This Week…

We’re zooming in on a well-known, impactful, and initially intimidating corner of the global financial system: the futures market. 

Whether you trade futures or not, all investors should understand how this market influences a vast array of underlying securities. 

In this issue, we’ll cover 2 things:

• The futures market basics that every investor needs to know.
• How some investors use futures as another speculative tool to gain an edge.

Now let’s get started.

Welcome to the Game

Welcome to The Game of Investing, a bi-weekly newsletter bringing you “aha” moments and actionable lessons from Real Vision experts. No matter your level of expertise, markets are tough — which is why we all have to put in the work. Ultimately, the game of investing is a competition with yourself. Our mission is to help you navigate the path to success. Prepare to level up.

LEVEL 1  — The Background & Basics

The futures market is an auction market where traders buy and sell contracts for delivery on an agreed-upon future date. These contracts lock in future delivery of the underlying security being sold at a price set today — aka for the future.

Unlike options contracts, which can become worthless at the date of expiration, when a futures contract expires, the buyer is required to buy and receive the underlying asset, and the seller is obligated to provide and deliver the underlying asset.

A few examples of major futures markets are the New York Mercantile Exchange (NYMEX), the Chicago Board of Trade (CBOT), and the London International Financial Futures and Options Exchange (LIFFE).

• Previously executed in physical trading pits, futures trading today is almost entirely electronic — ensuring quick execution, efficiency, and more accessibility.

The futures market was created for producers and suppliers of commodities to avoid market volatility.

• Futures contracts allow the suppliers of a contract to negotiate with an investor ahead of the actual delivery date.
• In buying the contract, that investor takes on both the risk and reward of future market volatility.

Today, investors can buy and sell futures on everything from oil to stocks, interest rates, implied equity volatility (VIX), or even crypto. And that same risk-reward balancing act is at the heart of it all.

And when it comes to some products, like the VIX, investors can’t trade the underlying asset at all. Only VIX futures are available to be traded.

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LEVEL 2 — Trading Futures

So, why trade futures? The futures market has longer hours, which means investors can watch overnight to get a sense of broader market behavior, potential key price levels, and more.

Primarily, investors trade futures for 2 reasons: hedging and speculation.

• Futures hedging strategies are most used by institutional investors or companies, often to manage the future price risk of that security in their larger portfolio.
• Speculating with futures is more common for individual investors who don’t own the underlying security. These investors use futures to express an opinion, then, before expiration, they will buy or sell an offsetting position to eliminate any obligation for delivery.

These days, thanks to a trading strategy called “rolling,” most futures contracts rarely result in delivery.

• Rolling contracts — If a trader owns a contract set for September delivery, he can “roll the contract” into December (or any later month) by simultaneously buying a December contract and selling the September contract. To do this, he just must pay the difference between the 2 positions.

Like any other security, futures activity levels all depend on market liquidity. To judge this, traders track open interest in futures markets. 

• Open interest — Measures the number of futures contracts held by traders in active positions. These positions have been opened, but have not been closed out, expired, or exercised (i.e. taken for delivery).

When open interest goes up, it represents new money coming into the market. When open interest decreases, it means money is leaving the market. Open interest in the futures market typically increases when the present-day outlook is uncertain (and vice versa), but it is not indicative of price direction.

Next Time

Thanks for reading. In our next issue, we’ll look at systematic trading strategies with a deep dive into the legendary “turtle traders.”

See you then.

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