Are You Ready to Trade Commodity Futures?
Remember trading basics
- Think about your financial experience and all financial resources and know how much you can afford to lose above your initial payment.
- Understand commodity futures and option contracts and your obligations in entering into those contracts.
- Understand your exposure to risk and other aspects of trading by reviewing the risk disclosure documents your broker is required to give you.
- Know whom to contact if you have any problems or questions.
And always ask questions and gather information before you open an account.
Is there anything I should watch out for?
- Use caution If it sounds too good to be true! Promises of huge returns with limited risk are often false.
- Be on the alert for anyone who down plays the importance of the disclosure statement; you should always receive it and read it completely before you open an account.
- Do your homework! Don't be pressured to "act now."
- Always ask questions.
- Beware when a salesperson tells you to borrow money to invest, and never agree to give money to someone you have never met.
- Watch out for guarantees of profit or boasts about past performance.
- Do not rely on promises of profits due to "predictable" seasonal or market cycles or claims based on the impact of current news events.
Understand Your Goals
Futures and option trading is inherently complex and risky, and it is not appropriate for all investors. You should know how much you potentially can lose and honestly evaluate if you can afford to lose it in view of your financial resources and investment goals. You should share your conclusions with your broker.
If you decide you have the resources and the reasons to invest in futures, you should also determine the extent to which you plan to rely on advice from a broker versus making your own trading decisions. Then you should evaluate and compare the methods of trading before choosing the one you feel will best implement your goals.
Finally, set some limits on the duration of your investment and the amount of loss you are willing to incur. Like other financial markets, futures and options markets are cyclical and gains may not be immediate.
And always remember that, because of the leveraged nature of futures, losses can be more than your original deposit.
- Risk disclosure documents
Because trading in futures and options is appropriate only for certain businesses and individuals, it's required that a broker provide you with a disclosure document that describes the risks involved in entering into futures and option contracts. The document provides you with an opportunity to carefully consider whether futures and options are appropriate for you in light of your experience, objectives, financial resources, and other circumstances. The broker must receive a signed and dated acknowledgment from you that you have received a disclosure document before he or she can accept any funds, securities, or property from you. Accounts opened through different types of commodity professionals require different types of risk disclosure documents.
Futures Commission Merchants or Introducing Brokers must provide you with a disclosure statement that informs you of the risks inherent in trading futures contracts and/or options on futures contracts, as well as the effect that leverage may have on potential losses or gains. The disclosure statement must also inform you that trading futures in foreign markets carries particular risks because of fluctuations in currency exchange rates and differences in regulatory protection.
Commodity Pools disclosure documents must include more extensive information, including:
- Principal risk factors;
- The extent of your potential liability;
- The percentage return necessary for you to break even;
- Fees and expenses;
- Litigation during the last 5- years against the pool's operator, manager, trading advisors, principals, the pool's Futures Commission Merchants and Introducing Brokers;
- Actual or potential conflicts of interest of the pool's operator, manager or advisors;
- Past performance information;
- Information about the Commodity Trading Adviser or brokerage and principal officers;
- The business background of the pool's operator, manager, and advisors;
- The volatility of the trading markets;
- Possible limits on your ability to withdraw funds;
- Management, advisory, and brokerage fees;
- Whether foreign futures and option transactions are involved;
- The investment program of the commodity pool and use of proceeds;
- Whether those managing your money may trade for their own account;
- Information on any protection of your principal investment;
- Transferability and redemption;
- Liability of market participants;
- Distribution of profits and taxation;
- When trading will begin;
- The ownership of the commodity pool; and
- Reporting to pool participants.
Before a Registered Commodity Trading Advisor can legally solicit you about opening a trading account for your trading, a Commodity Trading Advisor (CTA) must give you a risk disclosure statement about risk of loss.
- How risk affects your returns
Your returns may change radically at any time because futures and options are subject, by nature, to abrupt changes in price. Commodity prices are volatile because they respond to many unpredictable factors: weather, labor strikes, inflation, foreign exchange rates, government monetary policies, etc. And, in an individual account, because your position in futures and options is leveraged, even a small move against your position may result in a large loss, including the loss of your entire initial margin payment and liability for additional losses. The same risk of loss applies to a commodity pool, but your loss may be limited to the amount of your investment.
- Strategies for reducing risk
In an individual account, there are certain types of orders (such as “stop-loss” orders or “stop limit” orders), which are designed to limit losses to certain amounts. However, these orders may not be effective in limiting losses because market conditions may make it impossible to execute your orders at a reasonable price. Strategies using combinations of positions, such as “spread” and “straddle” positions, may be as risky as taking simple “long” or “short” positions. In a commodity pool, you should ask the pool about any strategies it employs to reduce risk. As always, be extremely wary of claims of guaranteed profit and minimal risk.
- Options versus futures
Options do not necessarily carry less risk than futures. If you plan to trade through an individual account and are considering trading options on futures contracts, you should familiarize yourself with the types of options (puts or calls) that you contemplate trading and the risks associated with each. You should calculate the extent to which the value of the options must increase for your position to become profitable, taking into account the premium and all transaction costs. You should also understand that certain market conditions (such as lack of liquidity), market rules, or the pricing relationships between the underlying interest and the option may increase risk.
- Do the risks vary between puts and calls?
The purchaser of an option (known as a "long" call or being "long" a put) can do the following with an option position. The purchaser may "exercise" the option if it is profitable, or allow the option to expire if it is not profitable. The exercise of an option by someone who is "long" results either in a cash settlement or in the purchaser acquiring the underlying interest. If the option is on a futures contract, the purchaser will acquire a futures position with associated liabilities for margin. If a purchased option expires worthless, you will suffer a total loss of your investment, which will consist of the option premium plus transaction costs. If you are contemplating purchasing "deep-out-of-the-money" options, you should be aware that the chance of such options becoming profitable ordinarily is remote.
Selling, or shorting, an option generally involves considerably more risk-of-loss vs buying options. Although the option premium received by the option seller is fixed, the seller may sustain a trading-loss well in excess of that amount. The seller will be liable for additional margin to maintain the position if the market moves unfavorably. The seller will also be exposed to the risk that the purchaser will exercise the option, obligating the seller to either settle the option in cash or to acquire and deliver the underlying interest. If the position is "covered" by the seller holding a corresponding position in the underlying interest or a future or another option, the risk of loss may be reduced, but the loss may still exceed the premium received. If the option is not covered, the risk of loss can be unlimited.