Learn how futures contracts can help experienced traders and investors pursue their objectives while tying up less capital.
As an investor, which of the following best sums up your views on capital?
If you’re like most investors, you didn’t choose answer “A.” You do like to be efficient about capital use, and most would likely agree there’s room for improvement. So let’s settle on answer “D.”
And one way that experienced traders and investors can make efficient use of capital is by using futures.
A futures contract is an agreement to deliver, or accept delivery of, a predetermined amount of a commodity or financial product on a specified date. Futures are traded on exchanges, and contracts cover a number of asset classes including stock indices, interest rates, currencies, commodities such as grains, crude oil, precious metals and more.
When you buy or sell a futures contract, you don’t put up the entire notional value, but rather you post an initial margin requirement, essentially a “good faith” deposit. This means futures contracts are highly leveraged—a small investment controls a large amount of notional value. And leverage can be a double-edged sword; it can magnify your gains, but also your losses. In other words, a small amount of market movement can have a large effect—positive or negative—on the account’s P/L.
Plus, though the initial investment is typically small, futures positions are marked to market each day, and if the equity in your account drops below a certain amount, you’ll need to either top off the amount held as margin (i.e., make a deposit), or liquidate the position.
But futures can be a way for sophisticated investors to pursue their investment objectives.
Suppose you’ve got $40,000 and you’d like to invest it in a broad-based basket of stocks that closely mirrors the S&P 500 (let’s give it the ticker symbol SANDP), Let’s assume SANDP is trading around $226 a share, and ideally, you’d like as many as 500 shares. Your choices include:
Buying shares with cash. $40,000/$226 is about 177 shares, before transaction costs—far below your desired 500 shares, and your entire $40k would be tied up.
Buying shares on margin. Buying 500 shares outright at $226 a share would cost $113,000. But if you could buy it at a 30% margin, you could buy the 500 shares for ($113,000 x .30) = $33,900, plus transaction costs. So you could certainly do that, but it would tie up a good chunk of your available capital.
Buying E-mini S&P 500 futures. The E-mini S&P 500 futures contract (/ES) is a futures product with a notional contract size of $50 x the S&P 500 Index. If the index is trading at 2262, the futures contract has a notional value of ($50 x 2262) = $113,100. And though margin requirements vary based on market conditions, as of June 2017 the initial requirement at TD Ameritrade for an E-mini S&P 500 contract is $4400.
Buying the futures contract allows you the same notional exposure, while tying up a lot less capital.
The same logic can be applied the other way. Suppose you own a basket of stocks that closely mirrors SANDP, and you’re looking to hedge a portion of it. Perhaps you believe market conditions point to a possible pullback, or at least you see an elevated risk of a pullback, and you’d like to lighten the load. But it may not be practical for you to liquidate all, or even some of your positions. One idea would be to put on a hedge—that is, take a position to offset the risk of the position.
One way to do that in a capital-efficient manner is to enter a short position in E-mini S&P 500 futures. The quantity of futures you choose depends on a number of factors, including the notional value of your portfolio, the amount (or percentage) you'd like to hedge, and your portfolio's beta, the amount it typically fluctuates relative to changes in the S&P 500. Read more about using futures to hedge stocks.
Long or short, investing or hedging, futures can be a useful tool for capital efficiency. But futures aren’t for everyone, and not all accounts will qualify. Additional education can help you decide if futures are right for you.