What's in Your Wallet - Micro, Mini or Maxi?

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What's in Your Wallet - Micro, Mini or Maxi?

Risk, this is something we all try to avoid, but we also know that with risk comes reward. For some people placing their money in T-bills is comforting knowing they have no risk. However, they also get paid very little return for not taking any risk. Futures traders take a lot of risk and have the potential to make huge returns. The key to gaining these huge returns is managing this risk. Obviously, some of the ways we can control this risk is by having a well-written trading plan, trading the correct number of contracts so as not to be over leveraged, having a sufficient size trading account so we are not trading with scared money, and a strategy to deal with any catastrophic events that may occur while in the trade.

Electronic trading has opened up the opportunities for the retail trader to participate in the Commodity Futures markets. The Futures Exchanges are well aware that a trader with a small trading account will not be able to participate in some of the big moves that come in the Commodity Futures markets. In the past, traders had to trade the full size contract if they had the capital. Even if they had the capital to open a position many times they were still forced to liquidate their positions pre-maturely. This usually happened because the risk and volatility in the market would increase and the Exchange would raise the margin (cash required to hold a Futures position) forcing smaller traders out again.

The Exchanges saw a need for reducing the size of the contracts to help smaller traders participate. Figure 1 shows the Initial margin required for these different sized contracts:



Figure 1 shows us that to trade the full size Euro contract on the CMEGroup exchange, a trader must have at least $5,400 in their account to initiate a position. If the trader decided to trade a smaller size contract instead, they would only need $540 in the account. This sounds like a great deal for the small trader. But let's look a little deeper behind the scenes and see if this cheaper cost is really less risky and less expensive to trade.

A trader should be careful thinking that a contract with a smaller minimum dollar per tick size is less risky. For example, the E-mini S&P trades for $12.50 per tick and the E-mini Dow Futures trade for $5.00 per tick. You would think it would cost less to trade the Dow, right? Let's look at the overnight margin rate that the CMEGroup requires to hold these two positions.

    ï    E-mini S&P margin is $5,625
    ï    E-mini Dow margin is $6,500

Since overnight margin rates are set by the Exchanges based on risk and volatility, we can see that "less is not best" for risk management in this example.

Another issue that arises with these mini and micro contracts is liquidity (volume and open interest). One of my criteria for finding a contract to trade is that it must have good liquidity. For a contract to have this liquidity, it must benefit the Commercial traders. If you were to look at a Commitment of Traders report (measures the number of outstanding contracts and which category of trader holds them), you would see that the Commercials typically hold 50% to in some extreme cases 90% of the total Open Interest (Futures contracts that have not been offset).


Figure 2 shows the Open Interest for the full size Soybean contract. Make note of the total Open Interest quantity.

Now let's look at a Mini Soybean contract and the Open Interest in Figure 3.


Immediately, we notice the much smaller total Open Interest level and the lack of Commercial interest in the Mini Soybean contract. Why is this? It all comes down to the cost of doing business. In the Commodity Futures market, we must pay a commission on each contract we trade. There are no bulk commission rates as in the Equity markets. For example, if you buy 1 to 999 shares you would pay $9.99. If you were paying $6.00 round turn commission in your Futures account, it would cost you that much per contract. If you traded 1 contract it would be $6.00 or 3 contracts it would be $18.00.

For the Commercial traders to hedge their Commodities, they are usually dealing in very large quantities. Notice in Figure 2 that the contract size is 5,000 bushels where Figure 3 is only 1,000 bushels. If a Commercial trader was going to hedge 25K bushels of Soybeans, he has two options:

• Use the full size contract (5,000 bushels) and pay $30 in commissions (5 contracts * $6.00)
• Use the Mini size contract (1000 bushels) and pay $150 in commissions (25 contracts * $6.00)

It makes no financial sense for the Commercial traders to pay more in commissions to trade these mini and micro Futures contracts. That only leaves undercapitalized speculators to trade these products. When panic hits the markets, who do you think will provide any liquidity for these speculators? The Exchanges usually have market makers on these less liquid contracts, but we all know who gets the better price when it comes to market makers.

The full size electronic contracts all have electronically matched orders and there are "NO" market makers involved in the transaction. This is a big advantage over the Equities markets that still use market makers.

Commodity markets were created over 200 years ago to help these Commercials manage price risk of the actual Commodity they own or will need to purchase in the near future. Every day they are in the markets hedging their price risk. This daily activity usually accounts for about 60% of the daily volume.

When there is very low liquidity in a market, the bid and ask will be spread further apart. In the full size contracts, the bid and ask will usually be just 1 tick apart. In these mini and micro contracts, there can be very large spreads between the bid and ask. This creates excessive slippage when you get your orders filled, or worse yet, you might not be able to get it filled because there is nobody there to take the other side at your price. Just imagine how vulnerable your stops will be on a platform that takes very little volume to move the price. Figure 4 will be a 5 minute chart with volume of the mini Soybean contract.


Now let's look at a full size 5 minute Soybean contract chart with volume in Figure 5.


Even though the mini Soybean contract is only $1.25 per tick compared to $12.50 per tick for the full sized contract, notice how many intraday gaps are in Figure 4 compared to the fluid and liquid chart of Figure 5. To put things in perspective, this was a very quiet trading day in the Soybean market. Just imagine if there was a lot of fear in this market what these same gaps would look like?

For the reasons I have outlined in this article, I always recommend to traders that the only mini contracts anybody should "EVER" trade are the Stock Indexes (ES, NQ, YM, TF). There are mini Bonds, Gold, Oil, Grains, etc., but I strongly recommend you stay away from them. In the end, it is nice of the Exchanges to create these smaller contracts, but the only one who will truly benefit will be the broker and the Exchange collecting a fee. If you are undercapitalized, then I would suggest you trade ETFs until you have enough money to trade the full size Commodity Futures contracts.

"There are no secrets to success. It is the result of preparation, hard work and learning from failure." Colin Powell

Good Trading,
- Don Dawson


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