Fundamentals of Futures Trading

A futures contract is a financial contract to buy or sell an underlying instrument at a fixed date in the future, at a specific price. Future contracts can be issued on a variety of instruments such as Commodities, Indexes, and Currencies, to name a few. Some futures contracts may call for the physical delivery of the asset, while others are settled in cash. In real life, the actual delivery rate of the underlying goods specified in futures contracts is very low.

Introduction to Futures Trading

One of the characteristics of the Futures Markets is the amount of leverage you can obtain without actually borrowing money, as in a margin loan in a securities account. For instance, let’s look at the S&P 500 E-Mini future compared to the SPYDER ETF (SPY). The tick value of an E-Mini S&P 500 contract is $12.50 per tick, to obtain the equivalent in SPY you would need to buy 1,250 shares as the minimum tick value is $0.01. Assume SPY is trading at $120 per share than the cost to buy 1,250 shares in a margin account would be: 1,250 x 120 = $150,000 x 50% (initial margin requirements in a securities account) = $75,000.

Even in a “Portfolio Margin Account” where the initial requirement is around 15% (assuming an unhedged open position) the initial margin requirement is $22,500. Compare that to the E-Mini S&P 500 Futures margin requirement of $5,000* and you can see the increased leverage Futures trading can offer. Keep in mind that this increased leverage can both increase your profit margin and expose you to losses that in some cases can exceed your initial investment.

Futures margin requirements are not to be confused with margin requirements for securities. In securities the investor is required to deposit an amount to purchase (or sell short) equal to 50% of the total cost of the trade, before commissions. This is due to the fact that the actual asset, shares of stock, will be exchanged at the time the trade is executed, plus settlement days.

Trading Futures

In Futures, no physical or monetary asset is exchanged until the Futures Contract expires. Therefore, the margin monies posted for a Futures trade is known as a Performance Bond and/or “Good Faith Deposit”. This deposit is held as a form of “Escrow or Earnest Money” deposit to be used later when the contract expires. The amount that needs to be deposited is set by the exchange the Futures Contract trades on, whereas Securities Margin requirements are set by regulatory authorities such as the Federal Reserve Bank and FINRA.

Most investors in Futures and Commodities do not make or take delivery of the underlying asset in the contracts they trade. Rather most execute an “offsetting trade” to remove their obligations in the contract position they entered. For example, if you bought the E-Mini S&P 500 futures on a Tuesday and then sold them on Wednesday the sale on Wednesday would be the “offsetting trade” and would close out your opening purchase.

In some Futures Contracts, there is no deliverable commodity at expiration, instead, they are settled in Cash. E-Mini S&P 500 is a Cash Settled Futures Contract as are the other stock indexes. In a Cash Settled Futures Contract, the difference between the purchase/sale price when opening the trade and the settlement price for the Futures Contract at expiration determines gain or loss. Keep in mind that you aren’t required to hold a position in these to the contract’s expiration, however, if you did, this is how the gain or loss would be determined.

Many Futures Contracts have Mini contracts and trade at a fraction of the price of its parent contract. These tend to be popular with individual traders as the reduced size brings with it a lower initial margin commitment, lower minimum tick sizes, and ultimately reduced risk when compared to a similar move in the parent contract.

Remember, futures markets give you broad market exposure, while single equities and ETF’s come with a risk of individuality, which includes earnings, dividends and governance issues. Futures can also provide you with opportunities in advancing and declining markets, without further margin requirements compared to equities, nor “hard to borrow” security issues.

Future market trading is just like any type of stock trading. By diligently analyzing the market, investors predict that the price of a certain stock will rise by a certain amount. Therefore, by instinct they would like to buy as many units of the stock so that when its value rises, they would turn in a profit.

Futures Trading: What to Need to Know

In a perfect world, the fearless forecast wins and everybody is happy. However, there is no crystal ball to predict the rising and falling of stock value. If the opposite happens, they obviously lose a substantial part of their investment and that is that. As investors, they roll with the punches and stop for the day.

Fortunately, there is an easy way, and this is where future market trading comes in. This presents an opportunity for investors to minimize their possible loses by buying only a token value of the stocks, which is called, exercising an option.

That way, their financial exposure is minimized. At the same time, it gives them a so-called advantage because by paying only a small amount per stock, which amounts to a token value, they control more units.

In ordinary parlance, the simplest representation of a lever is a block of wood or chisel that a construction worker would position under a heavy rock. By turning the block, he or she finds an easy way to move the rock from one point to the other, until it gets to where it is supposed to be.

Leveraging a Future Trading

So too with leveraging a futures trade, the investor ends up with more units under his or her control and bidding. This is the primary reason why some people prefer future market trading. It is like taking hold of the TV remote in one’s living room.

However, even a caveman can leverage. What is more difficult is to analyze stock trends. Obviously, this takes a lot of time, effort, and intellect. Nevertheless, like almost anybody on a learning curve, there eventually comes a time when the person becomes a master of the game.

Still, it is important not to become complacent or overconfident when that moment arrives. In addition, the learning curve is relatively not as stiff because the individual is dealing with short-term stock behavior. Some may look at the expiry date of every option like a ticking time bomb, but market players who make use of their time wisely might actually find this Godsend.

Just as anywhere else, everyone should be careful with borrowing, which in this world is referred to as buying on margin. It is just as easy to get addicted to the use of credit cards as to borrow money from the stockbroker.

Luckily, there are controls or regulations in place. Typically, investors can only borrow up to fifty percent of their total exposure. Future market trading owing to its unique attributes may look relatively simpler, but this is easier said than done

Fundamentals of Futures Trading

The origins of today’s futures and other derivative contracts trace back to antiquity. But modern futures markets as we know them today were formulated in Chicago by the mid-1800s in the context of the grain markets. Chicago became a natural pricing point for grain because of its strategic location at the hub of both water and rail transportation systems. Futures were created on the Chicago Board of Trade (CBOT) as a means to deal with the uncertainties associated with grain production and the resulting pricing pressures.

Financial futures were first introduced in the form of currency futures available on the Chicago Mercantile Exchange (CME) in 1972. This development was followed by the creation of interest rate, stock index and other financial futures. Over-the-counter (OTC) derivatives developed on a parallel path as the seminal interest rate swap (IRS) was transacted in 1980. This was followed by the development of many other derivatives including FX, equity, commodity and credit products.

E.g., a CBOT corn futures contract provides for the delivery from the seller (short) to the buyer (long) of 5,000 bushels of No. 2 yellow corn during a specified delivery month.

E.g., a CME Japanese yen futures contract provides for the delivery of 12,500,000 Japanese yen vs. payment of an equivalent value of U.S. dollars.

While futures contracts may provide for the actual or physical delivery of a commodity or financial instrument, most contracts do not culminate in a delivery. Rather, they are “offset” before delivery. Thus, one may buy futures today and subsequently sell the contract before the contract matures and delivery is required. It is the threat, if not the actual practice, of delivery that ensures that futures prices will converge to spot or cash prices by the delivery month. Many contracts call for a physical delivery, but sometimes it is infeasible to provide for actual delivery. For example, it would be difficult to make delivery of all 500 stocks included in the Standard & Poor’s 500 (S&P 500) Index. Thus, many contracts are “cash-settled” at the spot value of the underlying index or instrument.

Electronic Trading – We are all familiar with news footage of futures traders frantically buying and selling at high volume pitch in a trading pit via “open outcry.” But today, most trading is conducted on electronic or automated computer systems. The major purpose of a futures exchange is simply to allocate access to the direct trading process. In years past when most trading was conducted on the floor of an exchange, access was allocated by selling memberships to the highest bidder. But electronic trading systems facilitate direct access to the trading process from all corners of the globe, rendering the process much more inclusive and efficient.

Financial Sureties – Once a futures’ transaction is completed, it is said to be “cleared” by the exchange clearinghouse (CH). The CH essentially acts as a buyer to every seller; and, seller to every buyer. The clearinghouse will require an initial performance bond or “margin” deposit to secure the financial integrity of each transaction. Subsequently, futures trades are “marked-to-market” (MTM) daily. Thus, you pay any losses and collect any profits daily. As such, there are no “paper” profits or losses in futures markets.

Economic Function – Futures markets serve two essential economic purposes: to be used as a risk-management vehicle and for purposes of price discovery. Commercial producers and consumers of commodities as well as financial institutions such as banks, fund managers and other investors are routinely faced with price risks. Those risks are exacerbated in recent years in the wake of the subprime mortgage crisis, the European sovereign debt crisis and the growing demand for raw commodities from emerging market economies such as China and India.

Futures are used to hedge or offset those risks. In the process of providing a viable risk management tool, futures can smooth the volatility of their returns and decrease costs. The benefits of that process are felt by many others along the value chain even if they do not use futures directly. Price discovery refers to the fact that futures prices are often referenced as the basis for many other commercial transactions. Futures are competitively traded and, therefore, generate price references used the world over.

Conclusion – Futures are sometimes thought of as arcane trading vehicles only used by the most sophisticated professional traders. But even if you are not using futures directly, you are nonetheless benefiting from their use by commercial traders using futures for risk management and price discovery purposes. As such, futures have become an integral element of everyday business.

How To Trade Futures For Beginners | The Basics of Futures Trading

Why Futures Work Best For Day Trading

 THERE IS NO SUCH THING AS A PART-TIME DAY TRADER.

Day trading is a full-time job. Day trading is hard work and requires extreme concentration. The markets are very unforgiving and your opponent is most likely a professional trader at some large Investment Bank. They have much more capital than you do and if you are going to succeed you need to be able to think like a guerrilla fighter. You can’t take your opponent head-on, so you must try to outflank him. Let’s look at a few possible scenarios and see which one works best for day trading.

I WANT TO TRADE STOCK

Trading stock will work, but there are problems to overcome.

The first problem is how to select the portfolio of stock that you want to trade. The portfolio must have enough volatility to overcome the commissions and the spread between the bid and offer. The bid-offer spread is extremely important, if it is too large about the average daily price movement, you will have no chance to turn a profit. Here is an example.

ABC is a $6 stock with an average daily price range of 6% of its value. The cost of owning 100 shares is $600. The typical bid-offer spread is .01c (exchange minimums) and we will make 7 round turn trades per day.

If the stock has an average daily range of 6% that means that its range is going to be about .36C per day. So let’s do some math. The markets are open 240 days a year. If we make 7 trades a day we are giving up 7c in the bid-offer spread each time we trade. For 240 days we will make 1680 trades. So even if we get the “edge” (buy the bid or sell the offer) on half of the trades we will lose $840. So for us to make money the price of the stock would have to more than double in our perfect model. In the real world, we would also have to pay commissions.

Can anyone make money day trading?

Yes, Many investment banks serve as market makers in hundreds of stocks. The Investment banks own seats at the major exchanges and their cost of doing business is much lower than the average investor and that allows them to make money in low volatility stock trades.

Is it possible to make money day trading stock?

Yes it is possible and many traders have done so, but you have to be trading the right stock. To day-trade effectively you must be able to overcome the commissions and bid-offer spread.

Let’s look at a new example.

DEF was an IPO three years ago at $50 a share. It has matured and is now trading at $600 a share. Because of the increased liquidity, the bid-offer spread is still 1C a share and the stock is trading 2 million shares a day. It has daily volatility of 6%. DEF brings a different look to the market. Although its daily volatility is still 6% the nominal price change is no longer 36 cents a day it is $36 or 100 x the volatility of ABC!

DEF now has enough price change each day to allow a day trader to overcome the problems of volatility, the bid-offer spread, and commissions, unfortunately, DEF brings a new problem to bear, the capital.

Pattern Day Trading accounts for securities require the investor to have 25% of the value of the stock being day-traded as an initial margin requirement. In the case of DEF that would be $150 per share. Day trading 100 shares of this stock would require $15,000 in cash buying power in your account. Plus securities accounts that are coded as a Pattern Day Trading Account must have and maintain $25,000 in total account value otherwise the account can be restricted.

Is there a compromise between liquidity and capital?

The answer is yes. The futures index market is a hybrid of the volatility and the capital we need to trade.

Here is an example:

We believe that the S&P 500 is going higher, and we want to participate. We don’t want to buy an individual stock as we are not sure which one will rally, and we don’t have the capital to buy high-priced shares, but we want to participate in the market.

We open an account at a futures/commodities broker and deposit $10,000. We can now make our trade on the S&P 500 by trading the e-mini S&P (symbol ES). The ES controls a basket of stocks whose underlying value is over $60,000, but because it is a future, you only have to post approximately $2,000 to enter a day trade. If the S&P goes up as we expected we have unlimited reward potential, and we should have risk limited to $2000.

The futures market is the marriage that we seek, it allows us to trade a highly volatile product with unlimited reward, while at the same time limiting the amount of capital we need to participate.

Previous Post
What is Cash Conversion Cycle and How to Calculate

What is Cash Conversion Cycle and How to Calculate

Next Post
What is the MACD?

Predicting Momentum With MACD

Related Posts