Advantages of trading futures over stocks

Futures are derivative contracts that obtain value from financial assets (such as traditional stocks, bonds or stock indexes), so they can be used to obtain exposure to various financial instruments, including stocks, indices, currencies, and commodities. Futures are an excellent tool for hedging and managing risks; if someone has made speculative exposure or profit, it is mainly because they want to hedge the risk.

Due to its structure and trading methods, futures contracts have many inherent advantages over trading stocks.

Key points

  • Stock investors may have heard of the term “futures” or “future market,” but they themselves think these esoteric derivatives are not suitable for them.
  • Although futures may bring unique risks to investors, they have several advantages compared to trading ordinary stocks.
  • These advantages include greater leverage, lower transaction costs and longer transaction times.

1. Futures are highly leveraged investments

To trade futures, investors must invest margin-a small part of the total amount (usually 10% of the contract value). Margin is essentially collateral that investors must keep with their brokers or exchanges to prevent the market from opposing their positions and they suffer losses. This may exceed the margin amount, in which case investors must pay more to maintain the margin at a level.

Trading futures essentially means that investors can expose themselves to a higher stock value than when they bought the original socks. Therefore, if the market moves in his direction, their profits will also increase exponentially (10 times if the margin requirement is 10%).

For example, if investors want to invest $1250 in Apple (AAPL) stocks at $125, they can buy 10 stocks or hold 100 Apple stocks in future contracts (10% margin for 100 stocks: $1250). Now suppose that the price of Apple rises by $10. If investors invest in the stock, they will get a profit of $100, and if they open a position in Apple’s future contract, their profit will be $1,000.

2. The futures market is highly liquid

A large number of futures contracts are traded every day, so futures are very liquid. The continuous presence of buyers and sellers in the futures market ensures that market orders can be quickly placed. In addition, this means that prices will not fluctuate sharply, especially for contracts that are close to expiration. Therefore, large positions can also be easily liquidated without any adverse effects on prices.

In addition to being liquid, the trading hours of many futures markets have exceeded the traditional market time. The extended trading of stock index futures is usually carried out overnight, and some futures markets are traded 24/7.

3. Low commission and execution cost

The commission for future transactions is very low and will be charged when the position is closed. The prime broker or commission is usually as low as 0.5% of the contract value. However, it depends on the level of service provided by the broker. Online trading commissions may be as low as US$5 per side, and full-service brokers may charge US$50 per transaction.

Please note that online brokers are increasingly offering comprehensive free stock and ETF trading, which makes futures trading cost propositions more attractive than in the past.

4. Speculators can make faster (more) money

Investors with good judgment can make money quickly through futures, because basically their trading exposure is 10 times that of ordinary stocks. In addition, prices in the futures market tend to move faster than prices in the spot market or the spot market.

However, please note: Just as victory comes faster, futures also amplify the risk of loss. That is, it can be minimized by using stop loss orders. Due to the high leverage of futures, margin calls may come sooner for traders who make mistakes. This makes them a riskier tool than stocks when the market fluctuates rapidly.

5. Futures are very suitable for diversification or hedging

Futures are very important tools for hedging or managing different types of risks. Companies engaged in foreign trade use futures to manage foreign exchange risk. If they have a large investment, they will manage interest rate risk by locking in interest rates at the expected drop in interest rates, as well as by locking in the price risk of commodity prices such as oil, crops and metals used as inputs. Futures and derivatives help improve the efficiency of the underlying market because they reduce the unforeseen costs of directly purchasing assets. For example, doing long in S&P 500 index futures is much cheaper and more efficient than copying the index by buying each stock.

6. The futures market is more efficient and fairer

It is difficult to use inside information to trade in the futures market. For example, who can predict the next policy action of the Fed? Unlike a single stock where insiders or company managers can leak information to friends or family members to preemptively merge or go bankrupt, the futures market tends to trade market volumes that are not suitable for insider trading. Therefore, the futures market can be more efficient and bring a fairer impact to ordinary investors.

7. Futures contracts are basically just paper investments

Actually traded stocks/commodities are rarely exchanged or delivered unless someone trades to hedge against price increases and accepts the commodities/stocks at maturity. For investors who are only interested in speculative profits, futures are usually a paper transaction. This means that futures are not as cumbersome as holding individual stocks, which need to be tracked and stored somewhere (even if only as an electronic record). Companies need to know who owns their shares in order to pay dividends and record shareholder votes. No records are required for futures contracts.

8. Short selling is easier

You can short a stock by selling a futures contract. This is completely legal and applies to various futures contracts. On the contrary, it is not always possible to short all stocks, because different markets have different regulations, and some even completely prohibit short stocks. Short selling of stocks requires opening a margin account with a broker. In order to sell short, you must borrow stocks from the broker to sell stocks that you do not already own. If a stock is difficult to borrow, short selling these stocks may be expensive or even impossible.

Bottom line

Futures have a huge advantage, which makes them attractive to all kinds of investors (speculative or not). However, highly leveraged positions and large contract sizes make investors vulnerable to huge losses, even if market volatility is small. Therefore, before trading futures, you should develop strategies and conduct due diligence to understand their advantages and risks.

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