uses Stop-Loss Orders in his trading to ensure profits are 'locked
in' and losses are minimised.
How do Stop-Losses work?
A stop-loss is usually placed when a trade
is entered, although it can be entered or moved at any time. It is placed slightly below
or above the current market price, depending on whether you are buying or
For example, say Pork Bellies is trading at
$55.00 and you think prices are about to rise. You decide to buy one Pork Bellies
contract, but you don't want to risk more than $800 on the trade. A one-cent move in the
market is worth $4.00 on a pork bellies futures contract so, therefore, you would place
your stop at $53.00 (200 cents away from the current price x $4 per point = $800).
You can also move a stop-loss order to
protect any profits you accumulate.
Taking the Pork Bellies example: Two weeks
later, bellies are now trading at $65.00. You are now up $4000 (1000 cents of movement x
$4). To protect these profits, you can raise your stop-loss simply by calling your broker.
Say you place it at $63.00, you have locked it a profit of at least $3200 and now risk
$800 to your new stop level.
But what if the market went against you?
Going back to the original position when you bought at $55.00 with a stop at $53.00: what
happens if the market suddenly tumbles down to $51.00 during the day? Your trade would
automatically be 'stopped out' at your stop level of $53.00 for an $800 loss. The fact
that the market closed the day at $51.00 is irrelevant as you are now out of the market.
(Had you not used a stop-loss and viewed the market at the end of the day, you would have
large losses on your hands!)
The same would happen if the market reached
$65.00 and you had raised your stop to $63.00: If the market fell from here, say to
$62.80, you would be stopped out at $63.00 and would have a profit of $3200. Even if the
market suddenly reversed here and rose to $79.00, this would be irrelevant as you are now
out of the market.
This last example would be annoying because
if you hadn't been stopped out, you would now be $9600 in profit. But you were stopped out
at your $63.00 stop. The market only went 20-cents under this and reversed!
It is for this reason that some traders
don't use stops: they have been stopped out in the past JUST when the market was about to
go their way.
The solution is not to abandon using stops
as this is EXTREMELY RISKY. The solution is to use stops effectively.
fast moving markets it is sometimes impossible for brokers to get your orders exited
exactly on your stop loss limits. They are legally required to do their best, but if the
price in the trading pit suddenly jumps over your limit, you may be required to settle the
difference. In the above scenario, the price of Pork Bellies could open trading at $62.50,
fifty cents through your stop at $63.00. Your broker would have to exit your trade here
and, in fact, you would lose $1000, $200 more than your anticipated $800.)
to Get Market Information
Commodity prices can change direction much
faster than other investments, such as company stocks. Therefore, it is important for
traders to stay on top of market announcements. Professional traders may use a wide number
of techniques to do this, using fundamental information and technical
Fundamental data may
include government reports of weather, crop sizes, livestock numbers, producers
figures, money supply and interest rates. Other fundamental news that could affect a
commodity might be news of an outbreak of war.
Technical indicators are
mathematical tools used to plot market prices and behaviour patterns on a graph. These can
include trend lines, over-bought and over-sold indicators, moving averages, momentum
indicators, Elliott wave analysis and Gann theory.
Some traders use just one of these basic
methods religiously, disregarding the other completely. Others use a combination of the
Many investors, especially smaller
investors, devise their own trading method or purchase one from another trader. (Be
careful not to buy a system that has been over-optimised and curve-fitted to fit past
data. Many times, I have seen systems claiming 80%+ winning trades on past data, but when
I have run the system on current prices, the results are breakeven at best!)
They normally paper trade
the method (i.e. they follow the markets but only pretend to place the trades) for a few
months to make sure the method works for them before placing any actual trades.
Tracking price charts and keeping up with
fundamental data is a difficult full-time job some large organisations employ
dozens of staff to follow market moves. And some traders, especially those on the market
floor, may only hold a position for a few hours or even minutes.
So where does this leave the small,
independent investor who would like to trade in the lucrative futures markets?
Many trade on a daily or weekly basis, i.e.
they note or 'download' market prices at the end of each trading day and make their
decisions from this data. Often, they will leave a trade on for at least a few weeks
(possibly months). This is a much SAFER way of trading because any fluctuations are ridden
out and less panic-buying or selling is involved.
In the next section,
you will learn:
Futures Contracts for Beginners
Futures Trading Alternatives
Smaller Futures Contracts