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investing in the Futures Market - A private guide for Clients IntroductionThe derivatives markets serve an important purpose in modern economies particularly in the transfer of risk from those wishing to avoid risk, to those prepared to take risk (in the hope of a substantial return). Whilst the markets are primarily used by professional investment managers, they often have a great appeal to the part-time investor. Such parties must however, ensure that they enter the markets with their eyes open, as the rewards can be high, but the downside can be equally enormous.Should I get involved?Before getting involved in derivatives, a potential participant must examine their motives for using the products offered. Generally speaking there are four broad categories of market participant.HEDGERS:those who use futures and options to protect an existing portfolio ( or anticipated investment) against possible adverse market movement,ARBITRAGEURS:those who profit from price differentials of similar products in different markets, e.g. price differentials between the spot and futures price of a commodity. Usually only the professionals get involved in this area,INVESTORS:those who use futures to enhance the long-term performance of a portfolio of assetsSPECULATORS:those who use futures for short-term profits, e.g. to "bet" on short-term moves in the market.Clearly futures are very useful tools for those in categories 1 to 3 . They can also be excellent tools for speculators, but the pitfalls are great and the inexperienced must beware.Should I be speculating?On the face of it, the chances of making a profit or loss speculating in futures appear to be equal. In reality, the picture is much more daunting: studies of non-professional speculators trading in futures in the USA show that over 90% lose money.Furthermore, speculating in futures can be more dangerous than speculating in any shares, because of the gearing effect. With shares the most you can lose is what you pay initially, whereas with futures you can lose multiples of your original outlay.To make matters more difficult, profits and losses are calculated on a daily basis. So even if your position does well over a period of 3months, this could be to no avail if the market moves adversely at any time during the life of the contract.For example, a percentage move in the All-share index of the same magnitude as during the October 1987 crash, could see you lose 3 times your investment in the All Share index future - in only 3 days. Being on the right side of such a move would obviously be extremely profitable for a speculator, but the downside potential must be realistically assessed.While professionals are generally in a better position to be speculating than the man-in-the-street, they are certainly not immune to huge losses. The collapse of Barings Bank, for instance was caused by speculation in futures.So be sure you know what you are getting into before you get involved.Choosing a BrokerThe SAFEX membership is made up of banks, JSE brokers, independent brokers, institutions and corporates. Commissions are negotiable and members may trade either as principles (i.e. from their own books) or as agents (on behalf of clients).You can get an updated list of members from the SAFEX membership secretary or from theMembers link on this site. This list also shows whether the member is a broker or not. Try to find out a little about the broker you are considering using. For instance, look at: The financial security of the member; * If the broker offers you huge returns, why is he bothering to do so with your money and not his own? * How will you be charged? If the broker is paid according to the number of trades he performs, he may be tempted to overtrade. (This is called "churning" and his highly unethical) * Does the broker guarantee a stop-loss (in-writing)on your account? If the market moves strongly against you, will the broker look after your interests before those of his bigger...
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