INTRODUCTION TO THE FINANCIAL MARKETS & TRADING OPPORTUNITIES IN COMMODITY, CURRENCY, & FINANCIAL FUTURES
DANIEL MANKANI / PHILLIP GNI FUTURES Archived// Published on: Jan 2, 1995 @ 03:51 //
(I) International Financial Market
Any discussion of the Futures markets must begin with a brief discussion of International Financial markets in general. These markets consist primarily of the Equity market (i.e. stocks of the public corporations), the Debt Market, sometimes called the Fixed Income Market (i.e. corporate and government bonds) and last but not least, the Commodity, Currency and Financial Futures Market.
(A) The Equity Market
The best-known international market is the Equity Market. This market is the primarily source of capital to corporations throughout the world. An investor seeks not only to earn dividends (a share of profit) from the company in which he holds stock; he also seeks to gain from an increase from an increase in the market value of that stock. An increase in the market value of a particular stock can come from either of two forces. The first of these is the level of current earning and the perceived growth potential of that particular company. The second force leading to an increase in stock value is the general market attitude towards the Equity Market in general. During “Bull” markets, worldwide demand of equity investments increases and therefore the price of the stocks goes up. The opposite is the case during the “Bear” markets. In this latter case the general demand for equity instruments declines and therefore so does the value of most stocks shares. The general direction of the Equity Market is reflected in various indices such as the Standard & Poor’s, Nikkei-225, Hang Seng and the Dow Jones Indexes. The most important aspect of the Equity Market is that for an investor to profit within this market he must enter the market during a period when the prices are low and he must exit the market when prices are high. Unfortunately, most of us can only guess which way the market will move in the future. (See stock Index Trading)
(B) The Debt Market
The second best known international market is the Debt Market. It is within this marketplace that the governments and corporations of the world borrow money. When an investor buys bonds or other debt instruments, he is actually making a loan. In exchange for this loan he earn interest on his investment. This interest is usually a fixed amount paid periodically over the life of the instrument with the entire balance of the loan repaid in full at some future date. Government fiscal and monetary policy and the overall demand for borrowing worldwide influence international interest rates. As international interest rates rise and decline, the value of existing debt instrument follows. Wouldn’t we all like to be holding a bond with an interest-earning rate of 15 to 20 percent as many bonds did during the high interest period of the 70’s? It is of course possible to buy bonds, which were issued at higher interest rates, but we would have to pay a “Premium” to get them. Conversely, we could sell a bond issued at a lower rate than the current rate available but we would have to offer a “Discount” in order to sell it. Additional risks associated with the Debt Market are the rate of inflation and the potential for default. The safest debt instruments are those issued by governments however there is usually a very low interest rate spread between the rate of return on the instrument and the rate of inflation. This is due to the low default risk on the bond. Corporate bonds and other debt instruments usually bear a higher interest rate and therefore a greater return over inflation however the potential for default increases. This has been taken to extremes in the form of “Junk Bonds”. For an investor to reap consistent profits within this marketplace he must remain aware of current and projected government debt policy, current and projected inflationary trends and of course the general business outlook for the future. (See interest rates)
(C)The Commodity, Currency and Financial Futures Market
The third and the least well known international market are the Commodity, Currency and Financial Futures Market. It is within this market that the future flow of goods is facilitated. In addition, this market reflects investor’s current attitudes of the future value of goods and currencies and the future value of debt and equity investments.( See Forex , Futures, & Options )
To illustrate how the future markets facilities the flow of goods, consider the following simple (very simple) example. A cattle producer in Texas has cattle, which will go to the market at a future date. His cattle cost him $1,000.00 per head to raise and bring to market. The current market value for cattle is $1,500.00 per head, which would yield him a profit of $500.00 per head. Unfortunately, his cattle are not yet ready for market and therefore he is unable to ensure the sale price at delivery will still yield a profit, A quick look at the evening paper shows him that a futures contract for cattle to be delivered when he goes to the market will currently bring $1,400.00 per head. In an effort to protect his profit, he will enter a futures contract to sell his cattle at that date and price. Should the price of the cattle go down he will still get his $1,400.00 per head on the delivery date. If however, the price of cattle goes up, he would forego any additional profit on the sale of his cattle. His futures contract has locked-in the sale price of his cattle and protected him from any loss should the value decline before he can deliver.
As stated, this is a basic example of how the futures facilities the future flow of goods and commerce by reducing the uncertainty of prices in the future, other types of Futures contracts that can be traded with Phillip Futures are Stock Indices, Currencies, Metals, Interest Rates, Oil/Crude products, along with Agriculture’s including Cattle. The action taken by the cattle producer is known today as “Hedging”. Hedging is used throughout the world to guarantee both future delivery and price of over 100 various commodities (including live cattle). In the terminology of the market, the cattle producer “Sold short” that is to say he has sold something not yet ready for delivery. Conversely, a butcher may “Buy Long” to lock-in the price he would have to pay for cattle to be delivered at a future date.
As discussed above, “Hedging” is the term used for trading when the actual delivery of the commodity is desired and is used primarily to eliminate or offset the price risk of the open market. On the other hand “Speculation” is the term used when actual delivery is neither desired nor intended. A speculator trades on the basis of expected price fluctuations. He either believes the price of a commodity will go up or down prior to the date delivery is required. If the speculator believes the price will go up he will buy contracts “Buy long” and if he believes the price will go down he will sell contracts “Sell Short”. In order not to either take possessions of or be required to deliver the commodity he must always close his position prior to delivery. If today he “Sell short” he must later “Buy long” to cover his position. If the “Buy” price is lower than his “Sell” price he will make a profit. If today he “Buys Long” he must later “Sell Short ” to cover. If the “sell” price is higher than his “Buy” price he will make a profit.
In today’s complex world these contracts are handled on “Exchanges” located in most developed countries. The Exchange facilities trading between parties through the establishment of regulations, guidelines and procedures. In North America alone there are 16 different Exchanges, One of the Major Exchange in Asia is the SINGAPORE INTERNATIONAL MONETARY EXCHANGE (SIMEX) http://www.simex.com.
(2) Comprehensive Futures Trading Strategy
A speculative futures trader seeks to profit from changes in price for a given commodity. Many individual traders have sought this goal with little or no success. As yet, mankind has discovered no magic formula guaranteed to reach this illusive goal, however, some traders seem to profit more than others do. Indeed, some traders are able to earn substantial and consistent profits. Numerous books and other publications have been written on this subject and though various authors may approach the topic differently, most point to the following traits necessary for consistent trading success.
(A) Knowledge of the marketplace
Most successful traders have extensive knowledge of the marketplace and years of experience trading a diversified portfolio of Commodity, Currency and Financial Futures. Successful traders fall primarily into two categories. The first of these is the ‘Fundamental’ trader. For the Fundamental trader, expert understanding and analysis of supply and demand are the basis of his trading decisions. This would include seasonal price fluctuations, the level of rainfall, the general economic outlook, government fiscal and monetary policy, etc. His goal is to predict long-term prices based on the analysis of this data and then enter the marketplace accordingly. The second category of traders is the “Technical” trader. For the Technical trader, expert understanding and analysis of historical prices movements form the basis of his trading policy. Almost all Technical traders have developed a proprietary computer system that monitors and analysis price trend and seek to enter at some point to take advantage of these trends. Technical traders take positions in the market much more rapidly than Fundamental traders do. In addition, the Technical trader may exit the market almost immediately after entering it should prices rise or fall to predetermined levels. Varying opinions exist as to whether the Fundamental or Technical trader will perform the best but to no avail. A good Fundamental trader may well outperform a good Technical trader and vice-versa. The best bet in today’s market seems to be a trader who uses a technical trading system to evaluate opportunities and then applies fundamental knowledge of causes and effect prior to making trading decisions.
(B) Development of a Comprehensive Trading Plan
Whether a trader uses the Fundamental approach, the Technical approach or a combination of the two, he must approach the market with a comprehensive trading plan. He must plan in advance, which indicators call for entry into and which call for exit from the market. He must determine in advance what level of profit or loss per trade he will accept prior to existing the market. He must determine what level of risk is acceptable given that where there is no risk there is usually no reward. All of these factors must be weighted against the of capital available and the level of diversification desired. Commodity, Currency and financial Futures are traded using a substantial level of leverage(debt). Normally, only 5 to10 percent of the full contract value is required to effect a trade. This leverage naturally increases the return on investment when a gain is taken; it also increases the amount of loss to be repaid when a loss is taken. Great care must be taken to understand the function and liability of this leverage and no comprehensive trading plan exists without its consideration.
(C) Sufficient Capital
Successful traders hold sufficient capital to follow their trading plan. In most cases the level of capital required is substantial. Many traders believe that at least $10,000.00 is required to trade only a few contracts in one commodity. This level of capital is considered necessary to meet the initial margin requirement and the maintenance requirements of the exchange should the value of the position fall. If the necessary capital not available to ride out minor fluctuations in value, most trades would end in a loss. It must be understood that a successful trader will lose money on some of his trades even if he earns an overall profit on all trades combined.
(D) Full-time Systematic Management
Knowledge of the marketplace, a comprehensive trading plan and sufficient capital do not, by themselves, lead to success in the Commodity, Currency and Financial Futures Market. Full-time systematic management is the catalyst that combines these ingredients into a successful trading strategy. A successful trader / broker spends his or her entire working hours fulfilling the requirements of market research (from both fundamental and technical perspective), computer systems development, enhancement and testing, price monitoring and placing buy/sell orders with a dealer. This is simply not a part-time hobby from which you might earn a profit. The potential for due to the failure to adequately monitor, understand and take action in, is simply too great. While there are no guarantees, a useful alternative is of course to utilize the services of a professional broker, while investing and obtaining value added services, such as access to market information, recommendation and in depth analysis prior to submission of any trading instructions.
Daniel Mankani is a licensed futures broker rep at Phillip GNI Futures in Singapore and reached at 65 536 3559 or via email at email@example.com (copyright dynamictrader.com all rights reserved. reproduction is illegal and strickly forbidden. otherwise, feel free to quote, cite or review if full credit is given)
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