First things first

March 31, 2009 07:00 PM

T-bonds, currencies, metals, ags, financials, interest rates, softs - where to begin? For someone just starting out in futures trading, the hardest task often is deciding what to trade. Here are a few things to consider before choosing a market.

Making a decision about what to trade in today's markets is tough. Beginning traders are faced with a plethora of contracts from which to choose, covering everything from nonfat dry milk futures to currency cross-rates to rolling spot options. For someone without experience on the trading floor or in actual commodity production, it can be a financial minefield if you don't have a solid grasp of what contracts will fit your risk tolerance level and wallet size.

Several factors need to be considered before choosing a market. First, naturally, is money. Prospective traders should realize up front that all trades will not be winners - you can expect to lose money along the way. Count on this when determining how much risk capital to commit to a trade, risk capital being the amount of money you can afford to lose. Your trading account should consist of money available only after you take care of fixed expenses such as house payments, food costs, family living expenses, insurance, your child's education, etc.

Though you are ultimately the best judge of your financial situation, general guidelines can help in deciding whether you're financially ready to place a trade. For example, if you have a total net worth under $200,000 and have a family to consider, trading may not be the best option for you financially. And, even if you do have substantial net worth and assets, it is recommended you still commit only 10% of your risk capital to trading.

Start by comparing margin requirements of various contracts - you'll find immediately what you can and cannot afford to trade. (See "Decisions, decisions," below. Though this focuses on U.S. contracts, there also are trading opportunities in overseas markets, as well.) Find out from your broker or the exchanges what the initial margin requirements are for the commodities you're interested in, as well as the maintenance margin needed to keep your trading position open. Some brokers may require an added cushion as extra insurance.

When opening an account, be sure to have sufficient equity (excess margin) available so you aren't forced out of the market at the first adverse price move. For example, if you're trading soybeans, even a small price move can take a bite out of your margin: A 5¢ price move against you will cost $250 per contract. If you're trading multiple contracts, it adds up fast.

The Hunt Begins
When looking for a market to trade, common sense dictates you choose a market in which you are comfortable. If you don't understand how rolling spot options work or what factors can move interest rates, don't trade them. Or, if the high rewards of trading the S&P 500 market tempt you, but the volatility and capital requirement is beyond the scope of your bankbook, stand aside.

Learn to ask some basic questions when evaluating various commodities. For example, how "trending" is the market? The higher its trending potential, the more opportunity for steady returns. One look at an orange juice price chart - with its long sideways channels and explosive price moves - will tell you it's not a good place to start if you're after low-risk trades. The markets with the highest rewards often have the highest risk: Markets showing established trends are more apt to provide both a piece of the action and peace of mind, for example corn, copper, soybeans, wheat, Eurodollars and until recently, currencies.

These markets also are highly liquid, another crucial consideration when deciding what to trade. The market you choose needs to be large enough to guarantee adequate fills - that there will be enough players to allow you to get in and out of a trade easily. In an illiquid market you could lose all your profits getting out.

Once you find a liquid, trending market that gives you a "comfortable" risk/return ratio, the real work begins. Find out as much about your contract as possible to help gauge its risk/ reward potential. For starters, you need to know the exchange where it's traded and whether your broker executes trades there, as well as trading hours and the contract's expiration date.

Also, know its delivery months (when the contract matures); the size of the contract, usually in bushels, pounds, ounces, etc.; how prices are quoted; the minimum price fluctation (the size of each tick) and its dollar value; the daily trading limits (the maximum amount today's price can change from the previous day's close); and margin requirements. There are many sources for this kind of information, including your broker and the exchanges.

At some point, volatility should enter your evaluation. Volatility is perhaps the most basic determinant of whether a contract is right for your risk tolerance level - financially and emotionally. Many exchanges have historical volatility information available that shows the average price fluctuation of a contract over time. A combined look at volatility, margin, contract size and tick value gives a quick sense of how much a contract is likely to deviate over a given time period, how much it will cost you if it does, and if you can afford to hold the contract overnight. If you value your sleep, you may want to steer away from contracts that currently are extremely volatile, like coffee.

Study Up
Research the contracts you are trading and learn as much as possible about what moves prices. This task is more important for a fundamental trader, who predicts price direction based on supply and demand situations, than for a technical trader, who bases price predictions strictly on chart patterns.

Fundamental data about supply and demand comes from any one of a number of sources, however, a good place to start is always the government. Data, most of it free, is published regularly about everything from the number of cattle on feed to the amount of new houses built each month, and all of these numbers will be factored into futures prices. Find the reports that affect your market and related markets. For example, if you're trading live hog futures, not only should you know when the U.S. Department of Agriculture's Hogs & Pigs Report is released, but also be familiar with the Cold Storage, Livestock Slaughter and Feed Situation reports. Know how weather, marketing cycles and feed supply can affect producer profitability - and ultimately price.

Also, get to know your contract price inside and out. Historical price data gives a feel for what price is considered "high" and "low" for your market. How one contract trades in relation to another can be important as well. The relationship between the Knight Ridder Commodity Research Bureau (CRB) Index and the soybean market shows how one contract can often "predict" another's movement (see "Follow the leader," below).

Other good sources of perspective come from the Commodity Futures Trading Commission's biweekly Commitment of Traders report, and the Bullish Review newsletter, which both provide a picture of how large commercial hedging firms are positioned in any given market. Also, information on contrary opinion from sources such as Market Vane's Bullish Consensus and the Daily Sentiment Index from MBH Commodity Advisors is helpful in gauging how the majority of traders feel about whether a contract is overbought or oversold and ready for a change in direction.

Another decision is how many contracts to trade. Is it better to focus on one or diversify with several? The answer varies depending on the amount of time and capital you can commit: If one contract is all you can afford or take time to learn, then stick with one and specialize. It's often recommended that beginners trade no more than two or three contracts at a time, or a combination of related commodities such as grains, meats or softs. Diversification becomes increasingly important the more capital you invest.

If you want to see how effective a trader you are, try paper trading. Once you've collected all the information you can about the commodity you're interested in, track your position before making the actual financial commitment. Paper trading is an excellent way to get a feel for what moves prices and to gauge your potential success with a market.

The Long and Short of it
Before you begin trading, be sure you have a plan in mind: Are you going to stick with straight futures, options or utilize lower-risk spreads? Will you use fundamental analysis, technical analysis or a combination of both? Will you be a long-term or a short-term trader? There are advantages and disadvantages to both day-trading and longer term position trading. Given the volatility of many of today's markets, day traders (who get in and out of a trade within one trading session) sleep better knowing they're not exposed to dangerous moves on tomorrow's open. Unexpected overnight news can wreak havoc with a position that was making money just the night before.

To be profitable, however, day-traders are faced with the challenge of finding more volatile and liquid markets, and the demands of this style of trading may be restrictive for beginning and part-time traders.

If you aren't a floor trader and don't have access to real-time quotes, a better strategy would be intermediate- to long-term trading. This allows ample time to study a market in-depth, identify a trend and let profits run - as well as gives you enough opportunities to cut losses short.

Evaluating your options
A word about options: They often are touted as a low-risk and low-cost trading opportunity for those who aren't comfortable with the risk associated with a straight futures position. However, you must consider that options are decidedly more complicated instruments and their potential reward is often lower.

If you want to use options, be sure you know how and when to use them. Here are some guidelines on when to consider using options:

  • When the market is locked in a sideways trading range
  • When you can't afford financially or emotionally to risk an outright futures position
  • When you're taking a position opposite of the main trend.
  • When you're offsetting a futures position.

As your level of trading expertise grows, so will your trading opportunities. Though your strategies and markets may change over time, realize that you don't have to be an expert in all areas of the marketplace to be a successful trader - as long as you are committed to becoming an expert trader and continue to learn about the market, you're halfway there.

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