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Futures Trading Introduction - Part 3


Futures Contracts for Beginners
Futures Trading Alternatives
Smaller Futures Contracts
Spread Betting
Options Trading


Futures Contracts for Beginners

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 soybeans.

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.

Click Here for more Trading Tips.


Futures Trading Alternatives

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?


Smaller Futures Contracts

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 lot less.

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

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 doesn’t 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 298/302.

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 brokerage’s 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 the USA.

Also, any profits you make from a spread-bet will be free from capital gains tax.


Options Trading

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.


Summary

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.


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Disclaimer: There is risk of loss trading futures.
The information presented in this site is for informational purposes only. Investment in futures involves a high degree of risk, your investment may fall as well as rise, you may lose all your original investment and you may also have to pay more on the original amount invested. Consult your broker or advisor prior to making any investment decisions. Past or simulated performance is not a guide to future performance. Copyright 1999-2016 Futures-Investor.co.uk. All rights reserved.
Futures-Investor, Old Mill House, Rockfield, Monmouth, NP25 5QE. Tel: +44 (0) 1600 715 039 Email philriou@futures-investor.co.uk