This guide is intended to help those who are just starting to look at futures. This material will not contain strategies, quantitative edges, or any other conceivable edges. Just the basics.
*(TDOM & TDOY & First Profitable Open Concepts Invented By Larry Williams)
WHAT ARE FUTURES?
A futures contract is a type of derivative instrument, or financial contract, in which two parties agree to transact a set of financial instruments or physical commodities for future delivery at a particular price. If you buy a futures contract, you are basically agreeing to buy something that a seller has not yet produced for a set price. But participating in the futures market does not necessarily mean that you will be responsible for receiving or delivering large inventories of physical commodities – remember: buyers and sellers in the futures market primarily enter into futures contracts to hedge risk or speculate rather than to exchange physical goods (which is the primary activity of the cash/spot market). That is why futures are used as financial instruments by not only producers and consumers, but also speculators. (1)
WHAT IS A FUTURES CONTRACT?
Let’s say, for example, you decide to subscribe to cable TV. As a buyer, you enter into an agreement with the cable company to receive a specific number of cable channels at a certain price every month for the next year. This contract made with the cable company is similar to a futures contract, in that you have agreed to receive a product at a future date, with the price and terms for delivery already set. You have secured your price for now and the next year – even if the price of cable rises during that time. By entering into this agreement with the cable company, you have reduced your risk of higher prices.
That’s how the futures market works. Except instead of a cable TV provider, a producer of wheat may be trying to secure a selling price for next season’s crop, while a breadmaker may be trying to secure a buying price to determine how much bread can be made and at what profit. So, the farmer and the bread maker may enter into a futures contract requiring the delivery of 5,000 bushels of grain to the buyer in June at a price of $4 per bushel. By entering into this futures contract, the farmer and the bread maker secure a price that both parties believe will be a fair price in June. It is this contract – and not the grain per se – that can then be bought and sold in the futures market.
So, a futures contract is an agreement between two parties: a short position – the party who agrees to deliver a commodity – and a long position – the party who agrees to receive a commodity. In the above scenario, the farmer would be the holder of the short position (agreeing to sell) while the bread maker would be the holder of the long (agreeing to buy). We will talk more about the outlooks of the long and short positions in the section on strategies, but for now, it’s important to know that every contract involves both positions.
In every futures contract, everything is specified: the quantity and quality of the commodity, the specific price per unit, and the date and method of delivery. The “price” of a futures contract is represented by the agreed-upon price of the underlying commodity or financial instrument that will be delivered in the future. For example, in the above scenario, the price of the contract is 5,000 bushels of grain at a price of $4 per bushel. (2)
DIFFERENCE BETWEEN EQUITIES AND FUTURES.
Everyone is familiar with equity securities. These are the stock shares that trade on exchanges like the New York stock exchange, with traders yelling and hustling around the floor to buy low and sell high. Equity securities, more colloquially known as stock, represent ownership in a corporation. When this changes hands, the new owner instantly takes over ownership interest from the seller and takes ownership of the execution price.
Future contracts are different from stocks, but the underlying security of a futures contract may be equity securities. Futures contracts cover a wider universe of underlying securities than just stocks though; futures contracts may be made on commodities like gold or oil, interest rates, or even the weather!
A futures contract is a contract between two parties, in which the parties agree to sell and buy a set quantity and quality of some asset at an agreed upon later date, for an agreed upon price. Futures prices also trade on exchanges just like equities. Today, just like equities, most futures contract trading now takes place over electronic systems. Both the Chicago Board of Mercantile Exchange and the New York Stock Exchange own futures trading platforms, and very little open outcry trading takes place worldwide anymore.
Futures contracts fluctuate in price just like shares of a stock. The reasons for changes in price are the same principles of stock trading, as market conditions change, the future expected value of underlying security changes and the price of contracts adjust accordingly.
For instance, oil future contracts are very popular. A 30-day contract may have a price of $100 per barrel, meaning the buyer is locking in his purchase price in 30 days at $100 per barrel. If the price of oil in 30 days is actually $110, the buyer still only paid $100. He now owns an asset worth more at current market value than the price he paid. As the price of oil is rising, obviously the contract will not continue to trade at the same value, and the owner can either choose to hold the contract until expiration or sell for a profit on the secondary market.
A key fundamental difference between an equity security and a futures contract is the way in which the market determines prices. An equity security is always priced on what the market believes it is worth today. A futures contract will always be priced based on what the market expects it to be worth in the future, at expiration. If an asset is spot trading at some price, while rare, it is possible that the market will expect a lower price in the future, and the futures contract price will imply a lower future expected value.
Equity securities are much more liquid in large quantities, and very efficiently priced with very low spreads. Futures contracts are not necessarily as a liquid, though popularly traded futures contracts are about equally as liquid from a retail trader’s perspective. Spreads may be larger, however, and price may be more volatile.
For many people, the benefit of futures contracts is that they can trade assets in a wider spectrum than equities, and for those who are shrewd, there may be more potential to profit from inefficient pricing. (3)
THE POWER OF LEVERAGE (NOT MARGIN).
Leverage, when used judicially, is a beautiful thing. Real estate is a great example of an investment in which leverage used smartly works well. It’s rare to see a first-time home-buyer purchase a house without the assistance of financing. This use of leverage has helped many people buy homes who would otherwise have been excluded. More importantly, if purchased in the right market, the equity generated through the appreciation of the property enables the homeowner to move to a bigger home or another investment property. The media has deemed this “the American dream,” and it is made possible only by using leverage in a sensible manner.
The futures market is very similar, in that a trader has the benefit of ten-to-one leverage on most contracts that trade on major exchanges. Similar to leverage in real estate, when traders buy a futures contract, traders “control” a sizable amount of the underlying cash asset (this could be an index, currency, or physical commodity) for a small deposit referred to as a performance bond. This bond acts as collateral for controlling the asset.
The key when using leverage is to find the lowest risk opportunities so that if, and when a trader makes a mistake they lose little. For example in the Russell 2000 Index, $1320 is the intraday margin that controls approximately $96,000. For traders wishing to hold overnight positions, the margin is slightly higher (about $5000). (4)
In this example, you can see that a small fraction of money controls 96,000 dollars of that asset. Moreover, just because you control 96,000 does not mean you are at risk for this much. The E-mini S&P 500 has almost the same leverage as the Russell, a little bit higher. However, each contract that you buy or sell is worth 12.50 per .25 tick. Thus 4x.25=1, thus every point up or down is worth 50.00 bucks. Sublimation, you control a large asset, in theory, with a small fraction of capital, but your risk is what each point is worth or cent (like oil) is worth.
For more information about what contract is worth you can go to https://www.barchart.com/futures/contract-specifications
Know your risk of each commodity or index.
CONTRACT MONTHS AND ROLL.
For futures contracts specifying physical delivery, the delivery month is the month in which the seller must deliver, and the buyer must accept and pay for, the underlying.  For contracts specifying cash settlement, the delivery month is the month of a final mark-to-market. The exact dates of acceptable delivery vary considerably and will be specified by the exchange in the contract specifications.
For most futures contracts, at any given time, one contract will typically be traded much more active than others. This is called variously the front month or the top step contract.
Financial contracts traded on US futures exchanges (such as bonds, short-term interest rates, foreign exchange, and US stock indexes) tend to expire quarterly, in March, June, September, and December. For financial contracts traded on non-US futures exchanges, the expiration schedule may not be quarterly.
This table lists the conventional letter codes used in tickers to specify delivery month:
To name a specific contract in a financial futures market, the month code will follow the contract code, and in turn, be followed by the year. For example, CLZ3 is the December 2013 NYMEX crude oil contract. CL denotes crude oil (crude light), Z corresponds to the December delivery month, and 3 refers to 2013
QUARKS OF THE ROLL.
With contracts months, you can hedge either during the current contract month or in the future. If you are a day trader, you must be more sensitive to roll and always be trading the current month. Index’s tend to roll every three months (H, M, U, and Z). Metals such as Gold tend to roll every two months (G, J, M, Q, V, and Z) and commodities like Oil/ Natural Gas, tend to roll every month. If you are day trading it’s important to be in the most current contract month as you trade and be aware when a rollover is about to happen. You do not want to hold a position in a rollover because your broker will either deliver the physical commodity or charge you a fee to get out. If you are long or short going into the roll, close out your position and buy or sell them in the next contract date.
For example, let’s say I am currently long the E-mini S&P 500 at 1800.00 on the ESM16 (current front month) contract. I hold my position for about three months and roll is coming up. The next rollover contract month is going to be the “U” contract. Thus, on exchange regulated roll day, I will exact my current position at 1900.00 or wherever ESM16 will be and close it out. Then immediately buy the ESU16 contract for the following month. Or if I’m just day trading, I just need to make sure I’m aware of when contract roll happens and be out by the end of the day or EOD.
There are two parts to roll generally. There is an exchange regulated roll and then liquidation. Usually, liquidation follows a week after mandatory exchange roll. For most brokers, you have control of what contract to trade and when to roll. You don’t have to roll on the exact exchange regulated roll but then it is up to you to remember to roll. As a good rule of thumb, it is best to follow the exchange. As more volume is typically found on the front-month contract. After roll has happened, liquidation is next and sometimes you generally can have increased volatility around liquidation, especially during quad Witch.
For Specific Roll Over Times and Dates go to http://www.avatrade.com/trading-info/cfd-rollover-dates.
There are other places too.
OPTIONS EXPIRATION AND THE QUAD WITCH.
This should help explain liquidation more. Options generally expire the Third Friday of every month and can specific implications to markets when they happen, in terms of volatility and options strategies. However, during the course of the year, a magical volatile storm happens called the “Witching Hour”. This happens on the Third Friday of every March, June, September, and December. (Pretty much follows the expiration of the indexes). On this Third Friday of every March, June, September, and December, all index futures, stock index options, stock options, and single stock futures expire.
The term “witching” comes from the fact that in the past, the expiration of futures and options contracts occurred not only on the same day but at the same time. This often resulted in a period of greater-than-normal market volatility, which became known as the “witching hour.” Due to this increased volatility and frenzied market activity, many people trade very carefully or not at all during this time period. However, in my experience, this can be a very profitable time to trade if you know what you are doing.
Calendar for option expiration:
ADVANTAGES OF FUTURES MARKETS.
For most people that day trade, they never look to futures as a viable option, based on preconceived notions that have been perpetuated about futures and commodities. (I do not trade Forex). Most people gravitate towards penny stocks but futures/commodities can offer great risk rewards.
|Equities or Penny Stocks||Futures|
|Require 25K or more to get around PDT rule||In futures there is no PDT rule.|
|Hard to find shares to borrow, sometimes||Easy to go long or short|
|Hold over night borrows, can cost money||Overnight shorts don’t cost anything more than the value of the contract|
|Market only open from 9:30 A.M. to 4:00 P.M. EST. So if you are long or short overnight you can’t get out of your position.||Most index futures and commodities are open 23 hours a day. Most of them open on Sunday at 6:00 P.M. EST and go till Friday close. The advantage of this, is you can get out of a position at any time or put a stop in and get out. #addictedtotrading. =)|
Futures, which is a stage for all currencies, commodities, and indexes, is a highly liquid, highly regulated, highly efficient market in terms of transaction and structure. A small investor or trader is literally swimming in a sea of money and thus does not have to worry about getting orders filled or other problems with stocks. For every buyer, there is a seller for sure.
Another great part about futures is they are data rich. Unlike stocks, which can disappear over time (IE: Enron), one can backtest data in the futures market over long time horizons. This is a huge advantage because repeatable edges can be found in each market traded. Some edges are so robust through time, that it is quite shocking how they have transcended over 50 years of data and millions of variables.
To trade futures, you need a good broker. Not ETrade, not Suretrader, not Scottrade. This section will cover my recommended brokers. These are my opinions; I am not paid or compensated in any manner. Brokers are a dime a dozen, but I seek brokers that have the total package. Good commission structure, good fills, good charting software, and the ability to backtest and possible automation. Most brokerage houses are utter trash and charge low commission rates because they know this fact. Some of these recommendations do require data feeds from third parties. However, if you have interactive brokers you can hook up to all the charting software such as NinjaTrader and MultiCharts. You are free to your own opinions and some brokers offer such abilities of better shorts, such as Centerpoint. However, their charting package is very blah. Moreover, for me, I am slightly biased because anyone that does not have all the things I look for I throw out the window. ThinkorSwim will be mentioned below but they have started to really go south in terms of having a stable product and keeping up with the times.
|Brokers I Like||Brokers I Do Not Like|
|Multi Charts/ Investor RT||Scottrade|
|Stage 5 Trading||E-Trade|
|Ninja Trader *||Suretrader|
|Interactive Brokers *|
My Favs: *
Always remember you get what you pay for. =)
THE LONG HAUL.
In my opinion, it is important to be robust in trading and trade different asset classes. Equities, futures, and commodities give you much diversification. When equities suffer commodities rise and vice versa. Only when deleveraging in markets happen, do you get correlated markets for a while? However, relationships turn to normal and thus here we are in 2016, Natural Gas, Oil, Wheat and many others are making generational lows, as the market has made generational highs.