National Futures Association 
200 West Madison Street 
Chicago, Illinois 60606

Table of Contents  

1. Introduction 
2. Futures Markets: What, Why & Who 
3. The Market Participants 
4. What is a Futures Contract? 
5. The Process of Price Discovery 
6. After the Closing Bell 
7. The Arithmetic of Futures 
8. Trading 
9. Margins 
10. Basic Trading Strategies 
11. Buying (Going Long) to Profit from an Expected Price Increase Selling 
12. (Going Short) to Profit from an Expected Price Decrease Spreads 
13. Participating in Futures Trading 
14. Deciding How to Participate 
15. Regulation of Futures Trading 
16. Establishing an Account 
17. What to Look for in a Futures Contract 
18. The Contract Unit 
19. How Prices are Quoted 
20. Minimum Price Changes 
21. Daily Price Limits 
22. Position Limits 
23. Understanding (and Managing) the Risks of Futures Trading 
24. Choosing a Futures Contract 
25. Liquidity 
26. Timing 
27. Stop Orders 
28. Spreads 
29. Options on Futures Contracts 
30. Buying Call Options 
31. Buying Put Options 
32. How Option Premiums are Determined 
33. Selling Options 
34. In Closing 

Notwithstanding the rapid growth and diversification of futures markets, their primary purpose remains the same as it has been for nearly a century and a half, to provide an efficient and effective mechanism for the management of price risks. By buying or selling futures contracts--contracts that establish a price level now for items to be delivered later--individuals and businesses seek to achieve what amounts to insurance against adverse price changes. This is called hedging.  

Volume has increased from 14 million futures contracts traded in 1970 to 179 million futures and options on futures contracts traded in 1985.  

Other futures market participants are speculative investors who accept the risks that hedgers wish to avoid. Most speculators have no intention of making or taking delivery of the commodity but, rather, seek to profit from a change in the price. That is, they buy when they anticipate rising prices and sell when they anticipate declining prices. The interaction of hedgers and speculators 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--such as what to buy and sell and when to buy and sell--others choose to utilize the services of a professional trading advisor, or to avoid day-to-day trading responsibilities by establishing a fully managed trading account or participating in a commodity pool which is similar in concept to a mutual fund.  

For those individuals who fully understand and can afford the risks which are involved, the allocation of some portion of their capital to futures trading can provide a means of achieving greater diversification and a potentially higher overall rate of return on their investments. There are also a number of ways in which futures can be used in combination with stocks, bonds and other investments.  

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 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 control assets having a much greater value. As we will discuss and illustrate, the leverage of futures trading can work for you when prices move in the direction you anticipate or against you when prices move in the opposite direction.  

It is not the purpose of this brochure to suggest that you should--or should not--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.  

Intended to help provide you with the kinds of information you should first obtain--and the questions you should seek answers to--in regard to any investment you are considering: 

* 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  

* Alternate methods of participation  

* How prices are arrived at  

* The costs of trading  

* How gains and losses are realized  

* What forms of regulation and protection exist 

* The experience, integrity and track record of your broker or advisor  

* The financial stability of the firm with which you are dealing  

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

FUTURES MARKET  

The frantic shouting and signaling of bids and offers on the trading floor of a futures exchange undeniably convey an impression of chaos. The reality however, is that chaos is what futures markets replaced. Prior to the establishment of central grain markets in the mid-nineteenth century, the nation farmers carted their newly harvested crops over plank roads to major population and transportation centers each fall in search of buyers. The seasonal glut drove prices to giveaway levels and, indeed, to throwaway levels as grain often rotted in the streets or was dumped in rivers and lakes for lack of storage. Come spring, shortages frequently developed and foods made from corn and wheat became barely affordable luxuries. Throughout the year, it was each buyer and seller for himself with neither a place nor a mechanism for organized, competitive bidding. The first central markets were formed to meet that need. Eventually, contracts were entered into for forward as well as for spot (immediate) delivery. So-called forwards were the forerunners of present day futures contracts. 

Spurred by the need to manage price and interest rate risks that exist in virtually every type of modern business, today's futures markets have also become major financial markets. Participants include mortgage bankers as well as farmers, bond dealers as well as grain merchants, and multinational corporations as well as food processors, savings and loan associations, and individual speculators.  

Futures prices arrived at through competitive bidding are immediately and continuously relayed around the world by wire and satellite. A farmer in Nebraska, a merchant in Amsterdam, an importer in Tokyo and a speculator in Ohio thereby have simultaneous access to the latest market-derived price quotations. And, should they choose, they can establish a price level for future delivery--or for speculative purposes--simply by having their broker buy or sell the appropriate contracts. Images created by the fast-paced activity of the trading floor notwithstanding, regulated futures markets are a keystone of one of the world's most orderly envied and intensely competitive marketing systems. Should you at some time decide to trade in futures contracts, either for speculation or in connection with a risk management strategy, your orders to buy or sell would be communicated by phone from the brokerage office you use and then to the trading pit or ring for execution by a floor broker. If you are a buyer, the broker will seek a seller at the lowest available price. If you are a seller, the broker will seek a buyer at the highest available price. That's what the shouting and signaling is about.  

In either case, the person who takes the opposite side of your trade may be or may represent someone who is a commercial hedger or perhaps someone who is a public speculator. Or, quite possibly, the other party may be an independent floor trader. In becoming acquainted with futures markets, it is useful to have at least a general understanding of who these various market participants are, what they are doing and why.  

The details of hedging can be somewhat complex but the principle is simple. Hedgers are individuals and firms that make purchases and sales in the futures market solely for the purpose of establishing a known price level--weeks or months in advance--for something they later intend to buy or sell in the cash market (such as at a grain elevator or in the bond market). In this way they attempt to protect themselves against the risk of an unfavorable price change in the interim. Or hedgers may use futures to lock in an acceptable margin between their purchase cost and their selling price. Consider this example:  

A jewelry manufacturer will need to buy additional gold from his supplier in six months. Between now and then, however, he fears the price of gold may increase. That could be a problem because he has already published his catalog for a year ahead. 

To lock in the price level at which gold is presently being quoted for delivery in six months, he buys a futures contract at a price of, say, $350 an ounce.  

If, six months later, the cash market price of gold has risen to $370, he will have to pay his supplier that amount to acquire gold. However, the extra $20 an ounce cost will be offset by a $20 an ounce profit when the futures contract bought at $350 is sold for $370. In effect, the hedge provided insurance against an increase in the price of gold. It locked in a net cost of $350, regardless of what happened to the cash market price of gold. Had the price of gold declined instead of risen, he would have incurred a loss on his futures position but this would have been offset by the lower cost of acquiring gold in the cash market. 

The number and variety of hedging possibilities is practically limitless. A cattle feeder can hedge against a decline in livestock prices and a meat packer or supermarket chain can hedge against an increase in livestock prices. Borrowers can hedge against higher interest rates, and lenders against lower interest rates. Investors can hedge against an overall decline in stock prices, and those who anticipate having money to invest can hedge against an increase in the over-all level of stock prices. And the list goes on.  

Whatever the hedging strategy, the common denominator is that hedgers willingly give up the opportunity to benefit from favorable price changes in order to achieve protection against unfavorable price changes.  

Were you to speculate in futures contracts, the person taking the opposite side of your trade on any given occasion could be a hedger or it might well be another speculator--someone whose opinion about the probable direction of prices differs from your own.  

The arithmetic of speculation in futures contracts--including the opportunities it offers and the risks it involves--will be discussed in detail later on. For now, suffice it to say that speculators are individuals and firms who seek to profit from anticipated increases or decreases in futures prices. In so doing, they help provide the risk capital needed to facilitate hedging. 

Someone who expects a futures price to increase would purchase futures contracts in the hope of later bring able to sell them at a higher price. This is known as "going long." Conversely, someone who expects a futures price to decline would sell futures contracts in the hope of later being able to buy back identical and offsetting contracts at a lower price. The practice of selling futures contracts in anticipation of lower prices is known as "going short." One of the attractive features of futures trading is that it is equally easy to profit from declining prices (by selling) as it is to profit from rising prices (by buying).  

Persons known as floor traders or locals, who buy and sell for their own accounts on the trading floors of the exchanges, are the least known and understood of all futures market participants. Yet their role is an important one. Like specialists and market makers at securities exchanges, they help to provide market liquidity. If there isn't a hedger or another speculator who is immediately willing to take the other side of your order at or near the going price, the chances are there will be an independent floor trader who will do so, in the hope of minutes or even seconds later being able to make an offsetting trade at a small profit. In the grain markets, for example, there is frequently only one-fourth of a cent a bushel difference between the prices at which a floor trader buys and sells.  

Floor traders, of course, have no guarantee they will realize a profit. They may end up losing money on any given trade. Their presence, however, makes for more liquid and competitive markets. It should be pointed out, however, that unlike market makers or specialists, floor traders are not obligated to maintain a liquid market or to take the opposite side of customer orders.  

	Reasons for Buying futures contracts	Reasons for Selling futures contracts
Hedgers	To lock in a price and thereby obtain protection against rising prices	To lock in a price and thereby obtain protection against declining prices
Speculators and floor Traders	To profit from rising prices	To profit from declining prices

   

What is a Futures Contract? 

There are two types of futures contracts, those that provide for physical delivery of a particular commodity or item and those which call for a cash settlement. The month during which delivery or settlement is to occur is specified. Thus, a July futures contract is one providing for delivery or settlement in July.  

It should be noted that even in the case of delivery-type futures contracts,very few actually result in delivery.* Not many speculators have the desire to take or make delivery of, say, 5,000 bushels of wheat, or 112,000 pounds of sugar, or a million dollars worth of U.S. Treasury bills for that matter. Rather, the vast majority of speculators in futures markets choose to realize their gains or losses by buying or selling offsetting futures contracts prior to the delivery date. Selling a contract that was previously purchased liquidates a futures position in exactly the same way, for example, that selling 100 shares of IBM stock liquidates an earlier purchase of 100 shares of IBM stock. Similarly, a futures contract that was initially sold can be liquidated by an offsetting purchase. In either case, gain or loss is the difference between the buying price and the selling price.  

Even hedgers generally don't make or take delivery. Most, like the jewelry manufacturer illustrated earlier, find it more convenient to liquidate their futures positions and (if they realize a gain) use the money to offset whatever adverse price change has occurred in the cash market.  

* When delivery does occur it is in the form of a negotiable instrument (such as a warehouse receipt) that evidences the holder's ownership of the commodity, at some designated location.  

Since delivery on futures contracts is the exception rather than the rule, why do most contracts even have a delivery provision? There are two reasons. One is that it offers buyers and sellers the opportunity to take or make delivery of the physical commodity if they so choose. More importantly, however, the fact that buyers and sellers can take or make delivery helps to assure that futures prices will accurately reflect the cash market value of the commodity at the time the contract expires--i.e., that futures and cash prices will eventually converge. It is convergence that makes hedging an effective way to obtain protection against an adverse change in the cash market price.*  

* Convergence occurs at the expiration of the futures contract because any difference between the cash and futures prices would quickly be negated by profit-minded investors who would buy the commodity in the lowest-price market and sell it in the highest-price market until the price difference disappeared. This is known as arbitrage and is a form of trading generally best left to professionals in the cash and futures markets.  

Cash settlement futures contracts are precisely that, contracts which are settled in cash rather than by delivery at the time the contract expires. Stock index futures contracts, for example, are settled in cash on the basis of the index number at the close of the final day of trading. There is no provision for delivery of the shares of stock that make up the various indexes. That would be impractical. With a cash settlement contract, convergence is automatic.  

Futures prices increase and decrease largely because of the myriad factors that influence buyers' and sellers' judgments about what a particular commodity will be worth at a given time in the future (anywhere from less than a month to more than two years).  

As new supply and demand developments occur and as new and more current information becomes available, these judgments are reassessed and the price of a particular futures contract may be bid upward or downward. The process of reassessment--of price discovery--is continuous.  

Thus, in January, the price of a July futures contract would reflect the consensus of buyers' and sellers' opinions at that time as to what the value of a commodity or item will be when the contract expires in July. On any given day, with the arrival of new or more accurate information, the price of the July futures contract might increase or decrease in response to changing expectations.  

Competitive price discovery is a major economic function--and, indeed, a major economic benefit--of futures trading. The trading floor of a futures exchange is where available information about the future value of a commodity or item is translated into the language of price. In summary, futures prices are an ever changing barometer of supply and demand and, in a dynamic market, the only certainty is that prices will change.  

Once a closing bell signals the end of a day's trading, the exchange's clearing organization matches each purchase made that day with its corresponding sale and tallies each member firm's gains or losses based on that day's price changes--a massive undertaking considering that nearly two-thirds of a million futures contracts are bought and sold on an average day. Each firm, in turn, calculates the gains and losses for each of its customers having futures contracts.  

Gains and losses on futures contracts are not only calculated on a daily basis, they are credited and deducted on a daily basis. Thus, if a speculator were to have, say, a $300 profit as a result of the day's price changes, that amount would be immediately credited to his brokerage account and, unless required for other purposes, could be withdrawn. On the other hand, if the day's price changes had resulted in a $300 loss, his account would be immediately debited for that amount.  

The process just described is known as a daily cash settlement and is an important feature of futures trading. As will be seen when we discuss margin requirements, it is also the reason a customer who incurs a loss on a futures position may be called on to deposit additional funds to his account.  

To say that gains and losses in futures trading are the result of price changes is an accurate explanation but by no means a complete explanation. Perhaps more so than in any other form of speculation or investment, gains and losses in futures trading are highly leveraged. An understanding of leverage--and of how it can work to your advantage or disadvantage--is crucial to an understanding of futures trading.  

As mentioned in the introduction, the leverage of futures trading stems from the fact that only a relatively small amount of money (known as initial margin) is required to buy or sell a futures contract. On a particular day, a margin deposit of only $1,000 might enable you to buy or sell a futures contract covering $25,000 worth of soybeans. Or for $6,000, you might be able to purchase a futures contract covering common stocks worth $100,000. The smaller the margin in relation to the value of the futures contract, the greater the leverage.  

If you speculate in futures contracts and the price moves in the direction you anticipated, high leverage can produce large profits in relation to your initial margin. Conversely, if prices move in the opposite direction, high leverage can produce large losses in relation to your initial margin. Leverage is a two-edged sword.  

For example, assume that in anticipation of rising stock prices you buy one June S&P 500 stock index futures contract at a time when the June index is trading at 200. And assume your initial margin requirement is $6,000. Since the value of the futures contract is $500 times the index, each 1 point change in the index represents a $500 gain or loss.  

Thus, an increase in the index from 200 to 212 would double your $6,000 margin deposit and a decrease from 200 to 188 would wipe it out. That's a 100% gain or loss as the result of only a 6% change in the stock index!  

Said another way, while buying (or selling) a futures contract provides exactly the same dollars and cents profit potential as owning (or selling short) the actual commodities or items covered by the contract, low margin requirements sharply increase the percentage profit or loss potential. For example, it can be one thing to have the value of your portfolio of common stocks decline from $100,000 to $94,000 (a 6% loss) but quite another (at least emotionally) to deposit $6,000 as margin for a futures contract and end up losing that much or more as the result of only a 6% price decline. Futures trading thus requires not only the necessary financial resources but also the necessary financial and emotional temperament.  

An absolute requisite for anyone considering trading in futures contracts--whether it's sugar or stock indexes, pork bellies or petroleum--is to clearly understand the concept of leverage as well as the amount of gain or loss that will result from any given change in the futures price of the particular futures contract you would be trading. If you cannot afford the risk, or even if you are uncomfortable with the risk, the only sound advice is don't trade. Futures trading is not for everyone.  

As is apparent from the preceding discussion, the arithmetic of leverage is the arithmetic of margins. An understanding of margins--and of the several different kinds of margin--is essential to an understanding of futures trading.  

If your previous investment experience has mainly involved common stocks, you know that the term margin--as used in connection with securities--has to do with the cash down payment and money borrowed from a broker to purchase stocks. But used in connection with futures trading, margin has an altogether different meaning and serves an altogether different purpose. 

Rather than providing a down payment, the margin required to buy or sell a futures contract is solely a deposit of good faith money that can be drawn on by your brokerage firm to cover losses that you may incur in the course of futures trading. It is much like money held in an escrow account. Minimum margin requirements for a particular futures contract at a particular time are set by the exchange on which the contract is traded. They are typically about five percent of the current value of the futures contract. Exchanges continuously monitor market conditions and risks and, as necessary, raise or reduce their margin requirements. Individual brokerage firms may require higher margin amounts from their customers than the exchange-set minimums.  

There are two margin-related terms you should know: Initial margin and maintenance margin.  

Initial margin (sometimes called original margin) is the sum of money that the customer must deposit with the brokerage firm for each futures contract to be bought or sold. On any day that profits accrue on your open positions, the profits will be added to the balance in your margin account. On any day losses accrue, the losses will be deducted from the balance in your margin account.  

If and when the funds remaining available in your margin account are reduced by losses to below a certain level--known as the maintenance margin requirement--your broker will require that you deposit additional funds to bring the account back to the level of the initial margin. Or, you may also be asked for additional margin if the exchange or your brokerage firm raises its margin requirements. Requests for additional margin are known as margin calls.  

Assume, for example, that the initial margin needed to buy or sell a particular futures contract is $2,000 and that the maintenance margin requirement is $1,500. Should losses on open positions reduce the funds remaining in your trading account to, say, $1,400 (an amount less than the maintenance requirement), you will receive a margin call for the $600 needed to restore your account to $2,000.  

Before trading in futures contracts, be sure you understand the brokerage firm's Margin Agreement and know how and when the firm expects margin calls to be met. Some firms may require only that you mail a personal check. Others may insist you wire transfer funds from your bank or provide same-day or next-day delivery of a certified or cashier's check. If margin calls are not met in the prescribed time and form, the firm can protect itself by liquidating your open positions at the available market price (possibly resulting in an unsecured loss for which you would be liable).  

Even if you should decide to participate in futures trading in a way that doesn't involve having to make day-to-day trading decisions (such as a managed account or commodity pool), it is nonetheless useful to understand the dollars and cents of how futures trading gains and losses are realized. And, of course, if you intend to trade your own account, such an understanding is essential.  

Dozens of different strategies and variations of strategies are employed by futures traders in pursuit of speculative profits. Here is a brief description and illustration of several basic strategies.  

• Buying (Going Long) to Profit from an Expected Price Increase 

For example, assume it's now January, the July soybean futures contract is presently quoted at $6.00, and over the coming months you expect the price to increase. You decide to deposit the required initial margin of, say, $1,500 and buy one July soybean futures contract. Further assume that by April the July soybean futures price has risen to $6.40 and you decide to take your profit by selling. Since each contract is for 5,000 bushels, your 40-cent a bushel profit would be 5,000 bushels x 40 cents or $2,000 less transaction costs.  

		Price per bushel	Value of 5,000 bushel contract
January	Buy 1 July soybean futures contract	$6.00	$30,000
April	Sell 1 July soybean futures contract	$6.40	$32,000
	Gain	$ .40	$ 2,000

    * For simplicity examples do not take into account commissions and other transaction costs. These costs are important, however, and you should be sure you fully understand them.  Suppose, however, that rather than rising to $6.40, the July soybean futures price had declined to $5.60 and that, in order to avoid the possibility of further loss, you elect to sell the contract at that price. On 5,000 bushels your 40-cent a bushel loss would thus come to $2,000 plus transaction costs.  

		Price per bushel	Value of 5,000 bushel contract
January	Buy 1 July soybean futures contract	$6.00	$30,000
April	Sell 1 July bean futures contract	$5.60	$28,000
	Loss	$ .40	$ 2,000

  Note that the loss in this example exceeded your $1,500 initial margin. Your broker would then call upon you, as needed, for additional margin funds to cover the loss.  (Going short) to profit from an expected price decrease The only way going short to profit from an expected price decrease differs from going long to profit from an expected price increase is the sequence of the trades. Instead of first buying a futures contract, you first sell a futures contract. If, as expected, the price declines, a profit can be realized by later purchasing an offsetting futures contract at the lower price. The gain per unit will be the amount by which the purchase price is below the earlier selling price.  For example, assume that in January your research or other available information indicates a probable decrease in cattle prices over the next several months. In the hope of profiting, you deposit an initial margin of $2,000 and sell one April live cattle futures contract at a price of, say, 65 cents a pound. Each contract is for 40,000 pounds, meaning each 1 cent a pound change in price will increase or decrease the value of the futures contract by $400. If, by March, the price has declined to 60 cents a pound, an offsetting futures contract can be purchased at 5 cents a pound below the original selling price. On the 40,000 pound contract, that's a gain of 5 cents x 40,000 lbs. or $2,000 less transaction costs.  

		Price per pound	Value of 40,000 pound contract
January	Sell 1 April livecattle futures contract	65 cents	$26,000
March	Buy 1 April live cattle futures contract	60 cents	$24,000
	Gain	5 cents	$ 2,000

    Assume you were wrong. Instead of decreasing, the April live cattle futures price increases--to, say, 70 cents a pound by the time in March when you eventually liquidate your short futures position through an offsetting purchase. The outcome would be as follows:  

		Price per pound	Value of 40,000 pound contract
January	Sell 1 April live cattle futures contract	65 cents	$26,000
March	Buy 1 April live cattle futures contract	70 cents	$28,000
	Loss	5 cents	$ 2,000

  In this example, the loss of 5 cents a pound on the futures transaction resulted in a total loss of the $2,000 you deposited as initial margin plus transaction costs.  Spreads  While most speculative futures transactions revolve a simple purchase of futures contracts to profit from an expected price increase--or an equally simple sale to profit from an expected price decrease--numerous other possible strategies exist. Spreads are one example.  A spread, at least in its simplest form, involves buying one futures contract and selling another futures contract. The purpose is to profit from an expected change in the relationship between the purchase price of one and the selling price of the other.  As an illustration, assume it's now November, that the March wheat futures price is presently $3.10 a bushel and the May wheat futures price is presently $3.15 a bushel, a difference of 5 cents. Your analysis of market conditions indicates that, over the next few months, the price difference between the two contracts will widen to become greater than 5 cents. To profit if you are right, you could sell the March futures contract (the lower priced contract) and buy the May futures contract (the higher priced contract).  Assume time and events prove you right and that, by February, the March futures price has risen to $3.20 and May futures price is $3.35, a difference of 15 cents. By liquidating both contracts at this time, you can realize a net gain of 10 cents a bushel. Since each contract is 5,000 bushels, the total gain is $500.  

November	Sell March wheat	Buy May wheat	Spread
	$3.10 Bu.	$3.15 Bu.	5 cents
February	Buy March wheat	Sell May wheat
	$3.20	$3.35	15 cents
	$ .10 loss	$ .20 gain

 

Net gain 10 cents Bu. Gain on 5,000 Bu. contract $500 

Deciding How to Participate 

At the risk of oversimplification, choosing a method of participation is largely a matter of deciding how directly and extensively you, personally, want to be involved in making trading decisions and managing your account. Many futures traders prefer to do their own research and analysis and make their own decisions about what and when to buy and sell. That is, they manage their own futures trades in much the same way they would manage their own stock portfolios. Others choose to rely on or at least consider the recommendations of a brokerage firm or account executive. Some purchase independent trading advice. Others would rather have someone else be responsible for trading their account and therefore give trading authority to their broker. Still others purchase an interest in a commodity trading pool.

There's no formula for deciding. Your decision should, however, take into account such things as your knowledge of and any previous experience in futures trading, how much time and attention you are able to devote to trading, the amount of capital you can afford to commit to futures, and, by no means least, your individual temperament and tolerance for risk. The latter is important. Some individuals thrive on being directly involved in the fast pace of futures trading, others are unable, reluctant, or lack the time to make the immediate decisions that are frequently required. Some recognize and accept the fact that futures trading all but inevitably involves having some losing trades. Others lack the necessary disposition or discipline to acknowledge that they were wrong on this particular occasion and liquidate the position. 

Many experienced traders thus suggest that, of all the things you need to know before trading in futures contracts, one of the most important is to know yourself. This can help you make the right decision about whether to participate at all and, if so, in what way. 

In no event, it bears repeating, should you participate in futures trading unless the capital you would commit its risk capital. That is, capital which, in pursuit of larger profits, you can afford to lose. It should be capital over and above that needed for necessities, emergencies, savings and achieving your long-term investment objectives. You should also understand that, because of the leverage involved in futures, the profit and loss fluctuations may be wider than in most types of investment activity and you may be required to cover deficiencies due to losses over and above what you had expected to commit to futures.

Trade Your Own Account 

This involves opening your individual trading account and--with or without the recommendations of the brokerage firm--making your own trading decisions. You will also be responsible for assuring that adequate funds are on deposit with the brokerage firm for margin purposes, or that such funds are promptly provided as needed. 

Practically all of the major brokerage firms you are familiar with, and many you may not be familiar with, have departments or even separate divisions to serve clients who warn to allocate some portion of their investment capital to futures trading. All brokerage firms conducting futures business with the public must be registered with the Commodity Futures Trading Commission (CFTC, the independent regulatory agency of the federal government that administers the Commodity Exchange Act) as Futures Commission Merchants or Introducing Brokers and must be Members of National Futures Association (NFA, the industrywide self-regulatory association). 

Different firms offer different services. Some, for example, have extensive research departments and can provide current information and analysis concerning market developments as well as specific trading suggestions. Others tailor their services to clients who prefer to make market judgments and arrive at trading decisions on their own. Still others offer various combinations of these and other services. 

An individual trading account can be opened either directly with a Futures Commission Merchant or indirectly through an Introducing Broker. Whichever course you choose, the account itself will be carried by a Futures Commission Merchant, as will your money. Introducing Brokers do not accept or handle customer funds but most offer a variety of trading-related services.

Futures Commission Merchants are required to maintain the funds and property of their customers in segregated accounts, separate from the firm's own money. 

Along with the particular services a firm provides, discuss the commissions and trading costs that will be involved. And, as mentioned, clearly understand how the firm requires that any margin calls be met. If you have a question about whether a firm is properly registered with the CFTC and is a Member of NFA, you can (and should) contact NFA's Information Center toll-free at 800-621-3570 (within Illinois call 800-572-9400). 

Have Someone Manage Your Account 

A managed account is also your individual account. The major difference is that you give someone rise--an account manager--written power of attorney to make and execute decisions about what and when to trade. He or she will have discretionary authority to buy or sell for your account or will contact you for approval to make trades he or she suggests. You, of course, remain fully responsible for any losses which may be incurred and, as necessary, for meeting margin calls, including making up any deficiencies that exceed your margin deposits. 

Although an account manager is likely to be managing the accounts of other persons at the same time, there is no sharing of gains or losses of other customers. Trading gains or losses in your account will result solely from trades which were made for your account. 

Many Futures Commission Merchants and Introducing Brokers accept managed accounts. In most instances, the amount of money needed to open a managed account is larger than the amount required to establish an account you intend to trade yourself. Different firms and account managers, however, have different requirements and the range can be quite wide. Be certain to read and understand all of the literature and agreements you receive from the broker. 

Some account managers have their own trading approaches and accept only clients to whom that approach is acceptable. Others tailor their trading to a client's objectives. In either case, obtain enough information and ask enough questions to assure yourself that your money will be managed in a way that's consistent with your goals. 

Discuss fees.

In addition to commissions on trades made for your account, it is not uncommon for account managers to charge a management fee, and/or there may be some arrangement for the manager to participate in the net profits that his management produces. These charges are required to be fully disclosed in advance. Make sure you know about every charge to be made to your account and what each charge is for. 

While there can be no assurance that past performance will be indicative of future performance, it can be useful to inquire about the track record of an account manager you are considering. Account managers associated with a Futures Commission Merchant or Introducing Broker must generally meet certain experience requirements if the account is to be traded on a discretionary basis. 

Finally, take note of whether the account management agreement includes a provision to automatically liquidate positions and close out the account if and when losses exceed a certain amount. And, of course, you should know and agree on what will be done with profits, and what, if any, restrictions apply to withdrawals from the account. 

Use a Commodity Trading Advisor 

As the term implies, a Commodity Trading Advisor is an individual (or firm) that, for a fee, provides advice on commodity trading, including specific trading recommendations such as when to establish a particular long or short position and when to liquidate that position. Generally, to help you choose trading strategies that match your trading objectives, advisors offer analyses and judgments as to the prospective rewards and risks of the trades they suggest. Trading recommendations may be communicated by phone, wire or mail. Some offer the opportunity for you to phone when you have questions and some provide a frequently updated hotline you can call for a recording of current information and trading advice. 

Even though you may trade on the basis of an advisor's recommendations, you will need to open your own account with, and send your margin payments directly to, a Futures Commission Merchant. Commodity Trading Advisors cannot accept or handle their customers funds unless they are also registered as Futures Commission Merchants. 

Some Commodity Trading Advisors offer managed accounts. The account itself, however, must still be with a Futures Commission Merchant and in your name, with the advisor designated in writing to make and execute trading decisions on a discretionary basis. 

CFTC Regulations require that Commodity Trading Advisors provide their customers, in advance, with what is called a Disclosure Document. Read it carefully and ask the Commodity Trading Advisor to explain any points you don't understand. If your money is important to you, so is the information contained in the Disclosure Document! 

The prospectus-like document contains information about the advisor, his experience and, by no means least, his current (and any previous) performance records. If you use an advisor to manage your account, he must first obtain a signed acknowledgment from you that you have received and understood the Disclosure Document. As in any method of participating in futures trading, discuss and understand the advisor's fee arrangements. And if he will be managing your account, ask the same questions you would ask of any account manager you are considering. 

Commodity Trading Advisors must be registered as such with the CFTC, and those that accept authority to manage customer accounts must also be Members of NFA. You can verify that these requirements have been met by calling NFA toll-free at 800-621-3570 (within Illinois call 800-572-9400). 

Participate in Commodity Pool 

Another alternative method of participating in futures trading is through a commodity pool, which is similar in concept to a common stock mutual fund. It is the only method of participation in which you will not have your own individual trading account. Instead, your money will be combined with that of other pool participants and, in effect, traded as a single account. You share in the profits or losses of the pool in proportion to your investment in the pool. One potential advantage is greater diversification of risks than you might obtain if you were to establish your own trading account. Another is that your risk of loss is generally limited to your investment in the pool, because most pools are formed as limited partnerships. And you won't be subject to margin calls. 

Bear in mind, however, that the risks which a pool incurs in any given futures transaction are no different than the risks incurred by an individual trader. The pool still trades in futures contracts which are highly leveraged and in markets which can be highly volatile. And like an individual trader, the pool can suffer substantial losses as well as realize substantial profits. A major consideration, therefore, is who will be managing the pool in terms of directing its trading. 

While a pool must execute all of its trades through a brokerage firm which is registered with the CFTC as a Futures Commission Merchant, it may or may not have any other affiliation with the brokerage firm. Some brokerage firms, to serve those customers who prefer to participate in commodity trading through a pool, either operate or have a relationship with one or more commodity trading pools. Other pools operate independently.

A Commodity Pool Operator cannot accept your money until it has provided you with a Disclosure Document that contains information about the pool operator, the pool's principals and any outside persons who will be providing trading advice or making trading decisions. It must also disclose the previous performance records, if any, of all persons who will be operating or advising the pool lot, if none, a statement to that effect). Disclosure Documents contain important information and should be carefully read before you invest your money. Another requirement is that the Disclosure Document advise you of the risks involved. 

In the case of a new pool, there is frequently a provision that the pool will not begin trading until (and unless) a certain amount of money is raised. Normally, a time deadline is set and the Commodity Pool Operator is required to state in the Disclosure Document what that deadline is (or, if there is none, that the time period for raising, funds is indefinite). Be sure you understand the terms, including how your money will be invested in the meantime, what interest you will earn (if any), and how and when your investment will be returned in the event the pool does not commence trading. 

Determine whether you will be responsible for any losses in excess of your investment in the pool. If so, this must be indicated prominently at the beginning of the pool's Disclosure Document. 

Ask about fees and other costs, including what, if any, initial charges will be made against your investment for organizational or administrative expenses. Such information should be noted in the Disclosure Document. You should also determine from the Disclosure Document how the pool's operator and advisor are compensated. Understand, too, the procedure for redeeming your shares in the pool, any restrictions that may exist, and provisions for liquidating and dissolving the pool if more than a certain percentage of the capital were to be lost, 

Ask about the pool operator's general trading philosophy, what types of contracts will be traded, whether they will be day-traded, etc. 

With few exceptions, Commodity Pool Operators must be registered with the CFTC and be Members of NFA. You can verify that these requirements have been met by contacting NFA toll-free at 800-621-3570 (within Illinois call 800-572-9400).

Regulation of Futures Trading  Firms and individuals that conduct futures trading business with the public are subject to regulation by the CFTC and by NFA. All futures exchanges are also regulated by the CFTC.  NFA is a congressionally authorized self-regulatory organization subject to CFTC oversight. It exercises regulatory Authority with the CFTC over Futures Commission Merchants, Introducing Brokers, Commodity Trading Advisors, Commodity Pool Operators and Associated Persons (salespersons) of all of the foregoing. The NFA staff consists of more than 140 field auditors and investigators. In addition, NFA has the responsibility for registering persons and firms that are required to be registered with the CFTC.  Firms and individuals that violate NFA rules of professional ethics and conduct or that fail to comply with strictly enforced financial and record-keeping requirements can, if circumstances warrant, be permanently barred from engaging in any futures-related business with the public. The enforcement powers of the CFTC are similar to those of other major federal regulatory agencies, including the power to seek criminal prosecution by the Department of Justice where circumstances warrant such action.  Futures Commission Merchants which are members of an exchange are subject to not only CFTC and NFA regulation but to regulation by the exchanges of which they are members. Exchange regulatory staffs are responsible, subject to CFTC oversight, for the business conduct and financial responsibility of their member firms. Violations of exchange rules can result in substantial fines, suspension or revocation of trading privileges, and loss of exchange membership.  Words of Caution  It is against the law for any person or firm to offer futures contracts for purchase or sale unless those contracts are traded on one of the nation's regulated futures exchanges and unless the person or firm is registered with the CFTC. Moreover, persons and firms conducting futures-related business with the public must be Members of NFA. Thus, you should be extremely cautious if approached by someone attempting to sell you a commodity-related investment unless you are able to verify that the offeror is registered with the CFTC and is a Member of NFA.  In a number of cases, sellers of illegal off-exchange futures contracts have labeled their investments by different names--such as "deferred delivery," "forward" or "partial payment" contracts--in an attempt to avoid the strict laws applicable to regulated futures trading. Many operate out of telephone boiler rooms, employ high-pressure and misleading sales tactics, and may state that they are exempt from registration and regulatory requirements. This, in itself, should be reason enough to conduct a check before you write a check. You can quickly verify whether a particular firm or person is currently registered with the CFTC and is an NFA Member by phoning NFA toll-free at 800-621-3570 (within Illinois call 800-572-9400). 

Establishing an Account  At the time you apply to establish a futures trading account, you can expect to be asked for certain information beyond simply your name, address and phone number. The requested information will generally include (but not necessarily be limited to) your income, net worth, what previous investment or futures trading experience you have had, and any other information needed in order to advise you of the risks involved in trading futures contracts. At a minimum, the person or firm who will handle your account is required to provide you with risk disclosure documents or statements specified by the CFTC and obtain written acknowledgment that you have received and understood them.  Opening a futures account is a serious decision--no less so than making any major financial investment--and should obviously be approached as such. Just as you wouldn't consider buying a car or a house without carefully reading and understanding the terms of the contract, neither should you establish a trading account without first reading and understanding the Account Agreement and all other documents supplied by your broker. It is in your interest and the firm's interest that you dearly know your rights and obligations as well as the rights and obligations of the firm with which you are dealing before you enter into any futures transaction. If you have questions about exactly what any provisions of the Agreement mean, don't hesitate to ask. A good and continuing relationship can exist only if both parties have, from the outset, a clear understanding of the relationship.  Nor should you be hesitant to ask, in advance, what services you will be getting for the trading commissions the firm charges. As indicated earlier, not all firms offer identical services. And not all clients have identical needs. If it is important to you, for example, you might inquire about the firm's research capability, and whatever reports it makes available to clients. Other subjects of inquiry could be how transaction and statement information will be provided, and how your orders will be handled and executed.  If a Dispute Should Arise  All but a small percentage of transactions involving regulated futures contracts take place without problems or misunderstandings. However, in any business in which some 150 million or more contracts are traded each year, occasional disagreements are inevitable. Obviously, the best way to resolve a disagreement is through direct discussions by the parties involved. Failing this, however, participants in futures markets have several alternatives (unless some particular method has been agreed to in advance). Under certain circumstances, it may be possible to seek resolution through the exchange where the futures contracts were traded. Or a claim for reparations may be filed with the CFTC. However, a newer, generally faster and less expensive alternative is to apply to resolve the disagreement through the arbitration program conducted by National Futures Association. There are several advantages: 

You can elect, if you prefer, to have arbitrators who have no connection with the futures industry.  You do not have to allege or prove that any law or rule was broken only that you were dealt with improperly or unfairly.  In some cases, it may be possible to conduct arbitration entirely through written submissions. If a hearing is required, it can generally be scheduled at a time and place convenient for both parties.  Unless you wish to do so, you do not have to employ an attorney. 

For a plain language explanation of the arbitration program and how it works, write or phone NFA for a copy of Arbitration: A Way to Resolve Futures-Related Disputes. The booklet is available at no cost. 

What to Look for in a Futures Contract?  Whatever type of investment you are considering--including but not limited to futures contracts--it makes sense to begin by obtaining as much information as possible about that particular investment. The more you know in advance, the less likely there will be surprises later on. Moreover, even among futures contracts, there are important differences which--because they can affect your investment results--should be taken into account in making your investment decisions. 

The Contract Unit 

How Prices are Quoted 

Minimum Price Changes 

Daily Price Limits 

Position Limits 

Understanding (and Managing) 

Choosing a Futures Contract 

Liquidity 

Timing 

Stop Orders 

Spreads 

Options on Futures Contracts 

Buying Call Options 

Buying Put Options 

How Option Premiums are Determined 

Selling Options