Thus far in Chapter 1 we have touched base on a number of critical topics as it pertains to a trading career. Now we need to get into some details, so you can understand what you are trading and why.
A commodity futures contract is a bet on a future event. Commodity futures exchanges were originally formed for economic reasons. They enabled Consumers and Producers to enter into a contract to deliver and receive a specific amount of a commodity on a specified date in the future, but at a price that is agreed today. This helped to mitigate business volatility by locking in price on both sides.
If you know you can sell widgets (Or Fidgets? - Man, where the hell did those things come from? - like a swarm of locust they descended upon the youth and their unsuspecting parents) for $10 per unit, and you see your main input cost is trading at $5 a unit, you can lock in that price by entering into a Futures Contract and guarantee your profit of $5.
As the need of the consumer and producer are rarely in line from a timing perspective, this is where the speculator came in - they helped provide the liquidity by acting as buyer and seller, hoping to close their position with a profit.
So that's why Commodity Markets came into being, but what they are today is basically one big casino. You still have Business activity and hedging taking place, but the market is dominated now by speculators trying to better their opponent and earn their winnings. The amount of volume of trading taking place far exceeds the annual business activity in most of these markets.
While there are multiple Exchanges you will hear about like the COMEX, ICE, NYMEX, NYBOT and others, pretty much everything is electronic these days. As far as you are concerned you will never see a trading pit, and you will never take delivery of the underlying commodity. You will be in front of your computer screen buying and selling, just as you would a stock, or just as you would something on EBAY for that matter.
Each contract has fixed specifications that details what you are trading, the months you can trade it, the day you have to close or roll your position, the minimum permitted move, and dollar amount associated with the minimum move.
Lets discuss this in more detail, by looking at the specifications on a Gold Contract.
When you trade a Gold contract the contract size is 100 Troy Ounces. So when you by 1 Futures Contract on Gold, you are buying 100 ounces of Gold.
The months traded are Feb,Apr,June,Aug,Oct, Dec. Each one of these Months is a separate contract that you can trade, and each month will be priced differently. The differences in price between the months will be driven primarily by factors such as:
1) Storage Costs - If it is January, but you want to buy Gold for September, it costs money to store your gold for 9 months - So you'd expect Sep Gold to trade at a premium to Feb gold which is only 1 month of storage. When future months are priced higher than current months this is referred to as "Contango"
2) Seasonality, which is expected Supply and Demand for a given commodity during certain months. For example, Gasoline is more expensive during the summer peak driving season, and then drops off in the fall.
3) Some unexpected supply or demand shock which would cause closer months to be priced much higher than later months as the underlying commodity is in high demand/low supply today. When current month Futures are more expensive than back months this condition is referred to as "Backwardation"
Each Futures contract has a expiration date and first notice date. This is where things are slightly confusing because your broker will force you to close out your position a few days prior to first notice. First Notice is posted prior to Last trading day. They do this to ensure that you do not take Physical Delivery of the underlying commodity which most brokers will not permit.
It is important to understand this because if you do not exit your position prior to the specified date your broker provides, they will "force" liquidate your position for you - whether you like it or not, you are out. They will provide a warning that says something to the effect of "It's been detected you have a position approaching first notice. Exit or roll your position or you will be liquidated per policy"
The point here is that you don't want to be riding high on a money making position, not paying attention to the 1st notice date, to have the broker sell you out when you are away from your screen.
For example, the following could happen:
You come back to your desk & see that Gold just popped $20 higher on the Chinese Inflation number and you are already counting your cash... "Nice dinner, new watch for my girl... couple lap dances...this is gonna be a great weekend!"
When you go to your balances screen because you want to see how close the actual P&L was to the one you calculated in your head, you don't see your position anymore - WTF?!?! You then see the "alert" on your screen, notifying you that you were liquidated. So pay careful attention to first notice, and make sure you close, or roll into the next month if you want to keep that position, no later than 1 calendar week prior to first notice. This will ensure you avoid any forced liquidation errors.
When you deposit funds into your broker account this is your available funds to buy Futures. Think of it as your chip stack in a Poker Game. Each Future contract will require a initial margin amount and then a maintenance margin amount to hold the position over night. So for example, initial margin may be 6% of the contract value, but maintenance margin is 5% of contract value.
So specifically regarding Gold, we already know that 1 Contract = 100 ounces of Gold. If Gold is trading at $1,200 an ounce, the value of the contract is $120,000. To buy $120k of gold you deposit 6% or $7,200 with your broker. To hold the position you are required to have a account value of at least $6,000. If it drops below that you theoretically add more cash or your position is liquidated. I say theoretically because you will never be placing bets in a way that you would ever require a margin call. We will discuss this in detail later on.
Each Future has a specified trading increment or commonly referred to as "Tick". For gold the "tick" is 10 cent increments being equal to $10. So every time Gold moves up or down 10 cents you make or lose $10. Simple enough.
I hope when you read that Margin paragraph above that you either felt a chill run down your spine, or a tingling running up your leg! I just told you that you can buy $120k of Gold for a paltry $7,200 bucks.. Wowww.. If I buy 1 Gold contract and it pops up $30, I just banked $30*$100 or 3 Gs. (remember min increments is .10 = $10, so $1 move therefore = $100 in profit/loss)
Or another way to say this is.. Wowww.. If I buy 1 Gold contract and it falls $30, I just lost 3 Gs.. Holy Shit!! 🙁
Leverage of this caliber is Fuel in a Rocket - It can either propel you to outerspace..
"Yippeee.. I'm going to the moon!"
Or it can blow you out of the sky...
Failure to Launch...
wasn't that a chick flick starring Sara Jessica Parker, or maybe a marketing slogan for Viagra?
- Some sexy chick laying on the bed (next to former presidential candidate Bob Dole) wearing a loose sundress, speaking seductively in a British accent.."Don't let your failure to launch cause your woman to run to a real man who has rocket fuel in his pants..Try Viagra."
Zero Sum Game
The major difference between a Futures Market and the Stock Market is that in the Futures game each contract represents 1 buyer & 1 seller. So for every move in that market, somebody is getting richer, and someone else poorer by the exact same amount.
Traders are battling to try to take a bite out of each others chip stack.
In the stock market each issue has a specified number of outstanding share as determined by the board of directors which are sold to investors or traders. When the stock goes up everyone on the boat is going for the ride. When the stock goes down, your ship is headed over the falls with everyone in it. You do have short sellers in equity markets but they have to borrow the shares from a owner in order to sell them, and then capitalize on a downfall. In futures, each time you open a "Buy" position, somebody else is taking the other side of that, opening a "Sell".
Just like betting on a Football game - "Oh.. you like the Giants, well I like the Steelers". "Steelers suck man... you want to bet on the game?".. "Your on! 100 bucks "
The reason the zero sum game is so important to note is because of the psychological aspect of it. Every incremental move is a arm wresting match with one side feeling pain and the other one feeling pleasure. This leads to manic trading activity as the gyrating emotions of pain and pleasure of the participants are exhibited on the price screen. Wild swings back and forth each day or each hour for that matter reflect this chaotic battle.
Always remember that people do stupid things when they are scared..And when someone is losing money, nothing feels scarier. Your fight or flight instincts kick in.. adrenaline running, palms sweating, stomach turning..You gotta do something! - You close out to stop the pain, or maybe you add more to increase the rush.
Usually, either decision is a bad one, which is why this leads us to one of our Golden Rules.
We never make decisions of betting during the heat of the battle.
We have a pre-determined betting plan that is decided upon when we are calmly sitting at our desk on the weekend or during quiet trading hours at night. This will enable you to grab some popcorn and watch the manic gamblers push prices right into your desired buy zone and then... click.. you calmly execute your play - Knowing exactly your risk on the bet, as well as a good idea of where you will cash in some chips. This is the behavior of a Pro. This is how you will behave in the Marketplace.
Bid / Offer
To make a market in anything, you must have a buyer and a seller. The buyer will "Bid" or want to buy at a certain price, while the seller will "Offer" or want to sell at a certain price. In the Futures markets this is changing constantly & rapidly, as 1,000s of gambling fiends are getting excited, scared, angry, bored, happy or sad, and then they are expressing those emotions by hitting the buy and sell buttons on their keyboard (or a robot does it for them by script). These orders make their way to the electronic market place and this causes the Price of the Future, as well as Bid and Offer to Jump Around.
Market Makers are there to provide liquidity so they will always be there willing to buy or sell, but you are going to get the short end of the stick on price execution in exchange for them providing that service to you. This means that when you buy you pay the seller's price (or close to it) and when you sell, you will get the buyers' price. So you will lose on the Bid/Offer spread every time - Just accept that it's part of the cost of doing business. No different then a Poker game at the casino where they take a small rake from each pot.
Volume & Open Interest
Volume tells you how many contracts traded that day. This data is notoriously slow in being reported by the exchanges, so typically each day is not the exact volume. What is more important is that you get an idea of the average volume traded each day. You only want to trade in the contracts that are active and where there is liquidity. Without this, you may find that you have a winning position, or worse a losing one, that you can't get out of. Focus on trading in only the most Liquid markets and contracts.
Open interest tells you how many open Futures bets there are - Simple as that.
Which Broker you use is one of the most critical questions you need to research and answer for yourself. When you open a Stock Market account they have something called SIPC insurance - If for some reason the broker goes under, your acct, up to something like $250k in cash is insured.
There is no such insurance with a commodity broker or Futures Commission Merchant (FCM). You are trusting them with your cash. You trust that they will keep your cash in a separate custodial account which they are required to do by law. You trust they wont blow them selves up, and you with them, by placing too many risky bets that they can't cover.
You therefore don't want to go with a small unknown broker - Don't take a chance. Go with a company that has been around, is publicly traded with a stable share price, and stable revenues and earnings. You want a company where Employees and executives have a vested ownership in the firm - If they are watching out for their own ass, then yours will be covered as well.
Some companies that meet these requirements are Interactive Brokers, TD Ameritrade and Charles Schwab. We have used them for years, including through flash crashes, crisis, and outright Fraud. They clear for major hedge funds as well as retail and have billions in equity capital. We have never had a issue, view them to be safe and secure companies as does the S+P rating agency. Of course, you perform your own due diligence and make your own decision, as it is your money on the line here.
For beginners and intermediate traders we recommend TD or Schwab. They allow you to open an account and virtual trade for 3 months prior to funding. Even when you do fund, you can simply stick another hundred dollars in there to keep the account active and continue to Virtual Trade while you learn.
As a side note, if you have a decent enough chip stack, you should have multiple brokerage accounts funded so that you spread your chips around in case the unthinkable happens.
Internet Search PFG Best & MF Global. And then understand why 3ptCapital sends a big Fuck You to those two scumbags wherever they may be tonight.
In the Alchymist Platform we have a detailed Specs tab that will provide you a lot of the specific details for each contract. We don't provide Margin requirements because each broker is different, and those amounts are subject to change - so you will need to stay on top of this as well as First Notice Day when you start trading.
As you continue to make your way through this material, and start following the markets, these rules will become second hand to you, just like the rules in any other betting game.
In conclusion I'd like to quickly summarize this lesson:
Trading Futures is a zero sum betting game against another opponent. The inherent Leverage is so enormous that it permits you to make amazing returns on capital if only you don't blow yourself up first.