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 to court risk through speculation. A futures contract is known as a derivative because it derives its value from an underlying asset, such as a stock or bond index, or a more tangible product like gold or other commodities. But are stock futures good investments?
Are Futures Good for Trading?
Futures offer a way to protect existing positions or to profit rapidly from price movements in various markets. Due to these and other factors, stock futures offer many advantages over simply buying or selling stocks. Here are eight top reasons why.
1. Less Capital Required
If you have limited funds to invest — or if you simply don’t want to lay out as much capital — futures can be a good choice. Since futures are leveraged, you’ll only have 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 you were to buy stocks or ETFs with that money instead, all of your money might be tied up in a single investment.
For example, imagine you wanted to invest $20,000 into the S&P 500 index via an exchange-traded fund. You’d have to put up the full amount of the trade — $20,000 — if you were buying the ETF in a cash account. But if you instead bought futures on the S&P 500, you might only have to put up $2,000, or even as little as $1,000.
Leverage is one of the prime reasons that investing in futures is better than buying stocks — assuming you are correct in the timing of your trade. As futures may only require 5% to 10% collateral, your profits can be greatly amplified.
If the ETF gained 10%, your $20,000 in the ETF would generate a $2,000 profit. But the same movement could translate into a 100% gain or more on your futures position.
Remember the Risk
Of course, leverage cuts both ways. If your position moved against you, you could lose significantly more than you might by buying a stock or ETF outright. In fact, with a futures contract, you can actually lose more money than you initially invest.
Futures positions are “marked to market” every day, with the amount of gain or loss being credited to or debited from your account. If you don’t have sufficient collateral in your account to meet your losses, you’ll receive a margin call, requiring you to put up additional money to make your account square. But still, in most cases, you’ll have to put more money into your position if you buy a stock or ETF outright than if you receive a futures margin call.
Futures markets are extremely liquid. Not only can trades be executed essentially immediately, futures markets are nearly always open. Whereas the stock market is only open from 9:30 a.m. EST to 4:00 p.m. EST, futures markets are open nearly all the time. Stock futures trade six days a week — every day except Saturday — and are only closed for one hour per trading day, from 5:00 p.m. EST to 6:00 p.m. EST.
This means that compared to futures traders, stock traders — especially day traders — are essentially left out in the cold. If market-moving news is reported after the stock market closes, stock traders have to wait until the following morning to make a move. Futures traders, on the other hand, can act immediately in most cases. This is one of the major advantages that trading futures has over trading stocks.
4. Returns Can Be More Rapid
Leverage and liquidity are two factors that allow for more rapid returns in the futures market. Whereas the average long-term return of the S&P 500 index hovers around 10%, a futures trader could easily make 10% in a single day — and those gains can be captured at nearly any time, since futures trading is only closed for about 30 hours of every week.
5. Easier To Short
If you’re a stock investor and you want to hedge a position — or simply speculate that a stock will go down — you’ll have to borrow shares from your broker and sell them in the open market. This process is known as short-selling.
One of the problems with short-selling is that it can be hard — or expensive — to find shares to borrow to sell short. Additionally, some stocks cannot be shorted, and some brokerage firms may have restrictions limiting your ability to sell short. You might also have to pay a commission when you short those shares, and you’ll have to execute your trade during market hours.
With futures, however, none of these restrictions apply. There’s no need for your brokerage firm to find shares to short, you can sell a futures contract at nearly any time and your costs will generally be minimal.
6. Easy Way To Hedge Positions
One of the most common uses of futures is to hedge existing stock positions.
Imagine you own a stock at a gain but you feel the market overall is about to go down, perhaps due to macroeconomic factors. If you own a stock outright, you have two options: sell or hold. If you sell, you’ll have to pay capital gains tax on your profits, which no investor wants to do. If you hold, you might sit on the sidelines helplessly as you watch your profits evaporate.
If you instead sell futures against your stock, however, you can profit on your futures position while your stock is going down. This will result in no change to your portfolio value even though your stock fell in value. If you feel your hedge 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 fashion. News of corporate earnings shortfalls, bankruptcies, mergers and other market-moving news often finds its way into the ears of connected friends, family members and institutional investors ahead of the general public, making it hard for individual traders to get a fair shake trading individual stocks.
But in the futures market, price is the only information to be had. Every futures trader sees the same price action in the market at the same time, allowing each to make their own decisions about whether to buy or sell without worrying that another investor has an inside edge.
8. Lower Cost of Trading
Although the playing field has started to level, traditionally, futures have typically been a lower-cost investment than individual stocks. Until relatively recently, brokerages typically charged hundreds of dollars per trade for buying stocks, and many full-service firms still do. But commissions and fees for futures contracts were typically more in the $5 to $50 range.
In the 1990s and 2000s, trading costs began to come down, particularly for online brokerages, helping to level the playing field. In fact, many online brokerages now offer commission-free trading of stocks. But futures costs continue to fall as well, with many brokers offering trades for just $0.25 to $1.50 per contract and some online firms charging $0.
Are Futures Better Than Stocks?
If you’re up for the risk, futures can offer significantly higher returns than stocks — but they can also offer significant losses. If you’re interested in trading futures, consider first consulting with a financial advisor to get a good idea of what the risks and rewards look like and whether they’re a good fit for your goals.