>> OPTIONS & SPREADS: Trumpets, Lobsters, Champagne

"When I see motors gliding up at night to great houses in the fashionable squares, I journey in them: I ascend the stairways of those palaces; and ushered with eclat into drawing rooms of splendor, I sun myself in the painted smiles of the Mayfair Jezebels, and in that world of rouge and diamonds, glitter like a star.

"There I quaff the elixir and sweet essence of mundane triumph, eating truffles to the sound of trumpets and feasting at sunrise on lobster-salad and champagne.

"But it's all dust, it's all emptiness and ashes. Ah! far away from there I retire into the desert to contend triumphantly with Demons; to overcome in holy combats unspeakable Temptations, and purify, by prodigious purges, my heart of base desire."

Yes, occasionally Pearsall Smith's deep-rooted Quaker austerity would resurge, connecting opulence with sin and transforming him into a fancied ascetic on the desert. The Mayfair referred to was and is the fashionable, carriage-trade section of west London. You may have heard the velvet fog voice of Mel Torme sing, "Autumn in New York--transforms the slums into Mayfair."

Enraptured though Smith was by those "great houses in the fashionable squares," he ignored the fact that they could contain character-building and exchequer-strengthening qualities, qualities that a successful financial trader or a would-be success should not ignore. Here we raise the curtain on the key question of this piece: What is "good for" or "helpful to" or "appropriate for" an ace financial trader?

Think twice before you call anything "not important" or "not relevant." During World War I, General "Blackjack" Pershing was a stickler for discipline, even on seemingly minor matters not related to combat. He said, "The soldier who lets his shoes get dirty might let the firing mechanism of his rifle get dirty. The soldier who forgets to salute an officer might forget to obey him when ordered to go over the top."

Traders in stocks or futures or options need discipline and a clean firing mechanism; something akin to a good shooting eye; mapping and strategy skills at battalion headquarters in the field. Also, just as there is "conduct unbecoming an officer" there can be "conduct unbecoming a class-act trader."

In British naval terminology, the phrase "ship of the line" originated in 1706 and referred to a warship large enough to have a place in the line of battle. In the splinter-their-topsails-and-grab-their-gold realm of speculation, the "real pro" should and must be a "ship of the line" with heavy weaponry mentality-wise and ability-wise. Anything less gets smashed instantly and even the mightiest take their chances.

The jeweled clock in the captain's cabin may hold a significance other than time and more than sentiment. The naval officer who uses a Grub Street grog shop timepiece might also use junky maneuvers or gunnery technique. Far from "all emptiness and ashes," those "drawing rooms of splendor" that Pearsall Smith wrote about may well serve as a model. Keep a bit of the crystal and tapestry inside your soul. Also some Bank of England fiscal conservatism will not hurt. Several desiderata apply:

1. Try for class.

Who is not aware of the aura of distinction that surrounds the tycoon or the mogul? Phoning your broker certainly sounds classier than phoning your bookie. However, you err if you leave it at that and do not develop the idea further. Webster defines a "class act" as "something of outstanding quality or prestige."

Webster's numerous definitions of "class" run for 12 lines. Let us focus on one portion: "social rank. especially high social rank; high quality; ELEGANCE." The dictionary listing for "elegance" turned out to be a verbal jewelry store: "derived from the Latin 'eligere'--to elect, eligible, to select. Noun. Urbanity; tasteful richness of design or ornamentation (the sumptuous elegance of the furnishings); dignified gracefulness or restrained beauty of style--polish (the essay is marked by lucidity, wit and elegance); scientific precision, neatness and simplicity (the elegance of a mathematical proof)."

Synonym group: "choice, choicer, choicest. Adjectives. Selected with care; well-chosen; of high quality; worthy of being chosen. Syn. for 'elegant'." Check your own dictionary for "urbanity," "suave," "debonair." The speculator who incorporates essences from the preceding paragraph into his or her life and thinking and market schemata will acquire several more quail toward a full buffet, figuratively or literally.

You need not belong to a polo team or a yacht club. The Cartier gold-plated fountain pen for $800? The Rolex YachtMaster wristwatch for $19,000? Any investor who cannot find better things to do with the money deserves to buy Florida swampland. Involved are both the invisible and the visible, both the attitudinal and the tangible.

Horse racing is called "The Sport of Kings" but we all know that the kings are far outnumbered by the empty-pocketed horse-players who sit up nights thinking of ways to fool the pawnbrokers. This is conduct unbecoming a class-act trader. Also recall the adage, "The reason you never see any horse manure on the race track is that all the horses' asses are at the betting windows."

In a previous article on option spreads, I stated that the strategist is in effect a horse-owner at the long end of the spread and a bookmaker at the short end. I did NOT liken him to a blow-the-bankroll, adrenaline-junkie horse-player. The first two each take a risk in that no guarantee exists beforehand of the thoroughbred or the betting parlor proving profitable. Yet they cannot rightly be compared to the gambling degenerate who has wagered for years with nothing in the bank to show for it. The W. D. Gann maxim still stands: "Handle speculation like a business, not like a gamble."

Risk? Sure, but the businessman's risk, not the crapshooter's. The calculated risk. The limited-exposure risk. A tad of horse-betting may be all right as one of the trappings of Logan Pearsall Smith-type Anglophilia. Unless you tie your cravat like Lord Asquith at the derby, think twice about playing the ponies. If your love of things English is that pronounced, then you should also possess a sterling silver ewer and tureen, a Lord Macaulay or Thomas Carlyle hardbound first edition, and an antique chess set dating back to the Tudors or the Stuarts. Elegance!

2. Be tuned in to the psychology of "what makes it interesting."

Again the hot-blooded gambler provides a good example of what the class-act trader should avoid. How about a side bet on the football game to "make it interesting?" A card game is "no fun" unless money changes hands. In the throes of speculation fever, a trader in stocks or futures or options possesses a similar temperament. A business-like approach requires a certain detachment. It is fine to enjoy being the financial explorer or detective and great to make money at what you enjoy. The game is afoot, Watson! But . . . . too often, however, entertainment-value edges profitability off the road. The horse-player tingles at the sound of the bugle and the starting bell. Thrill upon thrill and, alas, empty pocket upon empty pocket. He would have done far better over the years by banking all that wagering money, but then no electricity through his nervous system. A speculator can likewise let electrical thrills eclipse profits. The successful trader may be compared to the distiller who makes money off of intoxicants but cannot be drunk while handling the complex equipment.

Investor psychology figures crucially, and within that, the psychology of what is interesting and why. That often confounds people. During my high school days, a fellow student mentioned to me that Mrs. Hagen, the math teacher, planned to take graduate courses that summer. Then he said, "How much can anybody love math?"

When diabetic neuropathy disabled my father, his brother, Dr. Dominic A. Donio, M.D. brought him some books and periodicals on the Civil War, a passion of doc's. My mother said to me, "How much can you love the Civil War?" People have asked the same question about everything from astronomy to model airplanes to Babylonian/Sumerian archaeology to avant-garde cinema to antique cars, full-size or shelf-miniature to the life of Disraeli to bird-watching to rococo paintings to mood & atmosphere photography to haunted Scottish castles to music from allegro on the Vivaldi violin to blues on the New Orleans saxophone.

It is no loss for you as either a person or trader if the depth of your fascination for and knowledge of various things puzzles the bored and directionless people, i.e., most people. If financial trading can prove both profitable and entertaining, fine, but if you must do without one, do without the latter. Too many traders and practically all gamblers have found the latter while doing without the former. The Renaissance man or woman--the person with a variety of interests and acuities--has the advantage. You need not float cash to "make it interesting." Ponder this. Expert on Italian Renaissance art Bernard Berenson wrote in his book The Venetian Painters of the Renaissance:

"In Venice there had long been a love of objects for their sensuous beauty. At an early date the Venetians had perfected an art in which there is scarcely any intellectual content whatever, and in which color, jewel-like or opaline, is almost everything. Venetian glass was at the same time an outcome of the Venetians' love of sensuous beauty and a continual stimulant to it. Pope Paul II, for example, who was a Venetian, took such a delight in the color and glow of jewels, that he was always looking at them and always handling them.

"When painting, accordingly, had reached the point where it was no longer dependent upon the Church, nor even expected to be decorative, but when it was used purely for pleasure, the day could not be far distant when people would expect painting to give them the same enjoyment they received from jewels and glass. In Bassano's works this taste found full satisfaction. Most of his pictures seem at first as dazzling, than as cooling and soothing, as the best kind of stained glass; while the coloring of details, particularly of those under high lights, is jewel-like, as clear and deep and satisfying as rubies and emeralds."

Contrast this. Turn-of-the-century steel magnate John W. Gates of American Steel & Wire Co. would be riding with a friend in a passenger train in the rain. They would bet each other a thousand dollars over which raindrop would reach the bottom of the window first. Under other circumstances, Gates and a horseplaying buddy would wet two cubes of sugar and bet each other a thousand on which cube a fly would land on first. Tacky curbstone wagering on a big budget. A pitiable way to make life interesting.

Had he been an art-lover, admission to a Venetian gallery or the Ducal Palace would have cost a few lire. Class need not be expensive, nor does an unlimited bank account always generate class or elegance. Gates could have bought an art collection but instead gravitated toward saloon bets near the brass cuspidor. A piano-roll object lesson. For better than government (bond, CD) profit, financial risk stands essential. But it is lousy entertainment fit for a drudge. Have other ways to "make life interesting" if you value your bankroll or your life.

3. Be the researcher and the learner.

At a writers' conference, author Gerald Green (Last Angry Man, Holocaust) lectured on the value of research, of sifting informational materials well and knowing Your subject-matter thoroughly before you write. To his surprise, the audience was visibly hostile toward him. Green had overlooked the tendency of writers' conferences to attract daydreaming incompetents. They envisioned fame and wealth as successful authors but he talked homework and sweat.

They the would-be mountain-climbers who never leave the house, he the real scaler of the Alps. How dare he open the door and let the chill in! Struggling would-be actors wait on tables and drive cabs during their quest for the Oscar or the Tony. However, you cannot expect self-proclaimed John Steinbecks or Margaret Mitchells to inconvenience themselves by doing research or to endure anything difficult. No wonder publishers are perennially deluged with smelly manuscripts. Sadly, this resembles the performance of many would-be millionaire traders.

At least 98% of humanity would rather eat barbed wire than dig for information. All homo sapiens like to think themselves knowledgeable--human ego being what it is--but only the tiniest percentage hunts down knowledge. The financial arena, like the publishing arena, is murderous to those who are long on hopes and short on the knowledge, the knack, the know-how.

The comic strip "B.C." stated the proverb, "Never get on a roller-coaster that leaves full and comes back half-empty." That could be a description of trading, writing, acting, gambling, considering how many quest forth and how few come back with anything. Also, some fields are worse than others in their coaxing. Major movie studios used to take out ads in newspapers nationwide, ads urging young people NOT to come to Hollywood in search of stardom.

Did you ever see an ad from a futures exchange or an options exchange, a race track or a casino, saying "Most of You Will Take a Pounding?" Of course, film studios made no profits from turn-downs or actor/actress over quantity. Those other places need loser dollars as much as winner dollars, perhaps more so since a winner is a minus on their ledgers, taking money out of the circuitry. To survive in such a milieu a speculator must be a man-of-war ship-of-the-line with an ample powder hold of knowledge and research data. Turn studying into a class act.

Financial and investment knowledge from the 1800's may be more applicable today than supposed. Data from today's financial news is sometimes relevant and sometimes not. Tons of informational rock hold only small specks of valuable radium. The amount of information needed is more than tiny but may be less than you think. Thus we arrive at the next rule.

4. Remember that you need not be an Einstein.

A fair number of physicists and engineers have taken up futures and options and have brought along calculus as the mathematical "hieroglyphics of the pharaohs." Do not feel intimidated by either the sheepskins or the abstruse symbolism. Stanley Yabroff, New York University professor of finance and manager of Gerald Commodities in Manhattan, said in a lecture, "You do not need calculus to trade successfully. All you need is the arithmetic you learned in fourth grade--add and subtract, multiply and divide."

I learned the fundamentals of calculus wall enough to receive a B in an NYU finance course that was heavy with it. In my trading, however, I found it to be excess baggage. My cousin Michael, a medical resident starting to invest in stocks, recently asked me on what basis I choose stocks for purposes of option spreads. I explained, "First, I look for stocks whose near-term options have meat on them, not nearly all devoured time-decay."

Since I specialize in horizontal calendar spreads or time spreads, I told him, I then look to see if the stock's far-term or farther-off-in-the-future options are lean or bargain-priced compared to the near-term ones, with the amount of time as a measuring factor. The time of our talk being early November, I pointed to Cisco Systems shares (stock symbol CSCO; option symbol CYQ) as an example. The December 55 put contract traded at about 2 while the stock was at 60.

The April contracts contained five times more time value than the December's. So did the CSCO/CYQ April 55 puts trade at 10, i.e., five time the 2? No, at 4-½. A bargain. Meaty near-term, lean far-term, enabling a spread strategist to sell the overpriced and buy the underpriced. I pointed out similar factors in the options of Microsoft (MSFT; MSQ), Netscape (NSCP; NQT), Compac (CPQ; CPQ) and IBM. Techno is beefy for now.

"Whether I use puts or calls depends on which way the underlying stock has been trending in recent months or weeks. A horizontal spread of calls above a rising stock, of puts below a descending one. If the stock crosses the "striking price" line and places the options 'in the money' buy back the near-term while the far-term gathers poundage. Fundamentals also help me to determine whether to choose puts or calls."

The most important fundamental in my calculations, though not the only one, is the PE or price-earnings ratio--the price of the share compared to the annual earnings per share. "You see, Mike? Cisco has a PE of 44, Microsoft 38, Netscape over 100. The average PE for exchange-listed stocks is about 18 so these shares appear inflated or overpriced. Compaq is 20 and IBM is only 13 which may sound good for call-buyers except that both those stocks appear to have hit a concrete ceiling in terms of upward progress lately." IBM soon climbed some, breaking 130.

Quarterly earnings reports must be termed a key fundamental because the day they come out they tend to shake a stock in one direction or another, temporarily or otherwise. A good earnings report in July launched IBM on what eventually became a 35-point-plus upward climb. A solid PE to start with helped much. Alas, the effect of the October quarterly report proved transitory. Netscape's October quarterly report scored a penny over analysts' expectations (.09 for the quarter instead of .08) so the shares climbed a few points then faltered, the PE still worse than 100. I currently have a put spread under it.

When preparing to take a spread position in either puts or calls, I find out from the broker WHEN the stock's quarterly earnings report comes out. Maybe I shall tolerate it amid my spread and maybe not. It adds to the risk. I use a discount broker who is theoretically an order-taker and not an information-getter but he can still obtain key fundamentals and news on a stock on his computer screen, i.e.; "First Boston upgrades Jones Consolidated stock from a hold to a buy."

So the company-underpinnings fundamentals that I use I could jot on half the back of an envelope. Yet they blend well with charting and trend-following. At a certain stage of development, the successful trader attains the knack of doing research well. At a more advanced stage he learns what research not to do and what data to omit or ignore. The footnotes in the annual report and the elevator conversation with the executive no longer seem like earth-shaking discoveries.

The legendary Nicholas Darvas habitually skipped the articles and columns in Barrons and turned directly to the Big Board listings. He declared, "It is too easy to be influenced by factors that don't mean anything." I read all of Barrons but I agree that one must ignore many quantities of data as useless or misleading, and the data comes from everywhere. One need not be an Einstein to trade successfully because so much of the intricate stuff should be overlooked anyway. Also you do not need the mathematical sigma and epsilon to tell you which options have meat hanging off of them.

However, this does not lessen the importance of research, that place on the map where so many money-losers step into quicksand. Jesse Livermore wrote, "The average American is from Missouri everywhere and at all times except when he goes to the brokers' offices and looks at the tape, whether it is stocks or commodities. The one game of all games that really requires study before making a play is the one he goes into without his usual highly intelligent preliminary and precautionary doubts. He will risk half his fortune in the stock market with less reflection than he devotes to the selection of a medium-priced automobile."

5. Remember the dictum of Don Vito Corleone: "Keep your friends close but your enemies closer."

The enemies of Mario Puzo's fictional Godfather were rival gangsters plotting against him. The enemies of the financial trader are the things that can go wrong. Study them and know them well, their details, quirks and capabilities. Frequently compose worst-case scenarios and figure that occasionally the worst will happen. Although I have quoted it before, that statement of Nicholas Darvas bears repeating: "There is no such thing as 'can't' in the stock market. A stock can do anything."

Minimize the risk. Limit your exposure. Panic early and do not let a small loss become a big one. Do not wind up having to pray, "God, please make the market turn around. I promise I'll never do it again." Anticipate beforehand what the market can do and what you will do if it does. Be able to say afterward, "That really exploded on the launching pad. I'm glad I sunk only a small portion of my capital into it." Even better, be able to say, I'm glad I pulled out early when the reversal started, lost a few pounds of flesh instead of the whole side of beef."

I write this over a period of several days. A couple of pages back I said I had a put spread under Netscape. While other traders use mental stop-losses, I have evolved in my head tendency to form graded stop-losses. As Netscape shares hovered in the mid-40s price range, my put spread stretched horizontally at 40, with 10 November contracts at the short end and 10 Januarys at the long end. Time decayed the short November puts to just under half a point. My money in the "gap" was a trifle ahead.

I could have bought back 10 Novembers for less than $500 to close out the short end, then created a new short end by selling 10 Decembers with the same striking price of 40 for slightly under $2,000. Nearly a $1,500 gain with a couple of phone calls, one to buy back November's, one to sell December's covered as were the November's by the January's. Tempting, but I wanted nothing to do with puts unless the underlying stock was descending and nothing to do with calls unless it was climbing. Otherwise the far-term long end of the spread could shrivel into a skeleton.

Ergo, the graded mental stop-loss. I figured the stock price in the 46 & a fraction/47 & a fraction area to be okay but fence straddling, 44/45 good, 42/43 great, and with put options the lower the share price the better of course. On the upper end, 48 or higher even fractionally was forbidden territory. Well, on the first Tuesday in November--election day--Netscape rose to 48-_ bid/48-¼-ask late in the trading day. I pulled out of both the short and long positions (the former first as required since it is covered by the latter) for a tallied 20% loss.

With a businessman's detachment I accepted the minus. Then I voted--the president, the man in congress, the two women in the state legislature; occasionally I had written to the latter three and others in government. The vote, the letters, jury service if practicable, participation in the community--all are herein recommended as good ideas for the class-act trader.

The next day, Netscape rose to a Wednesday high of 50-½, more than two additional points of bad news for put-holders. As I write this on Thursday evening, it showed a high today of 53-_ and a close of 53-_, up 3-_. During this month of Thanksgiving, I feel thankful that I ventured only a limited amount of capital and that I "panicked early" instead of "sitting tight and awaiting a turn-around." And I give thanks that I kept my enemy close, knew him well, knew what he can do. My graded mental stop-loss mapped out good territory, the great and ecstatic zones, and in the other direction the forbidden territory. Toes across that boundary stopped a bad deal early. Time for turkey and gravy.

6. Be careful what you call superstition.

Netscape's fundamentals (a poor FE and a piddling quarterly increase) pointed downward but the Technicals of the immediate past pointed upward. Most people know of the tendency of investment fundamentalists to dismiss technical charting as a palm-reading diagram. Yet it is scientific thanks to its basis in evidence and observation.

For Jones to reach Tenth Avenue from First, he has to cross Third and Fourth. Having crossed them, there is no guarantee that he will reach Tenth. Nevertheless, for people who do reach Tenth, it is hard-as-iron essential that they cross the intervening space first. A stock that climbs some distance might not reach the top of the chart, but those that do reach the top must climb some intermediate distances first. Thus those intermediate segments--the chartist's "higher tops and higher bottoms"--provide a workable signal if not a perfect one. Due to the imperfection, stop-losses or bail-outs can be necessary.

The fundamentals of a thoroughbred are the facts about him before he runs the race--bloodlines, track record, trainers opinion. Technical charting is the early furlongs of the race. If the good-fundamentals horse makes a weak showing there he probably will not win the race. If a lesser-bloodlines stallion or a dark horse zooms, take notice. Financial trading allows you to place bets or switch bets while the ponies run. Do not bet everything because anything can happen and any horse can stumble. But let what is happening before your eyes count for something.

Forever more, the fundamentalist and the technical chartist will denounce each other as either the sham-wizard or the theoretician out of touch with hard reality. Remember that you need not be an Einstein to blend the two.

7. Cultivate a suitable amount of patience.

I said a suitable amount, not an endless amount. Just as you demand profits from your investments, you should also demand them within a reasonable length of time. You are not a fruit tree planter who will wait a couple of decades for those richly-laden boughs. Slow-growth stocks and 10-year bonds may have a place in your portfolio, but a trader is almost by definition someone who expects the action and the profits to occur faster.

However, trying too much for lightning speed is the mark of a gambling degenerate. Why do you suppose "The Sport of Kings" became a wagerer's sport? A horse race is quick. Little time lapses between placing the bet and the results. It is the sport that comes closest in rapidity to a roll of the dice or a turn of the roulette wheel or a hand of poker. If you handle the trading of stocks or futures or options like a business instead of like a gamble, you should not have to wait eons for a profit but neither should you be panting and anxious.

Each form of trading has its own tempo and time-frame. I have found with option spreads that if the underlying stock moves more than slightly, action can occur within less than a week. If the shares tend toward inertness, time-decay on the short end of at least a calendar spread is at least a two to three-week phenomenon. With options, thinking in monthly cycles practically "comes with the territory," as with, after expiration, selling the following month.

With scientific, business-like financial trading, as with the curing of hams or the birth of calves or the brewing of beer, you adjust yourself to the time that the processes require, not the other way around. The patience required in breeding three-year olds for a derby and the short patience of horse gamblers stands as an immense contrast fixed in concrete. If you want to be like the owner of Whirlaway instead of like the sucker phoning his bookie, then be sure you resemble the one and not the other in scientific-mindedness, business sense and patience.

8. Be skeptical of what passes for "tradition" or "science" or "class."

In my April/May 1996 article in CTCN, I hatcheted the right-wing reactionaries for the simple reason that they have as much business calling themselves 'traditionalists" as a gypsy fortuneteller has calling herself a "scientific" palm-reader. The same is true of their pretensions toward what is "classy" or "scientific." Consider, for example, their anti-rook & roll witch-hunt hysteria. You will not hear talk like that at the opera house during intermissions of The Sicilian Vespers." Well over their heads, that level of culture fosters a certain tolerance and broad-mindedness.

Webster defines a "reactionary" as "one who advocates a return to certain customs or values of the past." The dictionary does not mention that reactionaryism is a short-range spyglass whose focus disintegrates beyond the barber shop quartet or the Model A or Laurel & Hardy or the Good Old Summertime sheet music at the dime store. A three-masted, iron-cannon trader requires heavier lading than this in his or her class-act cargo hold. "The solider who accepts dime novels about white-hat cowboys as "old-style literature" might accept barrelhouse rumors or huckstered land as a financial battle-plan."

While president, Ronald Reagan remarked that he "had doubts about the theory of evolution." At another time during his term, he said he "liked it better when actors kept their clothes on." Who was Reagan wooing when he made these statements? The archaeologists and paleontologists? The lovers of Dutch & Flemish paintings or Greco-Roman sculpture? Obviously he was courting the right-wing reactionaries and the fundamentalists, the lovers of "time-honored tradition" who saw every movie that Doris Day or Pat Boone ever made.

Anyone whose notion of tradition or elegance plunges deeper may be suspect. William F. Buckley, Jr.'s magazine The National Review (Sept. 16, 1996) carries a page 18 warning against "divisive multi-culturalism, and all the other symptoms of moral decay."

Rush Limbaugh made similar statements on TV. There are those who can appreciate why the city of Florence came to be called "the second Athens" and why Dresden with its art treasures has been termed "the German Florence."

But watch it. The Greek-American or Italian-American or German-American who embraces his heritage and advocates ethnic diversity in the US stands accused of "divisive multi-culturalism, and all the other symptoms of moral decay." Supposedly, the "ideal American" is the backwater Bible-thumper whose heritage includes Norman Rockwell homogeneity and covered bridges, candy kisses music, the white-hat cowboy who always won, and no bare navels on the film screen.

Venetian painters of the 1500's showed fine detailing that Richard Muther called "the delicate shades of red hair and the soft gleam of powdered skin." Yet did anyone ever hear William F. Buckley mention Titian or Tintoretto, or for that matter Rachmaninoff or Balanchine, to his "old time religion" fans or his tobacco-growing fans or his blue-collar fans? He knows enough not to talk over their heads.

Bill Buckley's smattering of Anglophilia tend more toward Prince Albert on the tobacco can than toward Thomas Gainsborough or Christopher Wren. Even worse than robbing Peter to pay Paul is robbing Benjamin Britten to pay the Moral Majority. Anglo-American traders who want ship-fittings of elegant English brass are advised to skip The National Review and go straight to the writings of Sir Joshua Reynolds, John Ruskin, Samuel Johnson, Thomas Middleton and Joseph Addison. Macaulay and Carlyle have already been mentioned.

How exquisitely authors' inks and ale blended at the Mermaid Tavern in London's Cheapside district. How adeptly the Venetian artist captured the sapphire and turquoise of the lagoons in his pigments. My fascination with word origins brought me to the discovery that "exquisite" derives from Latin and originally meant "to quest after" or "to search out." "Adept" sprang from late Latin and referred to the alchemist who discovered how to transmute base metals into gold. They thought he existed.

Questing and searching, adeptness and gold--all fit into the financial trader's mission or strategy. Slice off a part of the class and elegance from Mayfair's "world of rouge and diamonds." Trumpets and lobsters and champagne can sit pleasantly on both the digestive system and the soul.

Source - Greg Donio

>> Options Trading Volume And Open Interest

Price movements in the options market result from the decisions of millions of traders. But there are a number of useful statistics besides price movements that tell you what those other market participants are doing. Here we take a closer look at two factors you should consider when trading options: daily trading volume and open interest.

1. Daily Trading Volume
Trading volume gives you important insight into the strength of the current market direction for the option's underlying stock. The volume, or market breadth, is measured in shares and tells you how meaningful the price movement in the market is.

Keep in mind that trading volume is relative and needs to be compared to the average daily volume of the stock in question. A large percentage change in price accompanied by larger than normal volume is a solid indication of market strength in the direction of the change. But large percentage increases in price accompanied by small trading volumes are less likely to indicate a market direction. In fact, they may indicate that a reversal is likely in the near term.

2. The Importance of Open Interest
Open interest is a concept all option traders need to understand. Although it is always one of the data fields on most option quote displays - along with bid price, ask price, volume and implied volatility - many traders ignore open interest. But while it may be less important than the option's price, or even current volume, open interest provides useful information that should be considered when entering an option position.

First, let's look at exactly what open interest represents. Unlike stock trading, in which there is a fixed number of shares to be traded, option trading can involve the creation of a new option contract when a trade is placed. Open interest will tell you the total number of option contracts that are currently open - in other words, contracts that have been traded but not yet liquidated by either an offsetting trade or an exercise or assignment.

For example, say we look at Microsoft and open interest tells us that there have been 81,700 options opened for the March 27.5 call option. You may be wondering if that number refers to options bought or sold. The answer is that you have no way to know for sure.

When you buy or sell an option, the transaction needs to be entered as either an opening or a closing transaction. If you buy 10 of the Microsoft March 27.5 calls, you are buying the calls to 'open'. That purchase will add 10 to the open interest figure. If you wanted to get out of the position, you would sell those same options to 'close' and open interest would then fall by 10.

Selling an option can also add to the open interest. If you owned 1,000 shares of Microsoft and wanted to do a covered call by selling 10 of the March 27.5 calls, you would be entering a sale to open. Since it is an opening transaction, it would add 10 to the open interest. If you later wanted to repurchase the options, you would enter a transaction to buy to close. Open interest would then decrease by 10.

Things get a little more complicated if the options you trade are not created by the transaction, but instead the other side is taken by someone doing a closing transaction. For example, if you are buying 10 of the Microsoft March 27.5 calls to open, and you are matched with someone that is selling 10 of the Microsoft March 27.5 calls to close, then the total open interest number will not change.

So when you are looking at the total open interest of an option, there is no way of knowing whether the options were bought or sold - which is probably why many option traders ignore open interest altogether. However, you shouldn't assume that the open interest figure provides no important information.

One way to use open interest is to look at it relative to the volume of contracts traded. When the volume exceeds the existing open interest on a given day, this suggests that trading in that option was exceptionally high that day. Open interest can help you determine whether there is unusually high or low volume for any particular option.

Open interest also gives you key information regarding the liquidity of an option. If there is no open interest for an option, there is no secondary market for that option. When options have large open interest, it means they have a large number of buyers and sellers, and an active secondary market will increase the odds of getting option orders filled at good prices. So, all other things being equal, the bigger the open interest, the easier it will be to trade that option at a reasonable spread between the bid and ask.

3. Conclusion
Trading does not occur in a vacuum. Indicators and reports that show you what other market participants are doing can be a valuable addition to your trading system. Daily trading volume and open interest can be used to find trading ideas you might otherwise overlook. These indicators are also useful for making sure that the options you trade are liquid, allowing you easily to enter and exit a trade, as well as ensure you get the best possible price.

>>Open Interest

Contents of this article –

1) What is Open Interest

2) Discovering Open Interest – Part I

3) Discovering Open Interest – Part II

What is Open Interest

1. The total number of options and/or futures contracts that are not closed or delivered on a particular day.

2. The number of buy market orders before the stock market opens.

A common misconception is that open interest is the same thing as volume of options and futures trades. This is not correct as demonstrated in the following example:

On Jan 1, A buys an option, which leaves an open interest and also creates trading volume of 1.
On Jan 2, C and D create trading volume of 5 and there are also 5 more options left open.
On Jan 3, A takes an offsetting position and therefore open interest is reduced by 1, and trading volume is 1.
On Jan 4, E simply replaces C and therefore open interest does not change, trading volume increases by 5.

Open interest, the total number of open contracts on a security, applies primarily to the futures market. It is often used to confirm trends and trend reversals for futures and options contracts.

Discovering Open Interest – Part II

What Open Interest Tells Us
A contract has both a buyer and a seller, so the two market players combine to make one contract. The open-interest position that is reported each day represents the increase or decrease in the number of contracts for that day, and it is shown as a positive or negative number. An increase in open interest along with an increase in price is said to confirm an upward trend. Similarly, an increase in open interest along with a decrease in price confirms a downward trend. An increase or decrease in prices while open interest remains flat or declining may indicate a possible trend reversal.

Rules of Open Interest
Now, there are certain rules to open interest that must be understood and remembered. They have been written in many different publications, so here I have included an excellent version of these rules written by chartist Martin Pring in his book "Martin Pring on Market Momentum":

1. If prices are rising and open interest is increasing at a rate faster than its five-year seasonal average, this is a bullish sign. More participants are entering the market, involving additional buying, and any purchases are generally aggressive in nature.
2. If the open-interest numbers flatten following a rising trend in both price and open interest, take this as a warning sign of an impending top.
3. High open interest at market tops is a bearish signal if the price drop is sudden, since this will force many 'weak' longs to liquidate. Occasionally, such conditions set off a self-feeding, downward spiral.
4. An unusually high or record open interest in a bull market is a danger signal. When a rising trend of open interest begins to reverse, expect a bear trend to get underway.
5. A breakout from a trading range will be much stronger if open interest rises during the consolidation. This is because many traders will be caught on the wrong side of the market when the breakout finally takes place. When the price moves out of the trading range, these traders are forced to abandon their positions. It is possible to take this rule one step further and say the greater the rise in open interest during the consolidation, the greater the potential for the subsequent move.
6. Rising prices and a decline in open interest at a rate greater than the seasonal norm is bearish. This market condition develops because short covering and not fundamental demand is fueling the rising price trend. In these circumstances money is flowing out of the market. Consequently, when the short covering has run its course, prices will decline.
7. If prices are declining and the open interest rises more than the seasonal average, this indicates that new short positions are being opened. As long as this process continues it is a bearish factor, but once the shorts begin to cover it turns bullish.
8. A decline in both price and open interest indicates liquidation by discouraged traders with long positions. As long as this trend continues, it is a bearish sign. Once open interest stabilizes at a low level, the liquidation is over and prices are then in a position to rally again.

Chart Created with Tradestation

In this 2002 chart of the COMEX Gold Continuous Pit Contract, the price is rising, the open interest is falling off and the volume is diminishing. As a rule of thumb, this scenario results in a weak market.

If prices are rising and the volume and open interest are both up, the market is decidedly strong. If the prices are rising and the volume and open interest are both down, the market is weakening. Now, if prices are declining and the volume and open interest are up, the market is weak, but when prices are declining and the volume and open interest are down, the market is gaining strength.

Discovering Open Interest – Part II

In the Part 1 of this two-part series, we opened the door to open interest, an indicator often used by traders to confirm trends and trend reversals for both the futures and options markets. Open interest represents the total number of open contracts on a security.

This article explains the importance of the relationship between volume and open interest in confirming trends and their impending changes.

Volume
Used in conjunction with open interest, volume represents the total number of shares or contracts that have changed hands in a one-day trading session in the commodities or options market. The greater the amount of trading during a market session, the higher the trading volume. A new student to technical analysis can easily see that the volume represents a measure of intensity or pressure behind a price trend. The greater the volume the more we can expect the existing trend to continue rather than reverse.

Technicians believe that volume precedes price, which means that the loss of either upside price pressure in an uptrend or downside pressure in a downtrend will show up in the volume figures before presenting itself as a reversal in trend on the bar chart. The rules that have been set in stone for both volume and open interest are combined because of their similarity; however, having said that, there are always exceptions to the rule, and we should look at them.

General Rules for Volume and Open Interest
Let's summarize these with an easy-to-read chart:

So, price action increasing in an uptrend and open interest on the rise are interpreted as new money coming into the market (reflecting new buyers) and is considered bullish. Now, if the price action is rising and the open interest is on the decline, short sellers covering their positions are causing the rally. Money is therefore leaving the marketplace and is considered bearish.

If prices are in a downtrend and open interest is on the rise, chartists know that new money is coming into the market, showing aggressive new short selling. This scenario will prove out a continuation of a downtrend and a bearish condition. Lastly, if the total open interest is falling off and prices are declining, the price decline is being caused by disgruntled long position holders being forced to liquidate their positions. Technicians view this scenario as a strong position technically because the downtrend will end as all the sellers have sold their positions. The following chart therefore emerges:

When open interest is high at a market top and the price falls off dramatically, this scenario should be considered bearish. In other terms, this means that all of the long position holders that bought near the top of the market are now in a loss position, and their panic to sell keeps the price action under pressure.

There is no need to study a chart for this indicator since the rules are the most important area to study and remember. If you are a new technician starting to understand the basic parameters of this study, look at many different charts of gold, silver, and other commodities so you can begin to recognize the patterns that develop.

Remember it's your money - invest it wisely.

Source: Investopedia

>> Futures Fundamentals

Contents of this article –

1) Futures Fundamentals: Introduction

2) Futures Fundamentals: A Brief History

3) Futures Fundamentals: How The Market Works

4) Futures Fundamentals: The Players

5) Futures Fundamentals: Characteristics

6) Futures Fundamentals: Strategies

7) Futures Fundamentals: How To Trade

8) Futures Fundamentals: Conclusion

Futures Fundamentals: Introduction

What we know as the futures market of today came from some humble beginnings. Trading in futures originated in Japan during the eighteenth century and was primarily used for the trading of rice and silk. It wasn't until the 1850s that the U.S. started using futures markets to buy and sell commodities such as cotton, corn and wheat.

A futures contract is a type of derivative instrument, or financial contract, in which two parties agree to transact a set of financial instruments or physical commodities for future delivery at a particular price. If you buy a futures contract, you are basically agreeing to buy something that a seller has not yet produced for a set price. But participating in the futures market does not necessarily mean that you will be responsible for receiving or delivering large inventories of physical commodities - remember, buyers and sellers in the futures market primarily enter into futures contracts to hedge risk or speculate rather than to exchange physical goods (which is the primary activity of the cash/spot market). That is why futures are used as financial instruments by not only producers and consumers but also speculators.

The consensus in the investment world is that the futures market is a major financial hub, providing an outlet for intense competition among buyers and sellers and, more importantly, providing a center to manage price risks. The futures market is extremely liquid, risky and complex by nature, but it can be understood if we break down how it functions.

While futures are not for the risk averse, they are useful for a wide range of people. In this tutorial, you'll learn how the futures market works, who uses futures and which strategies will make you a successful trader on the futures market.

Futures Fundamentals: A Brief History

Before the North American futures market originated some 150 years ago, farmers would grow their crops and then bring them to market in the hope of selling their inventory. But without any indication of demand, supply often exceeded what was needed and unpurchased crops were left to rot in the streets! Conversely, when a given commodity - wheat, for instance - was out of season, the goods made from it became very expensive because the crop was no longer available.

In the mid-nineteenth century, central grain markets were established and a central marketplace was created for farmers to bring their commodities and sell them either for immediate delivery (spot trading) or for forward delivery. The latter contracts - forward contracts - were the forerunners to today's futures contracts. In fact, this concept saved many a farmer the loss of crops and profits and helped stabilize supply and prices in the off-season.

Today's futures market is a global marketplace for not only agricultural goods, but also for currencies and financial instruments such as Treasury bonds and securities (securities futures). It's a diverse meeting place of farmers, exporters, importers, manufacturers and speculators. Thanks to modern technology, commodities prices are seen throughout the world, so a Kansas farmer can match a bid from a buyer in Europe.

Futures Fundamentals: How The Market Works

The futures market is a centralized marketplace for buyers and sellers from around the world who meet and enter into futures contracts. Pricing can be based on an open cry system, or bids and offers can be matched electronically. The futures contract will state the price that will be paid and the date of delivery. But don't worry, as we mentioned earlier, almost all futures contracts end without the actual physical delivery of the commodity.

What Exactly Is a Futures Contract?
Let's say, for example, that you decide to subscribe to cable TV. As the buyer, you enter into an agreement with the cable company to receive a specific number of cable channels at a certain price every month for the next year. This contract made with the cable company is similar to a futures contract, in that you have agreed to receive a product at a future date, with the price and terms for delivery already set. You have secured your price for now and the next year - even if the price of cable rises during that time. By entering into this agreement with the cable company, you have reduced your risk of higher prices.

That's how the futures market works. Except instead of a cable TV provider, a producer of wheat may be trying to secure a selling price for next season's crop, while a bread maker may be trying to secure a buying price to determine how much bread can be made and at what profit. So the farmer and the bread maker may enter into a futures contract requiring the delivery of 5,000 bushels of grain to the buyer in June at a price of $4 per bushel. By entering into this futures contract, the farmer and the bread maker secure a price that both parties believe will be a fair price in June. It is this contract - and not the grain per se - that can then be bought and sold in the futures market.

So, a futures contract is an agreement between two parties: a short position - the party who agrees to deliver a commodity - and a long position - the party who agrees to receive a commodity. In the above scenario, the farmer would be the holder of the short position (agreeing to sell) while the bread maker would be the holder of the long (agreeing to buy). We will talk more about the outlooks of the long and short positions in the section on strategies, but for now it's important to know that every contract involves both positions.

In every futures contract, everything is specified: the quantity and quality of the commodity, the specific price per unit, and the date and method of delivery. The “price” of a futures contract is represented by the agreed-upon price of the underlying commodity or financial instrument that will be delivered in the future. For example, in the above scenario, the price of the contract is 5,000 bushels of grain at a price of $4 per bushel.

Profit And Loss - Cash Settlement
The profits and losses of a futures contract depend on the daily movements of the market for that contract and are calculated on a daily basis. For example, say the futures contracts for wheat increases to $5 per bushel the day after the above farmer and bread maker enter into their futures contract of $4 per bushel. The farmer, as the holder of the short position, has lost $1 per bushel because the selling price just increased from the future price at which he is obliged to sell his wheat. The bread maker, as the long position, has profited by $1 per bushel because the price he is obliged to pay is less than what the rest of the market is obliged to pay in the future for wheat.

On the day the change occurs, the farmer's account is debited $5,000 ($1 per bushel X 5,000 bushels) and the bread maker's account is credited by $5,000 ($1 per bushel X 5,000 bushels). As the market moves every day, these kinds of adjustments are made accordingly. Unlike the stock market, futures positions are settled on a daily basis, which means that gains and losses from a day's trading are deducted or credited to a person's account each day. In the stock market, the capital gains or losses from movements in price aren't realized until the investor decides to sell the stock or cover his or her short position.

As the accounts of the parties in futures contracts are adjusted every day, most transactions in the futures market are settled in cash, and the actual physical commodity is bought or sold in the cash market. Prices in the cash and futures market tend to move parallel to one another, and when a futures contract expires, the prices merge into one price. So on the date either party decides to close out their futures position, the contract will be settled. If the contract was settled at $5 per bushel, the farmer would lose $5,000 on the futures contract and the bread maker would have made $5,000 on the contract.

But after the settlement of the futures contract, the bread maker still needs wheat to make bread, so he will in actuality buy his wheat in the cash market (or from a wheat pool) for $5 per bushel (a total of $25,000) because that's the price of wheat in the cash market when he closes out his contract. However, technically, the bread maker's futures profits of $5,000 go towards his purchase, which means he still pays his locked-in price of $4 per bushel ($25,000 - $5,000 = $20,000). The farmer, after also closing out the contract, can sell his wheat on the cash market at $5 per bushel but because of his losses from the futures contract with the bread maker, the farmer still actually receives only $4 per bushel. In other words, the farmer's loss in the futures contract is offset by the higher selling price in the cash market - this is referred to as hedging.

Now that you see that a futures contract is really more like a financial position, you can also see that the two parties in the wheat futures contract discussed above could be two speculators rather than a farmer and a bread maker. In such a case, the short speculator would simply have lost $5,000 while the long speculator would have gained that amount. In other words, neither would have to go to the cash market to buy or sell the commodity after the contract expires.)

Economic Importance of the Futures Market
Because the futures market is both highly active and central to the global marketplace, it's a good source for vital market information and sentiment indicators.

Price Discovery - Due to its highly competitive nature, the futures market has become an important economic tool to determine prices based on today's and tomorrow's estimated amount of supply and demand. Futures market prices depend on a continuous flow of information from around the world and thus require a high amount of transparency. Factors such as weather, war, debt default, refugee displacement, land reclamation and deforestation can all have a major effect on supply and demand and, as a result, the present and future price of a commodity. This kind of information and the way people absorb it constantly changes the price of a commodity. This process is known as price discovery.

Risk Reduction - Futures markets are also a place for people to reduce risk when making purchases. Risks are reduced because the price is pre-set, therefore letting participants know how much they will need to buy or sell. This helps reduce the ultimate cost to the retail buyer because with less risk there is less of a chance that manufacturers will jack up prices to make up for profit losses in the cash market.

Futures Fundamentals: The Players

The players in the futures market fall into two categories: hedgers and speculators.

Hedgers
Farmers, manufacturers, importers and exporters can all be hedgers. A hedger buys or sells in the futures market to secure the future price of a commodity intended to be sold at a later date in the cash market. This helps protect against price risks.

The holders of the long position in futures contracts (the buyers of the commodity), are trying to secure as low a price as possible. The short holders of the contract (the sellers of the commodity) will want to secure as high a price as possible. The futures contract, however, provides a definite price certainty for both parties, which reduces the risks associated with price volatility. Hedging by means of futures contracts can also be used as a means to lock in an acceptable price margin between the cost of the raw material and the retail cost of the final product sold.

Example: A silversmith must secure a certain amount of silver in six months time for earrings and bracelets that have already been advertised in an upcoming catalog with specific prices. But what if the price of silver goes up over the next six months? Because the prices of the earrings and bracelets are already set, the extra cost of the silver can't be passed on to the retail buyer, meaning it would be passed on to the silversmith. The silversmith needs to hedge, or minimize her risk against a possible price increase in silver. How? The silversmith would enter the futures market and purchase a silver contract for settlement in six months time (let's say June) at a price of $5 per ounce. At the end of the six months, the price of silver in the cash market is actually $6 per ounce, so the silversmith benefits from the futures contract and escapes the higher price. Had the price of silver declined in the cash market, the silversmith would, in the end, have been better off without the futures contract. At the same time, however, because the silver market is very volatile, the silver maker was still sheltering himself from risk by entering into the futures contract. So that's basically what hedging is: the attempt to minimize risk as much as possible by locking in prices for future purchases and sales. Someone going long in a securities future contract now can hedge against rising equity prices in three months. If at the time of the contract's expiration the equity price has risen, the investor's contract can be closed out at the higher price. The opposite could happen as well: a hedger could go short in a contract today to hedge against declining stock prices in the future. A potato farmer would hedge against lower French fry prices, while a fast food chain would hedge against higher potato prices. A company in need of a loan in six months could hedge against rising interest rates in the future, while a coffee beanery could hedge against rising coffee bean prices next year.

Speculators
Other market participants, however, do not aim to minimize risk but rather to benefit from the inherently risky nature of the futures market. These are the speculators, and they aim to profit from the very price change that hedgers are protecting themselves against. Hedgers want to minimize their risk no matter what they're investing in, while speculators want to increase their risk and therefore maximize their profits.

In the futures market, a speculator buying a contract low in order to sell high in the future would most likely be buying that contract from a hedger selling a contract low in anticipation of declining prices in the future.

Unlike the hedger, the speculator does not actually seek to own the commodity in question. Rather, he or she will enter the market seeking profits by offsetting rising and declining prices through the buying and selling of contracts.

Trader	Short	Long
The Hedger	Secure a price now to protect against future declining prices	Secure a price now to protect against future rising prices
The Speculator	Secure a price now in anticipation of declining prices	Secure a price now in anticipation of rising prices

In a fast-paced market into which information is continuously being fed, speculators and hedgers bounce off of - and benefit from - each other. The closer it gets to the time of the contract's expiration, the more solid the information entering the market will be regarding the commodity in question. Thus, all can expect a more accurate reflection of supply and demand and the corresponding price.

Regulatory Bodies
The U.S. futures market is regulated by the Commodity Futures Trading Commission (CFTC) an independent agency of the U.S. government. The market is also subject to regulation by the National Futures Association (NFA), a self-regulatory body authorized by the U.S. Congress and subject to CFTC supervision.

A broker and/or firm must be registered with the CFTC in order to issue or buy or sell futures contracts. Futures brokers must also be registered with the NFA and the CFTC in order to conduct business. The CFTC has the power to seek criminal prosecution through the Department of Justice in cases of illegal activity, while violations against the NFA's business ethics and code of conduct can permanently bar a company or a person from dealing on the futures exchange. It is imperative for investors wanting to enter the futures market to understand these regulations and make sure that the brokers, traders or companies acting on their behalf are licensed by the CFTC.

In the unfortunate event of conflict or illegal loss, you can look to the NFA for arbitration and appeal to the CFTC for reparations. Know your rights as an investor!

Futures Fundamentals: Characteristics

Given the nature of the futures market, the calculation of profit and loss will be slightly different than on a normal stock exchange. Let's take a look at the main concepts:

Margins
In the futures market, margin has a definition distinct from its definition in the stock market, where margin is the use of borrowed money to purchase securities. In the futures market, margin refers to the initial deposit of "good faith" made into an account in order to enter into a futures contract. This margin is referred to as good faith because it is this money that is used to debit any day-to-day losses.

When you open a futures contract, the futures exchange will state a minimum amount of money that you must deposit into your account. This original deposit of money is called the initial margin. When your contract is liquidated, you will be refunded the initial margin plus or minus any gains or losses that occur over the span of the futures contract. In other words, the amount in your margin account changes daily as the market fluctuates in relation to your futures contract. The minimum-level margin is determined by the futures exchange and is usually 5% to 10% of the futures contract. These predetermined initial margin amounts are continuously under review: at times of high market volatility, initial margin requirements can be raised.

The initial margin is the minimum amount required to enter into a new futures contract, but the maintenance margin is the lowest amount an account can reach before needing to be replenished. For example, if your margin account drops to a certain level because of a series of daily losses, brokers are required to make a margin call and request that you make an additional deposit into your account to bring the margin back up to the initial amount.

Let's say that you had to deposit an initial margin of $1,000 on a contract and the maintenance margin level is $500. A series of losses dropped the value of your account to $400. This would then prompt the broker to make a margin call to you, requesting a deposit of at least an additional $600 to bring the account back up to the initial margin level of $1,000.

Word to the wise: when a margin call is made, the funds usually have to be delivered immediately. If they are not, the brokerage can have the right to liquidate your position completely in order to make up for any losses it may have incurred on your behalf.

Leverage: The Double-Edged Sword
In the futures market, leverage refers to having control over large cash amounts of commodities with comparatively small levels of capital. In other words, with a relatively small amount of cash, you can enter into a futures contract that is worth much more than you initially have to pay (deposit into your margin account). It is said that in the futures market, more than any other form of investment, price changes are highly leveraged, meaning a small change in a futures price can translate into a huge gain or loss.

Futures positions are highly leveraged because the initial margins that are set by the exchanges are relatively small compared to the cash value of the contracts in question (which is part of the reason why the futures market is useful but also very risky). The smaller the margin in relation to the cash value of the futures contract, the higher the leverage. So for an initial margin of $5,000, you may be able to enter into a long position in a futures contract for 30,000 pounds of coffee valued at $50,000, which would be considered highly leveraged investments.

You already know that the futures market can be extremely risky and,therefore, not for the faint of heart. This should become more obvious once you understand the arithmetic of leverage. Highly leveraged investments can produce two results: great profits or greater losses.

As a result of leverage, if the price of the futures contract moves up even slightly, the profit gain will be large in comparison to the initial margin. However, if the price just inches downwards, that same high leverage will yield huge losses in comparison to the initial margin deposit. For example, say that in anticipation of a rise in stock prices across the board, you buy a futures contract with a margin deposit of $10,000, for an index currently standing at 1300. The value of the contract is worth $250 times the index (e.g. $250 x 1300 = $325,000), meaning that for every point gain or loss, $250 will be gained or lost.

If after a couple of months, the index realized a gain of 5%, this would mean the index gained 65 points to stand at 1365. In terms of money, this would mean that you as an investor earned a profit of $16,250 (65 points x $250); a profit of 162%!

On the other hand, if the index declined 5%, it would result in a monetary loss of $16,250 - a huge amount compared to the initial margin deposit made to obtain the contract. This means you still have to pay $6,250 out of your pocket to cover your losses. The fact that a small change of 5% to the index could result in such a large profit or loss to the investor (sometimes even more than the initial investment made) is the risky arithmetic of leverage. Consequently, while the value of a commodity or a financial instrument may not exhibit very much price volatility, the same percentage gains and losses are much more dramatic in futures contracts due to low margins and high leverage.

Pricing and Limits
As we mentioned before, contracts in the futures market are a result of competitive price discovery. Prices are quoted as they would be in the cash market: in dollars and cents or per unit (gold ounces, bushels, barrels, index points, percentages and so on).

Prices on futures contracts, however, have a minimum amount that they can move. These minimums are established by the futures exchanges and are known as “ticks.” For example, the minimum sum that a bushel of grain can move upwards or downwards in a day is a quarter of one U.S. cent. For futures investors, it's important to understand how the minimum price movement for each commodity will affect the size of the contract in question. If you had a grain contract for 3,000 bushels, a minimum of $7.50 (0.25 cents x 3,000) could be gained or lost on that particular contract in one day.

Futures prices also have a price change limit that determines the prices between which the contracts can trade on a daily basis. The price change limit is added to and subtracted from the previous day's close and the results remain the upper and lower price boundary for the day.

Say that the price change limit on silver per ounce is $0.25. Yesterday, the price per ounce closed at $5. Today's upper price boundary for silver would be $5.25 and the lower boundary would be $4.75. If at any moment during the day the price of futures contracts for silver reaches either boundary, the exchange shuts down all trading of silver futures for the day. The next day, the new boundaries are again calculated by adding and subtracting $0.25 to the previous day's close. Each day the silver ounce could increase or decrease by $0.25 until an equilibrium price is found. Because trading shuts down if prices reach their daily limits, there may be occasions when it is NOT possible to liquidate an existing futures position at will.

The exchange can revise this price limit if it feels it's necessary. It's not uncommon for the exchange to abolish daily price limits in the month that the contract expires (delivery or “spot” month). This is because trading is often volatile during this month, as sellers and buyers try to obtain the best price possible before the expiration of the contract.

In order to avoid any unfair advantages, the CTFC and the futures exchanges impose limits on the total amount of contracts or units of a commodity in which any single person can invest. These are known as position limits and they ensure that no one person can control the market price for a particular commodity.

Futures Fundamentals: Strategies

Essentially, futures contracts try to predict what the value of an index or commodity will be at some date in the future. Speculators in the futures market can use different strategies to take advantage of rising and declining prices. The most common are known as going long, going short and spreads.

Going Long
When an investor goes long - that is, enters a contract by agreeing to buy and receive delivery of the underlying at a set price - it means that he or she is trying to profit from an anticipated future price increase.

For example, let's say that, with an initial margin of $2,000 in June, Joe the speculator buys one September contract of gold at $350 per ounce, for a total of 1,000 ounces or $350,000. By buying in June, Joe is going long, with the expectation that the price of gold will rise by the time the contract expires in September.

By August, the price of gold increases by $2 to $352 per ounce and Joe decides to sell the contract in order to realize a profit. The 1,000 ounce contract would now be worth $352,000 and the profit would be $2,000. Given the very high leverage (remember the initial margin was $2,000), by going long, Joe made a 100% profit!

Of course, the opposite would be true if the price of gold per ounce had fallen by $2. The speculator would have realized a 100% loss. It's also important to remember that throughout the time that Joe held the contract, the margin may have dropped below the maintenance margin level. He would, therefore, have had to respond to several margin calls, resulting in an even bigger loss or smaller profit.

Going Short
A speculator who goes short - that is, enters into a futures contract by agreeing to sell and deliver the underlying at a set price - is looking to make a profit from declining price levels. By selling high now, the contract can be repurchased in the future at a lower price, thus generating a profit for the speculator.

Let's say that Sara did some research and came to the conclusion that the price of oil was going to decline over the next six months. She could sell a contract today, in November, at the current higher price, and buy it back within the next six months after the price has declined. This strategy is called going short and is used when speculators take advantage of a declining market.

Suppose that, with an initial margin deposit of $3,000, Sara sold one May crude oil contract (one contract is equivalent to 1,000 barrels) at $25 per barrel, for a total value of $25,000.

By March, the price of oil had reached $20 per barrel and Sara felt it was time to cash in on her profits. As such, she bought back the contract which was valued at $20,000. By going short, Sara made a profit of $5,000! But again, if Sara's research had not been thorough, and she had made a different decision, her strategy could have ended in a big loss.

Spreads
As you can see, going long and going short are positions that basically involve the buying or selling of a contract now in order to take advantage of rising or declining prices in the future. Another common strategy used by futures traders is called “spreads.”

Spreads involve taking advantage of the price difference between two different contracts of the same commodity. Spreading is considered to be one of the most conservative forms of trading in the futures market because it is much safer than the trading of long/short (naked) futures contracts.

There are many different types of spreads, including:

Calendar Spread - This involves the simultaneous purchase and sale of two futures of the same type, having the same price, but different delivery dates. Intermarket Spread - Here the investor, with contracts of the same month, goes long in one market and short in another market. For example, the investor may take Short June Wheat and Long June Pork Bellies. Inter-Exchange Spread - This is any type of spread in which each position is created in different futures exchanges. For example, the investor may create a position in the Chicago Board of Trade (CBOT) and the London International Financial Futures and Options Exchange (LIFFE).

Futures Fundamentals: How To Trade

At the risk of repeating ourselves, it's important to note that futures trading is not for everyone. You can invest in the futures market in a number of different ways, but before taking the plunge, you must be sure of the amount of risk you're willing to take. As a futures trader, you should have a solid understanding of how the market and contracts function. You'll also need to determine how much time, attention, and research you can dedicate to the investment. Talk to your broker and ask questions before opening a futures account.

Unlike traditional equity traders, futures traders are advised to only use funds that have been earmarked as pure "risk capital"- the risks really are that high. Once you've made the initial decision to enter the market, the next question should be “How?” Here are three different approaches to consider:

Do It Yourself - As an investor, you can trade your own account without the aid or advice of a broker. This involves the most risk because you become responsible for managing funds, ordering trades, maintaining margins, acquiring research and coming up with your own analysis of how the market will move in relation to the commodity in which you've invested. It requires time and complete attention to the market.

Open a Managed Account - Another way to participate in the market is by opening a managed account, similar to an equity account. Your broker would have the power to trade on your behalf, following conditions agreed upon when the account was opened. This method could lessen your financial risk because a professional would be making informed decisions on your behalf. However, you would still be responsible for any losses incurred as well as for margin calls. And you'd probably have to pay an extra management fee.

Join a Commodity Pool - A third way to enter the market, and one that offers the smallest risk, is to join a commodity pool. Like a mutual fund, the commodity pool is a group of commodities which can be invested in. No one person has an individual account; funds are combined with others and traded as one. The profits and losses are directly proportionate to the amount of money invested. By entering a commodity pool, you also gain the opportunity to invest in diverse types of commodities. You are also not subject to margin calls. However, it is essential that the pool be managed by a skilled broker, because the risks of the futures market are still present in the commodity pool.

Futures Fundamentals: Conclusion

Buying and selling in the futures market can seem risky and complicated. As we've already said, futures trading is not for everyone, but it works for a wide range of people. This tutorial has introduced you to the fundamentals of futures. If you want to know more, talk to your broker.

Let's review the basics:

• The futures market is a global marketplace, initially created as a place for farmers and merchants to buy and sell commodities for either spot or future delivery. This was done to lessen the risk of both waste and scarcity.
• Rather than trade in physical commodities, futures markets buy and sell futures contracts, which state the price per unit, type, value, quality and quantity of the commodity in question, as well as the month the contract expires.
• The players in the futures market are hedgers and speculators. A hedger tries to minimize risk by buying or selling now in an effort to avoid rising or declining prices. Conversely, the speculator will try to profit from the risks by buying or selling now in anticipation of rising or declining prices.
• The CFTC and the NFA are the regulatory bodies governing and monitoring futures markets in the U.S. It is important to know your rights.
• Futures accounts are credited or debited daily depending on profits or losses incurred. The futures market is also characterized as being highly leveraged due to its margins; although leverage works as a double-edged sword. It's important to understand the arithmetic of leverage when calculating profit and loss, as well as the minimum price movements and daily price limits at which contracts can trade.
• “Going long,” “going short,” and “spreads” are the most common strategies used when trading on the futures market.
• Once you make the decision to trade in commodities, there are several ways to participate in the futures market. All of them involve risk - some more than others. You can trade your own account, have a managed account or join a commodity pool.

Source: Investopedia