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FUTURES BASICS COLLECTION

The futures advantage


by Active Trader Staff (Active Trader, October 2002).

Market mechanics
by Active Trader Staff (Active Trader, November 2002).

Flavors of futures: Using the right price data


by Active Trader Staff (Active Trader, January 2004).

10

Rolling over
by Active Trader Staff (Active Trader, May 2003).

13

Open interest
by Kira McCaffrey Brecht (Active Trader, February 2003).

16

Overnight futures trading


Kira McCaffrey Brecht (Active Trader, February 2004).

18

Understanding futures margin


by Kira McCaffrey Brecht (Active Trader, January 2003).

20

All traders, big and small: The Commitment of Traders report


by Kira McCaffrey Brecht (Active Trader, March 2003).

22

Commodity indices
by Active Trader Staff (Active Trader, May 2006).

24

&

FUTURES

OPTIONS

Basics

The FUTURES advantage


Experienced market participants know that futures offer
unique short-term trading benefits. For those unfamiliar
with futures, Part I of our two-part guide explains basic
principles, highlights key trading concepts and helps
minimize the risks of trading in this arena.

BY ACTIVE TRADER STAFF

n a bear stock market, traders are


often hard-pressed to find quality
trading opportunities, especially
if they are uncomfortable operating from the short side of the market.
Sometimes, looking outside equities into
arenas such as futures can present fresh
trading possibilities. Even in bullish
stock market conditions, there has
always been that dedicated group of
traders that prefers futures over stocks,
for a number of reasons.
Unfortunately, to some long-time
stock traders, futures are intimidating
trading instruments. In reality, though,
theres essentially no difference between
stock and futures from a strategic perspective. For the most part, the same
approaches used to exploit short-term
trading opportunities in stocks can be
applied to futures, and vice versa.
However, futures have characteristics
that make trading them slightly different
from trading stocks: In addition to low
margin requirements and some unique
terminology, futures are contracts,
which, like option contracts, have a limited life span.

Stock equity vs. futures contracts


When you buy a stock, you purchase a
slice of that company and become an
equity shareholder. You benefit from
the companys profitability through an
increase in share value, dividend distribution, or both. But for the most part, the
2

bottom line is that if the price of your


stock goes up, you make money; if it
goes down, you lose money.
Futures are no different. If youre long a
futures contract and the price goes up, you
make money; if not, you lose money. If
youre short and the price goes down, you
profit; if it rallies, you dont. Stocks and
futures are traded much the same way, on
exchanges (either trading floors or electronic exchanges) that, in the U.S., are regulated by the federal government. You can
open an account with a registered broker
and buy and sell futures. The distinguishing characteristic of futures is that they are
contracts they do not represent equity
ownership, as do stocks.
When you trade futures, you are not
trading an actual commodity or financial
instrument crude oil, Japanese yen,
soybeans, T-notes, the S&P 500 index or
whatever the case may be youre only
entering into a contract to buy or sell
these instruments at a predetermined
point in the future. The relationship
between futures contracts and their
underlying markets is discussed in the
next section.

A contractual agreement
If you go long December 2002 crude oil
futures at 26.20, you havent purchased
crude oil youve entered into a contract to buy crude oil at that price in
December 2002. You will be obligated to
honor this contract and take delivery
of the physical crude oil unless you sell
your futures contract to someone else
before the end of the exchange-designated delivery period for the December
2002 crude oil contract.
If your crude oil futures rally to 27.65

and you sell your contracts by the


appropriate time, you will make a profit
of 1.45, which, because each point in
crude oil futures is worth $1,000, comes
out to $1,450 per contract.
Similarly, if you had gone short
December crude oil futures and had
failed to offset (in this case, buy back)
your position by the delivery period, you
would be obligated to sell crude oil
(make delivery) at 26.20 in December. If
you bought back your contracts at 27.65,
you would have lost $1,450 per contract.
Futures exchanges dictate the conditions by which physical commodities are
exchanged as the result of a futures trade.
These rules are part of the contract specifications of each futures contract. Table 1
shows the contract specifications for the
S&P 500 E-Mini futures traded at the
Chicago Mercantile Exchange (CME).
Futures market groups lists the different kinds of futures and the (domestic)
futures exchanges at which theyre traded.

Delivery vs. cash settled


Many futures contracts (mostly those on
physical commodities such as crude oil,
gold, soybeans, coffee, corn and so on)
are deliverable that is, they can be
exchanged at the designated time for the
physical commodity underlying the contract.
Cash-settled futures, such as the S&P
500 index and S&P 500 E-Mini contracts,
are not deliverable; they cannot be
exchanged for a physical commodity.
Cash settlement involves marking-tomarket all open positions when a futures
contract expires and debiting or crediting
the difference between the futures con-

www.activetradermag.com October 2002 ACTIVE TRADER

FUTURES TERMINOLOGY
Back month(s): The contract months that follow the current
front month. Sometimes back month is used specifically to
identify the contract immediately following the front-month
contract. For example, in October, the current front month
in the S&P futures is the December contract, because it is
nearest to expiration. The next month in the series, March
(of the following calendar year), is the back month.
Basis: The price difference between a futures contract and
its underlying market (i.e., S&P 500 futures and the S&P 500
cash index). The basis is sometimes referred to as premium or discount, depending on whether the futures are
trading above or below the cash market. For example, if the
S&P 500 index is at 975 and the futures are trading at 977,
the futures are trading at a 2-point premium to the cash
index; if the futures are trading at 973, they are at a 2-point
discount to the cash index.
Carrying costs (or cost of carry): The cost of storing a
physical commodity such as corn, oil or coffee over a period
of time. Carrying costs include insurance and interest. These
costs are reflected in the price of a futures contract.
Cash market: The market for immediate delivery and payment for commodities, also referred to as the spot market. The index upon which an index futures contract is based
is also often referred to as cash.
Cash-settled: A futures contract that is not deliverable.
Instead, it is marked-to-market at expiration on a cash
basis, and the difference between the contract price and
the settlement price is credited or debited to the traders
account.
Commodity Futures Trading Commission (CFTC):
Established in 1975, the CFTC regulates all futures and
futures options trading in the U.S.
Contract: The unit of trading in the futures market. The
contract size represents either the amount of the underlying
physical commodity being traded or the nominal cash value
of a cash-settled contract. For example, one corn contract
on the Chicago Board of Trade represents 5,000 bushels,
while one S&P 500 index contract at the Chicago Mercantile
Exchange is measured as $250 times the index. The terms of
futures contracts are determined by each exchange and are
called the contract specifications.
Contract months: The designated months a given futures
contract is traded in. Many financial futures, including stock
index futures, trade in the quarterly cycle March, June,
September, December. When one month expires, trading
switches to the next month in the cycle.
Daily price limit (or daily limit): How far prices can move
above or below the previous days closing price in the following trading session before trading in that contract is halted.

ACTIVE TRADER October 2002 www.activetradermag.com

Deliverable: A futures contract that can result in the


exchange of a physical commodity, such as crude oil, gold,
T-bonds and various grain contracts.
Delivery: The process of exchanging a physical commodity
(and making and taking payment) as a result of the execution of a futures contract. Although 98 percent of all futures
contracts are not delivered, there are market participants
who do take delivery of physically settled contracts such as
wheat, crude oil and T-notes. Commodities generally are
delivered to a designated warehouse; T-note delivery is
taken by a book-entry transfer of ownership, although no
certificates exchange hands.
Delivery period (delivery dates): The specific time period
during which a delivery can occur for a futures contract.
These dates vary from market to market and are determined
by the exchange. They typically fall during the month designated by a specific contract e.g., the delivery period for
December T-notes will be a specific period in December.
Expiration: The final day of trading for a futures contract.
Expiration days vary from market to market.
Front month: The contract month nearest to expiration. On
Aug. 1, the September S&P futures contract is the front
month and the next contract in the S&P series, December, is
the back month. In most cases, but not all, volume is concentrated in the front-month contract.
Futures Clearing Merchant (FCM): A firm or person engaged
in soliciting, accepting and placing futures orders, and managing accounts for individuals as well as institutional
investors i.e., a futures broker. Many FCMs are well-known
companies such as Merrill Lynch and Goldman Sachs.
National Futures Association (NFA): The NFA, which began
operations in 1982, is a self-regulatory organization for the
U.S. futures industry designed to protect investors in the
futures markets. Firms and individuals who trade futures on
behalf of the public must become members of the NFA.
Rollover: The process of one futures contract month expiring
and the next futures contract month becoming the new front
month. Traders who have open positions in the expiring contract month must roll their positions forward to the next
contract month by liquidating the existing position and reestablishing it in the new contract. For example, a trader long
September S&P futures who wants to maintain his position
after the September contract expires must sell his September
futures by Sept. 20 (the expiration day for the September
contract) and go long the December 2002 contract.
Tick: The minimum price fluctuation in a futures contract.
For example, a tick in the T-bond futures is 132 (each tick is
worth $31.25); a tick in crude oil futures is .01 ($10). In the
S&Ps, a tick is .10 ($25).

Quoting futures

futures ticker symbol designates the commodity or financial instrument being traded,
the contract month and year. Generally, every futures contract has a
one- or two-character symbol: For example, crude oil is CL, the Japanese
yen is JY and the S&P 500 is SP.
Futures trade in distinct contract
months and each month is designated by
a different letter, as shown below.
Month
January
February
March
April
May
June
July
August
September
October
November
December

Symbol
F
G
H
J
K
M
N
Q
U
V
X
Z

Also, because some futures contracts can trade several years into the
future, there may be a month for
which trading is taking place in more
than one year (e.g., both Dec. 2002
and Dec. 2003). Accordingly, the third
element of a futures ticker symbol is
the year. Sometimes the year is
expressed in two digits (03 designating 2003); sometimes it is shown as
a single digit (3).
For example, there are four distinct
S&P 500 futures contracts for a given
calendar
year:
March,
June,
September and December. These have
unique ticker symbols: The December
2002 contract is SPZ02 (or SPZ2), the
March 2003 contract is SPH03 (or
SPH3); the June 2003 contract is
SPM03 (or SPM3), the September 2003
S&P futures contract is SPU03 (or
SPU3), and so on.
The December 2002 Japanese yen
contract would be JYZ02 (or JYZ2);
January 2003 crude oil would be
CLF03 (or CLF3).

tract trade price and the settlement price


of the contract at expiration, which will
be the same as the cash price that day. For
example, if you bought a December 2002
S&P futures at 975.00, held the contract
until expiration, and the contract settled
at 995.00, your account would be credited the difference 20 points, or $5,000
($250 per point*20).
Contrary to myth (the trader who
was long wheat futures wakes up one
morning to find a truck dumping a
mountain of grain on his front lawn),
the vast majority of futures trades do
not involve making or taking delivery of
the underlying instruments especially for short-term traders. Those transactions that do typically involve large
commercial dealers and hedgers such as
grain merchants, oil refineries and so on.
Most trades especially shorter-term
ones are offset before delivery enters
the picture. Short-term futures traders,
like their stock counterparts, try to profit from the price fluctuations of futures
contracts. They are not interested in
owning or selling physical commodities.

Characteristics
of futures contracts
Like any other type of contract, including options, futures have finite life
spans. Unlike stocks, which represent
essentially the same asset (aside from
their values) month after month and
year after year, futures are traded in
series of contract months, each of which
is a unique asset.
For example, Oracle (ORCL) was
Oracle last year and presumably still will
be next year. By contrast, the crude oil
available for delivery next month is not
the same crude oil that will be available
for delivery eight months from now; last
seasons corn crop is not the same as this
seasons. For the same commodity, each
contract month is a specific asset with
different factors affecting its price.
The S&Ps, T-notes, foreign currencies
and many other financial futures trade
in contract months of March, June,
September and December, which is
referred to as the quarterly expiration
cycle. See Quoting futures, left, for
more information on futures contract
months and price-quoting conventions.
Contract size refers to the amount of
the underlying commodity represented
by a single futures contract. For example, corn, wheat and some other agricul-

tural commodities trade in contracts of


5,000 bushels. Crude oil trades in contracts of 1,000 barrels. To determine the
value of a futures contract based on a
physical commodity, simply multiply
the contract size by the current contract
price. With January crude oil futures
trading at 26.10, the value of one
December crude oil contract is $26,100
(26.10*1,000 barrels).
For some cash-settled futures, including stock index futures such as the S&P
500 futures, the contract size and value
(which is nominal) is calculated by multiplying the contract price by a dollar
figure. For example, the dollar multiplier for the S&P 500 futures contract is
$250. With the December S&P futures
trading at 975.00, the value of a single
contract is $243,750 (975*$250). If the
S&P E-mini futures, which are one-fifth
the size of the regular S&P contract,
were trading at 975, the contract value
would be $48,750 (975*50).

Benefits:
Flexibility and leverage
From a practical standpoint, the big differences between futures and stocks are
the absence of short-selling regulations
and lower margin requirements for
futures.
Futures can be sold short as easily as
they can be bought its not necessary
to wait for an uptick, as is the case when
short-selling stocks. This is a significant
advantage for short-term traders who
need to be able to operate on both sides
of the market. (Index-tracking stocks
such as SPY and QQQ, and options, provide similar benefits, as will be discussed in next months installment.)
The second advantage of futures
(although it has a downside, explained in
the following section) is their increased
leverage relative to stocks. Fifty percent
margin (2-to-1 buying power) is the maximum allowable leverage for an
overnight stock position (25 percent, or 4to-1 buying power, for pattern day
traders), but margin in the futures market varies from contract to contract and is
often less than 10 percent.
In early August, the required margin
(often referred to in the futures industry
as the performance bond or goodfaith deposit) for the S&P futures was
roughly 7 percent. This means that to
buy one S&P contract trading at 975.00
(with a value of $243,750) you would

www.activetradermag.com October 2002 ACTIVE TRADER

TABLE 1 CONTRACT SPECIFICATIONS


Exchanges determine the contract size, expiration date, delivery terms and
other contract details on the futures they trade. These contract specs are
for the S&P 500 E-Mini futures.
Ticker Symbol

ES

Contract Size

$50 times E-mini S&P 500 futures price

Price Limits

5%, 10%, 15% and 20%

Minimum Price
Fluctuation (Tick)

.25 index points = $12.50 per contract


(Futures calendar spreads:
.10 index points = $5 per contract)

Contract Months

March, June, Sept., Dec.

Regular Trading Hours


(Central Time)

Virtually 24 hours per day


(from 5:30 p.m. Sunday to 3:15 p.m. Friday)

Last Trading Day

Trading can occur up to 8:30 a.m. (CT)


on the third Friday of the contract month

Final Settlement Date

The third Friday of the contract month

Position Limits

Position limits work in conjunction with existing


S&P 500 position limits

Source: Chicago Mercantile Exchange (www.cme.com)

need approximately $17,000 in margin to


hold your position. Leveraging an
equivalent dollar amount of stock would
require $121,875 because of the 50-percent margin rate. This means that if the
market rallies, your percentage gain will
be much larger for your futures position
than the comparable stock position.

The risk of futures:


Leverage and liquidity
The leverage that makes large percentage gains possible in futures trading also
makes possible equally large percentage
losses. If your position moves against
you when you are trading on minimum
margin, you can lose more than your initial investment. This is why futures are
often believed to be exceptionally risky.
However, traders who take conservative risk control measures i.e., those
who place and adhere to stop orders that
keep losses small reduce the risk that
comes with increased leverage. For example, if youre trading the S&P futures and
your stop order is 4 points away from
your entry (with each point representing
$250), your dollar risk is $1,000 per contract. Barring excessive slippage or a
complete market meltdown, losing most
or all of your money is not likely to happen. How much of a percentage risk
$1,000 represents depends on how much

cash you have in your trading account. If


your current account equity is $50,000,
your risk on this trade is 2 percent.
Also, traders sometimes forget that no
one is forced to trade on minimum margin. Futures industry regulations and
exchange margin rates may make it possible for you to trade on minimum margin (exchanges set futures margin rates
and brokers can set higher, but not
lower, rates), but they do not require you
to do so. By trading with more money
than is minimally required, you automatically reduce the risk of disproportional losses.
Another consideration in the futures
markets is liquidity. The most popular
contracts are highly liquid and pose few
execution problems, except on occasion
for the largest traders or in fast-market
conditions. However, the lack of liquidity in less popular and new futures contracts can result in wide spreads and
greater slippage.
Finally, some traders think having to
deal with ongoing contract expirations
and rollovers (carrying over an open
futures position from one contract
month to the next) makes futures trading more cumbersome and costly than
stock trading. Next month, well examine this issue and other practical aspects
of trading futures.

ACTIVE TRADER October 2002 www.activetradermag.com

Futures market groups

utures contracts fall into several broadly defined groups.


Although futures were originally traded on agricultural products, financial futures now account
for the vast majority of futures trading volume. The contracts listed here
represent some of the higher-volume
instruments in the different groups,
but other contracts exist.
Financials
Stock indices: S&P 500 (and E-Mini);
S&P Midcap 400 (and E-Mini);
Nasdaq 100 (and E-mini); Dow Jones
Industrials (and mini-sized; CBOT);
Russell 2000 (and E-Mini); Nikkei
225; Fortune e-50.
Primary U.S. exchange: CME.
Interest rates: T-bonds; T-notes;
Fed Funds; Eurodollars; T-bills;
LIBOR.
Primary U.S. exchanges: CBOT and
CME.
Currencies: Eurocurrency; Japanese
yen; Swiss franc; British pound;
Australian dollar; Canadian dollar;
Mexican peso; Brazilian Real;
Russian Ruble; New Zealand dollar.
Primary U.S. exchange: CME.
Energy
Crude oil; heating oil; gasoline;
natural gas.
Primary U.S. exchange: NYMEX.
Metals
Gold; silver; platinum; copper;
palladium; aluminum.
Primary U.S. exchange: NYMEX.
Agricultural
Soybeans; soybean oil; soybean
meal; corn; wheat; rice; oats.
Primary U.S. exchange: CBOT.
Meats
Live cattle; feeder cattle; pork
bellies; lean hogs; pork cutouts.
Primary U.S. exchange: CME.
Food and Fiber
Coffee; sugar; cocoa; lumber (CME);
cotton; frozen concentrated orange
juice.
Primary U.S. exchange: NYBT.

&

FUTURES

Basics

OPTIONS

MARKET MECHANICS
If youve never traded futures, you need to familiarize
yourself with some of their unique properties.
Understanding the mechanics of futures contracts
will allow you to focus on strategy instead of things
like rollover and price limits.
BY ACTIVE TRADER STAFF

roper trading requires know- rollover, which was covered briefly in possible effects, these aspects of futures
ing how the markets youre last months article. Others include daily trading ultimately shouldnt be signifiin function. As The futures price limits and the risk of slippage in cantly more of a concern than stock
advantage (Active Trader, less popular markets. Although its nec- splits and dividends are for equity
October 2002, p. 72) explained, from a essary to understand and factor in their traders.
strategic standpoint where to
enter, where to take a profit,
FIGURE 1 OPEN INTEREST
where to take a loss trading
A longer-term chart of the December 2002 crude oil contracts shows volume (middle
futures is no different than tradpanel) ebbing and flowing and then gradually increasing in the latter half of 2002.
ing stocks. The same forces that
Open interest increased notably in the first quarter of 2002, as the market broke out
move stocks or any other market
of a trading range and rallied approximately 20 percent.
greed and fear, in reaction to
December 2002 Crude Oil (CLZ02), daily
various pieces of news
26.00
move futures markets.
However, last months article
also addressed the reality that
24.00
futures have two features that
result in minor but noticeable
22.00
differences in the mechanics of
trading futures compared to
stocks: 1) low margin (high
20.00
leverage); and 2) futures are
Volume
traded in individual contract
2,000
months with finite life spans
1,000
that represent unique assets.
Those unfamiliar with the
0
60,000
Open interest
kinds of traders who make up
40,000
the futures community and
how transactions are executed
20,000
should read, Futures market
0
10 17 26 31 7 14 22 28 4 11 19 25 4 11 18 25 1 8 15 22 29 6 13 20 28 3 10 17 24
players.
January 2002 February
March
April
May
June
The most important of
Source: QCharts (www.qcharts.com)
futures unique characteristics is

www.activetradermag.com November 2002 ACTIVE TRADER

Slippage
Slippage the difference between the priate exchange Web site.
open limit bid or offer and stay there the
price at which you get filled compared to
For example, the daily limit in soy- entire session, with the potential to repeat
the market price when you placed your bean futures is 50 cents. If soybeans the performance the next day. The trader
order is more of an issue in futures
trading than in typical stock trading.
Many futures contracts are thinly
FIGURE 2 COMMITMENT OF TRADERS REPORT
traded, especially compared to the
The COT report shows the trading activity of commercial traders in the futures
highly liquid stocks most individual
and futures options markets. Here, the statistics for the 10-year T-Note futures
equity traders follow. As a result, the
are shown.
difference between the bid-ask
spread can be significant in some
markets (and even some of the back
months of more liquid markets).
Traders who use limit orders to
enter trades will not be affected by
slippage (other than missing trades
entirely). However those who use
market orders and all traders who
use stop orders should be aware of
the potential of getting filled relatively far away from their desired price,
especially if the market is reacting to
an economic report such as unemployment. If the pit is overwhelmed
with orders, the exchange may determine fast market conditions exist.
In a fast market situation the market
becomes temporarily illiquid because
of a preponderance of either buyers
or sellers, resulting in quick, dramatic price shifts. Brokers are not held to
best execution rules during these
periods.
However, under normal conditions in most popular futures conSource: Commodity Futures Trading Commission (www.cftc.gov)
tracts, such as T-notes and bonds,
S&P 500 and S&P E-mini futures,
slippage is less of an issue. The type of today trade 50 cents above yesterdays caught on the wrong side of a locked limit
order you use, and how you enter it, can closing price, the market is said to be market can suffer huge losses.
also alleviate some of the impact of slip- limit bid, and no trades can occur
page. (See Giving orders, for more above that price for the remainder of the Open interest
information on order types.)
trading session. If the price falls 50 cents A volume-related statistic unique to
below yesterdays closing price, the mar- futures is called open interest, which is the
Daily limits
ket is limit offer and no more trades number of open positions in a particular
Daily limits are price levels established can occur below that price during the futures contract. It is an additional reflecby futures exchanges that dictate how far session. Trades can, however, be execut- tion of the depth and liquidity of a marprice can move from the previous closing ed at or below the limit bid price, and at ket. Although people sometimes refer to
price in the current trading session.
or above the limit offer price.
long or short open interest in futures,
Many futures contracts do not have
In extreme situations, futures markets because the number of longs must equal
daily limits. To find out if a particular can (and have, on more than one occa- the number of shorts, long open interest is
contract is subject to price limits, consult sion) become locked limit bid or offer the same as short open interest, which is
the contract specifications on the appro- for several days. A market can literally the same as total open interest.
ACTIVE TRADER November 2002 www.activetradermag.com

&

FUTURES

OPTIONS

Basics continued

Some traders monitor open interest to


gauge the level of interest in a market
and the strength of a price move. For
example, if open interest consistently
increases as a trend develops, this is seen
as evidence more traders are taking
longer-term positions in the market.
Figure 1 shows open interest and volume
in the December 2002 crude oil futures.

Commitment of Traders data


Another piece of data exclusive to
futures is the Commitment of Traders
(COT) report published by the Commodity Futures Trading Commission
(CFTC). The report shows the positions
of large commercial dealers and hedgers
in futures and futures option markets
(see Figure 2).
The COT report is the futures market

equivalent of services that monitor the


positions and trading activity of institutional traders in the stock market. For
traders, the goal of analyzing this data is
the same in stocks and futures: to find
out what large professional traders are
doing in the hope it will shed light on
future market direction. Just as a stock
trader wouldnt want to take a position
on the opposite side of a large mutual

Futures market players

o understand why futures margin is so low compared to


stocks, its necessary to discuss the origins of the
futures markets and the economic role they play.
The futures markets arose as a way of centralizing trading in
certain agricultural commodities (grains, etc.), the prices of
which tended to fluctuate wildly without a way for market participants to determine fair value in a non-fragmented market,
and plan their future grain needs and hedge market risks accordingly. A drought in one area could send grain prices through
the roof while prices were substantially lower in another unaffected area.
Economically, futures markets exist to allow commercial
commodity producers and dealers, and financial institutions, to
hedge risk by buying and selling futures against their physical
commodity or financial holdings. For example, a farmer (or
more likely, an agribusiness company) who expects a bumper
crop and a steady decline in wheat prices could protect the
value of the wheat he would like to bring to market by shorting
wheat futures.
If he went short at 3.45 cents/bushel, for example, and the
price of corn subsequently dropped, he would lose money on his
actual corn crop but would offset those losses with the profits
from the short sale he could buy back his corn contracts at a
profit, or deliver the actual corn at the price at which he sold
his futures (see last months article for more on delivery).

Hedgers
The farmer is referred to as a hedger, because hes hedging
the risk he is exposed to in the cash corn market. A different
kind of hedger would be a stock fund manager who wanted to
protect his portfolio against a market drop by selling stock
index futures.
The reason futures margin is low is that hedgers have natural collateral in the form of their physical commodity holdings.
The grain producer who shorts wheat futures can, if necessary,
satisfy the contract by delivering the grain.
But markets cannot function with hedgers alone, because it
is likely the majority of the commercial hedgers in the market
have similar goals, and thus would be on the same side of the
market.

Thats where speculators come in those who buy and sell


futures contracts to profit from their price swings without ever
intending to make or take delivery of a commodity or financial
instrument.
Speculators include public traders who, like their stock counterparts, trade from home or a trading office and risk their own
money, as well as professional commodity trading advisors
(CTAs) and hedge fund managers. Trading floors have their own
breed of private trader, called locals.

Speculators
Most futures trading in the United States is still done as it was
a century ago: face to face on exchange floors, similar to how
stocks are traded on the New York Stock Exchange (NYSE). (This
is a source of pride to many in the industry, and a source of
frustration to many others.)
The open outcry system brings traders together in polygonal
pits, in which brokers, filling orders on behalf of public and
institutional traders, and local traders, buying and selling futures
for themselves, communicate with shouted bids and offers and
hand signals. (In the last couple of years, electronic futures trading systems, such as the Chicago Mercantile Exchanges Globex,
have increased dramatically in popularity; the electronically traded E-mini S&P 500 futures contract routinely has higher volume
than the full-sized, pit-traded S&P 500 contract. Also, the
German exchange Eurex, a completely electronic exchange, is
currently the worlds No. 1 futures exchange.)
There are no NYSE specialists or Nasdaq-style market makers
in the futures pits (locals are sometimes referred to as market
makers, though). Each trader is an independent operator, with
no mandate from the exchange to create either an orderly or
two-sided market, as are stock specialists and market makers.
Without the locals and other speculators to provide liquidity,
large commercial futures traders would find it difficult to use
futures markets to offset their risk.
Most exchanges set different margin rates a higher rate for
speculators (and to establish a new position) and a lower rate
for hedgers (and to maintain a position).

www.activetradermag.com November 2002 ACTIVE TRADER

fund increasing its stake in a stock, neither would a futures trader be wise to
fade the activities of commercial commodity dealers.
Originally published once a month,
the COT report is now published weekly
(you can access it at www.cftc.gov).

The reality of rollover


If you are holding a futures position
when one contract month ends and the
next begins, you will have to exit your
position in the expiring contract and reestablish it in the next contract month
a process called rollover.
The good news for short-term traders
is that rollovers should rarely be an issue
relatively few trade opportunities are
missed by avoiding rollover. As a result,
rollovers shouldnt impact a trading system, other than adding another commission charge and potential slippage.
Nonetheless, short-term traders must
determine whether these additional costs
will render a particular system or trade
ineffective. For example, if youre putting
on a swing trade that might last three or
four days and generate a modest profit
(or loss), increasing your commissions
and slippage might mean the difference
between being profitable or unprofitable.
For longer-term traders, rollovers
should not significantly impact the system one way or the other. Presumably, if
youre holding a position for many
months, youre doing so because its
profitable, in which case your gains
make the additional costs insignificant.
As far as the mechanics of switching
from the outgoing front month contract
to the emerging front month, its important to roll over a position when
theres enough liquidity to avoid unnecessary slippage. This varies from market
to market, but in general, during the last
two weeks of an expiring contracts life,
volume is adequate both in the outgoing
and upcoming contracts to get out of one
and into another without giving up too
much (depending, of course, on how liquid the market is in the first place).
Its a good idea to review the volume
and open interest patterns in your markets for the last year and determine if
there is a gradual change between contracts or if the volume changes dramatically from one contract to the next on a
specific date.

It is often possible to roll over using a


spread order, simultaneously buying/selling one contract month and selling/buying the other. Such orders are
traded as a single transaction at a differential (spread), so you lock in your
prices (if you use a limit order) instead of
legging in and out of the two contract
months, which can result in slippage on
both trades. Not all markets, however,
will accept spread orders.
Futures pits generally roll over at specific times: The current front month
becomes the new (furthest out) back
month, and the next month in the trading cycle becomes the new front month.
When this happens, the contracts usually switch pits, or switch areas in a pit if
they are traded in the same one.
For example, the S&P 500 futures at the
Chicago Mercantile Exchange have two
pits the large front-month pit and the
small back-month pit. When rollover
occurs say, from the September contract
to the December contract September
will be traded in the small pit and
December will be traded in the big pit.
If you are trading a deliverable market
(i.e., physical commodities and certain
financial products such as T-notes and
bonds), youll want to roll over before
First Notice Day (the first day on
which a notice of intent to deliver may
occur) or you run a high risk of having to
make or take delivery of the commodity.
Exchange Web sites (see Futures reference, Active Trader, October 2002, p.
76) will provide the dates for First Notice
Day in their contracts, as well as
Delivery Day (the day the check is delivered for the exchange of goods), and Last
Trading Day (the final trading day). You
also can check with your broker for these
dates (some post them online).

Stock index futures vs.


index-tracking stocks
Although futures markets started out as
a way to trade grains and other agricultural products, financial futures now
dwarf the trading volume in physical
commodities. In addition to interest rate
futures, stock index futures are among
the most popular futures contracts.
With all the seeming complications of
futures expirations and rollovers,
price limits, potential slippage its fair
to ask why a stock index futures trader

ACTIVE TRADER November 2002 www.activetradermag.com

would choose these instruments over


the apparently simpler index-tracking
stocks, or exchange-traded funds (ETFs),
such as Spiders (SPY), Diamonds (DIA)
and Qs (QQQ), which track the S&P 500,
Dow Jones Industrial Average and
Nasdaq 100 indices, respectively.
Like futures, these instruments can be
sold short as easily as they can be bought
(no uptick requirement), and they are
incredibly liquid (QQQ is the most
actively traded equity product in the
U.S.).
The reason some traders prefer
futures is leverage. Even day traders in
equities cannot exceed 4:1 buying power
(25 percent margin), and overnight stock
traders have only 2:1 buying power. A
trader who wanted to hold a $100,000
position overnight in SPY would need
$50,000 initial margin; by contrast, an Emini S&P futures trader would need
only $6,000 to leverage the same position
(as of late August).
This means the futures traders gains
would be more than three times the size
of the SPY traders gains. Of course, the
futures traders losses would be just as
large, as well. However, trading a system with favorable probabilities that
limits trade risk (e.g., by using stop-loss
orders) to a specific, small amount will
reduce the catastrophic risk of trading
futures on minimum margin.
For more information on ETFs and
related instruments, see this months
cover story, Funds for all.

Additional reading
Schwager on Futures: Technical
Analysis and Futures: Fundamental
Analysis by Jack D. Schwager (John
Wiley and Sons, 1995)
Trading Systems and Methods
(originally titled Commodity Trading
Systems and Methods) by Perry J.
Kaufman (John Wiley and Sons, 1998)
The Elements of Successful Trading
by Robert Rotella (Prentice Hall
Press, 1992)
Short-term T-bond trading and
The futures advantage, Active
Trader, October 2002
9

&

FUTURES

Basics

OPTIONS

FLAVORS OF FUTURES:
Using the right price data
Futures price data comes in more than one format. Depending on your analysis
and trading needs, one type of data may be more appropriate than others.

BY ACTIVE TRADER STAFF

FIGURE 1 SIDE-BY-SIDE CONTRACTS


Different contract months on the same market are distinct
assets with different prices. On the last day of the June E-Mini
S&P futures, the September contract closed 10 points lower
than the June contract.

tock traders usually dont give much thought


to the price data they use in historical
research and system testing, aside from its
basic accuracy or cleanliness. Thats
June 2003 S&P 500 E-Mini (ESM03), daily
because data for a stock represents an unbroken stream
of prices for the same instrument. Oracle (ORCL) stock
1,010
represents the same asset today it did five years ago;
only the price is different. Stock price data, in effect,
1,000
comes in one flavor.
Futures price data, on the other hand, has a variety of
990
flavors. Because futures trade in contracts with limited
life spans (typically ranging from one to three months),
980
each contract month is a distinct asset even though it
970
represents the same market. For example, the January
2004 crude oil contract (CLF04) and the April 2004
960
crude oil contract (CLJ04) trade simultaneously on the
New York Mercantile Exchange and they reflect the
950
same underlying commodity. However, they are not
identical assets because the crude oil available for delivSeptember 2003 S&P 500 E-Mini (ESU03), daily
ery in January 2004 is not the same crude oil that will be
available for delivery in April 2004. As a result, these
1,010
concurrently trading contracts have different prices.
Figure 1 compares the June 2003 (ESM03) and
1,000
September 2003 (ESU03) E-Mini S&P 500 futures contracts: Both follow the same trajectory but have differ990
ent prices. On its last trading day (June 20), the June
contract closed at 1001.50, while the September con980
tract closed at 991.50, a difference of 10 points.
As a result, when performing long-term analysis in
970
the futures markets, it is necessary to create a single,
unbroken price series out of the many individual con960
tract months in a particular market. There are a few
methods data providers use to link together individual
950
futures contract data to create long-term price histoJune
9
16
ries, and they have different implications in analysis
Source: TradeStation
and trading system testing. Knowing the differences
will help you use the data that best suits your analysis
the price data to create a seamless stream of price action over time.
and trading needs.
Nearest futures and continuous futures are the most imporThere are three basic kinds of futures data series: nearest
futures, continuous futures and constant-forward (or perpetu- tant and commonly used data types. Nearest futures accurateal) futures. While the first type includes the price gaps between ly reflect individual contract price levels but not percentage
contracts, continuous and constant-forward futures series adjust price movement over multi-contract time periods. Continuous

10

www.activetradermag.com January 2004 ACTIVE TRADER

FIGURE 2 NEAREST FUTURES


futures accurately reflect price movement over multicontract time periods, but not the actual price levels
of individual contracts at a past point in time.

Front months, rollover and contract gaps


At any given time, one contract in a futures market is
referred to as the front month the contract nearest to expiration, in which the majority of trading
takes place. Toward the end of a contracts life, volume shifts to the next contract month in the series,
which becomes the new front month when the old
contract expires. Traders who want to hold positions
in an expiring contract must roll their positions forward by liquidating the position in the expiring
month and re-establishing in the new front month.

The nearest futures price series simply strings together consecutive


contract months, which contain the price differences from contract to
contract noted in Figure 1. The gap (and 20.55-point closing price drop)
from June 20 to June 23 never occurred, despite what the chart shows.
June 2003
S&P 500 E-Mini futures
(ES), daily

1,020.00
1,010.00
1,000.00
990.00
980.00

Nearest futures: raw data


Nearest futures simply refers to a consecutive series
of unadjusted contract months, as shown in Figure 2.
This series retains actual price levels of each individual contract, but not the accurate percent price
change over multi-contract time periods.
Say you were long the E-Mini S&P futures in late June
2003. Looking at Figure 2 might lead an uninformed
trader to think the S&P futures experienced a 20.55-point
drop (on a closing basis) at this time. However, this gap
is the difference between the last day of the June contract
and the September contract when the June contract
expired and the September contract became the new
front month. Similarly, if you tested a trading system on
this data, your results would reflect for better or
worse a 20.55-point move that never occurred.
From a historical analysis perspective, nearest
futures are best suited for those interested in
researching the price action of an individual contract
month using the actual prices at which the contract
traded at the time. But because of the price gaps from
contract to contract, this data series is not useful for
long-term system testing or analysis of price behavior spanning multiple contract months.

Continuous futures: closing the gaps

970.00

June 2

16

23

30 July

960.00

Data source: CQG

FIGURE 3 CONTINUOUS FUTURES


Continuous futures compensate for the contract-to-contract price
gaps by adjusting prices by the spread between the existing price
series and the newest contract to be added to the series. In this
case, the prices were back-adjusted: previous prices were
decreased by the difference between the September S&P E-Mini
futures and the June S&P E-Mini futures on the rollover date.
Continuous S&P 500 E-Mini futures
(ES), daily

1,010
1,000
990
980
970
960

950
Continuous futures prices adjust price data to
remove the gaps between the individual contract
940
months of the nearest futures series and create an
930
unbroken price data history that accurately captures
percentage price movement over any time period.
920
Continuous futures are a good choice for historically back-testing trading strategies over long time
June
July
periods. Figure 3 shows the continuous price series
Source:
TradeStation
for the E-Mini S&P. There are two ways to adjust
individual contract data to create a continuous
futures series: forward adjusting and back adjusting.
points), which would make the new, forward-adjusted September
Forward-adjusted prices: Assume its mid-June and the June closing price 1,001.50 the same as the final June closing price.
(nearest) E-Mini S&P 500 contract closed at 1,001.50 on its last tradThis price adjustment carries forward each day afterward: If the
ing day and the September (next) contract closed at 991.50 the same
next days September closing price was originally 995.00, it would
day. To create a continuous series between the two contract months,
be adjusted to 1,005.00, and so on. This process would be repeated
the new (September) data would be adjusted by adding to it the
when the September contract rolls into the December contract, and
price difference between the two contracts (in this case, 10.00
with all subsequent contracts.

ACTIVE TRADER January 2004 www.activetradermag.com

11

&

FUTURES

OPTIONS

Basics continued

To see why this makes sense, imagine a trader who had gone
long the June futures at 990.00 and wanted to roll the position
into the September contract on the close of the last day of the June
contract. The trader would sell the June contract at 1,001.50 (an
11.50-point gain) and buy the September contract at 991.50 (an
11.50-point loss), which is a wash. The continuous futures contract reflects this because it adjusted on that day the September
closing price to the same level as the June closing price, leaving
the value of any open positions before that date unchanged
which is precisely what would happen in real trading.
Back-adjusted prices. An equivalent process is to adjust all
the previous price data by the difference between the expiring
contract and the new front-month contract. Continuing with
the June-September E-Mini S&P example, instead of increasing
all new prices by 10 points, back adjusting in this case would
consist of decreasing all previous prices by 10 points (e.g., the
closing price of the last day of the June contract would be
changed to 991.50, and so on), as far back as the price series
extends. Some traders find back-adjusted data more convenient in that it leaves the most recent contract data at its actual
price levels. On the other hand, very long-term back adjusting
can result in negative past prices (although the price moves the
series reflects will still be accurate).
The continuous futures in Figure 3 are back-adjusted. Note the
price level on June 20, which was the June contract expiration
day, and June 23, the trading day after: The continuous series
closed at 991.50 10 points below the closing price for the June
contract, which was still (technically) the front month on that
day. On June 23, the continuous futures closed at 981, the same
closing price as the new front month, September. In other words,
all prices prior to June 23 in the series had been decreased by 10
points when the September contract was added to the data.

Rollover dates
When constructing continuous futures series in real time for
their customers, data providers dont necessarily begin the
adjustment the day after the expiring contract stops trading,
although they must have a consistent method of adding the latest contract month to the series.

Additional Active Trader reading


Rolling over, May 2003, p. 60.
The futures advantage, October 2002, p. 72.
Market mechanics, November 2002, p. 76.
Mini contracts have major impact, December 2002,
p. 64.
Understanding futures margin, January 2003, p. 72.
Open interest, February 2003, p. 74.
All traders, big and small: The Commitment of
Traders report, March 2003, p. 78.
Bullish Consensus Report, June 2003, p. 60.
Commodity indices: Tracking the futures market,
July 2003, p. 58.
Past articles can be purchased and downloaded from
www.activetradermag.com/purchase_articles.

12

For example, eSignal Inc. rolls over most of its contracts on the
second day before the last trading day of a contract to create its
continuous futures data, but rolls over certain illiquid contracts
up to three weeks before expiration, depending on volume.
Other data providers offer software that allows you to customize the rollover date of a continuous price series. For example, CSI Datas Unfair Advantage application gives traders a variety of rollover options based on date, open interest or volume.
The issue of where data vendors choose to link contract data is
separate from the issue of a trader deciding when to roll over a
futures position from one contract to the next. For more information on this subject, see Additional reading (below).

Constant-forward contracts
The constant-forward (or perpetual) futures price series also
removes price gaps from linked contract data, but does so by creating a price series that represents a futures contract with an expiration date at a fixed or constant future interval, such as 90 days
from the current day. The price series is created by weighting the
prices of the two nearest active contracts.
However, the constant-forward series does not represent actual price levels or price changes, and should be used with caution
as the basis of system tests for a specific market, or for monitoring the market for trading. It can, however, offer an additional,
hypothetical price series for traders to use in testing. Most
traders will have no practical use for price data of this kind.

The name game


One problem in the futures industry is a lack of convention in
describing price data: Different data providers may use different names to describe the same kind of data, or use identical
names to describe different kinds of data.
For example, some vendors refer to continuous futures series
as perpetual futures, while others sometimes refer to nearest
futures as continuous futures. This problem has eased somewhat
in recent years, with the definitions of nearest and continuous
futures used in this article becoming more entrenched. To be on
the safe side, though, always check with your data provider to
make sure youre getting the kind of data you want: Ask if its
adjusted, and if so, which method was used.

Best of both worlds


When analyzing or trading the current contract month, it is
obviously necessary to look at the actual (nearest futures) price
data. If your approach is dependent on a longer-term perspective, consulting the continuous contract series allows you to
look back in time and put current price action in the context of
the past several months or years of price history.
Also, continuous futures simplify historical back testing
because they are an unbroken price series. Testing with nearest
futures can produce accurate results but, depending on the
software you use, might require additional programming to
factor in the rollovers from one contract to the next and remove
the influence of the price gaps.
The only catch of using continuous futures in testing is that
you must remember to add in the appropriate slippage and
commission costs that would occur when rolling from one contract to the next. In effect, each position that straddles two contracts is an additional trade, the fees for which must be factored in to provide accurate test results. 

www.activetradermag.com January 2004 ACTIVE TRADER

&

FUTURES

Basics

OPTIONS

One thing that makes trading futures different from trading stocks
is the fact that futures are contracts with limited life spans.
If youre going to hold a long-term futures position,
or you have a short-term trade that straddles
the expiration of one contract month and
the beginning of another, you need
to understand rollover.

ROLLING OVER
BY ACTIVE TRADER STAFF

ew futures traders are


sometimes surprised to
find there is little difference
between futures and stocks
from a strategic perspective, that is.
General price behavior principles are
constant in both the stock and futures
markets (and virtually any other tradable market). However, there are
mechanical differences between stocks
and futures specifically, how these
instruments are traded.
The most important differences stem
from futures low margin (high leverage), their lack of short-selling restrictions and their nature as contracts with
limited life spans.
This last characteristic leads to the
topic of rolling over, which is the
process of maintaining an open futures
position when the current contract
month expires and the next contract
month begins. If you hold a position for
the length of a contracts life, two things
can happen: Your position will be

13

marked-to-market on the contracts settlement day, and your account will be


credited or debited accordingly. Or, you
run the risk of having to make or take
delivery of a physical commodity.
To avoid these scenarios, you have to
know how and when to roll your position from one contract month to the next,
liquidating your trade in the current
(expiring) contract and re-establishing it
in a later contract month.
Luckily, it is a fairly simple process.

Contract cycles, expiration


and rollover
Like options, futures contracts expire on
certain dates that are determined by the
exchange. These dates are readily available from the exchanges, many financial
publications and Web sites and, hopefully, your broker. Different markets have
different contract month cycles and different expiration dates.
For example, many futures markets
trade in the quarterly cycle of March,
June, September and December contracts (including many financial contracts, such as the S&P 500 E-Mini
futures). In May, the June contract is the
contract closest to expiration, and is
referred to as the front month, or near
month. The September, December and
March contracts are referred to as the

back months. When the June contract


expires, September becomes the new
front month, and so on.
In most futures contracts, the front
month will account for the majority of
trading volume in that market, with the
next contract month (which is sometimes simply referred to as the back
month) a distant second. However, as
the current contract approaches expiration, its volume declines and the volume
in the next contract month increases.
To roll over a position means to exit
it in one contract month and re-enter it in
a later (usually the next) contract month.
For example, if you were long the March
S&P E-Mini futures and you planned to
keep the trade past the March contracts
expiration day, you would sell the March
S&P E-Mini futures and simultaneously
buy the June S&P E-Mini futures.
Rollover refers to the switch that
occurs when the upcoming contract
month replaces the current, soon-toexpire contract month as the new front
month. Rollover does not automatically
occur on the expiration, or last trading
day. For example, the June 2003 S&P 500
E-Mini contract stops trading on June 20.
Rollover takes place one week earlier, on
June 13, which means the June contract
still has one more week of trading after it
has been supplanted by the September

www.activetradermag.com May 2003 ACTIVE TRADER

Rollover dates
The following list shows rollover
dates for a sampling of futures contracts. On these days, the next
month in the contract cycle becomes
the new front month, although the
current, expiring front month continues trading until its last trading day.
contract as the front month.
In a pit-traded contract such as the
full-sized S&P contract, the outgoing
and incoming contracts usually switch
pits, or switch areas in a pit if they are
traded in the same one. For example, the
S&P 500 futures at the Chicago
Mercantile Exchange have two pits
the large front-month pit, and the small
back-month pit. When rollover occurs
say, from the June contract to the
September contract June will switch
to the small pit and September will trade
in the big pit, and volume in the
September contract will typically supersede that in the June contract.
Thats how things work behind the
scenes. Whats the rollover process like
for individual traders?

How to roll over


There are two ways to roll over a position. First, you can simply liquidate a
position in the current contract and

simultaneously re-establish it in the next


contract month, as previously described.
If the trades are not entered simultaneously, you run the risk of the market
moving and one leg of your trade getting filled far away from the price you
intended. The goal is to have the trades
filled as much as possible at the same
time; the new position is established at
the same relative price at which the old
one was liquidated.
The second way to roll over is by
using a spread, which is an order executed as a single transaction at a price
differential (spread) between the two
contract months, so you lock in your
prices instead of legging in and out of
the two contract months and risking
adverse price moves.
For example, if the March 2003 S&P
futures were trading at 848.50 and the
June S&P futures were trading at 847.50,
you could enter a spread order at 1.00
(the differential between the two con-

FIGURE 1 CHANGING OF THE GUARD


In crude oil (CL), volume shifted gradually from the March 03 contract to the
April 03 contract. April volume didnt top March volume until two days
before the March contract stopped trading.
March 03 crude oil (CLH03), daily

37
33

Volume

120,000
60,000

April 03 crude oil (CLJ03), daily


33
Volume

120,000
60,000

13

27

Friday

Source: TradeStation Platform by TradeStation Group

ACTIVE TRADER May 2003 www.activetradermag.com

10

S&P 500 and Nasdaq 100 futures


(including E-Mini contracts): The
second Thursday of the expiration
month (one week before the last
trading day).
Crude oil: The 11th trading day of
the month prior to the contract
month.
T-notes/T-bonds: First position day
(generally the last Thursday of the
month prior to the contract month).
Currencies: Eighth trading day of the
delivery month.

tracts). However, you must make sure


the market you trade (as well as your
broker) accepts spread orders.
The other part of rolling over is when
to do it. It is not necessary to roll over a
position on the precise rollover day. In
most cases, you will have a reasonably
large time window in which you can roll
over positions without much trouble.

When to roll over


First, if the market you are trading is
deliverable (i.e., many physical commodities and certain financial futures
such as T-bonds and notes), youll want
to roll over before First Notice Day or
you run the risk of having to make or
take delivery of the actual commodity.
All futures exchanges have Web sites
that list the dates for First Notice Day
(the first day on which a notice of intent
to deliver may occur), Delivery Day (the
day the check is delivered for the
exchange of goods), and Last Trading
Day (the final trading day).
As mentioned, you also can check
with your broker to find out the important dates for the contracts you trade
(some brokers post them online).
Aside from avoiding the delivery
process, the other consideration is to roll
over a position when liquidity is suffi14

&

FUTURES

OPTIONS

Basics continued

FIGURE 2 S&P ROLLOVER


The volume shift in the S&Ps was much more abrupt than the crude oil
example in Figure 1. March 03 volume superseded Dec.02 volume on the
official rollover day.
December 02 S&P 500 futures (SPZ02), daily
930
Volume

120,000
90,000
60,000

March 03 S&P 500 futures (SPH03), daily


930
Volume
120,000
60,000
December
Source: TradeStation Platform by TradeStation Group

cient in both contracts to


avoid unnecessary slippage.
This varies from market to market, but in general, during the
last two weeks of a contracts
life, volume is sufficient in both contracts to get out of one and into another
without giving up too much on either
side (depending, of course, on how liquid the market is in the first place). One
simple approach is to roll over when
volume in the next contract month in
the cycle surpasses that of the current
contract month.
But you should always research the
volume characteristics of the markets
you trade to make sure this is a viable
approach. Review the volume and open
interest for the past year to determine if
there is a gradual change between contracts or if the volume changes dramatically from one contract to the next on a
specific date.
Figure 1 (p. 14) compares the March
2003 and April 2003 crude oil (CLH03
and CLJ03) contracts. The last trading
day for the March contract was Feb. 20.
Volume in the April contract did not rise
above March volume until two days
earlier, on Feb. 18. However, in January,
the April contract volume, although
15

lower than the March contract volume,


was relatively robust. This means
rolling over roughly a month before
the March contract expiration would
have posed little problem in terms of
slippage for most individual traders.
Figure 2 is a similar comparison of
the December 2002 and March 2003 S&P
500 (SPZ02 and SPH03) contracts. In this
case, volume in the March contract
topped that in the December contract on
Dec. 12 the official rollover date, one
week before the December contracts
last trading day. In November, the
March contract volume was a fraction of
the December contract volume, which
means a trader who rolled over his position roughly a month before the
December expiration might have suffered unnecessary slippage. March contract volume increased notably on the
first trading day of December, increasing the odds of a good execution. After
the rollover day, volume in the two contracts was very comparable.

The impact of rollover


If all this seems complex, dont worry. In
reality, rollovers shouldnt affect a
trading system, other than adding
another trade for which you have to pay

commissions and factor in potential


slippage. For longer-term traders, this is
simply a cost of doing business and will
generally not significantly impact the
system one way or the other.
However, short-term traders trying to
take smaller bites out of the market
must determine whether these additional costs will render a system ineffective.
For example, if youre putting on a
swing trade that might last four or five
days and take a modest profit (or loss),
increasing your commissions and slippage by rolling over could mean the difference between scratching out profits
or accumulating losses.

Additional reading
Understanding futures margin
(Active Trader, Jan. 2003, p. 72).
Open interest
(Active Trader, Feb. 2003, p. 74).
The Futures Advantage
(Active Trader, Oct. 2002, p. 72).
Market mechanics
(Active Trader, Nov. 2002, p. 76).
Note: Active Trader articles can
now be purchased online and downloaded directly to your computer.
Go to www.activetradermag.com
and click on Active Trader Store
and select Download articles.

www.activetradermag.com May 2003 ACTIVE TRADER

&

FUTURES

Basics

OPTIONS

Open interest
Along with volume, open interest gives traders a way to measure a markets
liquidity, as well as the strength or weakness of a price move.
BY KIRA McCAFFREY BRECHT

FIGURE 1 T-NOTE OPEN INTEREST


Open interest rises rapidly in September, when the December T-note contract
eventually becomes the most actively traded front month contract.
December 2002 10-year T-note futures (TYZ02), daily
11,600

11,500

pen interest refers to the


total number of outstand11,400
ing futures contracts (i.e.,
open positions) in a par11,300
ticular market at the end of the trading
day. This data reflects the total number of
11,200
long contracts (referred to as long open
interest) or short contracts (referred to as
short open interest), which are always
equal because for every long position,
950,000
there must be an opposing short posi750,000
tion.
Some traders use open interest data as
550,000
a proxy for liquidity to help determine
which contract month in a market is the
September
October
November
most tradable. Also, traders use open
Source: TradeStation Platform by TradeStation Group
interest figures as a confirming indicator
(often in conjunction with volume data)
to gauge the strength of price trends or
short position holder. In the last case, one player is entering a
the significance of pattern breakouts. In this respect, the high- trade and another player is exiting a trade, which results in no
er the open interest, the more fuel there is to energize a price change in the number of open contracts.
move.
Traders tend to pay more attention to total open interest data
Open interest is not as much a trading tool as a secondary when gauging the overall liquidity in a market. The open interdata series that can be used to confirm the strength or weak- est fluctuations in a specific delivery month, especially during
ness of a price move.
the first few weeks or months of a contracts life and heading
into expiration, dont reveal much regarding market character
Open interest defined
or direction; it is merely a function of the limited life of futures
Exchanges sometimes publish different open interest figures. contracts, for which longer-term positions are continually liqOpen interest is the number of open positions in a specific uidated in one contract and re-established in another.
futures contract delivery month. When a contract month first
starts trading, open interest is technically zero. Open interest Interpretation and uses
(in actively traded contracts) increases over time, until it even- Open interest reflects a markets liquidity, or level or participatually declines as positions are liquidated heading into expira- tion. A general rule of thumb is to trade delivery months with
tion. Total open interest is the total number of outstanding the highest levels of open interest. Illiquid contracts, or those
positions in all the delivery months of a futures market.
with low levels of open interest, should be avoided because of
In basic terms, open interest rises when a new buyer pur- the risk of poor trade executions (slippage). Generally, a conchases from a new seller. Open interest falls when an existing tract should have open interest of at least 5,000 contracts to be
long position sells to an existing short position. Open interest considered a viable trading vehicle.
will remain the same if a new buyer purchases from an existRising and falling open interest levels are considered a measing long position holder or a new seller sells to an existing ure of the strength or weakness of a price trend. Technical
16

www.activetradermag.com February 2003 ACTIVE TRADER

traders tend to rely on both volume and open interest in the be wrong and will be forced (at some point) to cover their losing positions, which will only intensify the markets move in
same fashion, and these indicators are often viewed together.
Generally speaking, strong rallies (or declines) should be the direction of the breakout.
Similarly, increased open interest can be used in conjunction
accompanied by increasing volume and open interest, which
suggests more traders are continuing to enter the market to with volume to confirm price pattern breakouts. For example,
fuel the trend. Conversely, trends accompanied by declining open interest and
volume are suspect: price is still moving
FIGURE 2 FUELING THE TREND
higher (or lower, in a downtrend), but
Open interest (here shown as vertical bars, or a histogram) usually wanes as
fewer market participants are participatexpiration approaches. In this case, though, it increased dramatically when
ing in the move.
the Eurocurrency jumped higher, which meant many more traders were
Figure 1 is a daily chart of the
establishing positions in this market.
December 2002 10-year T-note (TYZ02)
with an open interest line below prices.
December 2002 Euro FX futures (ECZ02), daily
Open interest increased throughout the
rally into the early-October price peak.
1.005
Once prices began to break down after
the Oct. 10 high, open interest levels
0.995
began to decline.
Figure 2 shows open interest increasing as the market rallies despite the
0.985
contract getting closer to expiration
suggesting more traders are piling into
0.975
the uptrend.

Key points

108,000

Rising open interest means new money


Increasing open interest
98,000
is entering the market. Thus, if prices are
in an uptrend and open interest is
88,000
increasing, this reflects aggressive new
buying and is a confirming bullish tech30 October 7
21
28
November
nical factor.
Conversely, rising prices and falling
Source: TradeStation Platform by TradeStation Group
open interest suggest the rally is being
caused in part by short-covering i.e.,
short traders are being forced out of their losing positions. if a market has formed a double bottom or a triangle pattern on
Money is leaving the market, a bearish technical sign that sug- the chart, a breakout that occurs on increasing volume and
gests the trend is running out of energy. The opposite condi- open interest suggests a potentially strong price move.
Open interest figures are reported by the exchanges a day
tions hold true for downtrending markets.
Open interest data can also reveal market character near the late (e.g., Wednesdays open interest is reported on Thursday,
end of major price moves. If a market has been in a long-last- etc.). As a result, traders must wait 24 hours to incorporate
ing uptrend or downtrend, with steadily increasing levels of open interest in their analysis.
open interest, a leveling off or decrease in open interest can be
a red flag the trend may be nearing its end.
Bottom line
During sideways (consolidation) periods, open interest can Open interest can be helpful in determining which futures
give an indication of the potential strength of an eventual contracts are liquid enough to trade effectively. Additionally,
upside or downside breakout. If open interest builds substan- open interest offers clues regarding trend strength, as rising
tially during a sideways trading zone, it suggests an increasing open interest reflects new money supporting a trend. Open
number of traders are placing bets on the long and short sides interest is not a primary technical tool simply a secondary
of the market. Once the market breaks out, half the traders will measure that can be used to understand price behavior. 
ACTIVE TRADER February 2003 www.activetradermag.com

17

&

FUTURES

Basics

OPTIONS

OVERNIGHT futures trading


Overnight trading sessions have become
an increasingly common part of the
futures landscape. Should you trade
these periods or include them in your
analysis?
BY KIRA MCCAFFREY BRECHT

hen the closing bells mark the end of open outcry trading at the various U.S. futures
exchanges, they do not necessarily signal the end
of trading in many futures contracts for that day.
Most high-volume U.S. futures markets, ranging from
Chicago stock index and interest rate contracts to New York
crude oil futures, trade for several hours in overnight electronic trading (in some cases, trading begins less than an hour
after the day session closes). During this time traders can initiate new positions or close out existing ones.
At the Chicago Mercantile Exchange (CME), for example,
virtually all futures contracts are traded electronically
overnight on the Globex trading system. For information on
specific Globex contracts and trading hours see
www.cme.com/files/GLOBEX HoursInsert.pdf.
In late November 2003, the Chicago Board of Trade (CBOT)
launched a new electronic trading platform called

eCBOTDirect. Most of the exchanges financial futures contracts and agricultural contracts can be traded via this system.
For more information on specific trading hours, see
www.cbot.com.
In New York, the New York Mercantile Exchange (NYMEX)
offers electronic trading on an after-hours basis on virtually all its
energy and metal contracts through its Internet-based ACCESS
electronic trading system. For hours, see www.nymex.com.
The New York Board of Trade (NYBOT) does not currently
offer overnight electronic trading on coffee, cocoa, sugar,
orange juice or cotton futures.
There are two aspects of overnight trading to address: whether
to include night-session data in your analysis, and whether the
overnight session offers any unique trading advantages or risk.

Getting the data

Generally, overnight electronic futures data is offered by price


quote vendors at no extra charge to subscribers. Day session
and night session data is typically distinFIGURE 1 NIGHT AND DAY
guished by different ticker symbols.
For example, eSignal customers interested in
The narrow range and spotty trading in the crude oil evening session illusNYMEX
crude oil data can look at CLZ3=1
trate the limitations and dangers of overnight trading. Although only the
(December 2003 crude oil futures evening
final portion of the day session is shown here (left), its range dwarfs that of
electronic session only), CLZ3=2 (December
the night session, when prices drifted in a roughly 25-cent sideways channel.
2003 crude oil futures pit session only) or
Light Crude Oil (CLF04), 45-minute
CLZ3, which represents a composite of both
32.70
32.65
the pit session and the evening ACCESS trad32.60
32.55
ing activity.
32.50
If there are multiple trading sessions, there
32.45
32.40
will be multiple symbols to define them, says
32.35
Jim Hamann, data quality control analyst at
32.30
32.25
FutureSource in Lombard, Il., which offers a
32.20
32.15
number of retail quote packages. The company
32.10
uses a similar set of three symbols to represent
32.05
32.00
pit trading, electronic trading and composite
31.95
data.
31.90
31.85
Traders can chart their choice of pit session,
31.80
31.75
electronic or composite price data across all
31.70
time frames on most analysis platforms.
31.65
31.60
Historical data is also segregated for the three
31.55
different symbols.
31.50
31.45
Many people need session-specific content,
13:20 15:20 16:35 17:50 19:05 20:20 21:35 22:50 Wed. 1:10 2:15 3:20 4:25 5:30
says an eSignal spokesman. Traders need to
Source: FutureSource.com
18

www.activetradermag.com February 2004 ACTIVE TRADER

explore their charting software and data collection feed to determine the symbols, which signify the different sessions.
For some of the mini futures contracts, which trade exclusively on an electronic platform and have no open outcry at all,
eSignal has synthetically created a symbol that tracks action solely during the hours the big contract is trading. For example, on
eSignal, the ES Z3=2 symbol represents E-Mini S&P trading
from 8:30 a.m. to 3:15 p.m. CT, which are the trading hours in the
full-size S&P open-outcry pit.
Many customers said the evening electronic [session] is just
noise, which was the impetus to create the synthetic symbol,
says the eSignal spokesman.
For this reason, many traders still ignore the night session
entirely, analyzing day-session data exclusively. Figure 1 is a
five-minute chart that shows trading in January 2004 crude oil
futures from the end of the Tuesday, Nov. 19, day session into
the evening session. Trading activity dropped off noticeably
during the overnight session.

FIGURE 2 COMPARING TOTAL TRADING TO THE DAY


SESSION
The top chart reflects the combined day (pit) session and
the overnight (electronic) session in crude oil, while the
bottom chart shows only the day-session data. Although the
charts are very similar overall, there are noticeable differences between certain bars.
33.00

December 2003 crude oil futures


composite (CLZ3), daily

32.00
31.00
30.00
29.00

December 2003 crude oil futures


pit session only (CLZ3=2), daily

33.00
32.00
31.00
30.00

Tonight is really tomorrow


The U.S. futures exchanges define evening electronic sessions
as belonging to the next days trading day. For example,
Sunday evening electronic trading in T-bond futures would
belong to Mondays session and is included in Mondays settlement action. The same goes for evening crude oil trading in
New York. Mondays session begins during Sunday evening
trading and settles with the close of the Monday day session.
Each session of the CMEs exclusively electronic E-mini S&P
contract session officially begins at 3:30 p.m. CT (except on
Sunday) and settles at 3:15 p.m. the next day. The overnight session for the full-sized S&P contract ends at 8:15 a.m. CT, 15 minutes before the day session opens, but this simply represents a
temporary suspension of trading, not an official close.
Accordingly, Tuesdays trading actually begins at 3:30 p.m. CT on
Monday and ends at 3:15 p.m. on Tuesday.
Tuesdays session is defined by the end of the day, when
the settlement price occurs, says FutureSources Hamann.

To analyze or not to analyze


Even though volume is much lighter in overnight electronic
trading sessions, many analysts and traders do incorporate
evening-session price action in their research and charting.
Tom Pawlicki, financial futures technical analyst at Refco, LLC
in Chicago, routinely studies the composite symbols of the
S&P, T-bond and Dow futures markets he watches.
Pawlicki has found that relying on the composite price bar
for T-bond futures gives him more accurate support and resistance price levels, and fewer misleading gaps between bars,
which he says often turn out to be meaningless.
Also, he has found that a price high or low set during the
evening electronic session will be a price point to which the
market returns to test at a later time.
The market treats the overnight high as the high for the
day, Pawlicki says. Sometimes there is only a couple of ticks
difference (between the overnight high and the pit session
high), but when the market tests an old high, it generally
equals the high set in the night session.
Overall, Pawlicki has found markets such as the S&P, Dow
and T-bond futures contracts respect the price action that
occurs overnight, and utilizing the composite symbol offers
ACTIVE TRADER February 2004 www.activetradermag.com

29.00
10

17

Source: eSignal

better technical analysis reference points, including work with


Fibonnaci retracements and trendlines.
Figure 2 compares daily bars of the pit-traded crude oil contract with those that reflect both pit and overnight trading.

Practicalities: Volume talks


John Bollinger, president of BollingerBands.com, advises
traders attempting to determine whether or not to incorporate
night session data into their analytical work to consider the
concept of the price-setting mechanism.
For example, he notes, the price of IBM is set primarily during the NYSE main session thats where the largest number of
people who care about IBM focus on it. If it is German bunds,
the price-setting mechanism is during the German day session.
So, whether a trader is trying to determine the importance of
overnight action in natural gas futures, gold futures or S&P
futures, Bollinger argues, people need to get that central concept straight in their minds for whatever they are trading.
Overnight electronic trading action needs to be related to
events in the main session, in order for the technician to be successful, Bollinger concludes.
Its important to understand that because night-session trading is generally thin, bid-ask spreads can be much larger than
they are in the day session, and getting in and out of trades
without giving up too much can be challenging. Be sure to
check the overnight volume figures for any markets you are
interested in, and watch the trading during that session to see
if trading is practical.
Overnight trading sessions can be useful, especially if you
know in advance a price point at which you want to buy or
sell. But because of the typically lower volatility and volume
(big moves and heavy trading mostly occur when a huge news
event rocks the markets), overnight trading does not usually
offer many intra-session trading opportunities. Beginners,
especially, should be wary. 
19

&

FUTURES

Basics

OPTIONS

Understanding FUTURES MARGIN


Margin is calculated differently for futures and stocks.
Find out how much money you need to make a futures trade
and what the implications are for your wallet.

BY KIRA MCCAFFREY BRECHT

ramatically lower margin


requirements are one of the
main differences of trading
futures vs. stocks. While
50-percent margin is required for stock
positions (25 percent for pattern day
traders under certain circumstances),
margins on futures contracts vary from
as low as 2 percent to 20 percent of the
value of the contract. The size, current
volatility and expected future volatility
of the contract determine margin rates.
In the futures industry, margin is actually referred to as a good-faith deposit
or a performance bond, and does not
represent a down payment on a purchase or short sale, as does the 50-percent margin in stocks. However, the
good-faith deposit in the futures industry represents a commitment by the
trader to make good on any change in
the price value of the futures contract.
Margin requirements on futures con20

tracts can and do change as the price of a


contract changes. Generally, if the futures
contract undergoes a sharp price rally or
selloff, the margin requirement would
increase proportionally. Or, if the exchange
determines potential for unusual price
volatility in the weeks or months ahead, it
may increase margin requirements (stock
index futures inflated margin requirements in the aftermath of the 1987 stock
market crash are a good example).
Commodity exchanges determine minimum margin requirements for each of
their contracts. Futures clearing firms
(brokers) will set rates for their customers,
which may be higher (but not lower) than
the minimum exchange requirements, although they are usually identical.

In 1865, the CBOT developed futures


contracts, which were standardized
according to quality, quantity, and delivery time and place. At that time, the
exchange also instituted a margining
system to reduce the risk of buyers and
sellers not fulfilling their contractual
obligations.
Futures margins are so low compared
to stock margins in part because of their
original function as hedging instruments
for physical commodities. Commercial
dealers could use their physical commodity holdings as natural collateral against
the contract. To maintain margin requirements in a futures account, traders can
use cash or U.S. Treasury securities.

Two levels of margin


Background
The Chicago Board of Trade (CBOT),
formed in 1848, originally used forward contracts as a way for buyers and
sellers to exchange commodities in the
future. However, forward contracts were
not standardized for commodity quality
or delivery time, and trade participants
often did not meet the obligations of
their forward contracts.

There are two types of futures margin


initial margin and maintenance margin.
Initial margin represents the amount
traders must deposit in their accounts to
place an order. Maintenance margin represents a set minimum value traders
must maintain in their margin accounts
and will change according to market
action. For example, if a position moves
against a trader, additional margin may

www.activetradermag.com January 2003 ACTIVE TRADER

be required, which is called maintenance.


Generally, if the value of a traders
position moves against him by 35 percent, the broker would issue a margin
call (a demand for more funds) to bring
the trader up to the maintenance margin
minimum. In one sense, exchanges are
requiring traders to pay for tomorrows
potential losses today in the form of
maintenance margin.

Two types of traders


Speculators and hedgers in the futures
industry are held to different margin
standards. Speculators, or traders who
buy and sell futures exclusively to profit
from price fluctuations, are generally
charged higher rates.
Most futures exchanges do not charge
hedgers, commercial traders (e.g., a
grain merchant or oil refinery) who use
futures contracts to offset cash positions,
initial margin only the maintenance
margin would apply to hedging
accounts. But speculative traders must
put up initial margin and then add the
maintenance margin, if their positions

move against them.


As of mid-October, the required initial
margin for a speculator trading the S&P
futures contract was $17,813, while
maintenance margin stood at $14,250. At
a price of 862.00, one S&P contract has a
value of about $215,575 ($250 times the
contract price). The margin to hold that
position is roughly 8 percent of the total
value of the contract. Trading the E-Mini
S&P contract requires much lower margin for speculators, with the initial level
at $3,563 and maintenance at $2,850.

High leverage: Gift and curse


Traders considering using futures contracts need to remember that exchange
margin requirements are only minimum
rates you can, and should, have more
than minimum margin in your account.
It is not prudent to trade on minimum
margin unless you are an experienced,
successful trader; such high leverage
will dramatically inflate your losses (and
yes, potentially, your profits). You run
the risk of losing more money than you
have in your account which can never

ACTIVE TRADER January 2003 www.activetradermag.com

happen if you trade without leverage.


However, traders who take conservative risk control measures i.e., those
who place and adhere to stop orders that
keep losses small can reduce the risk
that comes with increased leverage. For
example, if youre trading the S&P futures
and your stop order is 4 points away from
your entry (with each point representing
$250), your dollar risk is $1,000 per contract. Barring excessive slippage or a complete market meltdown, losing most or all
of your money is not likely to happen.
How much of a percentage risk $1,000
represents depends on how much cash
you have in your trading account. If your
current account equity is $50,000, your
risk on this trade is 2 percent.
Remember: No one is forced to trade
on minimum margin. Futures industry
regulations and exchange margin rates
may make it possible for you to trade on
minimum margin, but they do not
require you to do so. By trading with
more money than is minimally required,
you automatically reduce the risk of disproportional losses.

21

&

FUTURES

Basics

OPTIONS

ALL TRADERS, BIG AND SMALL:

The Commitment of Traders report


In futures, as in stocks, the institutional money usually dictates price action.
The Commitment of Traders report gives you a glimpse of what the big money is
doing in the markets you trade.

BY KIRA MCCAFFREY BRECHT

tion on a monthly, and then bi-weekly,


basis. In 2000, the CFTC began releasing
the data on a weekly basis, which provided traders with more timely open
interest information.
However, the reports weekly nature,
as well as its time delay, inevitably makes
it a longer-term analysis tool. The report
is released every Friday at 3:30 p.m. ET
and reflects open interest positions as of
the previous Tuesday. The data is available on the CFTCs Web site at:
www.cftc.gov/cftc/cftccotreports.htm.
Historical COT reports, dating back to
1986, are also available on the Web site.

Big fish, small fish


The COT report provides a breakdown
of open interest in major futures markets. Open interest figures represent the
total number of outstanding futures
positions held by market players at the
end of the trading day. Clearing members, futures commission merchants and
foreign brokers are required to report
daily the futures and options positions
of their customers that are above specific reporting levels set by the CFTC.
For each futures contract, data is
divided into three reporting categories: commercial, non-commercial and
non-reportable positions. The first two

he Commitment of Traders
(COT) report, published by
the Commodity Futures
Trading
Commission
(CFTC), lists the open positions (open
interest) of three categories of futures
traders large hedgers, large speculators and small traders.
Some futures traders use
this data to gauge the intenFIGURE 1 COMMITMENT OF TRADERS (COT) REPORT
tions of large, professional
futures participants under
The COT is a weekly report that lists the positions of large traders (as well as retail
the assumption the trading
traders) in every active futures market.
activity of these professionals will ultimately dictate
market direction. (Many
stock traders track the positions of institutional money
managers in the equity
market for the same purpose.)
Sometimes the COT is
referred to simply as the
large traders report.

Background
The CFTC, which is the
futures industry equivalent
of the Securities and Exchange Commission (SEC),
began gathering data for
this report in 1962, and initially released the informa22

Source: CFTC

www.activetradermag.com March 2003 ACTIVE TRADER

FIGURE 2 FOLLOWING THE MONEY


This weekly chart shows how the smart money commercial traders are often on the
opposite side of the market from small retail traders.
Crude Oil (CL), daily
30.00

groups are those who


27.00
hold positions above spe24.00
cific reporting levels.
21.00
The commercials are
Commercial Traders
often referred to as the
40,000
large hedgers and are traditionally thought of as
20,000
the smart money in a
35,000
given market. CommerSmall Traders
15,000
cial hedgers are those
-5,000
who actually deal in the
cash market (e.g., grain
Aug. Sept. Oct. Nov. Dec. 2002 Feb. Mar. Apr. May June July Aug. Sept. Oct. Nov. Dec.
merchants and oil comSource:
MarketPit.com (www.marketpit.com). Chart created with TradeStation 2000i by Omega Research.
panies, who either produce or consume the
However, to make use of this informa- particular market, traders following the
underlying commodity) and generally
have access to supply and demand tion, you need to calculate the net posi- smart money will interpret this as a
information other market players do not. tion, which is the difference between sign the market could move higher.
Because of the commercials privileged the longs and the shorts. Also, the data Large speculators sometimes get caught
position in the market and long-term cannot be analyzed in isolation, from at market tops and bottoms because they
outlook, traders track the buying and week to week; it needs to be compared are often longer-term trend followers
selling of these traders to get a read on against historical readings to gauge whose systems do not react quickly to
when positions in a certain group are at trend changes.
longer-term market direction.
Figure 2 shows a weekly crude oil
Non-commercial large traders include an extreme.
(CL) chart with the net long-short posilarge speculators such as commodity
tions of commercial hedgers and small
trading advisors (CTAs) and hedge Interpreting the data
funds. This group consists mostly of The COT report quantifies changes in traders. The two groups are on opposite
institutional and quasi-institutional net positions, and technical traders use sides of the market for most of the perimoney managers who do not deal in the this information to identify potential od, with the commercials usually on the
underlying cash markets, but speculate market turning points. For example, if correct side. Notice how in fall and early
in futures on a large-scale basis for their one group is at a historical net long or winter 2001 the commercials were conclients. Many traders in this category net short extreme for example, the sistently long while small traders were
tend to rely on mechanical (often trend- highest level in three years that would consistently short. When a rally ensued
be a warning signal that a potential in winter-spring 2002, the commercials
following) trading systems.
became net sellers, while the small
The final COT category is called the trend change is near.
The traditional interpretation of the traders incorrectly stepped up their buynon-reportable position category otherwise known as small traders i.e., the COT data is that the commercials tend to ing, which reached its peak at the early
be right, while the large speculators or April top.
general public.
One school of thought holds that the
small traders are wrong. For example,
large speculators might build up a large COT data works best when the two major
Report details
The COT data on the CFTC Web site con- net long position in a rallying futures groups large hedgers and large specutains a column identifying position hold- market, followed by small traders, but lators are at opposite extremes (i.e.,
ings as either long or short (see Figure 1). large commercials might start building a one is extremely long and the other is
One line summarizes the Com- large net short position at the same time extremely short). When the ball is
mitments, or the actual reported num- a sign the smart money anticipates a dropped, one of the groups will be wrong
bers, for each of the different trading market top. Similarly, if the commercials and will be forced to liquidate its posiare increasing their long positions in a tions, which fuels price movement.
groups.
ACTIVE TRADER March 2003 www.activetradermag.com

23

FUTURES

Basics

Commodity indices
Several indices track the commodity markets, but theyre very different in
composition and function. Learn how these benchmarks compare, and which ones
have tradable futures contracts.
BY ACTIVE TRADER STAFF

he surge in oil prices may have garnered most of the Reuters Commodity Research Bureau Index
headlines in the futures arena recently, but the past The CRB has 19 components and is based primarily on world
few years have been a bull market for many com- consumption. It is reviewed every six months, although the
modities.
components have not changed since 2003, when aluminum,
Besides oil and metals, other energy commodities have nickel, and unleaded gas were added, and platinum dropped.
enjoyed significant price increases over the past several years, The CRB has been changed 11 times and has had as many as 29
and especially over the past three or four. Of course, not every components.
commodity has had similar success, as some grain and soft
Until 1995, each commodity was given equal weight. Now,
commodities such as corn, soybeans, and cotton spiked up in however, the index uses a four-tiered system designed to rank
late 2003 and early 2004 but have mostly trailed off since.
each commodity. Group 1 currently consists of petroleum
Overall, though, the trend for commodities is up, as energy products and makes up 33 percent of the CRB (with crude oil
and metal markets have outweighed the drag produced by accounting for 23 percent of that). Groups 2 (seven highly liqother groups. This bull market is reflected in the
performance of various indices that track comFIGURE 1 COMMODITY BULL MARKET
modity prices just as stock indices track equity
prices.
Since the end of 2002, the commodity indices have seen their values
Commodity indices are comprised of nonincrease substantially.
financial physical commodities instruments
such as bonds, foreign currencies, or stock indices
are not included. Each index is different in terms
of component commodities, the weight given to
each commodity, and how they rebalance.
Figure 1 shows the weekly performance of three
commodity indices the Goldman Sachs
Commodity Index, the Reuters/Jeffries CRB Index,
and the Dow Jones AIG Commodity Index since
the end of 2001. Heres a closer look at the five
major commodity indices in the U.S.

Goldman Sachs Commodity Index


The GSCI has 24 components, weighted according to worldwide production. The GSCI has no
cap or floor for weighting any sector or individual commodity. This leads to an energy bias.
Crude oil makes up 30.5 percent of the index, and
aluminum (3.49 percent) is the largest non-energy
component.
The GSCI is rebalanced every year, and the
most recent adjustment has energy comprising 75
percent of its makeup.
24

Data source: eSignal

www.activetradermag.com May 2006 ACTIVE TRADER

uid commodities, 42 percent), 3 (four liquid commodities, 20 percent), and 4 (five


diversified commodities, 5 percent) are
all equally weighted within the group.
The index is rebalanced every month,
which results in decreased exposure to
commodities gaining in value and increased exposure to commodities declining in value.

Dow Jones AIG Commodity Index


There are 19 commodities in the DJAIG,
which considers liquidity and global
production in weighting the index. The
DJAIG uses diversification rules to
ensure the index is broad-based. It is
rebalanced every year, and no sector
(e.g., energy, metals) can account for
more than 33 percent of the index.
Similarly, no individual commodity
can represent more than 15 percent or less
than 2 percent of the index. So far in 2006,
energy commodities are at the maximum
33 percent, with crude oil (12.78 percent)
and natural gas (12.32 percent) the two
most important individual markets.

Deutsche Bank Liquid


Commodity Index
The DBLCI has only six components, representing the three largest commodity
groups energy, metals, and grains. The
indexs energy futures (crude oil and
heating oil) are rebalanced every month,
while the other four commodities (aluminum, gold, corn, and wheat) are rebalanced once a year. The commodities are
weighted based on production and usage.

Rogers International
Commodity Index
The Rogers Index, created and maintained by trader Jim Rogers, is a true
world index.
It is the largest index, with 35 components, including somewhat obscure (to
U.S. traders) products such as silk,
canola, barley, and Azuki beans. The
RICI is the only commodity index that
includes products traded primarily on
foreign futures exchanges.
The index is reviewed annually and is
weighted according to each commoditys
importance to the world economy.

TABLE 1 INDEX COMPOSITION


In addition to representing different commodities, the indices also weight their
component markets differently.
Weightings (%)

Commodity
Aluminum
Azuki beans
Barley
Brent crude
Canola
Cocoa
Coffee
Copper
Corn
Cotton
Crude oil
Feeder cattle
Gas oil
Gold
Heating oil
Lead
Live cattle
Live/lean hogs
Lumber
Natural gas
Nickel
Oats
Orange juice
Palladium
Platinum
Rice
Rubber
Red wheat
Silk
Silver
Soybean meal
Soybean oil
Soybeans
Sugar
Tin
Unleaded gas
Wheat
Wool
Zinc

S&P Commodity Index


The SPCI has 17 components and is the only one of the six commodity indices that does not have crude oil as its main component. The index is rebalanced once a year and is weighted
ACTIVE TRADER May 2006 www.activetradermag.com

Rogers Goldman Reuters


Intl.
Sachs
CRB
4
3.49
6
0.50
0.27
14.30
0.67
1
0.2
5
2
0.75
5
4
3.12
6
4.75
2.28
6
4
0.98
5
35
30.56
23
0.69
4.3
3
1.93
6
3
7.76
5
2
0.34
2
2.6
6
1
1.5
1
1
3
8.98
6
1
0.72
1
0.05
0.66
1
0.30
1.80
0.50
1
0.99
0.50
2
0.23
1
0.75
2
3
1.51
6
2
2.23
5
1
3
7.22
5
7
2.45
1
0.25
2
0.86

Dow
Jones
AIG
6.85

S&P

Deutsche
Bank Liq.
12.5

2.93
5.88
5.87
3.16
12.78

2.79
3.88
3.39
4.48
3.22
11.41

35

6.22
3.85

12.13

10
20

6.09
4.35

4.87
2.04

12.32
2.66

17.65

2
2.77
7.77
2.97

3.67
2.57
2.98
3.84
3.80

4.05
4.77

12.16
5.15

11.25

11.25

2.70

based on the two-year average of open interest.


The SPCI is the only index that does not include gold, as the
metal is not a widely consumed product.
Table 1 shows the individual composition of these indices.
25

FUTURES

Basics continued

TABLE 2 SECTOR COMPOSITION

Considerations

The percentage of each index devoted to a specific


sector has a large impact on the indexs performance.

Obviously, these indices are not created equally, and


they will react differently to changes in commodity
prices. From a single-commodity standpoint, a change
Weightings
in crude oil prices would affect the RICI (for which
Reuters
crude oil comprises 35 percent of the index) and the
Sector
GSCI
CRB DJAIG SPCI DBLCI RICI
GSCI (30.56 percent of the index) a great deal more than
Energy
73.12
39
33
44
55
44
the DJAIG (12.78 percent of the index) or the S&P
Grains
7.23
13
21.18 18.82 22.5 19.49
Commodity Index (11.41 percent).
Industrial Metals 8.53
13
18.09
14
12.5
14
However, the old adage, A rising tide lifts all boats
Livestock
4.79
7
10.44
3
0
3
applies to the commodity world as much as it does the
equity world. In other words, a rise in the price of crude
Precious Metals
2.16
7
8.22
7.1
10
7.10
oil is likely to cause an increase in other energy products
Softs
4.16
21
9.06 13.08 0
12.41
as well.
The Deutsche Bank index is based on this concept, as
its lack of diversification is offset by its inclusion of the
most influential commodities in each group.
Trading commodity indices
From that standpoint, a more important consideration when
Three of the six indices the Goldman Sachs Commodity Index
(Chicago Mercantile Exchange), the Reuters CRB Index (New looking at the composition of an index is the makeup of a parYork Board of Trade), and the Dow Jones AIG Index (Chicago ticular sector (Table 2). Any move in the energy sector would
Board of Trade) have futures contracts listed (the GSCI and the have a much greater impact on the energy-heavy GSCI than
any other index.
CRB also have options).
While energy is clearly the dominant sector in all indices, the
The Rogers Index can be traded through a TRAKR (which
functions like a futures contract but can be traded in a stock importance of other sectors depends on the index. The CRB
and the DJAIG have similar representations in energy (39 and
account) at the CME.
There are also mutual funds based on commodity indices, 33 percent, respectively), but soft commodities such as cotton,
the biggest of which are the Rogers International Raw sugar, and coffee comprise more than twice the percentage of
Materials Fund (which tracks the RICI), the Pimco Commodity the CRB than they do the DJAIG.
As a result, a downturn in soft commodity prices would
Real Return Strategy Fund (DJAIG), and the Oppenheimer
negate any rising energy prices to a greater extent in the CRB
Real Asset Fund (GSCI).
In early February, trading commodity indices advanced to a than the DJAIC.
new level when the Deutsche Bank Commodity Index Tracking
Fund began trading on the American Stock Exchange. The first Portfolio commodity perspective
ETF based on a commodity index, the fund (symbol: DBC) had Commodity indices are broad market gauges that function
average daily volume of more than 525,000 shares in its first nine like equity indices. Much like index tracking stocks that allow
traders to focus on a particular group rather than an individdays of trading quite respectable for a new issue.
An ETF on the Goldman Sachs Commodity Index is current- ual stock, commodity index futures, ETFs, and commodity
ly in the registration phase, but there is no timetable for when it mutual funds permit traders to take advantage of moves in
commodities without picking a particular product.
might begin trading.

26

www.activetradermag.com May 2006 ACTIVE TRADER