Slowinvesting.com and, a “bad-ass” $1m futures position

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SLOWINVESTING.COM

Is the domain name I just registered.  This will be my web site for Slow investing, within the context of the broader theme of sustainability.  It will profile long-term investing strategies, and the slow lifestyle as it applies to investing.

A PRIMER IN FUTURES OR, HOW TO TURN $1M IN T-BILLS INTO $25 CASH

*** NOTE:  After the original post, I corrected an error in the starting price platinum, and the subsequent calculations after the original post.  I had misread the July Platinum price at $2316 at TFC-Charts when it’s Apr 10 closing price was actually $2045.0 per ounce. ***

Last post I talked about some suggestions I made to a student participating in a trading contest.  The basic gist of it was, because you don’t have real money on the line, and good odds for taking the prize, go crazy and bet the farm.

The question came back – OK how do you do that?  GOOD question, since the mechanics of trading futures are quite a bit different from equities.  So, for anyone who’s interested, the following is the primer on how to set up a hypothetical short sale of a basket of gold, oil, and platinum futures (just to be REALLY contrarian) with $1M.
 
Futures can be highly leveraged (geared), because you only have to put up a relatively small percentage of the full value of the contract.  This is with a deposit called margin.   The purpose of margin is to provide some leeway to the broker if the position goes against you.  For example a gold contract traded on the COMEX in New York is for 100 ounces.  At today’s closing price of $935.90 per ounce, one contract is worth $935.90 x 100 = $93,590.  The margin you are required to put up to control such a contract is “only” $5400.  Your leverage is the contract value / margin, in this case 17.3x.  To put it another way, a 5.8% move against you in gold would wipe out your $5400.
 
Futures contracts trade in different delivery months.  At the Last Trading Date, if you have an open long position, you are obligated to take delivery of the 100 ounces of gold you’ve just bought.  If you have a short position, you are obliged to deliver 100 ounces of gold.  In practice, speculators never deliver physical gold, or take delivery of it, because of the transaction value involved (full amount), and the logistical problem of moving gold around and storing it.  Almost always, they just simply close the position before the Last Trading date, and book either a profit or a loss on the trade.
 
To open a position, you simply place a buy or sell order on the commodity exchange at the prevailing market price (market order), or a fixed price of your choosing if and when the price gets there (limit order).  If you sell, you are expecting the price to go down.  If you buy, you are expecting it to go up.  You close a sell, or short, position by buying back the contract, and you close a buy, or long, position by selling the contract.   The difference between the price at which you bought and at which sold is your profit or loss.  Unless delivery is involved, (which it never is for a speculator), a futures contract is simply a glorified bet on the direction of the commodity, backed by a goodwill deposit – the margin. 
 
The amount of margin required is revised from time to time by the exchange, and depends on the commodity, its price, and its volatility (how widely the price tends to swing on a daily basis.)  Another point about margin is that, because it is simply a form of collateral (much like a hotel damage deposit in case you trash the room), it doesn’t necessarily have to be cash – it can be in short-term Treasury bills that earn interest.
 
So the first thing we will do to create our position is immediately invest the entire $1M in a 90-day Treasury Bill.  The rate can be found under US Treasuries – 3 Months on the Bloomberg site at http://www.bloomberg.com/markets/rates/.  Today’s annual rate is 1.22% for a T-Bill that expires 10 July, so on a million dollars, for 1/4 of a year, your interest income will be $12,200 /4 = $3,050.  We can add that to our total at the contest end date of 7 July.
 
Now we deposit this T-Bill with a pretend futures broker who is very excited to be opening a new million dollar account.
 
As I mentioned, a standard gold contract (symbol GC) on the COMEX is 100 troy ounces.  That standard platinum contract (symbol PL) on the COMEX is 50 troy ounces, and the standard crude oil contract (symbol CL) on the NYMEX is 1000 barrels.
 
Since we don’t actually want the bother of having to find hundreds of barrels of oil, and hundreds of ounces of gold and platinum and then Fedex them to New York, we need to make sure we trade months with Last Trading days after July 7th.  The margins and months are shown below, with the links to the exchanges margin requirements included for reference.
 
Crude Oil Margin  http://www.nymex.com/CL_marg.aspx  $8775    Contract month Sep 08  Today’s price $106.06 /bbl
Gold Margin http://www.nymex.com/gol_fut_margin.aspx  $5400   Contract month Aug 08  Today’s price $935.90 /oz
Platinum Margin http://www.nymex.com/pla_fut_margin.aspx  $9450    Contract month  Jul 08 Today’s price $2045 /oz
 
The margin requirements are not really important at this point because we are not going to leverage ourselves anywhere near to what they allow.  I think 4x is plenty for our purposes (i.e. not get wiped out), so we are going to open futures positions for commodities in the face-value amount of $4,000,0000.  Our $1,000,000 Treasury Bill provides plenty of margin, covering 25% of the face value of the position.
 
The contract values as of today’s prices (see prices above):
 
Crude Oil = $106.06 x 1000 = $106,060
Gold = $935.90 x 100 = $93,590
Platinum = $2045.0x 50 = $102,250 
Let’s short 10 contract of platinum, 15 of gold, and the balance oil. 
Gold and Platinum = $1,403,850 + $1,022,500 = $2,426,350 
Remainder = $4,000,000 – $2,426,350 = $1,573,650
 
Crude oil = $1,573,650 / $106,060 = 14.8  Let’s round to 15.
15 crude oil contracts = $106,060 x 15 = $1,590,900
 
So the total value of 15 gold, 15 oil, and 10 platinum contracts = $2,426,350+$1,590,900 = $4,017,250.  Close enough.
 
Now we place an order to SELL 15 contracts each of August Gold and September Crude, and 10 contracts of July Platinum. (In lieu we’ll use April 10 Closing Prices).  With these orders, we are expecting (and want) these commodities to go DOWN.
 
So from hereon, every $1 move, in Gold is $1500, in oil is $15000, and in platinum, $500.
 
For each market, to calculate the profit/loss, it equals:
 
(Opening price – current price) x (contracts) x $100 for gold
 
(Opening price – current price) x (contracts) x $1000 for oil
 
(Opening price – current price) x (contracts) x $50 for platinum.
 
To get your total profit and loss, add the 3 totals above.  Note, if ever our loss exceeds $1,000,000, we will be wiped because the broker will cover our positions to ensure he is not at risk for any additional losses. The above calculation works for selling short – if you wanted to calculate it for a long position, you just reverse the opening and current price positions in the formula. 

In practice, our positions will be covered before reaching the $1M threshold once you reach what is called maintenance margin.  This is something less than the initial margins above. If our losses eat into the maintenance margin, our broker will begin to close out positions so that the equity remains at or above the minimum maintenance margin requirement.

The other thing about margins is that brokers may opt to require more margin than what the exchanges require, as an additional buffer.  In the real world you might have to put up a bit more money than the exchange margins, depending on your broker.
 
A good place to get both your current daily prices and chart is at www.tfccharts.com Here are the actual URLs for each chart we would need to track:
 
Crude Oil http://www.tfccharts.com/chart/CL_/98
Gold http://www.tfccharts.com/chart/DG/88
Platinum http://www.tfccharts.com/chart/PL_/78
 
So this is an example of how you could establish a “commodities are overpriced” bet in the futures market.  You could leverage it more, or less, by just adjusting how much face value of commodities you wish to control.  Kids, don’t you try this at home.
 
In REAP I am using commodity ETFs to represent long or short positions in gold, oil, natural gas and a group of grains.  The equivalent there to our analogy here is opening a $2M position with $1M of equity backing it – in other words 2x leverage.  I use this feature to take advantage of the volatility that extra leverage provides.  In two markets, grains and natural gas, I have positions in both the long and the short ETF so that when one is declining in value, it’s opposite is increasing in value.

For fun, I’m going track this hypothetical trade to its conclusion on July 07, and update its status with my other trading updates.  No trading allowed until closing the positions on 7 July, and I’ll throw in the towel and concede defeat at the first occurrence of breaching the aggregate maintenance margin (which I will calculate shortly and update here.)  I’m calling it the Commodities Nyet Bet. 

Cheers,
Allocator
a.k.a George Parkanyi
gparkanyi@hotmail.com

 Copyright 2008 – all rights reserved.

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Tags: asset management, commodities, Slow investing, Stock Market, trading