Futures: Dare You Defy The Odds?Amey Stone
Rick Powers, a New London (Conn.) financial planner specializing in charitable giving, gave two adult daughters some unusual birthday presents. The value of one gift depended on whether India tightened up on cotton exports; the other on whether Japanese smelters reduced their copper production: Both of them were futures contracts. His 27-year-old daughter, Jennifer Ligeti, received a December cotton contract. Daughter Kristin Harkness, 31, got copper futures. The investments paid off. Before fees, Ligeti's contract generated a tidy $1,100 profit from a measly 2.2 cents rise in cotton. Her sister's made $1,250 on a 5.3% copper-price hike.
Most individual investors in commodities don't fare as well as the Powers clan. Industry experts claim that between 75% and 90% of all small-time investors lose money in the futures markets--and counsel them to avoid this risky game.
SCARE EASY? Yet thousands of small investors say there is nothing like the thrill of speculating, not to mention that folks who have the knack can earn lucrative paybacks. Commodities are "the last great secret that's being kept from the public," says Philip Gotthelf, president of Equidex, which publishes futures information. He growls that the media and investment community "always try to scare the public away."
For those who don't scare easy, market conditions make this a favorable time to experiment with commodities. While many people believe stocks are overvalued, leaving few opportunities for aggressive investors, the commodities markets have been relatively depressed for years--until lately. The market rose 11.6% in 1993, the biggest percentage gain in 10 years, as measured by the Knight-Ridder Commodity Research Bureau Futures Price Index. The rising trends should continue, as the U.S. economy improves and as Europe and Japan ease out of recession, creating more demand for physical commodities, says Bill O'Neill, senior futures strategist at Merrill Lynch.
There has been a resurgence of interest in commodity futures among small investors, notes Morton Lane, president of Lind-Waldock & Co., a discount commodity brokerage in Chicago that in 1993 saw about a 25% increase in new accounts over 1992. People have been willing to take more risks as the economy has improved. And with recent dramatic weather, such as floods along the Mississippi River and blizzards in the Northeast, it hasn't been hard for neophytes to guess that prices of corn and natural gas would rise.
Professionally managed futures funds and pools have enjoyed enormous growth of late--but with mixed success. Total assets in these funds have jumped from about $1 billion in 1985 to $23 billion today, according to Managed Account Reports (MAR) in New York, which tracks the performance of futures-fund managers. But these funds, which have huge expenses and often require high minimum initial investments, are best used to add diversification. Studies have shown they don't correlate with the stock market and can actually reduce risk in a stock and bond portfolio. But they do not offer much protection from the volatility of commodity markets. MAR's index of 511 public funds and private pools rose a handy 15.2% in 1993, but in 1986, the index fell 11.5%.
Managed futures funds are a far cry from the high-stakes world of trading individual commodities. Critics such as Gotthelf say that in order to reap management fees, some brokerage firms "railroad" small investors into these funds--even though many of the investors really want to trade their own accounts. "That's sort of a shame because it reduces the profit potential substantially," he says.
SOUR SPOTS. Understanding how commodity futures work takes some concentration and a lot of study. A contract is simply an agreement between one party to sell and the other one to buy a set quantity of a commodity at a specified time and price. What creates the astounding profit potential of futures contracts--and the enormous risks--is that they are highly leveraged. That means you usually need to put up only from 3% to 10% of a contract's value to benefit from price changes. Yet your total exposure, or the amount at risk, is much greater.
Powers, for example, had to put up only about $1,000 in margin to buy his daughter's contract for 50,000 pounds of cotton at 57 cents a pound. Yet he controlled a total of $28,500 in cotton. When the price went up, to 59.2 cents, he made 2.2 cents on each pound, or $1,100 in total profits before trading costs. But if the price of copper had fallen 2.2 cents, Powers would have owed his broker that $1,100. Copper, like most other commodities, has a limit on how much the price can move in one day, and the market will "lock" up or down if it moves more than 2 cents. That can prevent individuals from getting out of positions that are going sour, so losses can mount for days.
Indeed, the odds are stacked against most individuals. Market moves are fast and sharp, and small investors are competing against the pros: huge grain traders, investment banks, and institutional traders with seats on the floors of the exchanges. By the time you call your broker to react to news in the market, the change may already be reflected in the price. Even after you place an order, the price will probably change slightly before it is executed, a factor known as "slippage."
A number of resources can aid those ready to take the plunge. John Wiley & Sons (800 225-5945) offers several books on futures trading, including Getting Started in Futures by Todd Lofton ($16.95). The exchanges themselves are eager to help individuals learn what to do and will supply free brochures, such as Introduction to Meat and Livestock Fundamentals from the Chicago Mercantile Exchange (800 331-3332).
Once you have scrutinized the materials, you can pick a trading strategy you're comfortable with. Many individuals use "technical" analysis--poring through charts to pick out historic pricing patterns. But other speculators base trades on "fundamental" analysis, a look at the forces of supply and demand in a given market. Of course, the fundamentals you need to consider are different for every commodity. Whatever strategy you choose, you will need to find sources for commodity information. Knight-Ridder (800 621-5271) offers charting services, and Weather Services Corp. in Bedford, Mass. (800 634-2549), provides global forecasts.
Many commodity traders also sell trading systems to the public. But these can be of questionable merit. According to Hulbert's Financial Digest, which tracks two such newsletters, Futures Hotline has lost a total of 19% in the past six years, and Timing Device lost 16% in 1993. As a rule, you should make sure you understand the logic behind the trade before accepting anyone else's suggestion.
Before putting money on the line, test your system by "paper trading," and do it for long enough so you won't confuse serendipity with skill. If you have come up with something that works, follow it religiously. The reason so many investors lose money is because they get greedy and ignore their system, Gotthelf says.
Brokerages will ask for information on your investment experience, net worth, and annual income before they will accept your business, although you can open an account with as little as $5,000 at some firms. If you want some advice and hand-holding, find an experienced full-service broker, who will charge you $70 and up per "round trip" trade. Or you can get in and out of a market for $30 or less through a discount broker.
BEATING RETREAT. Dealing with reputable brokers and advisers and understanding the impact of commissions are just as important as under- standing the nature of the investments, says Denis Klejna, who is director of enforcement at the Commodity Futures Trading Commission. Check out your broker and firm by calling the free hotline provided by the futures industry's regulatory agencies: 800 676-4632.
Whatever you do, don't play with more money than you can afford to lose. If you quickly blow the amount you have allocated for trading commodity futures, it's best to retreat to safer ground. You can always play the stock market. But, as Powers says, "after trading commodities, trading stocks is like watching the grass grow."
TABLE: KNOW THE STAKES Contract Current Total contract Minimum** Value of 5% Consider factors Commodity size price* value you put up price move like these COTTON 50,000 lb. .77 cents/lb. $38,360 $1,200 $1,918 Weather in China, Pakistan, and U.S. GOLD 100 troy oz. $384/oz. 38,430 1,3 1,922 Inflation, interest rates CRUDE OIL 1,000 bbl. $14.13/bbl. 14,130 1,550 707 Global economy, OPEC agreements ORANGE JUICE 15,000 lb. $1.10/lb. 16,462 1,000 823 Climate in Florida and Brazil PORK BELLIES 40,000 lb. .56 cents/lb. 22,248 1,080 1,112 Hog feed cost, domestic weather SOYBEANS 5,000 bu. $6.84/bu. 34,188 1,350 1,710 Soil moisture in U.S. and Brazil * As of Feb. 14, 1993 **Exchange initial margin requirements SOURCE: Lind-Waldock & Co., Merrill Lynch & Co.