Investor Best Practices

Getting Started

The decision to participate in futures trading should not be taken lightly. First and foremost, because futures trading is highly volatile and very risky, you should only trade futures using risk capital—capital you can afford to lose. It should be capital over and above that needed for necessities, emergencies, savings and achieving you long-term investment objectives.

You should also understand that, because of the leverage involved in futures, the profit and loss fluctuations may be wider than in most types of investment activity and you may be required to cover deficiencies due to losses over and above what you had expected to commit to futures.

Before you open a futures trading account, you should thoroughly understand the futures markets, as well as the opportunities and risks involved in futures trading. NFA offers several educational resources, including publications and online learning programs, to help you.

Next, choose which method of participation is right for you. There's no formula for deciding. Your decision should, however, take into account such things as:

  • Your knowledge of and any previous experience in futures trading;
  • How much time and attention you are able to devote to trading;
  • The amount of capital you can afford to commit to futures trading; and
  • Your individual temperament and tolerance for risk.

At the time you apply to establish a futures trading account, you can expect to be asked for certain information beyond simply your name, address and phone number. The requested information will generally include (but not necessarily be limited to) your income, net worth, what previous investment or futures trading experience you have had, and any other information needed in order to advise you of the risks involved in trading futures contracts. You will also be required to provide proof of identity to comply with federal law.

At a minimum, the person or firm who will handle your account is required to provide you with risk disclosure documents or statements specified by the CFTC and obtain written acknowledgment that you have received and understood them.

Opening a futures account is a serious decision and should obviously be approached as such. Just as you wouldn't consider buying a car or a house without carefully reading and understanding the terms of the contract, neither should you establish a trading account without first reading and understanding the Account Agreement and all other documents supplied by your broker. It is in your interest and the firm's interest that you clearly know your rights and obligations as well as the rights and obligations of the firm with which you are dealing before you enter into any futures transaction. If you have questions about exactly what any provisions of the Agreement mean, don't hesitate to ask. A good and continuing relationship can exist only if both parties have, from the outset, a clear understanding of the relationship.

Nor should you be hesitant to ask, in advance, what services you will be getting for the trading commissions the firm charges. As indicated earlier, not all firms offer identical services, and not all clients have identical needs. If it is important to you, for example, you might inquire about the firm's research capability and whatever reports it makes available to clients. Other subjects of inquiry could be how transaction and statement information will be provided, and how your orders will be handled and executed.

Trading your own futures account means you will be making all of your trading decisions and be responsible for assuring that adequate funds are on deposit with the brokerage firm for margin purposes.

All brokerage firms conducting futures business with the public must be registered with the CFTC as futures commission merchants (FCM) or introducing brokers (IB) and be NFA Members.

You should always conduct a background check on the firm using NFA's BASIC system.

Whether you open an account through an FCM or an IB, your funds will be held with the FCM. FCMs are required to maintain the funds and property of their customers in segregated accounts, separate from the firm's own money, if used for trading futures or options on futures on an exchange.

A managed account is also your individual account. The difference is that you give someone else - an account manager - written power of attorney to make and execute decisions about what and when to trade. He or she will have discretionary authority to buy or sell for your account or will contact you for approval to make trades he or she suggests. You, of course, remain fully responsible for any losses which may be incurred and, as necessary, for meeting margin calls, including making up any deficiencies that exceed your margin deposits. Although an account manager is likely to be managing the accounts of other persons at the same time, there is no sharing of gains or losses of other customers. Trading gains or losses in your account will result solely from trades which were made for your account.

Many FCMs and IBs accept managed accounts. In most instances, the amount of money needed to open a managed account is larger than the amount required to establish an account you intend to trade yourself. Different firms and account managers, however, have different requirements and the range can be quite wide. Be certain to read and understand all of the literature and agreements you receive from the broker.

Some account managers have their own trading approaches and accept only clients to whom that approach is acceptable. Others tailor their trading to a client's objectives. In either case, obtain enough information and ask enough questions to assure yourself that your money will be managed in a way that's consistent with your goals.

Discuss fees. In addition to commissions on trades made for your account, it is not uncommon for account managers to charge a management fee, and/or there may be some arrangement for the manager to participate in the net profits that his management produces. These charges are required to be fully disclosed in advance. Make sure you know about every charge to be made to your account and what each charge is for.

Finally, take note of whether the account management agreement includes a provision to automatically liquidate positions and close out the account if and when losses exceed a certain amount. And, of course, you should know and agree on what will be done with profits, and what, if any, restrictions apply to withdrawals from the account.

As the term implies, a commodity trading advisor (CTA) is an individual (or firm) that, for a fee, provides advice on commodity trading, including specific trading recommendations such as when to establish a particular long or short position and when to liquidate that position. Generally, to help you choose trading strategies that match your trading objectives, advisors offer analysis and judgments as to the prospective rewards and risks of the trades they suggest. Trading recommendations may be communicated by phone, online, or mail. Some provide a frequently updated hot-line or website you can access for current information and trading advice.

Even though you may trade on the basis of an advisor's recommendations, you will need to open your own account with, and send your margin payments directly to, an FCM. CTAs cannot accept or handle their customers' funds unless they are also registered as FCMs.

Some CTAs offer managed accounts, with the advisor designated in writing to make and execute trading decisions on a discretionary basis. The account itself, however, must still be with an FCM and in your name.

CFTC regulations require that CTAs provide their customers, in advance, with what is called a Disclosure Document. Read it carefully and ask the CTA to explain any points you don't understand. If your money is important to you, so is the information contained in the Disclosure Document.

The prospectus-like document contains information about the advisor, his experience and his current (and any previous) performance records. If you use an advisor to manage your account, he must first obtain a signed acknowledgment from you that you have received and understood the Disclosure Document. As in any method of participating in futures trading, discuss and understand the advisor's fee arrangements. And if he will be managing your account, ask the same questions you would ask of any account manager you are considering.

Most CTAs must be registered as such with the CFTC, and registered CTAs that accept authority to manage customer accounts must also be Members of NFA. You can verify whether an advisor is registered and an NFA Member by conducting a background check using NFA's BASIC system or by contacting NFA.

Another alternative method of participating in futures trading is through a commodity pool, which is similar in concept to a common stock mutual fund. It is the only method of participation in which you will not have your own individual trading account. Instead, your money will be combined with that of other pool participants and, in effect, traded as a single account. You share in the profits or losses of the pool in proportion to your investment in the pool. One potential advantage is greater diversification of risks than you might obtain if you were to establish your own trading account. Another is that your risk of loss is generally limited to your investment in the pool, because most pools are formed as limited partnerships. And you won't be subject to margin calls.

Bear in mind, however, that the risks that a pool incurs in any given futures transaction are no different than the risks incurred by an individual trader. The pool still trades in futures contracts, which are highly leveraged and in markets that can be highly volatile. And like an individual trader, the pool can suffer substantial losses. A major consideration, therefore, is who will be managing the pool in terms of directing its trading.

While a pool must execute all of its trades through a brokerage firm that is registered with the CFTC as an FCM, it may or may not have any other affiliation with the brokerage firm. Some brokerage firms, to serve those customers who prefer to participate in commodity trading through a pool, either operate or have a relationship with one or more commodity trading pools. Other pools operate independently.

In most instances, a commodity pool operator (CPO) cannot accept your money until it has provided you with a Disclosure Document that contains information about the pool operator, the pool's principals and any outside persons who will be providing trading advice or making trading decisions. It must also disclose the previous performance records, if any, of all persons who will be operating or advising the pool (or, if none, a statement to that effect). Disclosure Documents contain important information and should be carefully read before you invest your money. Another requirement is that the Disclosure Document advise you of the risks involved.

In the case of a new pool, there is frequently a provision that the pool will not begin trading until (and unless) a certain amount of money is raised. Normally, a time deadline is set and the CPO is required to state in the Disclosure Document what that deadline is (or, if there is none, that the time period for raising funds is indefinite). Be sure you understand the terms, including how your money will be invested in the meantime, what interest you will earn (if any), and how and when your investment will be returned in the event the pool does not commence trading.

Determine whether you will be responsible for any losses in excess of your investment in the pool. If so, this must be indicated prominently at the beginning of the pool's Disclosure Document.

Ask about fees and other costs, including what, if any, initial charges will be made against your investment for organizational or administrative expenses. Such information should be noted in the Disclosure Document. You should also determine from the Disclosure Document how the pool's operator and advisor are compensated. Understand, too, the procedure for redeeming your shares in the pool, any restrictions that may exist, and provisions for liquidating and dissolving the pool if more than a certain percentage of the capital were to be lost.

Ask about the pool operator's general trading philosophy, what types of contracts will be traded, whether they will be day-traded, etc.

With a few exceptions, CPOs must be registered with the CFTC and be Members of NFA. You can verify that these requirements have been met by conducting a background search on NFA's BASIC system or by contacting NFA.