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Futures Trading: To Hedge or Speculate? Tips For Investors

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October 1, 2010
Futures trading as a hedge
Fredrik Broden

Having been shunned for decades by investors opting for the “safety” of buy-and-hold strategies that haven't exactly panned out, futures’ time has come. And with it, so has the technology to trade them. If you're new to futures, let's start with the basics.

Maybe it's because the 1982 movie Trading Places still has resonance in popular culture, but futures trading still has a certain boom/bust image. It's either, “Looking good, Louis!” on the yacht, or down and out on the street. The reality is somewhere in between, futures can be a valuable tool for any retail trader or investor in different scenarios. Futures can be used for speculating, hedging a portfolio, or just gauging the mood of the market. If you've only heard stories about futures trading—scary or otherwise—or know a bit but want to know how to incorporate them into a trading strategy, read on. You'll make Billy Ray proud.

It Starts With a Tick

Trading futures is less an objective in and of itself than part of a larger plan of how you intend to make money trading. Do you scan the markets for trends or reversals? There are dozens of futures markets with different market characteristics and volatility. Are you a stock investor concerned about risk? Index futures can provide a fast and potent hedge. How about speculating on interest rates, physical commodities, or even environmental markets? Futures offer direct exposure to things as diverse as eurodollars and sulphur dioxide emissions.

On the other hand, futures can also wreak havoc on your P/L if you don't know what you're doing. So before you plunge in and start slinging, you have to understand the nuances of the futures you intend to trade. (And you thought orange juice was exotic!)

For example, what's the minimum tick size? Most stocks go up and down in penny increments. That's not to say that stocks don't change by a full point at a time, but each $1 is 100 pennies, or 100 minimum ticks. In contrast, different futures products have very different minimum ticks. Take the very popular e-mini S&P 500. Its future has a minimum tick size of $0.25, so you may see it move from 1100.00 to 1100.25, but not from 1100.00 to 1100.10. And the 0.25 move in the e-mini is worth $12.50 per contract, not $25, as you might expect. Crude oil futures have a minimum tick size of $0.01, and are worth $10 per contract. Because the minimum tick size and dollar value of that tick can be so important when hedging with futures, it's worth spending a bit of time familiarizing yourself with the contract specifications. A quick check on the CME Group's website (www.cmegroup.com) can get you up to speed with the basics.

Hedging With Futures

Speaking of hedging, that's a good place to start if you're new to futures. No, you're probably not growing 5,000 acres of corn and looking to hedge the crop (although there may be a few of you out there). But you probably have a position in stocks, funds, or options, and maybe you will lose money if the market drops. Stock index futures can be used to help reduce the loss on an underlying portfolio—but understanding how it works is critical before you actually put on the hedge.

The trick to hedging your portfolio is to estimate how much money it would lose in some drop in a benchmark index, and then how much a short futures position in that benchmark index would make in the same drop. In other words, you have positive deltas that represent risk if the market drops. Short futures have negative deltas that would make money if the market drops. To hedge your portfolio, you balance the positive deltas with the negative deltas.

Sound tricky? It doesn't have to be with the beta-weighting tools on the thinkorswim® from TD Ameritrade trading platform, which weighs the deltas (a measure of an option's sensitivity to changes in the price of the underlying asset) of the individual parts of your portfolio for their different volatility and sensitivity to changes in the overall market—i.e., their beta. The beta-weighting tool adjusts the deltas of the components stocks or funds by their beta to, say, the S&P 500 Index or Nasdaq, to name two possible benchmark indexes. Checking the box for “beta weighting,” then typing in the symbol of the future ("/ES “ for the e-mini S&P 500 future and “/NQ” for the e-mini Nasdaq future) converts the deltas of the parts of your portfolio into deltas of the benchmark future. When you look at the total deltas now, you'll see your portfolio's risk in terms of the future. You're almost there!

The next step is really important, and it gets to the nuances mentioned earlier. The beta-weighted delta indicates how much money the portfolio could theoretically make or lose if the benchmark future moves up or down one point. But you need to know how many dollars that future makes as it moves. The e-mini S&P makes or loses $50 when its price changes $1. If your portfolio's beta-weighted delta is equivalent to positive 250 e-mini S&P 500 futures, then selling five e-mini S&P 500 futures would theoretically give you zero overall deltas.

But selling index futures as a hedge against a stock portfolio takes discipline to execute. That includes getting out if the market starts to rally—you don't want those short futures to eat up the profits that your underlying stock or funds should be making. Give yourself either a specific time frame ("I'm nervous about the unemployment numbers coming out tomorrow, and I'll hedge with futures, but I'll hold the short futures for no more than a fixed number of days afterward") or a specific dollar amount, like a stop loss ("I'll hedge my portfolio with short futures, but if the market rallies, I'll buy them back if they lose more than a fixed amount"). Hedging with futures can help reduce risk, but it doesn't mean that you can put them on and forget about them. Futures have a very specific role when hedging a portfolio—and it's usually short-term. When the hedge has fulfilled its purpose, or isn't needed anymore, you should close it out.

Stopping Out

Because futures prices can move fast, you need to have a trading plan in place ahead of time, whether you plan to take advantage of the price movement or to get out of a losing position. Futures are highly leveraged—you don't have to put up much money relative to the significant risk they represent.

That leverage also means that losses can mount quickly, but technology can help you manage the risk. Stop-loss orders and trailing stop orders can be entered at the same time you enter the long or short futures positions. The thinkorswim from TD Ameritrade platform lets you base stop orders a certain number of points away from the current price, a certain number of ticks away, or a percentage move away. The first is the most often used—putting a sell stop, say, 2 points lower than where you buy the futures. But the second can be handy when you're trading futures with a strategy based on the number of ticks a product moves up or down. For instance, if the e-mini S&P future rises from 1100.00 to 1101.00, it can be seen as having moved 1.00 point or 4 ticks. Some trading strategies focus more on ticks.

The Myth of Clairvoyance

One of the things you may hear is that index futures predict the price of the market. That's not entirely true, but they can “lead” the market. The price of a future is related to its underlying or cash product (as the e-mini S&P 500 to the S&P 500 Index, or Treasury bond futures to the actual 30-year Treasury bonds) by a cost-to-carry relationship known as “basis.” It's a very specific financial calculation, and the difference between the future and the underlying is kept near that basis number through arbitrage. So, when you see a futures price higher or lower than the cash product, it doesn't mean the cash product will rise or fall in the future. But because futures are faster for executing trades (as opposed to, say, all 500 stocks in the S&P 500 or a silo of grain), futures will also change their prices more quickly than you might see in the basket of stocks. So, if you're a “tape reader” watching the intra-day up and down ticks in the market, the futures can provide a heads up to the short-term market sentiment that will be translated into individual stocks a bit later.

To trade futures, you need to open up a futures account because these trades are cleared and executed in a different way from stocks. But thinkorswim from TD Ameritrade lets you trade futures on the same platform that you're trading your stocks and options on. Your futures account will be listed under the same login as your equities account. That lets you switch back and forth from equities and options to futures just by selecting the active account in the upper right-hand corner of the platform. This makes managing your futures positions more convenient than ever.

So don't think of futures as a mysterious thing in the realm of billionaire speculators or something you only hear about on TV. They're trading products that can be useful for real traders, big or small. And the better you understand them, the more useful they can be.