Topics covered
- Advantages of Trading Futures vs Stocks
- Eight Advantages of Trading Futures.
- Futures are Highly Leveraged Investments
- Future Markets Are Very Liquid
- Commissions and Execution Costs Are Low.
- Speculators Can Make Fast Money
- Futures Are Great for Diversification or Hedging
- Futures Are Great for Diversification or Hedging
- Futures Contracts Are Basically Only Paper Investments
- Short Selling Is Easier
3. Characteristics of Futures Contract
4. Mechanics of Futures Market
5. Specifications of Futures Contract
6. Termination of Futures Contract
7. CONCLUSION
Advantages of Trading Futures vs. Stocks
Futures are derivative contracts that draw their value from a financial asset, such as an established stock, bond, or stock index. As a result, they can be used to get exposure to a variety of financial instruments, such as stocks, indices, currencies, and commodities.
Futures are a popular tool for risk management and hedging; if someone is already exposed to speculation or makes money from it, it is primarily because they want to protect themselves from risk.
Future contracts offer numerous inherent advantages to trading equities because of the way they are set up and transacted.
Eight Advantages of Trading Futures
1. Futures are Highly Leveraged Investments
Investors must deposit a margin, which is a portion of the entire amount (usually 10% of the contract value), in order to trade futures. The investor must maintain the margin with their broker or exchange effectively as collateral in the event that the market moves in the opposite direction of the position they have placed and they suffer losses. If this is greater than the margin, the investor will need to pay more to get the margin up to the maintenance level.
Essentially, trading futures allow investors to expose themselves to far more stock value than they could when purchasing the original socks. Therefore, if the market swings in his favor, their profits will also increase (10 times if the margin requirement is 10%).
For instance, if a buyer wishes to put $10,000 into the S&P 500 index, they can choose between buying 25 shares of the SPDR S&P 500 ETF (SPY), which trades at about $400 per share, or one E-mini futures contract, which has a $10,000 margin requirement. The investor would have made $25 if SPY rose to $401. The E-mini contract would have grown from $4000 to $4010 over that time, representing a $500 gain (1 index point = $50.00).
2. Future Markets Are Very Liquid
Futures are particularly liquid because they are exchanged in a massive volume every day. Future market orders can be placed fast because of the constant presence of buyers and sellers. Additionally, this means that costs do not change significantly, especially for contracts that are almost due for renewal. As a result, it is also possible to easily liquidate a sizable position without having an adverse effect on price.
Many futures markets trade outside of regular market hours in addition to being liquid. Extended stock index futures trading frequently occurs around the clock.
3. Commissions and Execution Costs Are Low
Futures trade commissions are paid after the position is closed and are extremely minimal. Typically, the entire commission or brokerage is less than 0.5% of the contract amount. However, it relies on the quality of the broker’s services. While full-service brokers may charge $50 for every deal, an online trading commission can be as low as $5 per side.
4. Speculators Can Make Fast Money
Futures trading essentially involves 10 times the exposure of regular stock trading, so a prudent investor can profit quickly. Additionally, prices in futures markets frequently fluctuate more quickly than those in cash or spot markets.
But a word of warning: Although winning can happen more quickly, futures also increase the likelihood of losing money. Nevertheless, it might be reduced by utilizing stop-loss orders. Futures may be a riskier instrument than a stock when markets are volatile because of their high level of leverage, which makes margin calls for traders with wrong-way bets more likely to occur sooner.
5. Futures Are Great for Diversification or Hedging
Futures are crucial tools for hedging or managing various types of risk. Futures are used by businesses engaged in international trade to manage three types of risk: foreign exchange risk, interest rate risk (by locking in a rate in anticipation of a decrease in rates if they have a sizable investment to make), and price risk (by locking in prices of commodities like metals, crops, and oil that are used as inputs).
Due to their ability to reduce unanticipated expenses associated with outright asset purchases, futures and derivatives contribute to the improvement of the underlying market’s efficiency. For instance, buying S&P 500 futures is far cheaper and more effective than buying all the stocks in the index to mimic it.
6. Futures Are Great for Diversification or Hedging
Trading on insider information in futures markets is challenging. Who, for instance, can confidently foresee the next Federal Reserve policy move? Futures markets often trade market aggregates that do not lend themselves to insider trading, unlike particular stocks where insiders or corporate management may have the ability to leak information to friends or family to front-run a merger or bankruptcy. Futures markets can be more effective and provide equitable treatment for common investors as a result.
7. Futures Contracts Are Basically Only Paper Investments
Except on rare occasions when someone trades to hedge against a price rise and receives delivery of the commodity/stock on expiration, the actual stock/commodity being traded is rarely exchanged or delivered. Typically, futures are a paper transaction for investors only interested in speculative gain. As a result, holding futures is less time-consuming than owning shares of actual equities, which require tracking and storage (even if only as an electronic record). To record shareholder votes and pay dividends, businesses need to know who owns their shares. All of such record keeping is not necessary for futures contracts.
8. Short Selling Is Easier
It is entirely legal and applicable to all types of futures contracts to gain short exposure on a stock by selling a futures contract. Contrarily, not all stocks can be sold short because different markets have different laws, some of which outright forbid the practice. A margin account with a broker is necessary for shorting stocks, and in order to sell what you don’t already own, you must borrow shares from your broker. Short-selling shares of a stock that is difficult to borrow may be expensive or perhaps impossible.
Characteristics of Futures Contract
- A standard contract is a futures contract. The exchanges choose the underlying asset’s quality and quantity as well as other factors like settlement day. The contracts’ standardized terms and conditions encourage liquidity. Futures contracts are therefore more liquid than forwarding contracts.
- The settlement of every deal is ensured by a clearing house. It serves as both a buyer and a seller to all buyers and sellers.
- Margin accounts are a concept in futures contracts. Later on in this post, we will go into more detail about this idea.
- Futures contracts, in contrast to forwards, are typically not resolved at expiration. Before expiration, the majority of futures contracts are closed out.
Mechanics of Futures Market
- The investor gives the broker the order.
- Additionally, the investor keeps a margin account with the broker.
- Order is placed with the trader by the broker, who then instructs the trader to execute it on the exchange.
- The margin is also deposited by the broker with the clearing house member, who then deposits it with the clearing house.
Specifications of Futures Contract
- If the asset is a commodity, the exchange will determine its grade, color, form, size, and other characteristics.
- The number of assets to be supplied under the contract.
- The delivery location will be chosen.
- The month of delivery will be chosen.
Termination of Futures Contract
Four options exist for terminating a futures contract:
- Delivery: The party in the short position can end the futures contract by delivering the good, and the party in the long position can do so by accepting delivery and paying the short future price.
- Cash Settlement – In this scenario, parties exchange cash based on the difference between the current value of the underlying asset and the anticipated future value, rather than delivering the underlying asset.
- Closeout – The majority of futures contracts are still unresolved. By entering into an offsetting contract, they are concluded. A party holding a long position may close it out by taking a short position. In a similar manner, a party holding a short position may close it out by taking a long position.
- Exchange for physicals – This is a trade where two parties agree to settle the trade-off of the exchange. Following their agreement to finalize the trade, these two parties are required to notify the exchange of the deal.
CONCLUSION
Futures on stock indexes are used for trading, investing, and hedging.
- Hedging against a portfolio of shares or equity index options may be done when employing stock index futures.
- Trading with stock index futures may encompass several activities, such as volatility trading (The greater the volatility, the greater the likelihood of profit taking – usually taking relatively small but regular profits).
- By using stock index futures, investors may gain exposure to a market or industry without having to own shares directly.