Understanding Futures' Tick Size and Tick Volume

Understanding a futures contract's tick size and tick value is essential in the trading of futures financial instruments. These financial instruments are a type of contract that lock in to prices in the present and are either sold or bought at that price in the future. Commodities and currency are often traded in the futures markets such as the Chicago Board Options Exchange (CBOE) and the Chicago Mercantile Exchange (CME)

Tick size is a metric used in futures exchanges and trading that accounts for the smallest unit measure by which the price of a financial instrument can move up or down. Not all financial instruments have the same tick sizes and even those that are similar i.e. Treasury securities, tick sizes vary.

To illustrate tick size further, according to the Chicago Mercantile Exchange (CME), the tick size for a 30 year U.S. Treasury Bond Future is 1/2 of 1/32 of a point. This means each basis point is comprised of individual ticks of .015625. If 100 basis points is one percent, then the tick size is 1/64th of a basis point which is between 1/100th and 2/100ths of a percent, or more accurately .00015625

Tick value represents cost or profit in proportion to the tick size. In other words, a move in tick size will have differing advantages and disadvantages depending on how much money one has invested. Since tick sizes can be so small, very large amounts of money or quantity are needed to influence price movement significantly enough to be worth while.

For example, suppose Mrs. Smith wants to take part in a foreign exchange option. She chooses a currency pair and an exchange rate with which to sell at at a future date. The currency pair is the U.S. Dollar against the Japanese Yen and the exchange rate is 81.3400, meaning one dollar can be purchased with .8134 Yen indicating the Yen is a stronger currency. Now suppose the value of the dollar rises against the Yen i.e. one dollar buys more Yen buy 1 uptick, which is 1/100th of a cent, how much does Mrs. Smith make or lose?

To answer this question we need to understand the futures tick size and value in addition to the amount invested and the strike price. If Mrs. Smith buys $100,000 Dollars with the right to sell at an exchange rate with the Yen at 81.34 within 60 days and the value of the dollar against the Yen increases by ten upticks to ¥81.44, then the value of the Yen has risen by 10,000 which after conversion to dollars at the new rate would be $8,144. In light of this not exercising the option and forgoing the option premium is a wiser choice.

Since futures markets are often highly leveraged to take advantage of relatively small tick movements the risk can be quite high. This is why understanding exactly what a futures tick size and value are is crucial because one small miscalculation could end up costing thousands of dollars if one is overly leveraged and/or a large tick movement occurs.

Sources:

1. http://bit.ly/cPXRPG (Chicago Mercantile Exchange)
2. http://yhoo.it/37rUpV (Yahoo Currency Exchange Convertor)
3. http://bit.ly/bwNEzH (Commodity Futures Trading Commission)

The ABCs of commodity futures

If you want to trade in the futures market there are a few things that might be helpful to know beforehand. For starters, you'll need some money in advance and sometimes a good credit rating to secure certain types of account needed for the commodity futures trading. Also, some knowledge of what it is you're investing in could be advisable as this may reduce your commodity futures trading risk.

• What are Commodity Futures: Commodity futures are financial contracts derived from a particular physical commodity such as corn or copper. These financial instruments are regulated by the Commodity Futures Trading Commission (CFTC) and are often traded back and forth without delivery and/or transfer of a commodity.

• How they work: Commodity futures are traded on special exchanges such as the Chicago Board of Trade. A buyer of futures contracts often purchases on credit meaning they only have to put down a certain fraction of money to buy the whole contract. As the price of commodities changes from day to day, the value of the futures contract also fluctuates in terms of what the underlying commodity is actually worth in relation to the contract.

• How to analyze them: To analyze the value of a future's contract it can be a good idea to investigate the supply and demand of the underlying commodity being traded, broader economic conditions, daily, monthly and yearly price fluctuations and conditions affecting the particular industry. For example, if a hurricane is about to hit the Gulf of Mexico this could positively affect the price of oil futures.

• Benefits of Commodity Futures: Futures trading can be exciting and rewarding. The benefits of futures contracts can be great if the price of a commodity rises after the contract is purchased for a lower price. For example, suppose used cars are a commodity. Person A goes to dealership B to buy 10 used cars 1 month in the future for a special deal price of $15,000. After signing the contract a reputable antique automobile association declares the cars special antiques thereby increasing the market price of those cars and benefiting the buyer of the contract.

• Risks: Inversely, had those automobiles been deemed junk, the value of the cars could drop below the contract price. The contract holder is then obligated to buy the cars at a price above what they are actually worth meaning the resale value of the contract is lower. Since the contract is often bought on credit, the cash deposit a contract holder has can decline faster than had the contract been bought dollar for dollar.

Tips to consider when trading commodity futures

Commodity futures trading is more sophisticated than straight equity trading because it involves derivative calculations, and a more complex set of relationships between the industry and the financial instrument. For this reason it can be considered a good idea to study the calculations required before hand and to plot derivative calculations upon actual commodities price movement to see where one would have been had one acted upon those calculations.

When buying and selling commodity futures, a few suggestions may prove helpful. Specifically, they are as follows:

• Margin Account: Only invest what you can afford to lose as the risk associated with futures trading are greater than straight equity trading and some other forms of investment.

• Commodity: Choose the commodity you know the best as this may assist you in predicting future prices better. Consider things like regulation of the commodity, imports and exports, and seasonality.

• Brokerage: When trading commodities futures a brokerage account is often used. Selecting a broker that his trustworthy, and reputable that provides a wide array of services and investment opportunities for an affordable commission price.

• Analyze: Pre-analysis of a particular commodity using financial tools, mathematical metrics, economic forecasting and market analysis can all assist in making more accurate assessments of the strength or weakness in a particular commodity investment. In turn, these types of analysis may help one be a better investor.

Trading commodity futures can be considered an advanced form of investing. The practice involves some important mathematical calculations and an understanding of the derivative markets and nature of commodities futures is quite important.

The better one knows the market, the trading process and the industry dynamics of the underlying commodity the more possible it becomes to trade successfully. While nothing is guaranteed in investing, it can be helpful to be as well informed as possible before investing. By utilizing the information and techniques illustrated above, one may be better prepared for commodities futures investing.