Forwards and Futures

A forward is a trade in which the delivery of the currency is set for a specific date in the future. Typical forward contracts are one, two, three, six, or 12 months in length.

Traders sometimes use forwards to take advantage of the difference between interest rates in different countries. If the European Central Bank’s (ECB) interest rate is five percent and the U.S.’s is three percent, a trader might convert his or her dollars into euros to gain the higher return offered by the ECB. At the same time, however, the trader could also buy dollars forward for delivery some time in the future, thus locking in the favorable exchange. When the trader delivers the contract, he has more dollars left over.

Of course, it’s not that easy to make money. The difference in interest rates is factored into most forward contracts by the market. Thus, a forward price may be cheaper or more expensive than the current spot price, depending on interest rates. Continuing with the preceding example, a forward contract for euros would be more expensive because of the superior rate of return available in Europe. This higher price is called a premium. A cheaper price is called a discount.

The value of a forward, therefore, is not calculated by the market’s anticipation of how much one currency is worth compared to another, but rather the difference in the interest rates of both countries.

A currency future, like a forward, is an agreement between a buyer and a seller to trade a currency at a certain price on a specified date in the future. The primary difference between a forward and a future is that a future is traded on a regulated exchange, but a forward is not.

Futures are not new to the markets. They were developed centuries ago to protect businesses from fluctuations in prices by transferring the risk to speculators. Hedgers can be businesses that want to protect themselves from price gyrations in materials they rely on.

For example, a baker might need to buy grain every year at a certain price. He might buy a grain future, thus protecting himself if a storm wipes out most of the crop and makes the price of grain skyrocket.

Speculators are on the other side of the hedge. They hope to make money if the price of the underlying commodity fluctuates in their favor. Using the same example of the baker, let’s say the weather is exceptionally good, the grain crop is huge, and the price falls because there’s so much grain on the market. The baker has already agreed to buy the grain at a higher price, so the speculator makes money on the difference between the two prices.

The baker would rather have the security of knowing that he has access to grain at a certain price instead of waiting to see what the market delivers, good or bad. Speculators, on the other hand, absorb that risk and get a chance to make money. In this sense, speculators play a critically important role in the economy. They provide a kind of insurance to the markets that protects corporations and individuals and encourages stability and innovation.

It makes sense that futures were first offered for currencies in 1972, when currencies were allowed to float against the U.S. dollar. (For a full discussion of those events, see Chapter 3, “The History of Forex (and Why You Should Care).) Transnational corporations were suddenly exposed to swings in currency values that could wreak havoc on their carefully planned business operations and balance sheets.

Futures contracts are typically traded over an exchange (exchange-traded contracts). To buy a future, an individual or corporation posts a small amount of cash as a margin or a bond. The price of futures fluctuates depending on market conditions.

If events cause the market to believe that a currency will rise in value over the next year, a contract that locks in a lower price will be worth more. The difference between the future price and the market price is settled at the end of each business day. This difference is added to (or subtracted from) the margin. Losses on the margin must be replenished, or the market participant’s position is closed.

Currency futures were first offered on the Chicago Mercantile Exchange (CME) in 1972. (Before then, the CME specialized in offering futures for commodities such as grain, pork, and orange juice.) Today, a full range of futures is available at the CME 24 hours a day via the GlobeEx trading platform.

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FUTURES

Futures look dangerous at first—nine out of ten traders go bust in their first year. As you look closer, it becomes clear that the danger is not in futures but in the people who trade them. Futures offer traders some of the best profit opportunities, but the dangers are commensurate with rewards. Futures make it easy for gamblers to shoot themselves in the foot, or higher. A trader with good money management skills needn’t fear futures.

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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Futures Contracts

Investors seeking to take a short position in a stock, a sector of the
stock market, or the overall market are not limited to the cash market.
Instead, investors can employ equity futures and options contracts to
capitalize on their expectations about a decline in value of a stock or
stock index. In this chapter, we describe the basic features of equity
futures and options contracts, their profit and loss profiles, and how
investors can use them to benefit from a decline in value.

FUTURES CONTRACTS
A futures contract is an agreement between a buyer and a seller wherein
(1) the buyer agrees to take delivery of something at a specified price at
the end of a designated period of time and (2) the seller agrees to make
delivery of something at a specified price at the end of a designated period
of time. Of course, no one buys or sells anything when entering into a
futures contract. Rather, the parties to the contract agree to buy or sell a
specific amount of a specific item at a specified future date. When we
speak of the “buyer” or the “seller” of a contract, we are simply adopting
the jargon of the futures market, which refers to parties of the contract in
terms of the future obligation to which they are committing themselves.


The price at which the parties agree to transact in the future is
called the futures price. The designated date at which the parties must
transact is called the settlement date or delivery date. The “something”
that the parties agree to exchange is called the underlying.

To illustrate, suppose there is a futures contract in which the underlying
to be bought or sold is the stock of Company X and the settlement
is three months from now. Assume further that Chuck buys this futures
contract, Donna sells this futures contract, and the price at which they
agree to transact in the future is $100. Then $100 is the futures price.
At the settlement date, Donna will deliver the stock of Company X to
Chuck. Chuck will pay Donna $100, the futures price.

When an investor takes a position in the market by buying a futures
contract (or agreeing to buy at the future date), the investor is said to be
in a long position or to be long futures. If, instead, the investor’s opening
position is the sale of a futures contract (which means the contractual
obligation to sell something in the future), the investor is said to be
in a short position or to be short futures.

The buyer of a futures contract will realize a profit if the futures price
increases; the seller of a futures contract will realize a profit if the futures
price decreases. For example, suppose that one month after Chuck and
Donna take their position in the futures contract, the futures price of the
stock of Company X increases to $120. Chuck, the buyer of the futures
contract, could then sell the futures contract and realize a profit of $20.
Effectively, he has agreed to buy, at the settlement date, the stock of Company
X for $100 and to sell the stock of Company X for $120. Donna,
the seller of the futures contract, will realize a loss of $20.

If the futures price falls to $40 and Donna buys the contract, she
realizes a profit of $60 because she agreed to sell the stock of Company
X for $100 and now can buy it for $40. Chuck would realize a loss of
$60. Thus, if the futures price decreases, the buyer of the futures contract
realizes a loss while the seller of a futures contract realizes a profit.

From this discussion it should be clear that if a futures contract in
which a stock that an investor is interested in shorting is available, then
selling a futures contract can accomplish the same objective as selling
the stock. The advantages of using futures to short rather than shorting
in the cash market will be explained later after we describe the mechanics
of futures trading.
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FOREX OR FUTURES: WHICH IS RIGHT FOR YOU?

The Foreign Exchange (FX) is one of the fastest-growing investment arenas
today. Large institutional investors and hedge funds are big players in the
forex market; and in the past three years, the Foreign Exchange market had
an estimated 50 percent increase in volume. Some had credited this increase
to the large activity created by the online currency trading for the retail
investor. The forex market is an over-the-counter market, which means
that there is no main exchange or clearinghouse. This is contrary to the futures
markets which offer futures trading in “open outcry” and electronic
access; which is transparent pricing through a trading platform. This en-

ables one to see the bids/asks and size, otherwise known as the “depth of
market” (dome).

In this book, we will be looking at the different aspects of trading the
currency markets, including the advantages and disadvantages of trading
the forex market. In addition, you will learn how to use other resources to
make better decisions on when to enter or exit your forex positions. Trading
the forex offers leverage, leverage that the individual controls. Through
the use of margin, an individual investor has the choice to increase or decrease
leverage through various means. Most currency firms offer 100 times
leverage on a regular size account; compare this leverage to the leverage offered
to the average equity investor, and you can see why many traders are
more attracted to trading the forex. As mentioned previously, leverage in
the forex market can also be customized to the individual trader, which
means that a trader can choose to lower or eliminate leverage while trading
foreign currencies.


FOREX VERSUS FUTURES MARKET
The futures market through the International Monetary Market (IMM) of
the Chicago Mercantile Exchange has many benefits as well. Founded in
1898, CME is the leader in the FX futures arena, accounting for 96 percent
of all currency futures contracts traded on a worldwide basis. The Chicago
Mercantile Exchange pioneered this segment by offering the world’s first financial
futures contracts on seven foreign currencies in May 1972. Since
that time, it has continued to expand its reach in FX by introducing new
products, expanding its customer base and leveraging the market leading
technology found in CME Globex®, its proprietary electronic trading platform.

The exchange handles over a billion contracts valued at more than
$638 trillion on an annual basis. It is a public company; and as of August 18,
2006, the stock (CME) was trading at 461.35. Amazing, considering that
when this stock was first released in its initial public offering (IPO) in December
2002, it was trading at under 40 per share! The history of the exchange
and the innovator of the IMM, Leo Melamed, who brought foreign
currency trading to life, is legendary. It has allowed investors, large and
small, to trade foreign currencies exclusively for nearly 25 years before the
explosive growth of spot forex was available. As with any product, there
are strengths and weaknesses. I wish to share with you the facts so you can
determine which investment vehicle suits your taste and trading style.

First, you should know the symbols for the individual futures currencies
as quoted against the U.S. dollar. There are just minor differences between
spot forex and futures symbols.

Note that futures trade in quarterly cycles; and to differentiate between
the various contract months, futures have universal symbols for each of the
different contract months. December is “Z,” March is “H,” June is “M,” and
September is “U.” Here is what you would use with a charting or quote ven-

dor to get a futures contract quote on a June 2007 euro currency—ECM7.

On some quote and charting services, the current year or the next contract
month going forward would be assumed and understood. The quotes symbols
for the different expiration months and various contract sizes of the futures
markets are confusing, but you can quickly learn these variables.

At times, the futures arguably have tighter “spreads” between the bid
and the asking prices; plus there is no interest charge or rollover fee every
other day. In addition, the futures markets offer options for longer-term
traders. There are transactions costs that apply per round turn; but if the
brokerage commission exchange, regulatory, and transaction charges are
less than the PIP spread in forex, an active speculator would be given a better
cost advantage using the futures markets instead of the forex spot market.

For example, let’s compare a trade in forex on a contract value similar
in size to one on the futures exchange. Use the example of a euro futures
contract on the CME with a contract size of USD125,000 worth of euros,
where each tick or PIP would be 12.50 in value. If the commissions and related
fees are $10, which is the average charge by most brokerage firms,
that is your transaction cost per round turn. That is $5 to buy and $5 to sell
out of the position. Keep in mind that the contract value is 25 percent
higher than a full-size forex position, too. If a day trader in forex trading in
a 100,000 full-lot-size contract pays two PIPs on every transaction of a position,
this trader would be charged $20 per round turn transaction. The futures
arena also has other interesting features and products; one is the U.S.
Dollar Index® contract traded on the New York Board of Trade. It is computed
using a trade-weighted geometric average of six currencies. It trades
virtually around the clock; the trading hours are from 7:00 P.M. to 10:00 P.M.,
then from 3:00 A.M. to 8:05 A.M., and then from 8:05 A.M. to 3:00 P.M. Unlike
the forex, there are daily limits on the price movement, with 200 ticks above
and below the prior day’s settlement, except during the last 30 minutes of
any trading session, when no limit applies. Should the price reach the limit
and remain within 100 ticks of the limit for 15 minutes, new limits will be
established 200 ticks above and below the previous price limit. The chart in
shows a breakdown of the six currencies and their respective
weights on the average. The top four include the euro, which is the heaviest
weight with 57.6 percent; then the Japanese yen with 13.6 percent; then
the British pound with 11.9 percent; and the Canadian dollar with 9.1 percent.
The Swedish krona is only 4.2 percent and the Swiss franc 3.6 percent.
Source: FOREX OR FUTURES: WHICH IS RIGHT FOR YOU?

Differences Between Options and Futures

The fundamental difference between futures and options is that the
buyer of an option (the long position) has the right but not the obligation
to enter into a transaction. The option writer is obligated to transact
if the buyer so desires (i.e., exercises the option). In contrast, both
parties are obligated to perform in the case of a futures contract.

In addition, to establish a position, the party who is long futures does not
pay the party who is short futures. In contrast, the party long an option
must make a payment (the option price) to the party who is short the
option in order to establish the position.

The payout structure also differs between a futures contract and an
option contract. The option price represents the cost of eliminating or
modifying the risk/reward relationship of the underlying. In contrast,
the payout for a futures contract is a dollar-for-dollar gain or loss for
the buyer and seller. When the futures price rises, the buyer gains at the
expense of the seller, while the buyer suffers a dollar-for-dollar loss
when the futures price drops.

Thus, futures payouts are symmetrical, while options are skewed.
The maximum loss for the option buyer is the option price. The loss to
the futures buyer is the full value of the contract. The option buyer has
limited downside losses but retains the benefits of an increase in the
value of the underlying. The maximum profit that can be realized by the
option writer is the option price, but there is significant downside exposure.
The losses or gains to the buyer and seller of a futures contract are
completely symmetrical.
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