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THE FUTURE OF FUTURES
Check out this special section for new ways to embrace futures trading. Easier access and new products are shaking up an old industry.
Bringing Futures Forward
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As futures trading evolves, contracts are shrinking; now, a new exchange promises to get even smaller
By Tom Preston
Becoming a modern investor requires buying shares of stock as the first, fundamental step. That could mean buying 100 shares of Apple (AAPL) or investing $1,000 in a mutual fund. But that simplicity belies the enor- mous legal and regulatory apparatus behind those shares of stock or that mutual fund. Without the right infra- structure, stock trading—and espe- cially mutual funds—wouldn’t exist. Futures, by comparison, are rela- tively straightforward. Sure, regu- lations govern futures trading, but an agreement or contract about the price of the future delivery of a product is simpler than ownership in a public company.
That’s why trading futures should become one of the first steps an investor takes, particularly in light of recent innovation in futures products—it’s innovation made possible by the centuries-old rela- tive simplicity of futures.
Stock trading likely began in 1602 when the Dutch East India Company sold shares of ownership to the public. It wasn’t a huge enterprise by modern standards because the company could keep track of only so many transactions with quill pens. Buying stock requires properly transferring ownership, making sure the number of shares isn’t greater than authorized, adhering to accepted accounting practices, paying divi dends to the right owners and looking after a lot of other details.
That’s why stock trading came centuries after the Babylonians— and later the Greeks and Romans— traded what would now be called futures on agricultural products. In a largely agricultural economy, the value of buying and selling tons of grain was readily apparent even before it was loaded onto ships or into ox carts.
The Code of Hammurabi included rules about buying and selling goods at a certain price on a future date. Agreeing to pay a certain number of shekels for a big pile of wheat after the next harvest made sense to both the miller and the farmer, and it required not much more than a handshake. Those handshakes occurred for centuries, smoothing trade and helping producers and users get a firmer grasp of their financial future. In the late 17th and early 18th centuries, Japan’s Dojima Rice Exchange began to trade futures more formally, and then in the 19th century both the Chicago Board of Trade and the London Metal Exchange were established to do the same thing in the West. Even though what would become the New York Stock Exchange was established in the late 18th century, stock ownership wasn’t widespread—it was futures prices that influenced economies.
Grain and copper were key commodities, and traders exchanged contracts for huge amounts of those products. That trading provides clues to a certain stage of futures development. A corn future, for example, delivers 5,000 bushels. That’s a lot of corn, and with each bushel weighing about 56 pounds, a corn future wasn’t designed to meet the needs of someone looking to make a batch of succotash. It’s clear that 250,000 pounds is industrial corn.
The same is true for gold (100 ounces), crude oil (1,000 barrels) and bonds ($100,000). Each innovation in futures has carried its industrial past. So, while futures products have exploded to cover just about everything investors want to speculate on or hedge—like equity index futures, currencies, precious and base metals, gasoline, natural gas, interest rates, bitcoin, volatility, and more—they have been “big,” with contracts sized to meet the needs of corporate or industrial users.
Stocks, on the other hand, have always been keyed to the individ ual investor. It’s always been possible to buy one share of stock instead of the round lot of 100. The arrival of mutual funds in the 20th century enabled investors to buy custom dollar amounts. But innovation in the equity markets has been slow compared to futures, with exchange-traded funds (ETFs) the next big development in the 1990s. And funds and ETFs are just ways to repackage stocks. Anyone who’s ever bothered to read the charter for a fund or ETF got a sense of the underlying complexity, which allows adding fees half-hidden from view. With equity products consumer-sized and their complexity disguised in legalese that’s largely ignored, Wall Street aggressively marketed stocks, not futures. But that’s starting to change. In the last 20 years, investors have become more sophisticated, and demand for consumer-friendly futures products has grown.
Getting small Futures are attractive because they enable individuals to speculate directly on specific commodities like corn or crude oil without having to trade an indirect product like stock in a fertilizer company or oil refiner. They enable stock index traders to trade the S&P 500 without the fees associated with funds or ETFs. They’re also capital efficient, requiring less initial capital for a given notional value of risk than a similar equity product.
Still, the industrial heritage of futures means different tick incre ments and sizes, high margin requirements and funky trading hours. When investors buy 100 shares of Apple or IBM (IBM) or Tesla (TSLA), they make $100 when the stock goes up $1. Not so with futures.
FUTURES PAST
1697 Dojima Rice Exchange is established in Japan
1848 Chicago Board of Trade (CBOT) opens first U.S.-based grain futures exchange
1877 London Metal Exchange is established
1971 Nixon changes dollar/gold relationship, opening the door for forex futures trading
1972 The Chicago Mercantile Exchange (CME) creates the International Monetary Market
1982 CME launches S&P 500 stock index futures
1992 Electronic futures launched on CME Globex
2002 CME IPOs on the NYSE
2005 CBOT IPOs on the NYSE
2017 Bitcoin futures open on the Chicago Board Options Exchange (Cboe)
2019 Coming soon: the Small Exchange
Against this backdrop, the Chicago Mercantile Exchange launched its E-mini S&P 500 futures in 1997, which are one-fifth the size of the standard S&P 500 futures. Those, along with a handful of other E-mini equity index futures, were pretty much the only consumer-sized futures available.
Twenty years later, the Small Exchange was conceived with individual investors in mind. With sub-$1,000 margin requirements, .01 ticks and $1 tick sizes, the Small Exchange futures products are the most accessible and consum er-friendly to date for equity indices, metals, energy, currencies and bonds. These innovations should level the playing field between stocks and futures for the attention of the individual investor. The Small Exchange’s smaller products, in particular, take advantage of the natural simplicity of futures. That simplicity is passed on to traders. Investors are no longer restricted to a traditional portfolio comprised of highly correlated equities and equity indices that offer no meaningful diversification.
It’s now possible, and affordable, to assemble a portfolio of futures in equities, interest rates, energy, currencies and metals to create real diversity for an account, even with limited capital. That’s not just about trading futures but also about finding a smarter way to build wealth.
Tom Preston, luckbox features editor, is the purveyor of probability and poster boy for a standard normal deviate. Chicago Board of Trade in 1908.
Tales from the Pits
Former floor traders recall their favorite moments from Chicago’s trading floors
From the first moment I saw the trading floor, I knew I had to be on it. And in the late 1990s, Chicago trading floors were the most important pieces of real estate in the country. Every economic statistic, political development and international incident instantly funneled through those rooms, shifting the fortunes of an entire community, from locals to clerks to the newspaper seller out in front of the exchange. The world was moved by the exchange and what happened in it. There was a vital, almost holy atmosphere about the place.” —Jonathan Hoenig traded on the Chicago Mercantile Exchange, MidAmerica Commodities Exchange, and Chicago Board of Trade floors from 1996-2000 and is now portfolio manager at Capitalistpig Hedge Fund, a Fox News contributor and the author of The Pit: Photographic Portrait of the Chicago Trading Floor. @jonathanhoenig
A CRUDE IBM TRADE
My buddy Jules and I were trading partners and we shared a clerk. Clerking on the trading floor was how most new traders got their start in the business. Our clerk’s name was Billy, and on this particularly crazy day Billy had worked his butt off. Although we primarily traded the S&P 100, occasionally Jules and I would put positions on in other stocks and futures. On this particularly busy, down day, Jules asked Billy to run over to the IBM pit to get a quote on a put spread. He was long and wanted to sell. Just before that, we were chatting about why the market was so weak. The consensus was that it was because crude oil broke to new lows under $10 and was approaching $9 a barrel in a late afternoon free-fall.
Billy, standing near the IBM pit, hand signaled (everything back then was done with hand signals) a $.90 bid for the IBM put spread. At least that’s what Jules thought. Jules aggressively signaled back, “Sell 50!” Billy gave him the fill sign and walked back to the S&P pit. This all happened two minutes before the close.
After the close, Billy told Jules he was price improved on his fill. Jules said great, because he badly wanted out of the IBM position for a profit. Billy snapped back, “What IBM trade?” Things went downhill quickly from there. It turns out Billy heard our crude oil conversion, and with crude oil on his mind he sold 50 crude oil contracts (each contract equals 1,000 barrels) on the all-time low tick of $9.08.
It was a Friday afternoon. I did a goodwill check on Billy over the weekend to make sure Jules hadn’t killed him. He was not a happy camper. Luckily though, the story has a happy ending. Crude opened Monday morning at $8.80, and Jules bought the low and made money on the entire debacle. The crude futures have never traded at that level again. And no, Billy did not share in the profits.
—Tom Sosnoff traded on the Chicago Board Options Exchange from 1980 to 1999 and is now co-CEO of tastytrade.
Traders signaled their intentions on the floor of the Chicago Board of Trade during a typical trading day in 1987. Seats cost $470,000 that year, up from $243,000 a year earlier.
LOOK AT THE SWISS
When I was a young trader in the Deutsch Mark pit, barely making a living, I spent much of my free time in the Chicago Mercantile Exchange library trying to find some methodology that would give me an edge. Those were the days before computers, when you constructed your own charts with a mechanical pencil. I studied candlesticks, Steidlmeyer and some crazy scheme called the Congestion Theory. Nothing worked, and with every passing day, it seemed that my dropping out of law school to trade was not such a great decision.
One day, I went to see a one of my father’s friends who was a successful trader and whom I had not wanted to bother. He was really nice—gave me a pep talk—and, on my way out, he said, “Take a look at the Swiss franc. It’s an obvious short.” I thanked him and ran to the pit before the market closed and sold five contracts, the largest position I had ever taken. I could barely sleep that night, and when I walked onto the floor at 5:30 the next morning and heard the call in the Swiss was 100 points lower, I could not believe my good fortune. When the market opened at 7:30, unable to contain my excitement, I bought back the five contracts by 7:30:10. I had made $6,250! This was the turning point— the moment my career really began. Then, as it happens, the currencies went into an extremely volatile bear market that began that day and lasted for at least a year, creating a lot of opportunities for pit traders like me.
About six months later, at a social event, I ran into my dad’s friend. We traveled in different circles, and I had not seen him since the pep talk and his life-changing trading tip. I went over to thank him—to tell him how much I appreciated what he had done for me. But before I could open my mouth, he said, “I hope you held onto your Swiss.” I looked him right in the eye and said with all the bravado of a successful trader, “Of course. Caught the whole move down. Changed my life.” And then, thinking about the five contracts I sold on the first day of a historic bear market and bought back 10 seconds later, I did not remember to thank him.
—David Silverman traded on the Chicago Mercantile Exchange floor from 1982-1997 and is now CEO of broker-dealer and marketmaker Alpha Trading LP.
ALWAYS PUT A NUMBER ON IT
I began my trading career on the floor of the Chicago Mercantile Exchange in the days when traders used open outcry trading. They conveyed bids and offers by voice in the pit. A trader would indicate both a direction (buy or sell) and the quantity to trade. For example, someone looking to buy a Canadian dollar contract would announce his intention by verbally bidding “12 bid for 10,” meaning the trader wanted to buy a maximum of 10 contracts at a price of 7610 (usually the first two numbers were dropped for expediency). This seemingly confusing method of verbalizing bids and offers worked quite efficiently. Strict adherence to these mechanics was the goal, but not often the practice. This played through in a fashion that definitely caught me off guard one day while trading “calendar spreads” in the forex markets.
Every 90 days, traders would “roll” their positions forward, and a portion of the pit was designated the “roll area.” I would actively make markets in these spreads. Typically, a larger order in the spreads would be between 100 and 200 contracts, which equated to an exposure ranging from $10 million to as much as $20 million notional. One day early in the session, an order filler from one of the larger brokerages came into the spread pit and asked where the bid was for the March-June spread. The first mouth open usually got the trade, so in my zeal to quote the market I yelled out, “6 bid at 7,” putting no quantity qualifier on it. The broker turned to me and said, “Buy 7,000.” Because I had not put a quantity on my bid/offer, I opened myself up to taking any amount another trader wanted. My spread book in most cases never exceeded two to three thousand spreads at any one time. But in a single trade I was now short a 7,000 spread—my largest exposure ever—all because I was trying to be quickest to the order and forgot to “put a number on it.”
Fortunately, with a cooperative market I was able to cover this position and pull about $10,000 in profit on this luckbox of a trade.
—Pete Mulmat traded on the floor of the Chicago Mercantile Exchange from 1980 to 2012 and is now chief commercial officer of the Small Exchange
YOUR WORD WAS YOUR BOND
I loved my time on the trading floor, not only for the opportunity to make big money and live the lifestyle that came with it, but also for the camaraderie among the colorful cast of characters who populated the pits.
Traders came from all walks of life. There were Ivy League grads, ex-Israeli Fighter Pilots and engineers. Others had barely graduated from high school. Your pedigree didn’t matter. You had to be fast and aggressive. Often, you had to be humble enough to accept defeat, admit your position was wrong and lock in a loser to minimize risk. Hopefully, you would live to fight another day.
The integrity that I witnessed there was astounding. Your word was your bond. It still amazes me when I think of the number of contracts that were traded amid the chaos and how the vast majority of out trades were settled amicably with words like, “I thought I was buying them, too. If you said I sold them, I take your word for it. Let’s split the error between us.”
Some traders did business unethically, but they didn’t last long. Their fellow traders ostracized them because no one wanted to trade with someone who wasn’t true to his word. Out trade: When two traders have a miscommunication that will ultimately result in one or both of them losing money.
—James Dore traded on the Chicago Board of Trade floor from 1991-2016 and is now director of market surveillance for the Small Exchange. @small_exchange
Think big, think positive, never show any sign of weakness. Always go for the throat. Buy low, sell high. Fear? That’s the other guy’s problem. Nothing you have ever experienced will prepare you for the unlimited carnage you are about to witness. Superbowl, World Series— they don’t know what pressure is. In this building, it’s either kill or be killed. You make no friends in the pits and you take no prisoners. One moment you’re up half a mil in soybeans and the next, boom, your kids don’t go to college and they’ve repossessed your Bentley. —Louis Winthorpe III, Trading Places (1983)
Don Roberts, president and CEO of the Small Exchange, has big plans to make futures small
Readers tell luckbox that many active stock and options traders don’t trade futures. Why not? Three obstacles have prevented retail investors and traders from adopting futures. Futures contracts aren’t easy to understand because each contract has its own tick increments, and they were simply too large for most investors to use prudently. Futures seem mysterious to many investors, much the way they viewed options trading a couple decades ago. At the Small Exchange we hope to change all that through the Small, Standard, Simple mantra and educational efforts to inform the public.
Creating smaller futures contracts that are affordable seems like a simple improvement. What took so long? Like many breakthroughs in investing, futures were originally designed for industrial, institutional and commercial uses. But retail investors want the same lower-fee investment products that institutional investors use, so the adoption of futures has evolved.
Investors and active traders care about fees. How will the Small Exchange’s products compare with other investment products offering similar exposures? We will be shaking things up. The exorbitant fees on existing exchanges for both equity and futures traders present a problem for everyone. The Small Exchange’s products will certainly offer lower costs for futures traders. But perhaps more importantly, the products will provide a better return on their capital relative to products currently offered. For example, say an investor wants to buy 100 shares of an exchange-traded fund (ETF) that costs $50. That would be $5,000 in a cash account or $2,500 in a Reg T margin account. The investor can get the same exposure with the Small Exchange equity index product for about $150. Those efficiencies extend to short sales. To sell a stock short, an investor has to borrow shares, pay interest and return those shares. This creates a hassle for customers and brokerage firms because of the added cost. With a futures contract, an investor can simply sell the indices—a pure play at a lower cost.
Can anyone trade these new futures contracts? Futures trading will not fit every portfolio. Investors can access the Small Exchange if their current brokerages offer futures trading. If a firm doesn’t work with the Small Exchange, investors can call their firms and express interest. The Small Exchange website will soon provide a list of firms participating in the exchange as a resource for investors who seek more options for managing risk and wealth.
Who will be the early adopters of Small Exchange futures contracts? Initially, active and sophisticated self-directed traders will participate, because the products increase opportunities for cost-efficient hedging and speculation. Later, additional retail investors will flock to futures because of the benefits of increased capital efficiency, lack of account minimums to day trade and absence of short-sale rules. Eventually, passive investors will also adopt our indices as low-cost, pure-play, long-term investment alternatives to ETFs.
The Small Exchange announced a subscription offer. How does that work? To build the world’s largest customercentric futures exchange, the Small Exchange has developed a pretty cool offering—a lifetime subscription to the exchange that provides half off exchange fees and a reduced price for market data for the lifetime of the holder. More information is available on the website. The offer is valid for all individual retail customers.
--Don Roberts
Why Millennials Should Love Futures
Simple access to low-cost, pure plays on commodities resonates with a new generation of investors
By Michael Gough
As a member of the millennials, the age group now in our 20s and 30s, I can attest to the accuracy of at least one generalization about our generation: We prefer “access,” not costly and cumbersome “ownership.” And we value the pure play. We’d rather grab an Uber or Lyft than commit to onerous car payments and ruinous deprecia tion. Who needs the parade of bills for gas, oil, tires, batteries, parking, insurance and repairs? Ride-sharing offers door-to-door transportation without undue expense—a pure play. We also prefer the freedom of renting over the slavery of a home mortgage. Who wants to take responsibility for dripping faucets and leaky roofs?
And why not forget about those pricey resorts? We’d rather spend vacation time in an affordable Airbnb. It’s a roof. And it’s likely to have more personality and more local character than a hotel room— another pure play.
These changes have combined to recast many companies as low-fee businesses providing direct and immediate access to the pure play. At the same time, purchasing stocks has become increasingly inexpensive and easy. To acquire stock in Starbucks (SBUX), for example, just open a Robinhood or Dough app, search SBUX and hit “buy.”
But before the new products from the Small Exchange, no one had come up with an easy way to trade the price of precious metals. Decades of legacy financial infrastructure still make it difficult to trade the most popular commodities such as oil, gold and interest rates. What’s the symbol for oil? Well, on a stock trading app there isn’t one.
Sure, we could buy Exxon Mobil stock, but that’s not the pure play. I don’t care about Exxon’s production capacity or quarterly earnings. I just want to make money when oil moves. I could also buy an oil mutual fund, but that’s just a basket of companies burdened with an unnecessary management fee.
Why should we pay a management fee when we can manage our own money? Look at the discrepancy in performance between crude oil and OIH, an oil services fund in “Oil Futures versus OIH,” right. While oil is up 25% since the start of the year, OIH is down 10%. Yet, $680 million in assets have found their way to this fund, as opposed to the pure play on the price of oil.
Expressing an opinion about oil, interest rates or foreign exchange requires something called a futures contract. These big, fat, legacy financial products provide direct exposure but are also so large they can make a $500 profit one minute and lose $1,000 in the next.
Wall Street had given us two choices: Either zig-zag to pure exposure with a convoluted fund, or trade it all-in with an oversized derivative. Why not go small? It’s something the new Small Exchange makes possible. The Small Exchange brings innovation to futures, a market offering capital efficiencies, tax advantages and pure price exposure. It’s time for cost-effective, pure-play, straightforward futures products for all generations, not just those with large sums of money to invest. Michael Gough enjoys retail trading, running, reading and writing code. He works in business and product development at the Small Exchange, building index-based futures and professional partnerships. Oil futures versus OIH While oil is up 25% since the start of the year, OIH is down 10%. Yet, $680 million in assets have found their way to this fund. Millennials are great at gathering information. Why should we pay a management fee when we can manage our own money?
Savvy investors will discover more uses for the smaller futures contracts exchanges are developing
By Michael Rechenthin
Exchange-traded funds (ETFs) work well for passive investors—but not for short-term traders or sophisticated investors. Still, anyone looking to reduce risk in a portfolio heavy in ETFs will find the new, smaller futures contracts from the Small Exchange an efficient means of trading, requiring just a fraction of the money that would be needed to buy stocks. With futures, leverage often comes to around 10-to-1.
ETF investors, on the other hand, provide margin 2-to-1 (or intraday 4-to-1). But not only is the leverage better with futures, the cost is 50% lower.
Then there are the tax advantages. Whether an investor has owned futures for a second, a minute or a month, gains and losses are marked-to-market and taxed at a blended rate of 60% long-term capital gains and 40% shortterm rate (which is ordinary income). But if an investor disposes of an ETF within one year, the government taxes 100% of it at the higher short-term capital gains rate.
Suppose an investor has a portfolio with 100 shares of S&P 500 ETF (SPY) and wants to use a Small Exchange futures product to hedge risk. As shown in “Buy this, not that,” right, 25 shares of SPY are equivalent to one Small Stocks 75. That’s because they both tend to move around $70 per day. To fully hedge 100 shares of SPY, an investor needs four contracts. If the objective is to partially hedge the position, sell one or two of the Small Stocks 75 contracts.
Buy this, not that Affordable futures contracts pose unique alternatives to ETFs.
Trader: Meet Pete Mulnat
Host of Splash Into Futures on the tastytrade network
Home Winnetka, Ill.
Years trading 37
How did you start trading? I studied economics in school and was fascinated by theory being played out in practice in markets every day. When I was 15, I started clerking on the floor of the Chicago Mercantile Exchange for my father, who was a cattle trader. I began trading on the floor when I was 20. In the ‘80s, markets were relatively small—the D-mark currency pit I started in had five other traders. When I moved off the floor in 2011, that same pit had 150 traders doing 300,000 contracts per day. Being able to refine and expand your skills as a trader as a market evolves is a tremendous way to become successful.
Favorite trading strategy for what you trade most? A combination of premium and static delta directional trades. With futures, for many years, you had to either pick a direction or not trade. With the growth in volume and liquidity in options on futures in the last five years, premium selling strategies have been an invaluable tool to enhance returns and add consistency to my trading. Strangles in combination with futures often are my go-to trade. By adding the strangle to a static delta, long or short, I can manage delta expansion on the options while taking advantage of high-volatility situations. To stay engaged in markets and diversify my portfolio, I found defined risk trades, like iron condors, attractive because of their low capital requirements and—by nature—the slower pace of movement in deltas and direction.
Average number of trades per day? 35
What percentage of your outcomes do you attribute to luck? 30%
Favorite trading moment or best trade and why? Oct. 31, 2011. I was trading the Japanese yen as it hit an all-time high in value against the U.S. dollar. I had been short this massive “up move” for several days, fighting a relentless rally. On Oct. 31, the Bank of Japan intervened in the forex markets, buying 5 billion of U.S. dollar/ Japanese yen and taking the currency from lifetime highs of 135 dollar/ yen to 1.24 in less than 10 minutes. Shorting this rally and the ensuing fall was one of my best.
