Questions anyone?

You have questions, there are answers. Futures recently asked a number of brokers for a list of the most common questions they get from new traders, and then we got the answers, insights and commentary from those same industry pros.

How are futures different from stocks? Besides trading on designated exchanges, futures and stocks have little else in common. Futures are legally binding contracts to either take, or make, delivery of a prespecified amount and quality of an item, known as “the underlying,” by a predetermined date, and those contracts are created by a futures exchange.

Stocks on the other hand are ownership shares issued directly by publicly held and traded companies. Investors are required to put up 50% of the value of a stock purchased whereas futures contracts can have margin requirements from 1% to 15%. While stocks are often more volatile than futures, the leverage afforded futures trading allow for more concentrated positions and traders can take on more risk through that leverage.

Can I sell short futures? Yes. While short selling stock is mostly restricted from retail traders, with futures getting short is as easy as getting long. There is no up tick rule and a trader does not have to borrow to short a future. “This can be a real advantage,” says John W. Rogers, general manager of Xpresstrade LLC.

What markets should I trade? The first consideration is to trade what you can afford. Cocoa, sugar and the grains tend to be relatively affordable, for example, while energies and stock indexes are more expensive.

“Generally, two factors make a market expensive to trade: the value of the contract and the volatility of the contract,” says Rick Thachuk, president of World Link Futures Inc. For instance, a full-sized crude oil futures contract consists of 1,000 barrels of oil, valued at about $69,000 at current prices. Margin is based on volatility and can change routinely.

Instruments with higher volatility, meaning subject to a wider range of price fluctuation, are more expensive to trade because they require higher margins and option premiums. Thachuk suggests that once you identify markets that you can afford to trade, you should test your trading program in a simulated trading account.

How does margin work? Margin demonstrates a trader’s financial ability to handle the economic risk of a trade and can be considered a good-faith deposit; and is required of both buyer and seller of a futures or forex contract, Thachuk explains. Margin is not a cost because you can get the money back once the position is closed. “Think of it as funds held on deposit for as long as the position is open,” he says.

Futures contracts have two types of margin: an initial margin and a maintenance margin. The initial margin is the minimum amount of cash that must be in the customer’s account the day the position is initiated. On the second day, and every day thereafter so long as the position remains open, only an amount of cash equal to the maintenance margin needs to be in the account (see “Door charge”) A margin call is issued whenever cash in the account drops below the maintenance margin, and the margin call is for an amount of cash necessary to bring equity back up to the initial margin level.

Suppose a trader who has $2,000 cash in their account sells one December Canadian dollar futures contract at $0.8924. If the initial margin of the Canadian dollar is $1,080 per contract, then the trader has enough cash in the account to place the trade. Let’s say the next day, the Canadian dollar rallies to $0.8957. Assuming the maintenance margin is $800 per contract, then the equity in the account is as follows (excluding transaction fees):

Starting equity$2,000

Profit/loss on trade

$0.8924-$0.8957x100,000 =-$ 330

Ending equity$1,670

Maintenance margin:$800

Excess equity:$870

The trader still has sufficient cash to meet the maintenance margin, so no margin call is issued. Now assume the next day the Canadian dollar rallies to $0.9048. The customer’s equity report is as follows:

Starting equity:$2,000

Profit/loss on trade

$0.8924 - $0.9048 x 100,000 = -$1,240

Ending equity:$760

Maintenance margin: $800

Excess equity:($40)

Cash in the account has dropped to $760, which is $40 below the required maintenance margin. The customer is issued a margin call for $320, the amount necessary to bring $760 back up to the initial margin of $1,080. The customer can either wire this money the next business day, or close the futures position.

“There is no reason for anxiety surrounding margin or the margin call,” Thachuk says. “Every trader should be able to calculate the point at which a futures must move to result in a margin call; and then plan to close the position well before this point is reached,” he says, adding that you can trade for years and without a margin call. “It’s just a matter of knowing how margin works and then being prepared.”

Can I lose more than I started with? Yes. While the high degree of leverage is an enticing aspect of futures trading, it cuts both ways. You could potentially lose all of the money in your account and still be required to deposit more to maintain your position. If your account is undermargined, your broker generally will reserve the right to cancel any outstanding orders and offset any or all open positions, making you liable for any deficiency or debit balance that results.

“Pay close attention to your account and watch your risk and position,” Rogers says. He recommends using stops to limit your losses to a certain amount. “If you are afraid of that aspect of the market, you should consider options. You can’t lose more than you initially invest when you buy options.”

Selling a call, buying a put: same thing, right? No. “When trading options it is important to understand when you have rights and when you incur obligations,” says Dan Passarelli, an instructor at the Options Institute at the Chicago Board Options Exchange. “Buying a put gives the holder the right to sell the stock at the strike price. The maximum risk is the premium paid. Profit potential is unlimited. Selling a call incurs the seller the obligation to sell the stock at the strike price if assigned. The maximum gain is the premium received. Maximum loss is potentially unlimited.”

What are the differences of pit vs. electronic trading? While trading is essentially the same in both arenas, there are a few key differences between the processes. Customer bids and offers are matched between brokers standing in the pit. “In open outcry, a human is executing each trade and there can be a delay in getting fills and fill reports,” Rogers says.

In electronic or screen-based trading, customers send buy or sell orders directly from their computers to an electronic marketplace; executable trades are automatically matched. The electronic market participants replace the brokers standing in the pit.

One advantage of electronic trading is a higher degree of price transparency, as the top five current bids and offers are posted on most electronic trading screens. In addition, electronic trading tends to be faster and more accurate. “There are almost no outtrades in electronic trading and rarely is there a time when a trade is busted,” Rogers says.

How do futures trades offset? Futures position offsets are based on trade date and trade price criteria, and follow three central rules:

Trades bought and sold during the same trading session always are offset first, by matching the lowest-price buy with the lowest-price sale, the next-lowest-price buy with the next-lowest-price sale, and so on.

If an account has a net long or short position at the end of the day, the unpaired trades are matched against open positions bearing the oldest trade date.

Open positions from the prior day are offset by taking the lowest price first.

Which is better, options or futures? “Buying options has the low-risk advantage; the absolute most that a trader can lose is the premium paid for the option plus transaction fees,” Thachuk says. With futures and naked option writing (selling) you have unlimited risk.

A trader who buys an option must correctly call the direction of the market, buying calls to profit from a price rally or buying puts to profit from a price decline, and also has to get the timing right. Out-of-the-money options are cheaper but will not necessarily move with the underlying. Many neophyte option traders exclaim, “the market moved the way I expected but my option did not appreciate.” An option buyer also faces time risk. Options continually lose value as expiration approaches.

“Having to do both of these things correctly makes options a difficult investment, albeit still a low-risk one,” Thachuk says.

The futures trader, on the other hand, is not as constrained by time. The trader can hold a futures position during sideways price movements without incurring a significant loss, waiting for the anticipated price move.

Why is my option price not moving with the futures? Options typically move by less than the corresponding futures. In general, at-the-money options will move in price by approximately half of the amount of the underlying futures. Options that are further out-of-the-money will move less, and options that are further in-the-money will move more. In the extreme, an option, which is deep out-of-the-money, will hardly move at all when the underlying futures moves, while an deep in-the-money option will move closely with the underlying futures. This is reflected in an options delta.

Options can be purchased to protect an existing position or to initiate a position. What you are trying to accomplish with the position will in large part determine your strike selection.

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