Did you know that after options, futures are the second fastest growing product of the financial space? Retail investors can get approved to trade futures through most major brokerages and unlike options, futures are open past the close. This allows investors to participate in the futures market 23 hours a day, five days a week. Wow, I guess money really doesn’t sleep.
Futures are a great tool for hedging and speculation but it’s easy to get hung up on concepts like contract specs, asset classes and margin. So here are Daily FX’s top 3 tips for getting started with futures.
Why you should use futures as a trading vehicle
The futures market offers traders a multitude of ways to express their views on various asset classes. Investors can trade futures in all of these categories (show list graphically)
- Equity Indexes (S&P 500, Nasdaq, Russell…)
- Interest Rates (30-year, 10-year, etc…)
- Energy (crude oil, natural gas, etc…)
- Metals (gold, silver, etc…)
- Agriculture (corn, beans, sugar, etc…)
- Foreign Currencies (Dollar, Euro, Yen, etc…)
In terms of strategy, traders usually trade futures for two reasons: speculation or hedging.
The most straightforward type of speculation in futures is, of course, a directional bet. For example, a trader believing that crude oil will bounce after recent weakness might buy crude oil futures. I mean have you seen the prices at the pump lately? An investor might also look to initiate a trade in a futures contract to reduce the likelihood that they will experience a loss in a volatile security or financial instrument, thereby hedging their position. But what exactly is a future?
Understanding contract specs
A futures contract represents an agreement to buy or sell the asset underlying the contract for the current price, at a predetermined point in the future. Futures exchanges set precise standards for each futures contract, based on the underlying asset. While futures can vary from oil to gold to soybeans, all futures contracts consist of the same 5 features.
- The underlying: what futures asset is being traded (gold, oil, corn, etc…)?
- The duration: when does the contract expire?
- The size of the contract: is it ounces of gold or barrels of oil?
- The value of the contract: the price of the underlying product multiplied by contract size
- The tick size of the contract: what is the smallest possible price increment?
Here’s why standardization is important. Going back to crude oil, one standard futures contract equates to 1,000 barrels.
By knowing the future contract’s size, we can now calculate the notional value of a futures contract – that is the total value of the underlying asset which we have bought or sold.
Hypothetically, imagine that crude oil is currently trading at $75/barrel. If one crude oil futures contract equates to 1,000 barrels, the notional value of one crude contract is therefore: $75 x 1,000 = $75,000.
Another important component of a futures contract is its “minimum tick size.” Minimum tick size is basically a fancy way of saying “minimum price increment” for a given futures contract. For stocks, it’s .01, so the value of your position changes by the number of pennies the underlying moves, multiplied by the number of shares you own. For futures, it is almost exactly the same – except that the minimum tick size may not always be a penny. It’s like when your significant other gets mad at you, sometimes an apology works but sometimes you need a new Lexus with a big red bow on it.
Let’s use oil again- which is easy because the minimum tick size for crude oil is also a penny ($.01). Each crude futures contract equates to 1000 barrels, meaning that every penny move will change the total value of the contract by: 1000 x $.01 = $10. So if you buy one crude oil futures contract, and oil prices increase by $.01, you’ll have made $10. Hooray! It’s important to note, however that this works in reverse as well, so if oil prices fall $1.00 (100 pennies), your loss is calculated by multiplying: 100 x $10 = $1,000. Futures contracts can make seemingly “small” positions incur huge gains or losses so it’s important to understand how they are priced before entering a trade.
While there is potential for profit with trading futures, investors should also carefully consider the potential for risk of loss associated with futures trading.
How Margin and Leverage Can Work For You
The biggest misconception with respect to futures is that they are dangerous because of the available leverage and limited margin required to hold a position. See this kids? This is your brain on futures. No scary PSA needed because the availability of leverage doesn’t mean you have to use it. In fact, responsible trading entails only using minimal amounts of leverage. Margin is the amount of capital needed to buy or sell one futures contract. When trading futures in a margin account, the amount of cash required on deposit is typically much lower than the 50% required for stock. In fact, the amount required on deposit for futures may only be 3%-12% of the total contract value. However, traders must keep in mind that leverage works both ways – with greater leverage comes greater risk of loss. We have lots of excellent examples of margin requirements and use of leverage in our guide.
In summary, with the right foundation and the right capitalization futures allow traders access to a wide array of asset classes virtually around the clock. Our in depth guide to futures teaches you why you should use futures, how to understand contract specs, and how to understand margin and leverage. For more details on learning about futures please download our free Futures for Beginners trading guide. Thanks for watching.