Back To The Futures Ups and downs aside, futures investing could help you diversify your portfolio.

Remember the movie "Trading Places"? How about thenews stories detailing the small fortune Hillary Clinton made incattle futures? For most people, these two examples--perhaps alongwith TV footage of traders in the Chicago futures pits screamingand gesturing wildly--are their only exposure to the futuresmarkets.

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

Futures' Past

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

Soon after the founding of the CBOT, so-called "toarrive" contracts came into use. These contracts enabledmerchants and others to contract for "forward" purchasesand sales. Thus, a continuous market was developed for farmers'grain whether storage silos were full or empty. Speculators helpedthe market remain liquid, buying grain when supplies exceededdemand, hoping to make a profit if prices rose. They also soldgrain when buyers needed a firm price, hoping to buy later whenprices had declined. Such actions decreased commodity pricevolatility. These forward contracts were eventually refined intothe futures contracts traded today.

Other types of commodities on which futures are traded includeenergy (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: hedgersand speculators. Futures markets exist primarily for hedging, orthe management of the risks inherent in the ownership ofcommodities. Hedgers may invest in the futures market for manyreasons, including to protect their inventory from pricefluctuations or to cover a carrying charge for inventoriesheld.

Hedgers reason that a loss in one market could mean a profit inanother. A farmer with a silo full of newly harvested corn, forexample, would be considered "long" on the cashcommodity, and he or she might take a futures position againstfuture 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 mightwant to hedge against the possibility that the stock market mayfall by selling a contract on that index in the futures market. Ifyour company does a great deal of business abroad, you might wantto use the futures markets to hedge the fluctuation of thecurrencies of the countries with which you trade.

If the only people who traded futures were hedgers, the marketswould be much smaller and less accessible--which brings us to theother type of futures animal: the speculator. Speculators areattracted to futures markets by the potential to make a profit ifthey can correctly predict the direction of prices on an underlyingcommodity. They provide liquidity in futures markets, butspeculation is just that: taking a high-risk position with theexpress intent of making a profit.

Risky Business

How do you select a commodity for your foray into futures? Somepeople act on a hunch. For example, they reason that colder weatherin South America means the price of coffee should rise as demandsurpasses supply. Others decide that futures trading sounds like anexciting and easy way to earn some fast profits.

Experts suggest, however, using either fundamental or technicalanalysis--or a combination of the two--to assess futuresopportunities. Fundamental analysis, like that of the stock market,is based on an understanding of the macroeconomic and microeconomicreasons behind price fluctuations. Technical analysis deals onlywith price fluctuations, using current charts of price movements toproject where prices are likely to go.

Both neophytes and some professionals wrongly assume that thehigh levels of risk associated with futures trading are due to themarket's volatility. Not so, says Stanley Dash, a commoditiestrading advisor and an instructor at the New York Institute ofFinance in New York City. "If you measure price volatility,the futures markets are no more or less volatile than the equitymarkets," says Dash. "The big difference is leverage. Theleverage available in futures is roughly 10 times that of equities,even if you trade on margin. Therein lies the risk--and theopportunity."

Leverage is the relationship between what an investment costsand the amount of capital it takes to control it. If you buy acontract worth $1,000 for $5,000, your leverage is 2:1. Stocktraders who trade on margin use this degree of leverage. Futurestraders can use much higher levels of leverage, sometimes as highas 20:1. The greater the leverage, the smaller the price movementneeded to provide a profit or incur a loss--which gives futurestheir 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 buyersor sellers of futures contracts must deposit with their brokers toensure contract performance. Minimum margin requirements are set bythe commodity exchange, but individual firms can set them higher.If the price fluctuations of a contract held by a customer resultin a loss, additional margin must be deposited. This is called amargin call. If the price of a contract results in a profit, moneycan be withdrawn.

Before you start trading, take the following precautions:

1. Follow a trading plan. Whether you favor technical orfundamental analysis, or a combination of the two, devise astrategy 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 tradingaccount, you should have at least double the required marginavailable in case you need it to satisfy a margin call or take anadditional position.

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

4. Don't expect your trading profits to pay your livingexpenses.

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

Think you're ready to trade? Pretend you're a pilottaking off, and check that all systems are go before leaving theground:

• Analyze the fundamentals to decide where the best possibilityof profit lies.

• Weigh risk against return, and don't take a big risk for asmall return.

• Timing is everything, so use your technical charts to determineif the time is right to enter the market.

• Have a clear-cut view of the market's trend before youinitiate a long or short position.

• Don't try to anticipate a trend. Wait for one to develop;then take a position.

Futures trading is speculative and risky, and because there isno assurance that it will be profitable, it is not appropriate foreveryone. Only risk or hedge capital should be committed. If youcan't live without it, don't put it in the futuresmarkets.

Lorayne Fiorillo is a financial advisor at PrudentialSecurities 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.

Next Step

• The Chicago Board of Trade offers a variety of educationalmaterials on futures. To request a copy of its publicationscatalog, call (312) 435-3558 or visit http://www.cbot.com

• For information on seminars, independent study books ortraining programs on futures trading, call the New York Instituteof Finance at (212) 859-5000.