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No matter what type of investment you are considering, 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. Specifically, be certain you understand such things as:
The Contract Unit
Futures contracts specify such things as the unit of trading and contract size (such as 5,000 bushels of grain, 40,000 pounds of livestock, or 100 troy ounces of gold). Foreign currency futures specify the number of marks, francs or pesos. U.S. Treasury obligation futures are in terms of instruments having a stated face value (such as $100,000 or $1 million) at maturity. Stock index futures contracts that call for cash settlement rather than delivery are based on a given index number times a specified dollar multiple. Whatever the yardstick, it’s important to know precisely what it is you would be buying or selling, and the quantity you would be buying or selling.
Nothing is more important in futures trading than clearly communicating with your brokerage firm about what you want to buy or sell, when you want to buy or sell, and any other conditions or limitations you may want to attach to your order. For example, if you want to buy or sell immediately at the best available price, whatever that happens to be, this is known simply as a “market” order. But there are many other types of orders that give the broker specific instructions about when and/or at what price to execute a purchase or sale. Your order instructions can specify not only when and at what price you are willing to establish a futures position but also include instructions about when and at what price, if possible, you want to liquidate the position. You also need to let the broker know whether you intend for an order to be a “day” order (valid for that day only) or an “open” order
(one that remains in effect until such time as it can be executed according to your instructions). Ask the brokerage firm you’re dealing with whether it can provide you with a written glossary of the various types of orders it and the exchanges can accept. Some firms offer recordkeeping books and online resources that can be handy for tracking your orders, executions, and open positions. Finally, be sure you have a full understanding of your firm’s order entry procedures.
How Prices are Quoted
Futures prices are usually quoted the same way prices are quoted in the cash market; in dollars, cents, and sometimes fractions of a cent, per bushel, pound or ounce; in points and percentages of a point for financial instruments; and in terms of an index number, for stock index contracts. Be certain you understand the price quotation system for the particular futures contract you are considering.
Minimum Price Changes
Exchanges establish the minimum amount that the price can fluctuate upward or downward. This is known as the “tick.” For example, each tick for grain is ¼¢ per bushel. On a 5,000 bushel futures contract, that’s $12.50. On a gold futures contract, the tick is 10¢ per ounce, which on a 100 ounce contract is $10. You’ll want to familiarize yourself with the minimum price fluctuation—the tick size—for whatever futures contracts you plan to trade. You’ll need to know how a price change of any given amount will affect the value of the contract.
Daily Price Limits
Exchanges establish daily price limits for trading in futures contracts. The limits are stated in terms of the previous day’s closing price plus or minus so many cents or dollars per trading unit. Once a futures price has increased by its daily limit, there can be no trading at any higher price until the next day of trading. Conversely, once a futures price has declined by its daily limit, there can be no trading at any lower price until the next day of trading. Thus, if the daily limit for a particular grain is currently 20¢ a bushel and the previous day’s settlement was $3, there can not be trading during the current day at any price below $2.80 or above $3.20. The price is allowed to increase or decrease by the limit amount each day.
For some contracts, daily price limits are eliminated during the month in which the contract expires. Because prices can become particularly volatile during the expiration month (also called the “delivery” or “spot” month), persons lacking experience in futures trading may wish to liquidate their positions prior to that time. Or, at the very least, trade cautiously and with an understanding of the risks that may be involved.
Daily price limits set by the exchanges are subject to change. They can be either increased or decreased. Because of daily price limits, there may be occasions when it is not possible to liquidate an existing futures position at will. In this event, possible alternative strategies should be discussed with a broker.
Although the average trader is unlikely to ever approach them, the exchanges and the CFTC establish limits on the maximum speculative position that any one person can have at one time in any one futures contract. The purpose is to prevent one buyer or seller from being able to exert undue influence on the price in either the establishment or liquidation of positions. Position limits are stated in number of contracts or total units of the commodity. The easiest way to obtain the types of information just discussed is from your broker or from the exchange where the contract is traded.
Past performance is not necessarily indicative of future results and the risk of loss does exist in futures trading.
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