One of the most common questions people may ask financial experts is if futures trading is worth it. For those of you not in the know, futures are a type of derivative contract, which is where they derive their value from their underlying asset – which can be either a stock, a bond, a mutual fund, or commodities. Unlike other kinds of derivative contracts, a futures contract more specifically allows you to buy or sell a contract at a future date and at a predetermined price. As such, it is a fantastic way for traders to gain exposure to a variety of different financial instruments.
So, what are the benefits of futures trading? Why should you choose them instead of just simply trading stocks? Here are a few advantages that we have listed below. If you’re interested in this topic, do make sure to keep on reading!
They are highly leveraged instruments
When you trade futures, you can take advantage of margin and leverage. A margin is essentially the fraction of a total amount of a trading position that the trader has to pay upfront. In essence, it is collateral that the broker keeps in case the market moves in the opposite direction and a trade incurs losses instead. Of course, do keep in mind that these losses could end up being more than the margin because losses are based on what the total trading position is equalled to, not what you paid upfront.
However, using margin and leverage is fantastic as traders can expose themselves to a position that has a greater value without needing a lot of funds in the first place. Additionally, anything earned has the potential of multiplying if the market moves in the right direction.
The futures market is very liquid
As futures contracts are traded in large numbers every day, the futures market is extremely liquid. In fact, the constant presence of both buyers and sellers ensures that market orders can be placed very quickly. This also means that prices do not fluctuate so dramatically, which is great if a contract is near its maturity. Thus, if a trader wants to clear out a large position, they can do so without having any adverse impact on its price.
Moreover, most futures markets trade beyond traditional market hours. Unlike trading stocks, where there are certain start and end times, futures trading generally runs around the clock. This means that traders can take advantage of more opportunities that may crop up.
Commission costs are low
For futures trading, commission costs are often low, and they are generally charged when the position has closed. Usually, the commission or the total brokerage fee is as low as 0.5% of the contract value. Of course, this will depend on the types of services offered by the broker (as well as if there are any additional fees).
Great for diversification and hedging
You can also use futures to hedge and manage a variety of risks. For instance, companies that often need to engage in foreign trade may use futures to manage foreign exchange risk or interest rate risk. This is done by locking in the interest rate in case it drops in the future – especially if there are large investments on the line. Futures contracts can also be used to lock in prices of assets like commodities such as oil, metals, and crops. For example, if a farmer is worried that crops can be damaged by adverse weather effects, then they can use a futures contract to hedge against risk and set a pre-determined price. If adverse weather condition does occur, then the farmer will fortunately not have to take the loss. Moreover, futures and other such derivatives can increase the efficiency of the underlying market because it is less expensive to purchase them in comparison to purchasing an asset outright. For instance, it is a lot cheaper to go long in S&P 500 futures than to purchase every stock.
Short selling easier
If you want to get some short exposure, you can do so by selling futures contracts. On the other hand, regarding stocks, one cannot always sell short on them, as there are different regulations in different markets. This means that while some may allow short selling, other markets may prohibit short selling altogether. Additionally, if you wish to short-sell stocks, then you must open a margin account with a broker, in order to borrow shares from your broker (so you can sell what you don’t already own). If a stock that you want to short happens to be hard to borrow, it can end up being extremely expensive and even impossible to short-sell them.
The market is more efficient and fair
It is a lot more difficult to trade using insider information in the futures markets. This is unlike stocks, where a few people with powerful connections may be able to take advantage and predict certain moves before anything is publicly announced. This is because single stocks tend to have insiders or corporate managers who can leak information to their friends or family members. Information can consist of whether a company is merging or filing for bankruptcy. However, a futures market does not lend itself to insider trading. As such, trading in the futures market can be a lot more efficient and fairer to the average retail trader who may not have such powerful connections.
Certain tax benefits
Although other people may not know this, futures trading can provide traders with certain tax benefits when compared to other short-term trading markets. This is because most successful futures trades are taxed on a 60/40 basis. This breakdown means 60% of earnings can be taxed as long-term capital gains, while the remaining 40% is usually taxed at 40% ordinary income. In comparison to stock trading, all earnings made and held in less than a year are taxed 100% as ordinary income.
Futures contracts tend to be paper investments
As the underlying asset tends to rarely be physically exchanged or delivered, futures generally remain as paper transactions to traders – especially since the majority of them are either looking to hedge against risk or speculate on the market. As a result, this means that futures are less cumbersome than say, holding shares of individual stocks. This is you need to keep track of stocks and store them in some area (even if it is only electronically). In fact, companies need to know who owns their shares so that they can pay out dividends and record any shareholder votes. On the flip side, futures contracts do not need to bother with all this complicated record-keeping.