What is a Futures Market ?
Years ago, when I wanted to start trading in stock markets, I came across a lot of information about stock markets that was very difficult to understand. I realized that the best way to learn was to just jump in and start swimming. I signed up for a trading account with a broker and started with a small part of my savings as seed money, experimenting and learning as I went along.
In this article, I will try to help you understand what a futures market is and how it is different from a stock market. Let's start our journey of exploration and if you feel lost somewhere along the way, feel free to step back and go over the article once again. There are also very good resources available online which you can refer to once you have the necessary background information from this article. To learn more about our Day Trading Course Online, feel free to contact me.
What is a stock market?
Stock markets fundamentally exist for companies to raise money which they can use to do better at their business. Money raised by companies in stock markets can be used by them for expansion of their business - the addition of new stores or products, acquire competitors or even to pay off debt that they owe to someone else.
Normal stocks which are traded in the stock market give you, the stockholder, ownership rights to the company. If a 100% publicly listed company has issued 1000 stocks in the public market and you own 10 of those stocks, you own a 1% stake in the company. This entitles you to a share of the profits. But then, companies cannot give away all the profit back to the stakeholders. They must pay back money to the people who they have borrowed from, usually banks. They also need to invest money back in their business to make sure they remain competitive. Some profit money is also kept aside as savings to be used when times get difficult and money is needed. The profit remaining after all these activities are distributed as dividends to the shareholders.
Dividends are not the only benefits of owning a stake in a company through stocks. As the company makes money it grows in value. Successful businesses grow faster, while not so successful ones might grow at a slower pace. Companies which make losses will have negative growth and lose value. Depending on the growth of the company, the stock price also increases or decreases. So, if invested in a good growing company, you will also grow your money invested in the company. This is reflected by an increase in the price of the stocks you own. So, if you had paid $10 for each of the 10 stocks that you own, you would have invested a total of $100 in the company. Now if the company has grown by 50%, your stocks will be worth $150. The reverse is also true, the company that you own stocks it might not be doing well and this can lead to your stocks losing value in the market and decreasing in price, resulting in a loss for you.
Also, company performance does not depend only on how well their employees work or how good their products are. The macro environment of the country that they operate in also matters. When I say macro environment, I mean things like, how well is my competition performing? how many people in that country have good jobs?, how many of them are willing to spend money on services and products?, how is the country doing with respect to other countries?, how well is the country growing?, Are there any wars that are being fought in the country? and, how stable are the general prices of goods & services?. A lot of these parameters are very random and can affect the performance of a company a lot. Randomness also introduces a lot of risks. A risk to the business and in turn a risk to the money that you have invested in the company.
We hate risks, don't we?
A risk is an uncertainty. We all know that we take insurance when there is a chance of things going wrong. In the stock markets, there are companies which are at different levels of risk based on the business they are in and the macroeconomic situation that they are operating in. So, it is understandable that as humans, people who invest in these stocks will also need ways in which they can minimize or manage the risks. This is more like taking insurance, but for stocks.
To solve this need for a way to reduce your risks in the stock market or trading markets in general, a new kind of market called the derivatives market was formed.
What is a derivatives market?
The derivatives market was created to trade contracts which are written based on an underlying asset. I use the term asset because the underlying item can be either a stock or can be a commodity like corn or a currency like a dollar or could be just about anything which is legal. There can be a lot of different things on which derivative contracts can be written. Similarly, derivative contracts can also be of various kinds.
If I were to list down a few kinds of derivative contracts, the following would be the most common,
Derivatives get their name from the fact that their price is determined based on the price of the underlying asset. So, in our stock market example before we assumed that your stock was worth $10 a pop. A derivative contract based on your stock will have a value which is derived based on the terms of the derivative contract.
Given this article's focus on the futures market, I will now discuss in detail the futures market in the rest of the article.
Things you need to know to understand futures market
Before we understand a futures contract and the futures market, we need to know a few key terms.
1. Spot Rate: The current price of the underlying asset on which the futures contract is based. In our stock market example, $10 is the spot rate. The underlying asset need not be only a company's stock traded in the US, it can also be a commodity traded across the world. let’s take corn as an example, the price of corn is around $5 per pound in the US, for the sake of argument. The same corn could cost $3.5 a pound in the UK (where they would call it to be about $3.5 or 2.8 GBP for 0.45 kilos). The point I am trying to make is that, depending on the underlying asset, multiple spot rates can exist.
2. Future: I know this is basic, but still wanted to talk about it so that we are all thinking the same thing when I use the work future later. Future refers to a time period further in time compared to the current time period. It could refer to a time period a couple of months from now or could refer to a time period a year from now or possibly even later than that.
3. Contract: This refers to a legally binding agreement between two or more signing parties, which is legally binding and can be enforced by the courts.
4. Market or Exchange: A market or exchange is a place where people can come together and trade/exchange things. This also can be where contracts are written, signed and agreed upon. With the internet now, most of the exchanges or markets have gone completely digital. The only way to access them is through your computer or an app on your phone. You can also use a reliable broker who can execute trades in the digital market on your behalf.
5. Hedging: Hedging means you take preventive or protective measures against whatever negatives effects that you could have to face in the future. Hedging is a big part of futures trading.
6. Speculation: Speculation is used to describe your views on how an asset might behave in the future. It could be in terms of price or any other attribute. Speculative trading which means you are trading based on speculation is also a big part of futures trading.
With this background information on key terms, let us dive straight into futures trading.
What are futures contracts and futures markets?
A futures contract is a contract executed between two parties, who agree to fix the rate or price of the underlying asset at a future point in time. The formal definition is, 'A futures contract is an agreement between two parties in which one party, the buyer, agrees to buy from the other party, the seller, an underlying asset or other derivatives, at a future date at a price agreed on today'. The futures trading is structured and regulated in modern times. These contracts are traded in organized markets which are called the futures market or exchange. These contracts are standardized and the exchange sets the rules on how these contracts will behave and how they will be executed.
Let’s look at some real-world contracts and then I will walk you through an example of how you can really trade in the futures market.
The S&P 500 is a major stock market index that is tracked here in the US. This index value is calculated as a weighted average of stock prices of 500 companies that are listed on NYSE or NASDAQ. These 500 stocks are picked based on an assumption that their performance will give a good approximation to that of the other U.S. equities (company stocks). To invest in the S&P 500, you can either buy up stocks in each of those 500 companies or you can buy into ETFs. An example of an S&P500 based ETF is the SPDR S&P 500 ETF.
Now, let's look at a futures product which is available on CME called the E-MINI S&P 500 FUTURES’. These are futures contracts which have the value of the S&P 500 index as their underlying asset. To trade in an Emini contract, you need to have an account with a minimum balance of $500 to trade one contract. This is where trading futures becomes interesting.
To take a position in the Emmi futures, you are only required to make an initial good faith margin deposit.
This is about 7% of the contract value in general and depends on how volatile the market is currently. This is the margin amount you need to enter the futures contract. Now to remain in the futures contract, you will also need to ensure that you have enough money in your account at the end of every trading day to continue holding the position. This is called the maintenance margin. For a one contract position, the maintenance margin will be about $4,500. Now, these margin requirements are those mandated by CME. Your broker might give you favorable terms by letting you take positions with lesser money than stated here. Some only need you to have $500 to take a day trading position in an Emini contract.
With this information, let's jump into an example.
Assume that it is the 4th of August, 2017. You see the Emini Futures December 2017 series trading around $2,470. You have a good feeling about the market and think that there will be an aggressive bull run in the days to come. You call your broker and ask him to buy into the Emini contract for December 2017 (everything is done electronically these days, so you just press the buy button instead). He gives you a deal and takes only $500 as an initial good faith margin deposit and tells you that you will need to maintain $4,500 in your margin account for this trade if you decide to hold this position overnight.
Now how do I make money in the Futures Market?
- Trading Day 0 – 8/4/2017 at U.S Market Open: Day on which you bought the futures contract.
- S&P 500 Index: 2,476.83 (the Index and the Future price are only correlation and there’s nothing really you need to know, only that it goes up and down the same range)
- Futures Price: $2470
- Futures Price Change: $0
- Trading Day 0 – 7/8/2017 1 hour after U.S Market Open: Things are looking bright and shiny.
- S&P 500 Index: 2,480.91
- Futures Price: $2,471.00
- Futures Price Change: $1.00 ( 1 point)
- Your profit $50 (per contract) if you sold that position
Each .25 move up or down is equivalent to $12.50. If the price moved from 2471.00 to 2471.50, that is equivalent to $25 plus or minus.
If you went long and the market went down and you’re now down $50, with your account being $450, your broker will not force liquidate your account.
As you can see, your margin deposit has been depleted and gone below the crucial maintenance margin level of $500. You will have to pay your broker $50 to bring it back to $500. Not doing this will make your broker close out your position and return the remaining deposit post deductions. This is why it’s important to have enough fund for your account for any errors so you can continue to trade. We recommend having $3,000-$5,000 account per one contract.
Typical situation in the futures market
You might get worried and want to exit the contract. On a quick side note, in a futures contract where there are a lot of sellers and buyers active, it will be easier to sell or buy a contract without paying a premium or taking a cut. This is called spillage, there are enough buyer and sellers on each side that most cases you will get filled the price you want. The buying price is called a Bid and the selling offer price is called an Ask.
If the Bid is 2700 and the Ask is 2700.25, and you want to put a buy order at 2700, you will have to wait til you get your position filled. This is the first in first out rule where the amount of order (let’s say 500 contracts on each side) you are waiting in line for people to sell to you versus worrying about other exchanges cutting in front of the line or like regular stocks where they can and will not sell you any shares until you buy their price.
There’s only one exchange, however, if your internet connection is slow, and you are looking to buy the Ask, they (algos) might buy all the ask at 2700.25 and sell you one contract for 2700.50. Other times they will continue to have the price go up or down so that you will start chasing the market and buy or sell at a higher or lower price.
The more the number of people trading, the contract is said to be very liquid and you will much smaller difference between the highest bid and the lowest Ask. Emmi contracts are so fluid that the spread is generally 0.25. You might have noticed that Emmi futures price is always a multiple of 0.25. This is because 0.25 is the minimum tick size, i.e. the minimum movement possible on the Emmi futures price
Key highlights of Futures Trading:
Pros / Positives:
1.) Leverage: You trade using margins. So, using only $5,000 initial payment, you get to trade in futures worth technically 10 contracts. In this example, this is a 14x leverage. You can use less money to make trades which can win or lose you bigger sums of money. If you wanted to do the same in the stock market, you would have had to front the $123,500 to short the stock and a hefty margin to cover for that. In real-world, the leverage ratios vary with the futures market or exchange you trade on and the broker you use.
2.) Speculative/Hedging Trades: You can execute trades based on speculation or the need to hedge against downside risk. If you had taken short positions in the S&P 500 ETF to the tune of $123,500 (The same value that the futures contract was for) you have successfully hedged your position. You gained from the futures contract the value that was lost on the short position and using only less than 1/10th of the $123,500 position as margin. This is like taking insurance on your positions.
3.) Easy to take short or long positions: It is easier to take long or short positions by just buying or selling the contract.
4.) Lower taxes on gains: In the US, gains from futures get taxed at a lower blended rate than stocks or forex.
Cons / Negatives:
1.) Leverage: Since it’s a leveraged trade, your loss can also get amplified like your gains. Look out for margin calls. Always have cash available to satisfy margin calls. You don't want to be ruined financially by unexpected margin calls. Again, it’s recommended to have $3,000-$5,000 per one contract.
2.) Speculative Trading: Speculative trades conducted not for the needs of hedging a position can result in negative results for the traders. Tread with caution.
As can be seen, futures contracts are powerful instruments that are used strategically to help traders minimize their risks. These are instruments that help distribute the risk that you don't want to people who are willing to take on the risk. Use them wisely and you will be duly rewarded. Be reckless and the consequences can hurt you very deeply. But enough of the theory, get out there in the market and see how the trades are being done. Learn by doing, that is the best way there is.