Investing In The Futures Markets

Investing in the futures markets requires different considerations than an investment in a stock or bond fund.  In particular, although you might be willing to invest all your capital in an ETF, you might only want to invest a portion of it in the futures market.  This is because you can potentially loose more money than your initial investment.

Characteristics of a Futures Contract

In a typical buy and hold type investment in a stock or ETF you buy shares of the fund at a particular price and  then sell them at a later date.  If you invest in the futures market you cannot buy shares of the underlying product.  Instead you enter into an agreement whereby the two parties in the contract agree to buy or sell an asset  at a particular price but to be delivered and paid for later.  The asset can be a set of financial instruments or physical commodities.

Futures contracts are traded on a public futures exchange and are thus standardized.  In addition the futures market is regulated by the government.  In a futures contract, the buyer of the contract is said to have a long position and the seller is said to have a short position. The long is required to buy the underlying asset as per the specified time and price and the short is required to deliver this underlying asset.  That said, a lot of futures contracts are settled in cash and there is no actual delivery and receipts of underlying assets.

The E-mini S&P 500 Futures Contract

The main characteristics of a futures contract include the contract unit, the minimum price fluctuation, the margin requirement and the expiry date.

As an example let’s have a look at the S&P 500 which right now is trading at 2,829.85.  Say an investor had $100,000 they wanted to invest in the S&P 500.  They could do so buy buying shares of the SPY ETF.  This ETF seeks to provide investment results that, before expenses, correspond generally to the price and yield performance of the S&P 500.  Thus if the price of the SPY is $282.40 the investor would buy 354 shares for a total investment of $99,969.60 before commissions.

On the other hand, the investor could buy one contract of the E-Mini S&P 500 futures March contract or ES which is currently trading at 2830.50.  The contract unit for the ES  is $50 * the S&P 500 index.  Thus one contract would give the investor a market exposure of $50 * 2830.50 = $141,525.

The margin requirement for one ES contract is $5,050.  This means that the investor needs to have this amount of money in cash in his account to keep the position open.  If not the broker will automatically liquidate or close the position.

The March contract expires on the third Friday of March.  However the investor can close the position any time before that date.  Since the ES futures contracts are the most heavily traded futures contracts, liquidity should not be a problem especially if the investor has only a contract or two to trade.

The minimum price fluctuation for the ES contract is 0.25 index points.  Since the contract unit is $50 * the S&P 500 index, this means that your investment can go up and down in increments of $12.50.

Thus, whether you buy the SPY or the ES, if the S&P 500 goes up you make money, if the S&P 500 goes down you loose money.

Leverage in Stocks and Futures

One major difference between stocks and futures is leverage. That said, leverage and margin are possible for stock investments as well. Financial regulation allows brokers to offer this in margin accounts but not in registered accounts such as retirement accounts.

Leverage allows you to purchase or sell something by using less money than the face value of the product you are buying or selling. The amount of money required to purchase or sell the product you are interested in is called the margin or the margin requirement.

The most common example of leverage that people are familiar with is a home mortgage.  Say you are looking to buy a house that costs $200,000 and you put down $10,000 to secure a loan from a financial institution that covers the remaining cost of the house.  In this case you have a leverage of 20x since the house costs $200,000 but you’ve only spent $10,000 of your own money to buy it.

In the S&P 500 example above, if the investor was buying the SPY in a margin account (as opposed to a registered account) then they could potentially buy even more shares with $100,000.  For the SPY most brokers offer a 33% margin requirement.  This means that with $100,000 in your account you could potentially buy 1062 shares of the SPY for a total market value of $299,908.80.  Thus the investor has a leverage of 3x.

In the case of the ES contract, the investor had a margin requirement of $5,050 to purchase one contract which gave them a market exposure of $141,525 for a leverage of about 28x.

Thus, although leverage and margin are possible for stock investments, the margin requirements are much higher than those for futures markets and so the leverage is smaller.  Futures markets offer much higher leverage possibilities.

Leverage and market exposure

Besides the cost of your investment, when using leverage you also need to keep in mind your market exposure.

First let’s have a look at what happens when the S&P 500 moves up by about 1%.  Assuming that both the SPY and the ES track this move fairly accurately, then this means that rounded to the smallest price fluctuation, the SPY price is now $285.22 while the ES price is now at 2858.75.  Since the investor had 354 shares, the investment is now worth $100,967.88 for a total gain of $998.28.  If we divide $998.28 by $99,969.60 we get about 1%.

On the other hand if the investor had bought one contract of the ES he would be up 2858.75 – 2830.50 = 28.25 points.  Using the unit multiplier of $50 this translates to a gain of $1,412.50.  If we divide this by the initial market exposure of $141,525 we also get about 1%.

The difference between the two investments is the amount of monies required to generate the same gains.  When investing in an ETF without margin, the investor needed almost a $100,000 investment to generate a gain of $998.28.  However, when investing in the futures market, the investor needed an investment of only $5,050 to generate a gain of $1,412.50.  This gives him a significant return on capital of 27.97% compared to the 1% return on capital generated by the stock investment.

We can also apply this math to the home buying analogy.  Say you had an opportunity to flip the house a month later for $250,000 for a profit of $50,000.  Although the house itself only went up by 25%, your return on investment is 400% as you turned your $10,000 into $50,000.

Leverage Makes Everything Bigger

The main point to remember about leverage is that it makes everything bigger.  Leverage makes your wins bigger and your losses bigger too.  Thus in the examples above, if the S&P 500 had gone down by 1% you would have lost $998.28 if you had invested in the SPY and $1,412.50 if you had bought an ES contract.

Continuing with the analogy of the home buyer, let’s have a look at the situation where after a month the housing market drops sharply and your house price falls down to $150,000.  Unfortunately you still owe what you borrowed to the financial institution.  Thus your $10,000 has turned into a $40,000 loss.

This high leverage means that small changes in the price of the purchased asset result in big changes to your capital.  It is not uncommon for the losses to be close or even bigger than your invested capital whether that be the deposit on a home or the margin requirement on a futures contract.  Thus, if you were to use all the capital in your account to buy a futures contract, the possibility is very high that you are going to get wiped out.

Loss Recovery

Implicit in a buy and hold investment in a stock ETF is the assumption that you hold the same number of shares as the market goes up and down on its roller coaster.  No matter what the value of your investment is at, you still own the same number of shares.  This fact allows you to recover your losses when the markets recover.

To avoid getting wiped out, when you invest with futures contracts you need to make sure you can hold on to the same number of contracts in your initial investment. In particular, you need to have plenty of cash available in your account so that you can keep your position open.  For you to be able to do this, the free cash in your account must always be greater than the margin requirement for the contract you want to keep open.  This way you can survive the downturn and when the market turns in your favor you can recover your losses.

One can get an estimate of the capital requirement for each strategy buy doing a careful study of the historical performance and drawdowns of said strategy.  The minimum capital requirement is the sum total of the worst historical drawdown and the margin requirement for one contract.  This will give you an estimate of what percentage of your capital you could use to invest in futures contracts and what percentage you want to keep in cash.

For example if you have $10,500 to invest in the futures markets and the margin requirement for the E-Mini S&P 500 March futures contract is $5,050, you know that you can take a loss of up to $5,450 and still keep your position open if you have only one contract.  If you have two contracts, then you can only carry a loss of $400 before you have to close a position.  And, since you have two contracts open, any loss is going to be twice as big as when you have only one contract open.

Risk Management

When computing the minimum capital requirement mentioned above it is important to keep in mind that this is only an estimate.  This is because there is no guarantee that future drawdowns are not going to be bigger than those in the past.

In fact for strategies trading the stock indices such as the S&P 500, Russell 2000 or the Nasdaq 100 with a percentage stop loss there is a high likelihood that drawdowns are in fact going to get bigger as time goes on.  This is because these markets have an upward bias and their values are generally on the rise.  For example the S&P 500 was at around 1000 in 2009 and it is around 2750 now.  Thus a loss of 1% in 2009 would have meant a loss of 10 points or $500 whereas a loss of 1% now would mean a drop of 27.5 points or $1,375.

The investor has to decide what they are comfortable with.  A more conservative investor would allocate a bigger dollar amount to one contract while a more aggressive investor would allocate a smaller dollar amount that is closer to the margin requirement for one contract.  The extra cash in the account is only needed when the strategy hits a rough spot.  When the strategy has winning trades, this extra cash sits idly in the account.  Thus the investor has to reach a compromise between having enough cash in the account to weather the rough times and putting extra cash to work to improve the returns on allocated capital.

In essence, all other things being equal, the investor is in charge of the ultimate performance of the strategy.  By allocating more capital to one contract they are reducing the average annual returns as well as the maximum drawdown.  On the other hand, by allocating less capital to the strategy they are increasing the average annual returns while opening themselves up to bigger drawdowns.  The Risk Reward ratio, which is the ratio of the average annual returns to the maximum drawdown, will not change.

The Worst Case Scenario

In our opening paragraph to this chapter we made the statement that when investing in the futures markets the investor can potentially loose more money than their initial investment.  The question that follows is : Exactly how much more can one loose?

The answer to this question is found once again by looking at the market exposure.  Say for example that the investor has bought one contract of the E-Mini S&P 500.  As mentioned before this would have a market exposure of $141,525.  Thus as per our previous mathematical computations, if the S&P 500 dropped by 1% the investor would experience approximately a $1,415 loss.  Similarly if the S&P dropped by 10% the loss would be about $14,150 and if the market dropped by 20% the loss would be $28,300 etc…  In the worst case scenario if the S&P 500 went to 0 then the investor would be out the whole $141,525.

If on the other hand the investor has sold one contract of the E-Mini S&P 500, then his liability is on the long side.  This means that he will loose money when the market goes up.  Since in theory the market could keep going up forever, his liability on this side would be infinite.

Although all these numbers are theoretically possible, in practice they are very unlikely.  As a first layer of protection, many strategies use stop losses that automatically close the position when triggered.  Also, as mentioned before, a lot of brokers will automatically liquidate and close the position when margin requirements are not met.  That said, stop losses to do not offer any protection when markets are closed.  Thus it is worth considering what would happen to an open position if an adverse event occurs when the markets are closed such as during a holiday or during the weekend.

Many unexpected and tragic events have happened in the past including 9/11 as well as the great recession and the stock market has not crashed to zero.  Conversely we have experienced great euphoria during the dot.com boom and the housing boom and the markets did not reach the sky.  In fact, as we shall see when we have a look at some of the strategies I trade as part of my portfolio, these strategies did very well during high volatility times such as the 2008 financial crisis as well as during the smooth sailing years such as the market rally of 2013 and 2017.

In addition, financial markets have become much more sophisticated over the years.  This includes new technologies such as circuit breakers that halt trading in the case of an outlier event.  Thus events such as Black Monday in 1987 and Black Thursday in 1929 where the stock markets fell very hard in a brief period of time are less likely to happen again in the same manner.  For example the CME Futures group has set price limits on the ES contract that halts after hours trading if price drops by 5%.

A Personal Choice

Risk permeates every aspect of our lives and is part of investing as well.  To the novice investor, looking at an investment in the futures markets for the first time, the thought of loosing all their capital and then some can be a scary thought.  This is a healthy fear as it prevents the investor from making foolish decisions.

Every investor should properly educate themselves before allocating their hard earned monies to an investment, whether it be in the futures markets or elsewhere.  In particular, when considering an investment in the futures market, an investor should make sure they allocate enough capital to the strategy such that they can survive the inevitable drawdowns that are to come and reap the benefits when the market turns in their favor.  Furthermore their due diligence should make sure that the strategy they choose to invest in is free from the pitfalls discussed in BUYER BEWARE and has all the characteristics described in CHOOSING A GOOD STRATEGY.

In my opinion, if one takes the measures described above, then the futures markets offer an attractive investment proposition.  The leverage that is inherent to a futures investment combined with a proven strategy with a good risk to reward ratio offers the investor a good opportunity for a better return on capital than that of other conventional investments.

Ultimately however the amount of risk tolerance is a personal choice that every investor must make for their own account.  The investor is solely responsible for their decision.

Further Reading

The CME Group has a good educational section about investing in the futures markets.

For an Introduction to Futures please click here.

For an Introduction to Equity Index products please click here.

To download a guide about Trading In Futures please click here.

To see a more detailed discussion about Circuit Breakers and price limits please click here.

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