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Back To The Futures

Ups and downs aside, futures investing could help you diversify your portfolio.
August 1, 1998
URL: http://www.entrepreneur.com/article/16184

Remember the movie "Trading Places"? How about the news stories detailing the small fortune Hillary Clinton made in cattle futures? For most people, these two examples--perhaps along with TV footage of traders in the Chicago futures pits screaming and gesturing wildly--are their only exposure to the futures markets.

But futures are worth looking into, as they can provide additional diversification in a portfolio comprised solely of stocks and bonds. With stock markets trading at historic highs, investors seeking ways to protect their portfolios or participate in broad market movements sometimes look to the futures markets as additional investment arenas.

Futures' Past

There's a lot more to futures than pork bellies, coffee and frozen orange juice. The trading of futures on various types of commodities has long been part of the economic scene. In 1848, 82 merchants founded the Chicago Board of Trade (CBOT). Prior to this time, there was no organized market in which farmers could sell their products and no commonly accepted weighing, measuring or grading procedures. Supplies of agricultural commodities were either too large or too small, and consumers were at the mercy of merchants, who were themselves subject to the whims of Mother Nature.

Soon after the founding of the CBOT, so-called "to arrive" contracts came into use. These contracts enabled merchants and others to contract for "forward" purchases and sales. Thus, a continuous market was developed for farmers' grain whether storage silos were full or empty. Speculators helped the market remain liquid, buying grain when supplies exceeded demand, hoping to make a profit if prices rose. They also sold grain when buyers needed a firm price, hoping to buy later when prices had declined. Such actions decreased commodity price volatility. These forward contracts were eventually refined into the futures contracts traded today.

Other types of commodities on which futures are traded include energy (crude oil, natural gas, heating oil and unleaded gas), metals (gold, silver, aluminum, platinum, copper and lead), interest rates, stock indices and currencies.

Either a Hedger or a Speculator Be

Futures market participants fall into two categories: hedgers and speculators. Futures markets exist primarily for hedging, or the management of the risks inherent in the ownership of commodities. Hedgers may invest in the futures market for many reasons, including to protect their inventory from price fluctuations or to cover a carrying charge for inventories held.

Hedgers reason that a loss in one market could mean a profit in another. A farmer with a silo full of newly harvested corn, for example, would be considered "long" on the cash commodity, and he or she might take a futures position against future declines in the price of corn. In agricultural commodities, other hedgers include exporters, importers and processors.

Those who hold investments that mirror a specific index might want to hedge against the possibility that the stock market may fall by selling a contract on that index in the futures market. If your company does a great deal of business abroad, you might want to use the futures markets to hedge the fluctuation of the currencies of the countries with which you trade.

If the only people who traded futures were hedgers, the markets would be much smaller and less accessible--which brings us to the other type of futures animal: the speculator. Speculators are attracted to futures markets by the potential to make a profit if they can correctly predict the direction of prices on an underlying commodity. They provide liquidity in futures markets, but speculation is just that: taking a high-risk position with the express intent of making a profit.

Risky Business

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.

Margin for error

To set up a futures account, investors must provide margin. Margin in the futures markets is defined as the money that buyers or sellers of futures contracts must deposit with their brokers to ensure contract performance. Minimum margin requirements are set by the commodity exchange, but individual firms can set them higher. If the price fluctuations of a contract held by a customer result in a loss, additional margin must be deposited. This is called a margin call. If the price of a contract results in a profit, money can be withdrawn.

Before you start trading, take the following precautions:

1. Follow a trading plan. Whether you favor technical or fundamental analysis, or a combination of the two, devise a strategy and stick with it.

2. Don't trade with money you can't afford to lose. While you don't have to keep extra cash in your trading account, you should have at least double the required margin available in case you need it to satisfy a margin call or take an additional position.

3. Don't put all your eggs in one basket. Successful traders minimize their risk by spreading out their trades in several situations over time.

4. Don't expect your trading profits to pay your living expenses.

No matter what your level of expertise, commodity trading can't be reduced to an exact science with predictable results. The idea is to avoid big losses and be right enough of the time to make your trading profitable.

Think you're ready to trade? Pretend you're a pilot taking off, and check that all systems are go before leaving the ground:

Futures trading is speculative and risky, and because there is no assurance that it will be profitable, it is not appropriate for everyone. Only risk or hedge capital should be committed. If you can't live without it, don't put it in the futures markets.

Lorayne Fiorillo is a financial advisor at Prudential Securities Inc. Past performance is no guarantee of future returns. For more information, write to Lorayne in care of Entrepreneur, 2392 Morse Ave., Irvine, CA 92614.

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