How Futures Auctions Work Part 1 (Trading Participants and Psychology)

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One of the primary reasons traders fail is that we look at trading from an inside-out perspective. We feel that what we do (“inside”) has an influence on the market (“out”). To participate successfully in the marketplace, we’ve got to turn that perspective around, shift to an outside-in viewpoint. To do that, we have to get a deeper understanding of how securities auctions work. We must familiarize ourselves with the trading participants, become aware of trading psychology that impacts our moves, and understand what makes prices move, which is part 2 of this series.

Trading participants

Who are the trading participants? Well, that depends on the market you’re talking about. Most markets will have institutional traders – private and public – along with independent traders like us. But there may be different actors among various exchanges. For example, the FOREX will have a population of government and central bank traders, while the commodities “pit” will attract farmers and livestock processors. The cross-section of trading participants is pretty broad.
However, any market is going to have two camps among traders: hedgers and speculators. For the purpose of our discussion, we’re going to focus on these groups as they operate within the futures markets.

Hedgers

Hedgers are traders who establish a position for the purpose of reducing the price risk that arises as part of their normal, ongoing business enterprise. By establishing a position in a futures contract, the risk is transferred to other hedgers who have the opposite exposure or, more likely, to speculators who assume the risk for the potential to earn profit. For example, a farmer who anticipates having a harvest of corn to sell in the fall may sell corn futures prior to harvest as a hedge against a drop in price of corn. On the other side, a food processor may take the opposite position to protect against rising corn prices. (Hedgers actually provide the principal motivation behind futures trades and the justification for the existence of the futures market.)

Hedgers use futures contracts for protection against adverse future price movements in the underlying cash “commodity”, such as coffee or the S&P 500 index. The rationale of hedging is based upon the demonstrated tendency of cash prices and futures values to move in tandem. In our example, the corn processor wishes to buy corn at a low price. If corn prices go up, the owner must pay the farmer more, so to protect against a price spike, the processor can “hedge” his risk exposure by buying corn futures contracts to cover the amount of corn he expects to buy. Since cash and futures prices do tend to move in tandem, the futures position will profit if corn prices rise enough to offset losses from buying the commodity at its spot price.

Speculators

Speculators are those market participants who trade futures for the purpose of earning profit. This group consists of the majority of traders for most if not all of the listed futures markets. Speculators assume risk with the hope of earning profit by price movement alone. Trades are facilitated by those managing their own trading accounts or on behalf of others. While they’re motivated primarily by greed, speculators provide the useful function of liquidity to a market.

Speculators participate in futures auctions because:

1. If his judgment is good, he can make money faster in the futures market faster because futures prices tend to change more quickly than other instruments.
2. Futures are highly leveraged investments. The trader puts up a small fraction of the value of the underlying contract (usually 10%-15% and sometimes less) as margin, and can ride on the full value of the contract as it moves up and down.
3. In general, futures lack the “inside information” that is present among instruments like stocks and bonds, which can create an unfair advantage.
4. Most futures markets are very broad and liquid. Transactions can be completed quickly, lowering the risk of adverse market moves between the time of the decision to trade and the trade’s execution.

The psychology of trading

Trading psychology as a subject could take up an entire trading course. We’re going to keep it simple here. All traders, at one time or another, have been victimized by their own trading phobias. Every individual is different and, while traders share a common goal of making (or protecting) money, we go about our trading practices under a unique blend of potential psychological trading issues.

Common psychological trading issues (along with their root causes)

• Pressure of being stopped out or taking a loss. A trader repeatedly fears failure and is concerned that she cannot take another loss. This fear occurs when the trader’s ego is at stake.
• Getting out of trades too early. To relieve anxiety, the trader closes a position because of a belief that price should move immediately in his favor. There is a need for instant gratification.
• Adding on to a losing position (“doubling down”). When price moves away from a target, instead of admitting failure, he compounds the problem by committing more heavily to it. Again, ego is at stake.
• Wishing and hoping. Here the trader is unable to accept the present market conditions and doesn’t want to take control or take responsibility for the trade. This extends from a lack of faith in a solid, proven trading approach.
• Compulsive trading. The excitement of the unknown is the draw into trading. In this circumstance, addiction and gambling issues are present.
• Anger following a losing trade. The feeling of being a victim of the markets. In this case, “it’s the market’s fault”. The trader likely has unrealistic expectations about her trades. The trader ties self-worth to success in the markets.
• Excessive joy after a winning trade. The sense of invincibility. Feeling unrealistically “in control” of the markets. The trader is convinced she has all the answers.
• Overthinking a trade (second-guessing trading signals). Fear of loss or being wrong. Wanting a sure thing where sure things don’t exist. Not understanding that loss is a part of trading and the outcome of each trade is unknown. Not accepting there is risk in trading. Not accepting the unknown.
• Trading too frequently. The trader feels a need to conquer the market. Many times this might arise out of greed or trying to get even with the market for previous losses. This has a mix of ego and compulsive trading factors as its cause.
• Trading with money you cannot afford to lose. Taking unfounded risks without sufficient rules and guidance using borrowed money or funds that should be used for other purposes. The trader clings to a belief that this is her only opportunity at being successful or getting out of debt.

We can see how powerful psychology in trading is. For better or worse, if you show the same successful trading approach to one hundred different traders, no two will trade it exactly the same way. Why? Because each trader has a unique belief system paired with specific circumstances. And that belief system will determine his or her trading style.

In Part Two, we cover why prices move in a particular direction.