Q&A
Futures For You
Inside The Futures World
Want to find out how the futures markets really work?
DeCarley Trading senior analyst and broker Carley Garner responds to your questions
about today's futures markets. To submit a question, post your question
at https://Message-Boards.Traders.com. Answers will be posted there, and selected questions will appear in a future issue of S&C.
LIQUID MARKETS
The liquid futures markets seem to be the most efficient and as a result the most difficult to profit from, especially when compared to stocks or options. Do you agree?
It is true that more futures (and options on futures) traders lose money than not. However, the same odds seem to apply to active stock and stock option speculators. I am not referring to stock investors who buy and hold, but those trying to beat the market via aggressive trading strategies.
There are, however, a couple of factors that may make the futures markets a little more difficult to master than equities — leverage and perceived price volatility. It is also these factors that make such markets attractive trading arenas.
Futures trades are granted a significant amount of leverage. The exchange-required margin is far less than the actual value of any given futures contract. For instance, an emini S&P trader must have about $6,000 in his or her trading account to hold a futures contract overnight, but the trader is responsible for gains and losses on the full value of the contract. Each emini S&P futures contract represents a value of the point value of $50 multiplied by the current price. If the S&P is trading at 885, emini traders are subject to gains and losses tied to $44,250 (885 x $50) worth of the underlying index. These circumstances allow significant volatility in the trading accounts of those utilizing the available leverage.
As you can imagine, leverage is nice for those on the right side of the market but painful for those who aren’t. It is this supercharged pace of profit and loss that makes futures trading more difficult than stock trading. Keep in mind that traders can lessen their exposure to risk by reducing leverage through overfunding an account or use of options. Just because the exchange requires $6,000 to hold an emini S&P overnight doesn’t mean that traders can’t deposit the full value of the contract, or purchase protective options against it. Doing so would eliminate, or mitigate, the amount of leveraged and, hopefully, trading account volatility.
The commodity and financial futures markets are often considered to be more volatile than equities. This may be more perception than reality. Nonetheless, it likely has a profound impact on trader psychology.
In most cases, the futures markets aren’t any more volatile than the average share of stock but are often assumed to be, due to the leverage granted and the difficulty of diversification. For example, a stock investor can smooth out account swings by participating in mutual funds rather than individual stocks. Conversely, futures traders are typically exposing themselves to a single market rather than an index or basket; this creates the feeling of relatively high volatility.
In all fairness, it is not uncommon for a stock price to see dramatic movement. Take Bank of America’s share price, for example; the 52-week high is $40.65, while the low has been $2.53. Even in the midst of historical commodity volatility, I can’t think of one futures contract that experienced such a dramatic trading range.
USING FUTURES SPREADS
Some people go short some futures contracts and long on other futures contracts at the same time. Do you know why?
When a trader goes long a futures contract in one market and short a futures contract in a related market, it is referred to as a futures spread. The purpose of such a trade is to either speculate on the price difference between the two contracts being spread, or it can be a directional play in which the trader prefers to hedge the risk of being wrong.
For instance, a trader who believes interest rates will go down may consider buying a 30-year bond futures (remember that interest rates and bond prices are inversely related). However, if that trader is uneasy about the risks involved, she may choose to sell a correlated futures contract such as the 10-year note. In theory, because of the difference in maturity lengths, bond prices will move in a larger magnitude than the T-note but the direction of the movement will be similar.
If this is the case, the trader should be making more on the long bond futures than is being lost on the short note as market prices appreciate (yields depreciate). Conversely, should prices decline, the trader will be recouping some of the losses on the long T-bond position with gains from the short T-note. This spread trader is taking a primary position intended to profit from a directional move and then simultaneously taking a secondary position aimed at mitigating the risk of the trade.
Other spread traders aren’t necessarily looking to speculate on market direction, but on the size of the spread. Grain traders often spread various products against each other once the relationship between the two contracts strays from the norm.
Take corn and wheat prices. Corn is primarily used for animal feed due to its affordability, while humans most commonly consume wheat. However, if the spread between the two becomes too close together, wheat may become an alternative to corn for feed. If this happens, there may be a tendency for the spread between the two to widen once again. A spread trader may look to buy wheat and sell corn in anticipation of the distance between the prices of the two contracts widening.
Spread traders looking for the spread to widen will buy the higher-priced contract and those looking for the spread to narrow will sell the higher-priced contract. In this case, wheat trades at a premium to corn; thus, the trader is buying the spread, looking for it to widen.
Of course, we have to remember that there is substantial risk in trading options and futures and is not suitable for everyone.