Many investors are beginning to look to futures to diversify their stock-heavy portfolios. There are fundamental differences, though, between stocks and futures that investors need to understand before making that first trade.
The most important difference is that futures are a contract with definitive specifications for every product offered. While stock trading is relatively straightforward — common stock is common stock and the price is the price — different futures contracts have unique price metrics based on the contract specifications for those particular futures (see "Comparing apples to apples").
As such, it is vital to understand what a futures contract says, the important metrics to pay attention to and how this all can affect a trade’s outcome.
According to Brian Wagner, senior broker at Efutures.com, "[When you are trading a futures contract], you are trading a piece of paper that gives you the obligation to buy or sell that commodity," he says.
This is one of the key differences from stocks. Whereas equity trades are trading the actual piece of company stock, a futures trade deals only with the contract that gives the buyer and seller certain obligations at some point in the future. While the specifics of each product are different, most futures contracts designate issues such as delivery, contract size, tick value and daily price limits.
As a general rule, most traders would exit a position, either by closing it out or rolling to the next delivery month, well before expiration when the contract may be significantly less liquid. In addition, position limits narrow in many contracts as they approach their last trading day.
Still, understanding the delivery details of the product to be traded is essential.Delivery can take two forms – physical delivery or cash settlement. A physically delivered contract, such as corn, is just that; at expiration the buyer is notified and given a receipt for the delivery of that specific commodity. A cash settlement contract, such as the E-mini S&P 500, is settled in cash at the end of the last trading day for the contract.
All futures have a contract month. Depending on the contract, the product may have contracts available on a monthly basis (such as crude oil), bi-monthly (such as live cattle) or in five months of the year (such as corn).
While financial contracts, whether cash settled or physically delivered, trade on a quarterly cycle and the specific months have no significance other than time to expiration and the resultant interest rate calculations, for agricultural and energy contracts the specific contract months are more important to follow. Market fundamentals will affect grains in storage and crops in the ground differently. For instance, in the growing season the front-month soybean contracts will be May and July, but both represent the previous year’s crop or grains in storage. The November bean contract represents that year’s crop. It is important to understand the interplay of fundamentals on new and old crop.
Perhaps more dramatic is the difference in energy contracts, that trade monthly in heating and cooling months.
Not understanding delivery form and delivery dates can lead to some very difficult situations. "[Some new futures traders] don’t realize that when they buy March corn, that that is a deliverable product," says Kurt Kinker, chief market analyst at Mirus Futures. "A lot of new customers just think, ‘I’m buying corn,’ and expect that position to last forever like a stock. They end up in situations where suddenly they are being notified of delivery."
Additionally, first notice days need to be considered. First notice day is the first day a seller can notify the buyer of intent to deliver the commodity in fulfillment of the contract. Again, this varies based on contract, but for corn it is the last business day preceding the contract month.
A very small percentage of futures are held to delivery and only by those on the commercial side. Again, retail speculators should exit or roll all positions well before expiration — ideally before rollover when the next delivery month trades as the front month — as the contract becomes less liquid when it moves from the front month to spot.
In addition to different delivery possibilities, futures contracts can vary widely on pricing structure.
"Traders need to know what the tick value is, how much it moves and the daily limit. It tells you how much can go against you in a day," Wagner says. "If you are short in a contract that is moving limit up, it is important to know how much that is going to cost you."
Unlike in equities where a $1 move in a stock equals $100 based on the minimum 100-share trade, tick sizes in futures are influenced by contract size, contract pricing and minimum tick size. Because futures are offered on such a variety of products, there is no standard contract size. Corn, wheat and soybeans trade in 5,000 bushel contracts whereas crude oil trades in 1,000 barrel contracts and gold, 100 ounces. Exchanges offer various mini-contracts as well. Contract size is important because it factors into how the minimum tick size affects price. Also, for certain contracts, limits change following a large move; the daily price limit does not represent your total risk as markets can lock limit up or down for several days in a row.
Depending on the contract, minimum tick size can make a big difference in a trader’s account. While some contracts, such as live cattle, have a minimum tick size that equals a $10 profit/loss per tick, others, such as corn, have a tick size that equals a $12.50 profit/loss per tick. This is calculated by multiplying the minimum tick size by the contract size. For instance, corn is a 5,000-bushel contract with a minimum tick size of 0.0025 per bushel.
Agricultural futures contract specs include a U.S. Department of Agriculture grade. A damaged crop because of weather or blight could not only produce less yield, but also less of the minimum grade quality. Contract specs also include delivery points. In recent years, the Chicago wheat contract had not been converging properly with its cash equivalent. While many analysts blamed long-only commodity indexes, many insiders blamed it on too few and hard-to-access delivery points. As a result, CME Group altered the contract specs to allow for more delivery points and convergence improved.
To be successful, futures exchanges also need to pay constant attention to contract specifications. If a contract has low liquidity or other such problems, exchanges need to revisit that contract and optimize it for the marketplace. Sometimes it only takes a tweak to the specifications; other times new contracts are needed.
According to Robin Ross, managing director of interest rate products and services at CME Group, this is what happened when CME Group launched its Ultra 30-year T-bond contract in January 2010. Because of a changing interest rate environment, customers were asking for a longer-term contract.
"The idea for the Ultra came purely from customer demand," Ross says. "From an asset manager stand point, the [current] 30-year futures contract was really like using a 15-year bond. It wasn’t giving them the duration they were looking for."
The old 30-year contract specifications required bonds with at least 15 years to expiry. A majority of those bonds were at that lower end because of the Treasury Department’s decision to stop issuing new 30-year debt in 2001. As a result, when the Treasury Department again began issuing 30-year T-bonds, CME Group was able to create the physically deliverable Ultra bond as a supply of bonds with at least 25 years to maturity became available.
Look before you leap
Across the board, experts stress that understanding the contract specs on a product before trading it is part of your process in preparing to trade.
Kinker offered new traders this advice. "You need to know the product. Go to the exchange website and read all the contract specs. Not anything in particular or things one through five, but read all of it," he says. "Take your time, learn the product and learn the contract specs."