Speculating - Trading Applications

Trading Applications
Even though it is the investor who is ultimately responsible for any speculative position, you as a futures trader need to understand the cash flows of how gains and losses are realized. You may just be moving into an entry-level position now, with all these strategic concerns still several pay grades above yours, but you will probably be trading on your own account at some point and will need to get a feel for this. Ultimately, though, it is based on fairly straightforward thinking.

Recommending Speculative Trades
This section is split out by the NFA, the futures industry's self-regulating entity which put together the Series 3 exam. To review:

  1. To profit from expected price increases, recommend to your client to take a long position (buy contracts).
  2. To profit from expected price decreases, recommend to your client to take a short position (sell contracts).
  3. To hedge risk or to profit from expected changes in the basis, recommend to your client to enter into a spread position.
    1. If you expect the basis to widen, then sell the nearby futures contract and buy the distant futures contract.
    2. If you expect the basis to narrow, then buy the nearby futures contract and sell the distant futures contract

Using Orders to Speculate
Perhaps the safest way to participate in a speculative futures position is through a commodity pool or similar managed account. Here, the client can benefit from professional management. He or she should be able to evaluate the third party manager or work with a professional who has experience in doing so. Some investors prefer to trade themselves.


Review the "Basic characteristics and uses of different orders" Chapter 5: Orders and Price Analysis

Market orders often serve as the default order type. There are times, though, when structuring a trade differently when opening or closing a position is of greater benefit to the investor.

A stop order is placed at a price that you the trader believe the market will reach in order to put on the trade. This sort of order helps the investor confirm the direction of the market before entering a trade. Buying on a stop is the equivalent of waiting for the contract to move up in price; selling on a stop is the equivalent of waiting for the contract to move down in price. Once the stop price is reached, the order becomes a market order; that is, it can be filled at, above or below the stated stop price. Such moves, of course, are usually small and the stop price is proximate to the market price.

A stop order might linger a bit before it is actually executed, though. A market-if-touched order must trade at the first available price after the stated price is reached and so might be closer to the stated price.

A stop-limit order is similar to a stop order, but it becomes a limit order rather than a market order when the security trades at the price specified on the stop. That is, it may only trade a specified price, not at the current market price. Thus, the order will only be filled at the price specified or better (lower for a buy, higher for a sell). Thus, it is possible that a stop-limit order will remain unfilled if the hoped-for market conditions fail to materialize.

The one-cancels-other (OCO) order stipulates that, if one part of the order is executed, then the other part must be canceled. Used mostly as a tactic to liquidate a position, investors invoke OCO to lock in gains or avoid losses. One example would be a stop order combined with a market-if-touched order. If the position price decreases, a stop order cuts the loss, and the market-if-touched order is cancelled. If the position price increases, the market-if-touched order could capture the gain, and the stop order would be cancelled.

Other Speculative Strategies
These approaches involve the sequence (ordering) of trades and are not types of orders themselves.

  1. Pyramiding: a momentum approach to riding a profitable position in a rising market, pyramiding entails little more than increasing the trader's position by decreasing increments. Assuming the price of palladium is increasing, the trader puts on four additional contracts, then three, then two, then one. The graphic depiction of this approach illustrates a pyramid.
  2. Roll Forward: also used in rising markets, this approach involves the simultaneous liquidation of the contract nearing delivery and purchase of a contract for a more distant delivery month.
Summary And Review
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