The textbook definition of a Futures Contract is a commitment to receive or deliver a fixed quantity of a physical commodity or financial instrument at a specific future date. Each contract has its’ own specifications in regards to: 1) Contract Size 2) Specific months traded 3) The exchange it trades on and hours traded 4) Minimum Price movement 5) Maximum Daily Move, up or down. 6) First Notice or last trading day, in which you will have to close or “roll”(move position to next desired Month) your position.
As you are not a Commercial producer or consumer that intends to receive or deliver the underlying commodity, your broker will force you to liquidate prior to first notice so as not to risk delivery. If you ignore their warning or simply forget, they will close your position for you.
So this is the textbook definition - But what is a Future contract to Speculators of Price Movement?
1) It’s an electronic or “paper” bet on the expected future price direction of our chosen betting vehicle.
2) This bet is for a fixed period of time. So it is not like a stock where you buy it and hold for years as an investment. Rather, you have to continually roll your position or close it, which means you are by nature a short term trader, whereby losses and gains are being tallied on a frequent basis.
3) But Most Importantly, it is an extremely leveraged instrument. Typically, margins required to purchase the contract are only 5-10% of the total contract value, which means you can buy a whole lot of product for very, very little capital outlay. I refer to it as Explosive Leverage.
It is this leverage that gives us the opportunity to either make amazing profits or suffer ruinous losses. Because we are human beings that have an innate desire to not be wrong, and because we love the thrill of gambling which leads us to bet bigger than one should, it’s typically the devastating loss that is being experienced by most.
4) The most accurate definition I can provide is that a Futures Contract, and associated options, are WMDs – Weapons of Mass Destruction. A WMD is a weapon that can kill and bring significant harm to large numbers of humans as well as cause great damage to human made structures.
Yes, this is quite an accurate description – Significant Harm…Great Damage.
In the late 90’s Michael Bay action flick “The Rock”, Nick Cage plays a geeky FBI chemical weapons expert that is sent to Alcatraz to help neutralize rockets that are loaded with Sarin Gas. Every time he handles the chemical weapon he has a terrified look on his face, sweating profusely as he makes each move as his life depends on it.
“What I’m dealing with here is one of the deadliest substances the earth has ever known”
Futures, and options on futures, have the same deadly characteristics, and if not handled by experts with the utmost attention and care, can, and absolutely will destroy you financially. Don’t believe me? Let’s take you through a recent case study.
Swiss Franc - National Currency or WMD?
In 2011 the Swiss National Bank Introduced an exchange rate peg of the Swiss Franc to the Euro. The Franc was considered a safe haven asset by Global Investors who would buy during times of market stress and turmoil, and this is exactly what we were experiencing at the time. These funds flows into the Franc were causing dramatic appreciation in the currency, and this in turn was hurting their Export focused economy.
As the currency appreciated, foreigners were buying a lot less Swiss watches and chocolates, so something had to be done.
“Hey, I have an idea! - Let’s trash our currency by printing it in unlimited quantities and then buying Euros.” This fixed the Swiss/Eur Cross rate at 1.2SF to 1 EUR. Aahhh, the best laid plans of mice and men…
The SNB did achieve its’ objective of artificially suppressing their currency, but it came at a cost – Approx $480b worth of Foreign Currency reserves, and growing, on their balance sheet. This was equivalent to about 70% of Swiss GDP. This wasn’t sustainable, the meddling bankers knew it, and so the jig was up.
On Jan 15, 2015, the SNB announced they were removing the peg, and in an instant the Franc soared against the EUR going from 1.2 Francs Per Eur, to .85 Francs per 1 Eur. A move of 35 big Points in 1 day!
So let’s put some perspective around this. To buy a Swiss/Eur Future you are required to put up margin of approx. $3,200. Each Point move in this currency cross will result in a gain or loss of $1,000. And move it did on Jan 15, to the tune of 35 big points x $1,000 or $35k loss per contract! WMD indeed.
So let’s say you worked and saved $20k to start your own trading business. Your system gave you a sell signal on the Franc. You have enough equity margin to buy 6 contracts, but to “play it safe” you settle for 3 – You know how risky the market’s are, and this is the prudent move.
It’s getting late, and after watching reruns of Friends with your spouse you go to sleep. Next morning you wake up, while drinking your coffee and eating a toasted bagel, you log into your brokerage account to see overnight your equity went from +$20k to down 70k! In any instance such as this, your broker is not going to wait around to give you a chance to explain, or beg, or deposit more funds - their alarms will be going off right away - You better believe they will close your position first and then talk later.
I can’t properly do justice in these words to convey the feeling you have when you get wiped out, nevermind going into negative equity! I experienced wipeout personally on numerous occasions while I was getting my education in the school of hard knocks. Sickening, disgusting, despair, a feeling of total loss. The worst thing about it, and most ironic, is that it’s the trader himself who puts his own neck in the guillotine.
Why inconvenience your executioner, give him a helping hand.
"So I just stick my neck in there, and I then get to pick up the easy money?"
If you are new to trading, there is no reason to ever have this happen to you. If you aren’t new and this has happened before, lets commit to never letting it happen again.
There are countless other cases such as these, but I’m not here to write a book – I’m here to make a point – and the point of this chapter is to imbed into your trading fiber the danger and seriousness of the game we choose to play. You must become an expert, and you must handle these Explosive devices with extreme care. You are dealing with WMDs – Never forget it!
Now that I hopefully have your attention, I have some good news – There is a bullet proof way to ensure this never happens to you. It’s the same way you insure against catastrophic loss against property and self – You buy insurance. Every time. Never leave home without it.