The US stock market is volatile. To hedge against large swings, we use stock futures; 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 in that they’re rarely held until their expiration date.
What Are Futures Contracts?
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 on a future 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 as well as a continuous expiration future). If you think the S&P will be higher in three months, you will go long, and if lower, you would 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, and 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) as well, and still made money, before its August rally, the price dipped to $136/share, and you repurchase the contract for $13,600 that you sold, making a $400 profit.
What Are Stock Futures Margin/Leverage?
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 the point when you will have to provide additional funds to bring the contract up to that level maximum loss level.
Futures prices are based on the current cash value of the underlying index. With the S and 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 nearest expiration date for the contract
The S&P index futures are the most popular future by far, with their prefix symbol SP. There are also both 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.
What are Stock Futures Trading Strategies?
While a single stock future can be risky, you can use them in combination 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. You first agree to sell 100 shares of Apple in a month, and the second you buy Apple in six months. This way, you gain from any short-term losses and from the long-term gains.
An intermarket spread involves related market futures such as two different indexes with the same delivery date, hoping that one’s loss will mean the gain in the other. 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 that one will outperform the other.
With speculation, you are using futures to gain off of minor stock price changes by taking advantage of margin to do so. 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%.)
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.
What are stock futures? They’re a way to improve your returns and hedge against wild fluctuations. If you have the time and diligence to speculate, then they can be very profitable in short order. If you are not good at picking stocks, you will probably want to leave futures to others or only as a hedge to prevent bad decisions.
As always, never open a single position that is more than you can afford to lose and good luck with all of your trades.