Trading Futures: Some Of The Most Important Aspects
I am the CIO of Shadowtraders.com
I am the CIO of Shadowtraders.com. My name is Barbara Cohen. While I am the CIO, I am also a Futures Market daytrader. Over 10 years ago when I first began trading, I was a computer programmer. My specialty was writing software for automated black boxes. My clients were institutional Futures traders who taught me about trading Futures. Writing Futures Market software afforded me the knowledge of why it was that so many professional daytraders were not trading the stock market but instead trading the Futures Market. Now, we, at Shadowtraders, offer an online Futures trading course that the client can take at their own pace, deliver Futures Market Trading Seminars, write Futures Market trading software with Futures Market strategies, and provide a daily Chatroom where we can monitor the Futures Market real time. We have even provided seminars inside the Chicago Mercantile Exchange (CME).
For those of you unfamiliar with trading Futures, we'll start at the beginning. For those of you well versed in trading Futures, hang tight ... you may just hear something new. The first question I get asked over and over is, "So what's the Futures Market and why would I want to trade it?"
Wikipedia states that "A Futures Market is a financial exchange where people can trade Futures Contracts." And a Futures Contract is "a legally binding agreement to buy specified quantities of commodities or financial instruments at a specified price with delivery set at a specified time in the future."
Notice the word "Contract". The first major difference between the Futures Market and, say, the Stock Market is that the Futures Market deals in contracts, not shares. You are not buying a "share (or piece) of a company". A Futures Contract is an agreement between a buyer and seller to trade a quantity of a specific commodity or financial instrument, for example, gallons of gas or bushels of wheat.
It is easy to understand how commodities Futures Contracts work. An airline, for example, contracts for 100,000 gallons of fuel for their planes at a certain price today, but does not take delivery until sometime next year.
Southwest Airlines was able to survive well when crude oil was trading at $140/barrel, while the other airlines were having difficulty. They purchased crude oil Futures Contracts with the oil companies years earlier when the oil was cheap, but delayed delivery until 2007-2008. When the price of oil is cheap again, they will arrange for new Futures Contracts to be delivered in future years.
Arranging Futures Contracts for airlines is not trading you say.
In every Futures Contract transaction, there is a degree of risk. Futures Contracts are all about leveraging risk against the value of the underlying asset you want to buy.
Southwest took on some risk. The price of crude could fall well below the current price they paid (so they would have paid more than they would have needed to). Yet simultaneously, Southwest reduced their risk because they figured that oil would go higher than their contract price. In the case of Southwest, the leverage worked.
While Southwest acquired risk, so did the oil companies. They determined that they had reduced risk, because they believed that crude oil prices would fall below the contract price they made with Southwest. Yet they acquired risk because they knew that the price of oil could potentially rise higher than their contract price, resulting in loss of additional revenue they might have had). For the oil companies, the leverage was not so good.
But "I'm not Southwest Airlines, I am an individual investor. I don't want to buy 100,000 gallons of oil. How do I trade Futures?"
The CME that trades Futures instruments, recognizes that individual investors want to trade Futures, similarly to the major corporations. The CME recognizes that individual traders want to leverage risk. They recognize that individuals are not willing to risk millions on gallons of crude oil contracts or bushels of wheat. The CME provides contracts specifically designed for individual investors to trade Futures.
Look at it this way...as an individual investor, you can trade on so many exchanges. You can trade large cap stocks with the New York Stock Exchange, tech stocks with the NASDAQ, ETFs with the AMEX, and options with the CBOT. In order to entice you to trade Futures, the CME needed to create an exchange that made other exchanges seem less desirable to professional traders.
The CME created "E-mini Futures Contracts" specifically tailored to individual investors. The "e" in E-mini meant they are traded electronically. The CME gives you a trading platform for your desktop where your trades go straight to the CME. The "mini" means that the contract is a smaller version of the exact same contract that the larger institutions trade.
The most popular CME E-mini Futures Contract is the S&P 500. This E-mini is based upon the S&P 500 index that represents the top 500 stocks in the NYSE. The S&P 500 index is price-weighted, meaning some of the stocks have more "weight" or "pull" than others. Being larger companies, they can move the value of the index higher or lower more than others. But indexes cannot be traded.
And you thought that Futures Contracts were just based on commodities like corn, wheat, rice, crude oil.
Say you were able to trade all the top 500 stocks on the NYSE at once. Now that's leveraging risk If two stocks did not do so well, you would still have positions in 498 other stocks. You wouldn't be picking any one stock. You wouldn't be spending hours researching specific stocks. You could trade all of them simultaneously. Of course, it would cost a huge fortune to trade 500 stocks. Think of buying and selling S&P 500 E-mini Futures Contracts is as if you were trading all 500 stocks at once, for a much smaller amount.
So how did the CME entice traders to trade E-mini's? Check out the advantages of trading E-mini Futures Contracts. You'll quickly see why many professional day traders gave up trading anywhere but the CME ...
S&P 500 E-mini contracts are heavily traded with extreme liquidity. That means lots of volume and for you...lots of action. Lots of volume means you'll be filled quickly often in as little as 1 second. When the S&P 500 was first traded in 1997, the average trading volume was barely 7,000 contracts / day. Now, the average is more like 2 million contracts daily with upwards of 3million not unheard of.
The E-mini is a totally electronic environment. There are no Market Makers on the CME who might refuse to fill your trade like there are on the NYSE. The CME book is FIFO, first in first out. That makes trading on the CME a level playing field for all traders, whether you are trading 1 contract or 100.
Commissions for E-mini Futures is based upon "Round Trip" instead of in-and-out.
The difference between the Bid price (the highest price that a buyer is willing to pay for a contract) and the Ask price (the lowest price that a seller is willing to sell a contract for) is just one "Tick" on the CME.
(The minimum difference in price between the Bid and Ask for Futures trading is known as a Tick. The S&P 500 E-Mini trades using 25 cent increments. 1 Tick being 25 cents. 4 ticks being 1 point. If you profit 1 tick with your trade, you receive $12.50, 4 ticks = $50.)
Let's look at a 1 tick -- Bid / Ask spread. With Market Makers, the difference between the Bid and Ask can be more than 1 penny, especially when the Market Maker is making his living on the spread.
When you are trading E-mini Futures Contracts, it means you'll only need to monitor 1 chart, the same chart, each day, day in and day out. Could you become a really consistent trader if you watched the same chart every day?
Stock traders usually have to watch several stocks at the same time. Watching multiple charts means flipping the charts back and forth for in case you miss something.
There is no need to do nightly research. You're trading all 500 stocks at the same time. You won't be researching this or that stock, worrying about whisper numbers, quarterly reporting, pre-announcements, or accounting minefields.
Traders who trade options must handle 4 conditions to be successful: underlying price, strike price, volatility, and time decay. These traders might be right but lose on their trade because they were wrong about time, the option expiring worthless before they could profit. Futures traders need only worry about 2 conditions: an advancing or a declining market. Time decay is not something Futures traders need have any concern with.
Margins are very favorable to Futures traders. You can trade 1 S&P 500 E-mini contract for as little as $400 / contract on margin. To trade stocks, at a minimum you'll need to buy a lot of 100 shares. An average stock is $25/share, or $2500 to get in the door.
Here's another major difference. The SEC defines a daytrade as a transaction that opened and closed during the same trading day. A "pattern daytrader" is one who makes 4 or more daytrades in a 5 day period. To daytrade stocks (since 9-11), you are required to have at least $25,000 in your brokerage account (or your account will be frozen for 90 days if you are caught daytrading).
Day trading Futures has no such restrictions. A brokerage account requires far less capital. Most Futures brokers allow you to open an account with just $2,500. This opens the trading Market to even small investors.
You can trade the e-mini futures long (hoping the contracts will go up) and you can trade the futures short (hoping the contracts will go down). Lately, there have been bans put on short selling financial stocks, bans on naked short selling including the 1,000 top stocks, bans on short selling stocks that are less than $5, etc.
There are no restrictions on short selling e-mini Futures Contracts because Futures are not shares of a particular company, they are contracts. For traders, it is essential to taking full advantage of the Market's volatility. So not being able to short means that half of your trading is not available to you. If you always have to trade long, that means a long wait for the Market to swing up in order to enter a trade. If the Market is down 200 or more points......that could be a long wait.
In a Bear Market, trading short is essential. There are very sharp ups and downs in the S&P, DOW, and NASDAQ. Giving traders ample opportunities throughout the day to profit is essential to success.
If you want to trade with an IRA or 401k account, once you exit a trade, you won't have to wait for the trade to settle before you can use that same money for the next trade. One second after you exit your current trade, that same money is available to you for another trade. With stock trading, once you exit a trade, you may wait as long as 3 days for your money to settle before you can use that money to trade with again.
Because we are trading Futures, rules that were originally intended for commodity trades also apply to E-mini Futures trades. There is a 60/40 split on taxes: 60% of your trade is considered long term (15% tax bracket) and 40% of your trade is considered short term (28% tax bracket). Compare this to stocks. If you hold stock less than 1 year, it is considered a short term trade. You must hold the stock for over a year in order to qualify for long term capital gains. With Futures, all your trading is broken down by the 60/40 rule, even if your average trade is 2 minutes.
At year end, you'll receive a 1099-B statement from your Futures broker, with only 1 figure, a net number of all your trading, not each individual trade. If you profited by $50,000, the 1099-b only shows $50,000. You can now claim $30,000 as long term capital gains and $20,000 as short term, the 60/40 split.
When doing your taxes at year end, it becomes a much easier task. You only need to make 1 entry on your return. If you are trading stocks, you need to itemize each and every trade you made. If you are a daytrader and trade many stocks, you'll need hours and hours to enter all your trades. With Futures trading, you are done in a minute.
Futures trade virtually 24/6. The only day you cannot trade Futures is Saturday. Many stocks do not trade off hours, and if they do, it is very light trading. The S&P 500 e-mini is traded all over the world. Depending upon the time of day, we can see heavy trading on the e-mini. For example, at 2:00am EST, the Japanese trade the e-mini. At 5:00am EST, the Europeans trade the e-mini. If you have insomnia or cats that get you up in the middle of the night to go out, e-mini trading is definitely for you.
Each Futures Contract is traded on only 1 exchange/1 book....the CME. Stocks, however, can trade across different exchanges, each exchange having different Bid/Ask prices. E-mini Futures contracts have just one price - the CME price. Large NYSE cap stocks trade on multiple exchanges, each exchange can post a different price.
Fills are guaranteed. If the E-mini price goes through your offer, you get filled...no questions asked. This can be a major problem for individual Forex traders. You could be in a trade waiting to exit with an offer to sell. The Forex contract goes right by your price but you do not get filled. Read the fine print in your Forex Brokerage contract that says they do not guarantee fills.
The CME Clearing House for trades is the guarantor to each of its clearing members and ensures trade integrity.
Futures Contracts that expire, do not expire worthless. Your money rolls to the new contract, unlike Options that expire worthless.
To wrap it up, say you are an individual investor. You have been watching the Stock Market lately and now you're bullish. You want to get into the action because you see the Market is coming back up.
Unfortunately, you only have $5,000 to invest. You've traded stocks before and know that with just $5,000, you would have to limit your investment to just one or two stocks. That means a great deal of nightly research to determine which stock to choose.
What could you do with the $5000? You could purchase a mutual fund so at least you would be part of more than one or two stock moves. But realistically, with upfront load fees, your $5000 investment doesn't go very far. Instead what if you traded S&P 500 E-mini Futures Contracts. With $5,000, you would be able to trade 5 contracts ($2,000 - Note -- never trade all the money in your account in 1 trade). If you made just 4 ticks a day, you would earn about $170-180/day after commissions, $3,500 per month, $42,000 after 12 months. Even adjusting for your losses, you would net somewhere around $30,000....on your $2,000 investment! That equates to a 1700% profit annually. Putting the $5,000 in your bank account, if you were to earn 3% (and that's a lot now), you'd profit $150/year. In one day's trading you would have profited more than the amount the bank would pay you in interest for 12 months.
And once you get into trading Futures, the S&P 500 E-mini is not the only future you can trade. The CME's trading platform is called Globex. There are dozens of Futures Contracts available on Globex today. Want to trade gold, crude oil or gasoline? You'll find an e-mini contract for each of those. There are e-mini's for the NASDAQ, the DOW, or the Midcaps. And as your abilities improve, you can trade the commodities (corn, wheat, sugar, etc.).
I know that's a lot of information crammed into this article. There is so much more to cover concerning trading E-Mini Futures Contracts, this is just the tip of the iceberg.
by: Barbara Cohen.
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