Futures are derivative contracts that derive value from a financial asset, comparable to a standard stock, bond, or stock index, and thus might be used to achieve exposure to numerous financial instruments, including stocks, indexes, currencies, and commodities.
Futures are a standard vehicle for hedging and managing risk; If someone is already exposed to or earns profits through speculation, it’s primarily attributable to their desire to hedge risks.
Future contracts, due to the way in which they’re structured and traded, have many inherent benefits over trading stocks.
Key Takeaways
- Stock investors can have heard the term “futures” or “futures market,” but thought to themselves that these esoteric derivatives are usually not for them.
- While futures can pose unique risks for investors, there are several advantages to futures over trading straight stocks.
- These benefits include greater leverage, lower trading costs, and longer trading hours.
8 Benefits of Trading Futures
1. Futures Are Highly Leveraged Investments
To trade futures, an investor has to place in a margin—a fraction of the whole amount (typically 10% of the contract value). The margin is actually collateral that the investor has to maintain with their broker or exchange in case the market moves opposite to the position they’ve taken they usually incur losses. This will be greater than the margin amount, wherein case the investor has to pay more to bring the margin to a maintenance level.
What trading futures essentially means for the investor is that they’ll expose themself to a much greater value of stocks than they may when buying the unique socks. And thus their profits also multiply if the market moves in his direction (10 times if the margin requirement is 10%).
For instance, if the investor wants to take a position $10,000 into the S&P 500 index they’ll either buy 25 shares of the SPDR S&P 500 ETF (SPY) priced at around $400 per share, or 1 E-mini futures contract with a margin requirement of $10,000. If SPY increased to $401, the investor would have made $25. Over that very same period, the E-mini contract would have increased from $4000 to $4010 leading to a $500 gain (1 index point = $50.00).
2. Future Markets Are Very Liquid
Future contracts are traded in huge numbers every single day and hence futures are very liquid. The constant presence of buyers and sellers in future markets ensures market orders might be placed quickly. Also, this entails that the costs don’t fluctuate drastically, especially for contracts which might be near maturity. Thus, a big position may additionally be cleared out quite easily with none opposed impact on price.
Along with being liquid, many futures markets trade beyond traditional market hours. Prolonged trading in stock index futures often runs across the clock.
3. Commissions and Execution Costs Are Low
Commissions on future trades are very low and are charged when the position is closed. The full brokerage or commission will likely be as little as 0.5% of the contract value. Nonetheless, it is dependent upon the extent of service provided by the broker. A web based trading commission could also be as little as $5 per side, whereas full-service brokers may charge $50 per trade.
Note that online brokers are increasingly offering free stock and ETF trading across the board, making the transaction cost proposition for futures a bit less attractive than it had been up to now.
4. Speculators Can Make Fast Money
An investor with logic could make quick money in futures because essentially they’re trading with 10 times as much exposure as with normal stocks. Also, prices in the long run markets are likely to move faster than within the money or spot markets.
A word of caution, nonetheless: Just as wins can come quicker, futures also magnify the chance of losing money. That said, it may very well be minimized through the use of stop-loss orders. Because futures are highly leveraged, margin calls might come sooner for traders with wrong-way bets, making them potentially a more dangerous instrument than a stock when markets move fast.
5. Futures Are Great for Diversification or Hedging
Futures are very essential vehicles for hedging or managing different sorts of risk. Firms engaged in foreign trade use futures to administer foreign exchange risk, rate of interest risk by locking in an rate of interest in anticipation of a drop in rates in the event that they have a large investment to make, and price risk to lock in prices of commodities comparable to oil, crops, and metals that function inputs. Futures and derivatives help increase the efficiency of the underlying market because they lower unexpected costs of buying an asset outright. For instance, it’s less expensive and more efficient to go long in S&P 500 futures than to duplicate the index by purchasing every stock.
6. Future Markets Are More Efficient and Fair
It’s difficult to trade on inside information in future markets. For instance, who can predict for certain the subsequent Federal Reserve policy motion? Unlike single stocks which have insiders or corporate managers who can leak information to friends or family to front-run a merger or bankruptcy, futures markets are likely to trade market aggregates that don’t lend themselves to insider trading. Consequently, futures markets might be more efficient and provides average investors a fairer shake.
7. Futures Contracts Are Mainly Only Paper Investments
The actual stock/commodity being traded isn’t exchanged or delivered, except on the occasion when someone trades to hedge against a price rise and takes delivery of the commodity/stock on expiration. Futures are often a paper transaction for investors interested solely on speculative profit. This implies futures are less cumbersome than holding shares of individual stocks, which must be kept track of and stored someplace (even when only as an electronic record). Firms must know who owns their shares to be able to pay out dividends and to record shareholder votes. Futures contracts don’t need any of that record keeping.
8. Short Selling Is Easier
One can get short exposure on a stock by selling a futures contract, and it is totally legal and applies to all types of futures contracts. Quite the opposite, one cannot all the time short sell all stocks, as there are different regulations in several markets, some prohibiting short selling of stocks altogether. Short selling stocks requires a margin account with a broker, and to sell short, you should borrow shares out of your broker to sell what you do not already own. If a stock is tough to borrow, it may possibly be expensive and even not possible to short-sell those shares.
The Bottom Line
Futures have great benefits that make them appealing to all types of investors—speculative or not. Nonetheless, highly-leveraged positions and enormous contract sizes make the investor vulnerable to large losses, even for small movements out there. Thus, one should strategize and do due diligence before trading futures and understand each their benefits in addition to their risks.