What Are Futures?
Welcome to the futures market - and relax - it's not as complicated as you might think!
The futures market can provide opportunities that other financial markets simply cannot offer. If you were to write down the perfect investment, it would probably go something like this. I wish I could invest in:
I wish I could invest in:
- A product that would always be in high demand.
- Something that can't be ruined by a greedy CEO and Board of Directors.
- Something that would move enough to make lots of money every day.
- Something where I didn't have to put very much money down but could still make a huge return!
- Something I could buy or sell whenever I wanted - not just 9-5pm!
- Something that would always go up in value.
Yes, we have seen this wish list before, and we have some good news for you and some bad. The bad first. Unfortunately, such an investment does not exist - it's the always going up part that ruins it every time. The good news is that there is an investment that comes pretty close: futures!
The futures market provides unparalleled access to the most basic and in-demand products in the world. Among the many investment opportunities in the futures market are commodities such as gold, oil, wheat, and orange juice (these are the kinds of products that are always in demand!). It also includes currencies such as the US Dollar, British Pound, and Japanese Yen (also high demand!). It also includes financial market indexes such as the Dow Jones Industrial Average, Nasdaq Composite, and the S&P 500 (again high demand!).
When you trade the stock market, you have a lot to consider in terms of who is running a company, what the company offers, whether the product or service has longevity, how the company performs in different economic cycles, etc.
In the futures market, you deal with the world's most basic and fundamental products. Rather than worrying about who is running a particular aluminum company or whether they will be in business next year, you can just buy aluminum - with a level of comfort knowing there is always a market and use for aluminum.
Every day, banks deposit and lend money to customers. Instead of finding a bank with a strong fundamental balance sheet and solid management, why not invest in the product a bank makes its living from - currency. As you may be aware from recent world events, the values of currencies are constantly fluctuating, creating the opportunity to make money from the ever-changing value of money.
When it comes to success, mutual fund managers have one major challenge in life - to provide a better return than the market index. Some are successful, while others fail. Market indexes provide a baseline or fundamental benchmark for performance in the financial world. You could give your money to a money manager and give them a crack at outperforming the markets - or you could just invest in the over 25 different index futures! Chances are good that these indexes will still be ticking when your money manager has come and gone!
In addition to these advantages, futures have many other benefits over other financial instruments, including:
Futures are one of the most efficient investment vehicles in existence. What do we mean? Simply stated, with futures you can make a large investment with a small amount of money. This concept is known as "leverage." Leverage can be a boon to investors on the winning side of the market, as gains can be greater with futures than with other investments (this is how you invest in something that doesn't require a lot of money but still has upside potential). However, leverage can be a double-edged sword, inflicting a lot of pain if you are on the losing side of the trade.
With leverage, a little bit of money goes a long way. This means that excess funds in your account could be used for other purposes, including investing in other assets. Diversification is a good thing when it comes to investing since it helps to average things out! Portfolio diversification is something we will cover in detail later in the course.
Futures are known for their considerable price movement, which is another key benefit. Like leverage, volatility can work for or against you. However, most traders want markets that move - and futures move! Just take a look at where the price of crude oil has gone over the last year, and you'll see what we mean (didn't you want an investment that moves enough to make lots of money every day?).
Most futures markets today trade around the clock. It's easy to get in and out of positions in popular and liquid futures markets, and you can do so at the click of a button, with lightning-fast speed. Futures markets are investor-friendly, and that has helped drive the incredible growth these markets have experienced in recent years.
Not only do investors like futures, the IRS smiles favorably on this market as well. Futures enjoy unique tax treatment not available to the equities market. Generally, securities transactions are taxed as either short-term capital gains, or more favorably as long-term capital gains. Futures transactions, however, are simply lumped together and reported on a single Form 1099 at year-end. Profits are then taxed at the "60/40" rate - 60 percent taxed at the favorable long-term rate and 40 percent taxed at the short-term rate. We're not tax advisors, so please consult your tax specialist about your individual circumstances.
In the futures market, supply and demand form the basis of price direction - not quarterly earnings, corporate filings or management changes. Instead, the data that moves futures markets often comes from government reports that are found in the public domain. For example, the U.S. Department of Agriculture estimates crop sizes and international demand for wheat, corn and soybeans. The economy also plays an important role in futures pricing, and most economic reports are also public domain and come from central banks and various government agencies.
Not a Whole New World
Unfortunately, many people have never heard of futures trading or, worse, they have heard of futures and the stories have not been pretty. Put the horror stories aside for a moment and consider this: every time you invest you assume some level of risk. Futures are no exception. You can and many people do lose money investing in futures. However, just like any risky venture, there are steps you can take to minimize your risk.
First and foremost, if you have ever traded stocks or options, you'll want to keep in mind what you have learned related to risk, portfolio management, discipline and emotional control. In fact, many of the concepts and knowledge you have gained trading stocks and options will translate nicely to futures. Concepts such as long and short, order types, margin, etc. all have similarities to futures trading.
Another similarity between equities and futures trading is the fundamental objective. When buying stocks or options, your objective is to buy when prices are low and sell when prices are high. This is the same objective in the futures market. There are some twists in "how" to buy low and sell high, but the objective is the same (the twists will be explained in greater detail in Module 3).
Futures traders are also able to build on the skills they have learned trading stocks and options. Concepts such as discipline, trading plan, psychology, etc. all play a role in your success as a futures trader.
A review of the characteristics of successful futures traders reveals three common factors that have more influence on their success than any other:
- Financial Resources
The futures market can be risky, but people just like you are able to manage the risk and find success trading futures. How do they do it?
First, they have money. More specifically, they have enough money to stay in the markets long enough to make money. Experienced traders will try to get specific and tell you that you need $10,000 to $30,000 to get started. Rather than giving a specific dollar figure, it is important to understand why futures traders need significant financial resources to be successful.
Most futures traders will experience a drawdown - a streak of losing trades that reduces the capital in one's trading account. Your account must be large enough to withstand the inevitable drawdown. Drawdowns are perfectly correlated to the amount of risk you take on each trade. If you are swinging for the fences, you'll have larger drawdowns. If you are looking for small but consistent profits, you will have smaller drawdowns.
The second characteristic of successful futures traders is their trading plan. Rooted in sound financial principles, your trading plan should be simple to follow, simple to understand and simple to implement. If you were to survey the country's most successful futures traders, you would discover that they all use different strategies; in other words each trader has his or her own unique trading plan. A successful trading plan helps you identify a competitive edge in the markets. You will also notice that each trading plan has its own set of flaws. A successful trader's plan should include detailed instructions to compensate for these shortfalls.
Unfortunately, this type of trading plan is not created overnight. There are ample resources available to help you get started creating a simple trading plan (optionsXpress has a repository of professional lectures, forums, and discussions with ideas that will help you). However, the success of your plan depends on refinement. It is refined with time. It is refined with experience. It is refined with knowledge. When you first delve into the futures market, your trading plan must make accommodations for the acquisition of experience and knowledge over time. Time is needed to get over the learning curve. Experience is needed to learn the intricacies of the futures market. Knowledge is needed to understand the definitions, structure and boundaries of the futures market.
Finally, if you don't have the discipline to manage your trades according to plan, you won't last very long in the futures market. They say that pride precedes the fall and nowhere is that more true than in the futures market. Your trading plan helps you keep your trading objective. When you fail to use discipline, your trading becomes subjective without rhyme or reason. It will be difficult for you to improve your trading success if every decision you make is according to your whims, passion and emotion. Historically, people who experience large drawdowns in futures do so because of feelings, opinions and not admitting or believing they might be wrong.
Disciplined traders are aware of the following emotional pitfalls and seek to avoid them:
- Trading for the thrill of it
- Trading to make back lost money
- Lack of money management
- Lack of a defined trading plan
- Inability to admit mistakes
Your success in the futures markets has as much to do with your financial, intellectual and emotional preparation as it does with your execution. This course will help you prepare to trade futures, but you will also need to work on preparing yourself in these other ways as well.
The Investor Life Cycle
For many of the reasons we have already mentioned, over time, traders naturally gravitate to the futures market. In fact there is a growth cycle most investors go through as they develop knowledge and understanding of the financial markets.
First investors look toward mutual funds to provide growth and financial independence. For the daring few who choose to progress beyond the mutual funds, they seek the financial returns of the stock market. Traders will generally cut their teeth in this exciting financial market for 2-3 years when they naturally gravitate to the derivatives or options market. Those traders who endure the learning curve of the options market tend find a home in the futures market some 5-7 years into their trading career.
Today, however, investors are trumping the learning curve and short-circuiting the time curve to discover the wonderful opportunities that are available in the futures market much sooner - and for good reason, too.
Today's futures markets have grown beyond the traditional commodities market of yesterday. Today, grains, gold and oil have yielded ground to a broader range of instruments including stocks, indexes, currencies and even carbon emissions futures! Today's futures markets have grown beyond the boundaries of American borders to include a global financial market; futures trading in England, Germany, Japan and Australia has exploded as new global trading networks have evolved.
But what does this mean for you? Traditionally, the futures market was for that elite class of traders with RISK tattooed across the bicep. To set your stress at ease, today's futures trading has made huge strides away from that stigma. Today, new products are being released with variable definitions, sizes, multipliers, etc. You can purchase "mini" futures that reduce your exposure to risk and make investing more palatable.