Futures and options trading; What they know and you don’t

HS003339What makes a great futures and options trader? Effective traders have four distinguishing characteristics.

  • Technical knowledge of futures and options, the futures market in both bull and bear phases and the trading platform that they operate. Futures contracts are promises to buy (or sell) commodity X (in known quantities and of a specified quality) on a specified date yet to come. Futures and options are traded electronically on the global futures exchange. This is a World wide market that never closes and brings buyers and sellers together in real time and where prices are fluctuating constantly. The exchange clearing house is the third party in all contracts. It sets margin requirements, and enables all contract settlements. Futures contracts are a kind of security, like a stock or a bond but not ‘direct’ in the sense that stocks are. Futures for speculators are contracts one level away from stocks because they are in the future and two levels away from real estate because they are about prices on a computer screen rather than physical assets. The price of commodity X at any one point in time is set by the interaction of global supply and demand. Take coffee for example, this a commodity traded in the futures exchange. The supply of coffee beans now and in the foreseeable future is limited by the number of plantations in the World and their productivity. Weather conditions or geopolitical events (even rumors) can cause significant variations in price over the long term. On the demand side the price is determined by the popularity of coffee as a beverage. It requires a great deal of detailed analysis and study to separate out the factors that influence the price of coffee and by what magnitude they change it. The interplay of global demand and supply is a hugely complicated process that does however lend itself to technical ‘charting’ analysis. Many futures traders succeed in predicting and making profit from price trend movements in commodities. The commodity X however is not necessarily a physical product. It can also be a financial derivative, such as securitzed bundles of mortgage debts or even even totally man-made and referenced things such as stock indices or interest rates.
  • A mental model of how the prices in futures and options market are determined and what makes them move in the short, medium and long term. For the great futures trader the actual commodity is largely a matter of little interest. The great trader will study the market conditions, make their best ‘guess’ as to the direction of the price movement in their chosen time span and buy (or sell) contracts in that direction. There is always a date in the future called the ‘delivery’ or ‘final settlement’ date. The price of the futures contract on the exchange at the close of trading each day is called the ‘settlement’ price. A futures contract is an obligation on the trader to make or take delivery under the terms of the contract. Both the seller and the buyer of a futures contract must fulfill the terms of the contact on the settlement date. The wise trader never commits more money than they can afford to lose on their total trades. Traders only deal in cash profits and losses, while coffee companies deal in the actual delivery of physical coffee beans. Traders can get out of contract commitments before the actual settlement dates by offsetting their position, selling a long position or covering a ‘short’ position by buying back and in effect closing the contract down.┬áMini futures, or Emini contracts, are lower value versions of normal futures contracts with lower margin requirements. These are popular with new and individual traders.
  • An effective strategy that isn’t about reading price movements in a crystal ball. Trading futures is much like trading stocks. It is important to have a market entry strategy based on proven trading signals and a predetermined exit strategy that takes profit or cuts losses. There are three stages in the development of an effective trading strategy. First plan it, then test it out in simulated trades, then do it for real. A simple Internet search will throw up endless advice on futures and options strategies. There are also numerous trading platforms where you can open a practice account to implement your chosen strategies using real data but without risking real money. An effective strategy is one that makes money over a period of time. It does not necessarily mean that all trades are money-spinners.
  • A psychological profile that tolerates risk, works in detail to reduce it and never relies on blind faith or hope to turn a bad situation good. Futures trading is not for the faint hearted. There will come a time when commodity prices move against open positions. Some you will win and some you will lose but the great trader knows that the overall balance will be positive when the strategy is right.┬áTraders have access to a great deal of trading information in real time but using too much leverage or opening large positions relative to the size of the account, is a strategy that can give heavy losses. The mentality of the trader is as important as an effective strategy. It requires attention to detail and resilience in the face of contrary price movements. It also requires patience and self belief to not ‘jump ship’ in the face of short term adversity.
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