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T h i r d E d i t i o n

THE FUTURES
GAME
Who Wins? Who Loses?
And Why?

Richard J. Teweles
Frank J. Jones

Edited by
Ben Warwick

Boston, Massachusetts Burr Ridge, Illinois


Dubuque, Iowa Madison, Wisconsin New York, New York
San Francisco, California St. Louis, Missouri
C O N T E N T S

Preface xxiü

PART ONE

BASICS OF THE GAME 1

Chapter 1
Why Trade Futures? 3
Introduction 3
Economic Function of the Speculator 4
Speculating or Gambling? 5
The Evolution of Futures Trading 6
Development of the Futures Contract 9
Attacks against Futures Trading 13
Why Do Speculators Speculate? 17
Speculate in What? 18
Futures versus Securities and Other Speculations 19
Should You Speculate? 24

Chapter 2
The Nature of the Futures Markets 27
Introduction 27
Nature of the Contract 28
Nature of Exchange Operations 29
Nature of the Open Interest 33
Speculators 34
Floor Traders 35
Hedgers 36
Nature of Cash and Futures Price Relations 37
Introduction 37
Hedging Carried Out to Eliminate the Risks Associated
with Price Fluctuations 38

vii
Hedging Carried Out to Reduce the Risks Associated
with Price Fluctuations 39
Hedging Carried Out to Profit from Movements in the Basis 41
Hedging Carried Out to Maximize Expected Returns for a Given Risk
(Variability of Return) or Minimize Risk for a Given Expected Return 49
Critical Comment 50

Chapter 3
The Mechanics of Futures Trading 70
Introduction 70
The Firm 70
Opening the Account 72
Contract Information 74
Daily Trading Limits 91
Taking a Position 92
Liquidating a Position 93
Types of Orders 94
Daily Operating Statement 97
Buying Power 98
The Monthly Statement 98
Regulatory Requirements 100
Tax Considerations 102
Capital Gains Treatment 102
Other Issues 104

Chapter 4
The Behavior of Futures Prices 105
Introduction 105
The Efficient-Market Hypothesis 107
Premises 108
Behavior of Traders 109
Empirical Studies 112
Introduction 112
Level One: Weak-Form Efficiency 114
Price Patterns 114
Filter Rules 117
Trend-Following Strategies 120
Spectral Analysis 121

viii Contents
Chaos Theory 122
Level Two: Semistrong Efficiency 123
Level Three: Strong-Form Efficiency 125
Is There a Risk Premium in Futures Prices? 125
Statistical Evidence 126
Other Causes of Bias 133
Notes from a Trader 134

PART TWO

PLAYING THE GAME—TRADING 137

Chapter 5
Approaches to Trade Selection: Fundamentals 139
Decision Making 139
Introduction 139
The Efficient Market—A Reprise 140
Specific Approaches 141
The Fundamental Approach 142
Model Building 145
Explaining versus Forecasting 147
Keys to Better Forecasting 148
Notes from a Trader 150
Basic Data 151
The Analytical Framework 151
Opportunity Cost of Capital 152
Increased Market Efficiency 152

Chapter 6
Approaches to Trade Selection: Technical Analysis 154
Introduction 154
Patterns on Price Charts 156
Bar Charts 157
Point-and-Figure Charts 159
Striking the Balance—Advantages and Disadvantages of Using
Price Patterns in Trading 161
The Advantages 161

Contents ix
The Disadvantages 163
Trend-Following Methods 163
Moving Averages 164
Striking the Balance—Advantages and Disadvantages of Using
Trend-Following Methods 167
The Advantages 167
The Disadvantages 167
Character-of-Market Analysis 167
Oscillators 168
Striking the Balance—Advantages and Disadvantages of Using
the Oscillator 169
The Advantages 169
The Disadvantages 170
Traditional Volume and Open-Interest Methods 171
Striking the Balance—Advantages and Disadvantages of Using
Traditional Volume and Open-Interest Methods 174
The Advantages 174
The Disadvantages 174
Analysis of Open Interest to Determine Activities of Large
and Small Traders 174
Striking the Balance—Advantages and Disadvantages of Using Open
Interest to Reveal the Activities of Large and Small Traders 175
The Advantages 175
The Disadvantages 176
Contrary Opinion 176
Striking the Balance—Advantages and Disadvantages of Using
Contrary Opinion 179
The Advantages 179
The Disadvantages 180
Structural Theories 180
Seasonal Price Movements 181
Striking the Balance—Advantages and Disadvantages
of Using Seasonals 182
The Advantages 182
The Disadvantages 182
Time Cycles 183
Striking the Balance—Advantages and Disadvantages of Using
Time Cycles 184
The Advantages 184
The Disadvantages 184

x Contents
The Elliott Wave Theory 185
Striking the Balance—Advantages and Disadvantages of Using
the Elliott Wave Theory 187
The Advantages 187
The Disadvantages 187
Notes from a Trader 189

Chapter 7
Spreads 191
Introduction 191
Spreads 191
Significance of Price Differences 193
Spread Positions 196
Intracommodity Spreads 196
Intercommodity Spreads 199
Intermarket Spreads 200
Combinations 201
Low-Risk Spreads 201
Tax Spreads 203
Problems 203
Mistakes 205
Notes from a Trader 209

Chapter 8
Options 211
Development of Options on Futures 211
Futures vs. Options 215
Futures 215
Options 215
The Development of the Option Pricing Model 217
Calls 219
Puts 227
Strategies 230
Bull Strategies 231
Bear Strategies 232
Combinations of Futures and Options—The Tinkertoy Approach 232
Futures 233

Contents xi
Puts from Calls and Futures 233
Other Strategies 235
Straddles 236
Spreads 238
Overview and Conclusions 242
Notes from a Trader 242

Chapter 9
The Game Plan 246
Introduction 246
The Broad Plan 248
Key Elements of the Plan 250
Capital 250
Trade Selection and Evaluation 251
Choosing a Trade-Selection Method 251
Evaluating a Trade-Selection Method 254
Number of Markets to Follow 256
Time Horizon 257
Adding to Positions 258
Stops 259
The Plan in Action 261
Form of the Plan 261
A Specific Plan 266
Commodity Pools and Managed Funds 269
Structure of a Commodity Pool 271
The Growth of Managed Futures Funds 271
Public Funds, Private Funds, and Investment Advisory Services 272
Selecting a Fund 273
Mistakes 274
Notes from a Trader 276

Chapter 10
Money Management 277
Introduction 277
Expectation of the Game Played 278
Probability 278
Payoff 279

Xll Contents
Fair Bets 282
Good Bets 282
Bad Bets 283
Strategy for a Favorable Game 284
Real-Time Validation 285
Probability of Ruin 288
Conceptual Foundation 288
Multiple Positions 291
Stop-Loss Points 293
Strategy Following Significant Success 294
Strategy Following Significant Adversity 295
Systems 296
Size of Commitments 299
Notes from a Trader 301

PART THREE
LOSERS AND WINNERS 305

Chapter 11
Who Wins? Who Loses? And Why? 307
Introduction 307
Distribution of Profits and Losses 308
The Blair Stewart Study 308
The Hieronymus Study 310
The Houthakker Study 311
The Rockwell Study 312
The Ross Study 322
The Hartzmark and Leuthold Studies 322
The Gilbert and Brunetti Study 323
Additional Evidence 325
Skills of the Trader 325
Forecasting Skills 325
Behavioral Skills 327
Notes from a Trader 331

Contents xiii
PART FOUR

THE BROKER IN THE GAME 333


Chapter 12

Building, Maintaining, and Servicing a Futures Clientele 335


Introduction 335
Building a Futures Clientele 335
Sales Personality 335
Industry Knowledge 337
Prospect Knowledge 339
Skill in Selling 341
Maintaining a Futures Clientele 346
Servicing a Futures Clientele 347
Appendix: Preparation for the National Commodity Futures Examinations 351

Chapter 13

Compliance: I'll See You in Court 355


Introduction 355
Sources of Problems and Their Prevention 356
Soliciting the Account 356
The Registered Commodity Representative 356
Representations 356
Opening the Account 357
Suitability 357
Risk Letters 359
Special Types of Accounts 361
Deposit of Funds 361
Handling the Account 362
Trade Suggestions 362
Documentation of Orders 363
Discretion 364
Record Keeping 364
Churning 365
Margins 366
Dealing with Irreconcilable Differences 368
The Complaint 368
Legal Action 369
The Formal Demand 369

xiv Contents
The Arenas 370
Notes from a Trader 371
The Customer 371
The Broker 372

PART FIVE

CHOOSING THE GAME—MARKETS 373

Chapter 14
General Sources of Information 375
Periodicals 375
Historical and Real-Time Price Data 376
Trading and Research Software 377
Books 377
Government and Regulatory Agencies 377
U.S. Grains 378
U.S. Oilseeds 378
U.S. Cotton 378
U.S. Livestock 379
World Acreage and Production Reports by Country 379
Exchanges 381
The Internet 386
Notes from a Trader 387

Chapter 15
The Interest Rate Futures Market 388
Introduction 388
The Interest Rate Complex 389
Prices and Delivery Months 390
Supply 391
Demand 391
Determinants of Interest Rates 391
Hedge Uses 394
The Long Hedge 394
The Short Hedge 395

Contents
The Duration-Adjusted Hedge 395
Speculative Uses 396
Arbitrage Strategies 396
Notes from a Trader 398

Chapter 16
The Foreign Currency Futures Markets 400
Introduction 400
Available Contracts 404
Determinants of Exchange Rates 404
Purchasing Power Parity—the Law of One Price 405
Balance of Payments 406
Monetary Policy 409
Fiscal Policy 409
Central Bank Intervention 411
Hedge Uses 412
Speculative Uses 413
Notes from a Trader 417

Chapter 17
Grains and Oilseeds 418
Introduction 418
The Soybean Complex 418
Soybeans 420
Soybean Meal 421
Soybean Oil 423
Price Determinants 426
Futures Contracts 430
Hedging Uses 431
Speculative Uses 432
Sources of Information—The Soybean Complex 433
Notes from a Trader 434
Grains—Domestic 435
Wheat 435
Introduction 435
Supply 435
Demand 438

xvi Contents
Price Determinants 438
Futures Contracts 440
Pricing of Futures Contracts 442
Speculative Uses 442
Notes from a Trader 444
Corn 445
Introduction 445
Supply 445
Demand 448
Price Determinants 448
Government Policies 451
Futures Contracts 452
Pricing of Futures Contracts 452
Speculative Uses 452
Oats 453
Introduction 453
Supply 453
Demand 455
Price Determinants 455
Futures Contracts 456
Speculative Uses 457
Notes from a Trader—Corn and Oats 457
Sources of Information—Wheat, Corn, and Oats 458
Canadian Markets 459
Flaxseed 459
Introduction 459
Supply 460
Futures Contract 460
Canola 460
Introduction 460
Supply 462
Demand 463
Futures Contract 463
Barley 463
Introduction 463
Supply 463
Demand 464
Futures Contract 465
Speculative Uses of Canadian Futures Contracts 466
Sources of Information—Canadian Markets 467
Notes from a Trader—Canadian Markets 468

Contents xvii
Chapter 18

The Meat Futures Contracts 469


The Beef Complex 470
Introduction 470
Supply 471
Cow-Calf Operation 472
The Feedlot 474
The Packer 476
The Pipeline Method 477
The Cattle Cycle 478
Demand 482
Price Determinants 482
Futures Pricing 485
Futures Contracts 486
Hedge Uses 488
Speculative Uses 490
Sources of Information 490
Notes from a Trader 492
The Pork Complex 492
Introduction 492
Supply 493
The Pipeline Approach 499
Variations Affecting the Pipeline Approach 499
Demand 499
Price Determinants 501
Futures Contracts 501
Speculative Uses 503
Sources of Information 505
Notes from a Trader 507

Chapter 19

Precious and Industrial Metals 509


Precious Metals 509
Gold 509
Introduction 509
Supply 511
Demand 511
Price Determinants 511
Futures Contracts 513
Speculative Uses 514

xviii Contents
Silver 516
Introduction 516
Supply 516
Demand 516
Price Determinants 519
Futures Contracts 519
Speculative Uses 520
Platinum 521
Introduction 521
Supply 522
Demand 522
Pricing 522
Speculative Uses 525
Palladium 526
Notes from a Trader—Precious Metals 527
Industrial Metals 528
Copper 528
Introduction 528
Supply 529
Demand 530
Price Determinants 531
Futures Contracts 532
Aluminum 533
Introduction 533
Supply 534
Demand 537
Price Determinants 537
Futures Contracts 538
Speculative Uses 539
Other Base Metals 540
Lead 540
Nickel 541
Tin 541
Zinc 542
Notes from a Trader—Commercial Metals 543
Chapter 20

The Energy Markets 544


Introduction 544
Supply 545
Demand 550

Contents
Crude Oil 550
Heating Oil 552
Unleaded Gasoline 553
Natural Gas 553
Liquefied Propane Gas 553
Other Refinery Products 554
Kerosene and Jet Fuel 554
Residual fuel oil 554
Price Determinants 555
Futures Contracts 556
Speculative Uses 559
Notes from a Trader 563
Sources of Information 564

Chapter 21
The Food, Fiber, and Wood Products Markets 566
Coffee 566
Introduction 566
Supply 567
Demand 571
Price Determinants 573
Futures Contracts 575
Speculative Uses 576
Sources of Information 577
Notes from a Trader—Coffee 577
Sugar 578
Introduction 578
Supply 579
Demand 583
Price Determinants 584
International Sugar Agreement 585
Government Programs 586
Futures Contracts 587
Speculative Uses 588
Sources of Information 589
Notes from a Trader—Sugar 589
Cocoa Beans 590

XX Contents
Introduction 590
Supply 590
Demand 596
Price Determinants 596
Futures Contracts 598
Speculative Uses 599
Sources of Information 599
Notes from a Trader—Coffee 599
Cotton 600
Introduction 600
Supply 600
Demand 603
Price Determinants 604
Futures Contracts 607
Sources of Information 608
Notes from a Trader—Cotton 609
Orange Juice 609
Introduction 609
Supply 613
Demand 614
Price Determinants 614
Futures Contracts 615
Speculative Uses 616
Sources of Information 617
Notes from a Trader—Orange Juice 618
Lumber 618
Introduction 618
Supply 619
Demand 620
Price Determinants 622
Futures Contracts 623
Speculative Uses 626
Sources of Information 626
Notes from a Trader—Lumber 627
Other Markets 627
Butter 627
Cheddar Cheese 628

Contents
Milk 629
Shrimp 630
Notes from a Trader—Other Markets 631

Chapter 22
Index-based Futures Contracts 632
Stock Index Futures 632
Introduction 632
Hedging Uses of Stock Index Futures 635
Determinants of Stock Index Futures Prices 639
Corporate Profits 639
Interest Rates (Bills and Bond Prices) 639
Economic Conditions 640
Expectations 640
Arbitrage 643
Speculative Uses 644
Notes from a Trader—Stock Index Futures 647
Bond-index Futures 649
Municipal Bond Index Futures 649
Introduction 649
Uses for the Muni Bond Contract 651
Commodity-Indexed Futures 651
The Commodity Research Bureau Index 652
Advantages of the CRB Index 654
The Goldman Sachs Commodity Index 654
Advantages of the GSCI 656
Notes from a Trader—Index-based Futures Contracts 657

Index 659

xxii Contents