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HEDGERS AND SPECULATORS
There are two basic categories of futures participants: hedgers and speculators.
In general, hedgers use futures for protection against adverse future price movements in the underlying cash commodity. The rationale of hedging is based upon the demonstrated tendency of cash prices and futures values to move in tandem.
Hedgers are very often businesses, or individuals, who at one point or another deal in the underlying cash commodity. Take, for instance, a major food processor who cans corn. If corn prices go up. he must pay the farmer or corn dealer more. For protection against higher corn prices, the processor can "hedge" his risk exposure by buying enough corn futures contracts to cover the amount of corn he expects to buy. Since cash and futures prices do tend to move in tandem, the futures position will profit if corn prices rise enough to offset cash corn losses.
Speculators are the second major group of futures players. These participants include independent floor traders and investors. Independent floor traders, also called "locals", trade for their own accounts. Floor brokers handle trades for their personal clients or brokerage firms.
For speculators, futures have important advantages over other investments:
If the trader's judgment is good. he can make more money in the futures market faster because futures prices tend, on average, to change more quickly than real estate or stock prices, for example. On the other hand, bad trading judgment in futures markets can cause greater losses than might be the case with other investments.
Futures are highly leveraged investments. The trader puts up a small fraction of the value of the underlying contract (usually 10%-15% and sometimes less) as margin, yet he can ride on the full value of the contract as it moves up and down. The money he puts up is not a down payment on the underlying contract, but a performance bond. The actual value of the contract is only exchanged on those rare occasions when delivery takes place. (Compare this to the stock investor who generally has to put up at least 50% of the value of his stocks.)
Moreover the commodity futures investor is not charged interest on the difference between the margin and the full contract value. In general, futures are harder to trade on inside information. After all, who can have the inside scoop on the weather or the Chairman of the Federal Reserve's next proclamation on the money supply? The open outcry method of trading - as opposed to a specialist system - insures a very public, fair and efficient market.
Commission charges on futures trades are small compared to other investments, and the investor pays them after the position is liquidated.
Most commodity markets are very broad and liquid. Transactions can be completed quickly, lowering the risk of adverse market moves between the time of the decision to trade and the trade's execution.
THE CLEARING HOUSE
Each futures exchange has a clearing association which operates in conjunction with the exchange in a manner similar to a bank clearing house.
Membership in the clearing association is composed exclusively of well-capitalized members of the exchange and corporations or partnerships one of whose officials must be an exchange member Exchange members who do not join the clearing association must clear their trades through a member of the association.
Every clearing-house member must put up fixed original margins and maintain them with the clearing house in the event of adverse price fluctuations. In such instances, the clearing house may call for additional margins throughout the day without waiting for routine end-of-day settlement.
It is worth noting here that parties to a trade who disagree about the information they exchanged in the pit (such as the price, number of contracts or month of the trade) must settle their differences and clear the trade before they are allowed to return to the floor the next morning. Disputes rarely arise, but if they do, exchanges have steps to follow in helping to resolve them.
MARKET ANALYSIS
Keep in mind that futures prices are more volatile than stock prices. An established company that has enjoyed a long history of solid earnings will probably continue to do so. But a commodity that has trended up during one year, may turn around in the opposite direction the next year - and very quickly, too. For this reason, the commodity trader cannot sit back and relax knowing that his futures contract will bring in smooth returns. He must do his homework. In the futures market that means forecasting using fundamental analysis, technical analysis (charting), or both.
Information Sources for Fundamental Analysis
The fundamental approach to forecasting futures prices involves monitoring demand and supply. Traders gather this information from a number of sources trade organizations, private newsgathering and research firms, and the press. The most complete source of information is the U.S. government through the Departments of Agriculture, Treasury and Commerce and the Federal Reserve Banks.Several brokerage firms issue market letters, which are usually in the form of digests of market information with opinions on future price trends.
Also, a few private advisory services provide commodity market information. They analyze available information from government and other sources, and make their own market and price forecasts.
TECHNICAL ANALYSIS
The cornerstone of technical trading is the belief that fundamental information, political events, natural disasters and psychological factors will quickly show up in some form of price movement. The chartist, therefore, searches for certain formations or patterns which indicate bullish or bearish shifts in fundamentals. If his analysis is correct, he can quickly profit from the changes without necessarily knowing the specific reasons for them.Fundamental traders can also use charting information. Since the market price itself may react before the fundamental information comes to light, chart action can alert the fundamental analyst that something is happening and encourage closer market analysis.
HOW CHARTING WORKS
Bar charts, one of the more popular tools of traders, include information on a particular futures market's price movements, volume and open interest. Such charts are produced daily, weekly and monthly. Studying historical patterns can help to provide a long-term perspective on the market.In addition to studying chart patterns, traders also look at moving averages, oscillators and other devices in ascertaining how bullish or bearish a market may be growing. Computer models are also used to check trend direction.
Charting is not an exact science. Allowances must be made for errors, and unexpected events can disrupt forecasts made on chart patterns. Even so, many market participants - both fundamental and technical traders - find that charting helps them stay on the right side of the market as well as pin down entry and exit points.
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Disclaimer - I am not a commodity trading advisor. The information on this site is for trading education only. There are no trading recommendations for any one individual made on this site and this information is paper trades for trading education. All trades are extemely risky and only risk capital should be used when trading.
U.S. Government Required Disclaimer - Commodity Futures Trading Commission Futures and Options trading has large potential rewards, but also large potential risk. You must be aware of the risks and be willing to accept them in order to invest in the futures and options markets. Don't trade with money you can't afford to lose. This is neither a solicitation nor an offer to Buy/Sell futures or options. No representation is being made that any account will or is likely to achieve profits or losses similar to those discussed on this web site. The past performance of any trading system or methodology is not necessarily indicative of future results.
CFTC RULE 4.41 - HYPOTHETICAL OR SIMULATED PERFORMANCE RESULTS HAVE CERTAIN LIMITATIONS. UNLIKE AN ACTUAL PERFORMANCE RECORD, SIMULATED RESULTS DO NOT REPRESENT ACTUAL TRADING. ALSO, SINCE THE TRADES HAVE NOT BEEN EXECUTED, THE RESULTS MAY HAVE UNDER-OR-OVER COMPENSATED FOR THE IMPACT, IF ANY, OF CERTAIN MARKET FACTORS, SUCH AS LACK OF LIQUIDITY. SIMULATED TRADING PROGRAMS IN GENERAL ARE ALSO SUBJECT TO THE FACT THAT THEY ARE DESIGNED WITH THE BENEFIT OF HINDSIGHT. NO REPRESENTATION IS BEING MADE THAT ANY ACCOUNT WILL OR IS LIKELY TO ACHIEVE PROFIT OR LOSSES SIMILAR TO THOSE SHOWN.