Exploring a New Road: The Basics of Futures Margin & Strategies

Exploring a New Road: The Basics of Futures Margin & Strategies

Key Takeaways

    Learn how futures can expand leverage and perhaps offer greater capital efficiency

    Consider futures as a way to try to reduce portfolio risk by adding exposure to traditionally non-correlated asset classes 

    Learn how to construct a beta-weighted portfolio hedge using index futures

You finally gave up the mini van, and you’re cruising along Tuscany’s winding roads in your flashy red sports car, testing the handsome machine’s powerful capabilities. You’re completely lost in the moment when you hear it—the closing bell. Jolted out of this gorgeous reverie, you realize you’d fallen asleep at your trading desk. The culprit? Dampened volatility, which can strike at any time.

If you’ve been trading stocks and options for a while, you might be looking for something new to try. If you’re already cozy with options strategies and how to use them, maybe some additional tools and instruments can give you more alternatives for managing positions. Let’s look at some futures trading basics and explore the idea of possibly adding some new trading vehicles to your existing fleet.

What’s the Speed Limit?

Suppose oil is on a tear, and you want a piece of the action. You might first turn to equities of oil-drilling companies or to exchange-traded funds (ETFs) whose underlying assets are oil companies. But would you consider trading oil futures?

We like what we know. And new things can feel mysterious. Maybe you think crude oil futures (/CL) are too rich or too risky or too scary. Before embracing different asset classes, it’s best to drill down and know the nuts and bolts of the new product.

Consider the breakdown of oil’s contract specs. The contract size is 1,000 barrels, with a tick size of $0.01, or $10 per contract. Say the price of oil is $45. The notional value of one oil futures contract would be $45,000. That may feel too rich. So you could look at the e-mini crude futures (/QM) contract with a multiplier of 500 barrels. The notional value in this case would be $22,500, or half of the big contract. It may still be too much for one trade, but think of what you’re getting. When you buy a futures contract, you’re getting exposure to 1,000 (or 500) barrels of oil.

Highways and Byways

No exploration of futures trading basics is complete without a look at margin. Don’t think of futures margin requirements in the same way as equity margin, which functions as a down payment. In other words, with equities, you have to put down 50% of the total cost before you can buy or sell on margin. With futures, the margin is more of a good faith deposit on the contract’s performance—more like leasing versus buying. You’ll discover different margins across commodities, but they’re standardized within a specific futures contract. Margin requirements for futures are a small percentage of the notional value, ranging anywhere from 1% to 15%. So in a word, you’ve got leverage, and with leverage comes the potential for greater profits but also greater losses.

There are also two types of futures margin requirements—initial and maintenance. The initial margin for a futures contract is the amount you’ll need to open a position. Once you open a position, your account must have a maintenance margin while the position is open. Again, that maintenance margin varies across commodities. But it’s usually about 80% to 90% of the initial margin. It’s something you’ll need to monitor closely when you have a trade open. And if the maintenance margin requirement changes, you may have to deposit more money, or your position could even be closed out by your broker (TD Ameritrade Futures & Forex LLC).

Let’s look at the E-Mini S&P 500 futures contract (/ES) and compare with an ETF that tracks the S&P 500 Index. Say /ES is trading at 2800. That makes the notional value of one /ES contract $140,000 (price times the multiplier of $50). Your initial margin may be $6,600, with a maintenance margin of $5,500.

Say the corresponding ETF is trading at $280 per share. To get the equivalent exposure of one /ES contract, you’d have to buy about 500 ETF shares. That would cost you $140,000, and with the Regulation T margin requirement, you’d have to put down $70,000 (50% of the total cost). Compare this to the initial margin of $6,600 for one /ES contract. Of course, you don’t have to buy 500 shares. Yet, even if you settled for 100, which would only give you one-fifth of the exposure of an /ES contract, you’d still need to have $10,750 in margin.

This is how futures expand your leverage and can give you greater capital efficiency. The expanded leverage makes them riskier, but it’s the reduction in buying power effect that can make trading futures attractive to traders. Think about your trading preferences and how all this might fit into your strategy toolbox (see figure 1).

Exploring a New Road: The Basics of Futures Margin & Strategies

FIGURE 1: FUTURES TRADING SCREEN. On the thinkorswim® platform from TD Ameritrade, from the Trade tab, select Futures Trader. You can customize your layout grid to show all your favorite futures products on one screen. Source: the thinkorswim® platform from TD Ameritrade. For illustrative purposes only. Past performance does not guarantee future results.

Optional Choices Like Leather Seats

Compared to equities, futures contracts are more correlated with spot price movement. At the same time, you have overnight access to a liquid electronic market. This lets you directly speculate in different markets. Let’s look at the “ags” (agriculture commodities) as examples. Keep in mind that liquidity in futures contracts tends to vary, especially for seasonals like ags. Weather, seasonal planting, harvesting patterns, whether crops are old or new—all these variables can impact a given yield, which ultimately affects a contract’s price.

Typically, agricultural contracts with higher liquidity include corn (/ZC), soybeans (/ZS), and wheat (/ZW). If you have a directional bias on any of these, and you choose to speculate using underlying futures contracts, one way to get a smaller piece but still maintain some exposure is to trade the “mini” contracts (/XC, /XK, /XW). You’ll have an advantage with a smaller piece of the pie because you may see that large price moves in commodities occur quickly, especially following crop reports. When trading a smaller contract, although the move would be the same, its impact is reduced because you have less exposure.

Hedging the Dream

Say you have a portfolio of stocks. If there’s something like a Brexit vote looming, you may want to reduce portfolio risk. Using futures contracts may help.

You can attempt to hedge your portfolio by reducing total delta, which can be accomplished by adding an opposite position in futures. Remember that deltas in futures aren’t exactly like deltas in equities. Futures deltas are based on contract multipliers, so they don’t change. In other words, delta for /CL contracts will be 1,000, 50 for /ES, 20 for /NQ, and so on.

Say you have an equity portfolio of 10 stocks drawn from the S&P 500. So you beta weight your portfolio against the S&P, and the total delta is about +80. That means a $1 move in the S&P 500 will increase or decrease the value of your portfolio by $80. Now, if you sell one /ES contract in your portfolio (/ES has a delta of 50), it will reduce your portfolio delta by 50, giving it a total delta of 30 and reducing the buying power of your portfolio by $6,600. But your delta exposure is reduced, along with the stress. In the sample portfolio in figure 2, total delta was 1,297, but it was reduced to 30 after beta weighting against the /ES. Conveniently, you can view your futures and equity accounts side by side on the thinkorswim platform (see figure 2).

Exploring a New Road: The Basics of Futures Margin & Strategies

FIGURE 2: FUTURES AND STOCKS SEEN TOGETHER. If your portfolio is made up of stocks and futures, you can view them together in your position statement from the Monitor tab and view your beta-weighted delta equivalents (pictured here using /ES). Source: the thinkorswim® platform from TD Ameritrade. For illustrative purposes only. Past performance does not guarantee future results.

Test-Drive a New Trading Life

After reviewing these futures trading basics, do you think futures might be a possible road for you?

Futures may help you engage capital more efficiently and directly speculate in your preferred markets while giving you a hedge in your portfolio. But they’re not for everyone, and not all account owners will qualify for a futures account.

If you’re ready to put on a futures trading racing helmet, get a feel for the instrument through a simulated trading account. You can monitor futures in overnight sessions, and as you get familiar and comfortable with how they move, you may find that a whole new world opens up for you. Who knows. You just might enjoy the ride.

Ready to take the plunge into futures trading?

TD Ameritrade offers a broad array of futures trading tools and resources. Trade more than 70 futures products virtually 24 hours a day, six days a week.

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