Last Updated on June 24, 2020
What are the common types of futures trading strategies? Here is a list:
- Calendar Spreads – Spreading the same future, but of different expiration dates
- Spreading 2 different futures to trade relative value
- Spreading a future and its underlying asset
- Spreading 2 similar futures that are listed on different exchanges
- Spreading unregulated futures
We will review each of these strategies and give them a score.
Scoring Criteria:
- Profitability
- This refers to potential profits if you manage to execute the trade
- Ease of execution
- This refers to how easy it is to execute the trade as an individual retail trader
- Complexity of trade
- Self-explanatory
Non-unique futures strategies
The following are strategies not specific to futures, but can be done with futures. We will not cover them in this article.
- Trading futures directionally and for leverage. This is known as trading in an outright manner.
- Trading futures because
the trader has no access to the underlying
- Because the underlying is not tradeable. Eg. Temperature futures
- Because the trader has geo-political limitations
Before we can talk about strategy, let’s do a quick summary of what futures are. You can skip the next part if you are familiar with futures.
What are futures?
Official definition: A futures contract is an obligation to buy or sell an asset at a certain price and time.
This means that a future contract will dictate that Trader X will buy Asset A at Price B from Trader Y at Time C.
Trader X buys a future from Trader Y.
Trader Y is able to sell (AKA short) this future without first owning it. This is because selling a future is simply an agreement to sell a certain asset in the future.
Asset A is known as the underlying asset, also known as the spot. (We will use the terms, underlying asset and spot interchangeably.)
Price B is the price of the future.
Time C is the expiration date of the future.
If you buy a coffee future contract, which expires in 6 months, at $105, it is an obligation to buy the underlying coffee product at $105 in 6 months’ time. The trader who sold you that same future at $105 is obliged to sell you the underlying coffee product at $105 in 6 months’ time.
Thus, you can think of a future as a product whose price is dependent on its underlying asset.
Expirations
Futures have expiration dates. The name of the future will include the expiration month and year.
Eg. The shortname for the Three-Month EURIBOR Futures that is traded on the Intercontinental Exchange (ICE) is I.
IU19 means that this I contract expires on September 2019.
I H22 means that this I contract expires on March 2022.
The letters U and H represent the month. The numbers represent the year.
How do I know which month the letters in the name refer to? Refer to this list.
This month code is standardised across all futures products (bonds and other asset classes).
Once the futures expire, 2 things can happen.
- Exchange of goods – If you bought a coffee future, you are now obliged to receive physical coffee from the seller of that futures. Congrats you are screwed.
- Cash-settled futures – Some futures don’t require physical delivery of goods. You pay (or get paid) the difference between the current underlying price and the price previously agreed upon.
Let’s use the previous example where the trade happened at $105 and assume that the coffee future is cash-settled. If prices today are at $110, then the buyer of that future profited $5 from the seller. The seller will pay the buyer $5 when the future expires and be done with it.
How to trade futures?
Trading futures involves taking advantage of the unique features of futures: 1) Futures expiration dates 2) Futures Rollovers and 3) Futures and their underlying assets.
Let’s cover this list of strategies one by one:
- Calendar Spreads – Spreading the same future, but of different expiration dates
- Spreading 2 different futures to trade relative value
- Spreading a future and its underlying asset
- Spreading 2 similar futures that are listed on different exchanges
- Spreading unregulated futures
Wait, what does spreading mean? It simply means to long one asset and short another.
Thus, when I say “Spreading a future and its underlying asset”, I mean to long the future and short the underlying asset, or vice versa.
» To live trading futures (live or demo), check out this guide: Interactive Brokers Python API (Native) – A Step-by-step Guide
Strategy 1: Calendar Spreads – Spreading the same future, but of different expiration dates
Buying one future of a certain expiration date and selling another of a different expiration date is known as a calendar spread.
This spread is known as an intra-contract spread as we are trading the same future of different expiration dates.
To better understand this strategy, we will look at a real-life example.
Case Study: Euribor Calendar Spreads and Butterflies
Asset background
- Asset: Three-Month Euribor Futures (Shortname: I)
- Details: Link to product specifications
- Exchange: Intercontinental Exchange (ICE)
- Opportunity in this strategy: This strategy creates a stable mean-reverting price structure.
The Euribor future is priced based on the Euribor (you don’t say).
Official definition (from Wikipedia): The Euro Interbank Offered Rate (Euribor) is a daily reference rate, published by the European Money Markets Institute,[1] based on the averaged interest rates at which Eurozone banks offer to lend unsecured funds to other banks in the euro wholesale money market (or interbank market).
In simple English: It is the average interest rate European banks charge each other for short term loans.
The Three-Month Euribor Futures expiring in Mar 2020 is known as the IH2020 contract. The I stands for the futures name, H tells us that the contract expires in March, and 2020 tells us it expires in 2020.
IH2020 can be written as IH0. IH2021 can be written as IH1 and so on.
IH0 can be interpreted as IH2010 or IH2030. But judging that we are in 2019 (as of this writing), it is understood that IH0 refers to IH2020.
Price vs Expected Interest Rates
The price of a Three-Month Euribor Future is inverse to interest rates.
It is approximated as 100.00 minus the expected interest rate [1] (at the time of the futures expiration).
Thus, if the Euribor rate is expected to be 2% at March 2020. IH2020 should be trading around 100 – 2 = 98.
Since the rates in Europe are negative, the chart above shows the IH2020 is trading at 100.41 (calculated from 100 – (-0.41)).
Understanding Calendar Spreads
When we buy an IH0 contract and sell an IM0 (expires in June 2020) contract, we are effectively longing a calendar spread of H0M0.
On the other hand, when we sell an IH0 contract and buy an IM0 contract, we are effectively shorting a calendar spread of H0M0.
When we long a H0M0 spread, we are essentially betting that the Euribor in June 2020 will rise (remember, when rates rise, future prices fall) compared to the March 2020’s rate.
In other words, we are betting that the price difference between IH0 and IM0 will narrow. If we short H0M0, we are betting that the price different will widen.
Mix and matching spreads
You can think of a H0M0 spread as an exposure to 3 months’ worth of Euribor risk.
Similarly, a H0H1 spread essentially contains 12 months’ worth of Euribor risks.
Spreads can be mixed and matched to equate to each other.
A H0H1 spread is equivalent to a H0M0 + M0U0 + U0Z0 + Z0H1 structure as each of the 4 latter spreads consists of 3 months’ worth of risks each.
There are other ways to recreate a H0H1 structure:
- H0U0 + U0H1 (6 months + 6 months)
- H0M0 + M0H1 (3 months + 9 months)
- H0Z0 + Z0H1 (9 months + 3 months)
This knowledge is useful for us when we want to rotate our positions, and it is important for us to understand the next part – Euribor Butterflies.
Euribor Butterflies
We are finally talking about the real strategy.
What do you think the following structure represents?
H0M0 – M0U0 (note that previously we were adding the 2, now we are minusing)
H0M0 – M0U0 can be written as H0 – 2*M0 + U0.
Look at that beautiful thang!
If you don’t know what’s the trade to fire for this price behaviour, you can close this tab now and go learn another profession.
The chart above represents a Euribor Butterfly. (And no, this is not the same as an option butterfly.)
When we long H0 – 2*M0 + U0, we are long 1 contract of H0, short 2 contracts of M0 and long 1 contract of U0.
We are essentially betting that the Euribor rates in June 2020 will rise relative to March 2020 and September 2020.
Hedging and Risk Exposure
If H0M0 + M0U0 has 6 months of Euribor exposure, how much exposure does H0M0 – M0U0 have?
The answer is ZERO!
The beautiful thing about the Euribor butterfly is that it is hedged to almost everything! You don’t even hold any net Euribor exposure.
It is hedged to most macroeconomic events, to stock market movements, to the country’s economic conditions, currency risks, to the credit rating up or downgrade of corporate bonds, tweets from politicians etc.
This means that you can sleep well at night.
This structure consists of futures of 3 different expirations. We can go one step further and build structures consisting of 4 or more expirations.
Why trade future butterflies
The obvious answer is to trade the butterfly’s mean reverting behaviour.
But if we break it down, there are 2 ways to trade this:
- Use it to bet on future Euribor price change
- Mean revert it by executing the butterfly at good prices
Method 1:
This was what we spoke about when we mentioned that longing a H0 – 2*M0 + U0 butterfly is essentially betting that the Euribor rates in June 2020 will rise relative to March 2020 and September 2020.
Method 2:
The mean reversion trade looks obvious but it is hard to execute.
Here your trading edge is that you can enter the individual contracts at better prices than the other market players.
In the above chart, you want to long the butterfly at the green lines and short at the red lines.
But but… the prices didn’t even hit those areas, how is that possible?
2 reasons:
First, the prices above are from the end-of-day. This means that there are opportunities to get prices nearer to the red and green lines if we look at the intra-day price data.
Second, remember that this chart is made up of 3 separate futures (H0, M0 and U0). The lazy and unprofitable way to enter these 3 legs is to be a price taker (i.e. buy at the ask price and sell at the bid price).
If we enter each trade at slightly better prices than just being a price taker, you’ll end up with prices nearer to the red and green lines.
That said, if you are a lazy trader, you can still be profitable as long as you are patient and wait for the prices to diverge far off the mean.
Other butterflies
In our case study, we used Euribor futures as our asset class, but there are other interest rate and non-interest assets (like commodities) we can trade.
Here is a list of interest rate products: STIR Futures
Ending notes for Strategy 1
We’ve only briefly talked about the basics of the butterfly strategy. The devil lies in the details.
The strength of this strategy is the trader’s execution prowess and asset selection.
There are risks for this strategy too. Most of it comes of black swan risks and poor execution, but there are ways to mitigate those.
Strategy 1 Grades
- Profitability (5 points = Very Profitable): 4/5
- Ease of execution (5 points = Very Difficult): 4/5
- Complexity of trade (5 points = Very Complex): 3/5
Strategy 2: Spreading 2 different futures to trade relative value
When we long Gold and short Silver, we are said to have long a Gold-Silver spread. We are betting that Gold rises relative to Silver.
This is called a relative value trade, as we are not concerned with the absolute price behaviour of Gold (or Silver). We are only concerned about how Gold rise or fall relative to Silver.
These spreads are known as inter-contract spreads as we are trading 2 separate contracts.
The above shows the spread between Gold and Silver Futures. Hedged by contract value as of today (8th Dec 2019).
Spreading to target specific risk exposures
Another way to think about relative value trading is to target specific risks.
Spreading between 2 different futures allows to hedge against unwanted exposures and keep specific exposures.
Example: Spreading 2 hypothetical stocks
Let’s say we believe Stock X has better technology than its competitors. We want to make a long bet on its tech.
In this case, we want to take a risk on Stock X’s tech prowess.
But Stock X is more than just its tech, it includes operations, management, marketing, stock market influence and other factors. If we long Stock X, we will essentially be taking a bet on those other factors too.
The solution? Hedge away the unwanted factors (i.e. hedge away unwanted risk)
We find a stock that is similar to Stock X in every way except its tech. Let’s call this Stock Y.
And we short Stock Y.
The final trade is to long Stock X and short Stock Y. To put this in math form:
Stock X – Stock Y = (A+B+C) – (A+B-D) = C – D
Where A, B, C, D are factors and C and D represent the tech of Stocks X and Y respectively.
Now, you’re left with C-D, which is the difference between the tech ability of Stock X and Y.
This is the targeted risk we want.
Hedging Ratios – How much to long and short
The short answer is, you want both assets of your spreads to move the same amount when the hedged exposure moves.
I’ll write a separate blog post on calculating hedging ratios.
Essentially, you want to be immune to the hedged exposure.
Example 1: Long Stock A and short Stock B
Both Stock A and B are correlated to the general stock market. This means that when the S&P500 moves, Stock A and B will move too.
How much Stock A and B move is proxied by a metric called market Beta. Beta measures the sensitivity of a stock price change to the relevant general market’s change.
If Stock A’s beta is 1.5, this means that it moves 1.5% when the market moves.
(p.s. Beta is a generic metric calculated from historical data. The value of the betas changes over time should only be used as an approximation.)
When we spread Stock A and B, we are trying to hedge away market risk.
To do that, we may enter more positions of the Stock with the lower beta and less of that with the higher beta.
Thus, if Stock A’s beta is 1.5 and B’s beta is 2, we long 4 shares of A and short 3 shares of B. (Math: 4 x 1.5 = 3 x 2)
Example 2: Long Bond A and short Bond B
There are no betas in bond. But there is duration.
Duration is a metric that measures the sensitivity of the price of a bond to a change in interest rates.
You can think of duration as the equivalent of beta for bonds.
Similarly, buy more of the bond with lower beta and less of that with higher beta.
Common Futures Spreads
Here is a list of common inter-contract futures spreads:
These spreads consist of 2 assets.
However, we can add more assets to our spreads. The more assets, the more stable the price behaviour of the spreads.
One example of a 3-legged structure is to long the 2-year, short the 5-year and long the 10-year treasuries in a duration-neutral manner. This is similar to our intra-contract butterflies in strategy 1.
Strategy 2 Grades
- Profitability (5 points = Very Profitable): 2.5/5
- This has less to do with the spread and more with your understanding on the underlying products
- Ease of execution (5 points = Very Difficult): 1/5
- Complexity of trade (5 points = Very Complex): 2/5
Strategy 3: Spreading a future and its underlying asset
A futures contract is based on an underlying asset (AKA spot).
The futures contract and the spot are priced equally on the future’s expiration date, but they are usually not priced equally leading up to the expiration date.
The basic idea of the trade
When the futures’ price is higher than the spot price, it is said to be in contango.
In contango, you want to short futures contract and long the spot leading up to the expiration date. This is known as a cash-and-carry-arbitrage.
When the futures’ price is lower than the spot price, it is said to be in normal backwardation (commonly known as just backwardation).
In backwardation, you want to long futures contract and short the spot leading up to the expiration date. This is known as a reverse cash-and-carry-arbitrage.
Reasons of Contango and Backwardation
Reasons for contango
- Increasing future demand
for the underlying
- With higher future demand, the future contract which settles in a later date, will be more in demand. More demand leads to more buyers and a higher price for the futures.
- Sudden increase in supply
of the underlying
- More supply leads to lower current spot price.
- Cost of storing of the
underlying asset is positive
- If the underlying needs a place to be stored, there is a cost associated with this storage. Eg. If our coffee future expires 6 months later, there is a “theoretical” storage cost to hold the physical coffee for 6 months. This causes the future price to be slightly higher than the spot.
Reasons for backwardation
- Decreasing future demand
for the underlying
- With lower future demand, the future contract which settles in a later date, will be less in demand. Less demand leads to less buyers and a lower price.
- Sudden decrease in supply of
the underlying
- Less supply leads to higher current spot price.
- Cost of storage is
negative (i.e. the is interest to be earned by storing the goods)
- Sometimes the stored goods can produce positive yield for the person who holds the goods. This is known as convenience yield. Eg. Holding oil might help one profit when there is a sudden supply crash or he can use it in some production process.
Risks of Cash-And-Carry-Arbitrage
Strictly speaking, an arbitrage is a risk free trade that takes advantage of a mispricing between 2 similar assets.
However, the cash-and-carry arbitrage is not risk free.
Here are some risks or factors that diminish this trade’s profitability:
- Cost of longing or shorting the spot is not zero. These costs might be equal to or more than the profit from the arbitrage
- Increase in margin requirements for futures
- Sudden demand or supply shock might cause a margin call
- Liquidity risks
Strategy 3 Grades
- Profitability (5 points = Very Profitable): 1/5
- This strategy is too obvious.
- Ease of execution (5 points = Very Difficult): 1/5
- Complexity of trade (5 points = Very Complex): 1/5
Strategy 4: Spreading 2 similar futures that are listed on different exchanges
This strategy involves longing one future and shorting a similar one on another exchange.
Let’s use gold as an example. Gold is listed on multiple exchanges.
If a gold future is traded at a lower price on COMEX and at a higher price on TOCOM (accounting for currency differences), we long Gold on COMEX and short it on TOCOM.
Reasons for futures mispricing
Mispricings arise between different exchanges as there might be regulatory controls at certain exchanges (eg. daily price move limits), demand or supply shocks in one country, different trading times, and the lag in the transfer of news.
Arbitrage Risks
Your risks will involve currency movements, capital controls, limitations over the transfer of goods.
Strategy 4 Grades
- Profitability (5 points = Very Profitable): 1.5/5
- The strategy is too obvious and competitive.
- Ease of execution (5 points = Very Difficult): 5/5
- Whatever opportunities remaining are hoarded by high-frequency hedge funds.
- Complexity of trade (5 points = Very Complex): 1/5
Strategy 5: Spreading Unregulated Futures
Unregulated futures are products that behave like futures, but they are not listed on traditional futures exchanges.
The most common type of unregulated futures is in the cryptocurrency market.
The biggest crypto futures exchange is BitMex (as of today, Dec 2019).
Unregulated futures are generally more inefficient and have more mispricings compared to traditional futures (partly due to possible market manipulation).
Thus, by following the first 4 strategies listed in this article and applying them to these unregulated futures, there is potential for profit.
Since these futures are not regulated, it is sort of a wild west. There are opportunities for profits but you might be get sucker-punched and lose money too.
Have fun in these markets, but do make sure it is legal to trade these unregulated futures in your country!
Strategy 5 Grades
- Profitability: ??
- Ease of execution: ??
- Complexity of trade: ??
What platform or broker should I use for futures trading?
I shan’t do a full review here but here is a list of brokers for retail traders:
Interactive Brokers – Lowest commissions
TD Ameritrade – Best trading platform
TradeStation – Great platform, competitive rates
Charles Schwab – Unique order types
E*TRADE – Well-rounded offering
Source: stockbrokers.com/guides/futures-trading
What does a professional futures trader computer screen look like?
A futures trader might have 4 to 8 computer screens.
This is how a professional futures trader’s typical screen will look like, especially if you are spreading intra-contract futures.
Related Questions
How much do you need to trade futures? A ballpark number is $10,000. Every futures trade requires you to put up money for margin. You need enough capital to 1) enter your trades with proper sizing position sizing, 2) buffer for losses and 3) maintain an account minimum.
This article will be helpful: “Minimum Capital Required to Start Day Trading Futures”
How to price futures? The academic answer is: Futures Price = Spot Price × (1 + Risk-Free Interest Rate – Income Yield).
More info here: Futures Pricing (Wikipedia)
This article is not financial advice!
