Futures Trading 2 - CBOT Introduction

Continue from Part 1 .... (by John Carter)

Key Points: How Do Futures Work?

• First off, when you buy a futures contract, you are not physically buying anything. This is simply a way to participate in the price movement of the market of your choice. If you think a market is going to move 10 points, you can buy a futures contract, long or short, and make money on the move if it goes in your direction. Also, if you own a stock index futures contract that expires, you are not going to get a bunch of stock certificates dumped on your doorstep. The expired contract will be converted to cash, and you will see the cash in your account.

• For price movement: If you have 1 contract in the E-mini S&P, and it moves 1 point (i.e., from 1032.75 to 1033.75) that translates into $50 in your profit and loss (P&L). For the E-mini Nasdaq, a 1 point move equates to $20. For the CBOT mini-sized Dow, a 1 point move is $5.00. So, if you buy 3 S&Ps, and you get 10 points, that is $50 x 10 points x 3 contracts = $1500.00. For the Nasdaq and the Dow, it is the same thing, except you would use $20 per point on the Nasdaq and $5.00 per point on the CBOT mini-sized Dow.

Figure 2.1 shows a CBOT mini-sized Dow trade with 10 contracts. In the above chart, a 27 point move in the CBOT mini-sized Dow with 10 contracts is $1350.00.
• Of course, this goes both ways so money management is the absolute key to trading futures. It is imperative that you know your stop before you start, and you stick to it no matter what. In futures trading, hoping and praying can lead to ruin. However, the nice thing about futures is that they are so quick and the fills so clean that you can get stopped out, then a few seconds later you are right back in. You can't be afraid to take small losses, period. Reentry is only a commission away.

• Electronic contracts were set up specifically for traders: They are super liquid and fills are instantaneous.

• If you think the market is going to breakout, you can buy a stock like INTC and watch it sit there while the market roars on without you. You were right on the market—but your stock pick didn't move with the market. With CBOT mini-sized Dow futures you are trading the market. It is what it is. There are no games.

• You can short on a downtick—this makes a huge difference in trying to get filled during a breakdown. If you short KLAC "at the market" on a breakdown, you may not get filled for 20 cents until it has an uptick. If you short the futures "at the market" on a breakdown, you get a quick fill at the current market price. With stocks, you had "bullets" for a while where you could set these up with your broker and short a stock on a downtick. Unfortunatley, these were recently removed.

• I used to be a big trader of OEX options for day trades. After trading futures, I stopped trading OEX options. The spreads and premium of options now looks ridiculous. Where else can you be dead right on an intraday move and still lose money? The OEX options market! Although I do use options for swing trading, I wouldn't day trade them with a 10 foot pole. Not when the CBOT mini-sized Dow futures are so clean and efficient.

• You can do most of your trades "at the market" and get good fills, unlike stocks and especially unlike options.

• For stocks, you need $25,000 to day trade. For futures you can open an account with $5,000 (or less) and day trade. There is no "day trading" rules or classifications.

• To buy one of the futures contracts discussed in these trading lessons, you need about $2,000 in your account. This varies by broker, and can be lower, but this is an average. This "deposit" money required by a broker before you can start trading is called margin, and you can think of it like putting down a 3% down payment on a house. So if you have a $10,000 account, you can buy 5 contracts, and sometimes more by utilizing lower intraday margin rates. However, for money management purposes, I heartily recommend giving some thought to how many contracts you trade in your account. This is a critical part of your trading plan. Just because you can trade 5 contracts in a $10,000 account doesn't mean you should! I typically trade 1 contract for every $10,000 to $15,000 that is in my account. This way your account swings will not be as severe, and you will be able to trade with a level head. One trader friend of mine trades 1 contract for every $50,000 in his account. He makes money and is never stressed out. For managed accounts, I usually trade 1 contract for each $25,000 in the account. Conversely, I've seen programs that say to take a $5,000 account and trade 5 contracts, and by doing this you can make six figures a year. This is insane and you would be better off donating that $5,000 to charity, because you will lose it all trading it that way. There are few guarantees in the futures industry, but losing all of your money trading with this much "maxed out" margin is the one sure bet available today.

• There are now futures on stocks. Using Single Stock Futures traded in the U.S. at OneChicago as swing trades in combination with index futures is a great way to trade and hedge your bets. Although some of the symbols have low actual volume, the "real volume" is based on that of the underlying stock. If you want to buy 100 contracts (1 contract = 100 shares of stock), and you put in a limit order in between the bid and the offer, you will get a nearly instantaneous fill.

• With futures, at the end of the year you don't have to list each individual futures trade like you do stocks for your U.S. tax return. You get a 1099 form from your broker with your total profit or loss for the year. All you put on your tax return is that number on the 1099. That is much easier and much less time consuming than listing out every trade, like you have to do with stocks. And the good news is taxes! For stocks, you have to hold them over a year to get classified at the cheaper "long term gain" rate. For futures, you get a 1099 that says, for example, $20,000 in gains for the year. Of this, 60% of the money is treated as long term gains (lower tax rate) and 40% at the short term rate. This is the "60/40" rule. This rule holds true even if you go flat at the end of every trading day.

• You can trade futures in your IRA. This means you can short stocks in your IRA (Single Stock Futures) or the indexes, which you are not allowed to do in a regular IRA. To set up your IRA for trading futures, you need to first go through a Trust Company set up specifically to do this. What you then do is open an account with the Trust Company, and then they will wire the funds to your futures broker. This way it stays classified as an IRA and you don't have to pay taxes on any gains. Not every futures broker is experienced with this. If you are interested in doing this, be sure to work with a broker that has done this before. It is one way to bring diversification to a portion of your retirement funds.

• Each stock index futures vehicle has four contracts that are traded each year: March (H), June (M), September (U) and December (Z). You will want to trade the closest month, as that is where the volume is concentrated. For example, if today is February 15, 2005, then the closest month is the March 2005 contract. To get a quote for the March 2005 contract on the CBOT mini-sized Dow, you would enter in the symbol, month and year. In this case, that would be YM (symbol), H (Month = March), 05 (Year = 2005). The full symbol would be YMH05. This is for TradeStation. For Esignal it would be YM H5. Each quote service is a little different. When one contract expires, you just start trading the next contract out. TIP: The stock index futures expire the same day as options expiration, on the third Friday of the month they are being traded in. However, you will want to start trading the next month out the week before expiration, as all of the volume will switch to the next month on Thursday of the preceding week. Bonds actually switch three weeks early. Each contract is a little different. If you aren't sure, just ask your broker, write it down and put it next to your PC (or email CBOT or CME to find out what you need to know, if it's not already listed on their websites). This way you will never mess this up. Also, because these are futures contracts expiring at different dates in the future, there is always a price difference between two contracts based on the market's expectation of where each contract will settle. While the March 2005 contract might say 10686 for the CBOT mini-sized Dow, the June contract might say something like 10694. Also note there is usually a 10 to 20 point different between the CBOT mini-sized Dow futures price and the Dow Jones Industrial AverageSM cash price. There is a very complicated explanation for this involving "fair value" and "future price projects" and yada, yada, yada. Bigger picture this it is just something to be aware of. Keep this in mind as you are switching contracts and calculating pivots.

That's the basics. The key is to just get comfortable with your futures broker layout. Do some "paper trades" on their simulator to get a feel of the system, and when you start out, just trade one contract to get a feel of how it works. You will make mistakes, and a mistake on 1 lot is a lot cheaper than a mistake on 10 lots or more. If you have never used a futures broker before, be sure to talk to other traders to check out rates, levels of service, and so forth.

If you want some more "Futures 101" reading, the CBOT has a publication called "Trading In Futures - An Introduction" that you can read online or order for free, plus there's an online interactive tutorial available in the education area of www.cbot.com.

Let's now take a look at why the CBOT mini-sized Dow is my favorite futures contract to trade.

Profitable Futures Trading.