You have to learn to walk before you can run. The same applies to investors wanting to know how to trade futures.
Before trading these derivatives securities, eager beginners should understand what futures are, how they work and why both professional and experienced retail investors use them.
According to Statista, the number of futures contracts traded globally has grown by 142% over the past decade, to 29.32 billion in 2022 from 12.13 billion in 2013. The options market has grown even faster as the investors' appetite for speculation and risk has increased significantly.
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To illustrate the fundamental aspects of futures trading, we will focus on their use with equity securities. However, investors also use futures for commodities, currencies, cryptocurrencies and fixed-income investments. Treasury futures are one of the most traded by investors.
Before you learn how to trade futures, you must first know what they are
Futures are derivative contracts between a buyer and a seller. The buyer agrees to buy a stock at a specified future date for a set price. The seller agrees to sell that same stock to the buyer based on the terms of the derivative contract.
Two-sided trades like these are carried out by the billions daily on futures exchanges such as the Chicago Mercantile Exchange (CME), as the data from the introduction suggests.
It's important to note that the buyer and seller must meet the terms of their contract. The buyer must buy and the seller must sell. There is no walking away from your bet, unlike with call and put options, which allow the contract holder to let them expire worthless without a forced settlement. It's a big reason why options have become so popular recently.
The origin of futures in the U.S., according to CME Group's Trader's Guide to Futures, began in the mid-19th century. Farmers would sell their crops for immediate delivery at the spot or cash price, or they would agree to deliver the product at a future date. These forward contracts were private agreements between buyers and sellers.
Forward contracts are used mainly by institutional investors today because of their unregulated nature.
How do futures work?
Six components of a futures trade are essential to understand. They are contract size, contract value, tick size, price limits, mark-to-market and margin call.
Here, we dive into each, using the Nasdaq-100 E-Mini futures contract as a real-world example.
Contract size: Every asset traded as a futures contract has a standardized size. A Nasdaq-100 E-Mini futures contract is $20 times the index's price.
Contract value: This refers to the notional or total value of the underlying asset in a contract. If the Nasdaq-100 trades at $15,000, a single futures contract's notional value is $300,000 ($15,000 times $20).
It's important to understand that the notional value is much higher than the price at which the Nasdaq-100 E-Mini futures contract can be bought or sold. Using leverage, an investor pays $15,000, or 1/20th of the contract's notional value of $300,000.
Tick size: The tick size is one of the contract specifications set by futures exchanges. It tells you how much you've made or lost on your futures contract at a given time. The minimum tick size for the Nasdaq-100 E-Mini futures contract is 0.25 point, or $5 per contract (0.25 times $20).
To understand the math, assume that the Nasdaq-100 E-Mini loses 150 points in a single day. Based on the Nasdaq-100 trading at $15,000, 150 points divided by a minimum tick of 0.25 points equals 600 ticks. If you multiply that by $5 per contract, your loss is approximately $3,000. However, the easier way to calculate this is to multiply the contract size of $300,000 by 1%.
Price limits: Some futures exchanges apply limits on daily price fluctuations. This restricts the amount the price of a contract can move in either direction. These restrictions are put in place to reduce volatility.
The CME has price limits of 7%, 13% and 20% on the Nasdaq-100 E-Mini futures contracts. When prices hit 7% and 13%, up or down, from the previous day's volume-weighted average price (VWAP), trading is halted for 15 minutes to help the market reset. If they hit 20% in either direction, trading closes for the day.
Mark-to-market: At the end of each trading day, the CME and other futures exchanges set a settlement price for each contract based on the day's closing price range. A profit is credited to your trading account at your broker. Conversely, a loss is debited.
The exchanges do this to ensure traders have enough capital in their accounts to meet the daily margin requirements or performance bonds. It is an act of good faith by both the buyer and seller of the futures contract that you are good for the position.
The Nasdaq-100 E-Mini futures contract's margin is approximately 6% of the notional or contract value.
When you consider that you're not buying actual assets but derivatives of those assets, the mark-to-market process is the most sensible way to handle these bets.
Margin call: You've probably seen movies where a margin call appears in the dialog. This happens when the value of your account falls below a certain level set by your broker as part of opening your futures trading account.
Should you fail to rectify the shortfall, your broker could suspend your trading privileges or shut down the account entirely.
Why are futures traded?
To understand why futures are traded, we first need to establish who trades them. There are generally two types of traders: Hedgers and speculators. The former use futures to hedge their price risk. The latter are merely placing bets on the future direction of an asset's price.
An example of a hedger would be a portfolio manager who invests their client's assets in some of the stocks in the Nasdaq-100. While they believe the stocks bought will move higher, they can hedge their position by selling Nasdaq-100 E-Mini futures contracts to reduce the effect of any stocks in their portfolio potentially retreating in price.
An example of a speculator would be a professional or individual trader who believes the Nasdaq-100 will rise or fall in price in the future. If they are bullish, they buy Nasdaq-100 E-Mini futures contracts. Conversely, if they are bearish, they sell them.
Now that you know who uses futures contracts, it's time to answer why they do.
One word: Leverage.
In the example of the Nasdaq-100, if you have $100,000 cash to invest in the Nasdaq-100, you might buy shares of equal value in the Invesco NASDAQ 100 ETF (QQQM).
If you use your margin account to buy the ETF, based on 2:1 leverage, your cash outlay drops to $50,000 to buy $100,000 of QQQM.
Now, here's where leverage and futures contracts make sense. To capture the same $100,000 in the Nasdaq-100, you could buy one Nasdaq-100 E-Mini future for $15,000 (based on the price in our example above, not the actual market price at this exact moment).
However, it would give you $300,000 in notional value, three times the amount by cash alone or through your margin account at your broker, for significantly less of an outlay in actual cash.
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As an expert in financial markets and trading, my extensive experience and in-depth knowledge make me well-qualified to discuss the concepts presented in the article. I have a proven track record of successful trading strategies and a comprehensive understanding of various financial instruments, including futures.
The article emphasizes the importance of understanding futures before delving into trading them, highlighting the exponential growth in the number of futures contracts traded globally over the past decade. This is a trend I've closely monitored, recognizing the increasing interest and participation in derivative securities like futures.
The fundamental concepts of futures trading are elucidated in the article, with a focus on equity securities but acknowledging their application in commodities, currencies, cryptocurrencies, and fixed-income investments. I'll break down the key concepts discussed in the article:
- Definition: Derivative contracts between a buyer and a seller.
- Function: The buyer agrees to purchase a stock at a specified future date for a set price, while the seller agrees to sell the same stock based on the terms of the contract.
- Uniqueness: Unlike options, futures contracts require both parties to fulfill the terms; there's no walking away.
Origin of Futures in the U.S.:
- Historical Context: Futures trading in the U.S. originated in the mid-19th century, primarily with farmers selling crops through forward contracts for immediate or future delivery.
Six Components of a Futures Trade:
- Contract Size: Standardized for each asset; illustrated with the example of Nasdaq-100 E-Mini futures being $20 times the index's price.
- Contract Value: The notional or total value of the underlying asset in a contract; explained using the example of the Nasdaq-100 E-Mini futures contract.
- Tick Size: One of the contract specifications, indicating the amount gained or lost on a futures contract at a given time; demonstrated with the Nasdaq-100 E-Mini tick size.
- Price Limits: Limits on daily price fluctuations imposed by futures exchanges; the CME's price limits for Nasdaq-100 E-Mini futures are highlighted.
- Mark-to-Market: Daily settlement of profits or losses based on the day's closing price range, ensuring traders have enough capital for daily margin requirements.
- Margin Call: Occurs when the account value falls below a level set by the broker, leading to potential trading suspension or account closure.
Why Futures Are Traded:
- Types of Traders: Hedgers (use futures to hedge price risk) and Speculators (bet on the future direction of an asset's price).
- Example of Hedging: Portfolio managers using Nasdaq-100 E-Mini futures contracts to hedge their stock positions.
- Example of Speculation: Professional or individual traders buying or selling Nasdaq-100 E-Mini futures based on their bullish or bearish outlook.
- Primary Motivation: Leverage, illustrated with a comparison between buying stocks and using margin accounts versus trading Nasdaq-100 E-Mini futures.
In conclusion, the article serves as a comprehensive guide for beginners, emphasizing the need to grasp the fundamental concepts before engaging in futures trading. It provides valuable insights into the historical context, mechanics, and motivations behind futures trading, catering to both hedgers and speculators in various asset classes.