INTRODUCTION

So you’re thinking about trading futures. Good for you!
In terms of sheer scope of opportunity to effectively pursue your financial
objectives, it’s hard to beat futures trading. The diversity of instruments
and markets included provides just about any trader everything they could
possibly need to employ all kinds of speculative and/or hedging activities.
In short, the futures market provides opportunities to trade markets in
which one would not otherwise easily be able to take part.



Gold is a great example.






To put things in perspective, gold started 2006 at around $520/oz. As of
this writing it is around $650/oz. That’s a gain of $13,000 per futures
contract, which is a return of nearly 350% on the $3750 margin needed to
initiate the position (about a $4300 gain on the mini gold contract which
has a margin requirement of about $1250).
Another excellent example is Crude Oil.


















In this case, a buyer at the start of 2006, when prices were around $61 per
barrel, would be up about $10,000 at the approximately $71/barrel price
as of this writing. That is on a $4725 margin deposit, which means a gain
of over 200% (gain would be $5000 on a $2350 margin for the mini).
Of course the situation works both ways. One can just as easily lose money
in futures trading.





The point being made here, though, is that if it were
not for the futures market it would be very hard for the average trader to


take part in markets like gold and crude oil (along with many others).
Once upon a time, the futures market was the realm of large institutions
and big time speculators. The increased availability of “mini” contracts,
with their lower margin requirements and smaller per tick values, though,
has made futures trading much more accessible to the average trader.



This guide will provide you a basic introduction to the futures market. It is
by no means a comprehensive discussion of everything futures related, but
the pages that follow do lay the ground work and do make suggestions as
to where one can go to learn more.





That said, let’s get going!



Definitions



First things first. We need to de-
fine just exactly what we’re talking
about here. To do that we need to
first talk about forward contracts.
A forward contract—or simply a
forward– is an agreement between
two parties to make a transaction
at some point in the future, gener-
ally with pre-defined specifica-
tions. For example, if you and I
agree that next week you will buy
my car from me for $5000, that
would be a forward contract. We





have a specified time, price, and asset being exchanged.
Now imagine instead that I am a farmer and you are in the flour business.
You need wheat to make your flour, so you get it from me. Of course my
crop won’t be ready until harvest time, so you and I make an agreement
that in three months you will buy 5,000 bushels of my wheat at $5 each.
That too is considered a forward contract. Simple enough, right?



Now that we have forwards sorted out, defining futures is pretty easy.
A futures contract is simply a standardized forward contract. That means
all of the contract terms are predefined. This is done by a futures ex-
change (of which there are many) to help facilitate easier trading.



Let’s use wheat as an example again. If it is just you and I making an ar-
rangement for you to buy my wheat, then it would be simple enough just to
agree on forward contract terms. In the massive global markets, though, it
isn’t always so easy for buyers and sellers to come together like that. So we
have the Chicago Board of Trade (CBOT) come in to act as a marketplace.
The CBOT, though, cannot have everyone trading on different forward
contract terms, though. It would make for a very inefficient operation. So
they standardize the contract terms.



In terms of wheat, the CBOT has decided that transactions will be done in
5,000 bushel lots. That means each contract is for the exchange of 5,000
bushels of wheat. The exchange has also defined the acceptable grades of
wheat (I won’t get in to that) and the months which the delivery of the
wheat can take place (March, May, July, September, December), and even
the days during which delivery must happen.





This might all seem quite complicated. It really isn’t. In fact, the contract
specifications are designed to make trading possible. Without them there
simply would not be a market. The fact of the matter is that speculators do
not really have to concern themselves with much beyond the contract size
and the price. We’ll get more in to that later.



Why Forwards and Futures?



At this stage you may be wondering why there are forward contracts and
futures markets—what purpose they serve. It’s a fair question.



We can assume that forward contracts go back millennia—for as long as
there have been farmers and those who needed their produce. The miller
needs wheat to produce flour and has to get it from the farmer. There is a
lot of uncertainty, though. Supply and demand considerations create price
fluctuations. The farmer and the miller cannot necessarily be sure of what
the price is going to be for wheat when the crop is ready. They both need
to be able to budget their income (farmer) and expenses (miller) so they
enter in to a forward contract which locks a price in. The farmer knows
how much he is going to receive for his wheat and that he’s got a locked-in
customer. At the same time the miller knows that he’s got a guaranteed
supply of wheat and what it’s going to cost him.



This sort of arrangement still goes on today. You may even be doing some-
thing like it yourself. Many companies which provide heating oil or natu-
ral gas offer customers the opportunity to lock in prices at a certain rate.
The idea is that you are protected against price increases. This is a forward
contract at its simplest level.



As long as there is price uncertainty, there will be the need for forward


contracts. The futures market is just a kind of wholesale operation to fa-
cilitate their arrangements.
Having said that, though, the futures markets of the modern day go way
beyond just putting producers of raw materials together with manufactur-
ers of end or intermediate products.



Actually, most of the trading done in futures these days is not done with
delivery of the actual product in mind. There are, of course, a great many
speculators. They are a necessity to help provide liquidity—despite what
some folks might otherwise think.
The futures markets also provide a hedging mechanism. They allow a wide
array of participants the opportunity to protect themselves against adverse
price action.



For example, imagine you are a multinational company doing trade in Ja-
pan. When you sell product to customers there you receive Yen, which you
will eventually want to convert in to Dollars. The exchange rate between
the Yen and the Dollar fluctuates constantly. In order to protect yourself
against the Yen weakening against the Dollar (thereby making the value of
your Yen profits lower) you can hedge yourself. That can be done in the
futures market.



There are all kinds of businesses and whatnot who have some kind of price
exposure in their operations. Many use the futures market to help protect
themselves. They don’t expect to deliver or take delivery of the product
they are hedging. They just use them to offset their price risk and secure
their business. This applies to mutual and hedge funds as well. Both use
futures to hedge their portfolios.

FUTURES TRADING

By now it has been established that futures trade on exchanges, much in
the same way that stocks do. These exchanges are located throughout the
world and represent both pit and electronic trading.

Pit, or floor, trading is done on-site at the exchange. This is what most
people think of when they picture the futures market. The traders who op-
erate in these sometimes frantic arenas are the folks who actually execute
the transactions as the buyers and sellers. In the case of those who work
for brokers or other institutions, they trade based on the flow of orders
coming from their employer. There are also pit traders who are just there
trading for their own account. As noted before, they help the process by
providing liquidity.

Pit trading is the traditional operation, but it is one which is becoming in-
creasingly phased out in favor of electronic trading. This newer method
involves no human interaction, but rather is a system of order matching.
Incoming orders are matched up by computer. This speeds up the process
and provides a high degree of transparency.

As an individual trader you take positions via a broker. Your orders get
routed to the exchange where they are actually executed. Whether that is
through the pit or electronically depends on the market you are trading,
and possibly the time of day. Some markets feature floor trading during
the normal daytime market hours with electronic trading taking over in
the “after hours” timeframe. Other markets are either completely pit
traded or totally electronic.

Opening and Closing Futures Positions

Because trading futures does not result in the actual exchange of anything
(for most traders anyway), it has to be thought of a bit differently than
would be the case with stocks, for example. You aren’t actually buying or
selling anything. You are entering in to an agreement. As such, it is more
correct to say you are going long or going short rather than buying or sell-
ing, though in practice buy and sell are frequently used.

Going long means entering in to a futures contract position whereby you
would be the purchaser. Using our wheat example, the person who is long
that contract is the one who will be buying the wheat at the contract’s end.
Going short, naturally, is the other side of the equation. The short is the
one who is to be the seller at contract conclusion.

You can think of it this way. You are long if an increase in price benefits
you. If a decrease in price is to your benefit then you are short.
So when you initiate a long or short position you are entering into a fu-
tures contract. Now let’s take a look at exiting a position.
Since taking a futures position means entering in to a contract, it’s not as
each as just breaking the contract. What we actually do is enter in to an
offsetting contract.

Bringing Wheat back in to the picture, imagine that we’ve gone long a fu-
tures contract. Now we want to get out of that position. To do so, we enter
into a new futures position in which we are short. Those two positions ne-
gate each other, so you end up with no net positions.

You might be thinking “Yeah, but I have two contracts now.” No need to
worry. The exchange handles that. Because you offset your positions, you
have no more commitment. The exchange keeps track of all the open long
and short positions to make sure they match up those who are looking to
actually take delivery with those who are actually looking to provide it.
Profits and Losses

We make profits in futures positions by closing them out with an offset at a
better price than at which we entered the initial contract. If we are long,
that means at a higher price, while if we are short it’s a lower price. This is
where the value of the futures contract comes in.

Imagine that we have gone long a Wheat contract at the price of $5/bushel
Keep in mind that a futures contract is 5,000 bushels, so the value of this
contract is $25,000. Let’s say the price moves up to $6/bushel. Now the
value of a contract is $30,000. If we offset our long position by taking a
short futures position at the current price, we make $5,000.

To understand how this works, let’s take a look at what the mechanics of
the situation would be if there were no exchange.

First we have the long position. If we went all the way through the process
to delivery we would have to pay $25,000 to receive 5,000 bushels of
Wheat. Now in the case of the short position we would actually receive
$30,000 to deliver 5,000 bushels of Wheat. So the net result is that we
would buy the wheat from one person and sell it to another, making a
$5,000 profit because of the difference in the prices of the two contracts.
Can you imagine what a hassle it would be to take delivery on one side and
provide the product on the other side? That’s why we can be thankful for
the futures exchange. It eliminates that whole delivery flip-flop process,
and actually gets us our money right away rather than having to wait for
the end of the contract.

Now consider that if we had to put up 3% margin on our long position it
would have been $750 as compared to our profit of $5,000. That’s a very
nice return, isn’t it. Right there is why so many people eagerly trade the
futures market. It provides one with enormous leverage and the potential
for very high rates of return. Just keep in mind that the leverage works
both ways, though. The losses can happen just as quickly and dramatically
as the gains if you aren’t careful about your risk management.

Margin

One of the things which confuses many who first start looking at futures
trading is the concept of margin and how it works. It really is not all that
complicated, though. I’ll explain by first providing a general idea of mar-
gin and leverage.

Leverage is the use of borrowed money (generally from one’s broker/
dealer) to take on a position which is larger than one would be able to do
with strictly one’s own funds. The money the trader is required to deposit
as surety for those borrowed funds is referred to as margin.

Using a real-world example, think in terms of buying a house. Home buy-
ers generally do not pay 100% of the price in cash. In most cases the buyer
can pay a certain percentage, which is referred to as the down payment,
but must borrow the remainder. This is the application of leverage and the
down payment can be thought of as margin.

In the markets, leverage and margin
are used in one of two fashions. One
can put up margin and apply lever-
age to take control of a collection of
assets larger than they would have
been able to do so otherwise, as in
buying a house. Alternately, one de-
posit’s margin is applied as surety
for the future fulfillment of an agree-
ment to exchange assets (futures
contract).

An example of how this works in the
first fashion can be seen the stock
market. As you may know, you can
purchase 100 shares of a $50 stock
by putting down only $2500 on de-
posit – 50% margin. Your broker
loans you the rest of the funds re-
quired to make the purchase, so you
are leveraging your $2500 to control
twice that much in assets. This is
similar to putting down 20% to pur-
chase a house with the bank loaning
you the rest.

In futures, however, you aren’t actu-
ally buying or selling anything right
away. You are entering in to an

agreement to do so later on. Therefore, there is no money changing hands
immediately.

In the futures market, however, you are required to put up margin as
surety against your failure to fulfill your end of the contract agreement.
This is where the idea of counter-party risk comes in—the counter-party
being the person on the other side of the contract.

At least that is how it would be in theory. In practical reality, as an indi-
vidual trader you are required to post margin as a protection against
changes in the value of the contract(s) you hold. It is partly your protec-
tion, but mostly it is to keep the system safe because in futures it is the ex-
change which is the counter-party on all contracts. In that way margin
serves the exact same purpose as it does in the stock market (as it does
when you buy a house).

Unlike in stocks, though, most of the time futures margin requirements
are 5% or less of the contracts’ value. What is that value? That’s pretty
easy to determine. Simply take the size of the contract and multiply it by
the contract price. Using our Wheat example from earlier, the contract
size is 5,000 bushels. If the contract price is $5/bushel, then the value of
the contract is $25,000 ($5 x 5,000). If the applicable margin rate is 3%,

you would be required to put up $750 as margin for each contract
( $25,000 x 0.03 ). This is where the leverage can really be seen. [Note:
The actual margin you are required to post for each contract is determined
by your broker based on certain exchange requirements.]

There’s another difference between futures margin and stock margin. In
the stock market, when you trade on margin you are borrowing from your
broker to do so. You get charged interest for that. In futures you don’t ac-
tually borrow any money because you don’t actually buy anything.

What’s more, in the stock market you take possession of shares and cash
leaves your account to do that. In futures, the money stays in your account
the whole time. That’s actually the requirement. The margin money must
be in your account. The result is that you can actually earn interest on that
money. Some brokers will pay interest on margin deposits.

Marked-to-Market

Something which differentiates futures from stocks is how accounts are
marked-to-market. In the stock market one’s account value with move up
and down with changes in the price of the stock(s) held therein. Any prof-
its made, however, cannot be withdrawn until the gains are realized by
selling the shares. This is not the case in futures.

The holder of a futures contract sees their account credited or debited each
day based on changes in futures prices. That is just like stocks, but unlike
in equities, these gains are considered realized and one could withdraw the
profits if so desired. This might seem a trivial point, but it isn’t.

Think about this example. You have $10,000 in your stock account. You
use that to buy $10,000 worth of XZY shares. If the price of that stock
doubles, your account value goes to $20,000. If you don’t sell the stock,
though, you can’t use that extra $10,000 to buy any more stock or to buy
shares in another company.

In futures, though, a $10,000 gain in the value of your positions does give
you additional free capital for further trades. You could take that money
and use it as margin to take on additional long or short positions, in the
same futures or other ones. This is a major advantage to futures trading
and one of the real attractions to it for many speculators.

Commissions

In the futures market brokerage commissions are generally charged on
what is referred to as a “round-turn” basis. That means you only pay the
commission when you close out a position. This contrasts with stocks
where most brokers charge you both when you enter and when you exit a
position. This is another reason why so many traders look on the futures
market so favorably.

Delivery

The delivery process is something that scares a lot of potential traders out
of the futures markets. They are concerned they’ll end up with a truckload
of something they most certainly don’t want ending up dropped off in their
driveway. This isn’t something which should prevent one from making use
of the futures markets to pursue your trading objectives, though.

Why?

Well, first of all, some of the more popular futures contracts—like the ones
for stock indices—are cash settled. That means no physical products of
any kind changes hands during the delivery process. In this situation, the
exchange just credits or debits the contract holders’ accounts as if they had
offset their position at the final price recorded when the contract was up.
For example, consider a futures contract in which the value of the contract
is 100 times the value of Index X. If one enters a long position at 100, the

value of the contract is thus $10,000. Now assume the index is at the 110
level when the contract matures. The contract value is then $11,000. The
long holder would then be credited with $1000 in profits at maturity.
Of course, most futures contracts do involve some kind of physical delivery
at maturity, at least in theory.

You see, a large majority of futures posi-
tions are not entered in to with delivery (or receipt of delivery) intended.
This is because much of the futures trading volume actually comes from
speculator and hedgers who are only looking to protect themselves from
price movements.

That said, delivery can and does happen. To avoid getting in to that kind
of situation when trading futures which feature physical delivery, simply
make sure to close/offset your open contract(s) prior to the deliver period.
The exchanges set the delivery dates and other terms for all contracts, and
that information is readily available either directly from them or through
any futures broker.

FUTURES PRICING

Futures are derivative instruments. That means their price is derived from
that of something else, the latter generally referred to as the underlying.
For example, wheat futures are based on the price of wheat.

As their name implies, though, futures contracts are influenced by events
to come. The prices involved take in to consideration current market fac-
tors, but also at least attempt to account for developments between the
present and the time the contract is delivered upon. We are talking supply
and demand considerations here.

Let’s consider our wheat example. The futures prices for any given con-
tract period are going to take into account anything which would impact
how much wheat is going to be demanded at the time of the contract’s de-
livery. That includes things like trade negotiations. If a trade deal is stuck
whereby the U.S. were to send a considerable amount of wheat to China,
that would represent and increase in demand and tend to push prices
higher. On the flip side, if an expected trade deal fell through, prices may
drop because of less than anticipated demand.

On the supply side, consider things like weather. A bad growing and/or
harvesting season could severely impact the amount of wheat produced.
Less available wheat means higher prices, while a bumper crop would see
an excess supply push prices down.

These sorts of things impact all markets in one way or another. It may not
be weather or international trade that is the driving force, but in every sin-
gle market there are factors which influence supply and factors which in-
fluence demand. Those factors are what determine prices.
Keep in mind, though, that the supply demand considerations can vary
from futures contract to futures contract. What impacts the supply and/or
demand for wheat deliverable against the July contract may not have any
impact at all on the wheat deliverable against the December contract, and
vice versa. That is why you can sometimes see substantial differences in
the prices of the various contract months, especially for agricultural goods.

Cost of Carry

Another factor in the pricing of futures contracts is what’s referred to as
the cost of carry. In brief, this is the expense incurred by the holder of a
commodity or other product over the duration of the futures contract.
This expense can come in a variety of forms.

For example, storing 5,000 bushels of wheat requires a place to keep it, so
you have a storage charge factored in to the price. That is going to be the
case for basically any physical good. This means that futures prices will al-
most always be higher than current spot/cash prices. Why? Because oth-
erwise no one would ever take a short position with intent to deliver be-
cause they would lose money.

At the same time, futures prices will never venture too far above the cur-
rent spot/cash (immediate delivery) market. If they did so, one could sim-
ply go short the futures, buy the product at current prices, store it, and de-
liver at the contract date, thereby making a nearly risk-free profit. Market
efficiency dictates that such selling of the futures contract would push
prices down enough to get them back in line relatively quickly.

Not only does the cost of carry (or just carry) imply that the futures price is
higher than the current cash price, it also implies that more forward fu-
tures contract prices are going to be higher than more nearby contract
prices. That means the December contract price is going to be higher than
the September contract price (for the same calendar year, obviously) be-
cause longer time to delivery means higher carry expenses.

Not all carry is positive, though. It is for physical products in the vast ma-
jority of cases, but for many other markets that is not the case. Anything
which actually produces income for the holder, as opposed to incurring an
expense, would result in what would be termed a negative carry. That
means the price of the futures would be lower than the current cash mar-
ket price, and the price of the more forward (further out) contracts are
lower than the nearer contracts.

What kinds of things produce income to hold, and thus negative carry? In-
teresting bearing securities like bonds are one. Dividend paying stocks,
and the indices which contain them, are another. That reverses the situa-
tion outlined for a positive carry market as we just described it above.
Keep in mind that the cost of carry (positive or negative) shrinks as one
moves closer to contract delivery. That creates a convergence between the
cash and futures prices such that they are virtually the same when the ac-
tual delivery date hits.

It should also be noted that the cost of carry, and thus the spread between
the futures and the current cash price, also accounts for the cost of actu-
ally making delivery factored in as well, if applicable.

Price Quotes

The futures markets have a fairly standard quoting convention which uses
a three part symbol. This symbol comprises of a 1-2 character code for the
instrument, one character code for the month (each month is assigned a
letter), and the last two digits of the year in questions.

For example: WN06 is the July 2006 Wheat futures contract. The CBOT
symbol for wheat is ‘W’, the code for July is ‘N’, and 2006 is represented
by the ‘06’. Below is an example of how one might see prices for futures
quoted. This is from FutureSource

In this case, the data is presented not only by symbol, but also verbiage ex-
plaining the commodity and month being displayed. After the ‘Month’ col-
umn is ‘Time’ which indicates when the price quotes were taken. The
‘Last’ column is the most recently traded price (in this case with a small ‘s’
indicated it as the day’s close or ‘settled’ price), with ‘Chg’ indicating the
different between the current and the previous close (last). The ‘Open’ is
the session’s first price traded, while the ‘High’ is the maximum traded
price and the ‘Low’ being the lowest traded price on the session.

Looking at the price quotes in question, there are some additional conven-
tions worth noting. The first is in terms of the price itself. Wheat is
quoted in terms of cents per bushel, so if one were to divide the prices
shown on the table by 100 it would produce a $/bushel rate.

Remembering that the wheat futures contract is 5,000 bushel, a 1 cent
move in price is equal to $50 ( 5,000 x $0.01 ). So if the September ‘06
contract (WNU06) went up from 429 to 439, a rise of 10 cents per bushel,
the profit for a long position holder would be $500 ($50/cent x 10 cents).
You are probably wondering about the ‘4 at the end of the first price, and
other similar figures on other contracts.

That is how fractions are dis-
played. What you see there is actually 8ths of a cent. So 4 would mean
4/8 or 1/2 cent. A 2 is thus 2/8 or 1/4, while a 6 would be 6/8 or 3/4. To
translate our July 2006 futures price it would be 415.5 cents per bushel.
The reasons these fractions are used is because Wheat prices actually move
in quarter cent increments (2/8).

These fractions of a cent are applied to the base tick value of the futures
contract. Since wheat has a $50/tick value (a tick being the standard price
movement increment—one cent in this case), a quarter of a tick (1/4 of a
cent per bushel) would be worth $12.50 ($50/4).
Different markets have different conventions for pricing and price move
increments. Some are decimals while others are fractions. Refer to the
contract specifications to get the specifics.

Price Limits

In many futures markets there are price limits. More specifically, there are
maximum limits to how far prices can move in a single trading session.
The idea is to maintain an orderly market and ensure that things do not
get too carried away—allowing participants to sleep on it, so to speak.

When price moves the maximum permitted amount, it is referred to as a
limit move. When the market makes a limit move and stays there, you
have what is known as a lock limit situation. When that happens, trading
literally stops. The reason for that is traders consider the clearing price of
the market to be beyond the permitted tradable price (previous close +/-
the allowed limit) - the clearing price being the one which will match up
willing buyers with willing sellers.

Limit moves have become less frequent than in the past, but still do hap-
pen from time to time.
It should be noted, though, that a limit move does not necessarily mean
the exchange halts trading. In most markets it does not.

There are some, such as stocks, in which the limits operate a bit differ-
ently, though. They are based on percentages, first of all. Secondly, hit-
ting them triggers what are often referred to as “circuit breakers”. That
means trading is officially halted for some period of time, then allowed to
resume. This is not done by the futures exchange, though. It is done by
the stock exchange itself. The futures just follow along for the ride.

Fast Markets
Before moving on, the concept of fast markets must be addressed. This is
a situation which happens in pit-traded futures whereby there are different
prices trading in different parts of the trading floor. These sorts of occur-

rences sometimes happen in large pits (like the Treasury Bond one) when
a major surprise data release or news announcement comes out.
In such a situation, the exchange will indicate fast market conditions. By
doing so they are telling folks that they cannot guarantee the reported
price quotes that are going out. It tells non-floor traders that they could
see fills (trade executions) on their orders at prices significantly different
than what their data feed indicates.

FUTURES MARKETS

As was noted at the beginning of this guide, the futures market takes in a
wide array of different tradables. Many people think of futures as only be-
ing “commodity futures”, which certainly was true out the outset. These
days, however, the largest trading volumes are in markets which do not
even represent hard products.

Commodities

Commodities are tangible things. They are actual products, often ones
which are used in the production of finished products. We used Wheat as
the example in our earlier discussion. That is a tangible good which is
used to make flour, for example.

The commodities market can be broken up in to several groupings:
Agricultural—This is pretty much anything grown by farmers in-
cluding Corn, Wheat, Soybeans, Cocoa, Sugar, Coffee and the related
goods produced from those base products.

Live Stock—These are animals such as cattle and live hogs and the
products derived from them (e.g. milk)
Energy—The products in this category are those used for power
generation such at Crude Oil and it’s distillates (Unleaded Gasoline,
Heating Oil) and Natural Gas.

Metals—Gold is the star of this group, but it also includes several
other precious and non-precious elements.

Currencies (Forex)

All of the major world currencies are represented in the futures markets
(and a few of the lesser ones as well). There are contracts both in terms of
their value against the US Dollar and in their values against each other (so-
called cross rates).

Delivery for currency futures is a little different than that for a physical
commodity. It means exchanging one currency for another. For example,
if one were long the Canadian Dollar futures it would mean exchanging US
Dollars for the Canadian Dollars at the contract rate. That is pretty easy.
If it a cross-rate pair such as British Pound-Japanese Yen, then the deliv-
ery is actually the exchange of Pounds for Yen at the contract rate.

The spot market volume by far dominates the futures trading volume on
an aggregate dollar basis, but there are many individual traders who prefer
to the futures because of the strict regulation and better market transpar-
ency. This compares to most spot trading which is done directly with a
dealer, not on the open market as such.

Interest Rates (fixed income)

One of the biggest futures market is that involving interest rates and the
products involved. This includes sovereign debt such as US Treasury Bills,
Notes, and Bonds. Eurocurrencies like the Eurodollar are included. There
are also futures markets for the mortgage backed security market.
Delivery for interest rate futures means the long trader will receive the
specified amount of the instrument in question. For example, on the Chi-
cago Board of Trading (CBOT) the US Treasury Bond contract has a size of
$100,000. That being the case, the individual holding the long side of that

Contract will, at delivery, receive $100,000 in par value worth of Treasury
Bonds. (Exactly which Bonds are deliverable against any given futures
contracts is defined by the exchange).

The interest rate market is a massive one. It is used by governments and
large institutions alike to manage their positions. That volume and liquid-
ity, in turn, also makes it a favorite trading arena for large hedge funds and
speculators who can trade large positions with relative ease.
Indices

A wide number of stock market index futures contracts exist and are quite
actively traded. They include all the big names such as the S&P 500 and
the Dow Jones Industrial Average (DJIA), as well as several of the less well
known ones like the NYSE Index and the Russell.

Index futures do not have physical delivery. They are cash settled.
The most popular index trading instruments for the individual trader are
the so called e-minis. These are electronically traded contracts of reduced
size. For example, the standard S&P 500 futures contracts are valued at
$500 per index point.

That makes them much too pricey for smaller trad-
ers. The e-mini S&P contract, though, only has a $50 per point multiplier,
which makes it much more readily tradable for non-institutional folks like
you and I. These are now among the most active futures contracts.

There are also several non-stock related indices. Two of the prime exam-
ples are the CRB Index and the Goldman Sachs Commodity Index (GSCI).
Another is the US Dollar Index. The Volatility Index (VIX) is also becom-
ing more popular.

Stocks
In recent
years there has been introduced Single Stock Futures. As the
name implies, these are contracts based on a single company’s shares,
such as Microsoft. They operate similarly to normal futures contracts in
terms of delivery and wha
tnot. They do require higher margin deposits,
though (20% or better).

Single stock futures do have physical delivery, so the long position holder
would buy the shares in question from the short at delivery.
Contract Specifications & Mini Contracts
It should be noted that while some futures contracts trade only on one ex-
change, many trade on multiple exchanges—some all over the world. That
can mean differing contract specifications, as each exchange is perfectly
within its rights to set its own.

Even for single-exchange markets like many of the agricultural products,
there can sometimes be different types of contracts or different sized ones
traded on the same exchange. The e-mini S&P futures spoken of above are
a perfect example. Below is a table of some of the more popular mini fu-
tures contracts.

The table lists only a few of the available mini contracts. The list of what
can be traded is growing, especially in terms of what can be electronically
traded. This serves to increase volumes for the exchanges involved, of
course, but also provides a great deal more opportunity for the smaller
traders who might otherwise be shut out of certain markets because of the
high margin requirements and point values.

It should be noted that even though the regular and mini contracts trade
separately (sometimes on different exchanges all together) there will gen-
erally be little to no difference between the actual prices of the various con-
tracts. Arbitragers will generally see to it that the prices stay in line.

How is the Forex Market Different?

There are some significant differences between the forex market and oth-
ers like the stock market. While it may be that a good trader can handle
any market, structural differences in forex can force a different approach.
Time

For most stock traders, the first difference they will notice between the
forex market and equities is timeframe. Although the hours of stock trad-
ing have been expanding in recent years, the forex market is still the only
one which can truly be viewed as 24-hour. There is ready forex trading ac-
tivity in all time zones during the week, and sometimes even on the week-
ends as well. Other markets may in fact transact 24-hours, but the volume
outside their primary trading day is thin and inconsistent.

No Exchanges

The lack of an exchange is probably the next big thing that sticks out as be-
ing different in forex. While it is true that there is exchange-based forex
trading in the form of futures, the primary trading takes place over-the-
counter via the spot market. There is no NYSE of forex.

On the largest scale, forex transactions are done in what is referred to as
the inter-bank market. That literally means banks trading with each other
on behalf of their customers. Larger speculators also operate in the inter-
bank market where they can execute multi-million dollar trades with ease.
Individual traders, who generally trade in much smaller sizes, primarily do
so through brokers and dealers.

This is something which can trouble stock traders. There is no central loca-
tion for price data, and no real volume information is attainable. Since
volume is an often reported figure in the stock market, the lack of it in spot
forex trading is something which takes a bit of getting used to for those
making the switch.


Also, the lack of an exchange means a difference in how trading is actually
done. In the stock market an order is submitted to a broker who facilitates
the trade with another broker/dealer (over-the-counter) or through an ex-
change. In spot forex much of the trading done by individuals is actually
executed directly with their broker/dealer. That means the broker takes
the other side of the trade. This is not always the case, but is the most com-
mon approach.

Transaction Costs

The lack of an exchange and the direct trade with the broker creates an-
other difference between stock and forex trading. In the stock market bro-
kers will generally charge a commission for each buy and sell transaction
you do.

In forex, though, most brokers do not charge any commis-
sions. Since they are taking the other side of all the customer trades, they
profit by making the spread between the bid and offer prices.

Some traders do not like the structure of the spot forex market. They are
not comfortable with their broker being on the other side of their trades as
they feel it presents a type of conflict of interest. They also question the
safety of their funds and the lack of overall regulation. There are some
worthwhile concerns, certainly, but the fact of the matter is that the major-
ity of forex brokers are very reliable and ethical. Those that are not don't
stay in business very long.

Margin Trading

The forex market is a 100% margin-based market. This is a familiar thing
for those used to trading futures.

In fact, spot forex trading is essentially trading a 2-day forward (futures)
contract. You do not take actual possession of any currency, but rather
have a theoretical agreement to do so in the future. That puts you in a po-
sition of benefiting from prices changes. For that your broker requires a
deposit on your trades to provide surety against any losses you may in-
cur.

How much of a deposit can vary. Some brokers will asked for as little
as 1/2%. That is fairly aggressive, though. Expect 1%-2% on the value of
the position in most cases.

Now, unlike the stock market, margin trading does not mean margin
loans. Your broker will not be lending you money to buy securities (at
least not the way a stock broker does). As such, there is no margin interest
charged. In fact, since you are the one putting money on deposit with your
broker, you may earn interest in your margin funds.
Interest Rate Carry (Rollover)

When trading forex, one is essentially borrowing one currency, converting
it in to another, and depositing it. This is all done on an overnight basis,
so the trader is paying the overnight interest rate on the borrowed cur-
rency and at the same time earning the overnight rate on the currency be-
ing held. This means the trader is either paying out or receiving interest on
their position, depending on whether the interest rate differential is for or
against them.

This is commonly handled is what is referred to as a rollover. Spot forex
trades are done on a trading day basis, and as such are technically closed
out at the end of each day. If you are holding your position longer than
that, your broker rolls you forward in to a new position for the next trading
day. This is generally done transparently, but it does mean that at the end
of each day you will either pay or receive the interest differential on your
position.

The type of trader you are and the way your broker handles rollover will be
the deciding factors in determining whether the interest rate differentials
are an important concern for you. Some brokers will not apply the day's
interest differential value on positions closed out during the trading day.
By that I mean if you were to enter a position at 10am and exit at 2pm, no
interest would come in to play.

If you were to open a position on Monday
and close it on Tuesday, though, you would have the interest for Monday
applied (the full day regardless of when you entered the position), but
nothing for Tuesday. (Note: There is at least one broker who calculates in-
terest on a continuous basis, so you will always make or pay the interest
differential on all positions, no matter when you put them on or took them
off).

It should also be noted that although some folks will claim there is no roll-
over in forex futures, the interest rate spread is definitely factored in. You
can see this when comparing the futures prices with the spot market
rates. As the futures contracts approach their delivery date their prices
will converge with the spot rate so that the holders will pay or receive the
differential just as if they had been in a spot position.

Intervention

Fixed income traders know that central bankers, like the Federal Reserve,
are active in the markets, buying and selling securities to influence prices,
and thereby interest rates. This is not something which happens in stocks,
but it does in the forex markets. This is known as intervention. It happens
when a central bank or other national monetary authority buys or sells
currency in the market with the objective of influencing exchange rates.

Intervention is most often seen at times when exchange rates get a bit out
of hand, either falling or rising too rapidly. At those times, central banks
may step in to try to nullify the trend. Sometimes it works. Sometimes
not.

The US has traditionally taken a hands-off approach when it comes to the
value of the Dollar, preferring to allow the markets to do their thing. Oth-
ers are not quite so willing to let speculators determine their currency's
value. The Bank of Japan has the most active track record in that regard.

Advantages of Forex

Trade on Your Schedule

The single biggest advantage the forex market has over other markets is its
24-hour nature. A trader can put on or take off positions literally any time
of day or night, regardless of their base of operations. That opens the game
up to a great many individuals who might not otherwise have the time
available to trade.

Consider, for example, the working person with a 9 to 5 type of job. Most
folks like that cannot be expected to operate effectively as day traders in a
market such as stocks. They just can't spend the requisite time watching
the market during trading hours. With forex, though, one could theoreti-
cally day trade in the evenings after work, or in the mornings before-
hand. The forex market is never really closed (yes, in some cases you can
even trade on the weekend!).

No (or low) Transaction Costs

For most traders, the forex market also offers the benefit of no transaction
costs. For the most part, forex brokers do not charge commissions (if they
do, they are relatively small). There is, of course, the bid/offer spread,
which can be viewed as a transaction cost, but the reality of the situation is
that most traders buy at the offer and sell at the bid in whatever other mar-
ket they trade, so that's really no different. Actually, the forex spreads can
be quite small in the major currency pairs.

Low (or no) Account Minimums

Forex trading is also open to a wider trading demographic in that there are
many opportunities to open smaller accounts than is the case in other
markets. In fact, there is at least one broker which has no minimum ac-
count size.

What's more, they also have no minimum trade size. That sort
of flexibility opens the door to essentially anyone who wants to explore
forex trading. This isn't to say that all brokers are that flexible. There are,
however, a great many which offer so-called mini-contracts.

Multiple Trading Vehicles

Additionally, forex trading can be done in a number of fashions. Many
folks tend to think strictly of the spot market. While that is certainly the
largest of the components, it is not the only one. The futures market has
become a bit more attractive with the expansion of e-mini currency con-
tracts. There are futures options as well. What's more, an array of other
option trading alternatives have been popping up, providing traders even
more ways to take positions in the forex market.

Always Moving

One of the biggest attractions to forex trading is that there's just about al-
ways something moving. There are a number of primary currencies in-
volved, each of which is continuously interacting with all the others.
Chances are, at any given time, there is movement in at least one of those
exchange rates based simply on the sheer volume of trading and the num-
ber of global news events providing impetus to action.

Easily Trade Long or Short

In the stock market there are restrictions imposed on selling short. In
forex there is nothing of the sort. It is just as easy to taking a short posi-
tion as it is to take a long one.
Disadvantages of Forex

No Exchange

The disadvantage to forex, some would say, is in the lack of an exchange
system in forex trading. Some traders find comfort in knowing that there
is a regulated mechanism backing their market participation. What's
more, the lack of a centralized data point means the spot forex market
does not have all the great add-on information stock and futures are used
to seeing (volume, for example).

Complex Nature

In terms of market analysis techniques, technical analysis is just as useful
in forex trading as in any other market - some might say more so. The
thing that gives some traders concern. however, is the complexity of the
fundamental side of the forex market. Currency exchange rates are influ-
enced by a wide variety of factors, which can fluctuate over time.

Two-Sides to Every Position

By it's very nature, there are always two sides to the forex market, because
currencies are quoted in terms of their value against each other. That
means for any given exchange rate there are two countries (or region's) to
take in to consideration. Sometimes issues related to one of the countries
will dominate, while sometimes the other will. It can be quite fluid in that
regard, which can sometimes lead to quite confusing reactions to news and
events.

While these issues may seem like significant barriers to trading forex for

some, the fact of the matter is that for most folks they are easily overcome.
Just like any market, forex requires some getting used to. Once you do,
though, it provides a wide array of opportunity.

Terminology and Market Conventions

Terminology and Market Conventions If you are going to trade forex you need to understand the terms and quot- ing conventions used, especially in regards to the spot market.
Notational Conventions
The forex market uses 3-letter codes for all currencies. These are com- monly known as SWIFT or ISO codes. For example, USD is the code for the US Dollar. Here are the codes for the other primary currencies:
AUD Australian Dollar CAD Canadian Dollar CHF Swiss Franc EUR European Euro GBP British Pound JPY Japanese Yen

Expressing a relational value between two currencies is done by combining two currency abbreviations in the fashion of XXX/YYY. This indicates the amount of YYY currency (the "quote" currency) equivalent to one unit of XXX ("base" currency). For example if the exchange rate for USD/JPY - the US Dollar to Japanese Yen rate - was 100 it would mean that each USD is worth 100 JPY.

Using this convention, changes up or down in the quoted exchange rate in-
dicate changes up or down in the value of the base currency. Using the USD/JPY example again, if the rate went from 100 to 101 it would mean a 1% increase in the value of the USD against the JPY. Similarly, a decline from 100 to 99 would represent a 1% fall in the USD value vs. the JPY. In theory, one could quote the exchange rates either way around - meaning if USD/JPY is 100 it is the same as saying JPY/USD is 0.01 (one JPY is worth $0.01). In practice, however, the forex market has specific conven- tions for the traded pairs. In most cases, USD is the base currency, with the other currency in question being the quote currency. USD/JPY is an example.

There are a few exceptions, though. When it was introduced in 1999, the market authorities decided the Euro would always be the base currency in all traded pairs. Before that, the Pound (GBP) held that distinction. Thus, when traded against either of those, the USD is the quote currency (EUR/ USD, GBP/USD).

The same also holds for former British Commonwealth currencies the Australian Dollar (AUD/USD) and the New Zealand Dollar (NZD/USD).
It is worth noting that forex futures contracts involving currencies as quoted against the US Dollar do not hold to the spot market conven- tion. Instead they all use the USD as the quote currency. Majors and Crosses
In the forex you will here the terms "majors" and "crosses" when traders refer to different categories of currency pairs. In general terms, the "majors" are the pairs which include the USD quoted against the other pri- mary industrialized currencies. Those include the ones listed above. So the majors are as follows:

While technically every currency pairing is a cross-rate, the term "cross" is
most commonly used to refer to currency pairings which do not include
the USD. For example, EUR/JPY is the Euro-Yen exchange rate. That
would be considered a cross.

Forex Price Quotes

With an understanding of what we are looking
at, now we can turn out focus to the actual
price quotes. The graphic shows a sample ta-
ble of quotes for an array of currency pairs -
majors and crosses.

One thing you will notice in the table is that
some pairs are quoted to four decimal places,
while others only go out two places. In gen-
eral, those pairs with values of 10 or less will
go out to four places, while those with higher
values will be quoted only at two places.

Regardless of how many decimal places a currency pair is quote to,
though, the term "pip" is used to define a single price movement value. So,
for a two decimal place pair, a pip would be .01, while for a four decimal
place pair a pip would be .0001.

We can see this in the quotes on the chart, especially when looking at the
bid/offer spreads. AUD/JPY is quoted at 79.60-79.64, which is a 4 pip
spread, while AUD/USD is quoted 0.7648-0.7650 for a 2 pip spread.

In recent times there has been introduced the "pipette", which is a fraction
of a pip. In essence, some of the more popular pairs like EUR/USD are
trading at five decimal places now, which is why you can see a spread of 1.5
listed on the chart (column to the right of the price quote itself). That
means the bid-offer spread is 1 and 5/10 pips.

One will sometimes here the term "figure" in spot forex trading. That is
used to refer to a price level which is a round 100 pip figure. In USD/JPY
that would be a multiple of 1 full JPY (such as 104), while in GBP/USD the
figure would be a $0.01 multiple (like 1.8800).

The term "yard" sometimes comes up as well. That is used to refer to a one
billion base currency transaction. So a yard of USD/JPY would be $1 bil-
lion.

Getting in to the Trading

Opening an Account

It is quite easy to start trading forex. There are a great many forex brokers
available and opening an account is pretty straightforward. Some things
you should consider as you look to identify the one best suited to you are:

• Account minimum deposit (if any)
• Transaction size flexibility
• Spreads
• Execution

• Commissions (if any)
• Security of deposited funds
• Allowable leverage
• Currency pairs available for trading
• Usability of the trading platform

The great thing is that nowadays the vast majority of brokers have avail-
able demo trading platforms you can use to evaluate their system. Be sure,
though, to make note of any differences there are between the real plat-
form and the demo one. Some brokers' platforms are both the same across
the board, but some have noticeable differences in things like execution
speeds. It wouldn't hurt to check around the discussion boards to see what
others are saying.

Actually, if you are new to forex trading it is well worth it to spend a while
trading via a demo platform first. It will help you develop and understand-
ing of how it all works. That way, when you do go live, you will be more
confident and ready for action.

Forex trading is really little different from an execution perspective than
most other markets. You can buy or sell. In most cases, the same types of
orders (stops, limits, etc.) are available. The trading platforms are very
modern and trades can be done very quickly. Anyone who has ever used
an online trading platform for any other market will have no trouble mak-
ing the move to forex and easily executing trades. For that matter, even
those new to trading will find entering and exiting forex positions a breeze.