Young and experienced investors alike may have heard of terms like futures or the futures market but are left scratching their heads as to what they are. How does trading futures vs stocks stack up?
Stocks are shares of ownership in publicly traded firms, while futures are contracts of an underlying asset like stocks, commodities, foreign currency, or foreign exchange products. The former is best for long-term value creation, while the latter is for speculative plays or complex risk management strategies.
- Futures appeal to speculative investors as they are highly leveraged investments that can multiply regular market returns with a fraction of the initial capital.
- Advantages of futures include longer market hours, highly liquid markets, and the ability to short sell.
- Futures are best suited for risk management and short-term plays due to how contracts are written and the speed of the futures markets.
Trading Futures vs Stocks
Like any asset class, futures and stocks have their own risk and reward profiles. Each can have a place in your trading strategy, depending on your risk tolerance and goals.
At Finance Futurists, we’ve learned that the most successful investment strategy is to put your money in a diversified portfolio and hold for 30-40 years to let compound interest do its magic. Trading individual stocks or futures is best done by experienced investors with prior research and sufficient risk capital. We’ve extensively covered investing with stocks, so we’ll focus on explaining futures and the advantages of trading futures vs stocks here.
How do Futures Contracts & the Futures Markets Work?
Futures are contracts that state the holder to buy or sell the underlying asset at an agreed-on price at a set date. The asset can be a commodity like oil or corn or stocks, bonds, currencies, or indexes. Buying a future means you sign onto the contract, while selling means you’re off it.
Futures products trade on exchanges like the New York Mercantile Exchange or the Chicago Board of Trade and are regulated by the Commodity Futures Trading Commission (CFTC). Futures markets are accessible from any major brokerage. An exchange will write the contract terms, but the obligation is created once a buyer and seller sign on. Usually, the contract terms are for less than a year.
So how does a future work exactly? Let’s use an example.
Two futures traders sign onto a natural gas futures contract for 500 barrels at an agreed-on price of $60 per barrel. The contract is worth $30,000. At expiration, the natural gas spot price is $75 per barrel giving the buyer the better deal with a $15 gain per barrel, netting them $7500 in total.
Also, the value of the contract differs from the notional value of its underlying assets, which is their market value on a spot market. Investors that exploit this difference in the value of the contract against that of the underlying assets make use of one of the biggest reasons for trading futures vs stocks.
Margin, Leverage, and Futures… Oh My!
Often, an investor takes on an initial margin to trade futures. Margin is borrowed money from a brokerage for an investor to trade with in exchange for collateral. Trading with margin is using leverage (or borrowed capital). Investors use financial leverage to scale their returns as well as their risk to potentially lose more than their initial investment.
Usually, an investor buys into 10% of the value of the contract with their initial margin. This setup levers their position by creating a potential 10x return opportunity if the market swings favorably. Leverage makes futures trading accessible to investors, or they would be used only by the wealthy. For example, single stock futures contracts start at 100 shares. Depending on the company behind the stock, this exceeds the cash buying power of many retail players.
If a trader wants to buy $2000 of Tesla (TSLA) stock at $100 a share there are two options. Option 1 is to buy 20 shares at $100 each while Option 2 is to buy a future contract with 200 shares. At a 10% margin requirement, the $2000 yields $20,000 of TSLA stock creating a large profit opportunity.
If an investor incurs losses, the brokerage uses the collateral to make up for the loss. If a loss exceeds the margin requirements, then a margin call is executed. Some of the asset is sold off or the investor adds extra funds. Trading with leverage is a critical prerequisite to trading futures, so be sure it is within your risk tolerance. Your brokerage may present you with a risk disclosure before you can open a futures account.
Types of Futures Contract
- Commodity Futures the underlying commodity (e.g. soybeans, metal) is the asset in the contract.
- Interest Rate Futures the underlying asset (e.g. US Treasury securities) makes interest. This futures type moves inversely to interest rates and hedges against rate changes.
- Stock or Stock Index Futures hedge against the volatility of individual stocks or an entire market index to ease trading and protect against speculation useful in periods of uncertainty.
- Currency Futures set exchange pricing of currencies
Are futures a form of options?
No, futures and options differ in their contractual setups. With options trading, the contract holder can buy or sell the underlying asset any time before the contract’s expiration. The holder of a futures contract is obligated to fulfill the contract and take custody of the asset at the contract’s end, but cannot take custody before then. However, the holder of a future can sell it to another party before it expires. Options players face the same risks involved with margin and should use only risk capital to trade.
Advantages of Trading Futures vs Stocks
1. Futures Trade For Longer Hours
The regular trading session for equity markets is open for 6.5 hours from 9:30 AM to 4 PM EST. However, futures products trade overnight, and some markets operate 24/7 like the stock index futures markets. Many financial commentators examine these same markets in the evening to project how markets react to the most recent news. As futures trading continues past market hours, future traders are often accustomed to the 24/7 crypto market.
2. Favorable Taxation
Tax treatment for futures differs from the treatment for stocks. In their 60-40 rule, the IRS states that the gains from futures contracts are to be taxed at a combination of 60% of your long-term capital gains rates and 40% of the short-term capital gains rates. The total possible max rate is 26.8%. The max long-term rate is 20%, while the short-term one is 37%. Tax reporting is the same as stocks, as any gain or loss is reported on the broker’s 1099-B.
In contrast, you only get that favorable tax treatment when you hold an equity for a year or longer. A short-term gain on equities trading can exceed the 60-40 tax rule if your highest marginal tax rate exceeds 26.8%.
Overall, the tax treatment on futures makes trading futures vs stocks an enticing offer for active investors with high financial knowledge or sector expertise and who want to execute short-term strategies.
3. Markets Are Highly Liquid
Futures markets offer high liquidity due to the high trading volume. This means there is a high enough volume of contracts being exchanged to meet the demands of buyers and sellers, so their orders are met. Coupled with the longer market hours, liquidity brings stability to futures prices. This effect makes futures more favorable for day trading. This means that large buy and sell orders do not cause rapid price fluctuations.
4. Futures Markets Are Fairer
Futures markets give traders a fairer chance than the stock markets. Trading futures is less susceptible to insider manipulation as the underlying assets in a contract are compiled from multiple sources. In contrast, investors with insider info (e.g. company managers, large investors) manipulate stocks or give themselves/close associates an advantage. Before critical news tanks a stock price, insiders can cash out and make big bucks while retail investors will be left holding the bag. Even the US Congress commits insider trading.
These trading actions are often left unchallenged by regulators, much to people’s anger. In fact, the Wall Street Bets movement took off because retail investors felt the market was rigged. The more equal flow of information is why the futures markets are regarded as more efficient than the stock markets.
5. Useful to Manage Risk
You can manage different risks with a futures contract, whether as an individual investor or company. The use of commodity futures smoothes out costs for a firm’s key inputs or the costs to acquire necessary assets for their operations. Futures reduce volatility in supply chain prices and stabilize consumer-facing prices.
Investors buy futures to hedge against short-term volatility in the stock market. With the stock market volatility and rising commodity prices of February March 2022, I bought into a commodity futures index fund (USCI) to counter it with success.
6. With Great Leverage, Comes Great Returns
Using leverage to magnify their return potential, futures traders can make a lot of money in a short time. However, the futures market can experience rapid price fluctuations that exceed those in other markets, making them much riskier. This big win or loss potential is only matched by trading virtual currencies like Bitcoin or Ethereum, which also have potentially significant risks and experience rapid price fluctuations. Though bitcoin futures are also a thing now.
But there’s also the same potential to lose out large. Day trading specifically doesn’t work out as 95% of those that do lose money.
A savvy futures trader likely has done deep research in their market and plays with only risk capital.
7. Short Selling is a Cake Walk!
To short an asset mean you bet on its price going down. A trader can easily use gain exposure to short selling with futures. It is doable, though it may require margin. You can order a bundle of stocks (usually in the hundreds) with margin to magnify your earnings potential from a successful short sale. The ease of short selling is one of the key benefits of trading futures vs stocks.
However, it’s a different story in the stock world. It is hard to short sell as you must have all the shares of the individual stocks you want to short even if you borrow margin from your brokerage. If the stock is illiquid, it can be difficult or impossible to get ahold of. This was the outcome of the Wall Street Bet’s massive buy of Gamestop stock, which denied short sellers the stock to short Gamestop. Plus, each market has its own rules, including full-on bans. Short selling can be difficult based on the market type, sector, and country that regulates that market.
Trading Futures Risks
Trading futures vs stocks means you take on substantial risk. A few notes:
- Using margin can quickly end up jeopardizing one’s financial security just as fast it will make one a winner.
- A margin call can easily come your way if a trade doesn’t work out or the market swings.
- Monitor the amount of margin your investment strategy uses, be mindful of margin requirements, and draw up risk management practices if you are trading futures vs stocks.
- Using stop-loss orders lowers the possible downside risk.
The Bottom Line
There are several considerable advantages to futures that include hedging against stock market volatility, magnifying the return potential of an initial investment, short selling, and making short-term plays. However, the use of leverage and the substantial risk and complex nature of futures markets will faze most retail investors or those with lower risk tolerance.
It’s up to you (and your financial advisor) to determine if the advantages of trading futures vs stocks makes sense for your investing strategy, especially considering how much risk capital you can afford to allocate. To become better versed in the trading futures, it’s best to establish a foundation of passive investing, gain experience in the markets, and develop a deep understanding of your specific assets of interest.