What Is Futures Trading?
Last updated on June 16th, 2015
Both PTU 2.0 and Trend Jumper from Netpicks make great use futures to day trade and they really are very simple instruments to trade – that’s one of the reasons they’re great to trade. However, to the uninitiated futures trading might seem to be a different world. Because of this some will choose to turn their backs on what are some of the very best products to day trade out there. So here are a few basics to get you started and help you avoid making that mistake.
WHAT IS A FUTURE?
A future is a contract to buy or sell something (e.g. a commodity, bond or stock index) of a certain specification at an agreed price and date. This also means that unlike stocks or forex for example, there is more than one contract of the same product available to trade. However, for the majority of products trading activity is prohibitively low in all but the nearest or “front month” expiration (prior to contract roll just before expiration). Depending on the specific instrument, futures contracts can be settled by delivery of the underlying product or in other cases they can be cash settled. Day traders never get involved in delivery though. They’ll always make sure that before expiration, all of the contracts that they’ve bought and sold for the specific expiry month they’ve been trading, add up to net zero.
BROKERS AND CLEARERS
The chances are that if you want to trade futures, you’ll have to get yourself a broker or clearer. Most companies offering futures trading online are brokers or IB’s (introducing brokers). They are basically the middlemen between a trader and the clearer and they charge an additional fee usually in the form of slightly higher commissions for their services. A clearer actually does all the work to ensure the trades are properly processed and your account is in order. If you go through a broker, you’ll still end up having to sign an agreement with a clearer. Some clearers also allow you to trade with them directly.
There are many different types of market that futures contracts are traded on. From crude oil to the S&P 500 stock index and pork bellies to frozen orange juice. These products have different trading profiles and because of this the futures contracts on them also have different specifications. The minimum price change is called a “tick”. A tick may be 0.0001, 0.01, 0.25, 0.5, 1, 2 or anything else for that matter – and the value it represents also varies depending on the product. A tick could be worth $1.25, $6.25, $10, $12.50, €10, €12.50 etc. Different futures products also have a different expiration schedule. Some have a new contract every month, some have a new contract every quarter and some have slightly more unusual schedules. But in order to avoid delivery, it is imperative that you make sure you know what the schedule is and when the trading activity for your market moves into the next expiry month (contract roll). You’ll also need to make a note of the product’s trading hours which along with tick size and value, can be found on their respective exchange’s website. Some products are open close to 24 hours a day Monday to Friday but some have shorter sessions. All products have at the very least a small maintenance shutdown period and so you should know this to ensure you don’t get stuck in a position.
MARGIN, LEVERAGE & COMMISSIONS
Margin is simply an amount of money put up to cover any potential trading losses each day. The amount is much smaller than the actual value of the product and therefore trading capital is leveraged. For example, the E-mini S&P 500 (product code = ES) at a price of 1700 is worth $85,000. However, at the time of writing the CME exchange initial margin for this product is $4,510 per contract and so the leverage is 19-1. Margin is based on volatility. The more volatile the markets are at any given time, the higher the margin rate. But if you trade intraday – meaning you don’t hold a position from one session into the next – brokers can offer a much lower margin rate. For the ES margins can be as low as $400 per day. This is very powerful but also where many beginners come unstuck – such low margins provide the opportunity to trade on undercapitalized accounts. Commissions are how brokers, clearers and exchanges make their money. Each time you buy or sell a contract, money is paid to these entities. This is based on the number of contracts you trade. So 1 contract costs 1 x commission rate and 5 contracts costs 5 x commission rate. The more you trade on average per month the better the commission rate you get as more business is always good for the brokers, clearers and exchanges. Typically, a trader not trading many contracts per month can expect to pay something in the region of $4-5 per round turn (a buy and a sell – i.e. a completed trade).
Let’s say we buy 1 contract of FDAX futures (Dax = German blue chip index) at a price of 8906.50 and sell it back at 8921.00. The Dax trades in 0.50 increments and each tick has a value of €12.50. Therefore 8921.00 – 8906.50 = 14.5 points of profit > 14.5 ÷ 0.5 points per tick = 29 > 29 x €12.50 per tick = €362.50.
Now let’s say we sell 2 contracts of CL futures (Crude Oil) at a price of 97.20 and buy one back at 97.05 and the other back at 96.83. CL trades in 0.01 increments and each tick is worth $10. Therefore (97.20 – 97.05) + (97.20 – 96.83) = 0.52 points of profit > 0.52 ÷ 0.01 points per tick = 52 > 52 x $10 per tick = $520 > $520 ÷ 2 contracts traded = $260 profit per contract.
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