Many traders trade nothing but stocks their entire life. Some however make the jump into the futures arena. Why is it that there is sometimes such a reluctance on the part of experienced traders to make that leap. For the most part it seems that there still exists the impression that futures are so much more risky than trading stocks. In fact, as long as a trader is employing a wise risk management program that includes stop orders, futures can be no more risky and sometimes less risky than trading stocks.
As long as a trader educates himself as to the nature of futures, and the details of their trading rules, futures offer another alternative that opens up a whole new world of trading.
What are the primary differences between these two instruments? What does a trader need to be aware of before deciding if futures are right for him/her? Here are 6 of the key differences:
1) Leverage - When buying stocks on margin, the most leverage that can be applied is about 3:1. Which means that for every dollar move in the stock, your account equity will move $3. However in the futures markets, leverage can be anywhere from 5:1 up to 100:1. This provides for a much greater reward potential, but obviously also a much greater risk potential. As an example, a single Live Cattle contract has an underlying value of approximately $37,000 at today's prices, but it only requires a margin deposit of $1600 - a gearing ratio of about 25:1. In essence, one can get a much bigger bang for a much smaller stake when trading futures.
2) Holding Period - When trading stocks, you can buy and hold a stock as long as you wish, assuming you can maintain any margin required. That means that your holding time can be anywhere from minutes to years. Futures contracts have a limited lifetime though. A trader must exit a position prior to what is known as First Notice Day, otherwise they risk taking delivery of the underlying commodity. Since most traders prefer to trade the more liquid near month contracts, trades have a relatively short life. Most futures trades have a timeframe from minutes (for the scalpers and day traders) to perhaps months.
3) Trading Schedule - If trading on North American stock markets, trading normally takes place between 9:30 and 4:00 EST. This means that you do not have to monitor positions after hours, but it also means that you are at risk of adverse price movements created by events that happen while markets are closed. Even if you utilize stop losses, if something happens overnight that affects your holdings, the price at market open the next day can be well below your stop loss, leading to potentially large losses. On the other hand, most (although not all) futures contracts trade almost continuously around the clock. What this means is that you can trade whenever you want, but also that prices will react in real time to overnight events, allowing a much greater chance that your stop orders will be filled, protecting you from more extreme losses.
4) Trading Price Limits - Most stocks have no limits and can move either up or down by an unlimited amount on any given trading day. Most futures have limits. They are restricted from moving either up or down by more than a set limit on a single trading day. Should the price reach a limit up, no further trading can take place that day, unless it falls back below the limit. If a market goes limit up or limit down for consecutive days, a trader can find herself locked into a position that she is unable to get out of.
5) Long and Short - When trading stocks, it is easy to play the long side of the market by just entering a buy order. It is much harder though to play the short side. One must first have his broker arrange to borrow the stock to sell, and you are always subject to being bought back in against your will if your broker can no longer borrow the stock. Futures are much more flexible, and one can participate on the long or short side of the market with equal ease.
6) Funds at Risk - If one pays for their stock purchase in full, the most they can lose is their initial investment. When trading futures the margin one puts up to cover the trade is only a performance bond. If the market should move against you, losses can be much greater than the initial investment. That is why it is always prudent to utilize stop orders to protect oneself.
While the above key differences are substantial, there are certainly many areas in which futures and stock trading are similar. Nowadays they can both be traded quickly and easily online through electronic trading platforms and with a wide variety of brokerage firms, from full-service to self-service discount channels. Most importantly, educate yourself fully before putting your money at risk in any market.
Bryan Moffitt is the owner of Futures Research Corp. - a company that provides traders with valuable analysis and research to improve their trading success in the futures markets