We're going to discuss some futures fundamentals in today's blog. They're a popular product for active-traders, provide some handsome tax-benefits and offer a low cost to entry. They can be used in any market environment and are really great during volatile times.
So what are futures?
A future is of course a financial product obligating the buyer/seller to purchase/sell an asset (commodity or financial instrument) at a predetermined future price and date.
Futures are standardized to trade on an exchange and may require the physical delivery of an asset or settlement in cash (both types exist).
Futures contracts may be used for speculative purposes or for hedging. For example, farmers may use futures to lock in a price for their crop by selling a futures contract representing a portion of their crop. Alternatively, a trader might establish a speculative position based on their expectation for future price movement.
First, the standardized nature of futures contracts is a critical factor to keep in mind. This structure means that each and every futures trade establishes an agreement on the following terms:
- Delivery Point
- Delivery Date and Time
One big reason is that the market is available to traders on close to a 24 hour basis. This flexibility allows traders to react to important breaking news instantly in the futures market, which can be imperative for portfolio managers hedging larger exposure in other products.
Some other reasons that traders use futures products include:
- Efficient Use of Capital
- Access to non-correlated returns (6 different sectors)
- Options-like mechanics (familiarity)
There are several other important terms that traders starting in the futures arena need to be keenly aware of:
Initial Margin: Amount of money required per contract to initiate a futures position.
Maintenance Margin: Minimum balance that must be maintained at all times (dropping below this level results in a margin call).
Day Trading Margin: This is the margin most of retail traders use. The cost, for an E-Mini S&P contract, is $500 at most brokers.
The amount of maintenance margin differs across products in the spectrum of futures. The level of maintenance margin will vary because certain products are more volatile, or possess a higher absolute price - all of which increases the net risk of the trade. The higher the risk of the futures product, the higher the initial and maintenance margins.
Notional value is another key concept to understand when trading futures. This is the total dollar value a trader has at risk in any given position. In stocks, notional value is calculated by multiplying the number of shares bought or sold times the execution price.
The notional value of a future is calculated in a similar manner - multiplying the price by the contract size/multiplier.
For example, "/CL" is an oil future that represents 1,000 barrels per contract. If "/CL" is trading at a price of $44.80, then you would multiply $44.80 x 1,000 to get the notional value of 1 contract in "/CL."
In this case, the notional value of one contract in "/CL" is $44,880.
We'll be continuing a special basics of futures blog section in the Landshark Investing Blog as well as the members only videos for the E-Mini Students.
You can also start learning more by subscribing to our Futures Videos on our YouTube Channel here.