While many of us will have heard the term futures contracts, not so many people are aware of the finer details. However, trading futures offer a number of benefits over trading stocks or other derivatives. This article will take a look at those benefits and outline the 12 best reasons to trade futures.
What are Futures?
As the term suggests, a futures contract is an agreement to buy or sell an asset at an agreed date in the future. It is possible to trade futures contracts on anything from coffee beans to iron ore, precious metals to oil, cryptocurrencies to market indices, and more.
There are three types of parties active in the futures market:
- Those looking to sell an asset for commercial reasons
- Those looking to buy an asset for commercial reasons
Each futures contract is based on a standardized structure which includes the following parameters:
- Unit of measurement
- Type of settlement (physical delivery or cash settlement)
- Quantity of goods in the contract
- Physical contract currency
- Futures contract currency
- Grade of product where applicable (for example, metals)
This standardization of futures contracts means that those investing or speculating in different futures markets know what to expect.
Futures Offer a Very High Leverage
The subject of leverage is most certainly a double edge sword. When the market moves in your favor, you can create spectacular returns. However, the exact opposite is true if the market moves against you. The degree of leverage achieved by the futures market is directly related to what is referred to as “margin.” This is the degree of capital you need to hold on deposit as a percentage of the value of your futures contract. The exact margin requirement will vary for different types of futures contracts, commodities, indices, etc. Typically, it will be between 3% and 12%.
We will use the E-mini S&P 500 futures contract, the most popular index futures market, as an example. The E-mini S&P 500 futures contract is worth $50 per point as opposed to $250 per point for the full S&P 500 futures contract. This allowed retail investors to trade futures contracts at 1/5th of the value of the original S&P futures contracts. Using a margin of 5%, the calculation for one E-mini S&P 500 futures contract is as follows:
|S&P 500 index||4550|
|Futures contract value||$50 x 4550 = $227,500|
|Initial margin outlay||5% x $227,500 = $11,375|
To demonstrate the impact of leverage, we will assume that the S&P 500 index increases by 5% in one day. The following calculations will compare and contrast the impact on profits by trading on margin and trading on cash settlement.
|S&P 500 index||4777.5|
|Futures contract value||$50 x 4777.5 = $238,875|
|Profit||$238,875 – $227,500 = $11,375|
|Gain on margin trading||100 x ($11,375/$11,375) = 100%|
|Gain on cash trading||100 x ($11,375/$227,500) = 5%|
By trading on a 5% margin against cash payment, this has created a leverage of 20 times. Unfortunately, if the market had fallen by 5%, this would have created the equivalent loss. Those are the pros and cons of margin trading.
|Margin||5%||50% to 100%||Full Premium|
Futures are Very High in Liquidity
As discussed above, the structure of futures contracts has been standardized. It is, therefore, easier to understand for institutional and retail investors. There are also numerous other factors that contribute to the very high liquidity in leading futures markets:
- Traded on regulated exchanges
- A high degree of transparency
- Security of delivery
- Highly efficient pricing
- Ability to trade in large volumes
- A mix of commercial/speculative investors
While some non-market participants are often critical of speculative investors, in many ways they enhance the degree of liquidity in leading futures markets. In what can become a self-fulfilling prophecy, greater liquidity will attract day traders, which will improve liquidity and attract more traders.
If we look at the oil futures market as one example, this gives access to the oil price, which would be difficult to replicate by exposure to individual oil companies. Consequently, large institutional investors looking to increase their exposure to the oil sector will often use the futures market rather than stocks or traded options.
It would be wrong to suggest there is limited liquidity in the index traded options market, but as this is often spread across different delivery dates and strike prices, the degree of liquidity is not as in-depth as in the futures market.
To put this into perspective, let us look at the value of average daily trades in the E-mini S&P 500 futures contract and Apple shares:
|Average daily volume||Asset value||Daily Trade|
|E-mini S&P 500 futures contract||1.5m||$226,450||$339,675,000,000|
Apple is one of the most heavily traded stocks on the S&P 500. This demonstrates the huge difference in trading values. The value of daily traded E-mini S&P 500 futures contracts is approaching 30 times that of Apple shares.
Commissions are Lower in the Futures Market
Historically, the commission charged on trading futures has been significantly lower than that for stock and traded options. While there will be a charge made by the exchange on which the contracts are traded, this is minuscule and based more on volume. As contracts such as the E-mini S&P 500 futures currently trade at in excess of $200,000, the effect of gearing has a much greater impact on returns than rates of commission. Some companies will only charge when the futures position has been closed, while others will charge a reduced fee on opening and closing trades.
The situation has become a little more complicated of late, with some online brokers offering cheap execution-only stock and traded option services. Investment commission tends to be structured in two ways, set fees for high net worth traders to a tiered structure for volume-based traders. There are still some extremely competitive commission rates available for futures traders, and it is important to do your research.
Assets are less Susceptible to Insider Trading
The subject of insider trading involves non-public information which may or may not impact the value of an asset. As the more popular futures markets tend to concentrate on asset classes as opposed to individual companies, they tend to be less susceptible to insider trading. Consequently, the value of futures contracts is seen by many as more transparent than individual stocks. This attracts a greater degree of confidence, and confidence leads to increased volume.
The movement in an index for example will reflect the movement in the underlying constituents of the index. The movement of a stock price or a stock traded option will reflect the movement of an individual company and is, therefore, more susceptible to insider trading. Regular examples of insider trading tend to revolve around corporate activity in areas including:
- Contract wins
- Takeovers and mergers
- Company results
- Financial issues
We have also seen instances of insider trading when it comes to oil futures and OPEC meetings, interest rate changes, and leaked economic data, but these tend to be less common. If you are looking to align your investments with a particular index as opposed to one or a group of companies, index futures are seen by many as more transparent.
No Restrictions for Short Selling
When looking at futures contracts, stocks, and traded options, the process of short selling is very different.
There are no restrictions when it comes to short-selling futures contracts. You would simply be trading on the margins, for example, 5% with the E-mini S&P 500 futures, with the exact amount depending on movement in the underlying asset. This is a very quick and very efficient way to short a particular asset, more traditionally an index. Long and short positions in index futures contracts have created extremely liquid markets.
Traded options consist of calls, the option to buy, and puts, the option to sell. Consequently, if looking to short a particular asset, either buy a put or sell a call option. When going short, the margins are much higher than futures contracts, often up to 20%. When buying put options, you will pay the full option premium (including time value). Depending upon the asset, there may be liquidity restraints not experienced in the futures market.
If looking to short sell a stock, you would need to borrow the stock to hold as collateral. Stock can be borrowed from third parties but not only is there a borrowing cost, there is also additional margin to pay. As some stocks are more liquid than others, you may have difficulty buying sufficient stock at the right price.
When selling futures contracts short, you are trading at the spot price. Therefore, there are no additional charges or time value involved.
|Shorting||No restrictions||Borrowing cost, margin, and liquidity issues||Potential liquidity issues|
The market is open nearly 24 hours a day
While stock markets around the world open and close at different times, in reality, financial markets never sleep. As the US closes, Japan is about to open. When Japan closes, the UK is ready to begin trading, and the circle continues. The trading times for stocks and stock options markets will mirror the times for the local market. For example, the US stock traded options market is open during normal US trading hours. However, the situation is very different when it comes to futures!
In essence, futures markets such as the E-mini S&P 500 and other leading indices can be traded 24-hour was a day, five days a week. This means that the opening bell for the S&P 500 will reflect futures contracts activity outside of traditional market opening hours. You will often see market observers highlighting changes in futures contracts as an indication of how the market will open. How does this help investors?
Let’s assume that you were long on the E-mini S&P 500 futures, and there was a significant economic/political announcement outside of the US market hours. Between Monday and Friday, 24-hour was a day, you would be able to trade your futures contract and therefore react there and then. If you hold stock or stock traded options, you would not be able to react to news outside of traditional market hours. Consequently, when the markets opened, the opening stock price/traded option price would already reflect the earlier news. Too late for you to react!
|Trading day||24 Hours Weekdays||Local Market Hours||Local Market Hours|
You don’t need a lot of money to get started
The key to futures trading is, as covered above, the degree of leverage created by trading on margin. You obviously need to take a cautious approach to over-leveraging your positions, but there is potential to start trading with as little as $500 in your account. However, this is only part of the equation.
While some smaller futures brokers will allow you to open an account by depositing just $500, others may require $5000 or more. On top of the relatively small amount needed to open some accounts, you will also need to consider the margin requirement on different futures contracts. Some of the relatively small foreign-exchange micro-contracts will require a margin of less than $1000. However, some of the larger contracts, such as the E-mini S&P 500 futures contract, will normally require a margin of around 5% – circa $11,000.
Even though there is a degree of leverage when trading options, this is much less than that available with futures contracts. Consequently, the equivalent margin call would be greater. While it is possible to trade stocks on margin, the degree of leverage is again much less than futures trading.
How much do you need to start trading?
While it is possible to start trading with just $500, this should be seen as part of your learning curve, not a road to riches. Once you understand the markets better, how certain contracts work and how to protect your investment going forward, you can then consider increasing your investment and exposure.
It is important not to “put all of your eggs in one basket” when starting with a relatively small investment pot. Take your time, limit your downside and maximize the upside while, more importantly, learning lessons along the way. We have a very useful blog post entitled “Get started with $500,” which will explain the process of beginning your investment career with a relatively low deposit.
Futures are a Great Diversification Option
Many investors often overlook the diversification opportunities created by futures contracts. While each futures contract is a reflection of one asset price, if we look at the E-mini S&P 500 this offers indirect exposure to the 500 individual constituents. The cost and time constraints in trading each individual constituent would be extremely inefficient. On the flip side of the coin, if you believe that the S&P 500 index is about to fall, you could sell a futures contract and buy back at a lower price.
If you also take a step back and look at the wider picture, in an instant, you could have exposure to all of the major worldwide indices, oil, metals, commodities, and any other asset class where futures contracts were traded. In a scenario where you believe that the oil price is due to increase in the short to medium term, you may be tempted to buy oil companies. However, what do you go for, the majors, exploration companies, or the midmarket providers?
Using oil futures, you would simply be able to buy into the oil price with the hope of selling at a higher price when your prediction comes true. This reduces the risks associated with exposure to one or a small number of companies and ensures that you benefit from any increase in oil prices.
Futures contracts also allow you to hedge against potential falls in the market which would impact your existing portfolio. By effectively selling futures contracts, this will protect your existing portfolio with, in theory, the profit on futures trading offsetting the reduction in the value of your investment portfolio. The use of futures contracts as hedging is akin to an insurance policy, creating a significant element of the huge liquidity we see today.
|Futures Contract||Individual Stocks||Options|
Futures Offer Attractive Tax Benefits
When looking at futures, stocks, and options in this article, we are predominately considering short-term investments, less than 12 months. This brings into play the 60/40 rule, which differentiates short-term stock/ETF capital gains compared to future contract/traded options gains.
Under current US legislation, short-term capital gains from futures trading come under the 60/40 rule. Consequently, 60% of the gain is taxed at the long-term capital gains tax rate of 15%, while only 40% is taxed at the individual’s income tax rate.
Stocks and ETFs
Short-term gains created by investing in stocks and ETFs are not considered under the 60/40 rule. Instead, investors will be taxed at their ordinary income tax rate on any capital gains.
Under normal circumstances, the short-term trading of options should see capital gains assessed under the 60/40 rule. The situation is complicated when individuals take up the option to acquire stock and sell after one year. In this instance, it is important to take advice.
There are significant benefits when trading options or futures contracts, which would fall under the 60/40 rule, as opposed to stocks and ETFs. The long-term capital tax rate is approximately half of the short-term capital gains rate (the individual’s income tax rate).
|60/40 Rule||Applicable||Not applicable||Applicable|
No Pattern Day Trading Rules
Under SEC regulations, traders/investors executing four or more day trades over five business days, using a margin account, will be classified as Pattern Day Traders (PDT). Consequently, they will be required to deposit $25,000 into their margin accounts. If the margin account balance falls below $25,000, their dealings will be restricted until further funds are deposited. These regulations relate to securities and stock options. However, futures contracts and futures options are not part of the SEC day trade rule.
There are obvious liquidity benefits for those using futures markets as a means of gaining exposure to various indices and assets.
|Pattern Day Trading Rules||Not applicable||Applicable||Varies|
Access a Wide Variety of Assets
It is only when you begin to look in-depth at futures markets that you realize the huge variety of assets covered. This includes:
- Index futures
- Currency futures
- Commodity futures
- Interest rate futures
Aside from index options, traded options are irrelevant for many of these markets. While the majority will have some form of a cash market, if you are acquiring commodities, you will also experience an array of additional charges for storage, etc. The efficiency and the deep-seated liquidity of the leading futures markets continue to attract new business.
One very recent example of the fast-moving nature of futures markets was the introduction of Bitcoin futures onto the Chicago Mercantile Exchange (CME). This comes at a time when many regulators around the world are attempting to block direct investment in cryptocurrencies by retail investors. Consequently, the option to trade in cryptocurrency futures offers an ideal, regulated, means of gaining exposure to that market.
|Access to a wide variety of assets||Strong||Weak||Medium|
No Need to Worry About time Decay
The issue of time decay is very important when comparing futures contracts and stock purchases with traded options. Futures contracts and stock purchases are traded at what are known as “spot prices” which is the price at the time of the investment. An option price is made up of two elements:
- Time value
- Intrinsic value
The intrinsic value is the difference between the strike price and the price of the asset at the time. So, for example, if you have the option to buy shares in XZY Company at $20, and the current price is $25, the intrinsic value is $5. If you have the option to buy the shares at $20 over the next three months, you will pay an additional time value premium. Let’s say the option was trading at $6. This would equate to a $ 1-time value and $5 intrinsic value.
If, in three months, on exercise day, the stock was still valued at $20, then each traded option would be valued at $5. This is because the value of the three-month period in which you could acquire the shares has deteriorated; there is no element of time value. As the value of futures contracts and stock investments are directly related to the underlying assets at the date of purchase, with no time value as such, there is no time decay.
|Time Decay||N/A||N/A||Time value eroded|
Get Into Futures Trading Today
While it is obviously important to do your research before contemplating trading futures, nothing beats the hustle and bustle of “real-time” investment. We have an array of informative articles explaining futures trading, futures contracts, and the options available to you. We also have the “Trader Career Path,” which is an evaluation on a virtual futures trading account based on real-time prices and real-time movements. The chance to dip your toe into the futures market and feel the pressure, even though you are trading virtual funds.
The Trader Career Path offers the opportunity to flex your muscles and prove your trading skills over the duration of your subscription. The analysis of your trading results takes into account your investment returns but also your attitude to risk. It is the ability to de-risk your investments while maximizing the returns which will stand you in good stead. Those who can pass the test based on its rules and objectives are offered a funded trading account, a stepping stone to a long-term investment career.
Contrary to popular belief, while investment in futures contracts is seen as riskier than stocks and options, it is all about minimizing the downside and maximizing the upside. Stop-loss limits, trading strategies, and the like are used to protect investment capital, effectively cutting your losers and running your winners.
Get to know the Trader Career Path
We hope you enjoyed this article.
Put your skills to the test with the Trader Career Path, our funding evaluation designed for traders to prove their skills and build a trading career. Traders who pass the evaluation get a funding offer from a proprietary trading firm and keep 80% of the profit they make from it. Don't miss this opportunity! Contact us to learn more. Take the first step towards your new trading career today