The foundations of advanced trading

published 16 October 2014

Most traders get started by dealing in stocks through their stockbroking account. For some people, this meets all their needs and they never have to consider other products. But some of us will get to a point where we want to put together a trade that can't easily or effectively be done using regular stocks.

We may want to employ leverage, meaning that we use borrowed money to boost our returns. We may want to go short, speculating on a fall in the price of an investment, rather than a rise. Or we may just want to access a wider range of assets than are available on the stock exchange.

It's possible to do some of this using exchange-traded products (ETPs). These are listed on the stock exchange and trade like a normal share, but track the price of another asset. Today, investors have access to a huge range of leveraged ETPs, short ETPs and ETPs that track assets such as commodities and currencies as well as stocks and bonds.

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However, while ETPs are very useful, they have their limits. There are many situations where traders would be best served switching to products that suit their needs better. In the rest of this guide, we'll take a look at what these are and how they work.

A beginner's guide to futures

The first product we'll look at is futures contracts. These are thought be the oldest type of standardised financial derivative, dating back to 18th-century Japan, where they were used to speculate on the price of rice.

However, modern futures markets really developed in America in the mid-19th century, when farmers and merchants began trading in agricultural commodity futures in Chicago.

Since then, futures have become one of the most actively traded types of financial instrument around the world, covering a huge range of physical assets (commodities such as agricultural products, energy and metals) and financial markets (such as shares, currencies and interest rates).

So how exactly do futures work?

A futures contract is an agreement between a buyer and a seller to exchange a specified quantity of a specific asset at a specific time in the future for a price agreed today. In some cases futures are settled by physically supplying the asset in question on the delivery date, in exchange for the promised price.

In others, one side will make a cash payment to the other that reflects the difference between the asset's price on the delivery date and the price at which the futures contract was agreed.

Futures contracts are traded on an exchange such as the Chicago Mercantile Exchange (CME) or the London International Financial Futures and Options Exchange (Liffe), which acts as your counterparty in all transactions struck on the exchange. This helps ensure that all contracts will be honoured.

Let's take a real-life example. We believe corn is going to rise in price by the end of the year. We decide to trade this by using the CME's corn futures, picking the contract for delivery in December.

Each CME corn futures contract has a standard size of 5,000 bushels (a bushel is a measure of weight of some agricultural goods). At the time, the contract is trading at 321 cents per bushel.

Through our broker, we buy two contracts, so the total size of our position is $32,100 (2 x 5,000 x $3.21). For every cent the price moves, the value of our position changes by $100. However, futures are a margined product, meaning we only put up a percentage of the face value of the contract at first.

The initial margin we need to put up varies according to the contract for the CME corn futures, it's $1,375 per contract, so $2,750 for our position. You can see from this that if the price moves by just 9%, it will wipe out our entire margin.

So, to ensure we can meet our obligations, CME will require us to post maintenance margin' if the trade goes against us. If we don't our position will be closed out at a loss.

We don't actually want to pay an additional $32,100 and take delivery of about 250 tons of corn. So before the settlement date arrives, we'll sell our contracts and close our position. As it happens, by next week the price rises to 325 cents and we sell. We make $400 (2 x 5,000 x 0.04) on our deposit of $2,750.

The benefits of using futures

You'll note three things from our example. First, we have leverage. Because we only put up a percentage of the value of the contract, small moves in the price make a big difference to the value of our account.

This worked in our favour here, but could equally have led to a big loss. Second, although we've bet on a rising corn price, we could just as easily have gone short by selling a contract rather than buying.

And third, we are trading the price of a physical asset corn that it would be tough to invest in directly. So we can see that using futures lets us achieve all the objectives we mentioned at the start of the article.

That said, it's likely that most readers of this guide will never trade futures. The amount of capital needed to trade many contracts is quite large. And few online brokers in the UK offer futures trading (iDealing, Interactive Brokers and Saxo Capital Markets and other brokers that use Saxo's platform are some that do). There are even easier ways to place similar trades, as we'll see later.

However, futures markets are very actively traded by institutions, and the prices you'll be quoted when you trade an asset using some other services such as spread betting will often be based on the current price available in the futures market for that asset.