Ever hear the story of farmers dumping excess grain in Lake Michigan rather than run up expensive storage costs and risk spoilage? Futures contracts eventually changed the water-logged destiny of future crops. The creation of these first derivative contracts allowed farmers to hedge their crop risk and protected grain buyers against volatile price swings. These days, futures markets span grains to metals to financial products, including stocks and bonds.
For advanced retail traders, portfolio managers, and institutional traders, futures might provide flexibility by allowing hedging against downside risk. Futures speculators, of course, believe they can potentially profit from risk taking. Even for a seasoned stock trader, entering the world of futures trading can be a challenge. However, once the differences between futures and stock markets—as well as potential advantages and risks—are understood, futures can offer unique leverage plus exposure to new markets.
Set It and Forget It? No Way
Next, it’s essential to understand that futures are derivatives. This means they derive their value from the price movement of another instrument. For example, the value of an oil futures contract is derived from the price of a barrel of oil. Derivatives are not a function of inherent value, but rather the changes in value of the underlying instrument that they track. Thus, hedging comes into play. A trader might offset a position in the underlying with a position in the related futures contract.
One very significant difference between futures and stocks is that futures contracts have a finite lifespan. Stocks typically can be purchased and placed in an account for long-term ownership. They can potentially exist forever. In contrast, futures contracts have an expiration date—a specific day on the calendar when that contract will terminate. This requires a more attentive trader. It is also critical to understand that most brokerages, including TD Ameritrade, will not allow you to carry any futures position that is physically settled into expiration. Instead, you must close or roll the contract to a new expiration.
It’s also essential to understand that each futures product has different trading hours, tick size, tick value, and initial margin.
One final major difference between stocks and futures is the variety of trades. With futures, there are several ways to trade other than the obvious “directional play" (essentially, strategies based on a trader's assessment of the broad market's direction, or a specific security's direction). Futures contracts with different expiration dates trade simultaneously, allowing strategies that use the relationships between the trading months, also known as calendar spreads.
Futures also allow a trader to control contracts with big “notional values” while only putting up a fraction of those values in buying power, or margin. This is more commonly referred to as leverage.
How much leverage? To calculate the notional value of a futures contract, take the amount of a one-point move in the future’s price and multiply it by the current price of the future. For example: a one-point move in /ES, or the S&P e-mini futures contract, is $50. Multiply 50 by the current value of /ES (we will use 2,000 for this example), and you will get a notional value of $100,000. But to control one /ES contract, the overnight margin requirement is $5,060. That’s roughly 5% of the notional value, or 20:1 leverage.
Keep in mind that greater leverage creates greater losses in the event of an adverse market movement. Use of leverage is not suitable for all investors.
The margin requirement for each individual futures contract is set by each exchange. Initial margins on futures also differ from product to product. For example, the margin for one /ES contract is $5,060. Compare that to the margin required for one e-mini Dow future (/YM), which is $4,290.
Clearing houses can raise or lower margin requirements as they deem necessary based on multiple factors, including perceived market volatility or risk. Brokerages can, too. For instance, TD Ameritrade can require more in margin than the exchange-set value based on internal risk management factors.
Bottom line: Futures may give qualifying, attentive traders access to a variety of potentially active markets to which they would otherwise not be exposed. Futures and futures options can play a significant role in portfolio risk management and help raise trading IQs. And remember, they provide leverage, allowing traders who can take on the risk to potentially use capital more efficiently.