You’ve probably heard of futures contracts, often lumped alongside options as the leveraged instruments within the “high-risk” category of investments. Despite their less favourable reputation among the retail investment community, the truth remains that futures are one of the best instruments for obtaining leverage – given you know what you are doing.
What Are Futures Contracts?
The standard textbook definition will talk about futures contracts being created as hedging instruments. For example, if a cotton farmer wishes to lock in the price he can sell his cotton crop 3 months from now, he simply needs to sell the futures contract that expires 3 months later. That way, he does not have to worry that prices will be much different 3 months from now (ensuring more predictable revenue).
Today, while the hedging function is still pretty ingrained within futures market participants, they are often used as speculation tools because of leverage. For example, with only approximately USD 4,000, you can control 1000 barrels of crude oil with one contract (assuming price is USD 50 per barrel, that’s basically controlling USD 50,000 with USD 4,000).
Technical Aspects Of Futures Contracts To Understand
Asset Classes (assuming US futures market): You can trade stock indices, treasury bonds, commodities, FX and so on.
Margin: There are 2 types of margin to know. The first is initial margin, this is your initial collateral that you have to put down in order to enter the position (the USD 4000 mentioned in the crude oil example). After that, you only need to watch the maintenance margin, which is typically lower than the initial. This is simply the number that your current account value has to stay above. If you take huge losses and the account value drops below the maintenance margin, you will be issued a margin call by your broker. Depending on your broker’s policy, your position is automatically liquidated or they will literally call you and ask you to top up your account.
Tick Size/Value: Unlike stock positions, of which P&L can be easily calculated according to (change in price x amount owned), you need to know what is the minimum tick size and its corresponding value in absolute dollars. For example, the E-mini S&P futures contracts trades in 0.25 point increments, with each point worth USD 12.50. So 1 point is equivalent to USD 50.
Calendar: Since futures contracts have expiry dates, the most traded (ie. Most liquid) contract typically changes from one quarter to the next. This is known as rollover. Thus, if you wish to have a multi-year buy-and-hold position, it is advisable to under how calendar rollovers are done and the risks involved.
Risks To Take Note Of When Trading Futures
You should be familiar with this – don’t trade with what you can’t afford to lose. The leverage offered by futures is a double-edged sword. Everything is great when your position is going well, but you can potentially lose ridiculous amounts if you take too much leverage.