Futures Trading 
An Introduction To The World Of Future Trading
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Futures Trading  - Managing Futures Contracts

Futures trading is unlike any other market, in that you will need to monitor your positions very carefully for several different reasons as we shall see shortly. You can buy 100 stocks or shares, put the certificate in a drawer and forget about them for several years. You aren't subject to margin calls, your risk is defined as the cost of the shares, and the stock does not expire, unless the company goes bankrupt.

Futures trading is very different!

Futures Trading - Performance Bond

In stock trading or share trading, we either trade using 100% cash, or for more experienced traders, a margin account. Typically a margin account will allow you to leverage 50% of your positions so if you have $25,000 you will be able to trade in $50,000 of stock value. Now if you don't understand the risks of trading on margin I would suggest you follow the link which will explain everything you need to know ( both good and bad!).

Now futures are highly leveraged instruments, and before you can trade in them you will be required to deposit a performance bond. This is your guarantee that you will honour your commitments under the terms of the contract. The performance bond is not set as a percentage like the margin account, instead it is a level set by the exchange and based on the volatility of the contracts that you are proposing to trade. Your broker cannot go below these pre-set limits, and in many cases they will probably set higher, particularly if you are a relative novice to futures trading. On many exchanges the 'margin' is referred to as good faith and reflects the roots of futures trading, where a deposit of good faith was made by each party to guarantee they would honour the contract. 

Futures Trading - Performance Bond Call

Just like a margin call, if your positions have lost money, then you may receive a performance bond call, in order to top up your performance bond. Exchanges do not allow trade debts to build up in the futures market, and if you do not respond immediately your contracts will be closed. A performance bond call may occur at any time particularly if the markets are volatile so you will need to monitor your positions closely.

Futures Trading - Marked To The Market

All futures contracts are settled on a daily basis and marked to the market by the exchange. In effect what happens is that any loss or gain in your positions is settled in cash in your account. Money will be added to you performance bond balance if you have made a profit that day, and deducted if you have made a loss. This rebalancing occurs every day after the close of trading, and is one of the mechanisms to stop futures traders building up big losses in open contracts. If your position has lost money and the balance falls below the performance bond minimum, then you will receive a performance bond call.

Futures Trading - Leverage

Futures contracts are highly leveraged instruments as the minimums set by the exchanges are quite small, compared to the actual values of the contracts being traded. Now as we all know, leverage is a double edged sword, not only does it magnify profits, but it also magnifies losses. Let's look at a simple example. Assume that in anticipation of rising stock prices you buy one June S&P 500 stock index futures contract at a time when the June index is trading at 1000. And assume your initial margin requirement is $10,000. Since the value of the futures contract is $250 times the index, each 1 point change in the index represents a $250 gain or loss.

Thus, an increase in the index from 1000 to 1040 would double your $10,000 margin deposit, and a decrease from 1000 to 960 would wipe it out. That's a 100% gain or loss as the result of only a 4% change in the stock index!

Now over the years many of the exchanges have introduced smaller futures contracts called e-minis which require smaller levels of performance bonds and in turn smaller leverage, as these are cut down versions of their bigger brothers, and ideal for the novice futures trader.

Futures Trading - Rollover

Now, the last element of your contract that you have to manage is rollover, another peculiarity when dealing with derivative contracts such as futures. Imagine you have a quarterly contract ( the March CAD/USD contract that we looked at previously) which as we know expires on the 18th March. It is early March and we know that the expiry date is approaching, and that in order not to take physical delivery then we have to close our contract - or do we? In fact we don't, as we can make another decision and actually roll the same contract over into the next period. So instead of trading the March contract, our position would now be the June CAD/USD contract. Now we would only do this is we believe that the contract will go in our favour in the next quarter, as there is a cost involved in rolling over positions. All brokers commissions vary but I can guarantee there will be a cost!

Now there is a lot of rubbish talked about rollover periods and how they affect the markets so please don't believe most of what you read about liquidity and/or volatility increasing or decreasing. The facts of rollovers are these :

Now if you are trading daily weekly or monthly contracts you will need to check to see how rollover is applied. In the Forex spot markets rollover occurs automatically with no intervention by the trader -some new fx traders don't even realise it is happening. Your futures broker may also offer an automatic facility for rollover of any open contracts, which is certainly available with the broker I use, and contracts are rolled on the 8 day notice.

OK - we've looked at the mechanics of the futures market and exchanges, but not really at how the contracts are priced, so I want to spend the next few minutes looking at something called "price discovery" - futures trading is nothing if not a learning experience!!

 

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