The derivatives market is the biggest market in the world and futures contracts are among the oldest investing instruments in history.
In this article, we are going to make an introduction to the futures contracts and present the futures spread strategy.
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What is an Index Futures Contract?
In 1864, futures contracts based on grain became available as a trading vehicle and before 1970, all futures contracts had strictly commodities as underline assets. Today, futures contracts can be derived from stock indices, interest rates, forex, etc.
A futures contract, in its basic definition, is a promise for receiving or delivering a predefined quantity of an underline asset at a predetermined date in the future.
Perpetual futures, on the other side, do not have a predefined date.
The main difference between options and futures contracts is that options contracts offer to a buyer, as the name implies, an option on whether or not he or she will exercise the contract or not.
A forward contract is basically the non-standardized, OTC version of a futures contract.
The main characteristic of futures contracts is asset delivery. short positions are obligated to deliver the underline asset, either commodity or cash settlement, and long positions must accept the delivery of the same asset at the expiration date. Of course, most traders are not interested in asset deliveries, and before the expiration date, they hedge their position by opening the reverse position. Many resources mention that only 3% of the overall futures contracts result in asset delivery.
Futures Contract Expiration Month Symbols
- January = F
- February = G
- March = H
- April = J
- May = K
- June = M
- July = N
- August = Q
- September = U
- October = V
- November = X
- December = Z
Stock Index Delivery Months
- March = H
- June = M
- September = U
- December = Z
The Chicago Mercantile Exchange (CME)
The oldest futures and options exchange in the world is the Chicago Board of Trade (CBOT) which was founded in 1848 in Chicago, Illinois in the US. At the time it acted as a centralized entity that cross-checked sellers and buyers of derivative products.
CME was founded in 1898 as an agricultural commodities exchange, and since 2002 CME is a public company with the ticker $CME. In 2008, it merged with CBOT to form the CME Group.
The image has been taken fromhttps://www.cmegroup.com/
The image has been created with Google Maps
The CME exchange, and thus futures trading, can be facilitated from Sunday at 05:00 PM to Friday at 05:45 PM. The futures market closes just for an hour every day. This makes the futures market a 23-hour tradable market.
For a European citizen in the +2 Zone, this would mean Monday at 00:00 AM to Saturday at 00:45 AM.
Since Futures contracts are traded during stock market off hours, one can see how the market is reacting in pre and after-hours.
A great webpage to track all opening and closing market hours ishttps://www.market-clock.com/.
Full-Sized, E-Minis, & Micro Futures Contracts
In 1865, the first futures contracts were created. The notional value of the initial Futures Contracts grew so much along with the stock market, that smaller investors would require a huge amount of capital to enter into a trader with them. To sold that problem, the CME Group introduced the “E-Mini Stock Index Futures Contracts” in 1999.
Since 2019, the CME group has introduced the “Micro E-Mini Stock Index Futures Contracts” to the market. A Micro E-Mini Futures Contract has 1/10th of the size of a standard E-Mini Futures Contract.
Full-Sized
- S&P 500 (SP) = $250 times index value
- Russell 2000 Index (RUT)= $100 times index value
- NASDAQ 100 (ND) = $100 times index value
- Dow (DJ) = $10 times index value
E-Minis
- E-mini S&P 500 (ES) = $50 times index value
- E-mini Russell 2000 Index (RTY)= $50 times index value
- E-mini NASDAQ 100 (NQ) = $20 times index value
- E-mini Dow (YM) = $5 times index value
Micros
- Micro E-Mini S&P 500 (MES)= $5 times index value
- Micro E-Mini Russel 2000 (M2K)= $5 times index value
- Micro E-Mini NASDAQ-100 (MNQ)= $2 times index value
- Micro E-Mini Dow (MYM)= $0.5 times the index value
The Inter-Market Futures Spread Trading Strategy
The term inter-market implies entering a trade in different underlines, but with the same expirations.
The term “spread” means that a trader would need to open simultaneously a long and a short futures position.
With this strategy, a trader tries to take advantage of the price discrepancies of two futures contracts, with the same expiration date, on two different but highly correlated underline assets. The end goal is to earn the difference in the price between the contract sold and the contract bought. These two positions are been treated as one position, and each individual position is called a “leg”.
E-Mini Stock Index Futures Contracts Spread Trading
Some possible index futures contracts to be traded as pairs, as they are described in Jack D. Schwager’s book “A Complete Guide to the Futures Market“ are:
- E-mini S&P 500 (ES) (Large Caps) with E-mini Dow (YM) (Blue-Chips)
- E-mini S&P 500 (ES) (Large Caps) with E-mini NASDAQ 100 (NQ) (Technology)
- E-mini S&P 500 (ES) (Large Caps) with E-mini Russell 2000 Index (RTY) (Small Caps)
- E-mini NASDAQ 100 (NQ) (Technology) with E-mini Dow (YM) (Blue-Chips)
- E-mini NASDAQ 100 (NQ) (Technology) with E-mini Russell 2000 Index (RTY) (Small Caps)
- E-mini Dow (YM) (Blue-Chips) with E-mini Russell 2000 Index (RTY) (Small Caps)
Sizing
The biggest issue when trading futures spread is the correct contract sizing. Even if one could successfully enter a trade with the correct bias, the sizing difference might bring the profit and loss of the overall trade to a loss if the contract sizing is skewed towards the losing side.
According to Value
One solution to the sizing problem would be the equal-weighted spread, calculated by the formula below:
A simple contract ratio calculator according to value. (created with Google Spreadsheet)
In the above screenshot, we calculate the contract number for each leg according to their contract value. The only thing that we need to define is the number in the blue box. If we are going to buy 1 NQ contract, then we need 1 ES contract to balance it. For 10 NQ contracts, 12 ES contracts will be more suitable.
According to Bias
Some trades may need to include their personal belief and view in their spread trade. For example, one might think that technology companies will outperform large-caps. Then the position should be skewed in Nasdaq’s favor.
According to Volatility
Another technique will be to adjust the contract ratio by historical volatility using the ATR indicator. The more volatile the index the lesser position should be obtained.
The Intra-Market Futures Spread Trading Strategy
On the other side, intra-market means entering a trade with the same underline, but with different expirations. This is also known as a calendar spread. This strategy is also known as “interdelivery spread”.
An example trade would be to buy the March ES contract and sell the June ES contract.
$E-mini Nasdaq 100 - main 2212(NQmain)$ c$E-mini S&P 500 - main 2212(ESmain)$ $E-mini Dow Jones - main 2212(YMmain)$
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