Tactics: Making the Leap to Futures

SPECIAL SECTION

luckbox is devoting this month’s tactics section to a special three-part series on futures, courtesy of Small Exchange tactics; essential trading strategies

BASIC

Making the Leap to Futures

By Mike Hart

Even investors with plenty of experience trading equities and exchange-traded funds (ETFs) may find the leap to futures a bit daunting. Futures can be big, and they move fast enough to steamroll the unprepared. But once an investor becomes familiar with the difference between stocks and futures—as well as some of the latter’s major advantages— futures can become manageable and fit into just about any portfolio.

The mechanics of trading equities options also apply to futures options. Futures can have liquid and active option markets that provide choices for anyone looking for high-probability trading strategies. But first, the basics. Implied volatility is a key to any trading strategy, and the relationship between a futures contract’s implied vol and that of an ETF that is closely tied to that future can be instructive.

Examples of ETFs that are closely related to futures include the S&P 500 (SPY), oil (USO) and gold (GLD). One interesting difference regarding futures volatility is that volatility can expand if price is moving higher or price is moving lower. This can be compared to equity options where volatility typically expands only on down moves. Worried about getting 300 tons of corn dumped in the driveway because of trading some futures options? Worry not.

Options on futures expire into one long/short future, whereas options on equities expire into 100 shares of long/short shares. To avoid assignment, traders typically close out futures options before expiration. When closing out, aim for a specific profit target or when the option no longer trades as the front month contract. The front-month contract refers to the expiration month that has the highest number of contracts traded, as well as generally the most liquid markets. Sometimes the futures close to expiration are no longer the front-month contract.

A futures contract, like options, has an expiration date. That’s one primary difference from equities. Because of that, it’s important to stay vigilant in active management of positions when trading futures. Rarely are futures contracts held to expiration. Instead, we look to roll futures to the next cycle to add duration to the trade.

Futures require significantly less buying power than equities to obtain static deltas. That’s often viewed as a dangerous disadvantage because it’s easy for them to become too large. Still, knowing the deltas of a portfolio (beta-weighted delta) sometimes requires adjustments, and futures are a great choice for that because of the low buying power.

Futures can become scalping vehicles as well. Investors can scalp by trading outright contracts, looking for short-term profits. It’s also possible to trade multi-product spreads using another futures contract (pairs trade) or combining with options (covered trades). An often overlooked advantage of futures is the favorable tax rate.

Trades are markedto-market and taxed at a rate of 40% for short term, which is ordinary income. Compare that with equities taxed at 100% at the short-term capital gains rate. F utures offer the often-overlooked advantage of a favorable tax rate.

No pattern day trading rule is associated with futures contracts. That means multi ple round-turn trades are possible in futures even if an account has less than $25,000. In equities, multiple daily scalp with less than a $25,000 balance will result in locking of the account.

Understanding the differences and similarities between futures and equities dispels the mystery and ameliorates fear. Remember the nervousness of trading that first stock option? Learning to view futures and futures options as just another product contributes to becoming a fully developed trader with a bigger toolkit. It’s part of making speculative trades or hedging a portfolio. Used correctly, futures can add a new dynamic to any trade strategy.

A look at the numbers: Investors can determine implied volatility by looking at the corresponding volatility product to each future or by using the ETF that most closely follows the future. Futures contract and its equivalent ETF number of shares: /ES, SPY = 500; /RTY, IWM = 500; /CL, USO = 1,000; /GC GLD = 1,000.

Mike Hart, a former floor trader at the Chicago Stock Exchange and proprietary futures trader, specializes in energy markets and interest rates. He’s a contributing member of the tastytrade research team.

INTERMEDIATE

Sizing Up Futures Contracts

Most traders find old school futures contracts too big for their accounts

By Michael Rechenthin

To trade futures, begin by understanding the sizes of the products, the expected moves and whether the futures product is appropriate for the size of the account. Good thing you got a guy to help determine all that—me!

Take the S&P 500 as an example—two products are available: the /ES and /MES. The /ES is worth approximately $144,000 and the /MES is one-tenth the value at $14,400. The smallest account to consider trading /ES is $21,000—which is approximately 20 times the approximate average one-day move of the product.

Investors who trade with too small an account can risk forcing the closing of a position that otherwise could be profitable.

Michael Rechenthin, Ph.D., (aka “Dr. Data”) is head of research and data science at tastytrade.

Follow the table Understand the size of futures products and their expected moves. Then determine whether a futures product is appropriate for the size of the account. The /M prefix on the symbols below refers to smaller (micro) contracts.

(See the original article online for the full table: https://issuu.com/luckbox/docs/1911-luckbox-issuu/65.)

Michael Rechenthin, Ph.D., aka "Dr. Data,” heads research and data science at tastytrade.

ADVANCED

Taking Futures to a New Level

Advanced uses of futures include scalping, pairs trading and delta hedging

By Anton Kulikov

Futures contracts offer retail traders some strategic advantages that aren’t available with stocks and exchange-traded funds (ETFs), including scalping, pairs trading and portfolio hedging.

Scalping may seem obvious, but futures scalping offers two advantages over scalping stocks or exchange-traded funds: tax efficiency and freedom from pattern day trading restric tions. Unlike stocks or ETFs, futures gains or losses are taxed at a generous 60/40 long-term/ short-term tax system.

That means that no matter how long an investor holds the trade, the feds tax 40% of the profit/loss (P/L) for futures contracts at the standard income tax rate, but 60% of the P/L will be taxed at the much lower capital gains tax rate.

For example, if investors make $10,000 in profits from scalping an ETF, versus $10,000 in prof its scalping /ES (futures contract), they pay less taxes on the /ES profits. Investors should consult a tax advisor about this saving because individual tax rates vary.

There’s also no pattern day trading restriction on futures or their options. That means if an account value is below $25,000, an investor can still trade futures and futures options as many times as they like throughout the day without worrying about getting locked out of the account.

The second futures strategy is called pairs trading, which enables traders to spread risk by buying one contract and selling another. That creates a trade that differs from just going long or short a single contract because the trader is involved in two different markets that are correlated but not identical in movement.

Why do that? Usually, traders enter into pairs trades if they think one asset is overbought relative to another positively correlated asset. That way, they reduce overall positional risk but express directional bias in two assets as opposed to just one.

Remember, the assets have to be correlated—but not perfectly. A correlation of 0.6 or higher would suffice. If the correlation is too weak, there’s no reason to believe the asset is overbought or oversold relative to the other because they have no statistical relationship.

A recent example of a profitable pairs trade was selling gold and buying silver. The two assets have a correlation of around 0.75, and in the past few years gold has been rising significantly more than silver on a percentage basis. That led to an opportunity to sell gold and buy silver, thus expressing the bias that the ratio of gold price to silver price would go down.

Remember, in pairs trading, investors look at the assets’ net changes relative to each other. It doesn’t matter if gold goes up or silver goes down. Traders care if the percentage change in silver outpaces the percentage change in gold or vice versa. (See “Gold versus silver,” below).

Gold versus silver: In pairs trading, investors look at the assets’ net changes relative to each other. It doesn’t matter if gold goes up or silver goes down.

The third strategy is delta hedging, or portfolio hedging. That’s a great use of futures because it enables investors to rebalance a portfolio’s directional exposure to the market without using a significant amount of capital.

Say an investor has a large portfolio with a beta-weighted delta to the Standard & Poor’s 500 Index (SPX) of +250. All that means is that on average, when the SPX moves up one point, the portfolio gains $250 in value, and when the SPX goes down one point, it loses $250 in value.

But what if that type of volatility seems unsuitable? Or what if an investor wants greater volatility in a portfolio and feels +250 is too low? Or what if an investor doesn’t want to be net long the market and thinks the market is going down in the short term?

Well, with futures contracts, investors can efficiently and cheaply change the market exposure of the portfolio, while keeping everything else in the portfolio the same. For example, say an investor wants less volatility than the +250 exposure.

They can achieve that by going short a futures contract that has the S&P 500 as its underlying. The P/L of the futures position will offset the P/L from the portfolio’s market exposure.

With futures contracts, investors can efficiently and cheaply change the market exposure of the portfolio, while keeping everything else in the portfolio the same.

The best part is that investors can track how much the futures contract reduces exposure. If one S&P 500 futures contract has a point multiplier of 50, that means each short contract reduces exposure by 50 deltas—it will go from +250 deltas to +200 deltas. If an investor has two contracts short, then it will go to +150, and so forth. To increase exposure to +300, the investor would go long one contract that would take it from +250 to +300.

A basic rule is that to reduce market exposure is to take the opposite position in the futures contract of the portfolio’s market exposure. To increase market exposure, take the same directional position in the futures contract as the portfolio’s exposure. Anton Kulikov is a trader, data scientist and research analyst at tastytrade.

Anton Kulikov is a trader, data scientist and research analyst at tastytrade.

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