Are you looking for a trading strategy that will shield you from the current volatility of the U.S. market? With stock futures, you can hedge your bets to maintain your portfolio’s value even in the face of a major move that could jeopardize your profits. Before diving into the world of early hours trading, here’s what you need to know about how stock futures work and how you can best use them to your advantage.
What Are Stock Futures?
Stock futures are contracts in which a trader agrees to a specific stock purchase or sale at a set price on an indicated date in the future.
Current stock futures prices fluctuate based on indices such as the S&P 500 and the Dow Jones Industrial Average. Because you don’t own the actual stock but have a contract to purchase it on the specified future date, you do not receive stockholder benefits such as dividends. However, unlike traditional stock market investing, which pays off only when the stock is on an upward trajectory, with futures you can profit whether the market goes up or down.
So how do futures work on the stock market? Traders choose to take either a long or short position on a specific stock future. If you opt for the long position, you will buy the specified stock at the end of the contract period. On the short side, you agree to sell the stock in question at the end of the contract. You should choose long if you think the stock price will go up over the next three months and go short if you think it will decrease over the same time frame.
Futures contracts expire on the third Friday of March and each quarterly month thereafter. When your contract expires, you can decide to pay out and take your profits or roll it over into a new futures contract, which will start on the second Thursday of the following month.
The change of value in each stock future is represented in your account when the market settles each day. This arrangement is called marked to market. Because the index futures reflects the cash index, it provides an indicator of where the price action is headed.
Sample Stock Futures Scenarios
Let’s take a look at a few examples using real numbers. Imagine you decide to go long on 250 shares of stock from XYZ company, currently trading at $100 per share. Using these numbers, your contract price would be $25,000, paid on April 1 with an expiration date of July 1. Then in June, the price goes up to $150 a share for XYZ stock. When the contract expires on July 1, you can sell your futures contract for $37,500, earning $12,500 in profit.
Now imagine you’re on the short side of a similar scenario. Instead of going up, XYZ stock plummets to $50 per share in June. Your initial price to enter the contract is $25,000. When the price drops, you can buy back the contract at a discount of $12,500, thus earning a profit of $12,500.
With stock futures, you can enter a contract by paying only the margin, which is a percentage of the contract price. The margin for this type of contract is usually 10 to 20%. While this scenario allows you to profit while retaining more of your liquid capital, you can also lose money if the stock rises exponentially when you are in the short position or plummets when you are in the long position.
The value of futures relies on early hours trading. Often, the value of a specific contract can change by the hour or even by the minute based on pre-stock market data such as NASDAQ premarking quotes. Smart premarket screening can give traders a clear sense of the best next move.
Smart Strategies for Stock Futures Investing
Because you can lose big with just a small change in the market, buying individual stock futures can be risky. For this reason, successful investors often use one or more of these strategies to limit their financial risk:
- Hedging their bet by going both long and short on a single stock. For example, a trader might take a long position on a traditional stock and a short position on a future contract for the same stock. With this scenario, you can make money whether the stock goes up or down.
- Using an intermarket spread. Choose two futures in a related market, such as technology. Go long on one and short on the other to potentially profit on both deals.
- Taking advantage of a calendar spread. With this strategy, you can profit from both long-term increases and short-term decreases by purchasing two futures contracts on the same stock, but with expiration dates several months apart.
- Utilizing a matched pair spread. For this type of spread, buy a short position on the stock futures for one company and a long position for the futures of a direct competitor. The idea is that you will at least break even and potentially earn as the firms battle it out over months.
Although it is not a risk-mitigating strategy, many futures investors engage in speculation. This involves taking advantage of small increases and decreases in the market by selling quickly to optimize profit.
Benefits of Investing in Stock Futures
Stock futures have many advantages for successful traders. For one, futures are much easier to trade on the margin than traditional stocks, which are subject to a complicated margin process. This means you can leverage your investment by getting more for your money. In the example above, the investor can buy 250 shares of XYZ futures at a 10% margin for $2,500, compared to just 25 shares of traditional XYZ stock for the same price.
If you like to sell stocks short, the process is also easier and less expensive when you invest in futures. When you short sell traditional stocks, you must borrow the stocks from the broker and incur associated transaction fees and interest. With futures, you can benefit from creative investment scenarios and potentially accumulate a serious windfall.
Drawbacks of Stock Futures
More conservative investors might be uncomfortable with the level of risk associated with stock futures. Unlike with traditional stocks, where you can only lose your initial investment, you could end up owing more than you put in with a bad stock futures deal. In addition, because futures values change so quickly, your contract could be liquidated immediately if the broker issues a margin call.
Futures as an Indicator
Because the Dow and other indices are only open for 6.5 hours in the day, they do not reflect trading and changes occurring in global markets 24 hours a day. The futures market provides a window into the overnight activity in other time zones. Take advantage of overseas stock market futures by watching the global cycle and beginning to get a feel for how patterns emerge in a 24-hour trading timeframe.
Getting Started With Stock Futures
If you plan to get into stock futures as a day trader (individual investor), you must be able to dedicate significant time each day to monitoring the market and deciding when to buy and sell futures effectively. If you are intrigued by the idea of trading futures but have limited time and/or knowledge, consider using a trustworthy brokerage firm. With this arrangement, you can give your broker permission to act on futures with your investment funds depending on your specific goals.
You can also invest in futures through a commodity pool, which is similar to a mutual fund. This scenario limits your risk further because you will not be responsible for an issued margin call.
When you join us at Raging Bull, you can take advantage of the latest investment advice. Sign up for a live webinar with one of our staff trading experts, and download your free e-book to get on the path to a bright financial future through day trading.