Futures and Equities

For those new to trading, understanding the difference between futures and equities and how they are traded can be somewhat intimidating. There are some key aspects of each that every investor needs to trade successfully:

Futures Contracts:

A futures contract is a legally binding agreement to buy or sell a standardized asset at a specific date or within a designated month. These contracts include detailed specifications, such as:

  • Pricing details and minimum price fluctuations
  • The quality and quantity of the commodity
  • Delivery date and location for the underlying asset (note: actual delivery is uncommon, as most contracts are settled before this date)

Examples of commonly traded commodities includes soybeans, crude oil, gold, corn, etc, as well as stock indexes and interest rates such as 10-year Treasuries. The futures markets are regulated by the Commodity Futures Trading Commission. 

 To place a buy or sell order for futures, investors need to open an account with a futures broker, many of whom are known either as an FCM (futures commission merchant) or an IB (Introducing broker who is affiliated with an FCM). Investors should also familiarize themselves with the various order types available in both markets.

Futures contracts may  be sold short as easily as buying long positions with the same margin requirement.

Equities (stock) Trading:

When investors buy shares of stock, they gain partial ownership of a company, with the ownership percentage based on the total number of shares issued. For example, if someone buys 1,000 shares of a company with 1 million shares outstanding, they own 0.1% of that company.

Owning stock usually provides voting rights on certain corporate matters and the ability to attend the annual shareholder meeting. Shares signify ownership of the company’s assets and the right to participate in future earnings, which are often reported on a per-share basis. Additionally, some companies offer dividends, distributing a portion of their profits to shareholders on a quarterly or annual basis. 

Equites are regulated by the Securities and Exchange Commission (SEC).

Comparing Futures and Equities:

Futures Contracts Expire; Stocks Do Not.

This is a significant distinction. Investors can hold shares of a publicly traded company indefinitely, unless the company is acquired or goes private. However, the common stock of a company that goes bankrupt is worthless.

In contrast, futures contracts have a set expiration date. For example, a crude oil futures contract for June 2023 will expire on a specific date. As the expiration date approaches, almost all traders close or “roll” their positions into later months.  Commodities cannot go bankrupt like companies. Futures contracts never become worthless.  Since commodities are not companies there are no insiders to manipulate prices with insider trading.

 Futures contracts may be easily traded either short or long with equivalent margin requirements. Most stock investors only take long positions. This reduces the trading opportunities by half.

Margin Trading in Futures vs. Stocks

In the stock market, buying on margin involves borrowing money from a broker to purchase shares, effectively leveraging a loan. This allows investors to buy more stock than they could otherwise afford, which can amplify both gains and losses.

According to Regulation T by the Federal Reserve, investors with margin accounts can typically borrow up to 50% of the purchase price of eligible securities (some brokerages may require a higher initial deposit).

In the futures market, margin works differently. Traders must deposit a good-faith amount known as the initial margin requirement, ensuring that both parties can fulfill the contract terms. These requirements vary by product and market volatility, usually ranging from 3% to 12% of the contract’s notional value.

Pros and Cons of Trading Futures vs. Stocks

The futures market offers access to essential commodities and can be used to diversify a portfolio, hedge against risks, or speculate on price changes.

For example, an investor might notice a correlation between stock and oil prices and decide to take a short position in oil futures to hedge against potential losses in oil stocks. However, such hedging does not guarantee profits or limit losses, and there is always the risk of incurring losses.

ExitPoints does not engage in hedging. Our system trades the swing time frame trends. The average duration of our system trades is usually about five market days for futures.

Leverage

Both futures and stock positions can quickly move against an investor, and high leverage can worsen losses. Margin trading can lead to losses exceeding the initial investment. If market prices move unfavorably for a futures position, it may trigger a margin call, requiring the trader to quickly add more funds. If the trader fails to provide sufficient funds in time, the position may be liquidated.

Margin calls can also occur in stock trading, making it essential to understand the basics of margin trading.