Using Futures for Capital Efficiency

Every trader wants to get the most out of their money and one way to do this is by increasing the efficiency of their investments. Some investments are more efficient than others, but they come with a different set of risks—like leverage.

A futures contract is an agreement to deliver, or accept delivery of, a predetermined amount of a commodity or financial product on a specified date. Futures are traded on exchanges, and contracts cover several asset classes, including equities, stock indexes, interest rates, currencies, and commodities.

The asset behind a futures contract could cost hundreds of thousands of dollars, which is known as the notional value. When buying or selling a futures contract, an investor or trader doesn't put up the entire notional value, but instead they post a fraction of the cost. This small initial deposit is called a margin, also known as a performance bond, and it means futures contracts are highly leveraged because the small initial margin requirements can establish a position in a larger asset. This type of margin can make the initial deposit more capital efficient than buying the entire asset. However, due to this leverage, a small price movement in the underlying asset can have a significant effect—positive or negative—on the account’s overall profit and loss¹. Traders are also required to keep a maintenance margin, or money that is deposited in your futures account to establish and maintain futures positions.

Futures positions are settled at the end of each day using a process called mark to market. If the equity in a trader's account drops below a certain amount, they need to either add more money to the amount held as margin by making a deposit, exiting additional holdings, or closing the position.

Let's say a trader has $80,000 and wants to invest it in a broad-based basket of stocks that closely mirrors the S&P 500^® index (SPX) with a fictional ticker symbol of SANDP. Assuming SANDP is trading at $226 per share, the trader is interested in buying 500 shares. Some choices a trader may consider include:

• Buying as much stock as $80,000 will get them
• Buying stock on margin (assuming a standard 50% margin, available to qualified Schwab accounts)
• Buying E-mini S&P 500 futures (/ES) (available to qualified Schwab accounts)

Here are potential outcomes of each choice.

Buying shares with cash. Before transaction costs, $80,000/$226 is about 353 shares—far below the desired 500 shares, and the entire $80,000 would be tied up.

Buying shares on margin. Buying 500 shares outright at $226 per share would cost $113,000. But if the trader could make the purchase at a 50% margin, they could buy the 500 shares for $56,500 ($113,000 x 0.50), plus transaction costs. While it wouldn't tie up all the capital, it would tie up a significant portion of the portfolio. Additionally, equity margin works like a loan, so the trader would have to pay interest on the borrowed amount.

Buying E-mini S&P 500 futures. The E-mini S&P 500 futures contract is a futures product with a notional contract size of $50. To calculate the notional value, multiply the contract size by the value of the S&P 500. If the index is trading at 2,262, the futures contract has a notional value of $113,100 ($50 x 2,262). Although requirements may vary based on market conditions, typical futures margin requirements range between 3% and 12% of a contract’s notional value. So, if the margin requirements were currently set at 5% of notional value, the initial margin requirement on an E-mini S&P 500 contract would be $5,655.

Buying the futures contract allows a trader the same notional exposure, while tying up less initial capital.

Trading on margin is available in both the futures and forex markets, but margin in futures and forex is much different than in equities. With equities, margin trading typically means a brokerage firm lends an account owner a portion (typically 30% to 50%) of the total purchase price, which boosts buying power by a similar amount. Securities already held can be used as collateral, and the trader pays interest on the loan.

In the futures market, margin constitutes a good-faith deposit placed with a broker in order to open and maintain a position. Here, margin is not a borrowing cost, and no interest is paid, but it’s a portion of the trader’s account balance set aside while the futures position remains open. Here's a sampling of initial and maintenance margins for some popular futures contracts.

There’s no interest charged for the margin trade because it isn’t a loan. It’s money set aside in case losses occur, but additional funds may be required to maintain the position above the original amount. A smaller margin requirement means higher leverage and more risk of significant loss, even with smaller market movement. Immediate liquidation of the position can happen at any time without notice.

A common use of futures is to hedge a portfolio because of the capital efficiency they provide. Suppose a trader owns a basket of stocks that closely mirrors the previous hypothetical example, SANDP, and they’re looking to hedge a portion of it. They believe market conditions point to a pullback, or an elevated risk of a pullback, and they want to mitigate the risk of loss. It may not be practical for them to liquidate all, or even some, of their positions, so they choose to hedge the portfolio instead.

This hedge is created by selling or shorting an E-mini S&P 500 futures contract. While the hedge is designed to help reduce risk, it’s important to note that this short position carries unlimited risk and is not suitable for all traders. Therefore, hedging with futures is meant to be a short-term trade and requires vigilance.

The number of futures contracts a trader chooses depends on a number of factors, including the notional value of the portfolio, the amount (or percentage) of the portfolio that the trader wants to hedge, and the portfolio's volatility.

Long or short, investing or hedging, futures can potentially be a useful tool that is also capital efficient. However, futures are not for everyone and involves significant risks. Also, not all accounts qualify to trade futures.