If you’re in the market to invest or perhaps you already have you may be wondering whether to trade in futures or stocks or possibly both. When making the decision on futures vs. stocks it is important that you understand the strengths and weaknesses of each.
It should be noted that this article is for educational purposes and to help you gain insight into futures vs stocks. It is not financial advice.
What are Stocks?
Stock is the value of a company and when you buy shares in a stock you are buying partial ownership of the company. So if you buy 500 shares in a company that has 500,000 shares, you own 0.1% of that company.
Once you become a shareholder you often ascertain certain benefits. You may:
- Have voting rights on company affairs. This won’t be universal but on specific issues.
- Attend the company shareholder meeting.
- Benefit from the company’s future earnings.
- Receive quarterly or annual dividends. This is a proportion of the company’s funds distributed to shareholders.
What are Futures Contracts?
Futures contracts are legally binding agreements between two parties to buy or sell a specific asset at a set price and date. Often this is a physical asset such as wheat or oil. It can also include other assets such as currencies and bonds.
They offer a lot of flexibility and offer price protection to the seller. They are considered harder to trade, however, than stocks and are considered riskier.
Futures vs. Stocks – Understand Margin
Margin works differently in futures than in stocks. It is important to grasp how they work in both instances although there are similarities too. They both require an intermediary to operate.
Margin and Stocks
Margin in the equity market is a loan from the broker to buy more stock with a view of making more profit. The margin is the amount you borrow from your broker to purchase stocks or securities. For example, the total amount of stock you want to buy is valued at $10,000, if your margin is 50%, you’ll put down $5000 with the broker putting up the remaining $5000.
It should be noted that certain rules may apply when purchasing securities such as the Federal Reserve allows no more than 50% margin in relation to buying securities.
Trading using margin is referred to as leverage trading.
The risk here is that should a price loss occur your broker will ask you to make a margin call. Here, you either close out positions to repay your loan, or you meet the price loss by staking more money to top up the difference.
Margin and Futures
Margin works a little differently in the futures market than in the equities market. When you open a position you put down a small percentage of the total contract value. This is your margin. The leverage is the total value of the contract minus the margin amount.
Should the contract value drop you’ll be asked by the broker to top up the margin by the value of the loss.
The advantage is that you can open a position for little outlay and potentially make a good return, the disadvantage is that potentially you are exposed to considerable risk. When you operate with leverage you can lose more than your original investment.
Advantages and Disadvantages of Futures Trading vs. Stocks
The more nuanced futures market offers more flexibility than the equities market and in some jurisdictions offers more favorable tax benefits. It also gives you direct access to commodities rather than secondary access.
Traders use the tool to diversify portfolios or to hedge against risk. Others, use it to price protect the value of an asset such as corn for example.
As a speculative instrument, futures gives you a good capacity for good returns. The downside is that the reverse is also true so the risks are greater.
Stocks, on the other hand, do carry risk as do all investments. The advantage stocks have is that should things go south the impact is not so severe.
As such, it is imperative that you do research into any investment and have an investment strategy. This will help you navigate the landscape and make the right decisions at the right time, which is crucial for trader success.