Futures Trading: To Hedge or Speculate? Tips For Investors

Futures Trading: To Hedge or Speculate? Tips For Investors

Having been shunned for decades by investors opting for the “safety” of buy-and-hold strategies that haven’t exactly panned out, futures’ time has come. And with it, so has the technology to trade them. If you’re new to futures, let’s start with the basics.

Maybe it’s because the 1982 movie Trading Places still has resonance in popular culture, but futures trading still has a certain boom/bust image. It’s either, “Looking good, Louis!” on the yacht, or down and out on the street. The reality is somewhere in between, futures can be a valuable tool for any retail trader or investor in different scenarios. Futures can be used for speculating, hedging a portfolio, or just gauging the mood of the market. If you’ve only heard stories about futures trading—scary or otherwise—or know a bit but want to know how to incorporate them into a trading strategy, read on. You’ll make Billy Ray proud.

It Starts With a Tick

Trading futures is less an objective in and of itself than part of a larger plan of how you intend to make money trading. Do you scan the markets for trends or reversals? There are dozens of futures markets with different market characteristics and volatility. Are you a stock investor concerned about risk? Index futures can provide a fast and potent hedge. How about speculating on interest rates, physical commodities, or even environmental markets? Futures offer direct exposure to things as diverse as eurodollars and sulphur dioxide emissions.

On the other hand, futures can also wreak havoc on your P/L if you don’t know what you’re doing. So before you plunge in and start slinging, you have to understand the nuances of the futures you intend to trade. (And you thought orange juice was exotic!)

For example, what’s the minimum tick size? Most stocks go up and down in penny increments. That’s not to say that stocks don’t change by a full point at a time, but each $1 is 100 pennies, or 100 minimum ticks. In contrast, different futures products have very different minimum ticks. Take the very popular e-mini S&P 500. Its future has a minimum tick size of $0.25, so you may see it move from 1100.00 to 1100.25, but not from 1100.00 to 1100.10. And the 0.25 move in the e-mini is worth $12.50 per contract, not $25, as you might expect. Crude oil futures have a minimum tick size of $0.01, and are worth $10 per contract. Because the minimum tick size and dollar value of that tick can be so important when hedging with futures, it’s worth spending a bit of time familiarizing yourself with the contract specifications. A quick check on the CME Group’s website (www.cmegroup.com) can get you up to speed with the basics.

Hedging With Futures

Speaking of hedging, that’s a good place to start if you’re new to futures. No, you’re probably not growing 5,000 acres of corn and looking to hedge the crop (although there may be a few of you out there). But you probably have a position in stocks, funds, or options, and maybe you will lose money if the market drops. Stock index futures can be used to help reduce the loss on an underlying portfolio—but understanding how it works is critical before you actually put on the hedge.

The trick to hedging your portfolio is to estimate how much money it would lose in some drop in a benchmark index, and then how much a short futures position in that benchmark index would make in the same drop. In other words, you have positive deltas that represent risk if the market drops. Short futures have negative deltas that would make money if the market drops. To hedge your portfolio, you balance the positive deltas with the negative deltas.

Sound tricky? It doesn’t have to be with the beta-weighting tools on the thinkorswim® from TD Ameritrade trading platform, which weighs the deltas (a measure of an option’s sensitivity to changes in the price of the underlying asset) of the individual parts of your portfolio for their different volatility and sensitivity to changes in the overall market—i.e., their beta. The beta-weighting tool adjusts the deltas of the components stocks or funds by their beta to, say, the S&P 500 Index or Nasdaq, to name two possible benchmark indexes. Checking the box for “beta weighting,” then typing in the symbol of the future (“/ES “ for the e-mini S&P 500 future and “/NQ” for the e-mini Nasdaq future) converts the deltas of the parts of your portfolio into deltas of the benchmark future. When you look at the total deltas now, you’ll see your portfolio’s risk in terms of the future. You’re almost there!

The next step is really important, and it gets to the nuances mentioned earlier. The beta-weighted delta indicates how much money the portfolio could theoretically make or lose if the benchmark future moves up or down one point. But you need to know how many dollars that future makes as it moves. The e-mini S&P makes or loses $50 when its price changes $1. If your portfolio’s beta-weighted delta is equivalent to positive 250 e-mini S&P 500 futures, then selling five e-mini S&P 500 futures would theoretically give you zero overall deltas.

But selling index futures as a hedge against a stock portfolio takes discipline to execute. That includes getting out if the market starts to rally—you don’t want those short futures to eat up the profits that your underlying stock or funds should be making. Give yourself either a specific time frame (“I’m nervous about the unemployment numbers coming out tomorrow, and I’ll hedge with futures, but I’ll hold the short futures for no more than a fixed number of days afterward”) or a specific dollar amount, like a stop loss (“I’ll hedge my portfolio with short futures, but if the market rallies, I’ll buy them back if they lose more than a fixed amount”). Hedging with futures can help reduce risk, but it doesn’t mean that you can put them on and forget about them. Futures have a very specific role when hedging a portfolio—and it’s usually short-term. When the hedge has fulfilled its purpose, or isn’t needed anymore, you should close it out.

Stopping Out

Because futures prices can move fast, you need to have a trading plan in place ahead of time, whether you plan to take advantage of the price movement or to get out of a losing position. Futures are highly leveraged—you don’t have to put up much money relative to the significant risk they represent.

That leverage also means that losses can mount quickly, but technology can help you manage the risk. Stop-loss orders and trailing stop orders can be entered at the same time you enter the long or short futures positions. The thinkorswim from TD Ameritrade platform lets you base stop orders a certain number of points away from the current price, a certain number of ticks away, or a percentage move away. The first is the most often used—putting a sell stop, say, 2 points lower than where you buy the futures. But the second can be handy when you’re trading futures with a strategy based on the number of ticks a product moves up or down. For instance, if the e-mini S&P future rises from 1100.00 to 1101.00, it can be seen as having moved 1.00 point or 4 ticks. Some trading strategies focus more on ticks.

The Myth of Clairvoyance

One of the things you may hear is that index futures predict the price of the market. That’s not entirely true, but they can “lead” the market. The price of a future is related to its underlying or cash product (as the e-mini S&P 500 to the S&P 500 Index, or Treasury bond futures to the actual 30-year Treasury bonds) by a cost-to-carry relationship known as “basis.” It’s a very specific financial calculation, and the difference between the future and the underlying is kept near that basis number through arbitrage. So, when you see a futures price higher or lower than the cash product, it doesn’t mean the cash product will rise or fall in the future. But because futures are faster for executing trades (as opposed to, say, all 500 stocks in the S&P 500 or a silo of grain), futures will also change their prices more quickly than you might see in the basket of stocks. So, if you’re a “tape reader” watching the intra-day up and down ticks in the market, the futures can provide a heads up to the short-term market sentiment that will be translated into individual stocks a bit later.

To trade futures, you need to open up a futures account because these trades are cleared and executed in a different way from stocks. But thinkorswim from TD Ameritrade lets you trade futures on the same platform that you’re trading your stocks and options on. Your futures account will be listed under the same login as your equities account. That lets you switch back and forth from equities and options to futures just by selecting the active account in the upper right-hand corner of the platform. This makes managing your futures positions more convenient than ever.

So don’t think of futures as a mysterious thing in the realm of billionaire speculators or something you only hear about on TV. They’re trading products that can be useful for real traders, big or small. And the better you understand them, the more useful they can be.

Futures Trading Tips:

Options aren’t the only game in town on thinkorswim from TD Ameritrade. Here are three tips for trading futures with the Active Trader tool.

Futures Trading: To Hedge or Speculate? Tips For Investors

FIGURE 1: With the Active Trader screen in the Trade tab, you can (1) bracket your orders, (2) Auto Send them without confirmation screens, and (3) trade like a market maker with price ladders. For illustrative purposes only.
Tip #1: Bracket Your Orders:

If you’re trading futures, the Active Trader screen under the Trade tab on the thinkorswim from TD Ameritrade platform can give you a lot of flexibility with your orders. One of the best features is the ability to create a bracket order, which is an OCO (one-cancels-other) stop and limit order, to be entered as soon as your original buy or sell is filled.

A bracket order for a long futures position, for example, would set a limit order at a higher price and a stop order at a lower price. Because it’s an OCO order, either the limit order or stop order would be executed, not both. The limit price sets a point where you would take profits, and the stop price sets a point where you want to limit the loss.

Associated with those brackets are the trigger prices. The stops and limit orders can be based on a price change in the futures price, a percentage change, or a tick change. If you click the icon next to the “link” field, you can control the order to one of these three. The “offset” field controls the number of points, percentage, or ticks that the stop and limit orders will be set away from the current price.

Once the bracket order is routed, you can see the stop and limit orders displayed on the chart, as well as the price ladder on Active Trader. If you want to change the stop or limit prices, you can simply drag and drop the order right on the chart or price ladder to the desired level, and a cancel/replace order for either, or both the stop and limit order, will be submitted.

Tip #2: The Little Wrench Thingy

Click the wrench icon at the top (right of the “Flat” button) to see the choices for order buttons such as Auto Send (routing orders without the order confirmation dialog—fast, but potentially dangerous), flatten (which closes any existing positions and cancels any working orders), and reverse (which reverses the quantity of your position from long to short or short to long).

Tip #3: Price Ladders for Cool People

Finally, trading on the price ladder is “market maker” style, where clicking on the bid price routes an order to buy, and clicking on the ask price routes an order to sell. That’s different from the “All Products” tab on the Trade page. The idea in the Active Trader tab is that you want to work your orders for the best fill price, and want to join other market participants to buy on the bid price or sell on the ask price. It’s tougher to get filled this way, but with a product that’s actively trading, you can get orders executed. Also, if you click on the bid above the current market, it creates a buy stop order, and if you click on the ask price below the current market, it creates a sell stop order. Active Trader assumes that you don’t want to pay above or sell below the current bid/ask prices.

Futures Trading Q + A:

Q: How is a future different from stock?

A: A stock represents ownership in a company. A future doesn’t represent ownership in the underlying commodity, product, or index; instead, it is a legally binding contract, an agreement between the buyer and seller to accept or deliver a specified quantity of the underlying asset (orange juice, Treasury bonds, etc.) by a set expiration date.

Q: How are margins calculated on futures?

A: Margins on futures are determined by the exchanges, and are based on the likely dollar value that the futures contract may change in a single trading day. More volatile products have higher margins. The system that clearing firms and exchanges use to determine the margin on futures positions is called SPAN (standardized portfolio analysis of risk), and is standard throughout the industry.

Q: What does marked to market mean?

A: Futures are marked to market daily. That means the cash from the daily profit or loss goes into (or out of) your account at the end of each day— not just when you close the position. Contrast this with stock trades, where the initial debit for a purchase is deducted from the cash in your account, and the cash proceeds from the sale go into your account only when you close the position and sell the stock. At the end of each trading day, the exchange that the future is traded on posts an official settlement price. That determines the daily profit or loss for any positions held overnight, and that profit or loss is added or deducted from the cash in your account.

Q: What is the basis?

A: Basis is the term for the difference in price between the contract months of the futures. It is the cost of owning the underlying product—whether that’s the S&P 500 Index, Treasury bonds, gold, etc.—from one expiration date to the next. The cost is composed mainly of interest charges, but can also include insurance and storage costs for physical commodities. Things like dividends on stock indexes and interest payments on bonds reduce the cost of carry. Basis can also reflect different supply and demand relationships. Crop cycles, shortages, or excess supplies expected in the future can also affect basis. Sometimes the futures in further expirations are more expensive; other times they are less so. The basis, then, can be positive or negative.

Q: How do I get a quote on futures?

A: Each future has a root symbol, such as /ES for the e-mini S&P 500 future, or /ZB for Treasury bonds. You can see root symbols of all the futures available on the thinkorswim from TD Ameritrade platform by clicking on the double dropdown arrows on the symbol field on the Trade page. Then click on the Futures tab to see a list of the symbols. In addition to the root symbol, each future has a month and year code. If you type in the root symbol on the Trade page, you can see the different expiration months for that future. The expiration month is indicated by a letter:

January F
February G
March H
April J
May K
June M
July N
August Q
September U
October V
November X
December Z

The expiration year is indicated by 0 for 2010, 1f or 2011, 2 for 2012, and 3 for 2013.

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