Which Markets to Trade

March 31, 2009 07:00 PM

Rick has been involved in various aspects of the futures and options markets, including positions as an economist and derivatives market analyst at the Bank of Canada and Finex. In 1996, he founded World Link Futures Inc. to serve the beginning futures trader.

There are approximately 200 futures markets in the United States, and exchanges are constantly designing new contracts to add to the list. With all of these available markets, how does a beginning trader decide which ones to trade?

Trade What You Can Afford
The first consideration is to trade what you can afford. Markets vary in affordability. This refers mostly to futures as opposed to options. For instance, futures contracts on cocoa, sugar and the grains tend to be relatively affordable, while the financials and energies are more expensive. The MidAm Exchange lists several financial contracts that have smaller sizes and are more affordable than those on the larger exchanges.

Generally, two factors make a futures market expensive to trade: the value of the contract and the volatility of the contract. For instance, crude oil futures are more expensive to trade than wheat futures because crude oil futures are worth more. The market value of a crude oil futures contract is around $32,000, while a wheat futures contract is $12,500. Also, the more volatile the market, the more expensive it is to trade. You want to be able to tolerate intraday price movements or "noise." For instance, the Swiss franc and Canadian dollar futures each have roughly the same contract size, yet the Swiss franc is nearly three times as volatile as the Canadian dollar.

Margin requirements reflect both of these factors and provide an easy reference for gauging the affordability of a futures market. The initial margin requirement of a crude oil futures contract is nearly four times greater than a wheat futures contract. The initial margin requirement for Swiss franc futures is about three times greater than for Canadian dollar futures. The size of your trading account determines which futures markets you can afford to trade. For account sizes under $5,000, it's advisable to restrict trading to those futures having an initial margin under $1,000. The more expensive markets are approachable when trading capital reaches $10,000.

Trade What You Know
Of the markets that you can afford, you should focus on those that you know. For instance, an individual with farming experience may feel most comfortable trading agricultural commodities. Similarly, a corporate treasurer may feel most comfortable trading financial futures, like bonds and foreign exchange. Trading markets that you know maintains your confidence and can improve profitability if your personal knowledge and experience give you some insight into future price movements.

While the behavior of prices may appear to be similar regardless of the particular market, there are important differences. Some markets are more volatile than others. Some operate under price limits, while others do not. Some markets tend to price gap more often than others, usually if the trading day is short. Crop years have an important impact on prices and spreads in some markets and not in others. Before you trade a market, it's important you understand its characteristics. It's a good idea to watch and learn the price behavior of a market for several weeks or longer before you put on your first trade.

Trade What Performs
Before placing the first trade, new traders should spend a considerable amount of time testing their trading programs in a simulated paper trading account. Whether systematic, meaning model-driven, or discretionary, meaning gut instinct, testing several markets likely will reveal a trading program to be more profitable in some markets than others. For instance, the recent quick and unexpected price reversals that have been characteristic of Canadian dollar futures may result in a contrarian trading program where, for example, a trader buys after a period of selling expecting prices to reverse. In the case of the Canadian dollar futures, the contrarian trading program typically would outperform a trend-following program (where a trader buys after a period of buying expecting prices to continue their upward movement).

From among the markets you can afford and have a comfortable understanding of, the markets to trade are those that result in the highest profitability of your trading program. Of course, as your capital and industry knowledge increase, more markets will become accessible.

(Editor's Note: For more on good markets for beginning traders, see "Mini markets, big potential")

About the Author
Rick Thachuk is president of WLF Futures, Options & Forex Education Network. Contact him via www.worldlinkfutures.com