Trading Futures and Hedging Your Appetite

Warren Buffett said it best: “Invest in what you know.” What could be more familiar than what you eat, what’s in your home, or the gas in your car? You can invest in what you know with stocks and options, but there’s another asset class you may be overlooking—futures.

If you’ve been avoiding futures because they seem complicated or risky, maybe it’s time to give them another look. You could speculate on the S&P 500, hedge against the risk of your portfolio falling, or see how futures relate to products you use. The things you can do with futures might surprise you (assuming, of course, that your account qualifies).

Whether you’re buying a house, gas, or stocks, there’s always a chance prices will rise or fall. Businesses and individuals can hedge prices by trading futures contracts—agreements to buy or sell something at a specific price at some point in the future. For example, the price you paid for a box of Twinkies could depend on corn (/ZC) or wheat futures (/ZW). Gasoline prices may be tied to crude oil futures (/CL). The price of a stock you like to trade could also be related to price swings in the S&P 500 Index futures.

Futures trading involves substantial risk and is not appropriate for everyone. But every trader should get to know futures, because what happens in the futures markets can spill over into the equity markets. Before the stock market opens each day, futures are already trading. Equity index futures activity can indicate which way the markets might open. You can also trade futures to hedge your lifestyle by using the same strategies as the pros but on a smaller, less-leveraged scale.

How to Speculate

To understand how futures can impact the stock market, let’s see how, as an example, a trader can speculate using either the S&P 500 E-mini (/ES), which is a smaller version of the big S&P 500 futures contract, or the Micro E-mini (/MES) contract, which is even smaller. /ES delivers the cash equivalent of $50 times the value of the contract, while /MES delivers the cash equivalent of $5 times the value of the contract. So, if /MES is valued at 3386, the notional value of a contract would be $16,930. Which futures contract you use depends on the size of your trading account. Because /MES is the newest kid on the block, let’s use it in our examples.

Before buying an /MES contract, a trader may have to put up some cash to cover the initial margin requirement. To find out how much, fire up the thinkorswim® platform from TD Ameritrade, select the Trade tab, and enter a symbol. You’ll see the initial margin requirements for each contract. So, if the initial margin is $1,320, that’s how much is required to initiate a position that could be worth $16,930. That’s called leverage. And it can be good and bad.

If the S&P 500 Index (SPX) moves up by 50 points, that could be a $250 gain. A 50-point drop could mean a $250 loss. Note: An account may need more cash to maintain the position. This is known as maintenance margin, and the amount can be found on the CME Group website. Typically, for /MES, it’s $1,200. If the account value falls below the maintenance margin, it’ll trigger a margin call, and you’ll have to come up with the cash pretty fast. That’s one downside of leverage.

That said, what’s the benefit of buying /MES or /ES futures over, say, an exchange-traded fund (ETF) or mutual fund that mimics S&P 500 stocks? When trading /MES or /ES, you’re not actually buying securities. You can use leverage to speculate on the stock market, and if things go your way, you could potentially make better returns while putting up a lot less cash. Of course, if things don’t go your way, there’s potential for significant losses.

Everyday Realities

Beyond equity indices, there are futures on physical commodities and financials. Just about everything you buy is associated with price-changing factors—weather, politics, supply, demand, and transportation. With futures, you can take all these factors into account ahead of time.

For example, you’re probably not going to find day-to-day price movements in your weekly grocery bill. Food price fluctuations are mostly dependent on agricultural futures. Farmers often use futures to protect their commodities from price changes. Gas prices, as you know, fluctuate more often. That’s because it’s a harder product to produce. Oil has to be discovered, extracted, refined, and distributed before it goes to the pump. On the other hand, financial futures are more abstract than physical commodities. We’re talking foreign currency markets, interest rate futures, and equity indices, which aren’t tangible in the “new car” kind of way.

As already mentioned, what happens in equity futures often spills into the stock market. Before markets open, one thing traders could do is observe equity futures. This can kick-start the speculative thinking. Anything can happen overnight, and often index futures like the Dow or S&P futures react first. These reactions can also give you some idea of how traders could be interpreting a news event. The movement in the futures markets can help you understand how interest rates are likely to move, or maybe what you can expect to pay next time you fill up your tank.

Hedging Your Lifestyle

Can futures be used to reduce the risk of big price moves for things like falling stock prices, interest rates, or gas prices? Let’s find out.

Protecting equities. Suppose a trader has a portfolio that comes pretty close to tracking the SPX. The trader has no intention of liquidating any positions. One alternative: Consider using the /ES or /MES to hedge an entire portfolio. Of course, it’s important to make sure the hedge is in proportion to the portfolio value. Hedging a $100,000 portfolio with /ES would be a stretch.

Let’s say a trader has a $100,000 portfolio. If the thinking is that the market’s going to drop 5%, then the trader may consider shorting /MES. Let’s do a little math. If the market drops 5%, the portfolio’s value could drop by $5,000. If /MES is trading at $3,386, a 5% drop would mean a decline of around 169 points. Because each point is worth $5, that’s roughly $846.50. So, theoretically, a 5% market drop would reduce the portfolio’s value by $4,153.50. It’d still be a loss, but that loss would be less than if the trader hadn’t shorted the futures contract. If the market rose, the portfolio would be exposed to additional losses. Again, the downside of leverage.

Hedging an adjustable-rate mortgage. Say someone took out a $500,000 mortgage with an adjustable rate tied to 10-year bonds. If interest rates rose by two percentage points (200 basis points), they might have to pay an additional $10,000 in interest over the life of the loan. That’s no small change. To reduce the risk of such a move, consider shorting 10-year Treasury bond futures (/ZN). Remember, bond prices and interest rates have an inverse relationship. A one-point move in /ZN is $1,000, so if interest rates rise, /ZN could offset the additional interest. It may not be the perfect hedge, but it could help.

Follow the (gas) money. Oil prices can be influenced by several factors, from global demand to geopolitical tension. If there’s a significant rise in gas prices, chances are crude oil futures (/CL) are moving higher as well. How do you make up for that? Buy futures, perhaps. And never forget the risks involved in futures trading and, more important, the effects of leverage.

Start out by watching futures for equity indices, crude oil, and bonds. Once you learn about futures and understand how they work, consider opening a futures account.

How to Trade Futures on thinkorswim

Ready to see how futures prices move? On the thinkorswim platform from TD Ameritrade, select the Trade tab, then Futures Trader. You’ll see a bunch of dashboards and charts. In the symbol box, enter /MES for Micro E-mini S&P Futures. The quote box displays the sell (bid) and ask (buy) price, as well as the number of contracts at those prices (see figure 1).

If you have a futures account, you can place your trades directly from the dashboard.

If you’ve opened a futures account and have started trading, you may want to check out the Active Trader tool on the Trade tab (see figure 2). Here you’ll see charts, buttons, and lots of changing numbers. It can be a little intimidating, but it also provides active futures traders with a lot of vital information.

1 – Charting. On the left is something familiar: a price chart. Enter a symbol such as /MES to bring up the chart. The platform will default to the most active contract. You can customize the chart as desired.

2 – Analyzing. Add studies such as moving averages, Fibonacci retracement levels, or the Commodity Channel Index (CCI).

3 – Placing orders. From the Control bar on the right, you can view the order-book depth, time and sales, trade price, and trade size. Prices are displayed vertically, with the prevailing price at the center. You can also see the number of contracts on the bid/ask and volume. Customize the trading buttons at the top to enter buy or sell market orders, or limit orders to buy on the bid price or sell on the ask price.