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Course1lesson1 PDF
Course1lesson1 PDF
Course #1
Basic Training/
Getting Started
Lesson #1
Background of Futures Trading
MBH Commodity Advisors n P.O. Box 353 n Winnetka, Illinois 60093
What Is Hedging?
The concept of hedging is based upon the assumption that movement in cash and futures prices will
parallel each other in movement after due allowance has been made for any seasonal or other trend in
the cash market.
In essence, the goal of the hedger is to lock in an approximate future price in order to eliminate his risk
of exposure to interim price fluctuations. The best way to understand hedging and the futures market
is by example. I will assume that you have no understanding of the futures market.
The Three Categories of “Players” in the Futures Game and their Roles
Producers
These individuals and/or firms actually produce or process the commodity that is being traded.
Whether it be silver, gold, petroleum, corn, live cattle, lumber, sugar or currencies, these are the people
who make the goods available either by mining them, harvesting them, raising them, growing them or
lending them.
They need to lock in costs. In other words, they have a product they want to sell at a determined price.
They may do this in order to guarantee a profit on an actual commodity they have on hand or have
produced, or they may want to lock in a price on an item in order to avoid losing more money on it if
it is already declining.
Finally, they may not have the goods at all. Rather they may be protecting themselves from a possible
side effect of declining or rising prices.
For example, a jewelry store with considerable gold and silver jewelry on hand may fear a decline in
the price of precious metals. They stand to lose money on their inventory as prices decline. Therefore,
they may choose to sell futures contracts of silver and/or gold in expectation of the decline. Thus, they
have profited from the futures sale.
Speculators
This is the largest group of futures traders. These people are sandwiched between the end-user and the
producer, providing a market buffer.
Perhaps no more than one to three percent of all futures contracts is actually completed by delivery.
The balance is closed out before any actual exchange of goods occurs.
Suffice it to say that speculators are often willing to take risks in markets at times and at prices that
may not be attractive to the other two groups.
Speculators do this in expectation of large percentage profit returns on price fluctuations.
The chart below shows the general relationship between the three basic groups of market participants.
More details will be given as your understanding of basic concepts increases.
Summary
The futures markets operate on very specific factors which, when, understood, can allow you to trade
profitably. To understand the markets, you must learn the underlying structure and functions of
commodity trading.
Summary
The bottom line of all futures trading is to either make money or to keep from losing it. The futures
markets provide an excellent vehicle for doing this.
The Vehicle
Many vehicles can take you to your goal. Some will lead you in the right direction, whereas others
will take you in the wrong direction. These vehicles are the systems and methods of futures trading.
I can’t tell you which system is best for you. All I can do is to acquaint you with the various methods
and with the guidelines for deciding which techniques are best for you.
The Fuel
The energy that drives the wheel of successful speculation is good old-fashioned money.
To make it, you have to have it, and to multiply it you have to use it wisely. You know the risk is
immense and that the odds are stacked against you. Your chances of making it in the competitive
world of futures trading are probably five or ten in 100, but they are reduced to zero by starting with
nothing.
Successful speculation is not a get-rich-quick scheme, a no-money-down real estate venture or a 15-
million-to-one odds lottery ticket. The facts of futures trading dictate very clearly that the more you
start with, the greater your chance of success and the less you start with, the greater your chance of
failure.
“How much is enough?” you ask.
I can give you some guidelines. Based on current conditions in the futures market, the beginner
should have sufficient capital to meet liberal marginal requirements on at least five contracts in the
futures market.
If we assume, for example, that the average margin on a futures contract is $2,500, then we are looking
at approximately $12,500 in speculative capital. I don’t think it is realistic for you to expect success if
you begin with less.
Don’t be fooled!
Some individuals will tell you that you need virtually nothing in the way of starting capital, whereas
others will tell you need much, much more. I won’t argue the fact that the more you have to start with
the better your odds of success, however, there is a limit on the downside.
Certainly you must consider the fact that you don’t want to risk everything. When someone asks me
how much he or she should risk in futures trading, I answer the question with a question. I ask, “How
much can you afford to lose?” One answer might be $10,000. I respond, “Take this slip of paper on
which I have written $10,000. Rip it into shreds. Flush it down the toilet. How do you feel?”
This small test represents a little experiment that may help you determine how much you can afford to
lose in the futures market without too serious an emotional reaction to the consequences.
Financially, the answer is different. How much can you afford to lose from this standpoint? I would
suggest that as a rule of thumb, you risk not more than 25 % of your total liquid risk capital!
Who’s Responsible?
It is always good to know that you alone have the responsibility for profits and losses. If you
have a partner or partners, it may be difficult to know who is responsible for each decision.
Lacking such knowledge will slow the teaming process and may, in fact, stall it entirely.
Fundamental or Technical
Another important decision which ideally should be made prior to the start of your trading is whether
your approach will focus primarily on trading signals from technical indicators or from trading ideas
based upon fundamentals.
I distinguish here between ideas and signals because they are two distinctly different types of
approaches generated by two distinctly different understandings of the futures markets.
Later on I will provide a very thorough discussion of the two approaches, outlining their strengths,
assets, liabilities, differences and methods of implementation. For now, suffice it to say that a
Summary
This section reviewed some basic principles and distinctions. You must learn them before you can
continue.
2. When you begin trading, what is the minimum amount of completely disposal, specula-
tive capital that I feel you need to being with?
a. $12,500
b. $5,000
c. $25,000
d. $2,000
4. The following is a list of four things that speculators do. Only three are true. Which one
is false?
a. They do not take delivery of the goods.
b. They often trade for short-term swings.
c. They are buyers and sellers of cash commodities.
d. They are often called traders.
7. When deciding how much you risk on each trade I told you that those who belong to the
“money management school” will tell you to take a per-trade risk based strictly on
money management while those who believe in the “systems approach” claim that each
trade is unique and that it is not possible to determine a prior rule for dollar risk. What
position did I suggest you follow?
a. The middle-of-the-road approach is usually safest.
b. Align yourself with one or the other extreme but be consistent.
c. Ask a friend or associate what they do and do the same.
d. Take a percentage of what you feel the profit potential could be and use that.
8. What is the amount of profits I feel you should remove from your account for every
winning trade that you make?
a. 50 to 75%
b. None
c. 10 to 25%
d. 2 to 3%
9. If you decide to become a day trader what kind of data should you have?
a. Information that you can glean from reading the daily papers.
b. Up-to-date, tick-by-tick, accurate and reliable data.
c. A friend or associate who trades also that you can compare notes with.
d. Only the history of past trades is needed.
10. When you use leverage, what is the typical percentage of the total value that a contract
can be bought or sold for?
a. 10 to 15%
b. 5 to 7%
c. 1 to 3%
d. 20 to 25%
When you have completed the questions in this quiz, email your answers to: jake@trade-futures.com