As a either a financial instrument or an investment vehicle, Futures contracts differ from stocks in a number of very significant ways. If you have experience in one and are considering trading the other, then ensuring that you understand the main attributes of each product type will help you to avoid unnecessary mistakes and losses.
Shares in a company’s stock represent partial ownership of that company, and allow you to benefit from things like shareholder voting rights as well as receive any dividend that is issued to investors in the company’s stock.
The value of each individual share that you own will rise or fall according to changes in the company’s value on the open market. In this way you gain exposure to market price change, and so stocks can be used as a vehicle for speculation.
A future, by contrast, is a legally binding contract. It is drawn up by an exchange and is standardized in its terms, meaning that lots of other identical contracts also exist. The contract is between two parties, a buyer (who hopes to profit from rising prices) and a seller (who hopes to profit from declining prices).
Because each contract requires both a buyer and a short seller, the short-selling of futures is very straightforward and doesn’t involve any of the complications of short-selling stocks, where the stock must first be borrowed. A futures contract functions much more like a simple bet on price direction.
The price of the future mirrors that of the commodity or asset as traded in the cash or “spot” market, which is known as the “underlying”. For example, the spot price of gold bullion is the underlying market for gold futures. As the price of gold rises or falls, so too will the price of a gold futures contract. Because a future derives its price from that of the underlying, it is known as a “derivative”. Buying or selling a future, which is merely a contract, does not imply ownership of the underlying asset.
It’s worth pointing out here that a number of ‘single stock futures’ are now available via the OneChicago exchange. These are simply a future contract for which a stock is the underlying; they share all the attributes and risks of futures and should be thought of as such.
Leverage for Stocks and Futures
Unlike stocks, which are bought and sold at their actual value (i.e. a share worth $100 will cost you one hundred dollars to purchase), futures are leveraged, which means that just a small deposit known as margin can be used to control a potion with a large face value (e.g. a futures contract worth $96,000 can be bought on margin for $6,000). A single futures contract tends to have a value similar to four or five hundred shares in an equivalent index. Although leverage is one of the main factors attracting people to futures, it must be employed with caution as it multiplies losses as well as gains.
Brokers for Stocks and Futures
In terms of brokerage, the differences between stocks and futures are far less pronounced. A handful of brokers offer both, some even allowing the two asset types to be traded from a single account, but if you plan to trade futures exclusively then you may benefit from the increased product knowledge and support that comes from a futures commission merchant. Whichever route you take, be sure to carry out due diligence and ensure that you trade only with a regulated and reputable firm.
Trading Stocks and Futures
There are no specific rules to trading any one product type successfully in contrast to the other. Futures tend to be more liquid and have more relaxed regulations regarding pattern daytrading, so they can be ideal if your strategy involves very short holding periods. Stocks, as already stated, can provide additional forms of income in terms of dividend payments, and these should be factored in when considering strategy returns.
With both stocks and futures the same trading rules apply: don’t risk more than you can afford to lose, make use of diversification and money management techniques, and trade using a carefully back-tested strategy.