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Reader Questions Answered

Futures vs. ETFs Performance Differences

Here’s an interesting, but somewhat complex question about oil trading I had come in by email. Well, at least the answer is complex.

Hi John,

While checking a performance comparison for the last 200 days between USO and the WTI Continuous Contract, I noticed that they had very similar performance up to the end of 2008, and from the start of 2009 they began diverging, with the ETF significantly underperforming the futures contract. What happened around new year’s time that suddenly caused this divergence? And what other ETF can I choose that better mimics the price action of WTI if I would rather avoid trading the futures contract?

Thank you

Rod

I’m not an oil trader or analyst (though back in the day I would cover the energy markets on a fill-in basis from time to time), so the really market-specific stuff is beyond my knowledge. I’ll do my best, though, to explain what I suspect is contributing to the difference in performance between the USO and the front month futures, which is basically what the continuous contract tracks.

US Oil Fund (USO) ETF
First of all, we need to look at what makes up the holdings of the USO. According to the fund website, the objective of the fund is:

… for the changes in percentage terms of its units’ net asset value (“NAV”) to reflect the changes in percentage terms of the spot price of light, sweet crude oil delivered to Cushing, Oklahoma, as measured by the changes in the price of the futures contract for light, sweet crude oil traded on the New York Mercantile Exchange (the “NYMEX”), less USO’s expenses.

At this writing the fund is indicated to be long about 45,000 contracts in the July futures, a position with a value of about $2.79 billion as of the May 20 closing price. The fund also shows nearly as much in cash ($2.76 billion). In and of itself, that sort of positioning would be a very good reason why USO is under-performing the front month futures contract. The ETF isn’t fully exposed to it so they cannot possibly match the gains.

I don’t know how those relative weightings have changed over time, though, so I cannot go beyond the current observation to specifically say that’s the entire reason. There may be other factors involved as well (see below). The big cash position definitely stands out, though.

Other Oil ETFs
There are a handful of other oil-focused ETFs out there. Here’s a list:

  • iPath S&P GSCI Oil Total Return ETN (OIL)
  • PowerShares DB Oil Fund (DBO)
  • United States 12 Month Oil Fund (USL)
  • PowerShares DB Crude Oil Long ETN (OLO)
  • United States Heating Oil Fund (UHN)

Some of the ETFs take an approach similar to USO in which they focus their holdings on front month futures to try to track nearby prices. Others, though, such as USL, actually use a spread of futures contracts across an array of months. That creates an interesting dynamic when it comes to comparing performance vs. the front month futures.

Contango and Backwardation
In normal circumstances prices of futures further into the future are priced cheaper than those in the front month. That’s a situation known as backwardation. The price of oil in the ground is less than the price of one in a barrel. Sometimes, though, things flip around into contango, which is when foward prices are higher than current ones.  That can come when near-term demand drops or there’s a glut of supply.

Now, if things hold in either contango or backwardation one would generally not expect to see much difference between the performance of front month oil and that of an ETF which includes holdings of several different month futures. When the situation flips, though, one of the two is going to outperform, potentially by a large margin. For example, if the market goes from backwardation to contango (means forward contracts go from priced less than front month to being price higher) an ETF holding forward months is going to outperform the front month futures (and vice versa in a contango to backwardation switch).

So the bottom line in all this is that you should make sure you know what the ETF you’re trading or investing in is holding so you can know what to expect.

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Reader Questions Answered

Where does forex leverage come from?

A question was posted on BabyPips which occurred to me as being something readers here might wonder about as well.

I understand that it comes from other people’s deposits and from the broker’s capital. However, where is the limit? I understand that with stocks, its basically a loan from a bank, i.e., you will pay interest if you hold it for any appreciable amount of time.

Forex has only the interest rates on the currency themselves. But, there has to be limit, right? To do a crazy example, let’s say you dumped $10mil cash in a forex account. At 1:400, that would be $4 billion. That makes no sense since most brokers don’t have nearly that amount of capital – even if they did, it would leave no capital left for other traders to use.

So where exactly does the money come from? Most offer high leverage in comparison to stocks, or certain other instruments, so I’m just wondering how this is possible. I’m aware that not everyone will be using 100% leverage 100% of the time, but there still has to be limits.

The question comes from what would seem to be an incorrect mental point of reference where the forex market is concerned. The poster is expressing things in terms of stocks where actual ownership of an asset takes place. This is erroneous. Spot forex is akin to the futures market where traders are exchanging agreements, not ownership.

Forex = Futures
In the futures market when a trader goes long gold, for example, what’s happening is that they are agreeing to buy gold at a defined price at some specified time in the future. They aren’t buying the gold now, just agreeing to so it in the future – thus the term “futures”. The value of their position is based on the fact that their agreement is at a fixed price, while market prices are changing, potentially giving them a chance to sell that gold (were they to take delivery) at a higher price than where they bought it. Of course they do not have to hold the futures position through until delivery. They can simply enter into an offsetting agreement and thereby get flat.

Spot forex is basically a 2-day futures contract (technically a forward, but they are essentially the same thing). That means when a trader goes long EUR/USD, for example, they have entered into an agreement to provide USD in exchange for receiving EUR. When the trader wants to close out that position they enter into an offsetting agreement (call it going short if you like). If the trader holds a position overnight, the broker basically offsets the open trade at the end of the current day and then opens a new one at the start of the new day. That’s the roll. Depending on the broker that is either obvious or transparent.

Margin is Surety, Not Down Payment
With forex being an agreement based market, not an ownership market, the capital requirements of the liquidity providers are much lower relative to the size of the trading volumes than would otherwise be the case. This is because margin in forex (and futures) is a surety for the broker (and the system as a whole) to make sure there is coverage for any variation in the value of the future/forward contract the trader might experience. This is different from in stocks where a trader operating on margin is actually borrowing money to be able to purchase (thus own) more stock than they could have otherwise, much like a home-buyer takes out a mortgage. The stock margin is basically a collateralized loan.

No Ownership Means Lower Capital Requirements
Since a forex broker isn”t actually exchanging EUR for USD when a customer goes long a lot of EUR/USD, it doesn’t need to have 100,000 EUR on-hand (putting aside the whole matching up of customer positions brokers do on the back end). It’s not like a stock dealer which actually has to have the capital (or sufficient lines of credit) to own the shares it’s making a market in.

That’s why forex brokers can offer such high leverage ratios.

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Reader Questions Answered

Volume in the Forex Market

Here’s an email question that came in recently which relates to volume in the forex market.

Hello John,

I’m a Forex trader. Is there something equivalent to a buy/sell pressure indicator for the MT4 platform that you know about or can recommend.

My trade plans are less effective when the O/S or O/B conditions last for a long time. One of the indicators I use is the stochastic.

Sometimes it undulates above 80 or 30 so I’m never sure when it undulates if it going to break the high/low of the previous wave.

I’ve seen some buy/sell pressure attempted with tricks for getting the currency’s volume or with number of tics but I don’t think it a reliable way to gather this data. Any thoughts would be appreciated…

–Ermalinda

Pretty much without exception, the volume figures you see in forex are not actual traded volume. They are tick volume, which indicates how many times a given price changed. While it can sometimes be an interesting indication of how active the market was in terms of price choppiness, it gives absolutely no indication of how much actual buy and selling is being done. As such, any technical indicators based upon tick volume are of dubious value from that perspective.

The only readily available public volume figures that I currently know of are in the futures and forex ETFs. They may, at times, be useful. Just keep in mind that they only represent a tiny fraction of what is done on the spot market.

As for the effectiveness of over-bought/sold trading with Stochastics, keep in mind that they will be good during range-bound periods but will kill you in trending conditions.

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Reader Questions Answered

Looking at Risk and Stops Across Markets

Here’s the core of a note I received from a member of my mailing list a short while back. It speaks to a subject some traders struggle with.

Have been studying trading for several years, traded a bit with various levels of success. Looked hard at Forex, but am now rather taking a liking to E-Minis: reason is risk. I find it relatively easy to limit your risk by catching a move with a tight hard s/l & moving s/l in the E-Mini, but for forex all strategies I normally see require a s/l of 20 – 35 pips. I do not like that at all.

What is your view?

It appears as though this individual is caught up in a faulty perspective. He’s focused on points (or pips) rather than what they represent.

In an S&P 500 e-mini contract a single point is worth $50, with the minimum price change of 0.25 being equal to $12.50. By comparisson a 20 pip move in the forex market could represent any number of possible values. Taking EUR/USD as an example, if we are trading a micro contract (1000 EUR) it would be $2.00. For a mini contract (10,000 EUR) it would move up to $20. When we get up to a full lot (100k EUR) it reaches $200.

In other words, depending on the size of your position, a 20-35 pip forex trade risk could be substantially smaller than the smallest possible movement in the e-mini contract. If the trader above is risking 2 points on his e-mini trades (for example), which is $100, then he could trade 5 mini EUR/USD contracts risking 20 pips  and have exactly the same exposure.

You shouldn’t compare markets on point/pip a basis. Focus instead on a value basis, especially a % of portfolio one.

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Reader Questions Answered

Picking a Broker

I got this broker question the other day.

The single most important question would be what broker do you use to trade your personal money(not a demo account)?  Secondly who would be someone there to contact you personally deal with?

For stocks and options I still have the original brokerage account I opened lo these many years ago. That’s with Charles Schwab. I’ve never seriously looked at anyone else because I’ve been satisfied with the service and all of that, so I was never motivated to make a switch. I’ve heard good things about others, but as I haven’t personally explored them yet myself, I do not feel comfortable commenting on them.

On the futures side, I currently trade with PFG Best. In the past I have used Lind Waldock and Interactive Brokers. I’ve been satisfied with all of them, though they will all appeal to different types of traders.

In forex I experimented with several different brokers before ending up with Oanda. I also use them exclusively in my trading education work. They are considerably different from other forex brokers in that they have no fixed lots or minimums of any kind.

I do not have personal contacts at any of the above brokerages except at PFG Best. In that case, however, my contact has move out of futures.

All the above said, I do not specifically recommend any of the above brokers for any given person. Each of us has different needs which some brokers address better than others. You should absolutely do your research and not just take my or anyone else’s advice without looking into things yourself.

One final note. Especially in the forex realm there is a lot of slamming of brokers on forum sites and whatnot. Some of it is legitimate, but if you just go by that stuff you’ll be scared of every broker out there. Keep in mind that people have a strong tendency to complain rather than praise and traders who have lost money are prone to wanting to place blame on someone other than themselves. In other words, take it all with a grain of salt.

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Trading Tips

Picking the Right Market to Trade

Here’s a question I know a lot of new traders have – or at least they should have – as they are getting started in trading.

I am trying to figure out what market fits “me” or “my personality”. How can you do that without having tried to trade all those markets first?

In the end, it might come down to giving different markets a test drive of sorts, but before that point there are a couple of things to think about when selecting a market to trade.

Trading Timeframe
Some markets can be ruled out based on the timeframe you have to work with. For example, you aren’t going to day trade stocks or futures if you can only access the market outside of exchange hours. Generally speaking, the longer your trading timeframe term the more markets are open to you. The shorter the timeframe, the fewer become realistic options.

Capital
As much as the barriers to entry have been lowered in many markets, there are still things that have minimums which rule some traders out. The futures market is a notable example there. The contracts are of a fixed size with specific margin requirements. If you don’t have the margin capital, plus a heathy amount beyond that, then you can’t play that market. Even a market like stocks where you could play with relatively little money might not make sense for some people because of the transaction costs.

Interests
It helps to trade a market you have an interest in. It will make you more eager to learn and understand and not just make it some abstract thing. This can be an important contributor to having a long-term positive trading experience.

Access to Tools and Information
This is a fairly minor point at this stage, but in some cases you will have better access to what you need to trade in one market than you will another.

I think you’ll find that if you work through this list you’ll probably find a market which suits you without having to try them all out. And even if you can’t make a final selection between a couple of alternatives, you can always demo trade those markets to see which one feels most right.

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The Basics Trading News

New Micro Forex Futures Contracts on the CME

Many forex traders (or would-be forex traders) look askance at trading in the spot market, especially through dealing brokers – those who make direct markets to their customers as opposed to the ECNs who are just pass-through conduits. The noted concerns are the idea that the broker is trading against them and that the market is unregulated. This leads them to the futures market.

I’ve discussed the the pluses and minuses of spot forex trading vs. forex futures trading previously. One of the major advantages of the former is that the existence of micro contracts and the like allows new traders and those with lightly capitalized accounts to play at a sufficiently small size. Futures don’t really offer those “micro” contracts.

Well, until now anyway.

The Chicago Merc is set to launch micros at the end of the first quarter this year. Those are contracts set at 1/10th the size of the normal contracts. Details can be found here.

One note at this point, however. The micro contracts only cover the major currencies against the USD. They do not include any crosses. Also 1/10th sized contracts may still be larger than ideal for small traders. The sizes are as follows:

EUR/USD: 12,500 EUR
USD/JPY: 10,000 USD
GBP/USD: 6,250 GBP
USD/CAD: 10,000 USD
AUD/USD: 10,000 AUD
USD/CHF: 10,000 CHF

As you can see, these are really what most spot forex traders would equate to mini contracts, not micros.