Trading Futures

Many people associate futures with risk, but after the technology stock bubble of the late 1990s and the accounting scandals and fraudulent dealings at Enron, Worldcom and other companies, futures may look a lot less risky than many stocks. Futures do have some inherent risk, but they can also actually reduce some of the risks that exist in the investment world. For the active trader, futures offer one of the best ways to get big returns quickly while helping you keep your risk under control. 

Here are the characteristics of a futures contract:

Temporary Replacement for a Future Transaction
A futures contract is an agreement today to meet the terms and obligations of a contract that matures at a specific date in the future. When you buy futures, you do not “own” anything but have the right to benefit from price appreciation; if you hold a long physical commodity futures contract until expiration, you may take delivery and own the actual commodity. If you sell futures, you do not “owe” anything but have the right to benefit from price depreciation; if you hold a short physical commodity futures contract until expiration, you are required to deliver the commodity to the buyer under terms specified by the contract.

Performance Bonds
One of the first things you need to realize about “margin money” is that it does not mean the same thing in the futures market as it does in the equities market.  The futures contract does not involve a down payment for future delivery as is the case in stocks. Instead, futures involves putting up an established "good-faith deposit" or a “performance bond” that confirms your willingness to fulfill the terms of the contract. It's like earnest money in an escrow account and is required for both the buyer and seller of a futures contract.

Exchanges set the minimum performance bonds for each futures contract, and these amounts change as market conditions change. Typically, the amount is only 3%-10% of the value of the contract, but the amount could be greater in volatile market conditions.

Standardized Contracts
In many transactions, specifications can be tailored to fit the needs of both parties, and the contact may be one of a kind. In futures, one contract is the same as any other futures contract for the same market, same month and same size. Contracts are interchangeable or fungible. The only thing in a futures contract that is not standardized and regulated is the price at which the transaction takes place. The corn you would receive at delivery for one futures contract, for example, is the same grade and type and quality as for any other corn futures contract.

Exchange-Traded
Futures contracts have two key characteristics: (1) They must be traded at a centralized marketplace – an open-outcry or electronic exchange – where all bids and offers come together and are matched in trading conducted by specific rules under the oversight of government regulators, and (2) the terms of the contract are guaranteed by a centralized clearinghouse so you never have to be concerned about a default on a contract. The exchange's clearing agency takes the opposite site of every futures transaction and resolves any potential disputes.

Time Element
Futures have an expiration date, usually a relatively short time into the future for the most active contract months. There is no buy-and-hold in futures because when the contract expires, it is settled according to the terms specified and goes off the board. Therefore, in addition to price direction, futures traders also have to consider the time frame within which they expect a price move to occur.

Why Futures Exist?
Futures are important tools in the business world for several legitimate purposes:

Price Discovery
Futures trading provides the means to determine market value in a centralized marketplace that brings together all the "bid" and "ask" (or "offer") prices to arrive at a value agreed upon by both the buyer and seller. Like any other auction market, traders bid on an item for sale and discover what other people think it is worth in a competitive setting. Bids and offers come from a variety of sources with a variety of motives for being involved in the market. By centralizing all buying and selling activity with the largest possible pool of participants, the market determines value at that particular moment in time.

For many physical commodities still traded on an open-outcry floor, the price established at the exchange is the price quoted around the world and is the basis of much physical trading.

Risk Transfer
Other than price discovery, perhaps the most useful purpose of futures is to transfer risk from someone who has it to someone who is willing to assume it. The market underlying futures carries real risk. Those bearing the risk of price change – producers of a commodity or owners of stocks in a stock index, for example – may use futures to pass that risk to someone who thinks the market will provide them with a profit for their willingness to take the risk.

All markets carry a risk for someone, whether prices go up or down. Futures produce no new risk but just shift the risk that exists in a transaction where both parties hope to benefit from a price movement in their direction.

Why Trade Futures?
“Commercials” or “hedgers” usually have business reasons for using futures to lock in prices or profit margins. For them, futures provide a way to reduce risk and to develop a sound business plan because they can remove some of the uncertainty about the future.

For many other futures market participants, however, the most important feature of futures is the ability to speculate on price movement with a relatively small amount of money. Here are some reasons why traders like futures:

Leverage
One of the first terms associated with futures is leverage – a small amount of money in futures has the potential to produce big returns. Of course, that feature can also have a downside if you do not manage your risk carefully. That means you need to monitor a futures position more carefully than you do most other trading instruments.

Here is a simple example to illustrate the power of leverage:

1. Assume you have $10,000 to invest/trade. You buy 500 shares of a $20 stock, paying the full price or all $10,000. If the stock goes up $5 a share or 25%, you gain $2,500 (500 shares X $5). Your return on investment is 25% ($2,500/$10,000).

2. You use the $10,000 to buy 1,000 shares of a $20 stock, paying the required 50% minimum margin and borrowing the rest. The value of shares you own is now $20,000. If the stock goes up $5 a share or 25%, you gain $5,000 (1,000 shares X $5). Your return on investment is 50% ($5,000/$10,000).

3. You put the $10,000 into a futures account and use it to buy two e-mini S&P 500 Index futures contracts. With the index at 1200, the value of your futures position is $120,000 (2 X 1200 X $50 per point). If the price of the index goes up 25% or 300 points, you gain $30,000 (300 points X 2 contracts = 600 total points X $50 per point). Your return on account is 300% ($30,000/$10,000). Of course, an index spread over 500 stocks is not as likely to rise 25% as is one $20 stock, but even if the S&P 500 Index goes up only 5%, you make more than you would with the 25% rise in stock prices.

What is important to remember is the other side of this leverage if the market should fall 25%. In Example 1 with the fully-funded stock purchase, a 25% loss would be $2,500, leaving you with $7,500 of your original starting amount. In Example 2 with the partially-funded purchase, a 25% loss would be $5,000, leaving $5,000 remaining in your account. In Example 3 with two e-mini futures contracts, a 25% loss or 300 points would amount to $30,000 or three times your starting account size. And you would be legally obligated to pay if you rode through that decline. Even if the e-mini dropped only 5% to 1140, you would lose $6,000 or 60% of your account.

While leverage can work for you, it can also work against you, making risk management and cutting your losses short two of the most important steps in futures trading.

Ease of Selling Short
One concept that seems to be difficult for many traders to grasp is the ability to sell something they don’t own. In futures, however, remember that you don’t own anything but are only agreeing to abide by the terms of the contract at some later date. Your performance bond acts as your guarantee for that agreement. Your futures position is simply the right to speculate on price movement up or down between the time you enter the position and the time you offset it.

Therefore, it as easy to sell futures as it is to buy. Everything about the trading process is the same except that you say "Sell" instead of "Buy." In addition to “buy low, sell high,” you can also “sell high, buy lower.”

Fast, Efficient Transactions
Futures transactions can be executed in seconds on a trading floor or in nanoseconds electronically. With today’s technology and many participants normally willing to take the other side of any order, you usually get not only a speedy turnaround but also into and out of a position at prices close to what you want.  Bid and ask spreads are relatively narrow in the most active markets, which can absorb sizable orders without disrupting the flow of prices.

In addition, the costs of establishing a futures position are quite reasonable as commissions have gotten lower and lower as competition has intensified recently.

Protection, Insurance
Without futures to provide protection, some participants could face losses from adverse price moves. Even if you have a relatively small investment portfolio in stocks, you might consider using single stock or stock index futures to provide protection against a downturn in the stock market while keeping stock holdings intact. Or if you suddenly receive a large sum of money that you want to invest in stocks, you could put the money to work quickly with a position in futures while you assemble the portfolio of stocks you want.

1. What Is a Good Trading Instrument?
2. Trading Equities
3. Trading Futures
4. The Role of an Exchange
5. The Role of the Brokerage Firm
6. The Role of the Regulator
7. How to Pick a Broker
8. How to Place Orders

Main Trading Resources Section