Investing In The Futures Markets

Investing in the futures markets requires different considerations than an investment in a stock or bond fund.  In a typical buy and hold type investment in a stock or bond fund you buy shares of the fund at a particular price and  then sell them at a later date.  If the price has gone up since you made your purchase then you make money, if the price goes down then you loose money.  You also have the possibility of making some additional income if the fund you invest in pays a dividend.

If you invest in the futures market you cannot buy shares of the underlying product.  Instead you enter into a contract whereby the two parties in the contract agree to transact a set of financial instruments or physical commodities for future delivery at a particular price.  For example, you can buy one contract of the E-Mini Gold August 2017 Futures which right now is trading at $1,279.00.  Similar to a stock investment, if the price goes up you make money and if the price goes down, you loose money.

Leverage in Stocks and Futures

One major difference between stocks and futures is leverage.  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.

For example, if you are looking at purchasing 100 shares of the SPY ETF, which right now is trading at $244.03, a margin requirement of 30% would require you to have $7,320.90 in your account.  This is because the face value of your investment is 100 shares @ $244.03 = $24,403.  30% of $24,403 is $7,320.90.  This is equivalent to saying you have a leverage of 3.3.  Similarly, if you wanted to purchase one contract of the E-Mini S&P 500 June futures which is currently trading at $2,435.25 you would need $4,400 in your account.  Although the contract is only trading for $2,435.25 this gives you an exposure of $121,762.50 (since the multiplier for this contract is 50) which implies that you have a leverage of around 27.7.

As illustrated in the example above,  leverage and margin are possible for stock investments.  Financial regulation allows brokers to offer this in margin accounts but not in registered accounts such as retirement accounts.  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 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.  When using leverage you need to keep in mind your market exposure.

For example, say you are required to invest $10,000 in order to purchase an investment with a face value or a market exposure of $100,000.  If the price of your investment goes up by 15% then you make $15,000.  One the other hand, if the price goes down by 15%, then you loose $15,000.  This means that because of leverage, you can actually loose more money than you have invested.  Because of leverage, when the market went up by 15%, your investment went up by 150%.  When the market went down by 15%, your investment went down by 150%.

The Power of Compounding

One characteristic of a buy and hold investment in a stock fund is the power of compounding.  If you buy shares in a fund and hold on to them for a period of time, you are automatically compounding your daily returns.

For example, if you buy 10 shares at $100 each, and over the next three days the market goes up by 5%, down by 1% and then up by 10% you end up with $1,143.45 which is a return of 14.35% on your original investment of $1000.  This is slightly higher than the 14% return you would have generated if you invested $1000 each day.  This small difference becomes much larger and more significant as time goes buy.

It is almost never talked about but compounding also works the other way.  In particular, through compounding, the buy and hold approach can protect you when the market crashes.  Say for example that the market goes down 50% two days in a row.  On the first day your $1,000 investment is worth $500.  On the second day your investment falls another 50% down to $250.  So although the market has fallen a total of 100%, your investment has only incurred a 75% loss.

Loss Recovery

In our discussion of the power of compounding in the above paragraph, we considered an example when the market fell badly.  Although the market had two consecutive days with a 50% loss, your investment was down only 75%.  Implicit in this example is the assumption that you are still holding the same number of shares.  The price of each share has fallen badly, but you still have 10 shares.  So if the market was to rally back, then, as long as you hold on to your 10 shares,  you are well positioned to recover your losses.

Another consideration that must be taken in account when investing in futures markets is loss recovery.  What happens when the markets move against you and you incur a loss?  How are you going to position yourself to take advantage of the market when it turns in your favor?

As discussed above, when entering futures contracts, your losses can be greater than your margin requirements.  This means that you need to have plenty of cash available on the side 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, if the market turns in your favor you can recover your losses.

Investing with Futures Contracts

Each futures contract comes with a multiplier that determines your market exposure for that contract as well as the leverage you carry for your investment.  Because of the high leverage that comes with futures contracts, you cannot invest the same way as you do with stocks.

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

To avoid this scenario, when you invest with futures contracts you need to keep in mind your market exposure.  This, together with a careful study of the historical performance and drawdowns of your investment strategy, can 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 $10,000 to invest in the futures markets and the margin requirement for the E-Mini S&P 500 June futures contract is $4,400, you know that you can take a loss of up to $5,600 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 $1,200 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.

Compounding with Futures Contracts

Compounding with futures contracts is possible provided one follows the guidelines described above.  Unlike a buy and hold investment in a stock fund, compounding is not done with every trade.  One must wait until the capital in the account is sufficient to cover the margin requirement for additional contracts as well as the bigger drawdowns that could be experienced with more contracts.

For example, if a strategy requires $10,000 in capital to cover margin requirements and potential losses for one contract, one can consider investing in two contracts when the capital is at least $20,000.

Further Reading

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

For an Introduction to Futures click here.

For an Introduction to Equity Index products click here.

To download a guide about trading in Futures click here.

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