When it comes to trading financial instruments, most people have at least heard of the common ones. These include stocks, bonds, and mutual funds. However, what some people may not know is that there are more financial instruments out there, such as exotic ones and derivatives.
For those not in the know, derivatives – or derivative contracts – are financial instruments that specifically derive their value from an underlying asset, which can be a stock, bond, or stock index. Derivative instruments include things such as options, futures, and forward contracts. This way, a trader can gain exposure to various financial instruments, without necessarily needing to own the underlying commodity, which is one of the reasons why they are becoming so popular nowadays.
Futures contracts specifically allow traders to buy or sell a specific commodity asset or security at a later future date for a set price and quantity. Futures contracts are generally traded on a futures exchange, which traders need to first open a brokerage account in order to gain access.
However, unlike an options contract, which can expire and become worthless, when a futures contract reaches its expiration date, the buyer is obligated to buy and receive the underlying asset, whereas the seller is obligated to sell and deliver the underlying asset.
Below, we have detailed a few of the common advantages futures trading has over stock trading. Here are a few of them below:
Futures are highly leveraged financial instruments
In order to start trading futures, an investor has to first put down a margin, which is a fraction of the total amount – usually around 10% of the contract’s value. The margin is a type of collateral that the investor has to keep with their broker in case the market moves in an unfavourable direction,and they end up incurring losses. These losses may sometimes be more than the margin amount, in which case the investor must pay more in order to bring the margin to a maintenance level.
When trading futures, investors have the ability to expose themselves to a greater value of stocks than they would have if they were just trading individual stocks. That means the potential for earnings is also amplified, especially if the market moves in a favourable direction. That said, on the flip side, leverage also puts investors at more risk when it comes to losing more than their original investment, because leverage is counted based on the total exposure of a position, not the initial margin of what a trader paid.
Futures markets are extremely liquid
The futures market – which is where traders go to trade futures – is extremely liquid. This is because futures contracts are traded in vast quantities every day. Additionally, the constant presence of buyers and sellers in the futures markets ensures that any market orders made can be placed extremely quickly. Moreover, this means that market prices do not fluctuate dramatically, especially for contracts that are near their maturity date. Thus, this means that a large position can be cleared out quite quickly and easily without adversely impacting prices.
In addition to being very liquid, many futures markets trade beyond traditional market hours, unlike the stock market, which is pretty set. In fact, extended trading on futures generally runs around the clock, 24/7, six days a week.
The execution and commission costs are low
When it comes to futures trading, commission costs tend to be pretty low, and they are generally charged once the position is closed. So, a total brokerage or commission is usually as low as 0.5% of the contract value. However, this depends on the level of service provided by the broker a trader works with, which is why it is so important to do thorough research before committing to a broker. An online trading commission can be as low as $5 per side, while full-service brokers may charge $50 per trade instead.
Great for hedging and diversification
Futures are fantastic when it comes to hedging and managing different types of risks, as well as hedging. For instance, companies that are engaged in foreign trade may use futures to lock in future prices and manage any foreign exchange risk. Companies can also use futures to manage interest rate risks if they anticipate a drop in rates or have sizable investments to make, in addition to price risks to lock in the price of any commodities such as metals, crops, and oil that are used as raw materials in manufacturing.
Futures and derivatives can also help to increase the efficiency of the underlying market because they can lower the unforeseen costs when it comes to purchasing an asset outright. For instance, it is a lot cheaper and more efficient to go long on in index futures than it is to replicate the index by buying every single stock in it.
Futures can further allow traders to access specific assets that are not typically found in financial markets. They can also be used if traders are looking for strategies designed to help manage some risk surrounding upcoming economic events that could end up impacting the markets.
Tend to be efficient and fair
The futures market tends to be more efficient and fairer, especially to newer investors, as it is difficult to trade on inside information in future markets. Unlike single stocks that have insiders or corporate managers who can leak information to close family and friends regarding a merger or bankruptcy, futures markets tend to not lend themselves to insider trading. This makes the futures market more efficient and gives average investors a better chance of competing with their more experienced counterparts.
Short-selling is easier
Short-selling tends to be easier when it comes to futures trading because one can simply gain short exposure on a stock by selling a futures contract. This is completely legal and applies to all types of futures contracts. However, one cannot always short-sell stocks, because there are different regulations when it comes to different markets. Some markets even prohibit the short-selling of stocks altogether. Additionally, short-selling typically requires a margin account with a broker, so to sell shorts, traders must borrow shares from their brokers to sell what they do not already own. If a stock is hard to borrow, it can be extremely expensive or impossible to short-sell those shares.