Futures used to be called commodities, the irreducible building blocks of the economy. Old-timers used to say that a commodity was something that hurt when you dropped it on your foot—gold, sugar, wheat, crude oil. In recent decades many financial instruments began to trade like commodities—currencies, bonds, stock indexes. The term futures includes traditional commodities along with new financial instruments.
A future is a contract to deliver or accept delivery of a specific quantity of a commodity by a certain date. A futures contract is binding on both buyer and seller. In options the buyer has the right but not an obligation to take delivery. If you buy a call or a put, you can walk away if you like. In futures, you have no such luxury. If the market goes against you, you have to add money to your margin or get out of your trade at a loss. Futures are stricter than options but are priced better for traders.
Buying a stock makes you a part owner of a company. When you buy a futures contract you don’t own anything, but enter into a binding contract for a future purchase of merchandise, be it a carload of wheat or a sheaf of Treasury bonds. The person who sells you that contract assumes the obligation to deliver. The money you pay for a stock goes to the seller, but in futures your margin money stays with the broker as a security, ensuring you’ll accept delivery when your contract comes due. They used to call margin money honest money. While in stocks you pay interest for margin borrowing, in futures you can collect interest on your margin.
Each futures contract has a settlement date, with different dates selling for different prices. Some professionals analyze their differences to predict reversals. Most futures traders do not wait and close out their contracts early, settling profits and losses in cash. Still, the existence of a delivery date forces people to act, providing a useful reality check. A person may sit on a losing stock for ten years, deluding himself it is only a paper loss. In futures, reality, in the form of the settlement date, always intrudes on a daydreamer.
To understand how futures work, let’s compare a futures trade with a cash trade—buying or selling a quantity of a commodity outright. Let’s say it’s February and gold is trading at $400 an ounce. Your analysis indicates it is likely to rise to $420 within weeks. With $40,000 you can buy a 100-ounce gold bar from a dealer. If your analysis is correct, in a few weeks your gold will be worth $42,000. You can sell it and make a $2,000 profit, or 5 percent before commissions—nice. Now let’s see what happens if you trade futures based on the same analysis.
Since it is February, April is the next delivery month for gold. One futures contract covers 100 oz. of gold, with a value of $40,000. The margin on this contract is only $1,000. In other words, you can control $40,000 worth of gold with a $1,000 deposit. If your analysis is correct and gold rallies $20 per oz., you’ll make roughly the same profit as you would have made had you bought 100 oz. of gold for cash—$2,000. Only now your profit is not 5% but 200%, since your margin was $1,000. Futures can really boost your gains!
Most people, once they understand how futures work, are flooded with greed. An amateur with $40,000 calls his broker and tells him to buy 40 contracts! If his analysis is correct and gold rallies to $420, he’ll make $2,000 per contract, or $80,000. He’ll triple his money in a few weeks! If he repeats this just a few times, he’ll be a millionaire before the end of the year! Such dreams of easy money ruin gamblers. What, if anything, do they overlook?
The trouble with markets is that they don’t move in straight lines. Charts are full of false breakouts, false reversals, and flat trading ranges. Gold may well rise from $400/oz. to $420/oz., but it is perfectly capable of dipping to $390 along the way. That $10 dip would have created a $1,000 paper loss for someone who bought 100 oz. of gold for cash. For a futures trader who holds a 100 oz. contract on a $1,000 margin that $10 decline represents a total wipeout. Long before he reaches that sad point, his broker will call and ask for more margin money. If you have committed most of your equity to a trade, you’ll have no reserves and your broker will sell you out.
Gamblers dream of fat profits, margin themselves to the hilt, and get kicked out of the game by the first wiggle that goes against them. Their long-term analysis may be right and gold may rise to its target price, but the beginner is doomed because he commits too much of his equity and has very thin reserves. Futures do not kill traders—poor money management kills traders.
Futures can be very attractive for those who have strong money management skills. They promise high rates of return but demand icecold discipline. When you first approach trading, you are better off with slower-moving stocks. Once you have matured as a trader, take a look at futures. They may be right for you if you’re very disciplined.
WHERE DO I GO FROM HERE? Winning in the Futures Markets by George Angell is the best introductory book for futures traders. (It is highly superior to all his other books.) The Futures Game by Teweles and Jones is a mini-encyclopedia that has educated generations of futures traders (be sure to get the latest edition). Economics of Futures Trading by Thomas A. Hieronymus is probably the most profound book on futures, but it’s long been out of print—try finding a used copy.
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