Thursday, January 14, 2010
Most people who start trading futures after having spent some time in the stock market expect the former to be like the latter. These people are usually in for a rude awakening. Intense volatility coupled with rock bottom margin requirements conflate to create a market environment not unlike a hurricane. In stocks, unless your're playing those crazy Russian IPOs with zero volume, a 5% swing might typically be a big day. In futures, a 5% price swing might mean the entirety of your life savings.
Let's take Lumber, for example. North American Softwood Lumber Futures (Random Length) are traded on the Chicago Mercantile Exchange and are priced in dollars per thousand board feet, one contract is equal to one hundred and ten thousand board feet. (Fun fact, 110 thousand board feet is exactly the amount of lumber that will fit in a boxcar. It's true, some guy told me that one time.) As of this writing, the front month (January) Lumber contract istrading at ~$220 per thousand board feet. That means that the net value of one contract of North American Softwood Lumber is $24,200. And yet, if you'd like to buy or sell one of these contracts, all you need to put up is ~$1800 (give or take, depends on your broker). So, today, with less than $2000, Joe Schmo can control nearly $25,000 worth of Lumber. That's an effective margin of 92%. Now, assume Joe is long 1 lumber contract, and the price moves down 5% to ~$209/mmBF. That 5% change is equivalent to a loss of $1210. Assuming Joe only put up $1800 to buy that contract, that leaves him down a whopping 67% on his initial investment, after only a 5% change in price. And remember, that's assuming he bought only one contract. Ouch.
To make things even more difficult, most of the commodity markets are open around the clock, so prices may be climbing or falling while you're eating breakfast, at the movies, or fast asleep. Take a look at this technical chart (retrieved via optionsXpress.com) of the March Crude Oil contract over the last three days, centered on yesterday's trading session:
What the hell is that? I mean, seriously, is that a prank? Oil opened the day at about $80.50 and closed the day essentially flat at about $80.35 per barrel. There was no news about oil, no major economic indicators were published, and yet, for some reason, between the hours of 9am and 1pm Eastern time, oil fell to about $78.80 per barrel and then rose back up to $80.75. If you were long March Oil, and only put up the minimum to enter into the contract, that kind of swing could potentially result in a margin call (depending on where you entered your position) immediately before jumping up to a multi-day high. If you were short, and were looking to exit at a price below $80.00, but, say, happened to live on the West Coast, you might be just arriving at work, only to realize upon powering up your computer that you missed the nadir you were looking for.
The moral is that when you're investing with futures contracts, you can't sit back and wait to see what the market does once you take a position. You need to remain active, agile, and vigilant. You need predetermined exit points, both to stop a loss AND to realize a gain, and you can't let emotion get the best of you.
Despite what your econ professor said, this market is not rational.