WHAT JOSEPH WROUGHT

Essay published Spring, 1981.

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A primary endeavor during the first decade of the modern futures market era was to explain the purpose of these markets, describe their structure, and teach how to use them. In other words, to educate. It was a mission we willingly undertook since we knew it to be the only certain road to success for these revolutionary markets.

To my knowledge, I was the first to recognize the connection between futures markets and the Bible. It became my personal trademark and offered a simple explanation for the difficult concept of hedging and the complex purposes of futures markets.

...and Joseph said unto the Pharaoh, 'There are to be seven years of great plenty throughout the land...after that there will be seven years of famine...'

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Thus Joseph outlined a plan to the Pharaoh that ushered in the first futures market. Joseph undertook the first recorded buy hedge on a grandiose scale. It became the model for hedging theory and is still applicable today. In fact, although the uses and techniques have dramatically changed from biblical times, Joseph's basic application of forward hedging is still the central reason why modern U.S. futures markets are not merely arenas of speculation.

Futures markets today are an important and integral part of the U.S. and world marketing systems and provide the best, and sometimes only, means of shifting inherent risks from the producer unto the speculator to the ultimate benefit of the consumer. Yet when one hears or reads about futures markets, the basic reasons for the existence of such markets—the fundamental benefits derived as a result of them and their importance to our national economy—are seldom the topics under discussion. Speculative opportunities or tales of fabulous fortunes won or lost are all you are likely to encounter. After all, economics is a dry science, and not many people will be turned on by an discussion of the system of price insurance or price discovery. Even in Joseph's day there were probably more Egyptians interested in how to turn the Pharaoh's dream into a buck than those wanting to discuss the beauty of Joseph's hedging plan.

Without question, futures markets have catapulted themselves to the forefront of the financial world and offer some of the most exciting instruments of investment available anywhere. During the last dozen or so years, futures transaction volume on U.S. commodity exchanges has grown tenfold, rising from 6.4 million contracts in 1965 to a 1978 record of 58.4 million, a record that which will again be surpassed in 1979. During this period, the scope of futures experienced a metamorphosis that is still hard to fathom. In less than a decade, futures markets shed their traditional and exclusively agricultural base and embraced virtually every important form of finance. Their dramatic metamorphosis included expansion into meats and live animals (a break with the sacred principle that futures could not be successfully applied to non-stored items), into metals and precious metals, and the giant leap into foreign currency and interest-bearing instruments (financial futures).

As a direct result of their growth and particularly as a result of their dramatic success with financial instruments, futures markets became a respectable member of the financial community. Indeed, the New York Stock Exchange and the American Stock Exchange—those sacred temples of investment who only a few years ago considered futures something akin to a snakebite—have now organized futures market divisions within their respective institutions.

Futures markets and the opportunities they offer are today topics of conversation from one end of the world to the other. Many different world financial centers are considering opening futures markets of their own. Brokerage firms, investment houses, security dealers, and banks that heretofore never considered these markets, are actively seeking membership in futures exchanges or other means of connecting themselves to these investment opportunities. Financial institutions the world over are seeking an understanding of these markets and the means by which to participate. At a minimum, two Federal agencies are squabbling about jurisdictional authority over these markets. Every month there is a seminar or workshop conducted pertaining to futures markets. Every major newspaper as well as every financial periodical has expanded its coverage of futures markets. A host of new futures advisory services and advisory publications have been created.

Futures markets have grown in geometric proportion and their continued expansion is inevitable. In fact, as a result of the successful financial instruments sector, futures markets are on the threshold of a quantum jump in volume. Therefore it is timely and appropriate to offer these words of caution to all would-be participants: futures market speculation is difficult and not for everyone; there are and there always will be more losers than winners; and anyone that approaches these markets with a cavalier attitude—as one might an occasional investment—is doomed to failure. These markets require study and thought. They also require risk capital which, if lost, will not materially affect one's life style. Above all, these markets are not for the faint of heart.

There are many who would argue that futures cannot be considered an investment. Certainly they are correct in terms of the classical definition of investment. Encyclopedia Britannica tells us that investment is the "process of exchanging income during one period of time for an asset that is expected to produce earnings in future periods". Does that definition mean that a purchase of Swiss francs on the IMM at 11:03 A.M. and a sale of them at 11:29 A.M. the same day for a profit of $24,000 is not an investment; yet a similar purchase of Swiss francs held in a bank for the next twelve months for a similar profit is an investment? In other words, we are used to a definition of investment that implies a longer duration than twenty-six minutes. But does the time element itself change the nature of the act? Are we not in either case doing the same thing; i.e., attempting to increase the value of our estate by exchanging dollars into something else. Hopefully, the something else will increase in value relative to the dollars we have spent in acquiring it. Clearly, if we buy real estate in the hope that five years from now it will net us a large profit, we are investing. But if twenty-six minutes after our purchase, oil is discovered on the premises and we are instantly offered a large profit for the real estate, have we now changed the nature of our original purchase if we accept the offer? I think not. Whether we held onto our purchase for five years or for a matter of minutes, the purpose was the same. If it was an investment in one case, it is an investment in either case.

The world is no longer as slow-paced as it once was. The world has shrunk and with it our concepts of time. A century ago, it took months to travel from New York to San Francisco; today it takes several hours. A decade ago, a complex mathematical theorem could take weeks to prove; today less than a few minutes. A century ago if someone in the U.S. invested in art by purchasing the Mona Lisa, it would take months before he could be offered a profit by someone in France; certainly, the art investor then had no intention of making a profit in terms of minutes. But today the same investment could show a profit in the length of time it takes to make a telephone call; is it, therefore, not to be considered an investment? The incomprehensible changes that have occurred by virtue of technology have had an incalculable effect on our lives and on our investment strategy. Time alone should not be the only criterion of what is or is not an investment.

Still, futures must be differentiated from most other forms of investment. Although the time element is the most striking difference, there are other distinguishing characteristics. For one thing, seldom is the investor in futures the recipient of the physical property in question; nor does he want it. Physical delivery is one of the inherent fears of the uninitiated futures traders. But taking delivery is normally left to the merchants who are in that particular business. Futures speculators do not as a rule take delivery of the product they trade. A futures speculator knows that whether he(1) is long or short, he should liquidate his position before delivery. His investment is intended to capitalize on the market fluctuations between the time he enters the market and the date of maturity of the contract. His investment is inherently of short duration; most contracts mature within a year of the date they are born with most of the activity occurring in contracts with only a few months of life remaining.

Investments in futures do not involve a specific item, such as is the case in real estate or art. All futures contracts are fungible. You buy or sell a contract of silver, coffee or cattle, but until delivery you cannot inspect the item. In fact, the item may not yet be in existence. It does not matter to you which unit (or carload) is yours since the specifications are created to make them all the same. Not only is quantity of one contract the same as the next, the quality of each contract is the same as well. Consequently, it is safer and easier to invest in futures than it is to invest in diamonds or coins. You need not worry about storing the item, about whether your particular purchase is chipped, warped or damaged, or whether it is of a quality good or better than another quantity of the same product.

Furthermore, in futures it is erroneous to believe that you actually purchased or sold the commodity in question. You didn't. When you trade in futures, what you are doing is establishing a price at which you may take or make delivery of the product in question. Naturally, you always have the option of receiving or delivering the actual product, but it is an option you generally never exercise. This brings to mind another distinction of futures investment. Since you do not actually own the product at the time of a futures purchase, you also do not have to own the product in question in order to sell it. This means that you can utilize both sides of the market (long and short), with equal ease. You need not invest only when you believe an item will increase in value—as is traditionally the case in most forms of investment—you can invest as easily when you believe the price of an item will decline in value. Of course, when you are short, you must buy back before maturity or you will be required to deliver the product, otherwise, you will be in default. Appropriately, there is an old saying in futures which reminds the short seller that "he who sells what isn't his'n must buy back or go to pris'n".

Recently, there was a scandal on the New York Mercantile Exchange involving thousands of contracts of potatoes. The shorts defaulted because they had sold more than they could deliver. This type of default rarely occurs, but when it does, it gives an unfortunate impression about futures markets and casts doubt on the whole system. Actually, the exchanges and the Commodity Futures Trading Commission (CFTC)—the federal agency governing futures markets—have the capability to prevent most defaults. Defaults are usually the result of a effort on the part of individuals to manipulate the price of a given product above or below its market value. Such actions, either by shorts or longs, are against the law and subjects the wrongdoers to severe penalties as was the case in the Maine potato incident.

Another major characteristic of futures is the leverage available to the speculator. Everyone knows you can invest in many things on margin. That is, you can buy or sell something without putting up the full price of the product. But in futures, since you do not actually buy or sell the commodity, your leverage is much greater. In fact, in futures, margin is a misnomer taken, no doubt, from the securities markets where it is applicable. In futures, margin in reality is a security deposit; it is an amount sufficient to protect the brokerage firm handling the account from the next immediate adverse price swing in the given market. But the required security deposit is actually very small compared to the real cost of the product. Most margins are anywhere from one to five percent of the actual purchase price. Margin is also necessary because futures markets uniquely operate on a no debt system. Every brokerage firm dealing in the market must settle up each day in cash with the exchange clearing system for the value change of all the positions of its customers in the market. The settlement is based on the closing prices of each commodity each business day. Your brokerage firm must settle with the exchange daily for the position you hold in the market. The brokerage firm, therefore, must have some of your money in case the position goes against you.

Finally, another major distinction of this form of investment is that you do not receive any interest on your money. Your profit, if any, will be based only on the price difference from when you entered the market and when you liquidated your position. This is true even if you invest in the financial futures sector and deal in something like Treasury bills. In futures, you will not be investing for interest income as you will when you purchase an actual Treasury bill; nor will you be banking a dividend paid by the corporation whose stock you purchased. In futures, you have put up some money in the hope that you will come out with more than you started—or at worst, break even. There is an old futures market saying: "I hope I break even today. I need the money."

The best advice one can offer a newcomer to this difficult arena of investment is to "Think it over. Maybe you shouldn't." But usually such warnings go unheeded. After all, most people like to think they will succeed. Besides, the lure to quick fortune is a much bigger force than any words of caution. Futures markets are the last frontier where someone with limited risk capital can get a chance at a big strike; in all other fields it takes big money to make big money. Not that one can enter the futures market with a couple of hundred dollars; still, you do not need a couple of hundred thousand either.

In my opinion, to start in futures it takes a minimum of about $25,000 of risk capital—money that, if lost, will not materially affect your lifestyle. Obviously, you should have a secure income and other investments that are of a lesser risk. The amount of money you have to lose will determine the type and size of the position you should undertake. An amount less than $25,000 substantially diminishes the chances of success in the fast pace of today's markets. At the same time, the right of access to the market regardless of the amount of risk capital should be defended as long as participants understand their risk of loss is enormous. After all, many investors succeed in pyramiding large profits over time even though they began with an amount far below what is considered prudent. Such cases are the exception, but they do illustrate that no one has the right to pass a law or otherwise categorically exclude anyone from the attempt. On the other hand, many investors with large pools of risk capital fail miserably and lose it all. The point is that the money itself is not enough. The market is the ultimate equalizer. It is only concerned with whether you are right or wrong and whether you have the psychological temperament to meet the challenge of failures as well as the fortitude to hang in there when successful.

What is as important as risk capital is to understand what you are doing and adhere to some prudent market rules. If you start with the minimum amount of risk capital, limit your positions to no more than one or two contracts at a time, and avoid highly volatile markets. Basically, there are two primary trading methods for the outside investor. The first and easiest is to open a discretionary (managed) account with a firm of your choice, giving your broker the discretion when and what to buy or sell for you. You will be able to close your account whenever you wish, but normally, you will not be involved in the decision-making process in this type of arrangement. Consequently, it is imperative to choose a broker and firm that has a decent track record. It is equally important to determine in which market the broker excels and to limit your account to those markets. Prior to opening your account, study the market in which you intend to invest. Learn what influences its price; learn some of its history; learn some of the statistics and language so that you can question your broker. This will not only keep him alert, it will make you feel like you are more in control.

One of there greatest failings of futures participants is that they over-trade. And while most brokers are honest and conscientious, they earn their money from commissions. So the more you trade, the larger the commissions, and the more you are exposed to the market. If you are constantly in one or another position, you have very little chance for success. Advise your broker that you would prefer to enter the market only a limited number of times a year and to look for market moves that, in his opinion, might involve major price shifts. Every commodity will have several major bull and bear swings each year. Try for those and leave the minor ups and downs which occur daily to the professionals who devote a large portion of their day to the market. Otherwise, you will surely be eaten up either by commissions, or when your broker is wrong, or by both.

The second trading method for the outside investor is more of a professional approach. With this method, the investor makes the final decision when and what to buy or sell. Thus it requires greater knowledge about the market, staying abreast of new factors, and keeping track of all daily market gyrations. This method can be the most rewarding over the long haul. Even with this approach, however, the broker you choose will be of prime importance. Again, his track record and specific market expertise are paramount factors in your chance for success. But since you will make the final decision each time, two things will happen: First, you will learn both from your successes as well as from your own mistakes; second, you will be ecstatic when you have figured the market correctly.

Whatever your approach, there are some salient rules to be followed or you will not have a chance. The most cardinal rule of all is: Be a lover not a fighter. Every professional knows that in the long run only the lovers make money. A lover follows the direction of the market: if the market is moving up, he is a bull or he stays out of the market; if it is moving down, he is a bear or stays out. A fighter, on the other hand, bucks the direction of the market and takes a position opposite the immediate trend: he picks the top of a bull trend to go short, or finds the bottom of a bear trend to go long. But a fighter never knows whether it is the top or the bottom; when he is right, he makes it big; when he is wrong, he goes for a bundle. In the long run, a fighter's chances are much less than that of a lover. All of us, including the best of the professionals, will, on occasion, forget this principle. And when we do, it is usually with devastating consequences.

Another important principle is to limit your losses. Much has been written about taking losses when you are wrong, but not enough can be said about it. The rule "not to meet a margin call" means if you are losing in the market to the point where you need to put up additional margin, do not do so, liquidate your position instead. That is probably an over-statement of a valid principle. The point is, it takes courage to admit you are wrong and that the money lost is gone. But if you learn to limit your losses, the profits will take care of themselves. As will become obvious to anyone watching futures markets for even a few weeks, the price gyrations in one product or another are momentous. Each price swing is another opportunity. Obviously, you cannot capitalize on all of them and you cannot expect to be right in every attempt you make. If you are right 50% of the time in the positions you undertake, and if your losses equal your gains, commissions will make you a net loser. To be a winner, you must make money even if you are right only 40% or even 30% of the time. Obviously, you must make a greater profit when you are right than you lose when you are wrong. Thus, it is imperative not to let a losing position get out of hand.

The primary difference between winners and losers in the field of futures is not that the winners are more often right than the losers, it is that the losers never want to admit when they are wrong. Therefore, as soon as you think you are wrong, or as soon as you or your broker begins to doubt the reason for your position, or as soon as your position shows a loss greater than you are willing to take, or as soon as your own good sense or rule of thumb tells you that you should limit your losses, then you should do just that—the sooner the better. Remind yourself that some of the time you will be on the right side of the market. Those are the times you will stay with your position and let the profits run.

Professional traders have one or another rule to guide them when they are wrong in the market—if not, they are quickly forced to find a different field of endeavor. An old and wise trader once told me his rule which was quite simple: if a market position causes him the loss of one moment of sleep, he automatically liquidates the position the next morning. His chart, he said, was in his stomach. His stomach was a good trader.

Which markets you trade and the number of markets traded at the same time are also important considerations. Most professional exchange members usually limit their largest commitment to one or two markets at a time and take only minor positions in others. In other words, the majority of all professionals feel they have expertise in one or two markets and primarily concentrate on those markets. If that is the professional approach, it certainly must be the approach by off-the-floor or non-professional investors.

Choose one or two markets that, either by virtue of your background or education, or by virtue of your immediate interest, suit you best. Concentrate on those markets and ignore those that you know little or nothing about. Above all else, do not trade or take positions in markets that have relatively low daily volume. Such markets are illiquid and will expose you to unwarranted dangers. By definition, illiquid markets have large price gaps between transactions and are difficult to exit. Every professional trader knows that the most important question about a given market is not whether you can get in but whether you can get out.

There is one overriding thought I would like to leave with all present and potential futures market participants. There is no magic formula for success. Don't look for one, nor listen to someone who says he has such a method. The investor must approach these markets in a businesslike fashion and must apply proven business rules and common sense. Do not depend on luck and do not consider these markets as something akin to gambling. The reasons the markets to go up and down have little to do with the rules of chance or probabilities. Ignore the claims of hot tips or inside information. Such claims in futures markets are a near impossibility.

Basically, price is determined by rules of economics and supply/demand equations. Often market gyrations appear random or make little sense; a market may rally or fall for reasons that, in retrospect, seem silly; sometimes you will hear that the cause for a recent drop in price was attributed to a concentrated effort by professional shorts—or vice versa; sometimes you will be told that the market is being squeezed by special groups or by foreign investors; sometimes you will hear accusations of manipulation; and sometimes you will be caught by forces resulting from unfounded rumors. In all such cases, if you are on the wrong side of the market and forced to take a loss, it will seem unfair and contrary to the sound principles of economics which, in your belief, should govern. There is no free market which is not—to one degree or another—subject to the same or similar market forces. In futures you are indeed dealing with future expectations, often with respect to supplies that are not yet in existence. That factor alone makes these markets much more vulnerable to intangible and imagined fears, anticipations, and predictions. By their definition, these markets are volatile as well as subject to emotional responses. It is axiomatic therefore that daily or intermediate price swings of futures markets are often unpredictable and treacherous.

Emotion, rumor, imagined expectations, unexpected world events, adverse weather conditions, the concentrated influx of many orders to buy or sell, and many, many other similar causes will often result in pushing a given futures market up or down in contravention to the dictates of logic or conventional economics. But such causes are generally of short duration and of relatively small consequence. With very few exceptions, the prices of all markets in the long run end up at levels that are determined only by the available supply of the given product and the demand for it. The in-between, intermediate of contra-trend price shifts are what make these markets so difficult, so challenging, and at the same time so rewarding.

Whether you have the capital to withstand the inconsequential, whether you have the determination and fortitude to stick with your beliefs when you are right, whether you have the aptitude and psychological stamina to admit when you are wrong, whether you have the discipline to follow strict business and market rules are the principal factors which, in the long run, will determine your success or failure in this most challenging form of investment.

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    (1) I apologize for the use of only the male gender in this article. I struggled with this problem attempting to use "he or she" or "his/her", etc., whenever I referred to the investor or potential investor; however, this method was really cumbersome and so I opted for the male version with the following caveat: Whenever I use the male gender, it is fully and honestly meant in the generic human sense; i.e., individual or person. In recent years, women have applied themselves to futures markets as members of exchanges, employees and investors in increasing numbers. Their performance, with few exceptions, has been outstanding, proving once again that they can do everything as well as their male counterparts—if not better.

Reprinted by permission. Excerpted from Melamed on the Markets, by Leo Melamed. John Wiley & Sons, 1993

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