Futures Trading: Everything You Need To Know(2/2).

Futures Trading: Everything You Need To Know(2/2).

This post is a continuation of a Futures Trading: Everything You Need To Know(1/2). I will try to make this post short and precise as much as possible. By now you have a solid knowledge of the futures market. We also touched some basics of trading futures. In this post, I will take it further, and explain how to make your first trade. This post will also help those who are gambling rather than creating value by trading futures. You will gain an in-depth knowledge of topics like, how to understand quotes, where you can trade futures apart from the top 10 exchanges, what are margins and how they work, how to calculate profit from futures trading, what is a hedge, how it is calculated, etc in this post. So, without further delay let’s jump inside the topics, know them and start trading.

Understanding Futures Contract Quotes

Futures Contract Quotes
Pic. Credit: www.investing.com

Let’s understand the quotes with reference to the picture above.

  1. The closing of the previous day, in this case, 33.71 points.
  2. Opening of current day, in this case, 33.73 points.
  3. Minimum & Maximum point oil traded in a trading day, in this case, the minimum is 32.36 and the maximum is 35.76 points.
  4. Minimum & Maximum point crude oil traded in a 52 week or 1 year time, in this case, the minimum is -40.32 and the maximum is 65.65 points.
  5. Change in points % for a year, in this case, it is decreased by 37.55% or -37.55%.
  6. The month represents the expiry month of the contract that is currently trading. The contract for next month expires in the current month, in this case, the June contract expired in May so the July 2020 contract is currently trading.
  7. Size of 1 contract i.e is 1,000 Barrels.
  8. Type of settlement, in this case, physical settlement.
  9. Settlement date for the currently expired contract i.e June Contract.
  10. Last Rollover Day is the day when the contract can be rolled over for the next settlement date, in this case, July 20 contract.
  11. Tick Size, the minimum tick movement oil can make, in this case, 0.01 point.
  12. Tick Value, the value of one tick size, in this case, $10.
  13. Base Symbol is for WTI Crude oil is CL
  14. 1 point and its value in terms of $ is point value, in this case, it is $1000.
  15. It is a representation of months when the expiry of the contract is available. The months are represented by alphabets which are given in the table below.
Month Month Code
January F
February G
March H
April J
May K
June M
July N
August Q
September U
October V
November X
December Z

Apart from these you will see ticker, which represents the contracts name, expiry month and the year. Let’s say a future contract of oil that has an expiration on July 2020, is represented by CLN20. Here, CL is the symbol, N is the Month Code, and 20 is the year.

Margin In Futures Trading

You might be familiar with the term margin, it is the amount you deposit with the broker to start trading, be it futures, stocks, forex, cryptocurrencies, commodities, etc. There are different types of margin you need to know before you start futures trading. It is one of the most primary thing, but can be complicated, and make you lose your entire money, if not understood at its essence. I will try to make it easier for you to understand the fundamentals, as the requirements are different in different exchanges for different instruments, it will be good if you know what are these, and how to read them. To understand margin, first take a look at the picture below:

Margin Requirement For Metals.

In the above table, you can see three types of margin 1. Day Trading Margin, 2. Initial Margin & 3. Maintenance Margin. The columns, which you should be concerned about depends upon the trading styles you wish to follow. Also remember apart from these margin requirements, you should keep minimum amount with the broker, as, account minimum(the minimum recommended amount you need to put with the particular broker before starting), which varies depending upon the brokers. Let’s dive deeper into margins.

Day Trading Margin

Day trading margin, also known popularly as intraday margins, are the margins that you need to keep with the broker in case you are opting for day trading. As a day trader of futures, you need to have a good time management and firm knowledge of the trading hours of futures exchanges, because if you are not aware of these, there are chances of you losing your entire account.

Let’s take an example to make this clear, CME exchange opens at 5 P.M. CT(Chicago Time) and closes on Friday 4 P.M CT, with a daily trading halt of 1 hour after 4 P.M. CT. You opened a gold futures(GC) at 6 P.M. CT on Sunday, you can hold this position till 3:59 P.M (CT) Monday, if you want to perform day trading, the day trading margin is only applicable till this time. To put it in simple numeric terms, you can hold 1 contract of GC position till 3:59 P.M(CT), if you have a margin of $1500. You might have a question now, Ok, what if I want to perform swing trade or carry this position for longer-term? It is essential to know about the initial and maintenance margin which we will discuss in the following paragraphs.

Initial Margin

This is the margin you must have before you want to hold futures contract positions for more than a day. Unlike day trading margins, initial margins are uniform across the exchanges, so this can help you feel a little relaxed, you need less research for margin requirements. These are designed to protect the account holder and the broker from possible loss due to market volatility. So, there is a higher amount that is required for the purpose of the initial margin.

Let’s make this clear with continuation to the above example, If you want to hold the position of your 1 GC position for more than a day, you need to have a balance equal to the initial margin i.e $10,065. Suppose, you deposited $53,000 with the broker, and opened 10 contracts of GC, is it possible? Well, technically it is possible, but it depends upon the time of opening position. If you opened a position during intraday hours then it is possible because it is deemed as day trading, but you cannot hold all opened positions for multiple days. You need an initial margin of $10,065/contract of gold, if you want to hold that position for multiple days. This comes out to $100,650 in your account, or you will have three option to protect yourself:

The first option, reduce your position size to 5 contracts and bring down the initial margin requirement to $50,325, which is less than your deposited amount of $53,000. The second option, close the position completely before the end of intraday trading hours. The third option, leave your position as is, and the broker will liquidate your 5 contracts before the end of intraday trading hours, for which you will also be charged some extra liquidation charges, which depends upon different brokers. For Now, assume you closed 5 contracts, and, now hold only 5 contracts.

Maintenance Margin

Now, you have a position size of 5 contracts open, your position was suffering loss of $700/contract, i.e $3500 in total. You now decide to hold this position till next week, because you have a good feeling about the market. You didn’t close your position at the end of Friday. Now, with the loss of $3500 at the end of Friday, your account balance was $49,500($53,000 – $3500).

Are you thinking how can you hold the position when your balance is lower than the initial margin requirement i.e $50,325($10,065 * 5)? Don’t be, because once you have opened position and your balance is well within your maintenance margin level you are good to hold your position.

Let’s take this further, on the next trading day, some events happened and as a result, gold prices declined more, and now you are suffering the further loss of $800 per contract i.e $4000($800 * 5). You now have an account balance of $45,500($49,500 – $4000) which is less than a maintenance margin of $45750($9150 * 5), you will get a margin call, where you need to either reduce the position, liquidate all position or add balance. If you opt for adding balance, you now have to add money which will bring your account balance to the initial margin level i.e $50,325 by further adding $4825($50,325 – $45500), and not the maintenance margin level. With this example, we can say the maintenance margin is the level you are required to maintain for holding your position comfortably, before you get a margin call.

In the above example, the valuation of your position was done on as required basis. However, in the real world, this process is performed on daily basis. Your positions are valued and settled daily as per intraday closing market value. This is done for all the positions, even if you plan to hold your position for a longer time, and, this process is called Mark To Market(MTM) process. Your positions are valued daily in terms of market price and your account is debited and credited accordingly.

Mini & Micro Contract

You might have also seen in the image above, Emini Gold and E-Micro Gold, wondering what the heck is this now? To put it in simple terms, these are the minified versions of the standard gold contract(GC), designed to increase and provide access to the futures trading for retail investors and traders. These have lower contract sizes, hence a lower margin is required in order to start trading. Micro and mini contracts are very good for retail traders and those who are starting out, because it gives you the chance to trade on the futures market with low exposure in the market. This will save you from a big loss, in case of adversity.

E-Micro contracts are 1/10th of the standard contract whereas E-mini contracts are 1/2 of the standard contract. In our above example, instead of GC contract, if you are holding MGC (E-Micro Gold) then your initial margin requirement for 5 contracts comes down to $5035. In GC contract 1 point adverse movement in GC, exposes your position to lose $100/contract, while, 1 point adverse movement in MGC, exposes your position to lose $10, and, 1 point adverse movement in QO(Emini Gold), exposes your position to lose $50. Micros are very good if you are starting futures trading.

Let’s make it even clearer with another example of our old friend Jack, let’s say that Jack has 10 contracts and he’s willing to have a 5-point loss and he’s got a $10,000 account. So looking at this from a GC trade, that would be a $10 per tick and we also know 1 point of GC is equal to the 10 ticks. Now, if Jack is ready to lose 5 points in 10 contracts he will be losing $5000, which is 50% of his portfolio gone, but what about the MGC? Well, that’s a $1 per tick so $500 loss, which means that’s just 5% of his account. So micro is a great spot to start with all this because you know the risk can spin out of control, as Warren Buffett said, never test the depth of river with both the feet, just dip your toe in the water, maybe just dip half of your foot in the water and the micro are a good way to do that.

How Futures Trading Profit/Loss Is Calculated?

Generally, these are done by your brokers automatically, but it is always good to know these things so that you can monitor your portfolio and profitability in a proper way. In order to calculate profit/loss on futures trading, you must go to the flashback of the previous post if you have forgotten about tick size and tick value. The amount you see in the quotes of a futures contract is given in terms of the point rather than in terms of $ or any other currencies. So, What is the point?

As I have already said that in the first image description the point value of crude oil is $1000. So, Point is the movement of the instrument in the left side of decimal, for example, the change of oil from 33 to 34, means movement of 1 point.

We now should know how much tick is equal to 1 point. Say in oil’s case we said, tick size of crude oil is 0.01, how much ticks will be 1 point? It comes out to 100 (1/0.01), meaning 100 tick change in crude oil is equal to the movement of 1 point.

How much is the value of 1 tick? It is $10 so what will be the value of 1 point of oil? You are correct, it comes out to $1000($10 * 100 Ticks). We can express this in the equation as

Point Value = Tick Size Required For One Point * Tick Value

This will vary depending upon trading instrument so you need to know tick size and tick value if you want to calculate point value to plan your profit and loss taking strategy. Now let’s go and dive deeper into understanding calculation of loss, our old friend Jack suffered in GC contract above.

As per example, Jack Was holding 10 contracts of Gold Futures, and he lost 5 points in his position. Let’s now calculate the point value of Gold.

Point Value = (1/0.1) * $10

Point Value of Gold Futures is $100, Jack lost 5 points i.e equal to $500/contract. He held 10 contracts so his total loss was $500 * 10 = $5000

The profit for the positions is also calculated similarly, as I always say focus on the process and concept, because it helps you understand any other things carried out from that concept easily.

How Hedge Ratio is calculated?

I hope the above calculation helped you understand how profit or loss is calculated on futures. I have said in the previous post while discussing contract value and notional value, these will be very useful in the calculation of hedge ratio, now let’s see how the futures market is used as a hedging instrument, by looking at hedge ratio calculation. Hedge is the process of safeguarding the portfolio against the negative impact on the spot market. Suppose there is a portfolio manager, whose portfolio has a $20M U.S. equity market exposure. How he/she can use the contract/notional value of E-mini S&P 500 futures to determine a hedge ratio?

Let’s first see how hedge ratio is calculated Hedge ratio = value at risk / contract value.

In our previous post, we calculated the contract value of E-mini S&P 500 to $147,772.50. So keeping the value into the above formula it becomes

Hedge Ratio = $20,000,000/$147,772.5

Therefore, Hedge Ratio = 135.34

It means the portfolio manager, to hedge against the market risk of his/her equity portfolio, he/she needs to sell 135 contracts of E-mini S&P 500 futures.

Making Your First Trade

You know all the basics, now you can easily start trading, but before you start you should choose a broker and while choosing broker there are some things that need to be considered, let’s see what are those:

Understanding Commission:

This is one of the most important things to be considered while choosing brokers, these are charged by brokers for providing the platform, which brings sellers and buyers together. This is a regular cost that you incur, while trading, so you have to understand what types of commission are charged. I am writing this because the advertisement from the brokers are sometimes misleading, and if you fall for those without due consideration, you can incur more cost, which affects your profitability. For reference, I am taking an example of a broker named Discount Trading as per their advertisement the commission is $0.49 but they have disclosed detailed commission in their commission tab, which you can access before opening account. Always choose brokers who are transparent in their commission and charges. This is made further clear with the below image.

Futures Trading Commission

In the above image, at the beginning, you can find commission based on Monthly Volume i.e if your monthly trading volume is up to $2999 you will be eligible to commission of $0.49. As you can see, the more monthly trading volume, the lower the commission rate you will be charged. You can also see there is an exchange commission, NFA (The National Futures Association) & normal commission. Here you can see a total of $1.74/per contract as commission for trading E-mini S&P 500 contract. You also need to see that $1.74 is per side i.e if you open a trade you are charged $1.74/contract, and when you close. you will again pay another $1.74/contract. So the total commission for a completed trade of E-mini S&P 500 is $3.48/contract. It is always advised to look into the commission in detail before opening an account.

Paper Trading

Paper trading offers you a chance to get accustomed to trading, and see if you’re on the right path before jumping in with both feet. Some Brokers provide the ability to perform paper trading before you start with your real money, but there are terms and conditions associated with it depending upon the brokers. Brokers like TD Ameritrade, CME Exchange, etc offer a chance of paper trading. This is essential if you want to test your strategy before you start with your real money.

Strategy Development

Fundamental Analysis of Futures
Fundamental Analysis

You first need to determine what strategy you feel most comfortable with and what to use. If you don’t have a strategy right now I would try to help you in determining what strategy you would feel most comfortable with. Because Strategy is not rocket science and these vary depending on persons’ preference and nature. It is essential before developing a strategy to ask yourself one question. And that question, you’ll need to ask yourself is, “What direction the contract value will move? “Is it going up or down or sideways?”

If you have a solid or confident answer to this question in a logical way, then you are good to go, but if you have a confusion about this then everything you learned previously, ultimately is worthless because you become a gambler. I mean, you’re literally just saying, “I don’t know, let’s just do this,” and you roll the dice. I’m assuming you are not reading this because you want to be a gambler. If you are not then you need to treat this seriously as a business.

You might be thinking, well how can I answer that question? How do I go about answering that question so it’s logical? You should have the logic behind this it doesn’t mean you should be guaranteed. I am letting you know what many traders and professionals do in order to find logical answers, these are not secrets they are widely known to everybody, the only difference is that professionals, they research it and amateurs they follow it. I wanna map out and walk you through a couple of different choices that you can explore and figure out what might be best for you, because what’s best for me may not be best for you. So, I will just give you an idea about what things can be considered to develop strategies that best suits your need as per your risk tolerance and capital at risk.

Now let’s take our trading to the next level, Along with above also consider another important question, that is “Is my potential reward worth the risk I am taking?” If you’ve ever done any research or especially if you get on social media or you know, message board forums, or really any sort of variation, I’ve seen people go back and forth yelling about this is the best strategy and this is the perfect strategy for you, I think let’s keep in mind that what is best for someone is not best for everyone, it is the process of making the product you should be focusing on rather than a readymade product. I could well tell you the strategy I follow and even right an Ebook and sell it to you, but it might help you in the short term. You will become dependent on that strategy & blinded, and when the environment around the investment changes you will be alone and try many other strategies before getting success because they might not be suitable to you. So just realize that there’s no right or wrong strategy, it’s all about you needing to find a strategy that allows you peace of mind.

So the analysis strategies that can help us tackle these questions are firstly, fundamental analysis. If you love digging through mounds and mounds of paperwork and doing your research, fundamental analysis may be something that you want to consider. The way this strategy works is by knowing things like,

What determines the contract value?

How supply versus demand work on price movement?

What is influencing the supply and demand?

How all this works together? etc,etc.

If you follow fundamental analysis it is always good to remember, that times change and you have to adapt, because economies & all its variations are always changing.

Technical Analysis

Secondly, there is technical analysis. So if you are someone that believes a picture is worth a thousand words. If your style says just visual, maybe you like psychology (Doesnot mean you have a psychology major). Unlike fundamental analysis, there’s much less paperwork because there’s just less things going on. In fundamental analysis, you have all sorts of science, politics, you also got economics, accounting, but in technical analysis, the pile of paperwork is much less because that pile of paperwork is just emotion patterns. It’s just understanding, visualizing, and seeing how people’s emotions are in the market. Not only is that paperwork smaller, but the nice thing is that people don’t change. Humans are emotional creatures. Fear, greed, excitement, etc are all those things that have been around forever. So once you learn the emotional patterns which are a certain amount of them, they don’t change because humans are humans, emotions are emotions and that’s what they’re based on.

Well, by looking at past history. And history in the world of technical analysis is all about price, value, and volume. So price and value, depending on what you’re trading and volume. But that’s the other great thing about technical analysis is once you learn it, you can go from trading stocks to futures to options to Forex to cryptocurrency to whatever you want because all those quote-unquote things, all those assets have a price and value, and then there’s volume attached with that. But this is what it’s all about for technical analysis, trying to gauge people’s emotions, trying to figure out how to best capitalize on how people’s emotions have influenced supply and demand looking back at the past. past can be a great indicator of the future. Now I didn’t say a guarantee of the future, but if you take and look at how people have acted in the past under certain circumstances, you know that can provide value going into the future.

Are you stuck with the thought in your mind about which to use? Well, my philosophy is you use both. And this is the choice, it’ll be up to you that it’s all personal, you know, your risk tolerance and your comfort levels. So you’re going to have a main actor, and that’s gonna be your main strategy. And then you’re going to have the side actor, and that’s just going to be an assisting strategy. Now, this is how it could work and this is how I would definitely use it in this way. But I’m not saying this is the only way. So this is just one way that it could work where you have the main hero and side hero working together. You can always find the best combination for both of them in terms of ratio, which best fits you.

Opening An Account With Brokers For Trading Futures

Now You are equipped with all the things you need to start and become profitable in trading futures. You need to open an account with the broker. This process is pretty simple and there are many brokers out there I have made a video to make this process easier. You can open an account from any part of the world with this broker.

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Brokers That You can Open Futures Trading Account From

Discount Trading
Ninja Trader
Interactive Brokers
E*Trade
Lightspeed
Generic Trade

As always if this article helped you gain knowledge, and better understand the futures market, please like this post and you can also share this post on your social media. You can like & follow Facebook Page, where you will get the notification, once I publish further posts. If you want me to cover anything more in my further posts, let me know in the comment below or on Facebook. Thank You for reading, happy learning and trading.