Beginner's Guide To

Trading Futures:
Introduction
By Brian Perry
Welcome to the Beginner's Guide to Trading Futures.
This guide will provide a general overview of
the futures market as well as descriptions of some of
the instruments and techniques common to the
market. As we will see, there are futures contracts that
cover many different classes of investments (i.e., stock
index, gold, orange juice) and it is impossible to go into
great detail on each of these. It is, therefore,
suggested that if after reading this guide you decide to
begin trading futures, you then spend some time
studying the specific market in which you interested in
trading. As with any endeavor, the more effort you put
into preparation, the greater your odds for success will
be once you actually begin.

Important Note: While futures can be used to

effectively hedge other investment positions, they can
also be used for speculation. Doing so carries the
potential for large rewards due to leverage (which will
be discussed in greater detail later) but also carries
commensurately outsized risks. Before beginning to
trade futures, you should not only prepare as much as
possible, but also make absolutely certain that you are
able and willing to accept any financial losses you
might incur.

The basic structure of this guide is as follows: we will

begin with a general overview of the futures market,
including a discussion of how futures work, how they
differ from other financial instruments, and
understanding the benefits and drawbacks of leverage.
In Section Two, we will move on to look at some
considerations prior to trading, such as what brokerage
firm you might use, the different types of futures
contracts available and the different kinds of trades
you might employ. Section Three will then focus on
evaluating futures, including fundamental and technical
analysis techniques as well as software packages that
might be useful. Finally, Section Four of this guide will
provide an example of a futures trade, by taking a
step-by-step look at instrument selection, market
analysis and trade execution. By the end of this guide,
you should have a basic understanding of what is
involved in trading futures, and a good foundation from
which to begin further study if you have decided that
futures trading is for you.

Beginner's Guide To
Trading Futures: The Basic
Structure of the Futures
Market
By Brian Perry
In this opening section, we will take a look at how the
futures market works, how it differs from other markets
and how the use of leverage impacts your investing.

How Futures Work

You are probably familiar with the concept of
financial derivatives. A derivative is simply any
financial instrument that "derives" its value from the
price movement of another instrument. In other words,
the price of the derivative is not a function of any
inherent value, but rather of changes in the value of
whatever instrument the derivative is tracking. For
example, the value of a derivative linked to the S&P
500 is a function of price movements in the S&P 500.
Futures are among the oldest derivatives contracts.
They were originally designed to allow farmers to
hedge against changes in the prices of their crops
between planting and when they could be harvested
and brought to market. As such, many futures
contracts focus on things such as livestock (cattle) and
grains (wheat). Since these beginnings, the futures
market has expanded to include contracts linked to a
wide variety of assets, including precious metals
(gold), industrial metals (aluminum), energy (oil),
bonds (Treasury bonds) and stocks (S&P 500).

There are several different ways of measuring

the commodities market, and the performance of
different indexes can be vastly different. The charts
below show the index composition of two popular
commodity indexes. As you can see, the index sector
weightings are quite different, with the result that
performance can vary greatly. Therefore, it can be
difficult to get a single view as to how the overall
"commodity market" is performing.
ure 1: Goldman Sachs Commodity Index Sector Breakdown

ure 2: Dow Jones-UBS Commodity Index

How Futures Differ from Other Financial

Instruments
Futures differ in several ways from many other
financial instruments. For starters, the value of a
futures contract is determined by the movement of
something else - the futures contract itself has no
inherent value. Secondly, futures have a finite life.
Unlike stocks, which can stay in existence forever, a
futures contract has a set expiration date, after which
the contract ceases to exist. This means that when
trading futures, market direction and timing are vitally
important. You will usually have some choices when
choosing how long you want to make a wager for.
For instance, there might be futures contracts on
soybeans with expiration dates spaced every couple
months for the next year and a half (i.e., December
2012, March 2013, June 2013, August 2013,
December 2013.) While it might be obvious that the
longest contract gives you the most time for your
opinion to be right, this extra time comes at a cost.
Longer-dated futures contracts will usually (but for
reasons beyond the scope of this article, not always)
be more expensive then shorter-dated contracts.
Longer-dated contracts can sometimes be illiquid as
well, further increasing your cost to buy and sell.

A third difference is that in addition to making outright

wagers on the direction of the market, many futures
traders employ more sophisticated trades the
outcomes of which depend upon the relationship of
different contracts with each other (these will be
explained later in this guide). Perhaps the most
important difference, however, between futures and
most other financial instruments available to individual
investors involves the use of leverage.
SEE: Futures Fundamentals: Introduction

Leverage
When buying or selling a futures contract, an investor
need not pay for the entire contract at the time the
trade is initiated. Instead, the individual makes a small
up-front payment in order to initiate a position. As an
example, let's look at a hypothetical trade in a futures
contract on the S&P 500. The value of this contract,
which trades on the CME, is $250 times the level of
the S&P 500. So, at a recent level for the S&P of
approximately 1400, the value of the futures contract is
$350,000 ($250 X 1400.) In order to initiate a trade,
however, an individual only needs to post an
initial margin of $21,875 (per current CME exchange
margin requirements found on CME Group's equity
index products chart).

Note: initial and maintenance margin levels are set by

the exchanges and are subject to change.

So what happens if the level of the S&P 500 changes?

Well, if the S&P rallies to 1500, which is slightly more
than a 7% increase, the contract would be worth
$375,000 ($250 X 1500.) Remember, that our investor
only posted an initial margin of $21,875, but has now
achieved a $25,000 profit for a-better-than 100% gain.
This ability to achieve such a large profit even given a
relatively modest move in the underlying index is a
direct result of leverage and is one of the reasons that
some people like to trade futures.

Let's now look, however, at what might happen if the

S&P 500 fell in value. If the S&P fell ten points to 1390,
the contract would be worth $347,500, and our
investor would have a loss of $2500. Each day, the
exchange will compare the value of the futures
contract to the client's account and either add profits or
subtract losses to the client's initial margin balance.
The exchange requires that this balance stay above
certain minimum levels, which in the case of the S&P
500 is $17,500. So in our example the trader would
have a paper loss of $2500, but would not be required
to post any additional cash to his or her account.

What would happen if the S&P fell to 1300? In that

case, the futures contract would only be worth
$325,000 and the client's initial margin of $21,875
would be wiped out. (Remember, leverage works both
ways, so in this case a slightly more than 7% fall in the
S&P would result in a complete loss of an investor's
money.) If this occurred, the individual would be hit
with a margin call, and would be required to deposit
more funds into his or her account in order to bring the
balance back up.

Beginner's Guide To
Trading Futures:
Considerations Prior to
Trading Futures
By Brian Perry
Prior to trading futures, there are several things to
consider. Among these are which brokerage firm you
wish to utilize; what types of futures you might want to
trade; and what kinds of trades you are going to
execute. We will now look at each of these topics in
greater detail.

Choosing a Brokerage Firm

Prior to trading futures you need to choose a
brokerage firm. You can choose afull-service broker,
which will give you a higher level of service and
advice, but will likely have somewhat higher fees.
Alternatively, you can choose a discount broker, which
will likely have more of a "do it yourself" approach, but
will also have lower commissions and fees. The
direction you choose to follow is entirely a matter of
personal preference and inclination, but many readers
interested in trading futures are probably self-directed
investors, and for them a discount broker probably
makes the most sense.

Some investors may choose to trade futures though an

existing brokerage relationship. Some large discount
brokerages such as TD Ameritrade and Charles
Schwab offer futures trading at reasonable prices.
Other investors might choose a brokerage firm that
specializes in the futures market. Although there are
too many of these to list, the CBOE maintains a
directory of futures brokers which can be found
at CME Group's broker directory.

As always, when choosing a broker, make sure that

you research each thoroughly, particularly if you are
not previously familiar with a particular one. Important
considerations include commission rates, margin
requirements, the types of trades handled, the level of
 executions provided, software and user interface for
monitoring and trading, and general customer service.

SEE: 10 Tips For Choosing An Online Broker

Categories of Futures Markets

If you are trading stocks, there are many different
kinds of companies (i.e., tech, oil, bank) and while the
mechanics of trading a stock remain the same, the
nuances of the underlying industries and companies
vary widely. The same is true with futures. All futures
contracts are similar, but because there are futures
contracts that track such a wide range of instruments,
it is important to be aware of the broad groupings that
exist (it might be helpful to think of each category as
similar to an "industry" in the stock market and then
each underlying contract as similar to a "stock.") The
main categories of futures contracts, as well as some
common contracts that fall into those categories, are
listed below.

Futures Markets by Category

riculture Energy Equity Index FX Interest Rates Metal

ains (corn, oil, Treasuries (2, 5, 10, 30
Crude Oil S&P 500 Euro/$ Gold
ybeans) year)
estock (cattle, Heating Money markets
Nasdaq 100 GBP/$ Silver
gs) oil (eurodollar, fed funds)
Natural
iry (milk, cheese) Nikkei 225 Yen/$ Interest Rate Swaps Platin
gas
Base
rest (lumber, E-mini S&P Metal
Coal Euro/Yen Barclays Aggregate Index
p) 500 (copp
steel)

You can trade as many or as few categories and

instruments as you like, but a few suggestions are in
order. For starters, you might want to consider what
you already know. So for example, if you have been
trading stocks for years, you may want to begin your
futures trading with equity indexes. That way you
already understand the underlying drivers of
movements in the market you are following, and only
need to learn the nuances of the futures market itself.
Similarly, if you worked at Exxon for 30 years, you
might want to choose to focus on energy initially since
you probably understand what drives the direction of
the oil market.
Once you have chosen a market category, the next
step is to determine what instruments you will trade.
Let's assume you have decided to trade energy. Now
you need to decide what contracts you will focus on. Is
your interest in crude oil, natural gas or coal? If you
decide to focus on crude oil, you can then choose from
among West Texas Intermediate, Brent Sea or a host
of other options. Each of these markets will trade at
different levels, and will have their own nuances as
well as different levels of liquidity, volatility, and varying
contract sizes and margin requirements. By this point,
it should be clear that there is a fair amount of
homework involved before beginning your futures
trading career.

A good place to find a listing of many available futures

products in the energy segment, as well as contract
specifications and margin requirements is CME
Group's energy product slate. Similar pages exist for
the other product categories as well. Ultimately, after
doing your homework, you will decide what product
you want to trade. The next step is to decide what type
of trades you want to do.

Trade Types
At the simplest level, you can decide to buy or sell a
futures contract, thereby wagering that the price will
rise or fall. These types of trades are familiar to most
investors from the stock market, and they are easy to
understand. Therefore, outright buys and sells are
probably a good place to start your futures trading. As
you progress in your trading career, however, you may
find that you want to employ some of the more
sophisticated futures trading techniques that exist.
Because this is a Beginner's Guide, we will not cover
these in great detail, but once you are aware of them it
should be easy enough to conduct additional research
online if you are so inclined. Two types of trades
commonly used by professional futures traders are:

 Basis trades: the trader is long (short) a futures

contract and short (long) the cash market. This is
a wager that the price differential between cash
and futures will fluctuate. For example, a trader
could buy 10-year U.S. Treasury bond futures and
short physical 10-year U.S. Treasury bonds.

 Spread trades: the trader is long and short two

different futures contracts. This is a wager that the
price difference between two different futures
contracts will change. For example, a trader could
purchase an S&P 500 contract for March delivery
and sell an S&P 500 contract for June delivery. Or
an oil trader might purchase a futures contract
on West Texas Intermediate (WTI) oil and sell a
contract on Brent Sea oil, betting that the price
difference between the two will change.
  Hedging: the trader sells a futures contract to
offset positions he or she holds in the cash
market. For instance, if you have a large portfolio
of stocks that you do not want to sell for tax
reasons, but you fear a sharp market decline, you
could sell S&P 500 futures as a hedge against a
stock market decline.

Beginner's Guide To
Trading Futures:
Evaluating Futures
By Brian Perry
Once you have decided which futures market is right
for you and have established an account with an
appropriate broker, the next step is to evaluate the
market. As with most financial markets, there are two
main types of tools that traders use to analyze futures:
fundamental analysis and technical analysis. We will
now take a look at each of these.

Fundamental Analysis
Fundamental analysis involves research into the
underlying factors that determine the price level for a
financial asset or a commodity. The type of analysis
you would want to perform will depend heavily on
which futures market you choose to invest in. For
instance, if you decide to trade futures on Treasury
Bonds, you would want to analyze the fundamental
factors that drive bond prices. These include the level
and direction of economic activity, Federal Reserve
monetary policy, supply and demand, investor
sentiment, and daily economic and news releases. On
the other hand, traders of futures contracts on corn
would be far more interested in analyzing weather
reports, details on acreage planted and crop yields,
supplies of alternative grains and shipping costs.

As the two brief examples above should make clear,

fundamental analyses will vary widely among different
futures markets and one market may in fact have very
little in common with another market. That is why many
traders choose to focus their attention on only one or
two futures markets. Doing so allows them to
concentrate their efforts on developing keen analytical
abilities for say, the oil market, while at the same time
developing experience in trading that commodity.
Rapidly switching from one futures market to another,
seeking to trade whichever is the most volatile or
popular at a given moment, is unlikely to be a
successful approach, particularly if you are employing
fundamental analysis.

Regardless of which market you focus on, it is

important to realize that you are likely to have at least
somewhat of an information disadvantage relative to
other market participants. There are two main types of
participants in the market: speculators and hedgers.
Speculators try to benefit by being on the right side of
price movements, while hedgers attempt to remove the
risk associated with future price movements from their
business. While in some markets (such as equity or
interest rate futures) it may theoretically be possible for
a very well-informed and dedicated individual to have
nearly as much information with which to conduct
analysis as a bank or institutional investor, in some
other markets this is just not practical.

For example, if you are trading corn, no matter how

many reports you read on the state of the market, you
are unlikely to have as firm of a grasp on the
fundamentals as a corn farmer in Iowa or Nebraska,
not to mention a large agricultural company such as
Monsanto. Similarly in the oil market, Exxon is likely to
have a better feel on the supply and demand in the oil
market for the next three months than even the most
well-informed individual trader.

Despite this information disadvantage, it is important to

be as well-informed about your chosen market(s) as
possible while at the same time maximizing your
advantages. Remember, Monsanto or Exxon are
interested in hedging their forward production, not
exploiting daily price movements, and they are also so
large that their trades can be cumbersome. As an
individual, you have the ability to be more nimble and
opportunistic than some larger institutions.

Regardless of the market you choose, before

beginning trading you should do a great deal of
additional research into the underlying
fundamentals and market conditions of that market in
order to maximize your opportunities for success.

Technical Analysis
The second main group of tools used to evaluate
futures markets includes those that fall under the
heading of technical analysis. While fundamental
analysis is concerned with determining the intrinsic
value of an asset, technical analysis tries to determine
future price action by evaluating prior price
movements. While many market participants do not
believe that analyzing charts provides any clues to
what will happen in the future, there are also many
proponents of technical analysis, particularly among
short-term traders.

One benefit of technical analysis is that unlike

fundamental analysis, many of the charts and tools
that technical analysts use can be carried from one
market to the next. That means that although there
may still be benefits to concentrating on certain
markets, a technical analyst may have more flexibility
than a fundamental analyst in moving from market to
market.

If you decide that technical analysis is right for you, I

encourage you to learn as much as possible about
various tools and techniques. An in-depth discussion
of these is beyond the scope of this guide, but a good
starting point for more information can be found
in Investopedia's technical analysis tutorial.
Regardless of whether you choose to focus on
fundamental or technical analysis, remember that you
do not have to rely on one to the complete exclusion of
the other. Even many fundamental analysts examine
charts to determine entry andexit points for trades they
have discovered through their research. Similarly,
even hardcore chartists pay attention to important
fundamental news developments and supply and
demand developments. (No matter what a chart says,
if a hurricane wipes out all large Gulf Coast oil
refineries, the price of oil is likely to rise because
supply will have decreased.)

SEE: Blending Technical And Fundamental Analysis

Tools and Techniques

In addition to fundamental and technical analysis,
there are a number of other tools and techniques that
can help you in trading futures. The most important of
these is risk management. As we discussed earlier,
the use of leverage in futures trading increases both
the reward and the risk. In order to avoid being wiped
out by unexpected market movements, individuals
need to practice strict risk management. This should
include always having a stop loss in mind when
entering a trade. This stop loss should be a level
where you exit the trade and cut your
losses, regardless of whether you still believe in your
original premise. Never forget the famous saying
"markets can stay irrational longer than you can stay
solvent." Even if your initial premise is ultimately
correct, irrational market dislocations can stay in place
much longer than they "should," and can wipe out your
capital, particularly when you are employing leverage.

Many traders also place physical stop loss orders at

the time they enter a trade. These orders are designed
to automatically execute if the level you select is
breeched.

Note: These are good to use but they are not failsafe,
as in very volatile markets your order may not be
executed at your desired level and your losses could
be greater than intended.

A final important risk management tool

is diversification. This means that you should spread
your capital among a number of small bets within the
futures market and across time. Remember, investing
is a marathon not a sprint. Diversification also means
that trading futures should not be the entirety of your
investment program. In addition to your trading
account you should also have other, longer-term
investments that you maintain in a different style and in
different investment vehicles.

Another tool that you may consider incorporating into

your futures trading program is a software charting
program. There are many of these, and which one you
prefer is largely a matter of personal taste. If you have
not used chart packages in the past, you can find
information on some of them atInvestopedia's Trading
Systems and Software hub.

Fundamental analysts will also want to make sure that

they have the necessary tools for conducting their
research. In addition to general market news sources
such as the Wall Street Journal or Barron's, you will
likely want to find more specific sources depending
upon which markets you choose to follow. For
instance, if you are active in the agriculture markets,
you will probably want to spend a fair amount of time
following and analyzing reports issued by the U.S.
Department of Agriculture. Similarly, energy traders
will want to follow OPECpronouncements closely, and
should probably read annual and quarterly reports put
out by major oil companies, such
as Exxon (NYSE:XOM), BP (NYSE:BP)
andChevron (NYSE:CVX). Again, as a fundamental
analyst, the better informed you are, the better your
analysis will be.

Beginner's Guide To
Trading Futures: A Real-
World Example
By Brian Perry
Now that you are more familiar with the concepts and
tools of trading futures, let's take a look at a
hypothetical step-by-step example.

Step 1: Choose a brokerage firm and open an account

- For this example, we will use brokerage firm "XYZ"
and open an account.

Step 2: Decide which category of futures to trade - For

this example, let's choose to trade metals futures.
Step 3: Decide what instrument to trade within your
chosen category - Let's choose gold.

Step 4: Conduct research on your chosen market -

This research might be fundamental or technical in
nature depending upon your preferences. Either way,
the more work you do, the better your trading results
are likely to be.

Step 5: Form an opinion on the market - Let's say that

after doing our research we decide that gold is likely to
rise from its current level of around $1675/oz. to
around $2000/oz. over the next six to 12 months.

Step 6: Decide how best to express our view - In this

case, since we think the price will rise, we want to buy
a futures contract on gold - but which one?

Step 7a: Evaluate the available contracts - There are

two gold contracts. The standard contract covers 100
ounces, and the "E-micro" contract covers 10 ounces.
In order to manage our risk in our initial foray into the
futures market, we will choose the E-micro contract.
Step 7b: Evaluate the available contracts - We next
choose the month in which we want the contract to
expire. Remember, with futures it isn't enough to get
the direction of the market right, you also need to get
the timing right. A longer contract gives us more time
to "be right" but is also more expensive. Since our
market view is for a move higher in 6-12 months, we
can pick a contract expiring in four months, eight
months, or 10 months. Let's choose 10 months.

Step 8: Execute the trade - Let's buy a 10-month E-

micro gold contract. For this exercise, let's assume we
pay a price of $1680.

Step 9: Post initial margin - In this case, the current

exchange requirement is $911.

Step 10: Set stop loss - Let's say we don't want to lose
more than 30% of our wager, so if the value of our
contract falls below $625 we will sell.

Step 11: Monitor the market and adjust position

accordingly.

Note: This example is purely hypothetical and is not a

recommendation or opinion. These are basic steps for
executing a futures trade and you may find that a
different process works for you. As you gain more
experience and knowledge, you are likely to develop
your own system that you are comfortable with.

Beginner's Guide To
Trading Futures:
Conclusion
By Brian Perry
This Beginner's Guide to Trading Futures has provided
an overview of how to begin evaluating and trading
futures. Because the futures market tracks so many
different indexes and commodities, it can be extremely
complicated. Therefore it is important that you
thoroughly understand the market which underlies the
futures contracts that you are trading. Furthermore,
because of the leverage they employ, trading futures
can be extremely dangerous, so it is also very
important that you employ rigorous risk management
to your futures trading program. Furthermore, studies
have shown that as many as 90% of futures traders
lose money, so you should never trade futures with
capital you cannot afford to lose.
Hopefully, this guide has provided you with a strong
foundation from which to begin further research. If you
have decided that futures trading is right for you, you
will be well-served to thoroughly research both the
futures market in general and your chosen subsector
of the market specifically. The more knowledge and
experience you have, the more likely you are to be a
successful futures trader.