INVESTMENT OUTLOOK : ASSESSING THE MAJOR MARKETS : Reducing Risks in Futures Trading : Chicago Scandal Shows Need for Non-Professional Investors to Protect Against Cheating
It wasn’t the happiest day in Charles Plocar’s life when the FBI called him last August to say he was among the victims of the commodity fraud scandal that was then erupting in Chicago’s futures pits. He’d been cheated when floor brokers executed his orders to buy futures contracts in U.S. dollars, Japanese yen and Treasury bonds.
The Sarasota, Fla., investment adviser vowed then that, although he would continue to trade futures, he’d do what he could to see that he didn’t get cheated. But today, after exploring his options, Plocar seems resigned to the fact that he may get swindled. “There’s not a lot you can do,” he says. “Even the big boys get hurt.”
Plocar’s remark may contain a grain of wisdom for the non-professional investor. When laymen plunge into the maelstrom of the futures markets, they must consider not only the inherent risks of the system but also the possibility that they may get cheated by the floor traders who are in the center of the furious action.
Futures traders make their livings swapping contracts in agricultural commodities, such as pork bellies (bacon), soybeans and corn, and financial commodities, such as foreign currencies and Treasury bonds. A related type of investment is an option, which entitles an investor to purchase a commodity or stock at a certain price within a certain period.
By buying a futures contract, the investor is in effect making a bet that the commodity will rise or fall in value by the specified date. Traders can typically borrow 90% of their investment (compared to 50% in the stock market). Because commodity prices fluctuate wildly, this can mean big profits--or punishing losses.
Futures trading has skyrocketed in the past two decades as more and more farmers, banks, investment firms and other businesses have relied on these markets to hedge investments. Some observers expect a continued rapid growth in the 1990s; trading in currency futures, for example, is expected to surge as international trade grows.
Certainly, the indictments of 47 traders and one clerk in Chicago’s commodity markets last August haven’t caused the pros to slow their trading activity; the Chicago Mercantile Exchange expects volume to rise 38% this year.
But if the pros keep trading, the scandal should prompt sober reflection among the non-professionals. They’re already at a disadvantage, many feel, because of their distance from the complex transactions carried on in the frenzy of the pits.
Many investment gurus advise their non-professional clients simply to stay out of the game. The commodities world is “just too fast, and too dominated by professionals,” says John Markese, research director for the American Assn. of Individual Investors.
Markese notes that because of those drawbacks, only about 1% of his group’s members invest in commodities.
And, although most traders may be honest, investors can’t be faulted for some nervousness about the fleecing of customers that was documented by the FBI investigation.
Consider that although the traders have in some cases been accused of cheating customers of only about $100 per trade, “that’s enough to make the difference between profit and loss for lots of people,” Markese says.
Consider also that, as Plocar says, even the biggest, most sophisticated users of the markets sometimes get hurt. In October, renowned money manager George Soros sued Shearson Lehman Hutton brokerage for allegedly defrauding his Quantum Fund out of $60 million during the October, 1987, stock market crash. According to Soros, Shearson brokers assigned to sell a huge Quantum order conspired with other traders to first sell the order at a discount, then run the market back up and profit richly by reselling the contracts at a higher price.
Keep in mind, too, that the so-called dual trading system that many critics fault for allowing cheating won’t necessarily be halted because of the scandal.
If you still want to venture into the pits, here are a few ways you may be able to reduce your risks.
* Use a “full-service” broker who will give you the guidance you need, rather than a discount broker who will simply execute trades, albeit at a lower price. Make sure that the broker does a lot of commodity trading, Markese recommends. Try to make sure by talking to other customers that he will take a small investor’s order seriously and try to secure the best price.
* Put in “limit orders” rather than “market orders.” The limit order means that your trade will be carried out only if the market reaches a certain price, but a market order simply instructs the broker to buy or sell at the available price, at his discretion.
* Keep a close eye on your trades to see that you aren’t getting consistently bad prices. At any moment there is a huge range of prices in a commodity pit, and you’re unlikely to get the highest price for a sell order, or the lowest for a buy. But if you’re consistently doing very badly, you may be a victim of a crime. The exchanges and several private companies print detailed records of the flow of orders and prices; so, if you’re willing to bother, you can determine how you fared relative to other investors.
* Look into professional management. If you don’t have the time or skill to keep a close eye on your trades, you might be wise to turn your money over to a commodity fund or pool. Not only do the good managers know the ins and outs of the market, but they have an edge simply because of the size of their orders; floor traders will take greater pains to see that larger orders are executed at a better price.
A LOOK BACK AT FUTURES TRADING 1988: 246 million
Source: Futures industry Assn.
