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A Guide to Understanding Opportunities and Risks in Futures Trading

from The National Futures Association

Introduction

Futures markets have been described as continuous auction markets and as clearing houses for the latest information about supply and demand. They are worldwide meeting places of buyers and sellers of an ever-expanding list of products that includes financial instruments such as U.S. Treasury bonds, stock indexes, and foreign currencies as well as traditional agricultural commodities, metals, and petroleum products. There is also active trading in options on futures contracts allowing option buyers to participate in futures markets with known risk.

Electronic information and communication technologies are providing new and better trading tools and new and more diverse trading opportunities. In some cases, entirely electronic markets function alongside open-outcry markets that have existed for more than a century and a half. Electronic order placement is increasingly commonplace. As such developments help make futures markets more useful to more people, it follows that they have become more widely and extensively used.

Notwithstanding the changes that have and are continuing to occur, the primary purpose of futures markets remains unchanged: To provide an efficient and effective mechanism for the management of price risks. By buying or selling futures contracts that establish a price now for a purchase or sale that will take place at a later time, individuals and businesses are able to achieve what amounts to insurance protection against adverse price changes. It is called hedging.

Simultaneously, other futures market participants are speculators. By buying or selling, depending on which direction they expect prices to move, they hope to profit from the very price changes that hedgers seek to avoid. The interaction of hedgers and speculators, each pursuing their own goals, helps to provide active, liquid, and competitive markets.

Speculative participation in futures trading has become increasingly attractive with the availability of alternative methods of participation. Whereas many futures traders continue to prefer to make their own trading decisions — what to buy and sell and when to buy and sell — others use the services of a professional trading advisor or avoid day-to-day trading responsibilities by establishing a fully managed trading account or by participating in a commodity pool that is similar in concept to a mutual fund.

For those individuals who fully understand and can afford the risks that are involved, the allocation of some portion of their investment capital — the portion that is truly risk capital — to futures speculation can provide a means of achieving greater portfolio diversification and a potentially higher overall rate of return on their investments. There are also a number of ways futures and options on futures can be used in combination with other investments to pursue larger profits or to limit risks.

Speculation in futures contracts, however, is clearly not appropriate for everyone. Just as it is possible to realize substantial profits in a short period of time, it is also possible to incur substantial losses in a short period of time. The possibility of large profits or losses in relation to the initial commitment of capital — including losses potentially larger than the initial commitment of capital — stems principally from the fact that futures trading is a highly leveraged form of speculation. Only a relatively small amount of money is required to participate in the price movements of assets having a much greater value. As we will illustrate, the leverage of futures trading can work for you when prices move the direction you anticipate or against you when prices move in the opposite direction.

The purpose of this course is not to suggest either that you should or shouldn’t participate in futures trading. That is a decision you should make only after consultation with your broker or financial advisor and in light of your own financial situation and objectives. Rather, the pages that follow are intended to help provide the kinds of information you should always obtain first — and questions you should ask — about any investment you are considering. Including:

  • Information about the investment itself and the risks involved.
  • How readily your investment or position can be liquidated when such action is necessary or desired.
  • Who the other market participants are.
  • Alternative methods of investing.
  • How prices are arrived at.
  • The costs of trading, including commission charges.
  • How gains and losses are realized.
  • What forms of regulation and investor protection exist.
  • The experience, integrity and track record of your broker or advisor.
  • The financial condition of the firm with which you are trading.

In sum, obtain the kinds of information you need to be an informed investor.

Next chapter: Early Futures Markets & Today's Futures Markets: What, Why & Who


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