ALTERNATIVE INVESTMENTS – PART III: THE FUTURES MARKETS

FORECASTS & TRENDS E-LETTER
By Gary D. Halbert
August 5, 2003

IN THIS ISSUE:

1. What You Need To Know About The Futures Markets.

2. Why The Futures Markets Are So Volatile & Risky.

3. Why Most Individuals Lose Money In Futures.

4. Why Most Futures Trading “Systems” Don’t Work.

5. The Only Way I Recommend Investing In Futures.

Introduction

This is the third installment of my “Alternative Investments” series. In Part I ( Click Here), I discussed the importance of alternative investments which may have the potential to perform well during times when traditional investments such as stocks and/or bonds are doing poorly. If The Bank Credit Analyst’s view ( Click Here) that the next recession could be very severe, then it will be important to be knowledgeable about alternative investments well ahead of time. That is what this series is all about.

In Part II ( Click Here), I discussed the world of “hedge funds” and how, if carefully selected, they can help diversify one’s portfolio. In this issue, I will discuss the commodities futures markets and why they are such a challenge for investors. This week, I will discuss why most investors lose money investing in the futures markets. This is valuable information you are not likely to read elsewhere.

I conclude with my advice as to the only ways I would ever recommend investing in the futures markets. Then, in the next week or two, I will have a follow-up E-Letter that goes into much more detail regarding the approaches to the futures markets that I would recommend for investors who are suitable for such programs.

First, A Little Background

Immediately after receiving my Masters degree in 1976, I was hired by Continental Grain Company, one of the largest international grain companies in the world. I started as a grain merchandiser in Ft. Worth, TX. On a daily basis, I dealt with grain elevator firms, cattle feedlots, cotton gins and others in the agriculture industry. I bought and sold large quantities of wheat, corn, soybeans, grain sorghum and other commodities across a five state region.

After about a year, I transferred to the company’s commodity futures brokerage subsidiary in Dallas where I began a decade-long career of helping regional grain elevator firms, cattle feedlots, cotton gins and others learn how to “hedge” their inventories from adverse price risk by using the futures markets.

In the mid-1980s, in addition to my hedging business, I began to expand into helping investors who wanted to participate in the futures markets. In 1987, I launched a multi-Advisor futures fund that is still in operation today. In the years since then, I have started several other such funds that also continue to operate today.

So, with that little bit of background, let’s get started.

How To Make A Small Fortune!

There is an old saying that goes: The best way to make a small fortune in the futures markets is to start with a large one. While this might sound amusing, it is absolutely true in most cases. Any discussion of investing in the futures markets should start with the following caveats: 1) futures trading is extremely risky; 2) you can lose more than you invest; and 3) on a percentage basis, very few individuals who trade futures make money – most lose money.

In the pages that follow, I will explain why most investors lose money in the futures markets. I’ll tell you why most of the products that are marketed to investors don’t work. Yet I will also tell you about the approaches to the futures markets that I believe offer the best chances for success. But first a little basic information about the futures markets.

If you are not familiar with the futures markets and how they work, you may want to stop here and scroll down to SPECIAL ARTICLES. I have included several links to some informational articles about the futures markets and how they work.

Much More Than Commodities

When I first started in 1976, the futures markets were largely made up of agricultural commodities (corn, wheat, soybeans, cotton, etc.), livestock (cattle, hogs, pork bellies, etc.), foods (coffee, cocoa, sugar, orange juice, etc.) and metals (gold, silver, copper, etc.). Futures markets in foreign currencies had just been introduced shortly before I got into the business in 1976.

Today, however, there are futures markets in just about anything you can imagine. In the early 1980s, we saw the introduction of so-called “financial futures.” A colleague of mine invented and introduced the Treasury bond futures contract at the Chicago Board of Trade (CBOT). The T-bond futures market is the single largest market in the world today. Since then, we have seen new futures markets in just about every type of financial market: T-notes, T-bills, Fed funds, Muni bonds, CDs, etc., etc. Likewise, we have seen new futures markets in dozens of stock index contracts (Dow, S&P, Nasdaq, Russell, etc., etc.). Today, there are literally hundreds of futures markets in everything from the exotic to the mundane.

When I got into the business in 1976, futures were mainly traded only in Chicago, New York and London. Yet today there are thriving futures markets all across the world. Most of the successful professional money managers in futures trading are active in the markets – both US and foreign markets – 24 hours a day, 7 days a week.

Why The Futures Markets Are So Risky

The futures markets are highly leveraged, often as high as 10 or 20 to one. Let me use an example. A gold futures contract represents 100 ounces; at a price of $350 per ounce, that’s $35,000 worth of gold. Yet an investor can buy a gold futures contract with apprx. only $2,000 deposited as “margin.” If gold drops from $350 to $330, the investor loses $2,000. If gold drops to $300, he loses $5,000. That’s $3,000 more than he originally invested, which he would have to meet in “margin calls” along the way, plus the commission when he finally gets out.

The fact that futures contracts are so highly leveraged means that these markets are inherently volatile. Wide and erratic price swings are commonplace. The smallest piece of news (or lack thereof) or even rumors can cause markets to swing wildly up or down or both, often within a single day.

The futures markets are not just impacted by the specific “supply and demand” factors for each commodity traded. While supply and demand factors are inherent in determining prices, many, many other factors influence these highly leveraged markets, such as: economic conditions, interest rates, inflation, geopolitics, news, public opinion and dozens of other factors which may, or may not, appear to be related.

Unlike stocks, bonds and certain other markets, the futures markets are a “zero-sum game.” What this means is that for every dollar that is gained, a dollar is lost. There are two parties to every futures contract. One party is “long” (meaning they bought) and will make money if the price goes up, and another party that is “short” and will make money if the price goes down. One side or the other has to lose, unless the price doesn’t change, and even then, both sides will pay a commission.

Most Individual Investors Lose Money

For the first seven years I was in the business, I worked almost exclusively with commercial agricultural firms who used the futures markets as a way to reduce the risk of adverse price fluctuations on their inventories of physical commodities. We were not in the markets to speculate; we were “hedging” to protect their profit margins.

I was the only “hedge broker” in our office. The other 8-10 brokers worked with investors who were trying to make money. During those years, it became obvious to me that most individual investors (referred to as “speculators”) lost money, often a lot of money trading futures.

One year in the early ‘80s, the company had a big conference in Chicago. Hundreds of brokers from all around the country were in attendance, as was I. One of the company’s top executives announced that he estimated, about one third of our speculative clients made money, about one third lost money and about one third broke even. He seemed to be proud of that number! I would later learn that if those numbers were true, they may actually have been impressive. Here’s why.

At another conference a couple of years later, myself and a small group of brokers sat and listened to a speaker who must remain unnamed. He had recently retired from one of the largest investment firms in the world. If I gave the firm’s name, everyone reading this would instantly recognize it. Anyway, this gentleman had been the president of the firm’s futures subsidiary for a decade. I’ll never forget what he told us.

He said that during his 10 years as president of the futures operation, over 90% of individual investors who traded their own accounts LOST money. According to him, only one-out-of-10 investors made money on average trading their own accounts in the futures markets. I was stunned, both at the numbers and that he admitted it!

How Investors Go Wrong – Let Me Count The Ways

Most investors don’t just wake up one morning and decide, “Gee, I think I want to try my hand in the futures markets.” No, most investors are solicited to open such accounts. They either get a phone call from a broker, or they see an ad in a newspaper or magazine, or they get something in the mail, or more recently, on the Internet.

In almost every case, the promoter or broker talks about (or writes about) the enormous potential for profit in the futures markets. Never mind the enormous risks I mentioned above and others. Never mind that the promoter or broker may have a long history of his clients losing money.

So the first way many investors go wrong is that they believe they can be successful, usually because they are encouraged to believe that by the promoter or broker.

As noted above, there are hundreds of variables that can affect the already highly leveraged and volatile futures markets. Most investors learn painfully that they cannot correctly predict which way the markets will go. They also learn that most brokers can’t either. At some point, most investors decide, I need a system to be successful.

Trading Systems, Books, Newsletters, Hotlines, Etc.

There are dozens, if not hundreds, of so-called futures trading “systems” out there for sale. They come in all shapes and sizes and prices, but almost all of them have two things in common: 1) they promise the moon, some even guarantee profits; and 2) they almost never work!

People often ask me about such systems, and I always have the same response: If it’s so successful, why would anyone want to sell it? I have seen cases where the promoters used systems until they didn’t work anymore, and only then did they decide to sell the systems to the public based on the earlier track record. My advice: Just say NO!

Likewise, there are dozens and dozens of books on the subject of futures trading. Some are actually quite good, some are mediocre and some are awful. But all are DATED material. More importantly, it’s one thing to read a book; it’s another to be able to actually do what they propose successfully. Most investors fail.

Ditto for newsletters and telephone hotlines that offer futures trading advice. I couldn’t guess how many newsletters, hotlines and similar services are out there today; suffice it to say hundreds. There are many inherent problems with trying to trade futures based on advice given in a newsletter, a hotline or even an Internet service. Even if the advice is generally good (which is rare), timing is a big problem.

My experience has been that for every one investor who has told me he was making consistent money following any of the services above, at least 10 told me they lost money and gave it up.

Most of the trading systems and services are very expensive. They hit you hard on the front end because they know you are unlikely to buy anything else or re-subscribe.

Don’t Do It On Your Own

My advice to anyone reading this who may be considering futures trading on your own is DON’T. The odds are heavily stacked against you! You can lose a lot of money – including more than you invest – very quickly.

Most of the advertised trading systems, newsletters, hotlines and Internet services don’t work either, at least for most investors. The futures markets are just too tough, too volatile, too complicated and too risky for investors to venture into on their own, in my opinion.

I tell you this as a 27-year veteran of the futures markets, just don’t go there on your own, or with a broker, or with an advertised system, or with newsletter or hotline advice, and certainly not with some unproven Internet promotion.

Also, if you receive an unsolicited phone call from someone trying to sell you a trading system or trying to get you to open an individual futures trading account, consider this bad news. While illegal, there are “boiler room” type operations that will promise you anything to get you to buy what they’re selling.

But There Is Some Good News

There are ways to greatly increase your odds for success in the futures markets. If you have been reading me for long, you will not be surprised that in this arena, as with most others, I recommend that you use PROFESSIONALS if you decide to invest in futures.

Just as with stocks or bonds or other investments, there are registered professional futures Trading Advisors that can manage your money in the futures markets. If carefully selected, these professionals can significantly increase your odds for investing successfully in the futures markets. As usual, there are good futures Trading Advisors, and there are bad ones. There are some with documented performance records going back 20 years or longer.

Keep in mind, however, that hiring a professional Trading Advisor does not eliminate the risks in the futures markets.

There are also hundreds of futures funds (and pools) you can invest in that are managed by one or more of these professional Trading Advisors. As with mutual funds, there are good ones and bad ones. There are services that track the performance of futures funds, and these can be used to identify funds with good performance records.

Only Go With Professional Trading Advisors Or Futures Funds

As should be obvious by now, I do NOT recommend that anyone reading this E-Letter attempt to trade in the futures markets on your own (unless you are an industry professional). The odds are highly stacked against you. The only way I recommend investing in the futures markets is with a carefully selected Trading Advisor or in carefully selected futures funds, and this is only if you are financially suitable for such an investment.

There is much to learn about selecting Trading Advisors and futures funds. Due to space limitations, I will write about Trading Advisors and futures funds in the next installment (Part IV) of the “Alternative Investments” series in the next week or two.

Summer’s Almost Over

How is it that summer goes by so fast, especially when you have kids? On a personal note, my 13 year-old son started football practice this week in the hot Texas sun. Yours truly did, too. I’ve coached both my kids in youth sports (football, basketball and baseball/softball) for the last eight years. This year, I was once again asked to be an assistant coach on the school football team, and I gladly accepted. I love it, even if it’s sweltering hot!

Anyway, I hope you’ve had a great summer. I did. Enjoy what’s left of it!

Wishing you well,

Gary D. Halbert

SPECIAL ARTICLES

Links to informational articles on the futures markets:

http://www.cftc.gov/opa/brochures/opaeconpurp.htm

http://www.cftc.gov.opa/brochures/opafutures.htm

http://www.nfa.futures.org/investor/bofc.asp