Comparing Shopping Style with Trading Equities and Futures
|Last week I had the chance to vacation on Vancouver Island, British Columbia. I can see why so many people visit the “Rock” as it is affectionately known by the locals. Very scenic mountains, ocean views and rivers everywhere you look.
While there we went to a little town called Duncan and visited the Farmers Market that is held each Saturday. Each table had various types of vegetables and fruits to sell, but I noticed something different. The buyer was able to buy just one vegetable or they could buy in quantity.
Where I live we have large retailers that sell in bulk. Costco comes to mind for this type of store in the Eastern United States. At Costco you tend to find buyers looking to purchase in bulk instead of one or two items at a time.
These two types of shopping styles are similar to trading in the Equity and Futures markets. You may be wondering how they can be?
Let’s start with Equity trading. Equity trading is much like the Farmers Market. Traders can buy just a single share or buy multiple shares if they wish. When a trader sees the last price on the screen they can buy or sell that stock for that exact price if they only want one share of the Stock. If Apple Stock was trading for $120.00 per share that would be all the investor/trader would have to pay plus a commission to the broker. This allows traders with smaller accounts to have more opportunities in the Equity markets.
The Futures markets are different however. Trading Futures is a lot like shopping at Costco. Futures traders are required to purchase contracts with large multiples of the Commodity. This would be like buying in bulk and unfortunately Futures traders cannot buy or sell the individual units of the Commodity as their fellow traders can in the Equity markets.
When a Futures trader sees a last price on their chart, in a newspaper or on a TV screen they are seeing a unit price for that Commodity. Let’s say you see a Crude Oil price for $59.15. This price represents only “one” barrel of Crude Oil at the wholesale level. If this was a Stock and you buy just one share then it would only cost you $59.15 plus commissions.
But like all other Commodities, Crude Oil is not traded as a unit. It is traded as a contract that has multiple units in it. The Crude Oil contract calls for delivery of 1,000 barrels (units) of Oil. Now that same purchase price is $59.15 X 1,000 = $59,150 (If you wished to take delivery of the contract)!! Since Futures markets use leverage (smaller amounts of capital to control much larger amounts) the trader would have to have at least $4,675 per contract to trade this Crude Oil contract of 1,000 barrels.
The only other option a Futures trader has to trade smaller contracts is a mini contract size. Unfortunately, all mini size contracts for Futures markets are very illiquid (extremely low volume). For this reason it is recommended to avoid trading any of the mini Futures contracts. The exception to that rule is the Stock Index mini contracts. Here the volume is much higher and more liquid than the full sized Stock Index Futures contracts.
The next time you are trading Futures and see the last price on your chart, remember this only represents the price per unit and not the entire contract. Listed below in Table 1 are some markets and their contract sizes:
* The contract values would only be required if you took delivery of the Commodity at the expiration of the contract. The capital to trade these would be about 5-10% of the contract value.
Perhaps now you can see why Futures prices can be much more volatile than Equity prices. In our Crude Oil example, if a trader went long at 59.15 he is effectively holding a contract worth $59,150. If the price falls to 58.32 that same contract is now only worth $58,320. The trader is sitting on a loss of $830 per contract!! As we have seen in the Futures markets this is not a big move and happens frequently. However, with the size of the contract the loss can grow exponentially.
If the trader was able to purchase just one barrel (unit) of Crude Oil at 59.15 and the price drops to 58.32 then their losses would only be .83, not even a whole dollar. There would be no panic in this situation.
Traders looking for smaller units to trade should perhaps consider the Farmers Market (Equity Markets), allowing them to choose how many veggies they wish to take away from the market.
For other traders with good risk management and a rule based strategy, then perhaps they may want to go shopping at Costco (Futures Market) and buy or sell in bulk where they can leverage their shopping dollars.
“Don’t find fault, find a remedy.” Henry Ford
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