Futures may not be well understood by the average investor, but they are often used by institutions and traders to either manage risk through hedging or avoid risk through speculation. A futures contract is called a derivative because it derives its value from an underlying asset, such as a stock or bond index, or a more tangible product, such as gold or other commodities. But are stock futures good investments?
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Are futures good for trading?
Futures offer a way to protect existing positions or quickly profit from price movements in different markets. Because of these and other factors, stock futures offer many advantages over simply buying or selling stocks. Here are eight main reasons why.
1. Less capital required
If you have limited funds to invest — or just don’t want to invest that much capital — futures can be a good choice. Because futures are leveraged, you only need to put up a small percentage of the amount you want to trade. This can free up the rest of your capital for other investments. If instead you bought stocks or ETFs with that money, all of your money could be tied up in a single investment.
For example, imagine you wanted to invest $20,000 in the S&P 500 index through an exchange traded fund. You would have to put up the full amount of the trade — $20,000 — if you bought the ETF in a cash account. But if you bought futures on the S&P 500 instead, you might only need to put up $2,000 or even $1,000.
2. Leverage
Leverage is one of the main reasons that investing in futures is better than buying stocks – provided you time your trade right. Since futures may only require 5% to 10% collateral, your profits can be significantly increased.
If the ETF gained 10%, your $20,000 in the ETF would generate a $2,000 profit. But the same move could result in a 100% gain or more on your futures position.
Think of the risk
Of course, leverage works both ways. If your position moves against you, you could lose significantly more than if you bought a stock or ETF outright. In fact, with a futures contract, you can lose more money than you originally invested.
Futures positions are “marked” daily, with the amount of profit or loss being credited or debited to your account. If you do not have enough collateral in your account to recover your losses, you will receive a margin call, prompting you to put up additional money to fund your account. Still, in most cases, you have to put more money into your position when you buy a stock or ETF outright than when you get a margin call on futures.
3. Liquidity
Futures markets are extremely liquid. Not only can trades be executed essentially instantaneously, futures markets are almost always open. While the stock market is only open from 9:30 a.m. EST to 4:00 p.m. EST, the futures markets are open most of the time. Stock futures trade six days a week – every day except Saturdays – and are closed for only one hour per trading day from 5:00 p.m. EST to 6:00 p.m. EST.
This means that stock traders — day traders in particular — are essentially left in the cold compared to futures traders. When market-moving news is reported after the market close, stock traders have to wait until the next morning to trade. Futures traders, on the other hand, can trade instantly in most cases. This is one of the main advantages that trading futures has over trading stocks.
4. Returns can be made faster
Leverage and liquidity are two factors that enable faster returns in the futures market. While the average long-term return for the S&P 500 index is about 10%, a futures trader could easily make 10% in a single day — and those gains can be made almost anytime since futures trading is only closed for about 30 hours each week.
5. Easier to short
If you’re a stock investor and want to hedge a position – or simply speculate that a stock will fall – you need to borrow stock from your broker and sell it on the open market. This process is known as a short sale.
One of the problems with short selling is that it can be difficult — or expensive — to find stocks to borrow for short selling. Additionally, some stocks cannot be shorted, and some brokerage firms may have restrictions that limit your ability to short. You may also have to pay a commission if you short these stocks and you will have to execute your trade during market hours.
However, none of these restrictions apply to futures. Your brokerage firm doesn’t have to find stocks that are too short, you can sell a futures contract almost any time, and your costs are generally minimal.
6. Easy way to hedge positions
One of the most common uses of futures is to hedge existing stock positions.
Imagine owning a stock at a profit, but feeling that the market as a whole is going down, perhaps due to macroeconomic factors. If you own a stock outright, you have two choices: sell it or hold it. If you sell, you’ll have to pay capital gains tax on your gains, which no investor wants to do. If you stand, you could sit helplessly on the sidelines and watch your winnings evaporate.
If you instead sell futures against your stocks, you can profit from your futures position while your stocks fall. This will not change your portfolio value even though your stock has lost value. If you think your hedging is no longer needed, you can easily liquidate your futures position immediately.
7. More efficient market than stocks
The stock market is full of inside information that the average trader can never access — at least not in a timely manner. News of corporate earnings losses, bankruptcies, mergers and other market-moving news often finds its way to the ears of close friends, family members and institutional investors before the general public, making it difficult for individual traders to give a fair shock to the retailer reach shares.
But in the futures market, price is the only information one can have. Every futures trader sees the same price movement in the market at the same time, so everyone can make their own decisions about whether to buy or sell without worrying that another investor has an inside advantage.
8. Lower trading costs
Although the playing field has gradually leveled out, futures have typically been a cheaper investment than individual stocks. Until relatively recently, brokers typically charged hundreds of dollars per trade to buy shares, and many full-service firms still do. But commissions and fees on futures contracts have typically been more in the $5 to $50 range.
In the 1990s and 2000s, trading costs began to fall, especially for online brokers, which helped level the playing field. In fact, many online brokers now offer commission-free trading in stocks. But futures costs continue to drop as well, with many brokers offering trades for as little as $0.25 to $1.50 per contract and some online firms charging $0.
Are futures better than stocks?
If you take the risk, futures can offer significantly higher returns than stocks — but they can also offer significant losses. If you are interested in trading futures, you should first consult a financial advisor to get a good idea of what the risks and rewards are and whether they align well with your objectives.
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