How to trade the Futures and Options

We will discuss this in detail in a moment. Before we do, you need to understand how this work. With the Futures (as with the Options) you are not buying the physical commodity, you buy a contract. The contract is tradeable, thus you can sell it onto someone else, or someone can sell it to you, but it is still a contract only, not the physical commodity. Thus you never own a physical asset. At no point in time are you able to convert or trade-in your contract for the physical asset. The only thing that will happen is that you will get out of the contract and at that point take ownership of the price difference between when you bought and got rid off the contract. In other words, the only thing that you will ever realize, is the price difference!

If you compare this to trading in stocks, with the stock you own a physical asset that has value and which you may hold as long as you wish before you sell it - it will always have a value. Thus when you buy 100 stock at a price of $170 each, you will pay $17,000 and will hold "an asset" valued at this amount. As the asset's value changes, so does your profit / loss.

Thus now, when you buy a Futures contract, how much do you pay for the contract!? Well you can't (pay for it), there is no value in the contract - the only thing that you will ever realize is the price difference!! And that we don't know yet! So, how does this work...?

MARGIN: The only concern that the Exchange has when it allows you to trade a contract, is whether you will be able to service your debt when the price difference gets known. The Exchange cannot take the risk that at that point in time you do not have the necessary financial backing to service your end of the deal - they can hardly hire the necessary legal teams to chase all over the world after every investor that defaulted on a contract - where will the money for this come from? Thus the Exchange introduced the concept of a margin account. For every commodity the Exchange calculates the risk associated with the commodity - by how much (price wise) can the commodity really change in a day, say if something really goes wrong. What size of sudden price-difference do they need to safeguard against. This is not a straight forward calculation. But the end result is a certain amount of money that they will ask you to put up as guarantee - we call it the margin required - to allow you to trade in that commodity.

This is how it works: When you open a trade (buy or sell a contract), the Exchange will ask that you put up a certain amount of money as guarantee - as margin. This sum of money will be taken out of your account and put somewhere in safe-keeping. It is no longer available to you. The moment you take the opposite position in the contract and are neutral again, they will return this money - the margin - to your account and it is available again for you to do with whatever you want - all that happened to it was that it was put aside as guarantee. Now once you are in the trade, the day to day price changes will realize live in your trading account (price-tick to price-tick actually, not day to day, it happens live!). Thus the "free" floating capital in your account will change all the time as the price of the contract (Futures or Options) changes. If for whatever reason your free floating cash in your account dips below zero the Exchange will immediately call (we call this a margin call) and request you to deposit more funds. Failing this, or if the contract continues to move against you, they will immediately sell you out of the market (buy or sell, whatever, give you the opposite position, neutralize your position in the market). The margin gets released and the loss gets settled. You are again free to trade as you wish - but of cause the free capital in your account is now much less - you probably will not be able to enter the same contract again (not enough margin) until you deposit more funds. In other words, through the margin requirement in order to open a position, the Exchange safeguards itself against you defaulting on your commitments.

The margin required to trade a commodity differs from commodity to commodity and is published by the Exchange. There are two margin amounts published - Initial Margin is the amount of margin required to OPEN the position. Then once it is open and you decide you want to hold the position overnight they will reduce the margin to the Maintenance Margin which is slightly less, usually around 80% of the Initial Margin. The margin requirements per commodity also changes over time. The Exchange tries to keep it the same, but from time to time they will re-evaluate the risk in a specific commodity and may change - either upgrade or downgrade - the margin requirements for a specific commodity. In general it is not a problem, you will always be informed of the margin requirements before you enter a trade, just be aware of the relative size in the back of your mind.

Thus, you are not free to open as many contracts as you like! You are limited in the number of contracts you open by the amount of margin that you have available to open the positions... OK, when you BUY an OPTION - in other words LONG, whether it a CALL or a PUT, you pay a premium for the option, your risk is limited to the premium you have already paid, therefore as far as the Exchange is concerned you do not pose any risk! Therefore there is no margin required to buy options!!. When you deal in the Futures, or SELL Options (short options), you are taking on risk and you need to put down margin! (Thus when you bought an option, there was no margin. When you sold that option, you are neutral again in the market, thus still no margin - you were never a risk to the Exchange!)

And this brings us to WHAT DO YOU NEED in order to be able to TRADE? You need FOUR things:
1. A Broker:Your broker is your key to the Exchange. You need someone to route your orders through to the exchange, to keep track of your orders, in short to manage your trades on the Exchange side. This is what your broker will do. He will ensure the necessary legal requirements are met, your orders are routed and executed correctly, etc. He will provide you with an interface to interact with him, some kind of inerface (web-based, maybe an application you install, maybe a Smartphone App) through which you are able to manage your account (transfer, move or withdraw funds), but also through which you are able to execute and manage your orders. A means by which you can communicate with him on what it is that you want to do. He makes the market data available for you to base our decision on, etc. (My broker gave me all three - I am able to manage my account from my iPad, I can view the market data on my iPad, enter and manage my positions. Later when at home with access to my PC I am able to use an interactive application to monitor and manage my positions. Doesn't matter where in the world I am, I may always open an app on my Smartphone and have full access to my business)
He is also the guy that you will phone when you have a position in the market and you have lost your internet connection and you need to check on that position, or ask someone to please monitor the position and take you out of the market at the right moment. Your broker is that person. He is on your side, he carries your best interests at heart. He does not do this for nothing, he gets paid for his services. This usually is in the form of a commission, a brokerage charge, that he will add onto every transaction that you perform. You cannot enter into this business without a reliable broker.
2. An Account: As highlighted above, you need to maintain the necessary margin in an account to use as guarantee when you enter your positions. You also need to provide the necessary free floating capital to absorb the price fluctuations in the market, ensure a positive balance at all times. Your broker will let you open and fund an account. He will make the necessary tools available for you to manage your account. What you want to look for is account security, how easy it is to fund your account, how easy it is to withdraw funds from your account, how easy it is to manage your account.
3. A Method to Enter the Market: You need some method whereby you decide when do you want to enter the market and in which direction? Do you use technical analysis, looking at momentum and moving averages and stochastics and stuff, or do you enter positions based on feeling? Do you subscribe to an advisory service? What method do you use to decide which markets do you want to transact in and when do you want to enter the market? In other words you need to invest in knowledge - knowledge about the markets and knowledge about how to tell where the market is most likely headed. You then need to decide when will you enter and in which direction..
4. A Money-Management (or Trade Management) Strategy: This is probably the most important aspect - the key to success. Once you are into a trade, how do you manage that position to completion? Get this right and you will make a success of your business. Get it wrong and you are in for a very tough time! The market is not a playground, if you get it wrong it will eat you alive, spit out what is left and move on without you! Unfortunately you cannot just invest in a system to give you this. This is something YOU have to come up with, YOU need to develop the necessary discipline, the necessary methodology. No one else can do this for you. It comes with experience.
When you decide to enter the market you have to have a very clear goal in mind - how much profit are you after, what do you want to achieve. But also how much of a loss are you willing to take and how will you take that loss, how will you get out of the market when things go wrong? You have to have a very clear understanding of this, a business plan, BEFORE you enter the market. (For example, in our Corn trade with the Futures (Trading Example), the moment we had $450 profit, the correct strategy would have been to put in a stop loss on the trade at half the profit, or at break-even, depending on the person - a standing order lying in the market and you would have been stopped out of that market when it corrected. An unsound strategy would have waited, eager to see more profit, then be surprised to see the sudden correction and the resultant loss. The unsound strategy would then start arguing with itself, telling itself it is only a correction, to not go out yet, just wait it out, it will turn profitable again - the market would have played havoc with unsound strategy's emotions. Unsound strategy would eventually have taken a $500 loss, on a trade that did give him $450 profit at some point and an opportunity to get out, even if it was only with $200! But $200, or $0 compared to -$500!?)

OK, this is what you need to trade these markets.

Where does the Options Explorer fit in?

(If you don't know what the Options Explorer is yet, you may use this link - BUT note this will kick you back to the optionsexplorer.co.za website and you will have to use the back button at the top of your browser to get back here). The Options Explorer will help you with:

  • 1. A method to enter the market: HOWEVER, remember that the Options Explorer is not a trading system, it will not monitor certain conditions in the market and tell you when to enter and when to exit. No, instead it is a powerful analysis tool wherethrough you may analyse the commodities options market, filter out the options that fits your trading style, or the options combinations that comply with a specific investment strategy, then allow you to analyse those specific strategies to plan where you want to enter the market. You still have to take the decision which market you prefer and when and how you will enter the market, the Options Explorer however assists you to identify and analyse the market opportunities, and
  • 2. A Money Management Strategy: The Options Explorer will allow you to, in detail, simulate a position BEFORE you enter the positions in order to plan ahead what you will do - in order to create a detailed trading plan. It will assist you to answer questions such as what is my objective with this trade? How much profit do I want to make? How much loss am I willing to take? How will I take that loss? If the market does this or that, how will I respond to that change? The Options Explorer allows you to analyse and answer these questions BEFORE you pull the trigger and enter the market
In other words, the Options Explorer addresses two important aspects of your trading business in order to allow you to make a success of this business!

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