How do you select a commodity for your foray into futures? Some people act on a hunch. For example, they reason that colder weather in South America means the price of coffee should rise as demand surpasses supply. Others decide that futures trading sounds like an exciting and easy way to earn some fast profits.
Experts suggest, however, using either fundamental or technical analysis--or a combination of the two--to assess futures opportunities. Fundamental analysis, like that of the stock market, is based on an understanding of the macroeconomic and microeconomic reasons behind price fluctuations. Technical analysis deals only with price fluctuations, using current charts of price movements to project where prices are likely to go.
Both neophytes and some professionals wrongly assume that the high levels of risk associated with futures trading are due to the market's volatility. Not so, says Stanley Dash, a commodities trading advisor and an instructor at the New York Institute of Finance in New York City. "If you measure price volatility, the futures markets are no more or less volatile than the equity markets," says Dash. "The big difference is leverage. The leverage available in futures is roughly 10 times that of equities, even if you trade on margin. Therein lies the risk--and the opportunity."
Leverage is the relationship between what an investment costs and the amount of capital it takes to control it. If you buy a contract worth $1,000 for $5,000, your leverage is 2:1. Stock traders who trade on margin use this degree of leverage. Futures traders can use much higher levels of leverage, sometimes as high as 20:1. The greater the leverage, the smaller the price movement needed to provide a profit or incur a loss--which gives futures their reputation as volatile instruments.