During the mid-1800’s, Chicago (in the United States of America) was becoming a major commercial center. Wheat farmers from across the country were coming to Chicago to sell their wheat to the grain dealers, who then sold it to commercial buyers all over the county.
At that time, Chicago had almost no wheat storage facilities and had poor methods for weighing and grading it. This left the farmer at the mercy of the grain dealers.
In 1848, a central exchange was formed where farmers and dealers could meet to deal in “spot” grain, which is selling wheat for cash and immediate delivery.
Soon after, a ‘futures market’ was used by farmers and dealers. This simply means that the farmer (seller) would contract with a dealer (buyer), to deliver wheat at a specific date in the future for a pre-determined price. Hence, the name “futures” trading evolved. This worked well for both parties, as the farmer knew in advance how much he was going to be paid in the future, and the buyer knew his future cost beforehand.
These contracts became so common that banks accepted them as collateral for loans. Sometimes a farmer who had sold his contract might not want to deliver the wheat, and would on-sell his contract to another farmer, who would take on the obligation to deliver.
Other times the buyer of the wheat might not want to take delivery, so he would sell his contract to someone who did want to take delivery of the wheat. Before long, speculators who saw an opportunity to buy and sell these contracts (hopefully at a profit) came into play.
These were the first commodities “traders” as we know them today, and they had no intention of ever taking actual delivery of the wheat. They began trading these contracts among each other, hoping to buy low and sell high, or sell high and buy low.
Financial trading has since become a business like any other. Financial trading success comes to those who are disciplined and committed to their business. If you treat this business as a game the reality is you will lose a lot of money.
However, if you are diligent in your studies and persistent in the application of the techniques discussed, you may join the ranks of those people that enjoy the untold freedom and wealth that trading brings.
Becoming extremely wealthy in the trading business is not uncommon. Many people have done it before, and many more will do it in the future. Even if you don’t have a lot of money to start trading with, you can still be successful.
However, if you start to trade thinking that you are going to get rich overnight, you’ll probably lose all that you invest.
Millions of dollars have been lost by people who enter the trading markets without sufficient training with the idea of getting rich overnight. Current wisdom is that over 80% of traders in the stock and futures markets lose money. I believe the true figure is closer to 90% for spread traders.
Most traders fail for the same reasons. They take uneducated risks in an attempt to obtain unrealistic outcomes. When they don’t get rich, or lose all their money, they blame the markets.
People who lose through uneducated and irresponsible trading should only blame themselves. Self-denial accounts for much of the negative stigma associated with trading. Many people see spread trading only as a form of gambling. Spread trading (sometimes referred to as spread betting) is gambling, but like all professionals, we can stack the odds in our favor.
Spread trading is different from trading stocks or buying futures. When you buy a stock, or a futures contract, you actually own it or can take delivery of the commodity. When you buy or sell a spread trade, you are speculating on the future direction of the price with no rights to ownership.
A spread trader simply buys or sells the price of the underlying contract according to their expectations of whether the price will rise or fall before a future date. As a spread trader, you have no right or obligation to accept delivery of the contract, share or commodity, as all settlements are cash in nature.
If you “buy,” then you are considered “long”, and are speculating that prices will rise. If you “sell”, you are considered to be “short”, and speculating the prices will decline. In other words, you are trying to buy low and sell high, or to sell high, and buy low.
We will be discussing this in detail later.
There are three positions in trading: long, short, and out.
Most of the time the third position is the correct position, but it’s not used often enough.
To understand how you, a speculator, fit into the picture, let’s look at a commodity trade from start to finish. Although this trade is based around a ‘real’ futures contract as opposed to a spread trade it provides an example of the underlying processes that drive prices.
A wheat farmer planted a crop about three months ago. In a few months it will be ready to harvest. After careful analysis, he estimated that it cost about $2.00 a bushel to grow his wheat, including paying for the entire overhead. Anything he can sell it for over $2.00 a bushel is profit.
Let’s assume that right now, wheat is selling for $3.00 a bushel, but the price has been going down over the last few months. He is concerned that if the price continues to drop, in three months the price may be lower than $2.00 a bushel, which is what it cost to grow. Since it’s going to be three months before his crop is ready for harvest, what can he do to assure himself a profit on the crop?
He can sell the future crop by calling a commodities broker and selling a futures contract for $3.00 a bushel to be delivered three months from now, in December, as an example.
His risk in doing this is that, if the price of wheat goes up to $3.50 a bushel during the next three months, the farmer will receive only $3.00 a bushel because he pre-sold it today for $3.00 a bushel.
On the other hand, if the price of wheat drops below $3.00, he has locked in a price of $3.00 a bushel. The farmer feels this is a good way to go, since the price of wheat has been going down, not up, in the last few weeks. This process is called “hedging.”
When the farmer calls his broker to “sell” (also called “going short”) a contract, the broker acts as a middleman, and helps find someone to “buy” (also called “going long”) the contract.
Who would want to buy the wheat contract at $3.00 a bushel?
It could be a large company that is buying wheat and is concerned that the price of wheat will be higher three months from now, and they want to protect themselves in case of a price increase.
Of course it could be a speculator who is looking to make a profit.
So the farmer sells a contract to lock in his profits, the other person buys a contract to guarantee their price, and the broker, acting as a middleman, earns a commission for doing this.
Imagine the role of the speculator. The speculator will carefully analyse the price action of wheat, and whilst the price has been dropping he thinks the price is going to stop dropping and start to go back up again.
The speculator thinks that in three months, the price is going to be $3.50 a bushel, not the $3.00 a bushel that it’s selling for today.
The speculator senses an opportunity to be able to buy a contract at today’s price of $3.00 a bushel and sell it a few months later for $3.50 a bushel. If he is correct and the price goes up, he will make a profit on the commodities contract.
When a contract is purchased at today’s price of $3.00, the person who sells the contract guarantees the buyer delivery. They must honor their end of the agreement, and sell it for $3.00 a bushel at the end of the contract, even if the price goes up.
On the other hand, if the price of wheat goes down, the buyer loses money.
How does the buyer lose money? If the price of wheat three months from now is $2.50 a bushel and the speculator agreed to buy it for $3.00 a bushel, he has lost 50¢ a bushel, for the total number of bushels in your futures contact.
Now for the good news! You can in some ways limit your losses. In other words, you can stack the odds in your favor. There are several ways to do this, and you will learn about them as you go through this trading course.
When we spread trade through a financial bookmaker, we assume the role of the speculator but without the obligation to accept delivery of any commodity, share or financial product. Our obligation is to make good any losses we may incur in the course of our trading and the bookmaker undertakes to ‘make a market’ in the contract and to pay us money if we win.
Most people who trade are average hard-working people, probably a lot like you, who are just trying to supplement their income and trade on a part-time basis. Based on my experience, I’d think that less than 1% of the speculative traders are full time.
There are basically two types of traders, although some people mix a little of both in their trading style.
The fundamental trader (a fundamentalist), is someone who studies the supply and demand of a given commodity; or the financial position of a company whose shares they are interested in.
Commodity fundamentalists may look at things like the weather patterns around the world, that might affect the world’s supply of a commodity like wheat. As a fundamentalist, you might buy a wheat contract because you think there is going to be a drought this summer in Australia, causing the price of wheat to go up because the supply will be down.
The share fundamentalist might analyse a company balance sheet and identify a high level of debt as a limitation to future growth and predict that the price will fall in the future. A fundamentalist may back their observations and thoughts about the markets using spread trading although most spread traders are known as technical traders.
The technical trader bases his decisions on current prices and market trends that are reflected on price charts. The ‘science’ of technical analysis has developed an increasing array of complex indicators that are created to give traders a winning edge.
As a trend follower, I see little advantage in many of these technical analysis indicators. There are some indicators that may have good mathematical validity as trading indicators and these are typically the most proven and historically valid indicators available.
Note that while financial spread betting has been around in various forms for over 30 years, it was not until the dotcom era that private investors woke up to the related opportunities. The development of online trading platforms meant traders and investors could make decisions from live pricing and interact directly with the market as opposed to going through a third party. More recently, there has been a rush by the financial spread betting industry to develop software for mobile phones and on-the-move devices to allow spread traders to trade wherever they are.