A Complete Guide to Technical Trading Tactics PDF

A Complete Guide to Technical Trading Tactics How to Profit Using Pivot Points, Candlesticks & Other Indicators JOHN L. PERSON John Wiley & Sons, Inc. A Complete Guide to Technical Trading Tactics Founded in 1807, John Wiley & Sons is the oldest independent publishing company in the United States. With offices in North America, Europe, Aus- tralia, and Asia, Wiley is globally committed to developing and marketing print and electronic products and services for our customers’ professional and personal knowledge and understanding. The Wiley Trading series features books by traders who have survived the market’s ever-changing temperament and have prospered—some by rein- venting systems, others by getting back to basics. Whether a novice trader, professional, or somewhere in-between, these books will provide the ad- vice and strategies needed to prosper today and well into the future. For a list of available titles, visit our web site at www.WileyFinance.com. A Complete Guide to Technical Trading Tactics How to Profit Using Pivot Points, Candlesticks & Other Indicators JOHN L. PERSON John Wiley & Sons, Inc. Copyright © 2004 by John L. Person. All rights reserved. Published by John Wiley & Sons, Inc., Hoboken, New Jersey. Published simultaneously in Canada. No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, scanning, or otherwise, except as permitted under Section 107 or 108 of the 1976 United States Copyright Act, without either the prior written permission of the Publisher, or authorization through payment of the appropriate per-copy fee to the Copyright Clearance Center, Inc., 222 Rosewood Drive, Danvers, MA 01923, 978-750-8400, fax 978-646-8600, or on the web at www.copyright.com. 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HG4638.P47 2004 332.63′2042—dc22 2003026687 Printed in the United States of America 10 9 8 7 6 5 4 3 2 1 Contents Preface ix Acknowledgments xv CHAPTER 1 Introduction to Futures and Options: Understanding the Mechanics 1 How the markets work, the elevator analogy, product for the times, important terminology such as margin, contract specifications, and leverage CHAPTER 2 Fundamentals: The Market Driver 19 Supply and demand issues, economic growth and productivity effects, major eco- nomic reports and their in role in market prices CHAPTER 3 Technical Analysis: The Art of Charts 33 Western-style bar charts and key reversals, point-and-figure charts that focus only on price, market profiling, price and time analysis CHAPTER 4 Candle Charts: Lighting the Path 43 Enlightening charting technique and its colorfully named patterns—hammers, stars, spinning tops, dojis, hanging man, and others—powerful reversal patterns, reliable continuation patterns, key examples in the dollar and bonds v vi CONTENTS CHAPTER 5 Chart Analysis: Volume, Open Interest, Price Patterns 67 Volume and open interest rules for traders, M tops and W bottoms, trend lines, measuring patterns, the head-and-shoulders, triangles, pennants and flags, dia- monds, wedges, funnels, gaps, islands, rounded bottoms, oops signals, opening range breakouts CHAPTER 6 Pivot Point Analysis: A Powerful Weapon 93 The pivot point formula for target trading, calculating support and resistance lev- els, importance of multiple verification from several sources, the P3T trading tech- nique, weekly and monthly charts and numbers, risk management techniques CHAPTER 7 Day-Trading, Swing Trading: Acting on Analysis 113 Trading to bounce off target numbers, calling tops and bottoms, weekly chart magnets, harami cross and other candle clues to market reversals, pivot points save the day, lining up the stars, the verify-verify-verify approach CHAPTER 8 Technical Indicators: Confirming Evidence 135 Moving averages and trends, simple rules with averages, tweaking and visualizing MACD, stochastics, false signals, Gann’s key numbers, Fibonacci ratios and projec- tions, time counts for cycles, Elliott wave and its clues CHAPTER 9 Market Sentiment: What Traders Are Thinking 161 Getting a market consensus from contrary opinion, Commitments of Traders reports, margin rate changes, Market Vane Bullish Consensus report, put-to-call ratios, volatility index (VIX), when the boat is tipping over, media effect CHAPTER 10 Order Placement: Executing the Plan 171 Importance of getting an order right, online platform concerns, impact of market conditions on orders, 14 top order entry selections you need to know, orders in after-hours trading, spreading concepts Contents vii CHAPTER 11 The Mental Game: Inside the Trader 189 Conquering fear, learning discipline, improving confidence, suggestions for suc- cess, I’ll-think-about-it syndrome, the paper trader, fear and greed factors, becom- ing a specialist, setting up an investment diary, setting a positive mind frame, dealing with adrenaline, establishing goals, positive affirmations, stress relief techniques, rewarding success to build success CHAPTER 12 The Tactical Trader: Tips and Techniques That Work 203 Pyramiding approaches, scale trading, stop reversals, breakouts, momentum trad- ing, the Friday 10:30 a.m. rule, stop placement near a magnet, trading multiple contracts CHAPTER 13 Options: A Primer 217 What options are and how to use them with futures, simple puts and calls, options premiums, the Greeks, comparison shopping, strangles and straddles, eight top option spreads, delta neutral techniques CHAPTER 14 Closing Bell: My Top 10 List 235 What the experts suggest, top 10 trading thoughts, measuring success Glossary 241 Bibliography 253 Index 255 Preface T he purpose of this book is to share some of the tips, techniques, and observations that have worked for me and other highly successful traders. After nearly 23 years as a registered broker in the futures and options field, I have come to know quite a few successful traders and have personally made many successful trades. I have also experienced my share of disasters and have known traders and investors who were doomed for permanent failure. Therefore, I am writing this book to help the new indi- vidual investor understand the mechanics of the markets and to serve as a refresher for the seasoned veteran trader. Most of the trade examples demonstrated in this book were direct trade recommendations from either The Bottom Line Financial and Futures Weekly Newsletter or those that appeared in the daily Dow report provided through the Chicago Board of Trade web site and at www.nationalfutures.com. Rather than demonstrating just one methodology of trading tactics using pivot point analysis, I wanted to show through various techniques how you can implement these calculations with other methods and indicators. Much of what I have learned over the course of 23 years in the industry did come from hard work and, I must admit, being around the right people at the right time. I do not want you to abandon your knowledge of traditional tech- nical analysis techniques. I would just like you to be open to integrating the numbers to help you confirm, validate, and identify entry and exit points when trading. I also want to relay the message that mathematically calculated support and resistance numbers, or pivot points, work on different markets and should be derived from different time frames—not only from a daily basis, but also from a weekly and monthly time frame. In addition, as most of the readers either know or will find out, trading is also a combination of strong emotional and personal characteristics. Through my experience and observations, I want to share and explain what ix x PREFACE works and what does not but, more important, to disclose why things go wrong when they do for those who failed. I believe it is important to take an inventory, so to speak, when things go right to capitalize on that experience by examining what you did so the results can be repeated. It is just as im- portant to examine what went wrong so you can learn from the experi- ence. By sharing with you the experiences and techniques that I and other professional traders have learned, the hope is that you will benefit and be- come a more profitable trader. I firmly believe that traders from all different levels of experience will benefit from the information contained in this book, whether it is actually gaining a new understanding or a new technique or refreshing, reviewing, or reviving your memory about tactics, strategies, or trading techniques that an advanced trader may have forgotten. My professional history may explain my qualifications for writing this book. I started in this business as a runner on the floor of the Chicago Mer- cantile Exchange in 1979. To illustrate a reference point in time, the Dow Jones Industrial Average was near the 900 level. The S&P 500 Index futures contract did not even exist back then. I became a registered commodity broker in 1982 and worked up through the ranks in the industry as I was studying economics at Loyola University. The head of the research depart- ment at the firm where I worked was George C. Lane. He, of course, is credited with developing the oscillator system known as stochastics. He was the first boss who tutored me in the art of technical analysis. Little did I know at that time that a true master of technical analysis was going to be responsible for helping to create the intrigue, financial rewards, and pas- sion for the futures industry that I have had throughout all these years. Granted, there were other individuals who had an influence on my ca- reer. Jack F., an old member of the Chicago Board of Trade, helped me un- derstand the importance of moving averages and the aspect of long-term charts. Back in 1985 and 1986 in what I call the great bond market boom, he was instrumental in helping me understand how to ride a strong trending market. In 1986, I captured what I call a winning tidal wave bull market run that remains legendary to this day for those who were on board with me, as well as friends who invested and knew me well. Another broker at a firm where I worked taught me this strange and unique method of plotting unconventional trend lines to predict price and time coordination. Harry A. was his name and this guy would tell you on a Monday that at 11:40 a.m. Wednesday the high in bonds would be 7812⁄32. Come Wednesday at 11:45 a.m. or so, the high was 7811⁄32, and I would watch the price take a disastrous plummet. His method, as I later found out, was based on Drummond geometry. Preface xi I had the privilege to work with a former chairman of the Chicago Board of Trade, Bill Mallers Sr., who was always looking for a new system. His thirst for achievement and passion for the markets amazed me. Another man in the office who worked for Bill Sr. was a fairly quiet, yet confident, guy. He always had a cigar stub in his mouth—never did smoke but just chewed on them. He sat near me and time after time would overhear my recommendations to clients, in particular my points of support and resis- tance. Almost on a daily basis he had the same target numbers, usually within a point or tick of mine. That is when we discovered we were doing the same thing. The amazing thing was he claimed to be a direct student of Charles Drummond. I was also fortunate to have been introduced to another fascinating man, Dan Gramza, an instructor for several futures exchanges and firms worldwide. His understanding of the market and the relationship between time, price, and volume is incredible. His teaching also included a wonder- ful tutoring in candle charting. When I discovered that, he humbly men- tioned that he knew Steve Nison and “helped” write some of Steve’s first book. When I got home, I immediately searched for the book in the storage box and, sure enough, there it was in the acknowledgment section on page IV. Not only was Dan mentioned in one of the best books on the basics of candle charting, in my opinion, he helped write chapter 8 in Steve’s book. My experience has ranged from learning stochastics from the creator of the indicator, moving averages from a famous floor trader and options from my own experience, Drummond geometry from two different fasci- nating people at two different times in my career, pivot point analysis, and then candle charting techniques from what I would call a master. In March 2003 I started hosting a radio program titled, The Personal In- vestment Hour. The format was to invite expert traders and analysts to share with listeners who they were and what they do to trade successfully. My guests have included John Murphy, Martin Pring, John Bollinger, Victor Niederhoffer, Gerald Appel, Linda Bradford Raschke, Larry Williams, and a fabulous roll call of other top experts. Most guests were thrilled to come on and share their story and methods. Some of the contents of those inter- views are mentioned in this book as well. In fact, the interviews were recorded and archived on my web site, www.nationalfutures.com, where anyone can go to listen to them. By writing this book, I can share with you how and what I do to produce the analysis that goes out every week in The Bottom Line Financial and Futures Newsletter. I believe my experience in the industry and the tech- niques that I have developed can be instrumental in helping you to become a better trader. I believe that you can successfully learn to better integrate xii PREFACE the two elements of market analysis: time and price. The elements that I have focused on from the technical side are: Pivot points, a leading price predictor that is based on price points using different time frames. Cycle analysis, which deals with predicting market turning points based on time. Candle chart patterns, which are based on price relationships between the open, high, low, and close and past chart points such as old highs or lows. Fibonacci ratio corrections and extension studies, which are based on past price points. Other studies such as volume are used to gauge the level of participation and to help uncover the strength or weakness of a market trend. The last—and maybe the most—important aspect of trading that this book covers is evaluating the psychological makeup of traders and provid- ing exercises that can help those who are having a rough period overcome their problems. Learning who you are and how you react to market condi- tions is a vital aspect of trading. I hope that reading this book will help you have a better understanding of what it takes to trade and to broaden your horizons in investing in the fu- tures and options market. More important, I want you to know how to learn to do it on your own. Industry experts agree that about 80 percent of the people who trade lose. With those odds against you, you need all the help you can get! Individual speculators need to know that it is a rewarding ad- venture as long as they can make it against the markets and their biggest competitor, every other trader. As a zero-sum game, for every loser there is a winner in futures trading. Or another way to think about it, perhaps, is that 20 traders are taking the money of 80 other traders. If you are going to trade successfully, you need to understand that it re- quires hard work and, above all, to think of trading as a business. As you read this book, I hope you learn that you do not need to have an IQ of 160 or be a mathematician or possess superhuman skills to be successful. What you do need to have is a fascination for this business, patience, discipline, a trading plan, identification of what type of trader you are, risk capital, and the desire to improve your financial life. Through the development of technology and the Internet, more infor- mation is accessible today for the individual speculator than ever before. I sincerely believe a knowledgeable and educated investor is a better trader. Preface xiii So if you are trading or are getting ready to trade, try to work at con- tinually learning what is available to you. Cutting-edge technology will con- tinue to offer more powerful and helpful trading tools to individual traders. It is up to you to learn how to use them to your advantage. I hope that you will benefit from the tips and techniques that are mentioned in these pages and certainly hope that you can apply them successfully in your trading. JOHN L. PERSON Palm Beach, Florida March 2004 Acknowledgments W riting requires intense devotion and discipline; I now have a new sense of respect for anyone who has ever written any books or published material, especially on the subject of technical analysis. I have many people to thank—those who were indirectly responsible and influential in my education throughout the years and, of course, my family, especially my wife, Mary, who also tolerated my perseverance for finishing this book at the expense of ignoring her and asking too many questions when I had computer problems. Mom, I know you wanted a lawyer in the family; instead you got a fu- tures trader. My son, John Paul, who decided not to get in the investment business; instead, he followed the entrepreneurial spirit and opened his own chain of cell phone stores. There is still a chance to convert him back to the investment world: He likes my stock picks! Special thanks to the Friday night “wanders” group, the best support group of friends one could ever have. Those I wish to mention directly: Lan Turner from Gecko Software, Stuart Unger, Barry Isaacson, Cheryl Fitz- patrick, Rory Obractin, and Jonathan W. Dean from FutureSource; Dan Gramza for inviting me to his class and taking my calls; Barbara Schmidt Bailey and Ted Doukas from the Chicago Board of Trade; and James Mooney, president of Infinity Brokerage Services. The more analysts and authors I met, the more I found how truly for- tunate I was in having Pamela van Giessen of John Wiley & Sons as my ed- itorial director. Thank you, Pam! My special thanks go to Darrell Jobman, who was directly responsible for orchestrating and directing me through the whole process of this project and directly responsible for helping to get this material organized and published. J. L. P. xv A Complete Guide to Technical Trading Tactics CHAPTER 1 Introduction to Futures and Options Understanding the Mechanics Success is turning knowledge into positive action. Thinking is easy, acting is difficult, and to put one’s thoughts into action is the most difficult thing in the world. —Johann Wolfgang von Goethe G oethe could have been referring to paper trading versus the act of ac- tually trading when he wrote the phrase above. Trading is exactly that: putting your thoughts or convictions about a price move into action by entering an order and placing money at risk. Investing is a totally different ball game. This book is about trading. The purpose of trading is to turn over or buy and sell (sell and buy) to build cash in an account by capitalizing on changes in price. It is not about acquiring and holding assets or property. Futures trading is becoming more attractive than ever before as in- vestors transfer their knowledge and trading skills from the stock market boom of the late 1990s to more active markets where the idea of creating wealth is still alive. As the equity markets became consumed by the bear market mentality liquidation phase, investors with knowledge of techni- cal analysis and computer skills flocked to open futures accounts to trade e-mini S&P 500 and e-mini Nasdaq 100 index futures. Stock market firms and brokers have developed futures divisions, and day-trading education experts have crawled out of the woodwork to teach in- vestors the art of day trading those products. Some of the numerous quality instructors come with a very high tuition cost; others are not so expensive. 1 2 INTRODUCTION TO FUTURES AND OPTIONS: Understanding the Mechanics Most likely, learning about trading at a reasonable price is why you are reading this book. However, reading this book alone will not guarantee that you will succeed in trading. You need to read this book, practice its princi- ples, and continue your trading education, realizing that the biggest obstacle in trading is what is between your left and right ears. I believe the techniques in this book are excellent strategies, and I hope you will apply and benefit from them. Teaching someone to become a successful trader and letting them experience the power of financial rewards is a satisfying and reward- ing pursuit. As investors look for markets beyond stocks or mutual funds in which to put their money, they will find a whole new world out there with different products to trade, among them futures. You may be among those investors who are afraid of and concerned about trading futures because of what you heard about them in the past. There are good reasons for being nervous about treading into any new market. But consider the scandals that have plagued Wall Street in the post-bubble era and may continue for some time. As history shows, there have been countless scandals on Wall Street in the past, and there almost certainly will be more in the future. So-called traditional invest- ing in stocks is not immune to risk and has its own set of problems. The question is: Will confidence in America’s corporate leadership return sooner rather than later? Stock ownership is at the highest level per capita in America’s history. More investors and private traders participate in the markets than ever before. In addition to stocks and mutual funds, there are a host of stock-related derivative products—exchange-traded funds such as QQQs, options such as the OEX, and many, many others including a rela- tively new and spectacular market development called single stock futures. The price direction of equities and all of these derivative instruments boils down to what will happen to the underlying forces of earnings and growth. Here is a brief story that may shed light on Americans’ changing view- point about investing. I was giving a seminar on the futures markets to an investment club. One older gentleman said his money was safe in the bank, and he wouldn’t give his money to the stock market again. I asked, “Why do you feel that way?” He responded, “They are all crooks!” “Well, if you think like that, why are you at a futures seminar?” I asked. “I always thought they were risky, but now I want to learn for myself,” he replied. “Futures trading is risky,” I agreed, “but what gave you the impression not to open a futures account before?” “My stock broker told me not to trade commodities, that I would lose my shirt,” he said. “So I kept buying the stocks he recommended, and, in- stead, I lost my shirt with him.” Trading Mentality 3 Not a happy story, but the amazing development is that the gentleman is getting back on the horse after falling off, this time getting his own edu- cation and finding out for himself whether futures are for him. This book is designed for people like him and for the more experienced technical trader as well. If you had a similar experience, then keep reading and studying and you will continue to increase your knowledge and com- petence. With that, you will gain confidence. The more knowledge and in- formation you have about a subject, the better you will become in dealing with it. As we all know, knowledge is power. Every investor should know that trading is like riding an elevator. You get on if you want to go up and then get out once you are where you want to be. If you want to go up but then realize that you are going down instead, bail out. Get off the elevator and get back on another ride going up. Risk management and turnover are the keys to successful trading. TRADING MENTALITY Most new investors are not familiar with trading the short side of the market. I have listened to many novices say that they have a hard time comprehend- ing how to sell something they do not even own. I always tell them that even if they buy a futures contract to go long, they are not going to own anything (except in rare instances where they may take actual delivery of some phys- ical commodities). All futures traders are doing is speculating on the direction of prices on a given product during a given time period. If they are right, they get re- warded; if they are wrong, of course, they get penalized. Remember the ele- vator analogy. If a building has 100 floors and you are on the 50th floor, you can play a guessing game to see if the elevator goes up or down and by how many floors. You can take the ride, but you don’t have to own the elevator to do so. The principle of trading is a very simple concept although we, as hu- mans, tend to make it quite complicated, especially those who have a hard time comprehending selling short. Trading is just a matter of interested par- ties coming together and speculating whether the price of a specific com- modity is going to go up or down. It is that simple. Let’s say Bill believes the price of commodity XYZ is going up, so he buys. A second trader, Pete, believes the price is going down, so he sells short. One could win, one could lose. Or, believe it or not, both Bill and Pete can be right and make money during the same day with their opposite po- sitions. Similarly, both could also lose within the same trading day doing the exact opposite trade at the same time. It happens all the time. Volatility 4 INTRODUCTION TO FUTURES AND OPTIONS: Understanding the Mechanics is the reason. Get to know that term as well as whipsaw, choppy, erratic market behavior, and other terms used in connection with volatility. The market’s behavior reflects the emotional condition of those who are doing the trading. The market is the by-product of those who use it. Some- times it seems like a jungle. It can be financially rewarding and exciting like discovering a wealth of mineral deposits in a hidden cavern behind thick brush. It can also be like enjoying the beauty and splendor of a sunset off the coast of Florida with the sun’s light descending on the low clouds as palm trees sway in the breeze. But it can also provide some of the scariest and most financially dangerous adventures you will ever experience. Trading will probably test your emotional strength and psyche. It will be the ultimate financial, emotional, and intellectual challenge you will ever en- counter. Fear, doubt, complacency, greed, anxiety, excitement, false pride— all can interfere with rational and intellectual thoughts. It is those feelings that create the jungle, and you may need help to overcome that jungle of emotion. Conquer those feelings and you may find the holy grail of trading: a confident winning attitude. Reading this book will give you the knowledge necessary to improve your life as a trader. You will be taught to take the emotion out of trading and to develop a method or trading plan. Remember, “Those who fail to plan, plan to fail.” I have devoted a chapter to the mental aspect of trading (Chapter 11) because I believe about 80 percent of successful trading is based on emo- tional makeup. The way to increase your confidence and competence levels is through knowledge, and that comes from learning solutions to problems and then applying or executing what you learn. HOLDING PENALTY As you learn different trading styles, remember this key concept: Futures are a trading vehicle and not—I repeat, not—a buy-and-hold, long-term invest- ment platform. Do not try to dictate or get married to an idea about the di- rection you think the market should go. This approach can lead to financial donations to other traders’ wealth, to an increase in your knowledge about your brokerage firm’s money wire transaction process, and, worse yet, to get- ting wiped out. You need to work at this business. You need to manage and maintain your positions and monitor price action. Game plans need to be established, and you will need to be flexible and quick to act. Access and communication to stay in touch with the market is important when you are trading. Futures trading should be used to make money on a price movement. It should not be a personal vendetta, trying to prove that you are right in your opinion of what the market should do. That outlook is why there are all kinds Getting Technical 5 of clichés about taking profits. For instance, “A profit is a profit, no matter how small.” That is a great line, but let’s define “small profit.” Coming to this business to risk thousands of dollars to make a hundred dollars or so isn’t the way this trading environment should be used. Another old saying describes someone who takes small profits and lets big losers ride: “Eating like a bird and crapping like an elephant.” That is the essence of a habit you don’t want. If this is a syndrome that you fall into, Chapter 11 offers exercises to help you work through it. If you catch yourself getting into that habit, stop trading. Try not to get used to taking small prof- its constantly and letting losses get large before taking them. You need to develop good discipline and strong emotional traits. Otherwise, fear of losing will hinder your performance. Think about this: If trading were easy and such a sure thing, why would you have to sign all of those disclaimers about how dangerous it is when you fill out an account application at a brokerage firm? So far I have mentioned buying, selling, winning, losing, and human emo- tions, and I have not yet covered a single aspect of technical analysis. This approach to the subject reflects my belief about what I consider the most important aspect of trading: your mental and emotional capacity. GETTING TECHNICAL Technical analysis is the study of a market’s price data, which is created by the emotions of the participants. Price reflects the current or anticipated value of a market from a supply and demand perspective. Price is the true and absolute reflection of value, as perceived by the various market partic- ipants at a particular point in time. There are a number of different forms of analysis. This book will go into further detail on most aspects of technical analysis, but my focus is on market reversals incorporating pivot point analysis with other methods to nail down time and price predictions. All traders have access to four common denominators: open, high, low, and closing price. How you analyze, interpret, and act on the information available is what gives you a trading style that differentiates you from other traders. Successful traders interpret correctly and act swiftly. There are five business days in every week and usually four weeks in every month. One day within a month will usually mark a price high, another day will generally mark a low, and the market will close somewhere between those points. Those facts define the monthly range. The successful trader does not consistently make a habit of buying the high of the range or selling the low of the range. But before jumping ahead of ourselves into subjects covered later in the book, we need to review what the futures markets are all about. Seasoned 6 INTRODUCTION TO FUTURES AND OPTIONS: Understanding the Mechanics traders may be able to skip over the next sections, but those new to futures should read them carefully because they contain important concepts and terminology that make futures different from most other markets. GETTING INTO FUTURES For futures traders, the choice of products varies from the traditional to the exciting new trading vehicles now available. Everyone can relate to many of these markets that you use every day, from energy products such as crude oil or natural gas to agricultural markets such as meats, grains, and the so- called softs (coffee, sugar, cocoa). Prices are dictated by supply and demand functions that often are affected by weather. In addition to supply/demand influences, futures markets may provide a safe-haven security function. Precious metals such as gold may start to in- crease in price as investors on a global scale believe it is necessary to hold on to hard assets instead of paper assets in times of political tension or because they fear potential inflation resulting from the massive liquidity pumped into the global economy from 2001 through 2003. Financial instru- ments such as Treasury notes and bonds and currencies are also popular trading vehicles. In short, diversified products in all of these areas are available to futures traders and provide advantages in liquidity and leverage. Many of these mar- kets also offer direct electronic access to traders. As long as there are prod- ucts subject to supply/demand and price fluctuations that carry an element of risk, there will be a role for futures in the business world. THE FUTURES INSTRUMENT Many people, including traders, refer to commodities and futures as one and the same thing. To clarify that point first, the term commodities means an actual physical product such as corn, wheat, soybeans, cattle, gold, coffee, crude oil, cotton, and the like. The term futures refers to the instrument or the contract that is actually traded on these underlying products. Futures contracts have set standards for quantity, quality, financial requirements, and delivery points, if any (many futures contracts have cash-settlement provi- sions so there is no delivery). As the years have passed, futures contracts have been developed for new “commodities” such as foreign currencies and a number of financial instru- ments including interest rate products such as Treasury bonds and notes, stock indexes such as the S&P 500 index and Dow Jones Industrial Average, The Futures Instrument 7 and, most recently, an innovative derivative product called single stock futures. Unlike equities, where stocks are quoted in dollars per share, different commodities have different contract values and different point values. The table of contract specifications for major U.S. futures markets (Table 1.1) lists the symbols and sizes of various futures contracts. For example, the contract size for corn is 5,000 bushels. If the value of one bushel is, say, $2.00, then the overall contract value is $10,000. The full-size S&P 500 index futures contract has a value of $250 times the index. If the index is at, say, 1,000, the value of the contract is $250,000, considerably larger than the value of the corn contract. Exchanges require a good-faith deposit—usually called margin, although it does not have the same meaning as margin in stocks—to play the game. For most futures contracts, you usually need to put up only 3 per- cent to 10 percent of the total contract value to trade. On the one hand, corn may have an initial margin requirement of $500 to $600—about 5 percent of the contract’s value—with a maintenance margin of $300. For that amount of money, you control 5,000 bushels of corn and can go long, speculating that prices will climb in the future, or sell short, speculating that the price will decline. The more volatile S&P contract, on the other hand, has a margin re- quirement closer to 7 percent or 8 percent or $18,000 to $20,000. The amount of money required to trade a contract may dictate what you trade if you have a small account. It has been argued that physical commodity products will find a fair value or an absolute value when they reach certain lows based on histori- cal price comparisons and will never go to zero due to laws of supply and demand (Economics 101). Unlike stocks, commodities do not declare bank- ruptcy or go out of business. The reason futures will always have some value is because they do not exist solely for traders to bet on price movement. Producers and end users are also major participants in most futures markets as they use futures to reduce risk from adverse changes in price and to discover the current fair value for products they have to buy or sell to stay in business. Traders in this category are referred to as commercials or hedgers. You probably are in a second group: the individual speculator trying to capitalize on price swings created by the up and down forces in the market- place. You may be trading from your home as a business or on the trading floor or trading as a sideline. A third category of futures traders includes the large speculators or fund managers who pool investors’ money together. These are sometimes referred to collectively as the commodity funds. One advantage of futures trading is that the government gives you an idea what each of these groups of traders is doing each week in the 8 INTRODUCTION TO FUTURES AND OPTIONS: Understanding the Mechanics TABLE 1.1 Major U.S. Futures Contract Specifications a Symbol Futures Contract Contract Size Contract Monthsb Exchangec Interest Rates ED Eurodollar, 90-day $1,000,000 H, M, U, Z CME TB Treasury bills, 90-day $1,000,000 H, M, U, Z CME FF Fed funds, 30-day $5,000,000 All months CBOT EM Libor $3,000,000 All months CME TU Treasury notes, 2-year $ 200,000 H, M, U, Z CBOT FV Treasury notes, 5-year $ 100,000 H, M, U, Z CBOT TY Treasury notes, 10-year $ 100,000 H, M, U, Z CBOT US Treasury bonds, 30-year $ 100,000 H, M, U, Z CBOT MB Municipal bonds $ 100,000 H, M, U, Z CBOT Indexes SP S&P 500 Stock Index $250 × index H, M, U, Z CME ES E-Mini S&P 500 Index $ 50 × index H, M, U, Z CME DJ Dow Jones Industrial Avg. $ 10 × index H, M, U, Z CBOT YJ Mini-sized Dow $ 5 × index H, M, U, Z CBOT YX NYSE Composite Index $500 × index H, M, U, Z NYBOT MV Mini-Value Line Index $100 × index H, M, U, Z KCBOT NK Nikkei 225 Stock Avg. $ 5 × average H, M, U, Z CME ER Euro-top 100 Stock Index $100 × index H, M, U, Z NYMEX FI FT-SE 100 Stock Index $ 50 × index H, M, U, Z CME MD S&P Mid-Cap 400 Index $500 × index H, M, U, Z CME CR CRB Futures Index $500 × index F, G, J, M, Q, X NYBOT GI Goldman Sachs Com. Index $250 × index All months CME Currencies AD Australian dollar 100,000 AD H, M, U, Z CME BP British pound 62,500 BP H, M, U, Z CME CD Canadian dollar 100,000 CD H, M, U, Z CME EC Euro currency 125,000 Euros H, M, U, Z CME FR French franc 500,000 FF H, M, U, Z CME JY Japanese yen 12,500,000 JY H, M, U, Z CME MP Mexican peso 500,000 MP H, M, U, Z CME SF Swiss franc 125,000 SF H, M, U, Z CME DX U.S. Dollar Index $100 × index H, M, U, Z NYBOT Metals GC Gold 100 troy oz. All months NYMEX SI Silver 5,000 troy oz. All months NYMEX HG Copper 25,000 lbs. All months NYMEX PL Platinum 50 troy oz. All months NYMEX PA Palladium 100 troy oz. All months NYMEX AL Aluminum 44,000 lb. All months NYMEX YG Gold 33.2 troy oz. All months CBOT YI Silver 1,000 troy oz. All months CBOT The Futures Instrument 9 TABLE 1.1 Continued a Symbol Futures Contract Contract Size Contract Monthsb Exchangec Energy CL Crude oil 1,000 bbl. All months NYMEX HO Heating oil 42,000 gal. All months NYMEX HU Unleaded gasoline 42,000 gal. All months NYMEX NG Natural gas 10,000 MBTU All months NYMEX Grains C Corn 5,000 bu. H, K, N, U, Z CBOT W Wheat, soft winter 5,000 bu. H, K, N, U, Z CBOT S Soybeans 5,000 bu. F, H, K, N, Q, CBOT U, X BO Soybean oil 60,000 lb. F, H, K, N, Q, CBOT U, V, Z SM Soybean meal 100 tons F, H, K, N, Q, CBOT U, V, Z O Oats 5,000 bu. H, K, N, U, Z CBOT KW Wheat, hard red winter 5,000 bu. H, K, N, U, Z KCBOT MW Wheat, spring 5,000 bu. H, K, N, U, Z MGE Meats LC Live cattle 40,000 lb. G, J, M, Q, V, Z CME FC Feeder cattle 50,000 lb. F, H, J, K, Q, CME U, V, X LH Lean hogs 40,000 lb. G, J, M, N, Q, CME V, Z PB Frozen pork bellies 40,000 lb. G, H, K, N, Q CME Foods, Other KC Coffee “C” 37,500 lb. H, K, N, U, Z NYBOT SB Sugar #11 (world) 112,000 lb. F, H, K, N, V NYBOT CO Cocoa 10 metric tons H, K, N, U, Z NYBOT CT Cotton 50,000 lb. All months NYBOT OJ Frozen orange juice 15,000 lb. F, H, K, N, U, X NYBOT LB Lumber, random length 110,000 bd. ft. F, H, K, N, U, X CME a Exchange symbols; data vendors may use other symbols. b c Contract months: Exchange abbreviations: F = January N = July CBOT = Chicago Board of Trade G = February Q = August CME = Chicago Mercantile Exchange H = March U = September KCBOT = Kansas City Board of Trade J = April V = October MGE = Minneapolis Grain Exchange K = May X = November NYBOT = New York Board of Trade M = June Z = December NYMEX = New York Mercantile Exchange 10 INTRODUCTION TO FUTURES AND OPTIONS: Understanding the Mechanics Commodity Futures Trading Commission’s Commitments of Traders report. I cover this subject in more detail later in the book, but the report is sort of like getting the inside scoop on who is doing what—like a delayed report on legalized insider trading. EXCHANGE FUNCTION Exchanges provide the contracts and the facility (trading pit or computer) where buyers and sellers can come together to trade, all monitored carefully by the exchange under the oversight of federal regulators to preserve the in- tegrity of the market. Futures exchanges make a major point of providing a level playing field for all participants and ensuring that the integrity and fi- nancial soundness of the marketplace remains intact. After all, if you have a winning trade and want to take your profits, you need to trust that the money you earned and deserve will be available. The futures industry is built on the principle of integrity. A few years ago the Chicago Board of Trade celebrated its 150th an- niversary. Originally established as a centralized marketplace for grain trad- ing, it has become known for its financial products and is one of the highest volume exchanges in the world. The Chicago Mercantile Exchange, also mostly known today for its financial products, and the New York futures ex- changes also trace their roots to the 19th century. So futures markets have been around for a long time and will continue to exist in the future. Just as the Chicago Mercantile Exchange moved from trading eggs and butter to products such as currencies, the Eurodollar, and stock indexes, ex- changes are constantly evolving to meet the changing needs of consumers and producers, adding new and exciting trading vehicles to the futures in- dustry. For example, milk producers saw a need to hedge their risk against often-volatile price movement in the cash market as values move from an ex- treme low to an extreme high. The Chicago Mercantile Exchange recognized the dairy industry’s needs and created a marketplace for participants to hedge their production or purchase needs. Major corporations such as Kraft Foods can now use futures to hedge against losses in the cash market. DIGGING INTO FUTURES Futures have a number of features that require more attention, beginning with the concept of margin. As previously mentioned, margin in futures is really a security deposit or performance bond. Digging into Futures 11 Typically, only a small fraction of the contract value (usually 3–10 percent) is required as a security deposit. With such a small deposit, it takes only a small price move to produce a big percentage return, providing the power of leverage for which futures are known. Exchanges set the minimum performance bond requirements for each contract and can change those requirements without notice, depending on market conditions. Brokerage firms may increase the amount of money re- quired beyond what the exchange has set if additional protection is deemed necessary. Sometimes this is done if volatility or price swings are larger than normal and the firm believes clients are at more risk than usual. For exam- ple, if the Federal Reserve makes a sudden interest rate adjustment, the mar- ket may panic, causing wild price moves. These volatile price fluctuations may be the basis for a decision that the amount of money required to trade should go up (or down) significantly at a moment’s notice. Although brokerage firms can require more than a minimum perfor- mance bond, they cannot lower the amount below the minimum require- ments that the exchanges have set. Most trading firms post their margin requirements on their web sites. For exact updates, you can always contact the exchanges for quick access to current information. The current system used in the industry is known as SPAN margining— Standard Portfolio Analysis of Risk System, developed by the Chicago Mer- cantile Exchange in 1988. Basically, it is a computer-generated calculation that takes into account a trader’s total position to help determine the risk associated with that position. This position could include strictly futures or could involve an intricate options and futures strategy. Margin and leverage give futures an advantage over other investment instruments, but it is also a two-edge sword. During an adverse price move against your position, the concept of leverage can turn into a bad situation as losses can grow exponentially. Overleveraged positions and undercapi- talized investors do get blown out, that is, positions and accounts can be liq- uidated with large losses and sometimes can leave large debits. However, traders do have control over leverage. By simply adding funds to the account to match the full value of the contracts you are trading, you can set up a sit- uation where you no longer have investment leverage. Within the system of margin, you should be familiar with two terms: ini- tial margin and maintenance margin. Initial margin is the amount of money you must have in your account to establish a futures position. If the market moves against your position and the amount in your account drops below the maintenance margin, you will get a margin call and must replenish your ac- count to the initial margin level immediately to maintain your position. We can illustrate the margin system using coffee futures. With coffee futures trading around 60–65 cents a pound in 2003, the New York Board of 12 INTRODUCTION TO FUTURES AND OPTIONS: Understanding the Mechanics Trade’s initial margin requirement was about $1,700 and the maintenance margin was $1,200. Based on a contract of 37,500 pounds and a price of 60 cents a pound, the total contract value was $22,500, putting the initial mar- gin at about 7.5 percent of the contract’s value. If the price of coffee futures goes up just 2 cents a pound, you have a gain of $750 or a return of about 44 percent on your initial margin money. However, if the price of coffee drops 2 cents a pound—not an unusual occurrence—you have a loss of $750 or 44 percent. Some traders think they are required to have $1,700 plus $1,200 or a total of $2,900 in their account to trade one coffee futures position. This is not so. The rules of margin are that you need at least $1,700 in your account to enter a coffee position. If your account balance drops below $1,200 at any time, as it would with a 2-cent price decline, then you may receive a re- quest to send in more money to get your account balance back to the orig- inal $1,700 level. When a margin call is generated, it is advisable to discuss the situation with your broker/trading advisor. From a regulatory standpoint, margin calls must be discussed with the client and met as soon as possible. Generally, clients are given a reasonable time to meet a margin call, depending on the amount of money involved and the nature of the situation. Brokerage firms have the right and the obligation to ensure the financial integrity of the mar- ketplace and, therefore, may liquidate your positions to ensure that your ac- count is restored to the proper margin requirements. Thus, it is important to stay in tune with the markets and in touch with your broker when you are holding positions. There are two other ways to meet a margin call: (1) You may liquidate the position at a loss or (2) the market may make a reversal, trading back in your favor and taking you off margin call status. The open trade equity in your account is credited or debited each day as the settlement price fluctuates. This futures industry practice is called marked to market. Traders often do not regard a setback as a loss until they are out of the market, and they are only looking at a so-called paper profit until they close out a winning position. It is a good idea to have excess cap- ital in your account beyond what is required. I recommend having at least 50 percent more than the initial margin requirement for each position you plan to take as a longer-term trade. For day traders, maintenance margin is sufficient. Futures contracts often involve large quantities of product with a frac- tion of the total contract value needed as a good-faith deposit. Not many peo- ple have $200,000 in cash to purchase a home, so they apply for a mortgage and put 3 percent to maybe 20 percent down. But buying a home and trading futures aren’t the same because of the leverage factor, and that is why op- tions have become extremely popular since the early 1990s. Contract Specifications 13 Investors who buy options have a right, but not an obligation, to fulfill the terms of an options contract at a specific strike price. They can buy calls to take advantage of price increases or buy puts to take advantage of price decreases. The risk in buying options is limited to the initial premium paid to acquire the option plus the commission and transaction fees associated with the transaction; that means no margin calls in the event of a short-term adverse price move. Simply stated, option buyers can enjoy staying power and a predetermined risk level. However, buying options is limited to a certain time period, and if the market does not move enough in your direction in that prescribed period of time, your entire premium or investment will be lost. Chapter 13 is devoted to a comprehensive description of trading in op- tions and the logical approach for understanding the terms and uses of dif- ferent strategies. CONTRACT SPECIFICATIONS In addition to the margin/security deposit difference, futures contracts have several other features that make them different from equities, as Table 1.1 indicates. Futures come in different contract sizes and expire in specific months. Equities all are priced on a uniform per-share basis, and they do not expire (although a company may go out of business, which could cause your investment to “expire”). Stocks may also have splits and reverse splits, and some even pay dividends. With equities, you can maintain a long-term position indefinitely. With futures, you can also have a long-term position, but that will require that you roll over from one contract to the next, liquidating your holding in an ex- piring contract and establishing a new position in a contract month that is further away. Novice traders and even traders coming off an exchange floor to trade from a computer need to realize that different futures markets trade in dif- ferent contract months, at different times of the day, and at different ex- changes. In stocks, you have one symbol for Intel (INTC) or IBM (IBM) or every other individual stock. In futures, a June contract for Japanese yen is not the same as a September Japanese yen contract, for example, and they have different symbols. First, you need to know the symbol for the market you want to trade— CL for crude oil, for example. Most quote vendors use the same symbols as they are pretty much a universal language in the futures industry. However, some vendors use the symbol CC instead of CO for cocoa or SU instead of SB for sugar. The mini-sized Dow contract may be YJ, YM, ZJ, or some other 14 INTRODUCTION TO FUTURES AND OPTIONS: Understanding the Mechanics symbol specific to a data service or brokerage firm. Most applications have a menu of symbols so you can look up the quotes or charts you want. Second, you need to know the symbols for each month. This can be somewhat confusing, especially to newcomers. The list of symbols for each contract month is shown at the bottom of Table 1.1. Notice that March is the only month that even contains the month’s symbol, H, as a letter in the name of the contract month. The trickiness in properly identifying a fu- tures contract is one reason new traders find futures trading more compli- cated than equity trading. It can lead to a hazardous situation when you are rolling out of a con- tract that has been trading for a while and switching to a new one. For ex- ample, if you have been trading a June contract and have to shift to the September contract as the June contract expires, you may still be in the habit of using June. When placing orders, a slip in identifying a contract can create problems and cost you money. Placing an order for a June contract when you really mean to trade the September contract can easily happen in futures trading if you get careless. There is a window of time when the June contract will still be trading but not actively as most of the trading ac- tivity shifts into the next month. For commodities, that time period is be- tween the first notice day and the last trading day for a contract. Orders will still be accepted for the expiring month in that time frame, and it will be up to you to cover your error if your order gets you into the wrong contract month. (Note: The trading tactics section in Chapter 12 provides a tech- nique that some big traders and floor professionals use as first notice day approaches. It may benefit you to be aware of the first notice day trick.) Third, you may need to know the exchange where the contract you want is traded. Although a number of futures markets are traded on only one ex- change, some are traded at several exchanges. For example, if you want to trade hard red winter wheat, you have to specify the wheat contract traded at the Kansas City Board of Trade, not the wheat contracts traded in Chicago or Minneapolis. Fourth, you may need to be specific about the time of day you want to trade or the size of the contract you want to trade. Table 1.1 does not show all the symbols differentiating between the day session’s regular trading hours and the electronic or after-hours night sessions. Nor are the symbols given for most of the mini-sized electronic products traded at the Chicago Mercantile Exchange and the Chicago Board of Trade. ELECTRONIC ERA More than 70 percent of all futures markets now trade around the clock, in- cluding agricultural markets that once were traded only in the pits of an ex- Electronic Era 15 change during a relatively short daily session. Orders can be placed elec- tronically on most companies’ online trading platforms, although many firms do not accept open orders and contingency orders for some markets. Chap- ter 10 explains the order process and contingency orders. It is also advisable to check with your trading firm regularly regarding any changes in trading hours and to see which orders are acceptable. The electronic product that started it all for the futures industry came from the Chicago Mercantile Exchange, as you might expect, when it devel- oped Globex and launched trading in the e-mini S&P 500 and Nasdaq 100 index futures contracts. These contracts have been particularly attractive to former investors in the stock market and are now among the most actively traded futures contracts. The Chicago Board of Trade launched a mini-sized contract based on the Dow Jones Industrial Average in April 2002, and its popularity accelerated in 2003, reaching a daily volume of more than 60,000 contracts a year later. The contract has several key features that make it an attractive trading vehicle: A 100 percent electronic market with 24-hour access. Lower margin than other stock index futures in dollars and as a per- centage of contract value ($2,700 versus $3,563 for the e-mini S&P in the middle of 2003). Simpler calculating and tracking components as the Dow only has 30 underlying stocks to monitor. For those with blue-chip stock portfolios, easier hedging by being able to go short the Dow as easily as going long. Dow futures correlate closely with the underlying Dow Jones Industrial Average. More spreading opportunities because the mini-sized Dow can be traded against individual single stock futures, Diamonds or S&P 500, Nasdaq 100, or other index futures. Smaller minimum price fluctuations. Each point or tick in the mini-sized Dow is $5. Each point in the e-mini S&P is $50, with the minimum tick size a quarter of a point or $12.50. The two contracts trade in about a 10-to-1 relationship—a 10-point move in the e-mini S&P and a 100-point move in the mini-sized Dow are each worth $500. A move of that size would equate to an 18.52 percent gain for the mini-sized Dow versus a 14 percent gain for the e-mini S&P, using the margin amounts previously mentioned. Perhaps the biggest attraction of the mini-sized Dow is that it is based on the best-known U.S. stock market barometer, which is more than a cen- tury old and recognized around the world. When you ask how the stock mar- ket did today, most people think of the Dow. 16 INTRODUCTION TO FUTURES AND OPTIONS: Understanding the Mechanics INVESTMENT REVOLUTION? Next to the electronically traded stock index contracts, probably the most exciting new futures market area is single stock futures (SSF). SSFs were launched on two new U.S. exchanges on November 8, 2002, after a two- decade moratorium on that type of contract. They had been trading on for- eign exchanges with moderate success for some time but had been banned in the United States by an agreement that allowed trading to begin in stock index futures in 1982. The realization that the United States might lose out on market share to foreign competitors in a potential major new market was high on the list of factors that prompted politicians and regulators at the Securities and Exchange Commission and Commodity Futures Trading Commission to finally resolve jurisdictional issues to allow trading in SSFs. SSFs are an innovative product and could change the way the world in- vests on Wall Street in the future. Investors who have limited their invest- ments to the stock market especially may benefit from this new market. Imagine having the leverage to trade 100 shares of a popular stock for only a 20 percent margin requirement and not having to pay a stock firm the bro- ker loan rate to sell a stock short (if they can loan it to you at all). Assume, for example, that Microsoft is priced at $25 per share. The futures contract size is 100 shares so the contract value is $2,500. With an initial margin re- quirement of 20 percent of the value of the contract, you have to put up only $500 to either buy or sell Microsoft futures instead of $1,250 it would take to buy 100 shares of Microsoft shares at the minimum margin rate in the stock market. With SSFs you can open a futures trading account, buy a cash Treasury bill, and trade a broad range of markets beyond SSFs while earning interest instead of paying interest. The best part is being able to go long or short with- out prejudice and having access to the market by trading from your com- puter at home or work. These developments may not make broker-dealers happy but are good news for individual traders. BULL MARKET FOR FUTURES These stock-related trading vehicles reinforce my optimism about the pop- ularity of futures trading, not only in the United States but also around the globe as people attempt to increase their wealth and raise their standard of living. I believe the explosive growth in futures has come out of the dismal losses many investors suffered during the great bear market in equities since the peak in 2000. Investors are now becoming more educated and open to other opportu- nities rather than limiting themselves to recommendations from their stock- Bull Market for Futures 17 broker or investment advisor. The story earlier in this chapter about the gentleman who never traded futures because his stockbroker said he would lose his shirt is a testimonial to the fact that more and more investors— most likely, people just like you—want to learn more. Here is another example. I gave a seminar presentation in August 2002 to the Chicago chapter of the Cornerstone Investors Group, speaking to about 70 people. I asked how many folks in the audience were trading fu- tures. I believe about three people raised their hands, and I think two were clients of mine. The president of the group, Mark Anderson, invited me back in April 2003, reminding me that I said to his group in 2002, “If the balance of you are not trading futures, then you will be sooner or later.” Just eight months after that 2002 seminar, I asked the same question at the April seminar, which had about 85 people. First, the investment club membership had grown and, second, it seemed like almost everyone raised their hands. I was shocked! What happened here? Well, this investor group had started to learn and discovered the benefits of trading futures and how to apply technical analy- sis to the markets. They were taking control of their own financial destiny. A whole lot of people are now interested in the futures markets and not just from the town of Schaumburg, Illinois, or in Tampa Bay, Florida, where the Cornerstone group was founded. The reach of traders wanting to learn this form of derivative trading stretches to Ireland, England, Europe, Asia, Australia—worldwide. I hope this book helps to keep you focused and fi- nancially prepared for the years ahead and helps you with the process of continually learning the ebb and flow of the markets. CHAPTER 2 Fundamentals The Market Driver Everyone needs constant education and training. The more you keep yourself informed, the better honed your instincts and decision-making capabilities. —Linda Conway T he term fundamental analysis refers to the study of tangible infor- mation about a market such as supply and demand statistics and ex- pectations about what these numbers might be. Markets are a two-way street: Supply and demand are key factors in determining price, and price often is a factor in supply and demand. Supply and demand comes from the perceived value that is placed on a stock, commodity, or any derivative product. In its simplest definition, sup- ply is the amount of a given stock, product, or commodity that is available to the market, either in excess or limited at a given price depending on the number of sellers. Price establishes a resistance level when the supply of a particular product or stock is adequately provided. Demand, the amount of buying or lack of buying, plays an integral role in establishing how high or low prices can go and is generated by buyers. Demand establishes a support level for prices. Numerous events directly affect the outcome of both supply and de- mand, but some are more critical than others. For example, for agriculture products from grains to livestock, weather is a crucial element in determin- ing supply. In the event of a drought, grain production could be in short supply and livestock could suffer weight loss or be forced to market in large numbers if it appears scarce feed may become too expensive. In harsh 19 20 FUNDAMENTALS: The Market Driver winters, grain movement could be slowed and livestock could perish, re- sulting in supply disruptions that could cause prices to go higher in a steady or rising demand environment. THE FED FACTOR In the financial arena, when the Federal Reserve lowers short-term interest rates, economic activity theoretically accelerates due to an increase in com- merce as a direct result of the cost of doing business becoming less expen- sive. However, events do not always unfold as theory suggests. The Federal Reserve began an aggressive campaign to lower interest rates to kick start the U.S. economy in 2001. It cut short-term rates 13 times, 11 of those cuts amounting to 4.75 percentage points coming during 2001, a difficult period for the U.S. economy. Then in November 2002 the Fed cut rates another 50 basis points in what it called a “preventive” action against possible economic weakness as the United States was preparing to attack Iraq to combat global terrorism and oust Saddam Hussein and his weapons of mass destruction. The invasion was a quick one—I think the UN Security Council meeting debates took longer than the actual military operation. However, U.S. economic growth still did not accelerate as expected, so on May 6, 2003, the Fed slashed rates for the 13th time. That 25-point cut dropped the Fed funds rate to 1 percent, and Federal Reserve Chairman Alan Greenspan even mentioned combating potential deflation as a reason for making this move! The whole investment world did an about-face. Most people thought the Fed was getting closer to actually raising interest rates rather than low- ering them, and there was speculation that the Fed would take other uncon- ventional means such as buying back 10-year and 30-year bonds to lower rates for longer-term maturities. Mortgage rates fell to the lowest level in nearly 50 years. The market’s focus shifted to watching the Producer Price Index, the Consumer Price Index, and employment plus any other reports that would hint at a stronger manufacturing sector as well as any that would indicate a decrease in the jobless rate. These were some unconventional responses to some unconventional moves, but the key point is that it is important to grasp the significance of the underlying economic fundamentals and the implications they might have for any market you are trading. Interest rates control the cost of money. Those who can foretell what money will cost to lend or borrow have the upper hand in the investment community. Rates dictate many other factors, especially because they are one of the variables in calculations to determine fair-market values from stock index futures to the broker loan rates for stock traders. It isn’t just Reports, Reports 21 mortgage companies that have to guard against changes in interest rates, but a broad range of businesses have to consider interest rate levels in their plans. REPORTS, REPORTS One of the advantages of trading futures is that the government releases dozens of reports every week, and the media provides additional material that offers insights into what might lie ahead for market prices. Determining the direction of the economy from reading economic reports is vital for un- derstanding the potential for the direction of interest rates as well as gaug- ing the health of the various sectors of the economy. For example, government reports such as those on employment may reveal what the potential for future household disposable income is and give analysts and economists an idea of how much spending could occur based on the number of Americans working. News articles give you the ability to follow and understand the political scene, both on international and domes- tic levels. If Congress passes a bill to donate more wheat than expected, then this action may have a more bullish impact on the price of wheat futures. Or if Congress passes laws to change the tax rate on capital gains, you might be able to speculate on what the stock market or other financial markets may do. If the European Central Bank announces a lower than expected interest rate adjustment, it is likely to affect the value of the euro and, inversely, the U.S. dollar. If values of these currencies shift abruptly and to a severe degree, then, of course, products that are imported and exported would be priced differently and, ultimately, could cause a ripple effect on costs and prices of goods and services in the United States and overseas. One reason you want to be educated and up-to-date on developments in the economy is because they usually dictate how different financial prod- ucts and futures prices will perform. The stock market likes to see healthy economic growth because that usually equates to better or substantially larger corporate profits. The bond market prefers a slower, more sustainable growth rate that will not lead to inflationary pressures. By watching and tracking economic data and getting insights from analysts and economists, investors will be better able to keep in tune with the markets and their investments. In fact, you should be aware of what could happen before most reports are released. That is why news services often give the schedule for current events and special reports. Publications such as Barron’s, Investors Busi- ness Daily, or the Wall Street Journal will often give you a consensus of analysts’ opinions on what to expect and show you what you need to know 22 FUNDAMENTALS: The Market Driver to stay in tune with the markets. Most futures brokerage firms also provide special calendars that include the dates and times that most major economic and agricultural reports are released. Trading is not an easy venture, and one helpful bit of advice I would emphasize is that you should always be aware of the day’s current events and scheduled reports if you are in the markets. Not knowing what day or time a report is released could be hazardous to your financial health. Know- ing about a major report before it is released is often useful because you have a chance to eliminate a surprise from an adverse market move. Even if you are not a fundamental trader, you should, at the very least, be aware of the main fundamental factors that might affect the markets you are trad- ing and the impact reports and events may have on the market. WHAT TO WATCH, WHAT IT MEANS Here are some of the economic terms, events, and reports that U.S. traders should know and watch, including a brief explanation of why they are im- portant to investors. If you did not pay attention in your economics classes, this section will bring you up to speed. Federal Open Market Committee (FOMC) Meetings and Policy Announcements The FOMC consists of seven governors of the Federal Reserve Board and five Federal Reserve Bank presidents. The FOMC meets eight times a year—roughly every six weeks—to determine the near-term direction of monetary policy. Whether there is a change in rates or not, the FOMC announces its decision immediately after FOMC meetings. A few accompanying statements the Fed may make after announcing any adjustments in interest rates may have as much influence on markets as a change or no change in rates themselves. For example, the FOMC may take a “neutral” stance on the outlook for the economy. Or it may point to prospects for growth or suggest the potential for economic weakness or in- flationary pressures. The FOMC actions or comments can have a powerful impact on markets. Treasury Bonds, Bills, and Notes The U.S. government issues sev- eral different kinds of bonds through the Bureau of the Public Debt, an agency of the U.S. Department of the Treasury. Treasury debt securities are classified according to their maturities: Treasury bills have maturities of 1 year or less. Treasury notes have maturities of 2 to 10 years. Treasury bonds have maturities of more than 10 years. What to Watch, What It Means 23 Treasury bonds, bills, and notes are all issued in face values of $1,000, though there are different purchase minimums for each type of security. Interest Rates, Financial Markets and Bonds U.S. Treasury bonds, by virtually any definition, are simply a loan. The U.S. government borrows the funds it needs to operate, including financing the federal deficit. Ultimately, taxpayers will have to pay back the loan. When a bond is issued, the price you pay is known as its face value. Once you buy it, the government promises to pay you back on a specific day known as the maturity date. It issues that instrument at a predetermined rate of interest, called the coupon. For instance, if you buy a bond with a $1,000 face value, a 6 percent coupon, and a 10-year maturity, you would collect interest payments totaling $60 in each of those 10 years. When the decade is up, you get back your $1,000. If you buy a U.S. Treasury bond and hold it until maturity, you will know exactly how much you’re going to get back. That’s why bonds are also known as fixed-income investments—they guarantee you a continuous set income backed by the U.S. government. What confuses most investors in bonds is the concept of yield and price. Simply stated, when yield goes up, price goes down, and vice versa. Government Reports Beige Book A combination of economic conditions from each of the 12 Federal Reserve regional districts, the Beige Book is aptly named because of the color of its cover (really). This report is usually released two weeks before the monetary policy meetings of the FOMC. The information on eco- nomic conditions is then used by the FOMC to set interest rate policy. If the Beige Book portrays an overheating economy or inflationary pressures, the Fed may be more inclined to raise interest rates to moderate the economic pace. Conversely, if the Beige Book portrays economic difficulties or reces- sion conditions, the Fed may see a need to lower interest rates to stimulate activity. Gross Domestic Product (GDP) GDP is the broadest measure of ag- gregate economic activity and accounts for almost every sector of the econ- omy. Analysts use this figure to track the economy’s overall performance because it usually indicates how strong or weak the economy is and helps to predict the potential profit margin for companies. It also helps analysts determine whether economic growth is accelerating or slowing down. The stock market likes to see healthy economic growth because that translates to higher corporate profits and higher share values. 24 FUNDAMENTALS: The Market Driver International Trade and Current Account Figures These num- bers measure the difference between imports and exports of both goods and services. Changes in the level of imports and exports are an important tool for gauging economic trends, both domestically and overseas. These reports can have a profound effect on the value of the dollar. That value, in turn, can help or hurt multinational corporations whose profits overseas can diminish when they convert their funds back to the United States, es- pecially if the U.S. dollar is overvalued. Another valuable aspect of such re- ports is that imports can help to indicate U.S. demand for foreign goods, and exports may show demand for U.S. goods in overseas countries. Index of Leading Economic Indicators (LEI) This report is a com- posite index of 10 economic indicators that typically lead overall economic activity. The LEI index helps to predict the health of the economy and may be an early clue about the prospects for recession or economic expansion. Consumer Price Index (CPI) The CPI measures the average price level of goods and services purchased by consumers and is the most widely fol- lowed indicator of inflation in the United States. Monthly changes represent the inflation rate that is quoted widely and influences a number of markets. Inflation is a general increase in the price of goods and services. The re- lationship between inflation and interest rates is the key to understanding how data such as the CPI influence the markets. Higher energy prices, man- ufacturing cost increases, medical costs, imbalances in global supply and demand of raw materials, and prices of food products all weigh on this re- port. For example, if gas prices at the pump escalate and the cost to fill up your car rises from, say, $30 a week to $50 or even $60 a week, you will have less spending money for other items. It may not affect you immediately, but a longer duration of higher prices will hit your pocketbook. Even weather can be a factor for short-term changes in food prices. What would be the cost of tomatoes at the grocery store after a damaging freeze in California or in Georgia? Maybe $3 or $4 per pound? Any grocery shopper can probably recall when such price spikes occurred. The restaurants that serve salads lose revenue as well as the farmer whose crop is destroyed. These factors all play a part in the CPI number. The core rate is the in- flation number that excludes the volatile food and energy components. Econ- omists track these numbers; you should, too. Producer Price Index (PPI) Formerly known as the Wholesale Price Index, the PPI is a measure of the average prices for a fixed basket of cap- ital and consumer goods paid by producers. The PPI measures price changes in the manufacturing sector. The inflation rate may depend on a general in- crease in the prices of goods and services. What to Watch, What It Means 25 Institute of Supply Management (ISM) Index Formerly known as the National Association of Purchasing Managers (NAPM) survey, the ISM report provides a composite diffusion index of national manufacturing con- ditions. Readings above 50 percent indicate an expanding factory sector, readings below 50 percent, a contracting sector. The ISM Index helps econ- omists and analysts get a detailed look at the manufacturing sector of the economy, a major source of economic strength that can have a bearing on the nation’s employment situation, a key to economic health. Durable Goods Orders This report (Manufacturers’ Shipments, In- ventories, and Orders) reflects new orders placed with domestic manufac- turers for immediate and future delivery of factory-made products. Orders for durable goods show how busy factories will be in the months to come as manufacturers work to fill those orders. The data not only provide insight into demand for things like washers, dryers, and cars but also take the tem- perature of the strength of the economy going forward. Industrial Production and Capacity Utilization These rates mea- sure the physical output of the nation’s factories, mines, and utilities and re- flect the usage level of available resources. Because the manufacturing sector accounts for an estimated one-quarter of the economy, these reports can sometimes have a big impact on stock and financial market movement. The capacity utilization rate provides an estimate of how much factory ca- pacity is in use. If the utilization rate gets too high (above 85 percent), it can lead to inflationary pressures. Factory Orders The dollar level of new orders for manufacturing durable and nondurable goods shows the potential for factories to increase or decrease activity based on the amount of orders they receive. This report provides insight into the demand for not only hard goods such as refrigera- tors and cars, but also nondurable items such as cigarettes and apparel. Business Inventories Fed Chairman Alan Greenspan is said to be among those who watch the report of business inventories, so you should become familiar with it as well. This report shows the dollar amount of in- ventories held by manufacturers, wholesalers, and retailers. The level of in- ventories in relation to sales is an important indicator for the future direction of factory production. Consumer Confidence If there is one area that has been watched most carefully in recent years, it is consumer sentiment. Several surveys or polls gauge consumer attitudes. Among the best known are those conducted by The Conference Board and the University of Michigan. These surveys 26 FUNDAMENTALS: The Market Driver reveal what consumers think about present conditions as well as what their expectations are for future economic conditions. The level of consumer confidence is generally assumed to be directly re- lated to the strength or weakness for consumer spending, which accounts for two-thirds of the U.S. economy. Generally speaking, the more confident con- sumers are about their own personal finances, the more likely they are to spend. If they have money in the bank and feel confident that their job is se- cure, buying an extra gadget or splurging on a night out usually won’t be any trouble. In contrast, if times are tough, then the purse strings get pulled in. These indications from one month to the next give analysts an idea of the potential for shifts in future spending habits that can help or hurt develop- ments in the economy from durable goods sales to home or car purchases. Employment Situation The key to consumer confidence often depends on the status of jobs. The monthly unemployment rate measures the num- ber of unemployed as a percentage of the nation’s workforce. Non-farm- payroll employment tallies the number of paid employees working part-time and or full-time in the nation’s business and government sectors. Several important components are included in this report, one being the average hourly workweek that reflects the number of hours worked in the nonfarm sector. Another component is average hourly earnings, which shows the hourly rate employees are receiving. There are two portions of this report, one a weekly report released every Thursday morning and the other the more influential monthly figures that are usually released on the first Friday of every month. Employment Cost Index (ECI) The ECI provides a measure of total employee compensation costs, including wages and salaries as well as ben- efits. It is the broadest measure of labor costs and helps analysts determine trends in the cost that employers have from paying employees. This mea- sure can give economists a clue as to whether inflation is perking up from a cost of business standpoint. If a company needs to pay more to hire qual- ified workers, then the cost of doing business increases and profit margins are reduced. Companies usually have to raise their prices to consumers as their costs increase. That is when the inflation theme starts to play out. Productivity and Costs Productivity measures the growth of labor efficiency in producing the economy’s goods and services. Unit labor costs reflect the labor costs of producing each unit of output. Both are followed as indicators of future inflationary trends. Productivity growth is critical be- cause it allows for higher wages and faster economic growth without infla- tionary consequences. What to Watch, What It Means 27 Personal Income and Spending Personal income is the estimated dollar amount of income received by Americans. Personal spending is the estimated dollar amount that consumers use for purchases of durable and nondurable goods and services. This economic number is important be- cause if consumers are spending more than they make, the spending will stop eventually, thus causing a downturn in the economy. Another aspect to consider is that consumers who save may be investing in the markets, and that activity can increase the value of stock prices. In addition, it can also add liquidity to the banking system if the money goes to savings or money market accounts. Retail Sales Retail sales numbers measure the total sales at stores that sell durable and nondurable goods. These figures can reveal the spending habits of consumers, and the trend of those spending sprees, more often than not, can influence analysts’ expectations for future developments in the economy. Housing Starts This report measures the number of residential units that are about to be constructed, a backbone of the American economy. When you purchase a new home, you are giving a boost to not only the raw material suppliers, builders, and their industries, but also to the producers of durable goods items such as refrigerators, washers, dryers, furniture, lawn care products, and many other items related to making a home. This is known as a ripple effect throughout the economy. Think of all the jobs pro- duced from construction to factory and transportation and even communi- cation and technology that go into the building, financing, and furnishing a new home. The economic impact is substantial, especially when there are a hun- dred thousand or more homes built in a month around the country. At the very least, the data from housing starts can help project the price direction for the sector of stocks involving home builders, mortgage bankers, and ap- pliance companies. Lumber and copper futures prices used to be dramati- cally affected by the housing starts figure. However, since the development of prefab and new construction materials, especially fiber optics and plastics (PVC, polyvinyl chloride, used for plumbing rather than copper), these prod- ucts are now less sensitive to building industry trends. New Home Sales Like housing starts, the level of new home sales (committed sales) indicates housing market trends. This information pro- vides another gauge for not only the demand for housing but also economic momentum. People have to be feeling pretty comfortable and confident in their own financial position to buy a home. Furthermore, as previously 28 FUNDAMENTALS: The Market Driver mentioned, this narrow piece of data has a powerful multiplier effect throughout the economy and, therefore, across markets where you may have your investments. Existing Home Sales Existing home sales (the number of previously constructed homes with a closed sale during the month, also known as home resales) are a larger share of the market than new home sales and provide another indication of housing market trends. This statistic also provides clues to the demand for housing and for economic momentum based on the ripple effect. Mortgage Bankers Association Purchase Applications Index This weekly index of purchase applications at mortgage lenders is a good leading indicator for single family home sales and housing construction and is an- other gauge of housing demand and the resulting economic momentum. Construction Spending This report goes beyond housing to show an- alysts the amount of new construction activity on residential and nonresi- dential building jobs. Commodities such as lumber are sensitive to housing industry trends. In addition, business owners usually will put money into the construction of a new facility or factory if they feel confident that business is good enough to validate an expansion. Consumer Credit One of the American consumers’ pastimes is to say “Charge it” to purchase goods and services on their credit cards. Overall changes in consumer credit can indicate the condition of individual con- sumer finances. On the one hand, economic activity is stimulated when con- sumers borrow within their means to buy cars and other major purchases. On the other hand, if consumers pile up too much debt relative to their income levels, they may have to stop spending on new goods and services just to pay off old debts. That stoppage could put a big dent in future economic growth. The demand for credit can also have a direct effect on interest rates. If the demand to borrow money exceeds the supply of willing lenders, inter- est rates rise. If credit demand falls and many willing lenders are fighting for customers, they may offer lower interest rates to attract business. Other Reports and Information The government isn’t the only source of information vital to the markets, of course. Private research reports, company reports, and even anecdotal ev- idence gleaned from the news or from your neighborhood may provide clues about the future of the economy and market prices. What to Watch, What It Means 29 For example, you may be able to take the temperature of the economy by watching travel reports. Are people going on vacations? Are they taking two weeks or just three days? Staying close to home or going to exotic places? Listening to your friends talking about their vacations and watching airline traffic statistics may give you clues about travel that may be a good guide for what’s happening to the economy that, in turn, may have a bearing on what you are trading. In good times people tend to spend bigger money on a vacation, where the number one activity is shopping, according to Travel magazine. Lots of consumer spending says a lot about the vibrancy of the economy and supports higher stock market prices. If you trade energy, more travel means airline fuel consumption goes up, and that may trigger an increase in energy prices. Statistics and reports from a number of private sources can back up or refute your observations. Reports from weather services may keep you ahead of the crowd on crop developments or prospects for heating oil. The National Oilseed Processors Association releases reports about the soybean “crush” that can help you analyze the outlook for not only soybeans but the feed component for livestock markets as well. The American Petroleum In- stitute releases weekly statistics on energy production and stocks. There are many other similar sources of information, not to mention the dozens of specialty newsletters providing information, insights, and advice on every market. Then, of course, there are the earnings reports and other information released by thousands of public companies that drive the prices of individ- ual stocks. Because there are many more equity traders in the investment world than there are futures traders, you may be more familiar with these reports. If the equity markets generate normal or even subnormal returns based on a historical standard as some forecast for the next few years, then the appetite for making money may attract individual investors to move into futures products because of the leverage available in futures and op- tions. And many futures traders will have to become more familiar with what affects the prices of stocks as new demands and needs for products that combine features of stocks and futures are introduced. Futures and options activity will continue to expand and change as both types of traders come to markets such as the popular e-mini S&P 500 index futures, which went from a daily volume of around 300,000 contracts in February 2002 to as many as 1,000,000 contracts a day within a matter of months. Those numbers offer proof that stock investors are flooding into the futures markets. The debut of single stock futures in November 2002 gave individual investors the unique opportunity to trade individual stocks with the features and benefits of the futures markets and will send futures volume in stocks-related markets even higher. 30 FUNDAMENTALS: The Market Driver More participation from a wider variety of players may create more volatility, making it more important than ever to know what to look for in reports and how they may affect price behavior. When looking at company

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