Before I can tell you the advantages and disadvantages of trading futures, it’s important to understand how it differs from trading stocks.
When you buy a stock, you own a part of the company. That is, you share the property with other investors. That’s why we say you buy share.
Futures trading, on the other hand, requires a contract to buy or sell the commodity in the future. that’s why they are called future.
You can buy or sell those futures contracts just as easily as trading stocks. In fact, you don’t even have to spend the money. However, it does tie up resources in the form of margin.
The problem is that the retained margin is not close to the actual value of the product if you were to buy it. This is known as the Notional Value. It is calculated as the market value multiplied by the leverage.
Ok, so I just threw two more terms at you that need definition:
Tea market value it is the price that traders are willing to pay. In general, this is determined by supply and demand. Tea leverage is the number of units of the future index.
For example, the E-Mini SP& 500 Futures has a leverage of 50. As of this writing, it is trading near a market value of 2100. Multiply that by the leverage (50) and you get $105,000. That is the Notional Value of the E-Mini S&P.
As you can see, if you buy an E-Mini S&P contract, you are controlling $105,000 in value. Unlike stocks, however, it is not owned by you. You only have one contract to buy or sell it, depending on whether you were long or short.
low margin required
What did you actually pay? That is known as the margin that the broker requires you to maintain while that trade is active. It varies, but it costs around $5,000.
If you bought a stock valued at $105,000, you would have to pay $105,000. If you used margin, you would still require a payment of half of that. The advantage of futures is that you only commit a small fraction.
However, the downside is that you need to know what you’re doing. If you let a futures trade slip past you, you are responsible for a large investment. Remember, it’s a contract.
That is why traders buy and sell futures contracts without ever buying the commodity.
What is the downside?
When trading futures, you must apply your due diligence to learn the notional value of the futures contract.
If you don’t pay attention to the Notional Value, and a trade keeps going against you and you don’t close the trade with a small loss, it can get out of control.
You could end up losing a lot of money in a short time. If you reach your margin limits, your broker will close the trade if you don’t. That means he’s been taken off the market and he may not have the resources to get back on the market. Game over!
For this reason, it must remain small. Don’t jump into bad trades in the hope of lowering your cost bases. Rather, just admit you were wrong and be available to play another day when an opportunity arises.
Advantages?
There are many, and these are the reasons why I love stock futures. The rest of this article will briefly list the advantages of futures trading.
long and short trades
Going short futures is just as easy as going long. It’s just a matter of deciding which direction you think the market is heading.
No daily trading limits
There is no daily transaction limit with Futures. Stocks can only be traded three times in a day before the IRS considers you a day trader. Futures can be bought and sold any number of times in a day, allowing for quick profits and taking advantage of intraday swings.
No penalties for wash sales
The IRS does not penalize you for taking a loss and re-entering the same trade within 30 days. When this is done with shares, it is considered a fictitious sale and you lose the benefit of deducting the loss unless you can carry it over to a future gain on the same shares.
The reason there is no penalty for futures is because futures prices are recorded as Marked to Market. I won’t go into that here. You can always do a Google search for the term if you’re interested.
24 hour trading
Futures are traded nearly 24 hours a day, except for weekends and short periods in between for exchange record keeping.
European-style trade
Stock options follow the American style that can be exercised at any time. When trading stock options, care must be taken to avoid being exercised if the option is in-the-money.
Most futures options are traded in the European style, which cannot be exercised before expiration. There are some exceptions, especially with weeklies. However, that is beyond the scope of this article.
Tax Advantage
Futures and options on futures are treated in accordance with IRS Section 1256. That provides a tax advantage since 60% of all earnings are considered long-term. This is true even if it is held for a few seconds.