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Futures margin is the cash that the investor must put up in order to hold a positionFUTURES To the novice, futures contracts can be quite confusing; yet they offer a unique opportunity to make money in todays volatile markets. Futures markets consist of a variety of commodities (e.g., gold, oil, soybeans, etc.); financial trading instruments (e.g., bonds, currencies); indexes (e.g, S&P 500, Nasdaq 100); and most recently, single stock futures (Microsoft, Intel, Citigroup). A futures contract is the agreement to buy or sell a uniform quantity and quality of physical or financial commodities at a designated time in the future at a specific price. The contracts themselves are traded on the futures market. Futures markets gave rise to two distinct types of traders: hedgers and speculators. Hedgers consist primarily of farmers and manufacturers. Futures contracts were initially used by farmers and manufacturers to protect themselves or lock in prices for a certain crop or product cycle. Hence, hedgers are primarily interested in actually selling or receiving the commodities themselves. Keep in mind that futures prices are directly driven by consumer supply and demand, which is primarily dependent on events and seasonal factors. For example, if you are a farmer who grows wheat, soybeans, and corn, you can sell your products even though they have not yet been farmed. If the price of corn is at a level that you like, you can sell a corresponding number of futures contracts against your expected production. An oil company can do the same thing, locking in the price of oil at a level to guarantee the price it will receive. For instance, British Petroleum (BP) may sell crude oil futures one year away to lock in that specific price. To make a profit, a company has to predetermine the price of its production and plan accordingly. The other players are the speculators. These traders play the futures markets to make a profit. Speculators do not expect to take delivery of a product or sell futures to lock in a crop price. Most contracts are now traded on a speculative basis. In other words, most people are in the futures market to try to make money on their best judgment as to the future price movement of the futures contract. For example, if you believe corn prices will rise in the next three months, you would buygo longthe corn futures three months out. If you believe corn prices will fall during this same period, you will sellgo shortthe corn futures contract three months out. Hedgers and speculators have a symbiotic relationship. They need one another for futures trading to work. Hedgers try to avoid risk while speculators thrive on it. Together they keep the markets active enough for everyone to get a piece of the action. Unlike stocks, where profits depend on company growth, futures markets are a zero-sum gamefor each buyer there is a seller and vice versa. Physical commodities are raw materials, which are traded on futures exchanges; examples include grains, meats, metals, and energies. Financial commodities include debt instruments (such as bonds), currencies, single stock futures, and indexes. In these markets, money is the actual commodity being traded, and price depends on a variety of factors including interest rates and the value of the U.S. dollar. Physical Commodities A wide variety of commodities can be profitably traded. Some are seasonal in nature, such as grains, food and fiber, livestock, metals, and energies. Some fluctuate due to seasonal changes in climate. Others may change due to world events, such as an Organization of Petroleum Exporting Countries (OPEC) meeting. Each market is unique. Physical commodity markets include: Grains (e.g., soybeans, wheat, corn). Food and fiber (e.g., coffee, cocoa, sugar, orange juice, cotton). Livestock (e.g., feeder cattle, live cattle, lean hogs, pork bellies). Metals (e.g., copper, gold, silver). Energies (e.g., crude oil, natural gas, heating oil, unleaded gas). Financial Commodities Commodity trading goes beyond grains, energy, cattle, and pork bellies and includes a variety of more complex financial instruments that trade actively across the globe. These so-called financial commodities include debt instruments like government bonds as well as Eurodollars and foreign currency exchange. Entire books can be written about any of these investments. However, a basic understanding of the most important financial commodities can also help traders make sense of the daily happenings in the financial markets at home and abroad. Debt Instruments Just as there are instruments to trade stocks, either individually or collectively as an index, there are numerous instruments available to trade interest rates. Welcome to the world of debt instruments! The first response I usually get when I talk about trading interest rates is, Who would want to trade interest rates? The simple answer is banks and other lending institutions that have loans outstanding, as well as investors who have a great deal of exposure in interest rate investments. Originally, the futures markets were primarily used to hedgeoffset or mitigaterisk. Today, financial commodities, including all the interest rate instruments, are growing at a faster rate than traditional commodities. The interest rate markets have participants from all over the world trading interest rates for hedging purposes and speculation. If you have interest rate risk or you just want to speculate on the direction of interest rates, there are plenty of markets and opportunities awaiting you. These markets are also traded extensively in off-exchange markets such as those created by banks and securities trading firms, also referred to as the overthe-counter (OTC) market. Bonds are one of the most popular forms of financial instruments. A bond is a debt obligation issued by a government or corporation that promises to pay its bondholders periodic interest at a fixed rate and to repay the principal of the loan at maturity at a specified future date. Bonds are usually issued with a value of $1,000 to $100,000, representing the principal or amount of money borrowed. Other popular financial instruments include: Treasury bill (T-bill). These short-term government securities have maturities of no more than one year. Treasury bills are issued through a competitive bidding process at a discount from par; there is no fixed interest rate. Treasury bond (T-bond). This marketable, fixed-interest U.S. govern ment debt security has a maturity of more than 10 years. The most often quoted T-bond is the 10-year bond. Treasury note (T-note). This is a marketable, fixed-interest U.S. gov ernment debt security with a maturity of between 1 and 10 years. Eurodollars. Eurodollars are dollars deposited in foreign banks. The futures contract reflects the rates offered between London branches of top U.S. banks and foreign banks. Currency Markets The currency markets are another very large market. Most countries have their own currencies. These currencies go up or down relative to each other based on a number of factors such as economic growth (present and future), interest rates, and supply and demand. Most major currencies are quoted against the U.S. dollar. Therefore, there will typically be an inverse relationship between the U.S. dollar and other currencies. The major currency futures traded at the Chicago Mercantile Exchange include the following: Euro (ECU or European currency unit). Swiss franc. British pound. Japanese yen. Canadian dollar. If the U.S. dollar goes up, then the Japanese yen will drop along with other foreign currencies. Keep in mind that the Canadian and U.S. dollars move similarly due to their physical proximity and the closeness of their economies. Each of these currencies will then have a rate relative to each of the others. This cross-reference is referred to as the cross rate. The yen/pound, euro/dollar, and so on will have their own rates at which they may be traded. Why are currencies traded? As you are probably aware, many products are sold across borders. A company may sell $100 million worth of computer equipment in Japan, and will likely be paid in yen. If the company prefers to be paid in U.S. dollars, it can go into the futures market or cash markettraded from bank to bankto change its yen purchase. By selling yen futures contracts, the company can lock in its profits in U.S. dollars. Speculators are also active in the currency markets, buying and selling based on their predictions for the changes in cross rates. Trillions (yes, trillions) of dollars are traded each day in the currency markets, 24 hours a day. Single Stock Futures The introduction of single stock futures (SSFs) in the United States on November 8, 2002, was one of the most anticipated events in todays financial world. Single stock futures offer widespread applications for both professionals and retail users. They were previously traded on the London Financial Futures and Options Exchange (which is now part of Euronext.liffethe international derivatives business of Euronext), and the U.S. market continues to hold high promise for these unique instruments. Single stock futures are futures contracts that are based on single stocks. As previously stated, a future is a contract to either buy or sell an underlying instrument at a predetermined price at a set date in the future. Unlike an option, the holder of the future has the obligation (as opposed to the right) to take delivery at expiration. One single stock futures contract represents 100 shares of stock, which will convert into stock if held to expiration. Like other futures contracts, SSFs have expiration months of March, June, September, and December. Speculators buy stock futures when they expect the share price to move higher, and sell futures when they want to profit from a move lower in the stock price. Hedgers can also use single stock futures to protect stock positions. Currently, there are approximately 115 single stock futures available to trade, including IBM, Microsoft, Citigroup, and Johnson & Johnson. Trading is done through an electronic exchange called OneChicago, which is a joint venture between the Chicago Board Options Exchange, the Chicago Mercantile Exchange, and the Chicago Board of Trade. In addition, trades clear through the Options Clearing Corporation (OCC). There are several things to consider when looking at single stock futures as opposed to the outright stock. First, while a future could be thought of as a price discovery tool for the stock, generally the stock and future will not trade at the same price. The price of an SSF is determined according to the following formula: SSF = Stock price (1 + time to expiration interest rate) - dividends Since SSFs have quarterly expirations, time to expiration is based on the remaining time until the end of the quarter. Normally the single stock future will trade above the stock; this is partially due to leverage of the future. Unlike stocks, SSFs require the buyer to put up margin of only a small portion of the underlying stock value in order to purchase, right now proposed to be about 20 percent of the cash value of the underlying stock. We should recognize here that margin in futures does not represent borrowed money, as in stocks. Futures margin is the cash that the investor must put up in order to hold a position. As the futures are marked to market at the end of the day, this amount may fluctuate. The only time the stock would trade over the future would be if there were a large dividend to be paidinvestors would likely hold the stock to collect the dividend. Futures holders do not collect dividends paid by the underlying stock. As options traders, we welcome the arrival of SSFs. Not only are they easier to execute than stock, but they are also less costly. For traders who trade stock, this added leverage will increase returns, whether the stock moves higher or lower in price. Prudent risk management and carefully thought out trading strategies, as always, will carry the day. |
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