Beginner's Guide To Trading Futures: Evaluating Futures
Once you have decided which futures market is right for you and have established an account with an appropriate broker, the next step is to evaluate the market. As with most financial markets, there are two main types of tools that traders use to analyze futures: fundamental analysis and technical analysis. We will now take a look at each of these.
Fundamental analysis involves research into the underlying factors that determine the price level for a financial asset or a commodity. The type of analysis you would want to perform will depend heavily on which futures market you choose to invest in. For instance, if you decide to trade futures on Treasury Bonds, you would want to analyze the fundamental factors that drive bond prices. These include the level and direction of economic activity, Federal Reserve monetary policy, supply and demand, investor sentiment, and daily economic and news releases. On the other hand, traders of futures contracts on corn would be far more interested in analyzing weather reports, details on acreage planted and crop yields, supplies of alternative grains and shipping costs.
As the two brief examples above should make clear, fundamental analyses will vary widely among different futures markets and one market may in fact have very little in common with another market. That is why many traders choose to focus their attention on only one or two futures markets. Doing so allows them to concentrate their efforts on developing keen analytical abilities for say, the oil market, while at the same time developing experience in trading that commodity. Rapidly switching from one futures market to another, seeking to trade whichever is the most volatile or popular at a given moment, is unlikely to be a successful approach, particularly if you are employing fundamental analysis.
Regardless of which market you focus on, it is important to realize that you are likely to have at least somewhat of an information disadvantage relative to other market participants. There are two main types of participants in the market: speculators and hedgers. Speculators try to benefit by being on the right side of price movements, while hedgers attempt to remove the risk associated with future price movements from their business. While in some markets (such as equity or interest rate futures) it may theoretically be possible for a very well-informed and dedicated individual to have nearly as much information with which to conduct analysis as a bank or institutional investor, in some other markets this is just not practical.
For example, if you are trading corn, no matter how many reports you read on the state of the market, you are unlikely to have as firm of a grasp on the fundamentals as a corn farmer in Iowa or Nebraska, not to mention a large agricultural company such as Monsanto. Similarly in the oil market, Exxon is likely to have a better feel on the supply and demand in the oil market for the next three months than even the most well-informed individual trader.
Despite this information disadvantage, it is important to be as well-informed about your chosen market(s) as possible while at the same time maximizing your advantages. Remember, Monsanto or Exxon are interested in hedging their forward production, not exploiting daily price movements, and they are also so large that their trades can be cumbersome. As an individual, you have the ability to be more nimble and opportunistic than some larger institutions.
Regardless of the market you choose, before beginning trading you should do a great deal of additional research into the underlying fundamentals and market conditions of that market in order to maximize your opportunities for success.
The second main group of tools used to evaluate futures markets includes those that fall under the heading of technical analysis. While fundamental analysis is concerned with determining the intrinsic value of an asset, technical analysis tries to determine future price action by evaluating prior price movements. While many market participants do not believe that analyzing charts provides any clues to what will happen in the future, there are also many proponents of technical analysis, particularly among short-term traders.
One benefit of technical analysis is that unlike fundamental analysis, many of the charts and tools that technical analysts use can be carried from one market to the next. That means that although there may still be benefits to concentrating on certain markets, a technical analyst may have more flexibility than a fundamental analyst in moving from market to market.
If you decide that technical analysis is right for you, I encourage you to learn as much as possible about various tools and techniques. An in-depth discussion of these is beyond the scope of this guide, but a good starting point for more information can be found in Investopedia's technical analysis tutorial.
Regardless of whether you choose to focus on fundamental or technical analysis, remember that you do not have to rely on one to the complete exclusion of the other. Even many fundamental analysts examine charts to determine entry and exit points for trades they have discovered through their research. Similarly, even hardcore chartists pay attention to important fundamental news developments and supply and demand developments. (No matter what a chart says, if a hurricane wipes out all large Gulf Coast oil refineries, the price of oil is likely to rise because supply will have decreased.)
SEE: Blending Technical And Fundamental Analysis
Tools and Techniques
In addition to fundamental and technical analysis, there are a number of other tools and techniques that can help you in trading futures. The most important of these is risk management. As we discussed earlier, the use of leverage in futures trading increases both the reward and the risk. In order to avoid being wiped out by unexpected market movements, individuals need to practice strict risk management. This should include always having a stop loss in mind when entering a trade. This stop loss should be a level where you exit the trade and cut your losses, regardless of whether you still believe in your original premise. Never forget the famous saying "markets can stay irrational longer than you can stay solvent." Even if your initial premise is ultimately correct, irrational market dislocations can stay in place much longer than they "should," and can wipe out your capital, particularly when you are employing leverage.
Many traders also place physical stop loss orders at the time they enter a trade. These orders are designed to automatically execute if the level you select is breeched.
Note: These are good to use but they are not failsafe, as in very volatile markets your order may not be executed at your desired level and your losses could be greater than intended.
A final important risk management tool is diversification. This means that you should spread your capital among a number of small bets within the futures market and across time. Remember, investing is a marathon not a sprint. Diversification also means that trading futures should not be the entirety of your investment program. In addition to your trading account you should also have other, longer-term investments that you maintain in a different style and in different investment vehicles.
Another tool that you may consider incorporating into your futures trading program is a software charting program. There are many of these, and which one you prefer is largely a matter of personal taste. If you have not used chart packages in the past, you can find information on some of them at Investopedia's Trading Systems and Software hub.
Fundamental analysts will also want to make sure that they have the necessary tools for conducting their research. In addition to general market news sources such as the Wall Street Journal or Barron's, you will likely want to find more specific sources depending upon which markets you choose to follow. For instance, if you are active in the agriculture markets, you will probably want to spend a fair amount of time following and analyzing reports issued by the U.S. Department of Agriculture. Similarly, energy traders will want to follow OPEC pronouncements closely, and should probably read annual and quarterly reports put out by major oil companies, such as Exxon (NYSE:XOM), BP (NYSE:BP) and Chevron (NYSE:CVX). Again, as a fundamental analyst, the better informed you are, the better your analysis will be.
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