Futures and stocks are two of the most significant asset types available to individual investors. They may both provide returns on investments, but for distinct reasons. Futures are typically viewed as riskier than stocks. Many investors primarily invest in one or the other, and they are either stock investors, hedgers of futures, or speculators. Should you invest in one or the other in the argument between futures and stocks? To shed light on the subject, we compare the risks and rewards of investing in futures vs stocks.
What Are Stocks?
When you purchase shares of stock, you acquire a piece of a company's ownership, the exact proportion dependent on the total number of stock shares issued. For instance, an investor who purchases 1,000 shares of a corporation with 1 million outstanding shares owns 0.1% of the company.
The ownership of stock grants the right to vote on certain corporate matters and attend the annual shareholder meeting. Your shares signify the license of the company's assets and the right to future profits (typically reported on a per-share basis). Some corporations may also deliver a quarterly or annual dividend, representing a percentage of the company's funds to shareholders.
What Are Futures?
Futures, futures contracts, and stocks are vastly different financial products. A stock is a form of equity security. When you purchase a stock, you are buying a portion of a corporation. If the stock price rises above what you paid for it and you sell it, you generate a profit by capitalizing on its price appreciation. You can lose money, but you can never lose more than your initial investment plus transaction costs.
When you invest in futures, you sign a contract rather than purchasing a stake in a firm. The agreement says that you will pay a special price for the underlying asset at some point in the future. You are essentially wagering that the underlying asset will cost a particular amount on the expiration date of the futures contract. The underlying asset could be a currency or a commodity, and however, it may be a financial asset such as a stock or bond. Typically, futures are short-term investments with maturities of one year or less.
Futures are exchanged on a regulated exchange, just like stocks. The Chicago Board of Trade and the New York Mercantile Exchange are two futures markets, and it is the futures exchanges that design and publish the contract terms. The amount of futures contracts that can be created is unlimited.
Different Types of Futures
Futures contracts cover many financial and commodity-based instruments, ranging from indexes, currencies, and debt to energy, metals, and agricultural items. Examples of available futures contracts are provided below.
Financial futures are comprised of index contracts and interest rate (debt) contracts. Index contracts provide exposure to specific market index values, whereas interest rate contracts expose a particular instrument of debt's interest rate.
Currency Futures
Currency contracts offer exposure to the exchange rate of fiat or digital currency.
Energy Futures
Energy contracts offer exposure to the price of everyday energy items utilized by businesses (for manufacturing, production, and transportation) as well as governments and consumers (for consumption).
Contracts for metals provide exposure to the price of particular metals that many businesses use in manufacturing and construction (e.g., gold for computers or steel for housing).
Grain Futures
Grain futures provide exposure to the prices of raw grain materials used for animal feed and commercial processing into other products (such as ethanol and corn syrup) and soybeans that have been processed.
Livestock Futures
Contracts on livestock provide exposure to the pricing of live animals utilized in the production, distribution, and processing of meat products.
Food & Fiber Futures
These contracts related to an increase in the prices of specific agricultural items that are grown instead of extracted or mined (also referred to as Softs) and dairy products.
Advantages of Stocks
When you invest in a stock, you truly own a little portion of a company, even if you receive a paper certificate in exchange. You can diversify a stock portfolio with nine to thirteen carefully selected stocks. There are not even required brokerage costs. You can invest independently and even purchase fractional shares if you utilize one of the numerous created free stock trading apps. Your only expense will be time if you do not use a broker. Since you do not depend on a broker's recommendations, you must conduct your research. That is only possible if you have above-average financial and stock market understanding.
Discount brokers do not provide advice, and most stock trading applications utilize Robo-advisors. It also presupposes that you are composed and will not sell in a panic if the market declines. In truth, and according to Warren Buffett, you need a diversified portfolio of properly selected stocks that are likely to do well over the long term.
You can grow your wealth by investing in stocks inside a tax-advantaged portfolio. Your investments can grow tax-deferred in an IRA or 401(k) until retirement, when you may be in a lower tax bracket. If you own stocks outside of a tax-advantaged portfolio and sell them, you will incur an income tax liability. If you sell an asset within a year of its purchase, you will be subject to the higher short-term capital gains tax. You will be liable to the lower capital gains tax rate if you sell after one year.
Advantages of Futures
Futures Are Speculatively Highly Leveraged Investments
Futures trading requires a margin deposit, a fraction of the total amount (typically 10 percent of the contract value). The margin is simply collateral that the investor must maintain with their broker or exchange if the market goes against their position and they incur losses. This may exceed the margin amount, in which case the investor must pay additional funds to maintain the margin.
Essentially, trading futures means that the investor can expose himself to a higher value of stocks than he could when purchasing the actual socks. Consequently, their profits will increase if the market moves in his favor (10 times if the margin requirement is 10 percent ).
Future Markets Are Very Liquid
Futures are particularly liquid as a result of the daily volume of trades. The persistent presence of buyers and sellers on futures markets facilitates the swift placement of market orders. Additionally, this implies that prices do not move significantly, particularly for nearing maturity contracts. Thus, it is also relatively simple to liquidate a multiple positions without affecting the price.
In addition to being liquid, many futures markets trade outside of standard market hours. Extended trading in stock index futures frequently occurs overnight, and some futures markets are open 24 hours a day, seven days a week.
Low Commissions and Execution Costs
When a position is closed, commissions on futures transactions are incredibly minimal. Typically, the entire commission or brokerage fee is less than 0.5 percent of the contract value. However, it depends on the degree of service the broker provides. A commission for online trading may be as low as $5 per side, whereas full-service brokers may charge $50 for every trade.
Speculators Can Make Money Rapidly
A shrewd trader can make quick money in futures since they are dealing with ten times as much exposure as with regular stocks. In addition, futures market prices tend to fluctuate more rapidly than cash or spot market prices.
However, a word of caution is warranted because futures increase the chance of losing money. However, it could be mitigated by the use of stop-loss orders. Because futures are highly leveraged, margin calls may arrive sooner for traders with wrong-way bets, making them a potentially riskier instrument than stocks during rapid market movements.
Futures Are Excellent for Diversification and Insurance
Futures are crucial instruments for hedging or managing various types of risk. Futures are used by companies engaged in international trade to manage foreign exchange risk. Interest rate risk by locking in an interest rate in anticipation of a drop in rates if they have a substantial investment, and price risk to lock in prices of commodities such as oil, crops, and metals that serve as inputs. Futures and derivatives boost the efficiency of the underlying market by reducing the unanticipated costs associated with buying an asset outright. For instance, it is significantly less expensive and more efficient to go long on S&P 500 futures than to duplicate the index by acquiring each stock.
Future Markets Are More Productive and Equitable
Futures markets make it impossible to trade on inside information. Who, for instance, can accurately foresee the following Federal Reserve policy action? Futures markets often sell market aggregates that do not lend themselves to insider trading, as opposed to single stocks where insiders or corporate managers can leak information to friends and family to front-run a merger or bankruptcy. Consequently, futures markets can be more efficient and equitable for average investors.
Essentially, Futures Contracts Are Paper Investments
The actual stock/commodity being traded is rarely exchanged or delivered, except when someone changes to hedge against a price increase and takes delivery on expiration. Futures are often a paper transaction for speculatively motivated investors. This indicates that having futures is less onerous than holding individual stocks, which must be tracked and stored (even if only as an electronic record). To pay dividends and record shareholder votes, businesses must identify the owners of their shares, and futures contracts do not require any of these records.
Selling on Credit Is Easier
It is lawful and applicable to all types of futures contracts to obtain short exposure on a stock by selling a futures contract. On the other hand, it is not always possible to short sell all stocks due to varying rules between markets, some of which forbid the short sale of stocks entirely. Short-selling stocks need a margin account with a broker, and to sell what you do not already own; you must borrow shares from your broker. Short selling a stock that is difficult to borrow can be expensive or perhaps impossible.
Risk of Futures
The most significant and most evident risk when entering into a futures contract is that trades can go against you. For instance, suppose you purchase 10,000 gallons of gasoline at $2 per gallon on a futures contract for delivery in three months. If the price increases to $2.25 per gallon by the futures contract's expiration date, you, as the buyer, will profit. You paid only $2 per gallon. What if, however, the price of a gallon of gasoline decreases to $1.75? You must still pay $2 a gallon to meet the conditions of your contract. So, you lose $0.25 per gallon. You have lost your original investment of $2 per gallon and an extra $0.25 per gallon as a consequence of the decrease in the cost of gasoline relative to what you agreed to pay.
The margin requirements represent an additional risk associated with futures trading. Typically, when you purchase a futures contract, you are not required to pay the total amount immediately. Instead, you can use your brokerage account to pay a portion of the contract's value and borrow the remainder from your broker. Given that futures contracts are marked to market daily, you may occasionally need to deposit more funds into your margin account to meet margin requirements. Your payment is known as a performance bond. If you lose money on the futures contract, you will also forfeit the required margin deposit. Futures can also be sold short with no minimum market increase.
Futures traders have access to a more significant amount of leverage than stock traders, and most brokers only offer a 50 percent margin requirement for stocks. It may be possible to obtain 20-1 leverage for a futures transaction, which can multiply your winnings and magnify your losses. If you invest in futures based on daily mark to market, you will experience financial flows, but they could be cash inflows or outflows.
Futures tax reporting is not as complex as you would believe. The broker will provide you with a 1099 B form that summarizes your trades at the end of the year. Futures may have more favorable tax treatment than stocks. Future returns are subject to the 60/40 rule, under which 60% of your gains are taxed at the long-term capital gains rate and 40% at the short-term capital gains rate.
Even if the futures market is more liquid and possibly more efficient than the stock market, the most significant risk associated with investing in futures is that you can lose a substantial amount of money.
Which Should You Select?
To decide whether to trade only stocks or futures, one must comprehend their similarities and contrasts. The capacity to diversify assets is one of the commonalities between stocks and futures; both offer investments in various businesses and areas. Additionally, both sorts of investments are liquid. Typically, you can purchase and sell stocks at a moment's notice, giving you rapid and easy access to your money. Additionally, the futures market is liquid, and futures contracts are continuously traded. Moreover, both stocks and futures can generate cash. Numerous stocks produce current revenue via dividends, and futures contracts create positive or negative cash flow since they are marked to market daily.
In addition to the significantly more considerable risk associated with futures, there are important distinctions. Cost is one such distinction. Futures trading incurs far higher transaction costs than stock trading. In addition, the two have pretty different time frames. Typically, stock investments are made for the long term, in part due to tax implications. The income tax rate on short-term capital gains is greater than the income tax rate on long-term capital gains. Short-term futures investments are made with maturities of less than one year.
Final Thoughts
Futures are attractive to all types of investors, whether they are speculative or not. However, overly leveraged positions and big contract sizes expose investors to enormous losses even for minor market changes. Before trading futures, one must establish a plan and conduct thorough research and be aware of both their benefits and risks.
To determine if you should invest in futures, stocks, or both, you must assess each variable. Despite some of the benefits of futures trading, it is not a game for the novice or tiny investors. It would help if you had a comprehensive understanding of the futures market and assistance from your broker or other financial experts. However, investing is a personal decision that ultimately depends on your risk tolerance, time horizon, and investment objectives.
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