Futures Primer: Wrapping Your Arms Around Futures

If you’re reading this magazine, you’ve likely been trading stocks and options for a bit and been around the block a few times. But the futures market? Perhaps that’s where you’ve drawn the line. “Thanks, but I’m good” you might be thinking, right?

Understandable. Futures are a different animal. But you may be closer to the futures market than you realize. Did you drink coffee this morning? Buy groceries this week? Refinance your mortgage this year? Guess what: If you said yes to any of these, in a way, you’ve already been a “participant” of sorts in the futures market.

Trading futures does come with potential benefits, such as diversification and portfolio hedging. But futures trading involves substantial risk and is not suitable for everyone. Like anything else, the more you know, the better. Let’s start with some of the basics.

Futures Contracts—What Are They?

In a nutshell, a futures contract is an agreement to buy or sell an asset at an agreed price at a specific time in the future. Many of these contracts are based on different commodities—grains, coffee, metals, livestock, sugar, oil and natural gas, or money itself (in the form of interest rate futures).

Futures contracts are “standardized” and have certain specs:

• Quality and quantity
• Unit pricing and minimum price fluctuation (aka tick size)
• Date and geographic location for physical “delivery” of the underlying (most contracts are liquidated before the delivery date; actual delivery never happens at TD Ameritrade)

The specs differ across products (see table 1). For now, let’s focus on three commodities—crude oil, corn, and gold—and two not-so-commodities—stock indices (the E-mini S&P 500 Index) and interest rates (10-year Treasury note/bonds).

Knowing the specs of each product helps you analyze futures contracts. So, when you bring up a futures chart on the thinkorswim® platform, you’ll know what a one-point move represents. And to look at price and volume data, select the Analyze tab, enter the futures contract symbol, and the traded futures contracts will appear. To see all actively traded options contracts, expand the Option Chain (see figure 1).

Futures vs. Equities

Unlike equities, each futures contract has an expiration date. Beginning traders might fear they’ll end up with 1,000 barrels of oil on their doorstep when their crude oil futures contract expires. Although it’s good to be aware of delivery, when traders buy a futures contract, they’re not necessarily buying the underlying asset—they’re simply buying an obligation to buy or sell the asset. But most futures contracts aren’t held to expiration. Trades can be closed or rolled into a later month.

Futures contracts are also leveraged; that means returns or losses can potentially amplify. Because margin requirements are typically smaller for futures contracts, traders could control a larger futures position with relatively little money down.

So, what’s actually happening when a futures contract is purchased? Traders post a good-faith deposit (initial margin requirement or performance bond) with their futures commission merchant to make sure each party (buyer and seller) can meet the obligations of the futures contract. Initial margin requirements vary depending on commodity and market volatility but are typically a small percentage of the notional value of the contract—often 5% to 6%, or even less. That’s a lot lower than the 50% leverage in equities under the Federal Reserve’s Regulation T, or “Reg T.”

Because futures can be highly leveraged, it’s not necessary to tie up a lot of capital to hedge a large portfolio. Futures also make it easier to achieve short market exposure, as compared to stocks or exchange-traded funds (ETFs). Think crude oil prices will decline? A “sell” order initiates a short crude futures contract position. However, shorting a stock or ETF could mean borrowing those shares from your broker. That might involve paying interest charges, making sure you have a large enough account size, and ensuring the shares are available for shorting.

Say a trader holds a $500,000 portfolio and is concerned about the prospect of negative surprises in an upcoming earnings season. This trader might consider hedging about a third of that portfolio by selling (or shorting) one E-mini S&P 500 contract (/ES) by putting up the initial margin (which was about $12,000 as of late 2020). Because the notional value of one E-mini S&P 500 contract is $50 times the index price, with /ES at 3,500, the initial margin would represent about 7% of the notional value:

             ($50 x 3,500) = $175,000

             $12,000/$175,000 = 0.069, or 6.9%

If the S&P 500 drops 50 points, the trader might consider buying back, or “closing out,” that futures position. Hypothetically, a $2,500 gain in the futures position could help offset any unrealized portfolio losses, thereby hedging portfolio risk. By taking a position in the futures contract, traders can gain similar notional exposure while using less capital.

Important reminder: Because margin magnifies profits and losses, a trader could gain or lose more than the initial amount used to purchase the futures position. If prices move against a position, it could result in a margin call. That could mean adding more funds to the account or risk getting liquidated.

Another big difference: Futures tend to be more volatile than many stocks. Many futures contracts don’t trade as actively as large stocks, and futures can experience sharp, sudden price swings. Volatility in futures can be from forces of nature droughts, hurricanes, geopolitical tensions, etc.

How Can Equity Option Traders Potentially Benefit from Futures?

Options and futures are both derivatives: Their values are derived from their underlying asset. But there are differences between the two. One is the daily cash settlement of futures (in other words, dollars, not gold bullion or barrels of oil). The value of a futures contract either makes or loses money at the end of the trading day. That can weigh on making a decision to either hold or sell the position. Futures traders don’t have to worry about time decay (theta) whereas futures options traders do.

Futures also provide nearly round-the-clock access to markets or asset classes while equity options don’t. And futures can provide possible diversification benefits.

Any trader ready to give futures a try can start by creating a watchlist of the most liquid contracts. Knowing what the futures market is doing ahead of the equity market’s open could provide a head start to the trading day’s actions. Plus, it’s a great way to get to know futures.