Futures Contract

CHAPTER

01

Futures Contract

Most traders get nervous or confused when they hear the words futures or options. In reality futures contracts are very basic instruments that serve a simple purpose. 

You will soon see that day trading futures contracts is really no different than stocks, forex, crypto, options, or any other market… BUT the futures market has some MAJOR advantages! 

What is a Futures Contract?

A futures contract is a legal agreement through an organized exchange to buy or sell a particular asset or commodity at a predetermined price but delivered and paid for on a future date.

History of Futures Contracts

Future contracts have been around for a very long term. They can be traced all the way back to 1750 BCE in Mesopotamia, located in present-day Iraq!

The need for futures contracts arose anytime two parties needed to exchange a good or asset for an agreed-upon price at a future date. In order to protect both parties in the transaction there needed to be a written contract. Thus, future contracts were born.

The first official futures exchange in the United State was the Chicago Board of Trade (CBOT) which opened in 1848.  The first futures contracts traded were corn, wheat, and soybeans. 

How Do Futures Contracts Work?

Imagine an oil producer who will produce 10 million barrels of oil over the next six months. It will be ready for delivery to consumers at the end of 6 months and the current price for a barrel of oil is $50.

The oil producer is in the business of producing oil, not speculating whether the price of oil will be above or below $50 in 6 months. If oil supplies go up and the price of oil falls drastically, the oil producer could be stuck with the oil and zero cash flow.

Along comes an airline company whose profits are also largely affected by the price of oil. The airline company can enter into a futures contract with the oil producer to purchase the oil when it’s ready in 6 months at a fixed price.

Locking in the price of oil now hedges the risk for both the oil producer and the airline company. 

Southwest Airlines did this in the early 2000’s, making them one of the few airlines to remain profitable as oil prices soared.

Futures Contract Settlement

Most new traders avoid trading future contracts because of the confusion surrounding settlements. It’s really quite simple.

Whenever someone decides to go long or short a futures contract they can settle a contract in three different ways.

  1. Closeout: Closeout is the settlement method day traders will use. With this method you will close out any positions prior to contract expiry and your account will be marked for your realized profit or loss.
  2. Physical Delivery: If a trader keeps a position open and allows it to expire then the contract will be settled by physical delivery or cash settlement. This will depend on contract specifications. Things like index futures obviously settle by cash settlement as you’re not going to take delivery of index futures. Oil futures are an example where the trader will take physical delivery of the product for use. (Similar to Southwest Airlines discussed earlier)
  3. Cash Settlement: Cash settlement does not require delivery. Instead the trader leaves the trade on and lets it expire and the transaction is completed by settling in cash.

As a day trader you won’t be using physical delivery or cash settlement as your settlement option. You will always close out of your positions prior to the expiry date and start trading the new contract.

Future Margin Requirements

Futures are traded on margin. This simply means you pay a fraction of the total value of a given contract and borrow the remainder from your broker, allowing you to control a larger asset with less capital.

There’s two types of margin, initial margin and maintenance margin.

Initial margin is the amount of funds required by an exchange to initiate a futures position. 

Maintenance margin is the minimum amount that must be maintained at any given time in your account while you are in a position.

If your account balance drops below the maintenance margin level, a few things can happen: 

  • You may receive a margin call where you will be required to add more funds immediately to bring the account back up to the initial margin level.
  • Margin Call: Your broker may allow you to reduce your position in accordance with the funds remaining in your account.
  • Liquidation: Your position may be liquidated automatically by your broker once it drops below the maintenance margin level.

Initial margin requirements are adjusted at times based on market volatility. As volatility increases so will the initial margin requirement.

Most brokers do have an intraday margin that is lower than the exchanges initial margin so check with your brokerage. My broker currently has an initial margin for intraday positions of $500 in Index Futures.

As a day trader, someone who doesn’t hold overnight positions, the margin requirements have less of an impact on your trading.

Types of Future Contracts

Futures allow you trade across a wide range of markets.

The futures market has expanded greatly since the traditional agricultural commodities began trading on the floor.

Now traders have access to multiple markets including metals, currencies, equity indexes (my personal favorite), interest rates, and energy.

For the purpose of this guide, we will focus on Index Futures as it’s where I believe anyone new to trading futures should begin.

Stock Index Futures

The four primary Index Futures day traders focus on are the E-mini S&P 500, E-mini Nasdaq 100, E-mini Dow, and E-mini Russel 2000. Each contract is slightly different so let’s do a quick overview.

E-mini S&P 500

Symbol: ES 
Expiration: Trading terminates at 9:30 a.m. ET on the 3rd Friday of the contract month. Contract months are March (H), June (M), September (U), and December (Z) 
Exchange: Chicago Mercantile Exchange (CME) 
Tick size/Minimum Price Fluctuation: 0.25 points 
Tick Value: $12.50 
Ticks Per Point: Four, making each point worth $50 per contract

One fifth the size of standard S&P Futures based on the underlying Standard & Poor’s 500 stock index. The index is made up of 500 individual stocks based on market capitalization. 

The E-mini S&P 500 (ES) is one fifth the size of standard S&P futures. E-mini S&P 500 futures and options are based on the underlying Standard & Poor’s 500 stock index. Composed of 500 individual stocks representing the largest companies, the S&P 500 Index is a leading indicator of large-cap U.S. equities.

 

E-mini Nasdaq 100

Symbol: NQ 
Expiration: Trading terminates at 9:30 a.m. ET on the 3rd Friday of the contract month. Contract months are March (H), June (M), September (U), and December (Z) 
Exchange: Chicago Mercantile Exchange (CME) 
Tick size/Minimum Price Fluctuation: 0.25 points 
Tick Value: $5.00
Ticks Per Point: Four, making each point worth $20 per contract

Though I primarily trade the S&P 500 due to liquidity, the NQ is my next favorite futures contract. Every contract has different characteristics. The NQ tends to be more volatile due to the nature of Nasdaq Stocks and can feel more volatile due to the pricing structure of the contract itself.

E-mini Dow

Symbol: YM 
Expiration: Trading terminates at 9:30 a.m. ET on the 3rd Friday of the contract month. Contract months are March (H), June (M), September (U), and December (Z) 
Exchange: Chicago Mercantile Exchange (CME) 
Tick size/Minimum Price Fluctuation: 0.10 points 
Tick Value: $5.00 
Ticks Per Point: 1, making each point worth $5 per contract

The E-mini dow is probably the index I trade the least. Again, every index has its own characteristics in terms of how it moves and I prefer the S&P 500 over the Dow E-mini. I primarily watch the Dow when looking at a macro picture of the market.

This doesn’t mean you shouldn’t check out the E-mini Dow as it’s characteristics can be more suitable for some traders. You have to find what suits you and your personality best.

E-mini Russell 2000

Symbol: RTY 
Expiration: Trading terminates at 9:30 a.m. ET on the 3rd Friday of the contract month. Contract months are March (H), June (M), September (U), and December (Z) 
Exchange: Chicago Mercantile Exchange (CME) 
Tick size/Minimum Price Fluctuation: 0.10 points 
Tick Value: $5.00 
Ticks Per Point: 10, making each point worth $50 per contract

The Russell index measures the performance of two thousand of the smallest-cap US companies which features the top American stocks by market cap. 

I still prefer the S&P 500 but over the years I have traded the Russell due to volatility. I’m always looking for a balance of the most active markets paired with liquidity.

Who Trades Futures?

Future traders can be categorized into two groups, hedgers and speculators.

Hedgers use the futures market to manage price risk of a given product. In our example from earlier, both the airline company and the oil producer were hedging against any large moves on the price of oil Thus both would be considered hedgers.

Speculators are traders who accept the price risk in an attempt to profit from favorable price movement. Speculators provide the majority of liquidity in the futures markets. As a result this allows hedgers to enter and exit the markets in a more efficient manner.

Speculators are made up of full time professional traders, small individual traders trading their own funds (like yourself), portfolio managers, and hedge funds.

How Does a Futures Trade Work?

From a day trader’s perspective, futures trading is very similar to trading any other security with a few minor differences in terminology. Before we look at an example of trade let’s go over some basics.

Contract Size
Every futures contract has a predetermined size that does not change. For example, the E-mini S&P 500 futures contract size is always $50 times the price of the index. Specifications for all futures contracts traded at the Chicago Mercantile Exchange (CME) can be found at https://www.cmegroup.com/

Contract Value
The contract value of a futures contract can be determined by multiplying the contract size by the current price of the derivative. For example, the E-mini S&P 500 has a contract size of $50. If the current price of the ES (E-mini S&P 500) is $2,905.00 then the contract value is $50 times $2,905.00 which equals $145,250.

Tick Size
The minimum price movement of a futures contract is measured in ticks. For you Forex traders a tick is similar to a pip. Tick size will vary from contract to contract. 

A tick on the ES (E-mini S&P 500) is equal to one-quarter of an index point. Since an index point is worth $50 on the ES, one tick is equivalent to $12.50.

Benefits of Trading Futures

When evaluating which market to trade you need to look at several primary factors including liquidity, news risk, volatility, tax advantages, and any PDT rules if they exist.

Market Liquidity

The liquidity of a market determines the ease at which you can enter and exit a security without affecting that securities price. 

When trading less liquid securities there becomes a point where you begin to manipulate the price when you enter or exit a trade. A good example of this trading penny stocks. Penny stocks tend to be very illiquid and if you have to exit a large position you could drastically influence the price. This creates two problems:

  1. It puts a cap on how large of a position you can put on limiting your overall income potential as a trader.
  2. During higher volatility (rapid changes in prices) it becomes impossible to calculate your Reward to Risk as you never can’t determine where you will for sure be able to exit a large position. This can be a recipe for disaster.

The liquidity of a market is especially important to me, let’s look at a real life example.

Trading Statement

Above is a trading statement from the 4th quarter of my second year trading at GPC, yes it was a long time ago, I’m getting old! 

Travel Zoo (TZOO) was my best stock of the year, in the 4th quarter I made over $200,000 from that stock alone.

TZOO Chart

TZOO had a wild ride that year from $8 up to almost $100 by the end of the year. 

Due to the low liquidity of the stock, I couldn’t put on more than a couple thousand shares on any given trade. If I were to put on a larger position and had to blow out of a trade I would have moved the market several points.

I was in a zone trading this quarter but unfortunately I was capped by what I could make due to the liquidity of the product I was trading, not because of my trading skills. If I had been trading a more liquid market like Index Futures, I may have made millions in that same quarter.

This is one of the primary reasons I eventually left equities and started trading futures. Your income ceiling is typically MUCH higher with futures than when compared to individual stocks.

News Risk

News risk impacts some markets more than others, but stocks are especially susceptible to news risk. Ever been long or short a stock and the stock gets halted?

A stock halt can occur at any time, typically for a breaking news release, and it leaves traders helpless as they are not able to exit their trades until the halt is lifted and the stock is reopened.

I’ve seen traders caught on the wrong side of trade halts and wipe out everything they made over the last year or more in seconds. I personally lost over six figures on GOOG during earnings on a trade halt that was due to an erroneous BTrade order. The most frustrating part was that I was up almost $20,000 right before it was haulted.

Obviously you have news risk in any market you’re going to trade. However, index futures are going to be less exposed to micro news events.

Volatility

Volatility is simply how much a given security moves throughout the day. The larger the range, the higher volatility.

When volatility is low and prices are range bound, most day traders tend to get chopped up and find it difficult to make money.

I personally like to trade securities with higher volatility. It really depends on your trading style as some systems perform better in less volatile markets.

Volatility is important for traders to pay attention to as it does change over time.

Gold Volatility

You can see on the above chart of gold that prices were much more volatile from 2005 – 2012 when compared to 2000 – 2004 and 2012 – 2019.

Taxes On Futures Trading

One of the greatest benefits of trading futures contracts for U.S. traders are the tax advantages. What ultimately matters at the end of the day is what you take home, not your gross P&L.

NOTE: JumpstartTrading.com and its affiliates do not provide tax, legal or accounting advice. This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, tax, legal or accounting advice. You should consult your own tax, legal and accounting advisors before engaging in any transaction.

Profits on futures contracts are taxed at 60% the more favorable long term gains and 40% as ordinary income. 

Let’s assume you’re in the highest tax bracket of 37% currently. Obviously not all of your income is taxed at 37% but for illustration purposes we will assume all the profit in this example is taxed at 37%.

Payable Tax on Stock Vs. Futures

Stock Profit: $100,000
Tax Rate 37%
Taxes: $37,000
Futures Profit: $100,000

60% Taxed at the Long Term Gains Rate of 20%: $60,000 x .20 = $12,000

40% Taxed at the Ordinary Income Rate of 37%: $40,000 x .37 = $14,800

Tax Savings of Trading Futures over Stocks: $37,000 – (12,000 + $14,800) = $10,200

Depending on your tax bracket, the blended rate ends up being between 28% and 30%. Up to almost a 10% SAVINGS!

Trading Futures - Tax Savings

The tax advantages alone make trading futures one of the best securities to trade in my opinion.

Futures Pattern Day Trading Rule (PDT Rules)

A futures trader does not fall under the Pattern Day Trading rules.

“FINRA rules define a pattern day trader as any customer who executes four or more “day trades” within five business days, provided that the number of day trades represents more than six percent of the customer’s total trades in the margin account for that same five business day period. Reference: https://www.sec.gov/files/daytrading.pdf

Currently, if you’re labeled a Pattern Day Trader you have to maintain a minimum account balance of $25,000 at all times.

Luckily, this FINRA rule does not apply to trading futures. However, do realize that FINRA has the PTD rule not to limit people from making money but to protect them from losing money.

With smaller margin requirements and no PTD rule, traders will typically expose themselves to more risk than they should. 

I don’t believe it’s necessary for someone to have $25,000 in a trading account to learn to trade. I actually believe the exact opposite. 

Today’s retail market has plenty of options for traders with smaller account sizes including the newly released Micro Futures.

Conclusion

After reading the benefits of trading futures contracts I hope you’re excited as I am for you!

Futures contracts, primarily Index Futures, are hands down my favorite products to trade. Once you’re past the confusion of the settlement process you begin to realize it’s really no different than day trading stocks except Futures have some additional advantages

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CHAPTER

05

Futures Trading Strategies

Coming Soon

CHAPTER

06

Trading Plan

Coming Soon

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