Understanding opportunities & risks in futures trading

TABLE OF CONTENTS

Introduction

Futures markets have been described as continuous auction markets and as clearing houses for the latest information about supply and demand. They are the meeting places of buyers and sellers of an ever-expanding list of commodities that today includes agricultural products, metals, petroleum, financial instruments, foreign currencies, and stock indexes. Trading in options on futures contracts enables option buyers to participate in futures markets with known risks.

The first recorded evidence of futures trading is from Japan in the 1600s with rice, there is also some evidence that the Chinese were trading rice futures as long ago as 6,000 years! In the United States, futures trading started in the grain markets in the mid 1800s. The Chicago Board of Trade was established in 1848. In the 1870s and 1880s the New York Coffee, Cotton and Produce Exchanges were born. The Chicago Mercantile exchange was in founded in1898. Today there are ten commodity exchanges in the United States and major futures trading exchanges in over twenty countries.

The biggest increase in futures trading activity occurred in the 1970s and 1980s when futures on financial instruments such as currencies, interest rate instruments, and stock market indexes started trading in Chicago. Notwithstanding the rapid growth and diversification of futures markets, their primary purpose remains the same as it has been for nearly a century and a half, to provide an efficient and effective mechanism for the management of price risks. By buying or selling futures contracts - contracts that establish a price level now for items to be delivered later - individuals and businesses seek to achieve what amounts to insurance against adverse price changes. This is called hedging.

The volume of futures and options contracts traded on U.S exchanges has increased from 179 million in 1985 to well over a billion in 2006. top

Other futures market participants are speculative investors who accept the risks that hedgers wish to avoid. Most speculators have no intention of making or taking delivery of the commodity, but rather seek to profit from a change in the price. That is, they buy when they anticipate rising prices and sell when they anticipate declining prices. The interaction of hedgers and speculators helps to provide active, liquid, and competitive markets. Speculative participation in futures trading has become increasingly attractive with the availability of alternative methods of participation. Whereas many futures traders continue to prefer to make their own trading decisions, such as what to buy and sell and when to buy and sell, others choose to utilize the services of a professional trading advisor to avoid day-to-day trading responsibilities by establishing a fully managed trading account or participating in a commodity pool which is similar in concept to a mutual fund.

For those individuals who fully understand and can afford the risks involved, the allocation of some portion of their capital to futures trading can provide a means of achieving greater diversification and a potentially higher overall rate of return on their investments. There are also a number of ways in which futures can be used in combination with stocks, bonds, and other investments.

Speculation in futures contracts, however, is clearly not appropriate for everyone. Just as it is possible to realize substantial profits in a short period of time, it is also possible to incur substantial losses in a short period of time. The possibility of large profits or losses in relation to the initial commitment of capital stems principally from the fact that futures trading is a highly leveraged form of speculation. Only a relatively small amount of money is required to control assets having a much greater value. As we will discuss and illustrate, the leverage of futures trading can work for you when prices move in the direction you anticipate or against you when prices move in the opposite direction. top

It is not the purpose of this article to suggest that you should, or should not, participate in futures trading. That is a decision you should make only after consultation with your broker or financial advisor and in light of your own financial situation and objectives. This article is intended to help provide you with the information you should obtain and the questions you should ask in regard to any investment you are considering, such as:

• Information about the investment itself and the risks involved
  
  

• How readily your position can be liquidated when such action is necessary or desired
  
  

• Who the other market participants are
  
  

• Alternate methods of participation
  
  

• How prices are determined
  
  

• The costs of trading
  
  

• How gains and losses are realized
  
  

• What forms of regulation and protection exist
  
  

• The experience, integrity, and track record of your broker or advisor
  
  

• The financial stability of the firm with which you are dealing
  
  

• In sum, the information you need to be an informed investor.
  

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Futures Markets: What, why & who

The frantic shouting and signaling of bids and offers on the trading floor of a futures exchange undeniably conveys an impression of chaos. The reality, however, is that chaos is what futures markets replaced. Prior to the establishment of central grain markets in the mid-nineteenth century, the nationâs farmers carted their newly harvested crops over plank roads to major population and transportation centers each fall in search of buyers. The seasonal glut drove prices to giveaway levels and, indeed, to throwaway levels as grain often rotted in the streets or was dumped in rivers and lakes for lack of storage. Come spring, shortages frequently developed and foods made from corn and wheat became barely affordable luxuries. Throughout the year, it was each buyer and seller for himself with neither a place nor a mechanism for organized, competitive bidding. The first central markets were formed to meet that need. Eventually, contracts were entered into for forward as well as for spot (immediate) delivery. So-called forwards were the forerunners of present day futures contracts.

Spurred by the need to manage price and interest rate risks that exist in virtually every type of modern business, today's futures markets have also become major financial markets. Participants include mortgage bankers as well as farmers, bond dealers as well as grain merchants, and multinational corporations as well as food processors, savings and loan associations, and individual speculators.

Futures prices determined through competitive bidding are immediately and continuously relayed around the world by wire and satellite. A farmer in Nebraska, a merchant in Amsterdam, an importer in Tokyo, and a speculator in Ohio thereby have simultaneous access to the latest market-derived price quotations. And, should they choose, they can establish a price level for future delivery - or for speculative purposes - simply by having their broker buy or sell the appropriate contracts. Images created by the fast-paced activity of the trading floor notwithstanding, regulated futures markets are a keystone of one of the world's most orderly, envied, and intensely competitive marketing systems. Should you at some time decide to trade in futures contracts, either for speculation or in connection with a risk management strategy, your orders to buy or sell would be communicated by phone from the brokerage office you use and then to the trading pit or ring for execution by a floor broker. If you are a buyer, the broker will seek a seller at the lowest available price. If you are a seller, the broker will seek a buyer at the highest available price. That's what the shouting and signaling is about.

In either case, the person who takes the opposite side of your trade may be or may represent someone who is a commercial hedger or perhaps someone who is a public speculator. Or, quite possibly, the other party may be an independent floor trader. In becoming acquainted with futures markets, it is useful to have at least a general understanding of who these various market participants are, what they are doing, and why. top

Market participants

•Hedgers

The details of hedging can be somewhat complex but the principle is simple. Hedgers are individuals and firms that make purchases and sales in the futures market solely for the purpose of establishing a known price level, weeks or months in advance, for something they later intend to buy or sell in the cash market (such as at a grain elevator or in the bond market). In this way they attempt to protect themselves against the risk of an unfavorable price change in the interim. Or hedgers may use futures to lock in an acceptable margin between their purchase cost and their selling price. Consider this example:

A jewelry manufacturer will need to buy additional gold from his supplier in six months. Between now and then, however, he fears the price of gold may increase. That could be a problem because he has already published his catalog for a year ahead.

To lock in the price level at which gold is presently being quoted for delivery in six months, he buys a futures contract at a price of, say, $350 an ounce.

If, six months later, the cash market price of gold has risen to $370, he will have to pay his supplier that amount to acquire gold. However, the extra $20 an ounce cost will be offset by a $20 an ounce profit when the futures contract bought at $350 is sold for $370. In effect, the hedge provided insurance against an increase in the price of gold. It locked in a net cost of $350, regardless of what happened to the cash market price of gold. Had the price of gold declined instead of risen, he would have incurred a loss on his futures position but this would have been offset by the lower cost of acquiring gold in the cash market.

The number and variety of hedging possibilities is practically limitless. A cattle feeder can hedge against a decline in livestock prices and a meat packer or supermarket chain can hedge against an increase in livestock prices. Borrowers can hedge against higher interest rates, and lenders against lower interest rates. Investors can hedge against an overall decline in stock prices, and those who anticipate having money to invest can hedge against an increase in the overall level of stock prices - and the list goes on. top

Whatever the hedging strategy, the common denominator is that hedgers willingly give up the opportunity to benefit from favorable price changes in order to achieve protection against unfavorable price changes.

•Speculators

Were you to speculate in futures contracts, the person taking the opposite side of your trade on any given occasion could be a hedger or it might well be another speculator - someone whose opinion about the probable direction of prices differs from your own.

The arithmetic of speculation in futures contracts, including the opportunities it offers and the risks it involves, will be discussed in detail later on. For now, suffice it to say that speculators are individuals and firms who seek to profit from anticipated increases or decreases in futures prices. In so doing, they help provide the risk capital needed to facilitate hedging.

Someone who expects a futures price to increase would purchase futures contracts in the hope of later being able to sell them at a higher price. This is known as "going long." Conversely, someone who expects a futures price to decline would sell futures contracts in the hope of later being able to buy back identical and offsetting contracts at a lower price. The practice of selling futures contracts in anticipation of lower prices is known as "going short." One of the attractive features of futures trading is that it is equally easy to profit from declining prices (by selling), as it is to profit from rising prices (by buying).

•Floor traders

Persons known as floor traders or locals, who buy and sell for their own accounts on the trading floors of the exchanges, are the least known and understood of all futures market participants, yet their role is an important one. Like specialists and market makers at securities exchanges, they help to provide market liquidity. If there isn't a hedger or another speculator who is immediately willing to take the other side of your order at or near the going price, the chances are there will be an independent floor trader who will do so, in the hope of minutes or even seconds later being able to make an offsetting trade at a small profit. In the grain markets, for example, there is frequently only one-fourth of a cent a bushel difference between the prices at which a floor trader buys and sells. top

Floor traders, of course, have no guarantee they will realize a profit. They may end up losing money on any given trade. Their presence, however, makes for more liquid and competitive markets. It should be pointed out, however, that unlike market makers or specialists, floor traders are not obligated to maintain a liquid market or to take the opposite side of customer orders.

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What is a futures contract?

There are two types of futures contracts: those that provide for physical delivery of a particular commodity or item and those that call for a cash settlement. The month during which delivery or settlement is to occur is specified. Thus, a July futures contract is one providing for delivery or settlement in July.

It should be noted that even in the case of delivery-type futures contracts, very few actually result in delivery.* Not many speculators have the desire to take or make delivery of 5,000 bushels of wheat, or 112,000 pounds of sugar, or a million dollars worth of U.S. Treasury bills. Rather, the vast majority of speculators in futures markets choose to realize their gains or losses by buying or selling offsetting futures contracts prior to the delivery date. Selling a previously purchased contract liquidates a futures position in exactly the same way, for example, that selling 100 shares of IBM stock liquidates an earlier purchase of 100 shares of IBM stock. Similarly, a futures contract that was initially sold can be liquidated by an offsetting purchase. In either case, gain or loss is the difference between the buying price and the selling price.

Even hedgers generally don't make or take delivery. Most, like the jewelry manufacturer illustrated earlier, find it more convenient to liquidate their futures positions and (if they realize a gain) use the money to offset whatever adverse price change has occurred in the cash market.

*When delivery does occur it is in the form of a negotiable instrument (such as a warehouse receipt) that evidences the holder's ownership of the commodity, at some designated location. top

Why delivery?

Since delivery on futures contracts is the exception rather than the rule, why do most contracts even have a delivery provision? There are two reasons. One is that it offers buyers and sellers the opportunity to take or make delivery of the physical commodity if they so choose. More importantly, however, the fact that buyers and sellers can take or make delivery helps to assure that futures prices will accurately reflect the cash market value of the commodity at the time the contract expires - i.e., that futures and cash prices will eventually converge. It is convergence that makes hedging an effective way to obtain protection against an adverse change in the cash market price.

Convergence occurs at the expiration of the futures contract because any difference between the cash and futures prices would quickly be negated by profit-minded investors who would buy the commodity in the lowest-price market and sell it in the highest-price market until the price difference disappeared. This is known as arbitrage and is a form of trading generally best left to professionals in the cash and futures markets.

Cash settlement futures contracts are contracts which are settled in cash rather than by delivery at the time the contract expires. Stock index futures contracts, for example, are settled in cash on the basis of the index number at the close of the final day of trading. There is no provision for delivery of the shares of stock that make up the various indexes. That would be impractical. With a cash settlement contract, convergence is automatic. top

The process of price discovery

Futures prices increase and decrease largely because of the myriad factors that influence buyers' and sellers' judgments about what a particular commodity will be worth at a given time in the future (anywhere from less than a month to more than two years).

As new supply and demand developments occur and as new and more current information becomes available, these judgments are reassessed and the price of a particular futures contract may be bid upward or downward. The process of reassessment - of price discovery - is continuous.

Thus, in January, the price of a July futures contract would reflect the consensus of buyers' and sellers' opinions at that time as to what the value of a commodity or item will be when the contract expires in July. On any given day, with the arrival of new or more accurate information, the price of the July futures contract might increase or decrease in response to changing expectations.

Competitive price discovery is a major economic function, and, indeed, a major economic benefit, of futures trading. The trading floor of a futures exchange is where available information about the future value of a commodity or item is translated into the language of price. In summary, futures prices are an ever-changing barometer of supply and demand and in a dynamic market; the only certainty is that prices will change. top

After the closing bell

Once a closing bell signals the end of a day's trading, the exchange's clearing organization matches each purchase made that day with its corresponding sale and tallies each member firm's gains or losses based on that day's price changes, a massive undertaking considering that nearly two-thirds of a million futures contracts are bought and sold on an average day. Each firm, in turn, calculates the gains and losses for each of its customers having futures contracts.

Gains and losses on futures contracts are not only calculated on a daily basis, they are credited and deducted on a daily basis. Thus, if a speculator were to have, say, a $300 profit as a result of the day's price changes, that amount would be immediately credited to his brokerage account and, unless required for other purposes, could be withdrawn. On the other hand, if the day's price changes had resulted in a $300 loss, his account would be immediately debited for that amount.

The process just described is known as a daily cash settlement and is an important feature of futures trading. As will be seen when we discuss margin requirements, it is also the reason a customer who incurs a loss on a futures position may be called on to deposit additional funds to his account. top

The arithmetic of futures trading

To say that gains and losses in futures trading are the result of price changes is an accurate explanation but by no means a complete explanation. Perhaps more so than in any other form of speculation or investment, gains and losses in futures trading are highly leveraged. An understanding of leverage, and of how it can work to your advantage or disadvantage - is crucial to an understanding of futures trading.

As mentioned in the introduction, the leverage of futures trading stems from the fact that only a relatively small amount of money (known as initial margin) is required to buy or sell a futures contract. On a particular day, a margin deposit of only $1,000 might enable you to buy or sell a futures contract containing $25,000 worth of soybeans. Or for $10,000, you might be able to purchase a futures contract containing common stocks worth $260,000. The smaller the margin in relation to the value of the futures contract, the greater the leverage.

If you speculate in futures contracts and the price moves in the direction you anticipated, high leverage could produce large profits in relation to your initial margin. Conversely, if prices move in the opposite direction, high leverage can produce large losses in relation to your initial margin. Leverage is a two-edged sword.

For example, assume that in anticipation of rising stock prices you buy one June S&P 500 stock index futures contract at a time when the June index is trading at 1000. Assume your initial margin requirement is $10,000. Since the value of the futures contract is $250 times the index, each 1-point change in the index represents a $250 gain or loss. top

Thus, an increase in the index from 1000 to 1040 would double your $10,000 margin deposit and a decrease from 1000 to 960 would wipe it out. That's a 100% gain or loss as the result of only a 4% change in the stock index!

Said another way, while buying (or selling) a futures contract provides exactly the same dollars and cents profit potential as owning (or selling short) the actual commodities or items covered by the contract, low margin requirements sharply increase the percentage profit or loss potential. For example, it can be one thing to have the value of your portfolio of common stocks decline from $100,000 to $96,000 (a 4% loss) but quite another (at least emotionally) to deposit $10,000 as margin for a futures contract and end up losing that much or more as the result of only a 4% price decline. Futures trading thus requires not only the necessary financial resources but also the necessary financial and emotional temperament. top

Trading

An absolute requisite for anyone considering trading in futures contracts, whether it's sugar or stock indexes, pork bellies or petroleum, is to clearly understand the concept of leverage as well as the amount of gain or loss that will result from any given change in the futures price of the particular futures contract you would be trading. If you cannot afford the risk, or even if you are uncomfortable with the risk, the only sound advice is not to trade. Futures trading is not for everyone. top

Margins

As is apparent from the preceding discussion, the arithmetic of leverage is the arithmetic of margins. An understanding of margins, and of the several different kinds of margin, is essential to an understanding of futures trading.

If your previous investment experience has mainly involved common stocks, you know that the term margin, as used in connection with securities, has to do with the cash down payment and money borrowed from a broker to purchase stocks. But used in connection with futures trading, margin has an altogether different meaning and serves an altogether different purpose.

Rather than providing a down payment, the margin required to buy or sell a futures contract is solely a deposit of good faith money that can be drawn on by your brokerage firm to cover losses that you may incur in the course of futures trading. It is much like money held in an escrow account. Minimum margin requirements for a particular futures contract at a particular time are set by the exchange on which the contract is traded. They are typically about five percent of the current value of the futures contract. Exchanges continuously monitor market conditions and risks and, as necessary, raise or reduce their margin requirements. Individual brokerage firms may require higher margin amounts from their customers than the exchange-set minimums.

There are two margin-related terms you should know: initial margin and maintenance margin:

Initial margin (sometimes called original margin) is the sum of money that the customer must deposit with the brokerage firm for each futures contract to be bought or sold. On any day that profits accrue on your open positions, the profits will be added to the balance in your margin account. On any day losses accrue; the losses will be deducted from the balance in your margin account. top

If and when the funds remaining available in your margin account are reduced by losses to below a certain level, known as the maintenance margin requirement, your broker will require that you deposit additional funds to bring the account back to the level of the initial margin. Or, you may be asked for additional margin if the exchange or your brokerage firm raises its margin requirements. Requests for additional margin are known as margin calls.

Assume, for example, that the initial margin needed to buy or sell a particular futures contract is $2,000 and that the maintenance margin requirement is $1,500. Should losses on open positions reduce the funds remaining in your trading account to, say, $1,400 (an amount less than the maintenance requirement), you will receive a margin call for the $600 needed to restore your account to $2,000.

Before trading in futures contracts, be sure you understand the brokerage firm's Margin Agreement and know how and when the firm expects margin calls to be met. Some firms may require only that you mail a personal check. Others may insist you wire transfer funds from your bank or provide same-day or next-day delivery of a certified or cashier's check. If margin calls are not met in the prescribed time and form, the firm can protect itself by liquidating your open positions at the available market price (possibly resulting in an unsecured loss for which you would be liable). top

Basic trading strategies

Even if you should decide to participate in futures trading in a way that doesn't involve having to make day-to-day trading decisions (such as a managed account or commodity pool), it is nonetheless useful to understand the dollars and cents of how futures trading gains and losses are calculated. And, of course, if you intend to trade your own account, such an understanding is essential.

Dozens of different strategies and variations of strategies are employed by futures traders in pursuit of speculative profits. Here is a brief description and illustration of several basic strategies:

•Buying (going long) to profit from an expected price increase

Someone expecting the price of a particular commodity or item to increase over a given period of time can seek to profit by buying futures contracts. If the trader is correct in forecasting the direction and timing of the price change, the futures contract can later be sold at the higher price, thereby yielding a profit.* If the price declines rather than increases, the trade will result in a loss. Because of leverage, the gain or loss may be greater than the initial margin deposit.

For example, assume it's now January, the July soybean futures contract is presently quoted at $6.00, and over the coming months you expect the price to increase. You decide to deposit the required initial margin of, say, $1,500 and buy one July soybean futures contract. Further assume that by April the July soybean futures price has risen to $6.40 and you decide to take your profit by selling. Since each contract is for 5,000 bushels, your 40-cent a bushel profit would be 5,000 bushels x 40 cents or $2,000 (less transaction costs). 

*For simplicity, examples do not take into account commissions and other transaction costs. These costs are important, however, and you should be sure you fully understand them. top

Suppose, however, that rather than rising to $6.40, the July soybean futures price had declined to $5.60 and that, in order to avoid the possibility of further loss, you elect to sell the contract at that price. On 5,000 bushels your 40-cent a bushel loss would come to $2,000 (plus transaction costs).

 

		Price per bushel	Value of 5,000 bushel contract
January	Buy 1 July soybean futures contract	$6.00	$30,000
April	Sell 1 July soybean futures contract	$5.60	$28,000
	Loss	40 cents	$2,000

Note that the loss in this example exceeded your $1,500 initial margin. Your broker would then call upon you, as needed, for additional margin funds to cover the loss.

•Selling (going short) to profit from an expected price decrease

The only way going short to profit from an expected price decrease differs from going long to profit from an expected price increase is the sequence of the trades. Instead of first buying a futures contract, you first sell a futures contract. If, as expected, the price declines, a profit can be realized by later purchasing an offsetting futures contract at the lower price. The gain per unit will be the amount by which the purchase price is below the earlier selling price.

For example, assume that in January your research or other available information indicates a probable decrease in cattle prices over the next several months. In the hope of profiting, you deposit an initial margin of $2,000 and sell one April live cattle futures contract at a price of, say, 65 cents a pound. Each contract is for 40,000 pounds, meaning each 1-cent a pound change in price will increase or decrease the value of the futures contract by $400. If, by March, the price has declined to 60 cents a pound, an offsetting futures contract can be purchased at 5 cents a pound below the original selling price. On the 40,000-pound contract, that's a gain of 5 cents x 40,000 lbs. or $2,000 less transaction costs.

Assume you were wrong. Instead of decreasing, the April live cattle futures price increases - to, say, 70 cents a pound by the time in March when you eventually liquidate your short futures position through an offsetting purchase. The outcome would be as follows:

In this example, the loss of 5 cents a pound on the futures transaction resulted in a total loss of the $2,000 you deposited as initial margin plus transaction costs. top

•Spreads

While most speculative futures transactions involve a simple purchase of futures contracts to profit from an expected price increase, or an equally simple sale to profit from an expected price decrease, numerous other possible strategies exist. Spreads are one example.

A spread, at least in its simplest form, involves buying one futures contract and selling another futures contract. The purpose is to profit from an expected change in the relationship between the purchase price of one and the selling price of the other.

As an illustration, assume it's now November, the March wheat futures price is presently $3.10 a bushel and the May wheat futures price is presently $3.15 a bushel, a difference of 5 cents. Your analysis of market conditions indicates that, over the next few months, the price difference between the two contracts will widen to become greater than 5 cents. To profit if you are right, you could sell the March futures contract (the lower priced contract) and buy the May futures contract (the higher priced contract).

Assume time and events prove you right and that, by February, the March futures price has risen to $3.20 and May futures price is $3.35, a difference of 15 cents. By liquidating both contracts at this time, you can realize a net gain of 10 cents a bushel. Since each contract is 5,000 bushels, the total gain is $500.

Net gain is 10 cents per Bu. Gain on a 5,000 Bu. contract is $500.

Had the spread (i.e. the price difference) moved 10 cents a bushel in the other direction rather than widened by 10 cents a bushel the transactions just illustrated would have resulted in a loss of $500.

Virtually unlimited numbers and types of spread possibilities exist, as do many other, even more complex futures trading strategies. These, however, are beyond the scope of an introductory booklet and should be considered only by someone who well understands the risk/reward arithmetic involved. top

Participating in futures trading

Now that you have an overview of what futures markets are, why they exist, and how they work, the next step is to consider various ways in which you may be able to participate in futures trading. There are a number of alternatives and the only best alternative, if you decide to participate at all, is whichever one is best for you. Also discussed below are the opening of a futures trading account, the regulatory safeguards provided to participants in futures markets, and methods for resolving disputes, should they arise. top

Deciding how to participate

At the risk of oversimplification, choosing a method of participation is largely a matter of deciding how directly and extensively you, personally, want to be involved in making trading decisions and managing your account. Many futures traders prefer to do their own research and analysis and make their own decisions about what and when to buy and sell. That is, they manage their own futures trades in much the same way they would manage their own stock portfolios. Others choose to rely on or at least consider the recommendations of a brokerage firm or account executive. Some purchase independent trading advice. Others would rather have someone else be responsible for trading their account and therefore give trading authority to their broker. Still others purchase an interest in a commodity trading pool.

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, and by no means least, your individual temperament and tolerance for risk. The latter is important. Some individuals thrive on being directly involved in the fast pace of futures trading; others are unable, are reluctant, or lack the time to make the immediate decisions that are frequently required. Some recognize and accept the fact that futures trading all but inevitably involves having some losing trades. Others lack the necessary discipline to acknowledge that they are wrong on a particular trade and liquidate the position.

Many experienced traders thus suggest that, of all the things you need to know before trading in futures contracts, one of the most important is to know yourself. This can help you make the right decision about whether to participate at all and, if so, in what way.

It bears repeating that you should not participate in