Everybody Gets What They Want
Legendary futures trader Ed Seykota grew one $5,000 client account by 250,000 percent into over $12,000,000 per the New York Times bestseller “Market Wizards” by Jack Schwager. That’s on a cash-on-cash basis.
But, this is not what Seykota is talking about when he says “everybody gets what they want.” He means that unconscious desires are immediately expressed when trading the frantic futures markets.
Careless gamblers are consumed by the fire in the pit when trades wipe out their accounts. For every man or woman made millionaire by the futures markets there are hundreds of financial body bags for those who fail.
This course is a professional primer of core concepts and strategies intended to increase your probability of survival in these markets. Take your first steps to exploring your possibility of futures trading as a business.
I am a professor of finance at a major state university business school. We are AACSB accredited, only 5% are.
The University of Puerto Rico trains the most CFAs and CPAs in the Caribbean region.
I am making my teachings available to you in this groundbreaking online course.
You will be converted into an informed futures trader. You will know what to do and when to do it. I will show you how to trade in simulation so that you never risk more than is prudent for your situation.
Terry S. emails, “Hats off to you Scott, it definitely shows you put a lot of effort and time into this course.”
Enroll now. Your learning is guaranteed or your good karma back (since this is a free course). Enroll now. -Doc Brown
I am Dr. Scott Brown. I hold a Ph.D. in finance from the University of South Carolina. I am a professor of finance of the AACSB accredited Graduate School of Business of the University of Puerto Rico.
Just 5% of all business schools in the world enjoy AACSB accreditation.
MBA degrees from these schools are highly prized.
I am teaching this course to help you avoid disaster. Many investors wipe out in these markets due to over-confidence.
Here are a couple of unbreakable rules…
Always begin with simulation. The Track N Trade Live Futures platform allows you to see what would have been your results if you risked cash.
Simulation allows you to risk nothing more than the subscription cost of the Track N Trade Live Futures platform to pay for the data feed. Do not trade cash money until you can profitably trade in simulation.
Adhere to this ###b
/b### to ensure that you do not under or over fund your account with trading capital.
Futures Day Trading / Options
Spreads / Forex
The best way to protect yourself from your own inexperience is to dramatically limit the amount of money with which you fund your new account. Futures contracts held as long term positions for more than a day require the most money to trade. Futures options can be traded for half as much.
Margin for day traders is much lower but you must enter and exit the market before the end of the day.
Forex requires the least to trade. It is also the noisiest market to trade.
Forex requires very little capital. This is low risk.
It is safer to learn a tricycle than to ride a bike.
Tricycle practice builds skills that are later used on a bicycle. Forex practice builds you up to trading more serious levered markets in futures and options.
Outright futures, futures options, and forex may be a complete waste of time for most investors after considering taxation. Sixty percent of profits will be taxed at your long terms capital gains rate.
Forty percent will be taxed at your ordinary tax rate. And, bookkeeping for such a business is very complicated.
Futures trading only makes sense after you have convinced yourself that you can earn much more than in the stock or bond market. Preferably, enough to make a living.
Outright trading in these markets requires the formation of a trading business. “How to Succeed in Business Even if you Don’t Know Where to Start” explains how to set one up.
This allows you to form Roth 401(k) and Solo 401(k) spousal accounts. These are ideal for index investing while you are building your futures trading business.
A detailed study of futures, futures options, and forex is fruitful. A wide array of Exchange Traded Funds (ETFs) allows you to use equity options in the form of puts and calls to replicate the cashflows of the most heavily traded futures and forex contracts.
The few who take the time to study the futures market as you are doing now are the ones who are most likely to excel over time.
What you are about to learn will allow you to control over a hundred thousand dollars in stocks for just over five thousand in deposit. Sound interesting?
Perhaps it does. But I must ask you a very important question?
Are you a compulsive gambler?
The investment markets are no place for compulsive gamblers. If you have a gambling problem, make sure you correct it before you begin your journey into futures trading.
Futures markets allow some individuals the opportunity to earn vast sums of money with small investments. Others use futures to hedge the risk of adverse changes in commodity prices, index levels, and interest rates. This is of interest to every serious stock or bond investor.
In this course, you will discover:
As a student of this course you will benefit from cutting edge knowledge and training from a trader and scholar recognized by the Chicago Board of Trade and the Certified Financial Analyst (CFA) Institute.
At the end of this course you will understand the business of futures speculation and the management process of hedging risk. You will also have determined if futures trading is right for your specific situation.
This section introduces you to the underlying concepts of forward and futures contracts. You must first understand futures prices. Then I will show you how futures and forward prices convert to cash as time passes.
Part I: Understanding the Forward Contract
Forward contracts have been traded long before the first futures contract. This is a simple customized agreement between a business person who needs to sell something today to a buyer who needs to buy something tomorrow, or vice-versa.
The buyer agrees to pay for something on a specific transaction date forward in time when the seller is obligated to deliver. These start as agreements arranged directly or by the attorneys of both parties.
The negotiation process leads to customized agreements known as forward contracts as transactions in a specific asset flourish.
These forward contracts stipulate
All four of these aspects can be customized.
The best example of a forward contract is in the forex market. This is the best forex trading software I have found. It is the TnT Live Forex Platform.
Use it to first practice in simulation.
Part II: Understanding the Forward Contract
The forward price is predetermined by the forward contract. The most common forward contract is the forex contract.
The forex contract is a simplified futures contract.
This means that the mechanics of forex is like futures. You can Segway from what you learn in this futures trading course to forex.
The forward price is set but each party faces default risk. Counter-party risk is the possibility that one party to the forward contract backs out of the deal.
Forward contracts can only be canceled by agreement of both parties.
To cancel the contract, both parties must agree upon cancelation. Sometimes the buyer or seller must pay cash to get the other party to agree to cancel a currency futures contract.
The Basics of Futures Contracts
A futures contract obligates two parties, the buyer and the seller, to consummate a pre-determined fully standardized transaction.
Buyer and seller are unaware of the identity of either party. Price negotiation is by open outcry in a futures pit. Or pricing is obtained through a continuous online auction process in an electronic futures market.
Futures contracts are completely standardized with terms that fully describe:
More Basics of Futures Contracts
A futures exchange is known as a pit. This is because the Chicago Board of Trade connected 8 banks of 3 step bleachers into an eight-sided pit-like structure.
Futures traders used to stand on different levels of the eight-sided pit and scream orders back and forth between brokers representing different groups of retail clients. Some brokers were able to buy or lease a seat on the futures exchange and began trading on their own.
Brokers also used to transact with local traders in the pits. This has largely dissipated due to the success of electronic futures trading exchanges.
Watch the Hollywood movie, “Trading Places” with Dan Ackroyd and Eddie Murphy to see how futures used to be traded.
Watch it today as a dvd rental on Netflix.
Futures contracts do not force you to lose if the other party reneges on the deal. The futures exchange forces everybody to trade through clearing firms that guarantee the contract and chase deadbeats with attorneys.
Contracts are easily canceled by a simple offsetting order; a sell cancels a prior buy order; a buy cancels a prior sell order.
Profits are promptly deposited into the winning traders account from the account of the losing trader.
Futures Exchanges Are Highly Organized
The Dōjima Rice Exchange was established in 1697 in Osaka, by Japanese rice brokers who developed a special charting nomenclature known as “candlesticks.” The Dojima became the first exchange in the world to trade futures contracts in 1710.
The success of the Dōjima futures exchange inspired American grain brokers to set up in Chicago.
Thus, the Chicago Board of Trade (CBOT) became the oldest organized futures exchange in the United States. It was established in 1848 when the McCormick Reaper ramped up grain harvesting opening the mid-west bread-basket to the world.
The futures exchange allowed grain traders to easily trade with one another with less fear of counterparty risk.
Other Major Exchanges came after that:
The Chicago Board of Trade (CBOT) and the Chicago Mercantile Exchange (CME) have since merged into the CMEGroup.
Early on, these exchanges exclusively traded grain contracts such as oats, corn, and wheat. This was later expanded to include a wider array of commodities. Nonetheless, agricultural futures still constitute an important part of organized futures exchanges.
Some academics point out that very little futures trading is speculative. Many accounts designated as hedging are used to speculate. The futures markets are collectively the biggest casino on Earth.
Financial Futures are a Modern Marvel
Financial futures are a major component of the modern organized futures exchange. Here are some interesting milestones.
Currency futures trading came about in 1972. Trading runs parallel to the interbank market for forex currency forward contracts.
Gold futures trading began in 1974. This may seem more like a commodity, and I agree with you. Gold is used widely as a financial tool by households and central banks who speculate in the value of the precious metal. This contract launched year end, 1974.
This was when the ownership of gold by U.S. citizens was legalized.
U.S. Treasury bill futures were introduced in 1976. These trade with short maturity underlying instruments.
U.S. Treasury bond futures began to trade in 1977. Bonds have later maturities than bills.
Eurodollar futures made it onto the trading scene in 1981. This allows for the trading of a risk free rate that is untampered by Congressional politics.
Stock Index futures were developed in 1982. The S&P E-Mini has become the juggernaut of all futures contracts. This creates portfolio insurance for hedgers who wish to trade with speculators.
Today, financial futures comprise most of all futures trading; success is unquestioned.
The 5 Core Concepts of Futures Contracts
All futures contracts clarify the identity of these five variables:
Here are how futures prices are printed in the newspapers. Now I will show you how prices are displayed in TnT Futures Live.
Here are more, Here again, these TnT Futures Live charts show you these prices.
Brush up on the basics!
The futures markets are also interlinked with the forward contract through the forex interbank market for foreign exchange.
Futures trading is not a win-win endeavor. It is win-lose. Or it is lose-win.
This is because futures contracts are a zero-sum transaction between a long buyer and a short seller. Any gains made by the buyer are offset by losses incurred by the seller (and vice-versa).
The futures exchanges keep track of daily gains and losses through a massive clearing firm known as a Futures Commission Merchants (FCM). The FCM allows the market to clear nightly as trades are marked to market.
There are just two uses for futures contracts; hedging or speculation. Both transactions are complimentary to establishing a fair and orderly market with optimal liquidity.
This is because commercial hedgers shift price risk to individual speculators and hedge funds. Speculators are thought to absorb price risk.
But, recent studies are making academics question this idea. It turns out that markets during global stress are more interconnected than financial economists once thought.
The Gist of Speculating with Futures to the Long Side
There are several odd terms in the trading of the financial markets. One such word is long.
This is the opposite of the word short as I explain below. A long position is created when you buy a futures contract. The action of buying is known as “going long.”
Each day that passes results in a change of price that is negotiated during the daily auction process; whether open out-cry or electronic. Each trading day money is added to or withdrawn from the futures account depending on higher or lower prices for long or short positions.
This continues until the expiration of the futures contract on the expiration date.
Live Example: Speculating in Gold Futures
Say you believe the price of gold will rise. The best tactic would be to buy a futures contract today. You will profit selling at a higher price; if you are right.
So, you go long 100 futures contracts that expire in 3 months. The futures price today is $1,300 per ounce. Each futures contract of gold controls 100 ounces.
Your "position value" is: $1,300 X 100 X 100 = $13,000,000. Imagine that the price of gold rises to $1,320 at expiration of the futures contract.
The new "position value" is: $1,320 X 100 X 100 = $13,200,000. Your "long" speculation profit is $200,000. If the market had dropped by the same amount (to $1,280) you would have lost $200,000.
Short Speculation with Futures
A common English use of the word short is to express lack. I might ask my wife, “Could you give me a twenty-dollar bill because I am short on cash.” This is a perfectly accepted use of the word short.
This term applies to commercial transactions of pre-selling items not held in inventory as far back as “The Gentleman's Magazine and Historical Chronicle,” Volume 17 from 1748. The financial term short selling has evolved from this linguistic inception over time.
Shorting the market is the action of selling a contract. The trader “goes short” when selling a forex (forward), futures, or option contract.
The long mark-to-market process works in reverse for short positions. Money is withdrawn from the futures trader’s margin account when the price rises. Price declines result in deposits.
Say you believe the price of gold will drop. you would have to sell gold to another trader who believes gold will rise, or is hedging to make money on the move.
You short 100 futures contracts with 3 months to expiration.
The futures price today is $1,300 per ounce. There are 100 ounces of gold in each futures contract.
Your "position value” is: $1,300 X 100 X 100 = $13,000,000.
Gold drops to $1,270 per ounce by the time the futures contract expires. Your “position value” has dropped: $1,270 X 100 X 100 = $12,700,000
You close the short position by buying a gold contract for a lot less than you sold it. Buying is a reversing trade to the initial selling that created the position. This automatically closes the trade by reversing it out.
This short trade profited $300,000.
What if the price of gold rose to $1,420 per ounce? In that case, you would have lost $200,000.
There is a reason that I have used very large values in these examples. If you grow as a futures speculator these are amounts that are at stake for large traders.
You don’t have to go big, or go home here.
A nice aspect of futures trading is scalability. Smaller positions with fewer contracts automatically cap your risk.
The size of your futures or option position is clearly important.
Managers Hedge with Futures to Reduce Risk
A hedger trades futures contracts to transfer factor price risk to a speculator. Economic factors for a business include interest rates, energy, labor, government policy, taxes, and management. Factors of production include commodities, capital, land, labor, and entrepreneurship.
Futures contracts are tied into both economic and production factors where speculators are willing and able to shoulder large economic and production input price risks. Futures markets reduce the risk of firms who supply households with common goods and services in the economic cycle.
This further reduces the risk of household savers who invest their wealth in these same firms through the stock and bond markets.
Financial futures span common economic factors. Commodity futures span common production factors.
Hedgers buy futures contracts to protect from rising factor prices. Alternatively, hedgers sell short to protect against falling factor prices.
Live Example of a Short Futures Hedge
A copper mine has a large inventory it sells over time. Rising copper prices increase the cost of inventory.
Suppose company managers seek to protect inventory value.
Selling copper futures contracts today offset potential decreases in the inventory value of raw copper for the housing industry.
The act of selling futures protects from falling prices. This is called short hedging.
Live Stock Market Short Hedging Example with Futures Contracts
USAirways managers Wolf and Gangwal were highly criticized for not hedging fuel cost. Over time this weakened the company and endangered employees.
Fuel is not the only item that is hedged. Remember, the corn futures contract? What if Frito Lay Doritos management has an inventory of 1,000,000 bushels of corn, valued at $3.00 per bushel?
Each contract of Chicago Mercantile Group corn is for 5,000 bushels.
Frito Lay fears that the price of corn will fall in the short run, and wants to protect the value of its inventory. Frito Lay can protect the value of their inventory by selling 200 three-month expiration futures contracts at $3.00 per bushel.
Selling futures contracts protects inventory value.
Managers can partially hedge by selling less than 200 contracts. But they must be cautious if corn prices rise dramatically.
Maintaining the short in that case will decrease the value of the corn inventory.
Live Example of Short Hedging with Corn Futures Contracts, Continued.
Frito Lay sells 200 near-term futures corn contracts to hedge.
Over the next month, the price of corn falls. Frito Lay sells its corn inventory at $3.00 per bushel.
The futures price falls, to $2.99 by expiration. In this case the hedge was not worth the effort because the price of corn dropped by just 1 cent.
The multiplier for corn futures is 50. This means that every one cent rise in the price of corn increases the value of a futures contract by $50.
On the other hand, if corn had dropped from $3.00 to $2.00 per bushel managers would have saved a cool million!
Many academics question the true extent of hedging in futures by Fortune 500 firms. Hedging can reduce losses under some conditions. But, it can also expose the firm to enormous opportunity costs.
The Short Hedge Details
The hedge was imperfect.
It “threw-off” cash to the tune of $56,250 when Starbucks needed to offset the decline in the value of their inventory in the amount of $57,000.
What would have instead happened if prices had increased by 6¢? The firm would have made more money on inventory but lost on the hedge. However, managers would have avoided any unexpected drop in corn prices.
Live Example of a Long Futures Hedge
Frito Lay must buy more corn at some future date when their inventory runs short. The firm will lose if the price of corn skyrockets beforehand.
Management can buy 200 futures contracts today if they have strong evidence that corn prices are rising. Every $1.00 increase in corn prices will save Frito Lay shareholders $1,000,000.
Live Example of Long Silver Futures Hedging
Suppose the U.S. Mint plans to purchase 100,000 ounces of silver next month. The U.S. Mint fears that the price of silver (which is $19 per ounce) will increase before they must buy.
The U.S. Mint wants to “fix” the price it will pay for silver.
How best? Here are the facts:
There is a silver futures contract trading on the COMEX. Each contract is for 5,000 ounces of silver.
The silver futures price with three months to expiration is $19.20 per ounce. Long futures contracts for inventory offer price protection.
20 futures contracts protect 100,000 ounces of silver. That’s because 100,000 ÷ 5,000 = 20.
Live Example of Long Hedging with Futures Contracts, Part II
The U.S. Mint must buy 20 near-term futures contracts to hedge. Imagine that over the next month, the price of silver increases. The U.S. Mint pays $35 per ounce for its silver.
The futures price also increases to $35.20 per ounce (With two months left on the futures contract). Was this long hedge a good deal?
Yes! Silver was a far better deal 3 months ago at $19 an ounce.
How well did buying futures contracts protect the U.S. Mint? Perfectly!
Losses in the cash market purchase were perfectly offset by the gains on the futures contract.
Not all industries hedge. In fact, hedging activity is a lot lower than people believe.
Hedging is costly. Managers must be careful to measure the benefits of hedging with the benefits of not hedging.
As a rule, the initial margin is set somewhere between 2% and 5% of the contract value.
The E-Mini for instance has a contract value of about one hundred thousand dollars. The initial margin is around five thousand.
Initial margin for the E-Mini is roughly 5% of contract value.
A futures exchange sells seats just like a stock exchange. Seats are a way of allowing members to exclusively trade on the exchange.
These member’s only clubs have two types.
First, brokers operate under a seat through the firm they work for. Floor brokers primarily handle trades for clients.
Second, “locals” buy seats. These are individuals living in the same city as the exchange. Locals are nearly extinct as screen trading drives them out of business. Per the Federal Reserve Bank of New York, “Because the success of locals’ trading is largely dependent on observing other traders on the floor, locals tend to avoid screen-based systems.”
The bulk of futures trading today operates across screen-based systems.
Futures Trading Margin Accounts
You must fund your account with cash. Most traders begin trading futures out of savings.
Don’t use retirement savings money for this. Only add money you save after fully funding your Roth IRA, Roth 401(k) and Solo 401(k).
Put this money in an indexed mutual fund such as the Vanguard 500 fund (VFINX) or the ETF SPDR (SPY) while you learn futures trading.
That’s $30,500 for a saver over 50 between the $6,500 and the $24,000 contributions to the Roth IRA and Roth 401(k). Or this amounts to $61,000 annually for two savers over 50.
Minimize the amount of money you risk.
This restricts your trading to contracts with low margin requirements. Buying futures options is also a cheaper way to direction trade futures.
Futures options come in two forms; puts and calls.
Spreads are even cheaper to trade. But, these limited direction bets are hampered by restricted payoffs — unlike buying puts and calls.
It does not make sense to seek out low payoff bets in such a highly leveraged market with ample high yield payoff strategies.
If you are going to trade a hard-core futures market such as E-Mini futures contracts you will need more money than for buying E-Mini puts and calls.
E-Mini puts are most commonly used to hedge retail investors who hold large stock portfolios in 401(k) and Roth accounts. The call is used to speculate to the upside in the S&P 500 index via the underlying E-Mini futures contract. Grain futures options are cheap.
Follow this table to ensure that you do not under or over fund your account with trading capital.
Futures Day Trading / Options
Spreads / Forex
Limiting the initial amount to fund an account limits losses when combined with stops and long option positions.
You control a futures contract with a small deposit called margin. The E-Mini contract requires that you have at least $4,620 in initial margin when you put on the trade. Once the trade is running you can hold the position as long as your account balance does not fall below $4,200 in maintenance margin.
This is the margin rate for Gecko Financial Services in the month of October of 2016.
Margin values change over time. Both margin values apply to position trades that are held overnight or over many days, weeks, or months.
Oddly, corn is now more expensive to day trade than the E-Mini.
Futures day traders enter and exit the market during the day trading session. E-Mini day trading requires $500 margin in the account per contract.
Corn, on the other hand is much cheaper to trade long term. Initial margin is just $1,265. Maintenance margin is $1,150. Day margin is $632.50.
You can find these values in these tabs in the Track N Trade platform.
These contracts are marked-to-market daily where loser pays winner in cash. Margin calls are issued whenever the account value falls below maintenance (day) levels. Don’t ever meet a margin call. Closing the position is better.
Then deal with the deficit.
Futures positions are closed by reversing trade. A purchase of 10 contracts is later closed by a reversing market or stop order to sell 10 contracts short at any time during the life of the position.
As I mentioned before, Initial Margin is a “good faith” deposit that is required when a futures position is first established.
Initial margin levels are very dependent on the price volatility of the underlying asset. A special algorithm called ###b/b### is used to calculate the initial margin required on a futures contract.
SPAN uses other variables to set margins that can differ by type of trader. Hedgers have lower margin requirements than speculators.
As the underlying asset price changes, the futures exchange deposits or withdraws cash from margin accounts in a meticulous accounting method called marking-to-market. If the trading account balance drops below maintenance margin levels, the futures trader is warned about the contract violation with a margin call.
A margin call is a legal demand that the broker deposit more money into the trading account. Failure to comply will result in prompt legal action on behalf of the Commission Futures Merchant (CFM). This process is very much akin to the foreclosure process on a home but much faster.
Don’t meet margin calls. Close the position.
Then pay your loss and decide if you want to close shop or continue trading.
Here is a live example of margin and marking-to-market. You open a futures trading account with Gecko Financial.
You believe Gold will increase in price. You also know that you will need to take a long position where 1 contract controls 100 ounces of gold futures.
Gecko Financial requires $5,940 of initial margin and $5,400 of maintenance margin. You deposit $5,940 into your futures margin account.
Trading Account Results for a Long Position in One Gold Futures Contract
This table tracks the changes in a trading account over time.
Initial Margin Deposit
Trader buys at close
Margin Call for $600
A cash market is where people pay for immediate delivery “on-the-spot.” Traders refer to the cash price for a futures contract as the spot market. M.I.T. economist Paul Samuelson was the first to point out that the futures contract must converge to the spot.
Cash implies "immediate" delivery but the actual receipt of the asset can be 2 or 3 days later.
Quoted Cash Prices
Quoted Cash Prices
There is a difference between the futures price and the cash-spot price. Some traders attempt to eke out a profit risk-free by scalping differences between cash and futures prices.
This specific type of trading is called cash-futures arbitrage.
I do not recommend that you attempt cash-futures arbitrage. But understanding this type of arbitrage helps you understand futures prices.
All traders know that cash prices and futures prices are rarely the same. Basis is the difference between the cash and the futures price.
basis = cash price – futures price
Again, Uncle Paul Samuelson from M.I.T. showed us that basis drops to zero by expiration. This is a mathematical way of saying that cash and futures prices must converge.
More Insights from Cash-Futures Arbitrage
The cash price rarely rises above the futures price. The market gives off an important trading clue when the market inverts as the spot rises above futures prices.
This is especially so for commodities with storage costs.
Another way to say this is that the basis is normally negative, i.e. basis < 0. This reflects carrying-charges for physical assets that underlie a commodity futures contract. When the spot is below the futures price the market is in normal backwardation.
Sometimes, the cash price is higher than the futures price, i.e. basis > 0. This is called an inverted market. Inverted markets are also said to be contango.
In 2000 interest rate futures showed that prices had formed an inverted yield curve. Bill Gross made a fortune on this observation. Inverted markets generate great opportunities for profits.
Basis is thought to be kept at an economically appropriate level by arbitrage. But, many financial economists have pointed out that barriers to arbitrage make this unlikely.
The futures price becomes the spot on the delivery (expiration) date. The size and sign of basis can help futures speculators visualize the likely direction of order flow into the future. In this equation, the futures price is the symbol F. S is the spot price. r is the risk-free rate, and T is the time remaining until the futures contract expires.
Spot Futures Parity with Dividends Helps Stock Investors
The S&P E-Mini futures contract is the most heavily traded. The introduction of this contract forced financial economists to incorporate stock dividend payments into the spot-futures parity model.
Again, spot-futures parity is particularly important for stock index futures— where some stocks pay dividends. This introduces an additional cash flow. This is the modified spot-futures parity formula where D represents a dividend paid at or near the end of the futures contract’s life.
You can also plug dividend yield (d = D/S) into the spot-futures parity formula this way.
Stock Market Indexes
Stock market indexes are very important as futures contracts. The biggest are the:
It is unwieldly to deliver so many different shares; stock index futures are cash settled. Thus, at futures contract expiration, no shares of stock are delivered.
The FCM simply marks-to-market the position one last time, and the contract ceases to exist.
Single Stock Futures
Single Stock Futures are new. They trade through the OneChicago single stock futures exchange. This began in November 2002.
OneChicago is a joint venture between the Chicago Board Options Exchange (CBOE), and the CME Group (formerly Chicago Mercantile Exchange, Inc. (CME), and the Chicago Board of Trade (CBOT).
There are 80 stocks trading Single Stock Futures contracts. These are structured like option contracts where the underlying asset for the single stock futures is 100 Shares of common stock.
Unlike stock indexes, shares are delivered on expiration. These contracts allow traders to sidestep the non-linearity of option pricing.
Single stock futures offer tax benefits over stock option trading in taxable accounts.
Futures are taxed at a rate of 60% at the trader’s long term capital gains rate and 40% at his or her ordinary rate. Stock options in an individual trading account are taxed at the trader’s top rate in the United States progressive tax schedule published in the Internal Revenue Code (IRC) by the Internal Revenue Service (IRS).
Additional futures contracts exist on 14 core industry sectors from Aerospace, through Semiconductors, to Software.
Each “sector” contract contains 5 stocks.
These OneChicago futures contracts are cash settled at expiration. They offer an interesting approach to investors who engage in sector rotation stock strategies.
Index arbitrage is a strategy of trading stock index futures and underlying stocks to exploit risk free differences from spot futures parity. The problem is that this is a directional bet on basis.
Changes in basis are highly random.
Index arbitrage is now implemented as an automated program trading strategy by large investment houses like J.P. Morgan. Index arbitrage and other forms of programmed trading comprise about 15% of total trading volume on the NYSE alone. Scalping the indexes through arbitrage are about 20% of all program trading.
Watch for the Triple Witching!
Futures and options trading is subject to the triple witching effect. This is because the S&P 500 futures contracts and options, as well as some stock options expire on the third Friday of just four months during the year; December, March, June, and September.
Expect unusual price behavior leading to higher volatility during triple witching and a few days after.
Cross Hedging Has Surprising Uses
Merchants can hedge spot positions with the most closely related commodity or financial futures contracts. Managers Wolf and Gangwal of U.S. Airways were heavily criticized by the pilots for not cross hedging rising jet fuel costs with a crude oil or gasoline contract.
The price of each is highly correlated.
Large Wall Street fund managers can protect stock portfolios from a fall in value by establishing a S&P 500 short hedge. These are tricky.
Prices fall unexpectedly and recover quickly. This is a lifesaver in a bear market such as those that started in 2000 and 2007. This is particularly useful for investors with large indexed equity holdings.
This is a “cross-hedge” for highly concentrated stock portfolios that do not move in tandem with changes in the value of the S&P 500 index. Charlie Munger, Warren Buffet’s partner famously holds a highly concentrated stock portfolio of between 1 and 3 stocks.
How Index Futures Hedge Stock Portfolios
The formula for hedging a portfolio with stock index futures is simple. Find the beta of any stock portfolio on common websites where the S&P 500 Index is the benchmark portfolio.
The dollar value of the portfolio to be hedged is,
The dollar value of one S&P 500 E-Mini futures contract, VF is 50 X S&P 500 index futures price.
Here is the formula:
How to Hedge a Stock Portfolio with Stock Index Futures — Live Example
Want to protect the value of a $2,000,000 portfolio over the next 3 months? This is a "short-hedge" because you are long the stock.
The portfolio beta is 1.45. The multiplier for the full-size S&P futures contract is $250.
The multiplier for the E-Mini is $50.
Smaller portfolios are best hedged with E-Mini S&P futures contracts. The S&P futures contract with 3-months to expiration has a price of 2,050. How many futures contracts do you need to sell?
Here is another example of a portfolio to Cross-Hedge
You can use futures contracts to cross-hedge U.S. Treasury notes. This protects your corporate bond portfolio against changing interest rates.
Since the value of the bond portfolio does not move in lock step with the value of U.S. Treasury notes this is called a “cross-hedge.” A short treasury bond futures hedge protects corporate bond portfolios against the risk of a general rise in interest rates during the life of the contract.
Bond prices drop when interest rates rise. Selling bond futures produces cash when bond prices fall.
How T-note Futures Hedge Bond Portfolios
The formula for calculating the number of T-note futures contracts needed to hedge a bond portfolio requires the following input values:
The formula is:
Duration is easy to estimate. Here’s a handy duration estimate.
Rule of Thumb:
The duration of an interest rate futures contract, DF, is equal to the duration of the underlying instrument, DU, plus the time remaining until contract maturity, MF. That is:
Say, you want to protect a $100,000,000 bond portfolio over the near term. You will "short-hedge". Further, the duration of this bond portfolio is 8.
The multiplier for the 10-year Treasury note futures contract is $100,000.
Suppose the duration of the underlying T-note is 6.5, and the futures contract has 0.5 years to expiration. Also, suppose the T-note futures price is 98 — which is 98% of the $100,000 par value. How many futures contracts do you need to short to hedge?
Futures Contract Delivery Options
The cheapest-to-deliver option is the seller’s choice to deliver the cheapest instrument when a futures contract allows several instruments for delivery.
For example, U.S. Treasury note futures allow delivery of any Treasury note with a maturity between 6 1/2 and 10 years. Note that the cheapest-to-deliver maturity may vary over time.
Professional bond traders using T-note futures to hedge risk are keenly aware of these features.
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I am an internationalspeaker oninvestments. In 2010 I gave a series of lectures onboard Brilliance of the Seas as a guest speaker on their Mediterranean cruise. Financial topics are normally forbidden for cruise speakers. But with me they make an exception because of my financial pedigree.
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I sponsored and organized an investing conference at Caesars Palace in Las Vegas in 2011 under my Wallet Doctor brand. This intimate conference was attended by 14 paying attendees.
As such many strides were made in financial education that week. For instance I met a woman who is a retired engineer from the Reno, Nevada area.
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I am an associate professor of finance of the AACSB Accredited Graduate School of Business at the University of Puerto Rico. My research appears in some of the most prestigious academic journals in the field of investments including the Journal of Financial Research and Financial Management. This work is highly regarded on both Main Street and Wall Street. My research on investment newsletter returns was considered so important to investors that it was featured in the CFA Digest.
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(See Brown, S., Cao-Alvira, J. & Powers, E. (2013). Do Investment Newsletters Move Markets? Financial Management, Vol. XXXXII, (2), 315-338. And see Brown, S., Powers, E., & Koch, T. (2009). Slippage and the Choice of Market or Limit orders in Futures Trading. Journal of Financial Research, Vol. XXXII (3), 305-309)
I hold a Ph.D. in Finance from the AACSB Accredited Darla Moore School of Business of the University of South Carolina. My dissertation on futures market slippage was sponsored by The Chicago Board of Trade. Eric Powers, Tim Koch, and Glenn Harrison composed my dissertation committee. Professor Powers holds his Ph.D. in finance from the Sloan School of Business at the Massachusetts Institute of Technology [MIT]. Eric is a leading researcher in corporate finance and is a thought leader in spin offs and carve outs.
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My dissertation proved that under normal conditions traders and investors are better off entering on market while protectingwith stop limit orders. The subsequent article was published in the prestigious Journal of Financial Research now domiciled at Texas Tech University — a leading research institution.
I earned a masters in international financial management from the Thunderbird American Graduate School of International Business. Thunderbird consistently ranks as the #1 international business school in the U.S. News & World Report, and BloombergBusinessWeek.
I spoke at the 2010 annual conference of the International Association of Business and Economics (IABE) conference in Las Vegas, Nevada. The research presented facts regarding price changes as orders flow increases in the stock market by advisory services.
I spoke at the 2010 Financial Management Association [FMA] annual conference in New York on investment newsletters. The paper was later published in the prestigious journal “Financial Management.”
I presented an important study named “Do Investment Newsletters Move Markets?” at the XLVI Annual Meeting of the Consejo Latinoamericano de Escuelas de Administración (CLADEA) in 2011 in San Juan, Puerto Rico. The year before that I presented my futures slippage research at a major renewable energy conference in Ubatuba, Brazil.
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I presented a working paper entitled “The Life Cycle of Make-whole Call Provisions” at the 2013 Annual Meeting of the Southern Finance Association in Fajardo, Puerto Rico in session B.2 Debt Issues chaired by Professor LeRoy D. Brooks of John Carroll University. Luis Garcia-Feijoo of Florida Atlantic University was the discussant. I chaired the session entitled “Credit And Default Risk: Origins And Resolution.” Then I was the discussant for research entitled "NPL Resolution: Bank-Level Evidence From A Low Income Country" by finance professor Lucy Chernykh of Clemson University and Abu S Amin of Sacred Heart University and Mahmood Osman Imam of the University of Dhaka in Bangladesh.
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In October of 2010 I arranged for the donation to The Graduate School of Business of the University of Puerto Rico of $67,248 worth of financial software to the department that has been used in different courses. This was graciously awarded by Gecko Software.
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Dr. Scott Brown, Associate Professor of Finance of the AACSB Accredited Graduate School of Business of the University of Puerto Rico.