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1. Commodity Futures contracts 2. Forex contracts 3. Single-Stock Futures contracts 4. Margin, Leverage, and Account Size |
Commodity futures contracts were originally intended to allow buyers and sellers of physical commodities such as wheat or crude oil to agree, in advance of delivery, on a price for a stated quantity of a particular commodity. For example, in mid-summer a grain farmer might wish to guarantee that he will receive a current price when he sells a portion of his wheat crop, even if prices go down; and at the same time a flour miller or bakery might wish to ensure that they will be able to buy a certain amount of grain for a current price, even if prices go up.
A commodity futures contract has a delivery or expiry date, which is usually on the third Friday of the final month of the contract. Typically, contracts may be available for purchase and sale a year or more before their expiry date. For most commodities, contracts are available with expiry dates every 3 months, typically H=March, M=June, U=September, and Z=December, where the letter code identifies the expiry month. For some commodities, contracts are available for every month of the year.
Commodity futures contracts can also be bought and sold by investors, speculators and traders, who have no intention of supplying or receiving the physical commodity. If a trader thinks the price will go up, they can buy a contract (go 'long'). If they think the price will go down, they can sell a contract (go 'short'). The futures market reportedly trades $30 billion per day.
Short-term traders might hold a position for only a few days, and day-traders buy and sell on the same day, not wanting to hold a position overnight. Long-term traders might hold a position for many weeks or months. When a long-term trader is holding a contract that is approaching its expiry date, they can roll the position over: close out that contract and take the same position in a newer contract.
A trader must put up a minimum amount of money, called the margin, in order to buy or sell a commodity futures contract. Typically the margin is only about 10% of the value of the contract, so there is a lot of leverage! For day-traders, the margin requirement is typically cut in half, since the risk of overnight price changes is eliminated.
Unlike many other investments, there is no fixed account size required to trade a futures contract. An aggressive person could trade a contract with an account size of only 3 times margin, or even less. A more conservative person might fund their account with 6 to 10 times margin. Then if the trades lose money, it will be a smaller percentage of their account.
Contracts are identified by a code such as 'CL04Z', where 'CL' identifies the commodity (Crude Light oil), and '04Z' specifies the contract expiry month (2004-December). For some commodities, a smaller contract called a "mini" or "e-mini" is available. For example, ES is a mini-S&P which is 1/5 the size of the big SP contract, and E7 is a mini-EC which is 1/2 the size of the big EC (Euro Currency FX) contract.
There is a commission for buying or selling a futures contract, and there may be additional smaller fees as well. The round-turn fee (i.e. buy and sell) for a full-size contract might range from $25 to $50 through a system-assist broker, and can be much less for online trading where you place the order directly using the Internet. The fee for a mini contract is usually less, for example half to three-quarters of the fee for the big contract.
More information can be obtained from many sources such as books and magazines, and on the websites of the stock exchanges that trade them, such as the Chicago Mercantile Exchange, or the Chicago Board of Trade.
Forex is short for Foreign Exchange. Forex contracts are similar to commodity futures contracts, and can be traded in much the same way. Some differences are that Forex contracts are available for various international currency pairs, but not for physical commodities; and Forex contracts are priced according to the current or "spot" exchange rates, rather than the rates at some time in the future. The major currencies traded are the US Dollar, Japanese Yen, Euro, British Pound, Swiss Franc, Canadian Dollar and Australian Dollar. Forex contracts are traded by hundreds of financial institutions around the world, rather than by a small number of commodity /stock exchanges, but the Forex market is not regulated in the same way as the Commodity Futures market.
The Forex market has very high volume - reportedly between $1.4 trillion and $3 trillion US dollars/day, and therefore high liquidity. Some brokers guarantee zero slippage except under extremely volatile market conditions. It has been said that 95% of the Forex volume is trading for profit, or speculation.
Currencies are quoted in pairs. The first is called the base currency, and the second is called the quote or counter currency. The quote for a currency pair indicates the number of quote currency units required to purchase one base currency unit. For example, if EUR/USD is quoted at 1.2289, then it would take $1.2289 US to buy one Euro. Quotes are given using five digits, with the least significant digit being called a point or a pip. Forex quotes include a bid and an ask price. There is usually no commission to buy or sell a Forex contract. Rather, the broker makes their money on the spread between the bid and ask price.
When a quote goes up, the value of the base (first) currency has increased. For example, when the US dollar is the base unit (e.g. USD/JPY) and the quote goes up, this means that the US dollar has strengthened relative to the other currency. When the US dollar is the quote currency (e.g. EUR/USD) and the quote goes up, this means that the US dollar has weakened relative to the other currency.
Contract size is 100,000 units of the base currency. For example, if you buy one full-sized USD/CAD contract at 1.2727, you are buying 100,000 US dollars and selling 127,270 Canadian dollars. Margin /leverage can be up to 100:1, so the minimum amount needed in your trading account for this transaction would be $1,000 US. If you used a more conservative 10:1 margin, the amount needed in your trading account would be $10,000 US. Mini contracts are also available, and are one-tenth the size.
Forex contracts can be traded 24 hours a day, 5.5 days a week beginning Sunday at 2 PM New York time. For positions open at 5 PM EST, there may be a daily rollover interest that the trader either earns or pays.
Volume of trading is expressed in terms of the number of units being traded. For example if a system trades one particular currency pair and one mini is being traded, this would be a volume of 10,000 units. If a system trades three different currency pairs independently and 2-mini lots are being traded, then the trading volume would be 3 currency-pairs * 2 minis /currency-pair * 10,000 units /mini = 60,000 units.
Maximum drawdown and system lease cost can be expressed relative to the number of units traded. For example, the maximum historical drawdown might be $9,800 per 100,000 units traded, and the system lease cost might be $100 /month per 100,000 units traded.
Single-Stock Futures (SSF) are a relatively new type of investment. Some basic information is as follows:
Further information can be obtained from the website for the OneChicago Exchange, an electronic exchange which was set up to trade Single-Stock Futures contracts. OneChicago also trades some narrow-based index futures, and some Exchange Traded Funds futures.
We report results for both Commodity Futures and Forex trading systems. In order to compare results from these different types of contracts, it is necessary to present the risks and rewards on a comparable basis. We achieve this by using account sizes that produce the same amount of leverage.
By leverage, we mean the ratio of the value of the contract(s) being traded to the account size. For Commodity Futures contracts, we usually use a conservative account size of 5 times margin. What does this represent in terms of leverage? Please refer to the Commodity Specifications page, and look at the column titled "Contract Value, Leverage at 5*Margin". The first number here indicates the dollar value of the contract, and the second number indicates the leverage when this contract is funded with an account value of 5 times margin. Note that the leverage varies significantly from one type of commodity to another.
Looking at the data for some commodity futures contracts for currencies, the leverage for EC and JY are both 10.9, and the leverage for SF is 8.2, for an average Leverage of 10.0 (as of mid 2004) when the account size is 5 * margin, which we use for our "conservative" account size. (On 2004-Oct-21 the average leverage was 10.9. However, we continue to use a leverage of 10 for simplicity.)
What account size would be needed for a system that trades Forex currency pairs to produce the same 10x leverage as for currency commodity contracts? Please refer to the Forex Specifications page, and note the "Contract Value in $US" column near the right. The account size can be determined as follows:
For example, the Sierra Hotel Forex results that we report are for trading 2 minis each for the USD/CHF, USD/CAD, EUR/USD, GBP/USD, and USD/JPY currency pairs. For these contracts the total Contract Value is $20K + $20K + $24.6K + $36K + $20K ~= $121K. Therefore the Account size for a leverage of 10x would be about $12K.
Note that the minimum margin for Forex is 1% of the contract value. Therefore when leverage = 10x (and account size = ContractValue / 10 as discussed above), the Forex account size is 10 * minimum margin. In other words, our conservative account size guideline for Forex is 10 * margin, which would produce approximately the same leverage as our "conservative" 5 * margin guideline for commodity futures contracts. This relationship is summarized in the following table.
| Margin and Leverage for our 'Conservative' Account Size | ||||
| Type of contract | Minimum margin | Conservative Account Size | Leverage for conservative account size | Comment |
| Commodity Futures Currency (e.g. EC) | About 2% of contract size | 5 * margin | about 10x | Minimum margin is based on an average for Euro Currency, Japanese Yen, and Swiss Franc. |
| Forex (e.g. EUR/USD) | 1% of contract size | 10 * minimum margin | exactly 10x | |
Last updated 2006-Apr-13