Understanding the Benefits of Futures
a.The Benefits of Portfolio Diversification
One of the most important characteristics of any investment portfolio is its diversity. Portfolio diversification helps offset exposure in any single position, and helps investors protect themselves against wide swings in key sectors.
Typically, traders diversify by trading both equities and bonds. But in times of market volatility, a portfolio can greatly benefit by the addition of futures and options on futures contracts.
Futures and options on futures give market participants the opportunity to hedge against market risk by sector and to raise and lower levels of desired exposure in times of anticipated and unanticipated event-driven volatility.
Whether adjusting for economic announcements such as FOMC meetings, earning seasons or non-farm payroll numbers, or guarding against unexpected macro events, futures and options on futures can play a valuable role in hedging against risk and carefully calibrating market exposure.
A market participant is invested in technology stocks and is looking to reduce exposure to expected announcements that can create price volatility.
By taking a short position in the E-Mini NASDAQ futures market, and offsetting sector-specific exposure, a market participant can protect against short-term downside risk and offset potential declines around specific economic events.
Every investment portfolio is unique, and each trader’s diversification strategy should be carefully balanced to the portfolio’s requirements.
The wide range of liquidity in futures and options on futures contracts provide the flexibility to diversify any trading plan and can be personalized around each trader’s long-term investment goals.
b.The Benefits of Day Trading Futures
The Benefits of Day Trading Futures
As an equity trader, have you ever been locked out of trading due to a day trading violation? Or have you missed an opportunity due to short selling restrictions?
Missed opportunities can be costly, so we will look at some of the restrictions in the United States for day trading cash equity products and compare that to day trading with futures.
Minimum Account Size
A pattern day trader who executes four or more round turns in a single security within a week is required to maintain a minimum equity of $25,000 in their brokerage account.
But a futures trader is not required to meet this minimum account size. In fact, as long as you maintain the minimum margin requirements for your positions, you can trade as frequently as you like at a size suitable to your trading needs.
An equity trader can only trade up to four times their maintenance margin excess on an intra-day basis. So if they have $30,000 maintenance excess available, they can only trade up to a value of $120,000. Exceed this amount and margin calls may further limit buying power and trading frequency.
With futures, that same margin may afford you the ability to trade a much larger notional value.
No Short Sale Restrictions
Another common struggle for equity day traders is that in order to short a security, there must be shares available to trade. And there are many reasons why shares may not be available.
In comparison, a futures trader does not have the same short sale restrictions. You can take a short position as easily as a long position.
When a trader shorts a stock, they are required to sell at a minimum of a tick above last traded price. This means in a down-trending market, an equity trader may never get to take a short position, thus losing out on a market opportunity. But futures trader can be short the market just as easily as being long.
As a futures trader, you can express your opinion long or short multiple times a day or week and you do not have to worry about day trading restrictions applicable to equities or the ability to take a short position in the market.
So why miss out on another opportunity because of restrictions? Make a move into futures.
c. The Benefits of Liquidity
The Benefits of Liquidity
Liquidity is perhaps one of the most important elements in gauging opportunities in a market.
At its core, liquidity is the collective expression of traders' opinions on the market.
Like any other market, these opinions are represented in a futures market either as existing positions held by traders, known as open interest, or as buy or sell orders communicated to the rest of the market but yet to be executed.
The size and price of these orders may vary considerably, but the key element to consider is that the more opinions that are expressed in the market, the more liquid the market is.
Liquidity is such an important element of market opportunity because the more participants there are, the more expressions of opinion on the market, the greater the likelihood that a single trader, like yourself, will encounter another with an opposing viewpoint that results in you both agreeing on a quantity and price to trade.
Compare the Natural Gas (NG) futures market to the U.S. natural gas (UNG) ETF market. One NG contract is equivalent to 10,000 mmbtu of natural gas exposure. At a price of $2.722 per mmbtu, the notional, or dollar, value of a single contract is $27,220.
Notional Value = Price X Contract Multiplier
Notional Value = $2.722 X 10,000 (NG multiplier)
Notional Value = $27,200
At an average daily volume of 322,441 contracts as of fourth quarter 2014, the dollar value total of natural gas futures traded between participants on an average day is just shy of $8.8 billion.
The UNG ETF contract, which tracks the price of natural gas, trades at $13.94 per share. UNG reports an average daily volume of 12,582,300 shares, making the average notional value traded within the market of only about $175 million per day.
Understanding liquidity in a market is a critical consideration for traders before jumping into a trade. Futures markets offer deep liquid markets that let traders express their opinions in a tremendously efficient way.
d. Managing Contract Expiration
Managing Contract Expiration
All futures contracts have a defined expiration and a specific delivery date. Part of managing your futures position is knowing what to do when your contracts approach expiration.
Most traders are in the futures markets to profit from variations in price movement, they do not want a cash settlement or a physical delivery when their contracts expire. So only a small percentage of trades actually go through delivery.
To avoid delivery, traders offset their position prior to expiration. One way to do this is by liquidating. A trader liquidates when they wish to exit an established position.
Rolling Contracts Forward
Another option to avoid delivery is to roll the contract forward, which means to offset your current position and establish a new position in a forward month. Traders do this when they do not want to give up their market exposure when the contract expires.
To illustrate, as futures contracts expire they roll off the board. So a trader with exposure in a March contract has to get out of the March position and move their interest into June.
There are two ways they can do this:
The first way is to leg in or initiate a spread. To leg in means selling the March contract, then buying a June contract in two separate transactions.
The second way is to initiate a spread, or position roll. With this option the closing order of the March contract and the opening order of the new June contract are executed simultaneously. Unlike legging in, there is no time gap between the two orders. That is important because a time gap can result in slippage, the potential loss from market moves between the closing and opening orders. Using the roll to move positions forward in a single transaction minimizes the chance of slippage.
Now that you know how to roll your position and manage expiration, you should feel much more confident trading futures.
e.The Benefits of Futures Margins
The Benefits of Futures Margin
When we talk about securities margin and futures margin, we are talking about two very different things. Understanding the difference is important.
In the securities world, margin is the money you borrow as a partial down payment, up to 50% of the purchase price, to buy and own a stock, bond or ETF. This practice is often referred to as buying on margin.
In futures markets, margin is the amount of money that you must deposit and keep on hand with your broker when you open a futures position. It is not a down payment and you do not own the underlying commodity.
The good news is that futures margin generally represents a smaller percentage of the notional value of the contract, typically 3-12% per futures contract as opposed to up to 50% of the face value of securities purchased on margin.
Margin requirements may fluctuate based on market conditions. When markets are changing rapidly and daily price moves become more volatile clearinghouse margin methodology may result in higher margin requirements to account for increased risk. In contrast, when market conditions and the margin methodology warrant, margin requirements may be reduced.
Types of Margins
There are two main kinds of margin in the futures markets: initial margin and maintenance margin.
Initial margin is the amount required by the exchange to initiate a futures position. While the exchange sets the margin amount, your broker may be required to collect additional funds for deposit.
Maintenance margin is the minimum amount that must be maintained at any given time in your account. If the funds in your account drop below this level, you may receive a margin call requiring you to add funds immediately to bring the account back up to the initial margin level.
If you do not or cannot meet the margin call, you may be able to reduce your position in accordance with the amount of funds remaining in your account, or your position may be liquidated automatically once it drops below the maintenance margin level.
A small change in a futures price can translate into a huge gain or loss, so understanding how futures margin works is essential to maximize the capital efficiencies that futures afford.
f.The Benefits of Open Access to Futures
The Benefits of Open Access to Futures
If you are only an equity trader, when a market is closed and an opportunity arises, you cannot take advantage of it. And worse, if you need to exit a position, you have to wait until the market opens.
You are probably familiar with U.S. stock market hours. But political events and natural disasters do not wait for the market to open and in a true global economy, many markets that affect the U.S. market trade outside U.S. market hours.
Trade 24 Hours a Day
In the world of futures, you can make a move nearly 24 hours a day, 6 days a week. That means a futures trader can react as the event unfolds.
Twenty four-hour access does not mean you have to stay glued to your trading screen. Say you are long in E-mini S&P position and you are concerned that China's manufacturing PMI report may be negative and drive the market lower. Instead of waiting for the report, you can place a stop order several hours before the report is released. It will be working while you are enjoying your evening.
You also can have an order working to take advantage of market opportunities so that you will not miss out.
It comes down to one question: where would you rather be to take advantage of market opportunities or to manage risk, on the sidelines waiting for the markets to open or already trading futures?
With nearly 24-hour access, futures markets give you the ability to express your opinion and manage risk around the clock.
g.The Power of Leverage
The Power of Leverage
Leverage can seem risky, but when used properly it is a game changer. Leverage is the ability to control a large contract value with a relatively small amount of capital. In the futures market, that capital is called performance bond, or initial margin, and is typically 3-12% of a contract's notional or cash value.
Assume that one E-mini S&P 500 future has a value of $103,800. You initiate a position by posting an initial margin of at least $5,060. In other words, you will have exposure to $103,800, but you have only put down a small percentage of the value. This is called greater capital efficiency.
Another benefit of leverage is gaining increased exposure. For example, if you have $10,000 with which you would like to express your opinion in the gold market. How can you maximize your $10,000? One option is to buy physical gold at $1,250 per ounce. This would afford you 8 oz. of gold.
Another option is to purchase shares of a GLD ETF. If the current price is $125 on GLD, you would be able to purchase 160 shares. That would afford you $20,000 in market exposure and you control the equivalent of 16 oz. of gold.
ETFs are subject to the Federal Regulation T requirement for 50% margin of purchase price, which means you can control $20,000 of exposure with $10,000 in capital.
A third option is to buy a Gold futures contract, which represents 100 oz. If initial margins are $4,400 you can guy two Gold futures contracts. You will have exposure to the equivalent of 200 oz. of gold.
Experienced futures traders understand the power of leverage, its risks and its potential benefits when used as part of a well-thought out risk management plan. Now you, too, can harness the power of leverage for greater capital efficiency and increased exposure.
h.Understanding the benefits of the Bid-Offer Spread
The Benefits of Bid-Offer Spreads
What does it mean when we say the energy complex is highly liquid with a tight bid offer spread? Is it a good thing?
One thing traders look for is the ability to get in and out of a market efficiently. A tight bid-offer spread makes that possible.
Tight Bid-Offer in Futures versus ETFs
An ETF is a security that tracks an index, a commodity, or a basket of assets like an index fund but trades like a stock on an exchange. A futures contract, on the other hand, is a contractual agreement to buy or sell a particular commodity or financial instrument at a predetermined price in the future.
A Crude Oil futures contract is currently priced at $100 per barrel and one futures contract is comprised of 1,000 barrels of oil. One thousand barrels times $100 gives the trader control of a notional value of $100,000. Since the minimum price fluctuation, or tick, for this contract is $0.01 per barrel, then a one-tick change would be worth $10.
Crude Oil Futures Notional = 1,000 barrels X $100
Crude Oil Futures Notional = $100,000
If the current price of a crude oil ETF share is $38, in order for an investor to manage the same notional value of one futures contract ($100,000), the investor would need to purchase the equivalent of 2,632 ETF shares.
Assuming 1 Oil ETF share = $38
Number of ETF shares to equate to 1 oil futures contract notional = $100,000 / $38 = 2,632 shares
Assume the ETF also trades in $0.01 increments. A one-tick price movement in the ETF position would equate to a change of $26.32 while a one-tick move in the futures contract is only $10.
Tight bid offer spreads may lower one of the costs associated with getting into and out of a position.