By Bruce Blythe
Stock trading versus futures trading: Each pose intriguing possibilities. But although stocks and futures share some common ground, they differ in several ways that investors should understand before diving in.
Buy low, sell high, right? It applies to both stocks and futures. That’s pretty straightforward. But with futures, there are a few unique wrinkles. Let’s look at a few basics.
What Is A Share Of Stock?
If you buy shares of stock, you’re purchasing partial ownership of a company, with the exact portion depending on the company’s total number of stock shares issued. For example, an investor who buys 1,000 shares of a company that has 1 million shares outstanding owns 0.1% of the company.
Owning shares of stock confers voting rights on some company affairs and the right to attend the company’s annual shareholder meeting. Your shares represent ownership of the company’s assets and a right to benefit from its future earnings (typically reported on a per-share basis). Some companies may also pay investors a quarterly or annual dividend, which is a proportion of the company’s funds distributed to shareholders.
What Is A Futures Contract?
A futures contract is a legally binding agreement to buy or sell a standardized asset on a specific date or during a specific month. Futures contracts are "standardized," or effectively interchangeable, and spell out certain contract specifications, including:
- The quality and quantity of a commodity
- Unit pricing of the asset and minimum price fluctuation (tick size)
- Date and geographic location for physical "delivery" of the underlying asset (but actual delivery rarely happens, as most contracts are liquidated before the delivery date)
Some of the most widely traded futures contracts are based on major commodities, such as crude oil, corn), gold, and soybeans; others are based on stock indices, like the S&P 500, or interest rates—10-year Treasuries, for example. It’s also important to note that futures trading involves substantial risk and is not appropriate for all investors.
Futures and Stocks Both Trade on Exchanges, and You’d Probably Use a Broker to Trade Either
Major stock exchanges, such as the NASDAQ and NYSE, provide a central forum for buyers and sellers to gather. The same principle applies to futures, with most U.S. trading going through the Chicago-based CME Group. With both futures and stocks, nearly all trading is done electronically.
Exchanges also play an important role in ensuring confidence in markets. Many exchanges operate clearinghouses, which serve as backstops or "counterparties" for every trade.
To place a buy order or sell order in stocks or futures, most likely you’d open an account with a broker (many futures brokers are known as futures commission merchants). With both stocks and futures, there are different types of orders investors should be aware of.
Futures Contracts Expire; Shares Of Stock Don’t
This is an important distinction. An investor could, in theory, hold shares of a company forever, as long as the company remains publicly traded, although there are a number of reasons this may not happen—for example, if the company is acquired or if it converts into a private entity.
A futures contract, in contrast, has a fixed life. June 2022 crude oil futures (/CL), for example, expire on a certain date based on the contract specifications. Most futures contracts aren’t held to expiration. As a contract nears its expiration, many futures traders close or "roll" their positions into a later month, as many firms do not allow physical delivery and will close out the position prior to expiration.
Margin Can Be Used To Trade Both Futures And Stocks, But There Are Key Differences
In the equity market, buying on margin means borrowing money—using "leverage"—from a broker to purchase stock. Margin is effectively a loan from the brokerage firm. Margin trading allows investors to buy more stock than they normally could, often with the aim of magnifying gains (although margin will also magnify losses).
Under the Federal Reserve’s Regulation T, or "Reg T," investors with margin accounts can borrow up to 50% of the purchase price of securities that can be purchased on margin (also known as "initial margin;" some brokerages require a deposit greater than 50% of the purchase price).
Margin works similarly in the futures market, but because margin requirements are typically much smaller for futures, a trader can control a larger position value with relatively little money down.
When trading futures, a trader puts down a good-faith deposit called the initial margin requirement, also known as a performance bond, which ensures each party (buyer and seller) can meet the obligations of the futures contract. Initial margin requirements vary by product and market volatility and are typically a small percentage of the notional value of the contract—often 3% to 12%.
What Are Some Advantages And Disadvantages Of Trading Futures Versus Stocks?
The futures market offers exposure to some of the world’s most important commodities and can be a tool to help diversify or hedge a portfolio, or speculate on the underlying commodity.
Suppose you hold oil company stocks that you want to keep for the long term, but you’re concerned a short-term drop in oil prices could crimp energy company earnings. Through crude futures, you could take a "short" position that would produce a profit if oil prices did indeed fall, but you would be exposed to unlimited risk on the upside should crude prices rise.
You could place an order to buy back that short position, and if the price of crude oil is below the price you originally sold the position at, any gain could help offset paper losses in energy shares. Futures can also, through leverage, be applied to attempt to maximize capital efficiency.
A futures or stock position can also quickly turn against you, and heavy leverage could make matters worse.
Because margin magnifies both profits and losses, it’s possible to lose more than the initial amount used to purchase the stock. If prices move against a futures trader’s position, it can produce a margin call, which means more funds must be added to the trader’s account immediately. If the trader doesn’t supply sufficient funds in time, the trader’s futures position may be liquidated.
Margin calls can also happen in stock trading, so it’s important to understand the basics of margin trading.
Disclaimer: TD Ameritrade® commentary for educational purposes only. Member SIPC. Options involve risks and are not suitable for all investors. Please read Characteristics and Risks of Standardized Options.