Who trades commodity futures and options and why?

The first group of participants in the commodities and options markets are commercial and institutional users of the commodities they trade. For example, a company or individual who holds an asset such as coffee, corn, soybeans, U.S. Treasury bonds, or a portfolio of stocks, wants the value of that asset to increase. That person also wants to limit, if possible, any loss in value. The company or individual may use the commodity markets to take an opposite position that can minimize the risk of financial loss from holding those assets when and if their price changes. This is form of futures trading is called "hedging."

Other participants are speculators who hope to profit from changes in the price of the futures contract. A speculator buying a contract or call option, or selling a put option, hopes to profit from rising prices, while a speculator selling a contract or call option, or buying a put option, hopes to profit from declining prices. Because, unlike a hedger, a speculator does not own the underlying commodity, the components of the underlying index, or other product, losses in the market are not offset by gains in the cash market, and speculators can lose substantial amounts.

Individuals do participate in the market. An individual who owns or runs a business might participate as a hedger. Or, an individual with a substantial and diversified portfolio of investments might speculate using futures and/or options trading. Individual investors should also have adequate resources to absorb the significant losses that can occur in futures and option trading.

Can commodities trading meet my investment goals?

Futures and option trading is inherently complex and risky, and it is not appropriate for all investors. You should know how much you potentially can lose and honestly evaluate if you can afford to lose it in view of your financial resources and investment goals. You should share your conclusions with your broker. If you decide you have the resources and the reasons to invest in futures, you should also determine the extent to which you plan to rely on advice from a broker versus making your own trading decisions. Then you should evaluate and compare the methods of futures trading before choosing the one you feel will best implement your goals. Finally, set some limits on the duration of your investment and the amount of loss you are willing to incur. Like other financial markets, futures and options markets are cyclical and gains may not be immediate. Finally, remember that, because of the leveraged nature of futures, losses can be more than your original deposit.

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How do I go about trading futures or option contracts?

In the United States, futures contracts and options on futures contracts must be executed on or subject to the rules of a commodity exchange. But you, as an individual, cannot trade directly on an exchange. A person or firm must trade on your behalf. People and firms who trade on your behalf as a customer generally must be registered with the Commodity Futures Trading Commission.

How do I open an account with a futures broker?

With an individual trading account, trading is done only for you. An individual account may be a "non-discretionary" account, which means that you make all the trading decisions and the broker may not execute any transactions without your prior approval. In a "discretionary" individual account, you give permission for the firm carrying your account or some third party to make trading decisions on your behalf.

You may open an individual account with a registered Futures Commission Merchant or through an Introducing Broker. An Introducing Broker may accept your orders and transmit them for execution to a Futures Commission Merchant with which the Introducing Broker has a relationship. An Introducing Broker is not permitted, however, to accept any funds from you. You deposit funds directly with the Futures Commission Merchant. In an individual discretionary account, you grant power-of-attorney to a Futures Commission Merchant, an Introducing Broker, one of their Associated Persons, or a Commodity Trading Advisor to make trading decisions on your behalf.

What are my contractual obligations?

When you enter into a commodity or option contract through an individual account, you are required to make a payment referred to as a "margin payment" or "performance bond." This payment is small relative to the value of your market position, providing you with the ability to "leverage" your funds. Because trading commodities and option contracts is leveraged, small changes in price, which occur frequently, can result in large gains or losses in a short period of time.

Each day, your broker will calculate the current value of contract positions held in your account. If the equity in your account has declined in value to the "maintenance margin level" (approximately 75 percent of the amount required to enter into the trades originally), you are required to provide more margin money to restore the initial margin level (this is called a "margin call"). This eliminates the need to make repeated margin calls when daily price changes are relatively small.

If you fail to meet a margin call within a reasonable period of time, which could be as little as one hour, your brokerage firm may close out your positions to reduce your margin deficiency. If your position were liquidated at a loss, you would continue to be liable for that loss. You can, therefore, lose substantially more than your original margin deposit.

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UNDERSTANDING YOUR RISK & OTHER ASPECTS OF TRADING

What is a risk disclosure document?

Because trading in commodities and options is appropriate only for certain businesses and individuals, the CFTC requires that a broker provide you with a disclosure document that describes the risks involved. The document provides you with an opportunity to carefully consider whether futures and options are appropriate for you in light of your experience, objectives, financial resources, and other circumstances. The broker must receive a signed and dated acknowledgment from you that you have received a disclosure document before he or she can accept any funds, securities, or property from you.

A Futures Commission Merchant or Introducing Broker must provide you with a disclosure statement that informs you of the risks inherent in trading futures contracts and/or options on futures contracts, as well as the effect that leverage may have on potential losses or gains. The disclosure statement must also inform you that trading futures in foreign markets carries particular risks because of fluctuations in currency exchange rates and differences in regulatory protection.

How does risk affect my returns?

Your returns may change radically at any time because futures and options are subject, by nature, to abrupt changes in price. Commodity prices are volatile because they respond to many unpredictable factors: weather, labor strikes, inflation, foreign exchange rates, government monetary policies, etc. And, in an individual account, because your position is leveraged, even a small move against your may result in a large loss, including the loss of your entire initial margin payment and liability for additional losses.

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Are there strategies for reducing risk?

In an individual account, there are certain types of orders (such as "stop-loss" orders or "stop limit" orders), which are designed to limit losses to certain amounts. However, these orders may not be effective in limiting losses because market conditions may make it impossible to execute your orders at a reasonable price. Strategies using combinations of positions, such as "spread" and "straddle" positions, may be as risky as taking simple "long" or "short" positions.

Do options carry less risk than futures?

Not necessarily. If you plan to trade through an individual account and are considering investing in options, you should familiarize yourself with the types of options (puts or calls) and the risks associated with each. You should calculate the extent to which the value of the options must increase for your position to become profitable, taking into account the premium and all transaction costs. You should also understand that certain market conditions (such as lack of liquidity), market rules, or the pricing relationships between the underlying commodity and the option may increase risk.

Do the risks vary between puts and calls?

The purchaser of an option (known as a "long" call or being "long" a put) can do the following with an option position. The purchaser may "exercise" the option if it is profitable, or allow the option to expire if it is not profitable. The exercise of an option by someone who is "long" results either in a cash settlement or in the purchaser acquiring the underlying interest. If the option is on a futures contract, the purchaser will acquire a futures position with associated liabilities for margin. If a purchased option expires worthless, you will suffer a total loss of your investment, which will consist of the option premium plus transaction costs.

Selling, or shorting, an option generally entails considerably greater risk than purchasing options. Although the premium received by the seller is fixed, the seller may sustain a loss well in excess of that amount. The seller will be liable for additional margin to maintain the position if the market moves unfavorably. The seller will also be exposed to the risk that the purchaser will exercise the option, obligating the seller to either settle the option in cash or to acquire and deliver the underlying interest. If the position is "covered" by the seller holding a corresponding position in the underlying interest or a future or another option, the risk of loss may be reduced, but the loss may still exceed the premium received. If the option is not covered, the risk of loss can be unlimited.

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A "BEFORE-YOU-TRADE" CHECKLIST

Before you begin to trade commodities, have you...

1) Clearly identified your financial goals, including the amount of risk and loss you can sustain?

2) Determined how much assistance, if any, you need from a commodities broker in making trading decisions?

3) Checked the registration status and disciplinary history of the broker you've selected with the National Futures Association?

If you have answered "Yes" to the three questions above, then you are ready start. Click Here to begin the simple process of opening your new futures trading account.