Futures Trading Introduction - Part 3
Contracts for Beginners
Futures Trading Alternatives
Smaller Futures Contracts
If you have a limited amount of capital to
invest, you probably can't afford to trade the larger contracts like the Nasdaq and
S&P500 as a slight percentage move could be worth thousands of dollars. But there are
still plenty of smaller and less expensive contracts you can trade.
All futures contracts have standardised
amounts of the commodity which are held by them. For example, if you buy a single pork
bellies contract, you are holding the value of 40,000lbs of pork bellies. If
you sell a single soybeans contract you are betting on the value of 5000 bushels of
Each point-move on a particular contract is
worth a specific amount, and these amounts vary between contracts. For example, a 1-cent
move on a Pork Bellies contract is worth $4, so a move in the market from $60.00 to $61.50
would be worth $600 per contract ($4 x 150 cents). In Soybeans, a 1-cent move in the
market is worth $50 so a jump from $500 to $505 is worth $250 ($50 x 5c).
Click Here to
view contract specifications of the major American futures markets.
Some contracts are worth a lot more than
others, especially if they are trading at historically high prices. For
example, at the time of writing, the Nasdaq Index moved up around 10% last month
worth nearly $50,000 per contract! (It is at an all time high, 20 times higher than 10
years ago.) But Wheat dropped around 10% per contract - worth about $1250 per contract.
(It is at its lowest price for years.)
Beginners need to first establish if they
can afford to trade the commodity - if they have enough margin in their account to cover
the trade, and if they can afford a sizeable move against their position. (Some traders
such as Larry Williams and Tom Basso feel that risking approximately 3% to 5% of total
trading capital on a position is about right. Remember too, that these traders are some of
the best in the world - if you are a beginning trader, you should be careful risking that
much!) Your broker will probably give you a list of dollar-per-point ratios for all the
different contracts, as well as their commission and margin requirements.
A trader also needs to establish the risk/reward
of trading on any particular commodity - how much you are risking to your stop loss and
how much you intend to win to your target price. (Alternatively, work out the average loss
and profit made by your trading system to find the expectancy of a trade's profits.)
It is also important for traders to spread
the risk of trading by using different types of commodity. For
example, just because you have enough capital to trade 5 contracts, don't buy five energy
contracts just because they have the largest risk/reward ratio. Instead, spread your risk
by trading some grains, some metal, some energy, some livestock and some currency (if they
are potentially rewarding).
You may also buy or sell more than one
contract on each commodity to keep the risk balanced. For example, a Pork Bellies contract
may be worth a lot more than a Soybeans contract. You may decide to buy two Pork Bellies
contracts and six Soybeans contracts to keep the values held on each market about equal.
None of your trades should risk more than 5%
of your trading capital if possible. (And in "trading capital", I mean
money you can afford to, and are prepared to LOSE!) That way, you would have to lose 20
trades in a row in order to get wiped out.
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Speculating on the commodity markets can
certainly be an excellent form of investment. But it can require a large amount of
capital to speculate effectively on the futures markets. To set up the smallest
futures account normally requires at least $5000, and many brokers require proof that you
can afford to pay any losses greater than the funds in your account. (In case the market
suddenly drops below your stop-loss level.)
Also, even the smallest futures contracts
require at least $1000-$3000 in margin for you to hold them. This means a speculator with
a $5000 account may only be able to trade one or two markets at a time.
Many top traders recommend spreading your risk between several markets at a time. And, as
mentioned above, you should only risk up to 5% of your trading capital on any position.
So if you haven't got $20,000 or $100,000 to
speculate with, what are your options?
Most of the widely traded futures contracts
are large contracts traded on the Chicago Board of Trade, The Chicago
Mercantile Exchange or the New York Mercantile Exchange. But there are also other
exchanges that trade much smaller futures contracts.
For example, the MIDAM exchange
(Mid-America) trades most of the major commodity and currency markets but under smaller
contracts. Typically they hold one-fifth to one-half the amount of the
commodity of the more popular contracts meaning the risks and margin requirements are a
Other exchanges around the world trade
smaller futures contracts of various commodities, such as Brent Crude Oil on the LPE,
London Wheat on LIFFE, and Copper, Aluminium and Tin on the LME.
Spread betting is a relatively new approach
of trading the futures markets. A spread betting company, such as IG Index, Financial
Spreads, or City Index doesnt charge a commission but gets paid on a
spread of the market price. This is usually a couple of points either side of
the actual market price, like an ask/bid spread.
For example, say the March Gold contract is
trading at $300 per ounce. Depending on which way you wanted to trade, you may be quoted
If you were buying you
would enter at $302 two points above the market price.
If you wanted to sell, you
would enter at $298 - two points under the market price.
Both the spreads go against
your market direction. If the value of one point on the contract was $100, in effect you
would be paying a 2 point spread worth $200.
This is quite a lot more expensive than a
normal futures brokerages commission charge and an exchange's ask/bid charge, and it
can be even higher if you place a stop-loss order. (Therefore, spread
betting is more suited to long-term trading and not short-term day trading - high
commissions will take away any profits.)
But the value of a spread betting
contract can be around half that of a real futures contract.
Therefore, the amount of money you need to
put into an account, to bet on a commodity, or the amount you can lose, is about half that
of trading a real contract. You can often put a guaranteed stop loss
order on your bet, too, which avoids the pitfalls of 'gapping' prices. (For example, say
you were long on Gold and your stop-loss was at 290. The market opened well down at 285,
you would be stopped at 290 with your guaranteed stop. Trading a normal futures contract,
your broker would have to stop you out at 285 and you would lose an extra $500.)
FinSpreads.com allow you to start trading
futures from only 1 penny per point. This compares with $250 per point on the S&P500,
so it is an easy way for a small investor to start futures trading. However, spread
betting is only available to UK and some European residents.... and is not available in
Also, any profits you make from a spread-bet
will be free from capital gains tax.
Options trading is available on a number of
investments including futures contracts. Options trading is a complete subject in itself
and can be more complicated that futures trading to understand. But basically, using an
option gives a trader the right to buy or sell a contract at a future
date, but not the obligation.
The trader needs to pay a premium for
this choice which can often work out less expensive than the margin requirements - or the
risk to a stop-loss order - in trading the futures contract. Should the trader not
exercise the option, he would lose the premium he paid for the option. But should he
exercise it, he could make a lot of money.
There is a lot of terminology in options
trading and it can be more complex than the simple 'buy or sell' method of futures
trading. Should you be interested in it, there are plenty of options books available from
my Online Bookstore.
Managed Futures Trading
It has been reported that up to 95% of
investors speculating on futures markets end up losing money (source: Bridge Trader
magazine). The reasons for this could be that many naiive investors become enticed by the
potential huge rewards associated with futures, when they are ill-prepared to compete with
the thousands of professional traders, some with decades of experience, access to the
trading pits, the use of million dollar technology, etc.
The markets can be cruel, and you should be
prepared for the worst.
An alternative is to use the skills of
professional traders who can manage your account to trade the exciting futures markets.
This is known as Managed Futures Trading. A Commodity Trading Advisor (CTA)
can be used to trade a client's funds under Power of Attorney.
Computerized trading systems
can also be used in order to stick rigidly to a trading system.
Yes, you can start trading futures with a
$5000 account - and even less to cover a trade on a spread bet. But you should have a lot
more than this in expendable income.
Speculating with absolute minimum capital is
renowned for its 'have to win' pressure. And this emotion will making trading extremely
difficult. If you lost 2, 3, 4 or even 5 trades in
succession, would you have the courage to be able to place the next trade?
If you have a small trading account this could be wiped out in a small
number of losing trades.
Even one losing trade can do a lot of
damage. For example, if you lose 50% of your trading capital in a few trades, you have to
make 100% return on what is left to get back to even.