Before Putting Your Money on the Line?You Should Know the Basics
If you are like most people, you work hard for your money and the last thing you want to do is see it evaporate in your trading account. Throughout my journey in the markets, I have yet to find a fool proof way to guarantee profitable trading, but what I am certain of is that you owe it to yourself to fully understand the products and markets that you intend to trade before risking a single dollar. What you will learn from this article is merely a stepping stone but without fully understanding the basics you may never lay the foundation necessary to become a successful trader.
When most people think of commodities they imagine fields of grain or bars of gold. However, a futures contract may be written on any commodity in which the underlying asset can be considered fungible. The term fungible purely means ?interchangeable?, or having the ability to ?comingle?, in trade. In other words, you wouldn?t prefer to have one bushel of corn over another. Corn is corn as long as it meets the exchanges definition of a deliverable grade. Financial products can be thought of in much of the same way. One unit of the S&P index is just as valuable (or not) as the next. Therefore, financial products can also be considered commodities and trade similarly on futures exchanges around the world.
Stock Index Futures
In the U.S. there are three primarily traded futures contracts based on domestic stock indices; the Dow, NASDAQ and the S&P. There are several other stock index futures available but as a speculator you want to be where the liquidity is and many of them simply don?t offer that. Please note that the Russell 2000 index futures contract has maintained a healthy amount of volume and open interest but will be undergoing massive changes in how it is traded and where the trades are cleared (different exchange), therefore I opted to leave it out of the discussion.
While the stock indices are all highly correlated in price, they have very distinct personalities. As a trader it is vital to be comfortable with the specifics of the contracts that you are trading and eventually the price characteristics of the underlying asset itself.
Dow Jones Industrial Average Futures
Dow futures are listed and traded on the Chicago Board of Trade (CBOT). The CBOT?s futures version of the Index closely follows the infamous Dow Jones Industrial Average comprised of 30 blue chip stocks. The exchange provides traders with the ability to speculate on the Dow in three different increments of risk and reward. The most commonly traded of the three is the mini-sized Dow. This particular contract is often referred to in the industry as the ?nickel Dow? because each point of movement in the futures market is worth $5 to a trader. The next most liquid Dow contract is the original version valued at $10 per tick. You should note that the mini-sized Dow is exactly half of the original Dow. Last but definitely not least, the CBOT has recently listed a Dow futures contract known simply as the ?Big Dow? and has a point value of $25.
Most traders have flocked to the mini-sized Dow; therefore this will be our focal point. Once you are comfortable in doing the math on the mini-sized Dow you can easily apply the same principals to the other two contracts respective to their point values. With that said, each of the CBOT listed Dow products are fungible. In other words, if you were long two mini contracts and short one regular Dow ($10) you would have the ability to call your broker and request that these positions offset each other.
As previously mentioned; each tick in the mini-sized Dow results in a profit or loss in the amount of $5. Unlike some of the true commodity futures contracts, the contract size of a stock index is not fixed. In fact, there is no contract size; instead, the contract value fluctuates with the market and is calculated by multiplying the index value by the point value. Accordingly, if the mini-sized Dow futures contract settled the trading day at 11,520 the value of the contract at that particular moment would be $57,600 ($5 x 11,520). Keep in mind that the margin for the mini-sized Dow is far less than $57,600 making it a highly leveraged trading vehicle. Margins are subject to change at any time, but the average seems to be between $2,500 and $3,000. As you can imagine, being responsible for the gains and losses of a contract valued at nearly $60,000 with as little as $2,500 could create large amounts of volatility in your trading account. However, it is this leverage that keeps traders coming back to the futures markets for more. Unfortunately, it is the same leverage that has resulted in many bitter ex-futures traders.
Calculating profit and loss in the mini-sized Dow, or any of the Dow futures contracts for that matter, is relatively easy. Unlike many other commodities or even financial futures, the Dow doesn?t trade in fractions or decimals; one tick is simply one point. Consequently, if a trader is long a mini-Dow futures contract from 11,257 and is able to liquidate the trade the next day at 11,348, the realized profit would have been 91 points or $455 (91 x $5). This is figured by subtracting the purchase price from the sale price and multiplying the point difference by $5.
11,348 ? 11,257 = 91
91 x $5 = $455 (minus commissions and fees)
Not bad for a day?s work; regrettably, it isn?t always that easy. Had the trader taken the exact opposite position by selling the contract at 11,257 and buying it back at 11,348 the loss would have been $455 plus commissions and fees.
Like the Dow, NASDAQ futures come in more than one size; the e-mini NASDAQ and the full sized version. NASDAQ futures are listed on the Chicago Mercantile Exchange (CME) and closely track the NASDAQ 100 index which is an index of the largest (in terms of market capitalization) 100 stocks listed on the NASDAQ exchange. The CME provides traders with two alternatives in speculation on the NASDAQ, a full sized contract and an e-mini version.
The original NASDAQ futures contract may be ambitious for beginning traders in that the leverage is high and so is the point value. Each index point of fluctuation in the NASDAQ 100 futures contract results in a profit or loss of $100 for any trader with an open futures position. Keep in mind that 10 to 20 point days are somewhat common and 50 to 60 aren?t necessarily rare events. Thus, there is a lot at stake for those willing to accept exposure in this market. Also take into account that in the stock indices, the contract size is the point value multiplied by the index value. With the NASDAQ trading at 1820 a trader is exposing themselves to the profit and loss potential equivalent to $182,000 of the underlying index. Unless you are very well margined and even tempered this contract should be off limits.
NASDAQ futures prices (both e-mini and original contract) trade in minimal increments of a quarter of a point depicted by a decimal, or simply .25. Therefore, each tick in the full sized contract is worth $25 (.25 x $100). If a trader is long the futures contract from 1820.25 and places a stop loss at 1802.50 she is risking 17.75 points or $1,775. For the average trader, that is too much to risk on one trade. This is especially true in a market that is capable of seeing such a price move in the blink of an eye and then taking it back in another blink. Realizing this, the CME wisely created a mini version of the NASDAQ 100 futures contract.
The e-mini NASDAQ 100 futures contract is fully electronic, making price ladders (explained in detail later on) and streaming real-time quotes an affordable possibility, and is exactly one fifth the size of the original contract. Likewise, the point value per full unit of movement is $20 (one fifth of the original $100) reducing the contract size considerably. With the futures market at 1820.00 an e-mini NASDAQ contract is equivalent to $36,400 of the underlying index. Profit, loss and risk calculations are also much ?easier on the eye? and the heart.
An e-mini NASDAQ trader long from 1805.50 and subsequently able to sell the position at 1832.75 would have been profitable by 27.25 points or $545. This is figured by subtracting the exit price by the entry price and multiplying the difference by $20.
1832.75 ? 1805.50 = 27.25
27.25 x $20 = $545 (minus commissions and fees)
S&P 500 Futures
The S&P 500 futures contract traded on the CME, AKA the ?big board?, represents the widely followed Standard and Poor?s 500. This index is seen as a benchmark of large capitalization stocks in the U.S. This, along with the e-mini version, is the most commonly traded stock index futures contract and has the trading volume and open interest to back it.
The full-sized S&P futures contract has a point value of $250 with a minimum tick of .10. Floor brokers often refer to an S&P point as a ?dollar?. For every point, or dollar, that the price moves higher or lower a trader will be making or losing $250. Thus, the contract size of the index is calculated by multiplying the index value by $250. For example, if the futures contract is currently trading at 1250.00 then one full sized S&P 500 futures contract is valued at $312,500. Similarly, a trader that goes long an S&P futures contract at 1289.40 and is forced to sell it due to margin trouble at 1253.20 he would have sustained a loss in the amount of 36.2 points or $9,050 plus the commissions paid to get into the trade. Once again, many traders aren?t willing to accept this type of volatility in their trading account and opt for the benefits of the e-mini version of the contract.
The e-mini S&P 500 is one fifth the size of its full-sized counterpart and unlike the larger version, the minimum tick is a quarter of a point or .25. With that said, the point value is $50 and the contract size is also one fifth the size of the original contract. If the e-mini S&P is trading at 1250.00 the value of the contract would be $62,500. Now that is more like it. An e-mini S&P futures trader is exposed to risk but relative to the ?Big Board? contract it is much more controllable. When it comes to leverage, less is sometimes ?more?.
A trader that goes long the e-mini S&P from 1235.00 and is able to sell the position at 1252.25 would have realized a profit of 17.25 points or $862.50. Again, this is figured by subtracting the sale price from the purchase price and multiplying the difference by $50.
1252.25 ? 1235.00 = 17.25
17.25 x $50 = $862.5
Along with the benefits of lower margins, risk and performance volatility the mini versions of the stock indices also offer increased liquidity and better trade execution. While there will always be a bid/ask spread and some slippage (variance in the fill price and what is expected on stop and market orders) in any market, orders in the mini-sized Dow, e-mini S&P and e-mini NASDAQ are electronically routed and executed making fill quality extremely favorable. The ease of entry and exit make these contracts very appealing to trade.
Additionally, the mini electronic versions of the stock indices allow trading platforms and thus traders, the ability to see real-time streaming quotes as well as what is known as a price ladder. A price ladder is simply a display of working orders surrounding the current market price. From here you will also be able to see market depth (the number of orders working) on both the bid (?Buy? column) and the ask (?Sell? column). The accompanying figure represents a sample price ladder for the e-mini S&P. Contrary to many assumptions, being able to see the market in real time and better yet seeing where others are placing orders hasn?t improved the odds for retail traders but you can how it can be useful.
The larger stock index contracts are most often traded in an open outcry environment although overnight sessions in each of the contracts mentioned in this article do offer electronic execution. There are definitely great aspects of open outcry and I believe that they provide a necessary function. However, when it comes to attaining live data for an open outcry traded contract it can become very expensive, thus the electronic versions tend to be much more transparent and convenient to trade.
Regardless of the contract or version you decide fits your needs as a trader, be sure to know exactly what you are getting into before entering a trade. After all, it is your money.
***There is substantial risk in trading options and futures. It is not suitable for everyone.