How to Trade Futures for Beginners

Upbeat music plays throughout.

Narrator:

If you're looking to trade futures, welcome! By the end of this video, you'll understand some basics of how to trade futures and how to place your first futures trade using thinkorswim^® papermoney^®, a trading simulation platform. Don't worry, we're going to walk you through everything step by step.

My name is Cameron May, and I'm an Education Coach at Charles Schwab. First, we'll dig into a few of the basics about futures and how they work. Next, we'll walk through a speculative trading strategy. Then, we'll show you how to place a basic, practice futures trade on the thinkorswim papermoney platform.

Futures aren't for everyone. The futures market can be fast-moving with a high degree of risk, so education is essential for anyone interested in trading in it. Before trading futures with real money, traders at Schwab must have a margin account with futures approval, but you can use the paperMoney simulated trading platform to practice trading futures anytime without actual cash.

Let's start with some definitions. A futures contract is an agreement to buy or sell an asset at a predetermined price at a specified time in the future. It's what's called a derivative because the contract "derives" its value from an underlying asset. This allows traders to use futures to speculate on the price movement of things like commodities or stock indexes. In this video we're going to focus on trading futures on the S&P 500^® stock index, which can allow traders to potentially profit from price changes in the S&P 500 without having to buy all the stocks in the index. The contract we'll look at is the Micro E-mini S&P 500 Index futures, which is traded using the symbol /MES.

Futures can offer traders some advantages. For example, futures can be traded close to around-the-clock. Different types of futures products have different trading hours, but at Schwab clients can trade /MES futures from 6 p.m. ET in the U.S. all the way until 5 p.m. ET the following afternoon, Sunday to Friday. This allows traders to react to global events outside of U.S. stock market hours. Futures also offer traders leverage, which lets them use a relatively small amount of capital to trade a large position. That capital is a good-faith deposit called the initial margin requirement, and is the amount of cash you have to initially commit to enter a futures position. Leverage on a futures contract comes from the fact that the initial margin requirement is usually a fraction of the notional value of the contract. Futures have a smaller initial margin requirement than stocks and there are no intraday trade limits. Keep in mind that although the initial margin requirement is typically lower for futures than for stocks, futures don't offer some of the potential benefits of owning stocks like voting rights or dividends. Additionally, futures contracts expire after a set period of time.

Because traders can use that little bit of money to enter a large position, small changes in the underlying can translate into large gains. However, the opposite is also true: Leverage can magnify losses quickly and with smaller price movements.

I'll walk through a basic example futures trade to show how this can play out. Let's say Trader A is bullish on the S&P 500 and buys a Micro E-Mini futures contract. You can short, or sell, futures, but in this video we're just going to focus on going long, which is another way of saying buying.

For this example, we'll say that /MES is trading at 5,600, which is a notional value of $28,000. Notional value is the cash equivalent value to owning the underlying asset, or the contract's total value. In other words, if you wanted to buy a portfolio that reflected the S&P 500 with the same value as an /MES contract, you'd have to invest $28,000.

However, by using a futures contract, Trader A can put down a fraction of the contract's $28,000 notional value. Margin is set by the futures exchange and is typically 3% to 12% of the contract's notional value. Some brokers may choose a higher requirement; therefore, initial margin can change at any time.

In this example, let's say the initial margin requirement is $2,073 for Trader A plus commissions and exchange fees.

There are two margins they need to be aware of when trading futures. In addition to initial margin, there's also maintenance margin. Maintenance margin is lower than initial margin. Typically, the initial margin requirement will be 110% of the maintenance margin requirement. When traders first enter a futures position, they need to put up the initial margin requirement; however, after establishing the position, traders are held to the maintenance margin requirement. Falling below this maintenance requirement would trigger a margin call.

Let's look at an example to help illustrate initial and maintenance margin levels.

For this example, Trader A has an initial margin of $2,073, their maintenance margin is $1,885, and their account balance is also $2,073. The cash for the initial margin is automatically set aside in their account once the order is entered.

The next day the S&P 500 falls 20 points. Let's see how this affects our trader.

There's minimum price fluctuation for contracts called the tick size, and for /MES it's 0.25 index points, or $1.25 per contract. The notional value of one contract is calculated by multiplying the current level of the index by $5. It's called the multiplier. Both are set by exchanges like CME Group or Cboe^® and vary from contract to contract.

So, with the S&P 500 falling 20 points, Trader A loses $100. To understand what this does to the trader's balance, let's discuss settlement.

At the end of each trading day, futures trades are settled, or what's called marked to market. This is where the daily gains or losses are credited to or subtracted from the account's cash. Traders who experience a loss will incur a cash debit to their account, and traders who experience a profit will receive a cash credit. Because Trader A lost $100, their account was debited, reducing their account balance to $1,973.

The next day the S&P 500 continues to slide and loses another 20 points, or $100. Because Trader A loses another $100, after settlement their account falls to $1,873, which is below the maintenance margin of $1,885.

Because Trader A's account balance is below the maintenance margin requirement, they're issued a margin call. In order for Trader A to stay in the trade, they must bring their account balance back up to the initial margin requirement of $2,073. This could include depositing more money, closing the position, or having their existing position appreciate. The funds are typically due the day they are issued, which would require action from the client or possibly the firm. In some cases, a longer time frame may be possible but it's not guaranteed.

The next day the S&P 500 rallies 45 points. That movement would mean Trader A's account increases by $225 and is now at $2,098. Their account balance is back above the initial margin requirement, which means if immediate action was not required, it could settle there at the end of the day, and the margin call would be satisfied. Remember, if their position hadn't appreciated in value, and immediate action by the firm had not been necessary, the trader would've been required to add funds or close their position.

To end our example, let's see how the trader fared. Trader A's account started at $2,073 and ended with $2,098 for a return of 1.2%.

Now that we've covered the basics of how stock index futures work, we're ready to jump into thinkorswim to run a paper trade. I'm going to show you a speculative, bullish intraday trade strategy. This means the goal is to buy a contract to enter, have it increase in value as the index rises, and then sell to exit for a profit in a matter of minutes to hours.

Alright, so we're in thinkorswim now. On the left here you've got your account information, and some customizable gadgets like up-to-date market news and a watchlist. On the right is the main platform window, with different tabs for trading, charts, analysis, and more. To make a little more room for our trade we're going to close the sidebar by selecting the Arrow.

Like any other trade, a futures trade is a series of decisions about what to trade, how much to trade, when to enter, and when to exit. We'll walk through each decision, starting with what to trade. For this example, we're going to stick with the Micro E-mini of the S&P 500. There are other types of S&P 500 futures, but /MES contracts are typically very liquid and have the smallest capital requirements, so they may be of interest for beginners and people with smaller accounts. I'll start by going to the Trade tab and entering /MES in the upper left box. In thinkorswim, the forward slash identifies that this is a futures contract and helps avoid confusion with similar stock symbols. The "MES" is the root symbol, which identifies that it's the micro contract associated with the S&P 500.

Depending on the time of the month you're performing a trade, you may see one or more contracts. The letter right after the root identifies what month the contract is, and the year follows that. You won't necessarily recognize the month immediately because they're based on a specific coding system for futures, which you'll get used to.

Today I'm going to make sure I'm trading on an active contract. Sometimes the previous contract still shows. If you enter the root symbol of /MES, it'll default to the active contract.  Current contracts have more volume, which, although not guaranteed, could give you a better chance of getting in and out of the trade at the price you want.

When we've got that we can select Active Trader. This is a customizable layout with tools specifically for trading fast-moving products like futures. Just a heads up that when we did that it defaulted to /ES. So, we'll have to change it back to /MES. We won't need the bottom two boxes today so let's remove them to give us some space. You can do that by selecting the waffle symbol and choosing one cell. Now on the left we have a chart and on the right, we have what's known as the Active Trader Ladder. It's showing us real time data on transactions. For example, these stairs on the left are showing the volume at different price levels, the numbers under Bid Size and Ask Size are showing orders placed on either side of their corresponding price. At the top, there's quick access to buy or sell.

Now that we've decided what to trade and set up our platform, we'll set up our chart a little bit. This will help us make decisions about when to enter and exit the trade later. By default, we're on the five-day, five-minute intraday chart though you could change the timeframe if you wanted something different by selecting where it says 5m and choosing another.

For the purposes of our trade, it's important to expand the chart to show the after-hours movements, which will help inform our entry and exit points of our trade. Here's how to do that. Select Chart Settings then go over to the Futures tab and then check Highlight Extended-Hours Trading session. I'll also uncheck Show volume subgraph, just to make things seem a little less cluttered. To lock in those changes, select Apply and then OK. Now we can see in the shaded area here what /MES did in the pre-market.

We'll also want to put on a 10-period moving average—this is a tool we'll use to help determine entries and exits, which I'll explain more about later. To add that to our chart I'll select Studies, Edit Studies, type in simple moving average then choose SimpleMovingAvg and click Add selected. By default, the moving average shows nine bars, which on our chart refers to nine five-minute bars, since each candle represents five minutes. For this trade, we're going to set it to 10 bars, or 10 five-minute bars. To do that I'll type in 10 and apply those changes. There it is on our chart.

Let's dive into the information the pre-market is giving us to look at highs and lows from the overnight period. Specifically, we're looking for support and resistance lines. You can think of support and resistance like rough floors or ceilings the price has tended to bounce off. They're a common tool for identifying entry and exit signals for trades across all kinds of assets. A line is often considered support or resistance when there are three to five touch points.

In order to find the previous day and pre-market highs and lows, I'll zoom out on the chart using the magnifying glass. The grey area here shows all of the overnight trading. I'm going to select the Drawing Tool to draw support and resistance lines. Now, looking at the chart it appears as though we have some resistance in this neighborhood, around 5,616. To draw that resistance line left click where you want it to start, it doesn't need to be exact. By default, the line will shoot off to the right. Click again on another point along the line to lock it in. One customization I like to make is to have the number the line represents appear on the line; it makes it easier to check in with throughout the day. To add that, right click on the line and then where it says Show Price, select the arrow to change it to On the right. Then select Save as default so the change is remembered going forward. Click OK and you can see here the number 5,616.05 appearing on the right side of the line.

Now we're going to identify the low from yesterday. To do that we'll left click around 5,577 and then left click again to draw it in there. You'll notice it did drop to a low of around 5,561 but remember we want several touch points on our lines. Also, around the open of the day I'm going to draw this resistance line around 5,629.

One other customization I personally like to add is some space to the right of chart so I'm not looking right at the edge and have some room to project price. To do that I'll select the gear here, then Time axis, expansion area, and enter 20 bars. That gives us some room.

When trading futures, many traders identify two potential exits: one for if the trade goes your way, called a price target, and one for if the trade moves against you, called a stop order. Having a predetermined target can help you counteract greed and take profits before your gains evaporate. It may be frustrating to miss out on gains if the index keeps rising after you exit, but having a plan and being consistent can help manage risk over time. And on the other hand, having a predetermined stop level is designed to help you set an order that attempts to close out of your position if losses begin to pile up.

Now, the market has already opened, but I'm going to use price movement from the beginning of the day to show you an example of how to use support and resistance to identify potential entries and exits. For bullish entry signals, traders often look for a bounce, where price touches then bounces off support, or a breakout, where price breaks through what had been a resistance level. They then project a target exit based on the distance between the previous level of support and resistance. This is an extremely basic strategy for identifying entries and exits that we're using as a demonstration. You can learn more sophisticated strategies over time.

Based on the support and resistance lines we're seeing here between 5,629 and 5,616, a possible bullish entry point could be a break above that 5,629 line we drew. If that turned out to be the case, we might put a stop at 5,616. To the upside, because the difference between our support and resistance lines is about 15 points, you might set a price target at about 5,645.

So now that we've identified our possible entry and exits, let me show you how the platform can help. With how quickly the futures market moves, manually entering single orders to enter and exit can be challenging. Instead, when we place the trade, we'll use what's known as a bracket order. A bracket order allows you to set one limit order at your target, and a stop order at your stop level. Limit and stop orders remain working until the product you are trading hits the price specified in one of the orders or they are manually cancelled. When the price of either order is hit, that order could then fill and then cancel the order which did not trigger. The bracket's objective is to simultaneously help protect against a trade going poorly, while positioning us for hopefully locking in upside gains.

Remember, though, there's never any guarantee your order will fill at the price you intend or at all.

This is a powerful feature of thinkorswim because it allows you to build a complex order ahead of time and then send it off quickly when an opportunity comes along. I'm going to select the arrow to open up the drop-down menu and head over to where it says Template.  If you don't see Template, just go into settings and add Order Template Selector into your Current Set. Change the Template setting to TRG with bracket. That gives us a range of new options, and what you want to look at is the STOP and the LIMIT. The stop is the lowest you want the price to go before triggering the exit order. The limit is the price you're hoping to reach to exit the trade profitably.

To determine our exits and entries for our pre-market example, I'll use the support and resistance lines at 5,616 and 5,629. That's about a 15 point run, generally speaking. In this case I'd likely set my entry at 5,630, my stop order at 5,616, and then, using the 15-point difference between support and resistance, my price target could be about 5,645, 15 points up from my entry signal. This is just an example I'm walking through but if I were going to actually send this trade, I'd change the number where it says Offset to +15 and –15 to set up the bracket we've been discussing. This just being a test, I can use the arrow here to slide over to see if my entry would have been triggered. The first candle closed at 5,635 and that would have been my buy signal. Clicking over a few more candles you'll notice the volatility. It's a good idea for new futures traders to consider avoiding the first 30 minutes of the trading day to avoid the volatility that's typically present. Moving a few more bars over and there we have it, our price target of 5,645 would have been hit and we could have been out for a profit.

So let's look for another similar entry opportunity and place the paper trade for real now.

The rest of the day conditions have turned to not be ideal for a bullish trade on the Micro E-mini S&P 500 but there's a lesson to be learned from that. Be aware of earnings reports, Fed announcements, economic data like the jobs reports and when they're coming up. New information can cause ripples of volatility in the futures market. Today, a few companies had earnings misses that turned a bullish start to the day into a bearish one. But now towards the end of the day, the S&P has leveled off. What we were looking for was a price pattern to hold at an intraday level, which we're seeing right here around 5,605. Zooming in you can see our support and resistance here now at 5,605 and 5,616. This time we have options for our entry. One is another breakthrough of resistance at 5,616 or a bounce off support at 5,605. Either way we can build our order before entering the trade. You can do that by selecting the carrot, changing the Template to TRG w/ bracket, and then the difference between 5,616 and 5,605 is about 10 so we'll set our offset order to +10 and –10, which would set our price target 10 points up from wherever we get in and our stop order down 10 points from wherever we get in. Note the number of contracts we'll set to one, but you might choose more depending on your account size and appetite for risk. Now we need to wait and see what it does.

It's a few minutes later and you can see that our moving average has leveled off and is turning upwards. I'm going to enter an order just above support, which is around 5,605. That's a little below where price is at the moment, but I'm hoping it will dip back down to around support, trigger my order, and then bounce back up to my target. I'll click buy at 5,606.50, and then review the Order Confirmation Dialog box. You can see the parts of my bracket order—the initial limit that would open the position, and then another limit that's my target 10 points above, and the stop 10 points below. Note the commissions I'll pay on whichever orders fill, as well as the buying power effect, which is the initial margin requirement for entering the trade. If everything looks good, hit Send.

Now that I've placed the bracket order, it appears on the chart. You can actually adjust the individual orders by dragging them up or down if you want. So now we're waiting for the price to fall back to support and hit our initial limit order that will open a long position. Ok, it just filled, so now we're in! It's time to watch closely and wait...

It's just a few minutes later and look the candle ticked up to the limit order set at our target right below resistance, and we're out with a winning trade. Futures move fast. You can see how the trade fared: We gained about 10 points, or about $50 by looking at the profit and loss in the Active Trader Ladder.

There are a few takeaways to consider with this trade. One is that it's important to identify entry and exit signals before getting into a trade. For us the entry was a bounce off the support line we drew, with an exit based on previous support and resistance. That's a very basic strategy, but as you learn more you can find other tools for identifying entries and exits. Starting with the end in mind is key for consistency and managing risk.

Also, the bracket order is potentially a helping hand. While trends tend to continue, the old saying goes that stocks (and other securities) take the stairs up and the elevator down. Orders are never guaranteed to fill at your intended price or even at all but having a bracket order can help you more consistently stick to your planned exits and entries.

The range you select for your limit and stop orders is important, too. If you pick too tight of a range, it can mean you trigger your stop order before you want to, incurring a loss on a trade that might eventually turn positive. That mostly has to do with risk appetite. And conversely, if you pick a limit order that is too high, you might never hit it. It is essential to remember that these orders may not fill as intended based on various exchange rules around price protection.

All right, those are the basics you need to place a practice futures trade on thinkorswim. The next step is to download the thinkorswim paperMoney platform to start practicing. When you start paper trading on thinkorswim yourself, it would be helpful to practice with more than just the S&P micro futures. The papermoney trading environment, and every futures trade, is different depending on the tendencies of the underlying product and numerous other factors, so the more time you put in practicing, the better off you might be if you decide to start risking real money. Also be sure to visit Insights & Education on schwab.com under the Learn tab for more education about futures, including our Fundamentals of Futures Trading course. Also, check out the "Trader Talks: Schwab Coaching Webcasts" channel on YouTube for more instruction on futures from coaches like me.

On-screen text: [Schwab logo] Own your tomorrow^®