To understand the futures market and why so many participants in it have no vested interest whatsoever in the goods that are traded in the market, beyond just looking to speculate on price movements, we need to first look at how financial markets operate.
Financial markets are not unlike any other form of public market, where things are bought and sold and anyone who goes to them will be able to do business provided that they have goods to sell that people want to buy, or are looking to buy what is being sold there.
In the early days of futures markets, when they first began, they were a means of people buying and selling contracts in order to fulfill a business purpose. This activity is certainly the backbone of the futures markets and without it, contracts would not be agreed to in the first place.
These contracts then become available to the public to buy and sell, to trade between each other, as they please. Sometimes one of the parties may be interested in possessing or selling the commodity or other asset that a futures contract deals with, but sometimes they may not, and it is not necessary at all to have any interest in the underlying asset.
The idea behind allowing futures contracts to be offered on the open market is to open up access to them to anyone, including speculators. This is the case whether the contracts are traded on an exchange or through brokers over the counter.
Having securities traded on public markets serves to provide both more liquidity and better price discovery. The net effect is that this added liquidity narrows spreads by permitting more participants, which increases both the supply and the demand of the futures contracts, or whatever else is traded.
An example of the better price discovery of a security is the case where someone may have offered a better price had they had access to the market, and if they don’t, this better price does not become discovered, but if they can place the order, it does.
There are some who feel that we should somehow restrict the participation of speculators in futures markets, particularly with commodity futures. This would be a bad idea even if it were possible, because it would reduce liquidity, increase spreads, and make trading futures more difficult.
Those who really do wish to trade private futures contracts are always free to do so, but if you choose to trade them in public, this is by the nature of these markets going to permit those who simply want to trade the contracts for profit to become involved to the extent they wish and have the means to do so.
Futures Contracts are a Zero Sum Proposition
Net of trading costs, all trades on the futures markets have a winner and a loser, and for every dollar gained, there will be someone who has lost the same amount.
This is different from many other securities such as stocks, where stocks can keep rising in price forever, over the long term anyway, and more people can be up money than are down money. Futures contracts are of a limited duration though, and end up setting, and in fact they settle every day, where someone makes a certain amount of profit and the other party loses a similar amount.
For those who are planning on executing contracts, they will be able to buy or sell the assets under the contract at the price they agreed upon. Regardless of where the price may have gone by way of the trading of the contracts that they entered into, this may end up benefiting one party or the other, but this in itself is a zero sum game as well.
Let’s assume that you want to buy a contract for a commodity and you feel that the price has been run up a little higher than you feel it should have, and perhaps this was caused by too much speculation on its rising in price. In this case, the price you paid is what you paid, and if you are right about this, you can simply wait until this corrects and benefit.
This goes to show that there are indeed trading skills in trading anything on a public market and where you enter the market always matters, whether you are looking to hedge your business with commodity futures or just looking to make some money from futures.
This is what is actually behind some people’s complaints about how speculation affects futures trading, but it’s not that the markets are more volatile, it’s because speculators tend to be better traders, and when they make money someone has to have a corresponding loss.
In this case the loss may be opportunity cost. You need to buy cattle, you wait because you think the price may come down, it goes up instead, you buy, then it goes down later. Trading is about proper timing and you are competing with all of the other people trading the stuff that you want to trade, and the money goes to whomever times their entries (and exits with speculators) better than others, based upon predicted price movements over time.
There’s a lot of dead money from speculators in the futures market in addition to the smart money, so having people speculate doesn’t necessarily mean that it becomes tougher. The futures market isn’t like some other markets though, and this really is a test of skill when it comes to trading the futures contracts.
The Futures Market is All About Trading, Not Investing
It is possible to roll over futures contracts, meaning that your position will be transferred to another contract with a different expiry date, and sometimes traders do roll over their positions. This happens in between trades more often than anything, and it’s usually not due to people being bullish or bearish on a particular asset traded on futures market for any great length of time.
Most certainly, people don’t invest in any sort of futures contract long term, even though you essentially can in theory by rolling over your contracts indefinitely, or just settling them for cash at expiration and moving on to the next contract.
In a sense, all activity involving futures contracts involves some sort of speculation, insofar as the entries can be timed. Even if you are looking to buy or sell a contract for the purposes of delivering or taking delivery of a commodity at the expiration of the contract, in other words you are not planning on exiting your position prior to exercising it, you are still speculating.
In this case, you are speculating that this is the proper time to enter the contract, versus waiting until later, and that’s one side of trading. The other side, the one that speculators also play, is when to exit it, as all futures speculation also contains an exit point as well as an entry one.
This is what trading is, looking to speculate on price movements by exiting at a more favorable price than you entered. Of course, not all trades are going to go your way and you will be exiting positions at a loss, but the goal in the end is to show a net profit from the trading.
What separates trading from investing is that with investing, investors are looking to do this over the long term, where the price increase is related more to how the underlying asset performs. If you buy stock in a company for instance, you expect that their business performance will drive the price of the stock higher over the long run, and you then expect to get a good return on your investment during this longer period.
Trading focuses much more on market activity, the supply and demand side of things, and does so over a shorter term than investing does. Supply and demand ultimately decides how stocks perform as well, and it’s all about supply and demand really, but trading looks at shorter term supply and demand more,
How Traders Speculate on Price Movements with Futures
Whenever you speculate on securities, the goal is to base your decisions upon predictions of where you think that the price will be headed during a certain period of time. Futures contracts run over several months but this does not mean that speculators are looking to determine price movements over this long of a period.
The desired trading period, the time frame of the trade, may be several months, it may be several minutes, or for any interval in between.
There are two main ways to assess a security’s outlook in the future, and that is to use fundamental analysis and technical analysis. Fundamental analysis looks to the underlying factors that drive supply and demand, like for instance weather patterns driving agricultural prices, affecting supply and demand of the asset itself, with technical analysis looking to measure trends in supply and demand of the contract directly.
Examples of the ways that technical analysis is used to predict price trends with futures trading include trend following, where price movement can cause further price movement in the same direction, or trend reversal, where a contract may be seen as being either overbought or oversold and a correction in price is anticipated.
What makes technical analysis valid is that these patterns are caused by the trading activity itself of a security, whether it be a futures contract or anything else. The fact that people speculate on futures, the fact that they will be more likely to buy something when it is going up and sell something when it is going down, or reverse the trend and do the opposite under certain conditions, cause this strategy to be to some degree self-fulfilling.
Although fundamental factors do drive the futures market, what is known is already priced in as they say, or is in the process of being priced in, and following the way that the market is reacting to such news is not only a more accurate way to measure this, unless someone has inside knowledge, anything else is just guesswork.
It can be argued that technical analysis does always trump fundamental analysis, and this argument is a pretty popular one with people on both sides, but with futures trading, there is no doubt that technical analysis rules the roost, at least if you have a proper understanding of the futures market.
This is especially the case given the fact that the shorter the time frame, the more accurate technical analysis is, and the longer the time frame, the more significant fundamental analysis is, and futures trading involves short to very short time frames by its nature.
There are a lot of people who speculate on the futures market to make extra money or even to make their living, and some make a very good living from this indeed, but it’s important to realize that this does require a fair bit of skill. All trading does, but futures speculating particularly does.
Eric has a deep understanding of what moves prices and how we can predict them to take advantage. He also understands why so many traders fail and how they may help themselves.