Leverage System in Future Markets

FUTURES MARKETS: LEVERAGE SYSTEM   

          We will go over several techniques for helping you identify trading opportunities in the futures markets. So far we have gone over using exchange traded funds versus stocks; pairs trading in related stocks; and using commodities for identifying opportunities in ETFs, such as the oil service.

HOLDRs (OIH) or the U.S. Oil Fund (USO) versus crude oil futures. The Euro Currency Trust (FXE) is a more direct move for stock traders playing the euro currency futures versus the U.S. dollar. Then there is the street- TRACKS Gold ETF (GLD) compared to the CBOT electronic gold futures contract, or now a trader can use the iShares Silver Trust to trade against the physical silver market.

Stock traders can now apply and take advantage of so many commodity markets; but as I mentioned, the futures market is a great investment vehicle to many savvy and financially well-funded traders. Even smaller-sized traders can benefit from trading the futures market through the responsible use of the margin system, otherwise referred to as a “good faith deposit.” What is a futures contract? It is a legally binding agreement to buy and sell a commodity or financial instrument sometime in the future at a price agreed upon at the time a transaction was made. Contracts are standardized according to delivery points of interest, quality, quantity, and time of accepting or making a delivery. It is estimated that less than 3 percent of all transactions actually result in a delivery. In the case of stock index trading, there is a cash settlement over the value of the contract.

 Stock Index Futures

For day or swing traders following the stock market, the futures market offers an advantage over stocks from tax liability perspective. Always check with your accountant; but, generally speaking, profits generated in a futures account are taxed at a rate significantly lower than that for a stock account.

One confusing aspect and perhaps a drawback for many traders switching from equities or even forex to trading futures is that there are so many products with various contract sizes. There is no consistency or constant in tick value fluctuations or dollar value in the price changes. For example, the CBOT mini-Dow contract is $5 times the overall Index. When the Dow was at 10,500, the overall value was 52,500. The margin was set at $2,600, or just under 5 percent. E-mini-S&Ps are 12.50 per tick (four ticks per point). If the point value is $50, the overall value of the contract if the S&P is at 1,200.00 is $60,000. In the currency markets, the euro is 12.50 per tick; the Canadian dollar is 10 per tick; the British pound is 6.25 per point but trades in a minimum two-tick fluctuation. (In my first book [A Complete Guide to Trading Tactics, Wiley, 2004], I listed all the commodities and the contract sizes on pages 8 and 9; please refer to that for a comparison. Or you can ask your futures broker to provide the listing of contract specifications.)

The exchanges where the individual futures products are traded set the margin requirements. Generally speaking, an initial margin requirement on a futures product runs anywhere from 2 percent up to 10 percent of a contract’s overall value. So now a trader needs to know which exchange the product is traded on, how much risk capital is needed to invest per contract, and how much each point value is. Let’s look at the New York Mercantile Exchange’s crude oil contract: The contract size is 1,000 gallons; every tick or point fluctuation equals $10. A $1 move per contract is a $1,000 price move. When prices were at $65 per barrel, the contract value was $65,000. The margin requirement was, at one point, nearly $9,000 per contract, almost 14 percent of the overall market value. The extremely high margin requirement reflected the extreme level of volatility and the inherent risk associated with that increased volatility.

The futures markets also have a value for stock traders to make decisions on asset allocations to their stock portfolios. In the agriculture sector, for example, you can study the price direction of soybeans, use traditional technical analysis tactics to determine the strength of a trend, and see if corresponding stocks linked to that market are worth switching or allocating funds toward. In Figure 1.27, we see soybeans making a seasonal harvest bottom at the end of November.

Another advantage futures have is that you can trade signals to diversify in other investments. Anticipating that the market may establish a seasonal bottom, you may want to explore stocks directly linked to the agriculture industry, instead of being exposed to potential risks due to what might appear to be an overleveraged investment vehicle, such as a futures contract. After all, every penny in soybean futures was $50 at the time that I was preparing this book, and the minimum margin requirement was $1,148. That means that on a small 20 cent move, you could lose nearly 95 percent of the initial investment per contract.

There are other considerations you could use, such as an options strategy, to effectively reduce risk exposure, such as going long a futures contract and buying a put option for protection; but in this strategy, you need to time the right option expiration. An alternative strategy would be going long a related market, such as stock in Monsanto shown in Figure 1.28.

Notice that this stock exploded in early November. The best part here is that there were seasonal factors to support a buy signal; and the technical picture shows what I call a “high close doji trigger,” which we will disclose in this book. In fact, this is a great example to demonstrate why using a like or related market analysis approach can help you achieve better results in your trading. Cycle and seasonal studies can really help you in selecting stocks. The futures markets can certainly aid in that analytical process. Not only do commodities move in cycles, but the economy and businesses do as well.

There is one man who sticks out above the rest as the premier expert in the field of intermarket relationships—John J. Murphy. He has written many books on the subject; the latest, titled Intermarket Analysis: Profiting from Global Market Relationships, will really help you in your educational journey.

Let’s look at two more agriculture related stocks: One in Figure 1.29 is Archer Daniels Midland, which as you can see did rise but not significantly; however, it did rise in tandem with the soybean market. The other stock is Bunge Limited, shown in Figure 1.30, which mirrored the chart pattern in Figure 1.29 and moved higher at almost exactly the same time that the bottom in the soybean futures was formed.

 Tandem Trading Techniques

Intermarket relationships have existed for years. It is very easy to track and look for trade setups in futures from a historical perspective, but timing a trade can be difficult due to the magnitude of the leverage as previously discussed. Don’t get me wrong; futures are a very viable investment vehicle. I have made a very lucrative living trading commodities for the past 26 years. I just want you to learn that you can use futures to help make diversified investment decisions on a broader scale.

The key to making money in the markets is managing risk . . . end of story. Knowing the right strategy and having exposure to other markets and strategies can help you achieve your financial goals. Using similar or like markets or those that trade in tandem, especially markets that have strong relationships, traders can develop trading techniques or strategies by using signals based on one market and applying them to another, such as commodities and stocks or an ETF. Keep in mind that not all relationships work all the time. Look at past market relationships, such as the dollar and gold: Generally when the dollar goes up, gold goes down; but that certainly was not the case in 2005. How about when the Fed raises interest rates? Generally, long-term bond yields rise as well; but that did not occur in 2005 either. In fact, commodities and bond yields usually trend together; and that did not occur in 2005. Federal Reserve chairman Alan Greenspan called the decline in long-term yields a “conundrum.”

As we saw commodity prices rise, we saw the Federal Reserve raise rates at a “moderate” pace, acting at 16 consecutive meetings to adjust the Fed funds rate by 0.25 percent each time. This was in response to the perception that inflation was rearing its ugly head. (As of the printing of this book, the Fed was still in rate-hiking mode!) Due to higher energy costs and as reflected in the Producer and Consumer Price Indexes, we had seen a pickup in inflation; and historically, many commodity prices rise besides gold and silver, such as sugar, coffee, and cotton.

The Reuters/Jefferies CRB (Commodity Research Bureau) Index, originally developed in 1957, is one of the most often cited indicators of overall commodity prices, offering investors a broad and reliable benchmark for the performance of the commodity sector. It is traded on the New York Board of Trade and started trading back in 1986. The “RJ/CRB” Index was revised in 2005 to reflect 19 commodity futures prices: aluminum, cocoa, coffee, copper, corn, cotton, crude oil, gold, heating oil, live cattle, lean hogs, natural gas, nickel, orange juice, silver, soybeans, sugar, unleaded gasoline, and wheat.

If you examine the chart of the RJ/CRB Index shown in Figure 1.31, the stratospheric rise is obvious and would indicate that inflation was or will be trickling down to consumers.

Again, price increases in commodities historically signal a rise in inflationary pressures.

Investors and traders can use stocks or ETFs to capitalize on commodity plays; but at times, it pays to diversify and have a commodity account. Not all stocks offer participation in all commodity moves, so it is wise to explore using commodity markets as an investment.

 A Case In Point

A fundamental event, besides an increase in demand, that helped create a shortage of supplies in energy and other commodities in 2005 was the weather. Hurricanes Katrina, Rita, and Wilma gave a lift to sugar and orange juice futures while harming certified coffee facilities in New Orleans and, to a lesser extent, Miami. These weather-related events were pure commodity market plays. Let me walk you through one of these 2005 events: The day before Hurricane Wilma passed through Florida, my wife and I had watched the Weather Channel intensely and decided to stick around because all the news reported that the hurricane would be downgraded to a tropical depression by the time it crossed over Naples and exited on the other side of Florida, in Palm Beach. The day before, we had played golf; and it was a splendid day: 83 degrees or so, a light breeze, and not a cloud in the sky. We were planning to leave for Chicago the following Sunday, and we could have easily changed our tickets and left early. Well, at 6 a.m. on October 24, we woke up and discovered that Wilma had gained strength and merged with another storm, named Alpha; and Wilma had turned into a low-grade Category 3 hurricane! All I could think of at the moment my wife turned the TV on was, “I better make some coffee because we are going to lose power.” By the time the coffee had finished brewing, click, all the lights went out.

However, we were prepared: The cars had gas, the shutters were up, and we had a generator; so life was not so bad for that week. The morning of the hurricane, CNBC had called to see if I was in Florida and asked me what I thought would happen to the orange juice crop. I did a live interview via my cell phone, reporting on the weather conditions and what might happen to the orange crop. I stated that “we could see at least a 10 percent price gain from the 1.11 level to possibly as high as 1.25, as the storm would pass through sections of Indian River County.” It was also that storm that devastated the soon-to-be-harvested sugar cane crop. As it turns out, that was a solid prediction and exactly what played out in the markets. If you had a commodity account, you may have taken up that opportunity in orange juice. In fact, orange juice eventually moved as high as 164 by May 11, 2006.