Futures are exchange-traded derivatives contracts that lock in the delivery of a commodity or security in the future at a price set today. A futures market is an auction market where commodities and futures contracts are bought and sold. With this comes a promise of delivery of the underlying instrument on a pre-determined future date. The future date is also referred to as the delivery date, while the pre-set price is the future price. Finally, we call the price of the underlying asset on the delivery date the settlement price.
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Both parties of a futures contract must fulfill the contract on the settlement date. Usually, the settlement price converges toward the futures price on the expiration or delivery date.
However, regardless of the price at expiration, the buyer must buy, or the seller must sell at the pre-determined price.
At this point, one of two things happens:
- The seller delivers the commodity to the buyer
- If it’s a cash-settled future, then the cash is transferred from the futures trader who sustained a loss to the one who made the profit.
Futures Trading Commodities
Luckily if you’re a stock trader, you can stick to what you’re comfortable with. You can trade futures on financial instruments like the S&P 500. How great is that?
Take our futures trading course if you need more help.
The US stock market is volatile, and we could use stock futures to hedge against large swings, potentially saving a portfolio.
To understand futures, imagine you make avocado toast. You need avocados. The price of avocados fluctuates. To be sure of a profit, you go into a contract with an avocado producer to buy at a set price three months from now. The farmer also wants to be sure she’s making a profit so she won’t settle for a contract that’s too cheap. And you won’t buy at too high of a price, but you both prevent any colossal price fluctuations.
All futures, including stocks, work this way. Buyers and sellers agree to a price on a date in the future. The US market allows for single stock futures and indexes like the S&P500. Stock futures differ from other commodities because they’re rarely held until expiration.
You never own the stock with a futures contract and thus can not receive dividends or a vote. You make money with stocks only if their price increases, but with futures, you can also make money with falling prices.
The two positions in futures are long and short. The long side agrees to buy the stock at the expiration date, while the short agrees to sell the stock at the expiration (expirations are every three months and have a continuous expiration future). So if you think the S&P will be higher in three months, you will go long, and if lower, you will go short.
In July, you want to go long Apple stock, so you purchase 100 shares at $140 with September 1 expiration future. The contract price is $14,000; if the price goes over this, you can sell the contract for a profit. If the price goes to $145 in August, you sell it for $14500 and make a $500 profit. You could have been on the short side(selling) and still made money before its August rally, the price dipped to $136/share, and you repurchased the contract for $13,600 that you sold, making a $400 profit.
Futures Trading Margin Requirements
With futures, you are buying on margin, which means you only pay a portion of the contract price, between 10 to 20% of the contract’s total price, so with our Apple example, $2,800(20% margin), but on the long wide we made $500 profit ($500/2800 =17.9%) or the sell-side $400/2800 (14.3%).
Futures are risky because if we had not predicted well and the stock price went to $136 and stayed there, we would be out $400 of our $2800, a 14.3% loss. Worst still, if Apple has dropped to $100/share, we would have to pay an additional $1600 ($14000(contract price)-$2800(margin)-$10000(100 shares at $100/share final price)=$1600).
Brokers will issue margin calls if the investment falls too low(or too high on the short side) to a predetermined “maintenance level.” The maintenance level is when you will have to provide additional funds to bring the contract up to the maximum loss level.
Futures prices are based on the current cash value of the underlying index. For example, with the S&P 500 future, the cash value is multiplied by [1+interest rate (x/360)] minus the dividends of all the S&P’s component stocks until the front month. Front-month is the month’s nearest expiration date for the contract.
US stocks futures are traded on the Chicago Exchange, and fees for a futures contract can be as low as $0.35 to $0.75. Playing in this market requires diligence and quick action, knowing when to buy and sell because the prices change quickly and drastically with leverage. You will also need a minimum margin and have funds for a margin call.
Suppose you are unwilling to devote this much time. In that case, you could join a commodity pool, like a mutual fund, a collection of investors that leave their money with a team of brokers who specialize in stock futures; commodity pools also do not require extra funds for margin calls.
The S&P index futures are the most popular future by far, with their prefix symbol SP. E-mini (1/5th the cost of the large contract and prefix symbol ES) and Micro E-mini (1/10th the size of the E-mini cost prefix ME) S&P500 futures available to trade through the CME group. You can find Dow Jones E-minis (prefix YM), Nasdaq index E-minis (prefix NQ), and Russell 2000 E-minis (prefix ER) futures available for trade too.
Without a doubt, the market of choice for many day traders is the E-mini S&P 500. Because the E-mini S&P futures trade electronically, and trade executions are quick.
Beyond that, futures traders can control around $75,000 worth of stock for about $3,500 in margin.
However, you don’t need to stick with the E-mini S&P 500. Indeed, the Dow futures, E-mini Nasdaq futures, and E-mini Russell futures are very popular to day trade.
Other good candidates for day trading include soybean, crude oil, the Japanese yen, and Euro F.X. These have daily volume and volatility in their futures prices.
A pivotal point to keep in mind is that each futures market differs. Because of this, you need to take time and study the markets before day trading to uncover and optimize techniques and develop a plan.
Micro E-Mini Futures
Micro e-mini futures trade on the S&P 500, Nasdaq-100, Dow Jones Industrial Average, and Russell 2000 indices. At 1/10th the size of their classic e-mini counterparts, micro e-mini futures make it easier for new traders to access the futures market, especially if they have a small brokerage account size.
Micro E-Mini Benefits
- Access to Deep Liquidity: Micro e-mini Futures enable traders to more easily access the futures market and reap the benefits of its deep liquidity
- Consistency: They’re designed to manage exposure to the 500 U.S. large-cap stocks tracked by the S&P 500 Index, widely regarded as the best single gauge of the U.S. stock market
- Capital Efficiency: When trading Micro E-mini futures, you tap into the powerful leverage the Futures markets provide. The MES allows you to control a considerable contract value with a small amount of capital
- Reduced Tick Value (means less risk): The Micro E-mini S&P 500 futures contract is $5 x the S&P 500 Index and has a minimum tick of 0.25 index points. The point value of the Micro E-Mini futures is 1/10th of the size of the regular E-Mini futures. For the MES, 0.25 index points = $1.25
- No Pattern Day Trading Rule: To day trade stocks, you need $25k in your account; otherwise, you’ll fall under the PDT rule
- Low Account Size to Get Started: Luckily, with the micro E-mini, you can get started with as little as $400
- Market Availability: You can pretty much trade the e-minis 24/7. Here’s the CME Globex’s specific breakdown: Sunday – Friday 6:00 p.m. – 5:00 p.m. Eastern Time (E.T.) with trading halt 4:15 p.m. – 4:30 p.m
- Trading Tick Charts. Tick charts represent price action intraday regarding the number of trades: a new bar is made after completing a certain number of trades (ticks).
While a single stock future can be risky, you can combine them to create safer returns. Risk reduction is accomplished with hedging. You are protecting yourself against significant market changes by taking an opposite position in the same investment.
You invest in Apple at $140/share, expecting it to go up, but you also take a 3-month short position with an Apple future. This way, if your Apple price goes down within three months, you will not lose as much or even profit in the futures market.
A Calendar spread is when you go long and short on the same stock but with two delivery dates. So, for example, you first agree to sell 100 shares of Apple in a month, and second, you buy Apple in six months. This way, you gain from any short-term losses and long-term gains.
An Intermarket spread involves related market futures, such as two different indexes with the same delivery date, hoping one’s loss will mean a gain in the other. For example, if you are bullish tech, you buy NASDAQ futures and sell E-mini S&P. Similarly, a matched pair spread would be with two competitors like airlines hoping one will outperform the other.
With speculation, you use futures to gain from minor stock price changes by taking advantage of the margin. For every 1% of the stock’s price moves, the margin will amplify this movement by between 5 and 10 times depending on the amount of required margin required (20% to 10%.)
Right Set of Rules
People have a chance to win in the stock market game, but they need the right rules and attitude to play by. Unfortunately, those good rules and attitudes collide head-on with the basic human nature of fear and greed.
However, anyone can learn how to trade if taught properly. Everything about the markets is teachable. Charting, analysis, and risk management aren’t that hard if you take the time to learn.
Quite frankly, the skills of a successful trader can be reduced to a simple set of rules. Unfortunately, it’s your emotions that are going to get the best of you.
“Trading was more teachable than I ever imagined. Even though I was the only one who thought it was teachable…it was teachable beyond my wildest imagination.” These words are from Richard Dennis.
The Complete Turtle Trader
‘The Complete Turtle Trader’ by Michael W. Covel is a story of how one trader Richard Dennis believed that we could reduce a successful trader’s skills to a set of rules.
With that, he and his partner, William Eckhardt, taught 23 students everything they needed to know about trading bonds, currencies, corn, oil, stocks, and all other markets in only two weeks. All by making them follow a simple set of trading rules.
Their students, or “Turtles,” came from all walks of life: kitchen workers, teachers, waiters, “unemployed,” and security guards. Each student got $1 million to trade with after their two weeks in the classroom.
And no, the classroom was not on the loud trading floor with traders widely waving their hands around, but rather a quiet office with no TVs or computers.
The results were shocking. Many students made over 100% or more within four years. Which, in case you didn’t know, is monster money-making.
Even more impressive is the record of two of their pupils, Jerry Parker and Paul Rabar. By 2007, both managed to earn over $3 billion. To this day, they still trade in a very similar fashion.
Frequently Asked Questions
- New York Mercantile Exchange (NYMEX)
- Chicago Mercantile Exchange (CME)
- Kansas City Board of Trade
- Chicago Board of Trade (CBoT)
- Minneapolis Grain Exchange.
- Chicago Board Options Exchange (CBOE)
Before electronic trading networks, trading took place in the very loud pits of NYC, Chicago, and London. Now, we can calmly trade futures from the comfort of homes.