In This Chapter

Active traders are attracted to more exotic financial products because they offer the opportunity for extraordinary gains. With this opportunity comes a corresponding amount of risk. This brief introduction to futures contracts and currency trading is also a warning that you should have some experience as an active trader of equities before attempting these securities.

Futures contracts are binding legal agreements that commit the owner to deliver or fill the terms of the contract at a future date. Unlike options, which convey a right, but not an obligation, future’s contracts obligate you to deliver the goods. Most people are familiar with the commodities markets in beef, orange juice, precious metals, and so on. If you have a future’s contract to deliver thousands of pounds of beef on a certain day, you are legally obligated to deliver. Of course, most futures contracts are offset or closed before the settlement date.

The purpose of the futures market is to provide a way for producers and consumers to hedge future price changes. For example, a farmer might be concerned about the price of wheat, but it will be months before he is ready to harvest his crop. He can sell (short) a futures contract of wheat for delivery at about the time his crop is to come in, thus locking in a price. When it is time to harvest his wheat, he has a price already fixed through the futures contract. If market prices are lower, he can close the futures contract for a profit to help offset the lower market price. If the market price is higher, he can offset his position and be out only the premium he paid for the future’s contract.

Food processors who need wheat can use the same strategy, but in reverse. Food producers want to lock in a low price for wheat now by buying a futures contract. If the price rises above the futures contract, producers profit and offset the higher price they are paying in the market for wheat. If the price falls below the futures price, producers would close out the contract and are only out the premium. This is a somewhat oversimplification of how the process works, but it is the basic idea of hedging future prices.

Traders are also players in the futures markets. Unlike producers and consumers who want to protect against future price uncertainty, traders hope to profit in a market of changing prices. Traders play an important role in the market by providing liquidity (in buying and selling contracts). Market rules help prevent traders from manipulating the price of the commodity.

What began as a way to stabilize prices of commodities has grown into a much larger securities market that includes a variety of financial securities as well as physical commodities. As a result, there are two types of future contracts: physical delivery contracts and cash settlement contracts. Physical delivery contracts are what you might expect: agricultural products, precious metals, and so on. Cash settlement contracts are for financial securities such as futures on stock indexes, Treasury notes and bonds, and other financial instruments. Active traders don’t plan on taking delivery of pork bellies (you must stay focused on contract dates or face awkward settlements). Financial and securities’ futures always settle in cash, meaning they are usually “marked to market” (their value is adjusted up or down) on their settlement day and your account credited or debited accordingly.

Active traders like futures contracts because a small deposit controls a large asset. The initial deposit you are required to make is called a performance bond (sometimes called a good-faith deposit). At the end of each day’s trading, all contracts are marked to market. If your contract gained value, your account is credited, and if it lost money, your account is debited. If the amount falls below the minimum required by the exchanges to keep the futures contract open, you will get a performance bond call from your broker requiring you to bring up the balance or face liquidation of the position. You will be required to make up any loss in your account even if it is more than your initial deposit.

The amount of this performance bond can equal 5 to 20 percent of the value of the contract. When you liquidate the contract, you receive the funds in the account as your profit or loss. The amount of the initial deposit depends on the future contract and market conditions. However, even at 20 percent you are experiencing a tremendous amount of leverage that can produce stunning gains or disastrous losses.

Futures contracts have time limits. They begin and end as stock options become due on certain cycles. Some are on a quarterly cycle, which gives the contracts a three-month life. You are responsible for closing out or extending your positions—or expect delivery and a bill for a lot of something you really don’t want.

Two terms you will hear in a variety of investment settings, but in particular in futures trading, are long and short. To be long in a futures contract means you have bought the contract and expect it to rise in value. If you are short in a contract, you have sold it and expect the commodity or financial instrument to fall in price.

Either position is closed by offsetting it with the opposite transaction. You can also roll your position into the next period through a transaction that lets you close out one position and open the exact same position in the new contract period. E-Mini contracts (more about these contracts next) have a three-month life and expire in March, June, September, and December, usually on the third Friday.

Ticks are the minimum units by which a future’s contract can change. The amount is set for each contract by the exchange. For example, the E-Mini S&P 500 futures contract (more about them below) has a tick of 0.25 of an index point or $12.50. Some E-Mini contracts trade in ticks worth one-tenth of a point. The purpose of fractional ticks is to allow traders to set precise buy and sell orders. To understand ticks, you also must understand the “multiplier” for the futures contract.

In the case of the E-Mini S&P 500, the multiplier is $50 per index point. The multiplier tells you two things. First, it tells you the value of the contract. If the S&P 500 Index is at 1250, the value of the contract is $62,500 (1250 × $50). Second, you get the value of the tick ($50 × 0.25 = $12.50).

As the E-Mini S&P 500 contract is traded, its value will rise and fall in ticks. If the index rises from 1250 to 1250.50, it has gone up two ticks or $25 dollars. If you are long (you have bought) the contract, your account is credited with two ticks or $25 dollars ($12.50 × 2 = $25).

All futures contracts, whether for commodities or financial instruments, have multipliers and ticks of varying sizes. Some of the futures contracts control huge dollar amounts with multipliers in the hundreds of dollars. A futures contract such as the full S&P 500 index has a multiplier of $250, giving it a value of several hundred thousand dollars. This becomes especially important when we discuss the advantages and dangers of the vast leverage built into contracts.

Most futures contracts have limits on how much they can move up or down in a single day’s trading. The amount is calculated differently for each contract. For example, a contract may have a $15.50 daily limit. If the price of the contract rises or falls by that much, the exchange halts all trading for the day. The next trading day, the limits are reintroduced around the closing price from the day before. Financial futures are measured in percentages rather than a specific dollar amount for limits, and the formulas can be complicated. Be sure you understand how they work before you begin trading. The Chicago Mercantile Exchange and the other exchanges that trade financial futures set the rules and provide that information for all the futures traded on their exchange. A list of those exchanges is found in Appendix A.

These trading limits prevent a free-fall or runaway market by shutting down trading. However, it also may make it difficult for you to get out of a bad situation. If something dreadful happens, and the market begins dropping rapidly, it may be hard to exit your position because trading will be halted as soon at the price limit is hit. As the equity in your account drains each day you can’t exit the position, you will get a performance bond call from your broker demanding more money in your account. As we’ll see in our discussions on leverage, it is possible to not only lose your performance bond deposit, but a whole lot more. Futures are one of the few trades you can make where it is possible to lose a lot more than you invested—that should be sufficient warning to anyone who thinks trading futures is the easy road to wealth.

The exchanges also prevent individuals and groups acting together from controlling large blocks of futures contracts. People have tried to “corner the market” in the past by buying huge quantities of contracts and manipulating prices. Controls are in place to prevent that from happening any longer.

Futures contracts are well suited for active, experienced traders. They cover a wide variety of commodities, precious metals, financial indexes, bonds, and foreign currency. There is something for every trading taste. However, many traders stick with the financial indexes, precious metals, bonds, and foreign currency. These tend to be the most volatile and, as we have discovered, that presents more possibilities for active traders.

The stock indexes in particular are very active and can be traded on an intraday basis or held for swing trading opportunities. Because it is just as easy to go short as it is to go long, you can play the market both ways in the same trading day. As volatile as indexes can be, they present some exciting short-term opportunities.

The exchanges also offer options on many futures contracts; however, those products are best addressed after you have mastered futures contracts.

Trading futures is not the same as opening an online brokerage account and buying a few shares of stock. The broker must be licensed to trade futures, and you’ll want a direct access service if you plan short-term trading.

Because of the high-risk nature of futures trading, you will be required to sign several documents including the performance bond, which obligates you to cover your loss even if they exceed the equity in your account—in other words, you are on the hook. If your account falls below the performance margin, expect a performance bond call and a polite insistence you bring the equity up immediately.

One of the most popular trading vehicles with active traders is the E-Mini futures contracts on stock indexes. These contracts use major stock indexes for their underlying target. The contracts are smaller (thus the “mini”) than regular futures contracts and that offers some advantages for active traders. The E-Mini contracts generally require a smaller performance bond and have a smaller multiplier. The contract still allows ample room for profits, but the potential for losses is much lower than with regular futures contracts. However, you can still suffer substantial losses if you are not careful.

E-Mini contracts are available on several exchanges and cover every major stock index and some not so major indexes. You can also trade E-Mini contracts on foreign stock indexes. Each contract has its own specifications, so you will want to familiarize yourself with the details before you begin trading. Contracts trade from Sunday afternoon though Friday afternoon, giving traders the opportunity to react to news events even when the stock market is closed.

One of the most popular of the E-Mini series is the E-Mini S&P 500 futures contract. We’ll look at it in some detail as a representative of the other E-Mini contracts and futures contracts in general.

The E-Mini S&P 500 contract is a more manageable version of a futures contract on the S&P 500 stock index. This is the most widely quoted index in the financial community and is often used as a proxy for the whole stock market.

As noted previously, one index point is worth $50 (as opposed to $250 for the full-size S&P 500 futures contract). When the S&P 500 index is at 1400, the contract is worth $70,000 ($50 × 1400 = $70,000). The performance bond set by CME is $4,000, although brokers are free to set a higher bond. The performance bond is subject to change by the exchange, so check with your broker. Each tick is 0.25 of a point, or $12.50.

The S&P 500 index is less volatile than the Dow or the Nasdaq 100. You can see how that is represented in the respective E-Mini contracts. The E-Mini contract for the Dow has a multiplier of $10 per index point and the Nasdaq 100 multiplier is $20 per index point.

For example, on an unusually active day for the S&P 500 Index, it traded in the range of 1394.83 to 1419.91. If you drop the decimals for the sake of simplicity, that’s a 25-point range, which means if you managed to buy at the bottom (1394) and sell at the top (1419), you made a $1,250 profit—excluding taxes, commissions, fees, and so on.

Of course, you could have bought the other way and suffered that big of a loss because on this particular day the market was in a nosedive. The savvy trader would have used the appropriate technical analysis tools and fundamental news to determine that the market was headed down this trading day and shorted the E-Mini S&P 500 futures contract.

On this same trading day, the Dow was down 265 points, for a move worth $2,650 ($10 × 265). A trader with a short position early in the day may have done very well.

The preceeding two examples may give the impression that it is easy to make money with E-Mini futures contracts—of course, it’s always easy to identify good trades after the fact. The problem is stock indexes have a habit of reversing themselves, sometimes several times in a single trading session. For the active trader, this means you need to be able to switch directions in an instant when the market begins moving against you.

For example, if your analysis indicates the market should be heading down, you might open your trading day with a short position. At mid-morning, for whatever reason, the market reverses itself and takes a solid jump. If you have protected your position with limit orders (more about these in Chapter 13), your position will be closed out with a small profit or loss, depending on where you put the order to close the position. If you didn’t put any limits on your position, your losses could mount dramatically if you aren’t paying attention to the market.

If your limit order closes your position, you are out of the market and must get back in if you want to participate. So, now the stock is headed up, but is it just a bump before coming back down or will it stay or climb at this level? Maybe this isn’t as easy as it seems! Careful use of moving averages and charts along with practice can help you develop a strategy for short-term trading of E-Mini contracts.

Many traders close their positions before going to bed, but you can keep them open for days or weeks if you are in a good position. By adjusting your limits and stops (more market orders), you can protect your profits and keep a contract position open. However, if you are right on the edge between a profit and a loss, be very careful about closing your eyes without the safety of standing limit orders that will get you out of the position if things go bad while you’re not looking.

In addition to straight long and short orders, traders can employ a number of other strategies ranging from mildly to very complicated. These include spreads where you buy and sell the same contract; hedging existing holdings; arbitrage; and much more complicated trades. When you are comfortable with how the futures market works and understand the risks, you may want to consider learning about the more complicated plays that are possible with futures, E-Mini futures contracts, and options on futures contracts.

Trading stock index E-Mini futures offers active traders numerous advantages, which is one of the reasons they are so actively traded. Among the benefits are:

The E-Mini stock index futures have some pitfalls you need to be aware of:

Trading futures and E-Mini stock index contracts offer active traders an exciting and challenging avenue to profits. It is not a place to begin your trading career, but for traders with some experience and a tolerance for risk, trading E-Mini futures contracts can be a very profitable full-time business.

As exciting and fast-paced as the futures market in stock indexes is, the foreign exchange currency market is bigger and faster (and potentially more risky). The foreign exchange currency market, also known as the forex, is the largest financial market in the world. The daily value of trades easily exceeds the equity markets.

Until recently, banks and other major financial institutions were the only ones trading currencies. With the growth of electronic trading, the forex opened to retail customers. The initial efforts met with some shady dealings, but those have largely been cleaned up and traders who work with reliable brokers should not have any problems.

Like most forms of investing money, you will still find scams that promise extraordinary profits. Any company that promises you will make huge profits with any type of investment is a scam. There are no sure trading systems that will always generate huge profits in real-life market conditions. If you want to make money trading currency in the forex market, you will have to learn how to trade, why currencies fluctuate in value relative to one another, and take some risk.

The forex is a completely different kind of market, trading currency or cash, which means it offers a level of diversification for portfolios of stocks, bonds, and real estate. It is also different because there is no central market or exchange. Trading runs 24 hours a day, six days a week as banks on the other side of the world open for business while we are still asleep.

Traders like the forex for several reasons, but two of the most important are liquidity and leverage. Traders who work with the major currencies will not have liquidity problems when it comes time to trade. The leverage in the forex is almost unbelievable to many traders. It can run from 100 to 250 times your investment. At 200 times leverage, a $1,000 investment lets you trade $200,000. You can see the advantage of that power—and the danger also. We’ll look at those factors in more detail later. A single unit in forex trading is $100,000, so you can see why a lot of leverage is necessary.

When you trade currencies on the forex you are hoping that one currency will appreciate in value relative to another (or you hope it will fall in value if you are short). Forex trades always involve two currencies, one you buy and the other you sell.

The currencies are quoted as pairs, with the base currency being the first one listed. For example, USD/JPY is the U.S. dollar and the Japanese yen. In this case, the quote would be for how many yen would be needed to buy a dollar. A quote might look like this:

The quote is showing the bid and ask price. The bid is what the market maker will buy at and the ask is what he will sell at. The ask is always the higher price. In the case of the Japanese yen, the price is quoted to two decimal places. Other currencies are quoted to four decimal places. In this case, one U.S. dollar can be bought for 109.16 yen or if you were shorting, sold for 109.06 yen. Let’s look at another quote:

Quotes typically only show the last two digits of the ask price. From this you would know that the ask price for Canadian dollars is 1.0205 (because the ask price is always higher). The difference between the bid and ask is the spread. In this case it equals 0.001 or 10 units of 0.0001 each (1.0205 - 1.0195 = 0.001). These units (0.0001) are called pips and they represent the minimum change in a currency quote (with the exception of the yen, which is 0.01). A pip or 0.0001 may seem like an insignificant amount of money (one one-hundredth of a cent). However, when you multiply them by many thousand thanks to the huge leverage in forex, you can see significant profits and losses.

Most traders focus on the currencies from eight countries and the pairs they form. This makes the learning curve fairly shallow in terms of knowing the components of the market (unlike the 10,000 plus stocks or 8,000 plus mutual funds). Here are the major currencies:

Of these the major pairs are: EUR/USD, USD/JPY, GBP/USD, and USD/CHF. There are three called commodity pairs: AUD/USD, USD/CAD, and NZD/USD.

There are many other currencies, but these are the ones favored by most traders.

Simply stated, you make money when the currency you buy appreciates in value relative to the currency (in the pair) you sold. When that happens, you sell the other currency back to make your profit. If you believe the USD will appreciate relative to the JPY, you would buy the USD/JPY pair. When you do this, you are buying USD and selling (shorting) JPY. If you are correct and the dollar does rise relative to the JPY, you are in a profitable position. To close the trade and capture your profit, you sell dollars and buy JPY. Since the dollar now buys more JPY, your profit is the difference between what you sold the JPY for and what you can now buy with appreciated dollars. You convert the profit from yen to dollars to deposit in your account.

Here’s a tangible example. You have 100:1 leverage in your account.

Your investment was $1,000 and your profit was $365 for a return of 36.5 percent. Of course, the market could have gone the other way, and you would have suffered a loss of that size or worse if you weren’t careful.

Most traders use protective stops and limit orders to make sure if the market turns against them, their losses are contained to a manageable amount. The illustration above shows a trade when there is a 50-pip move. The power of leverage is the only factor that makes the trade worthwhile. Many traders find that they need much more capital than $1,000 to successfully trade in the forex.

The preceeding illustration could have been a loss and traders with only $1,000 of capital would have lost over one-third of their trading capacity in one trade. One or two more bad trades (a real possibility in the fast-moving forex) and they are wiped out. How much capital you need depends on how aggressive you plan to trade and how many trades you plan to execute on a regular basis.

This is the simplest strategy for making money. There are other more sophisticated strategies for trading on the forex that will make more sense once you are comfortable trading in the basic fashion. You can also buy forward and future contracts on forex positions, although most traders prefer the cash or spot market.

Many online platforms and brokers offer forex trading or you can use one of the many dedicated forex brokers. All quality forex brokers will let you practice trade using their systems so you can get a feel for how they work and spend some time trading. If you plan to do forex trading on a regular or full-time basis, sign up for as many training sessions as you can and plan to spend quite a few hours practice trading. There is no substitute for trading against live market data.

Most forex brokers don’t charge a commission in the traditional sense. What they do charge are pips in the spread. It is important to know how many pips are charged and for which pairs. Most brokers either post this on their website or will provide it to you before you open an account.

Some brokers allow you to open accounts for $1,000 and sometimes less. These are for people still unsure about trading the forex. Most brokers offer a tiered service based on your initial deposit and the account balance you maintain. The higher those numbers, the more goodies in terms of tighter spreads, more research, and access to a more sophisticated platform you may receive. If you are serious about trading the forex full-time, plan on an initial stake of $25,000 to $50,000.

Forex trading is an exciting way to make a living or some extra money if you want to keep a day job and trade at night. It is easy to master the basics, but understanding the various forces that change the value of currencies around the world is much more complicated. The risks are very high due to the enormous leverage, but the corresponding rewards are equally staggering. Don’t think this is easy money, despite what you may read or hear. You are trading against and with major world banks and sophisticated money managers who live and breathe currency hedging every day.

The Least You Need to Know