Thinking of futures as just another asset class, let's start with the basics—here's how to use capital efficiently, speculate, and hedge with futures.
You finally gave up the mini van, and you’re cruising along Tuscany’s winding roads in your flashy red sports car, testing the handsome machine’s powerful capabilities. You’re completely lost in the moment when you hear it—the closing bell. Jolted out of this gorgeous reverie, you realize you’d fallen asleep at your trading desk. The culprit? Dampened vol can strike at any time.
If you’ve been trading equities and options for a while, you might be looking for something new. If you’re already cozy with option strategies and how to use them, maybe some new tools and instruments can give you more alternatives with which to manage positions, especially if you’re in a slump. Explore the idea of adding new trading vehicles to your existing fleet.
For instance, say oil is on a tear and you want a piece of the action. You might first turn to equities of oil drilling companies, or to exchange-traded funds (ETFs) whose underlying assets are oil companies. But did you consider trading oil futures?
We like what we know. And new things can feel mysterious. Maybe you think crude oil futures (/CL) are too rich or too risky or too scary. Before embracing different asset classes, it’s best to drill down and know the nuts and bolts of the new product.
Consider the breakdown of oil’s contract specs. The contract size is 1,000 barrels, with a tick size of $0.01, or $100 per contract. Say the price of oil is $45. The notional value of one oil futures contract would be $45,000. That may feel too rich. So one option is to look at the e-mini crude futures (/QM) contract with a multiplier of 500 barrels. The notional in this case would be $22,500, or half the big contract. It may still be too much for one trade, but think of what you’re getting. When you buy a futures contract, you’re getting exposure to 1,000, or 500, barrels of oil.
Let’s talk margin. Don’t think of futures margin in the same way as equity margin, which functions as a down payment. In other words, with equities you have to put down 50% of the total cost before you can buy or sell on margin. With futures, the margin is more of a good faith deposit on the contract’s performance—more like leasing versus buying. You’ll discover different margins across commodities, but they’re standardized within a specific futures contract. Margin requirements for futures is a small percentage of the notional value, which may range anywhere from 1% to 15%. So in a word, you’ve got leverage, and with leverage comes the potential for greater profits but also greater losses.
There are also two types of margin—initial and maintenance. The initial margin for a futures contract is the amount you’ll need to open a position. Once you open a position, your account must have a maintenance margin while the position is open. Again, that maintenance margin varies across commodities. But it’s usually about 80% to 90% of the initial margin. It’s something you will need to monitor closely when you have a trade open. And if the maintenance margin requirements change, you may have to deposit more or could even be closed by TDAFF (TD Ameritrade Futures & Forex LLC).
Let’s look at the E-Mini S&P (/ES) contract and make a comparison with an ETF that tracks the S&P index. Say /ES is trading at $2,167. That makes the notional value of one /ES contract $108,350 (price multiplied by multiplier of 50). Your initial margin may be $5,500, with a maintenance margin of $4,500.
Say the corresponding ETF is trading at $215 per share. To get the equivalent exposure of one /ES contract, you’d have to buy about 500 ETF shares. That would cost you $107,500, and with the Regulation T margin requirement, you’d have to put down $53,750 (50% of total cost). Compare this to the initial margin of $5,500 for one /ES contract. Of course, you don’t have to buy 500 shares. Yet, even if you settled for 100, which would only give you one-fifth of the exposure of an /ES contract, you’d still need to have $10,750 in margin.
This is how futures expand your leverage and can give you greater capital efficiency. The expanded leverage makes them riskier, but it’s the reduction in buying power effect that can make trading futures attractive to self-directed traders. Think about your trading preferences and how all this fits into your strategy toolbox.
FIGURE 1: FUTURES TRADING SCREEN.
From the Trade page, select Futures Trader to be able to place futures orders. Source: thinkorswim by TD Ameritrade. For illustrative purposes only.
Compared to equities, futures contracts are more correlated with spot price movement. At the same time, you have overnight access to a liquid electronic market. This lets you directly speculate in different markets. Let’s look at the “ags” (agriculture commodities) as examples. Keep in mind that liquidity in futures contracts tends to vary, especially for seasonals like ags. Weather, seasonal planting and harvesting patterns, whether crops are old or new—all these variables can impact a given yield, which ultimately affects a contract’s price.
Typically, ags contracts with higher liquidity include corn (/ZC), soybeans (/ZS), and wheat (/ZW). If you have a directional bias on any of these, and you choose to speculate using underlying futures contracts, one way to get a smaller piece but still maintain some exposure is to trade the “mini” contracts. You’ll have an advantage with a smaller piece of the pie because you may see that large price moves in commodities occur quickly, especially following crop reports. When trading a smaller contract, although the move would hold the same, because your exposure is less, the impact will be reduced.
Say you have a portfolio of stocks. If there’s something like a Brexit vote looming, you may want to reduce portfolio risk. Adding futures contracts may help. You can use futures to reduce risk on your equity portfolio by adding non-correlated products—those that tend to move opposite to equities, such as /ZC, /ZS, and /ZW—to your portfolio. And these don’t have to be big contracts. You can go smaller by adding the available minis—they’re a fraction of the size of the customary larger contracts. But keep in mind that smaller contracts may not be as liquid.
Another way to reduce portfolio risk is by reducing total delta, which can be accomplished by adding futures. Remember that deltas in futures are not exactly like deltas of equities. Futures deltas are based on contract multipliers, so they don’t change. In other words, delta for /CL contracts will be 1,000, for the /ES it will be 50, for the /NQ it’ll be 20, and so on.
Say you have an equity portfolio of 10 stocks drawn from the S&P 500. So you beta-weight your portfolio against the S&P, and the total delta is about +80. That means a one-dollar move in the S&P 500 will increase or decrease the value of your portfolio by $80. Now, if you sell one /ES contract in your portfolio (/ES has a delta of 50), it will reduce your portfolio delta by 50, giving it a total delta of 30. Of course, it will reduce the value of your portfolio by $5,500 (if we used the previous example, that would be your margin). But your delta exposure is reduced, along with the stress. In the example portfolio in Figure 2, total delta was 1,297, but it reduced to 30 after beta-weighting against the /ES. For your convenience, in the thinkorswim® platform, you can view your futures and equity accounts side by side.
FIGURE 2: FUTURES AND STOCKS SEEN TOGETHER.
If your portfolio is made up of stocks and futures, you can view them together in your position statement from the Monitor tab and view your beta-weighted delta equivalents (pictured here using /ES). Source: thinkorswim by TD Ameritrade. For illustrative purposes only.
As we’ve seen, futures are more accessible than you might think. They may help you engage capital more efficiently, and directly speculate in your preferred markets while giving you a hedge in your portfolio. Are futures the path before you?
While you’re putting on a racing helmet, get a feel for the instrument through a simulated futures account. Monitor them in overnight sessions, and as you get familiar and comfortable with how they move, you may find a whole new world open up for you. Who knows. You just might enjoy the ride.
For qualified accounts, you’ll need Level 3 options approval to trade futures. Log in to your account at tdameritrade.com. Under the Trade tab, go to Futures & Forex for more information.
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