Understand Opportunities and Risks in Futures Trading

Futures markets have been described as continuous auction markets and as clearing houses for the latest information about supply and demand. They are the meeting places of buyers and sellers of an ever-expanding list of commodities that today includes agricultural products, metals, petroleum, financial instruments, foreign currencies and stock indexes. Trading has also been initiated in options on futures contracts, enabling option buyers to participate in futures markets with known risks.

Notwithstanding the rapid growth and diversification of futures markets, their primary purpose remains the same as it has been for nearly a century and a half, to provide an efficient and effective mechanism for the management of price risks. By buying or selling futures contracts – contracts that establish a price level now for items to be delivered later – individuals and businesses seek to achieve what amounts to insurance against adverse price changes. This is called hedging.

Other futures market participants are speculative investors who accept the risks that hedgers wish to avoid. Most speculators have no intention of making or taking delivery of the commodity but, rather, seek to profit from a change in the price. That is, they buy when they anticipate rising prices and sell when they anticipate declining prices.

The interaction of hedgers and speculators helps to provide active, liquid and competitive markets. Speculative participation in futures trading has become increasingly attractive with the availability of alternative methods of participation. Whereas many futures traders continue to prefer to make their own trading decisions – such as what to buy and sell and when to buy and sell – others choose to utilize the services of a professional trading advisor, or to avoid day-to-day trading responsibilities by establishing a fully managed trading account or participating in a commodity pool which is similar in concept to a mutual fund.

For those individuals who fully understand and can afford the risks which are involved, the allocation of some portion of their capital to futures trading can provide a means of achieving greater diversification and a potentially higher overall rate of return on their investments. There are also a number of ways in which futures can be used in combination with stocks, bonds and other investments.

Speculation in futures contracts, however, is clearly not appropriate for everyone. Just as it is possible to realize substantial profits in a short period of time, it is also possible to incur substantial losses in a short period of time. The possibility of large profits or losses in relation to the initial commitment of capital stems principally from the fact that futures trading is a highly leveraged form of speculation. Only a relatively small amount of money is required to control assets having a much greater value.  The leverage of futures trading can work for you when prices move in the direction you anticipate, or against you when prices move in the opposite direction.

From the Orion Future Group web site, www.commoditybroker.com/futures101.asp , which provides excellent educational information from the National Futures Association on virtually every facet of futures trading.

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Grain Selling Tools and When to Use Them

• Price in upper 1/3 of price range
• Basis narrow or normal
• Expected price drop seasonal or cycle

Cash Forward Contract ...Use when:

• Price in upper 1/3 of price range
• Narrow or normal basis
• Price above cost of production

Futures (sell position…short) ...Use when:

• Price in upper price range before crop is ready to sell
• Basis wide (means cash is weaker)
• Price movement is unknown or expected to go lower

Future Fixed or Hedge-to-Arrive ...Use when:

• Price is high
• Basis wide
• Price above cost of production

Option (puts) ...Use when:

• Price is high
• Basis wide or unknown
• Unknown risk with price or yield

Delayed pricing contract (grain delivered) ...Use when:

• Price low
• Basis movement unknown
• Expected price to move seasonably or cycle higher

Basis Contract ...Use when:

• Price low
• Basis narrow or plus
• Expect seasonal or cycle highs coming

Storage ...Use when:

• Price low
• Basis wide
• Expected price move higher seasonally or cycle
• Storage available

Government Loan ...Use when:

• Price low
• Basis wide
• Discounts in the market
• Storage available

Futures (buy position…long) ...Use when:

• Price low
• Basis wide
• Basis expected to narrow
• Trend up seasonally & cycle

Option (calls) ...Use when:

• Price low
• Basis narrow
• Trend up seasonally or cycle

Min. Price Contract
(grain delivered) ...Use when:

• Price low
• Basis narrow
• Trend up

Source: Mike Lockhart, NCTC Farm Business Management