Trading is a business that requires skills and knowledge. In trading, what you choose to trade is also equally important, as every market offers different opportunities over another.
In this article, I’d like to share why I trade futures over other asset classes (eg. stocks).
Highlights of Futures
Futures represent an agreement to buy or sell an asset at a future date at an agreed-upon price.
As traders, our goal is to seek value & profit from price changes in the futures market, which is very similar to stock trading. (ie. Buy high sell higher/short-selling)
There are many types of futures products to trade such as Indices, Commodities, Metals, and Energy.
What are Futures?
Let’s start by answering an important question: What are futures?
Futures represent an agreement to buy or sell an asset at a future date at an agreed-upon price.
Imagine this:
You run a bakery business and your main ingredient is flour. Logically, any price fluctuation in flour would affect your profit margin. So, if you foresee a potential increase in flour price in the near future, what can you do?
One way you can protect yourself (a.k.a. hedge) against this is by entering into an agreement with a flour supplier today. In this agreement, you and the supplier would agree to transact flour one year from now (Jan 2024) with today’s price (Jan 2023).
Hence, if the price of flour does increase a year from now, you are protected against the price hike as you have secured your flour with a cheaper price – neat business decision!
How do Futures work?
The example you have just read above is an extremely common practice among businesses.
Consider airlines like AirAsia and its fuel supply:
Let’s say AirAsia wants to lock in its fuel prices to avoid an unexpected increase in price.
So, what they’ll do is buy a contract in the futures market, agreeing to buy a set amount of fuel for delivery in the future at a specified price.
In this case, AirAsia uses the futures market to protect itself from unexpected risks and price swings in fuel supply.
What does the Futures market mean for traders like you and me?
While the futures market is often used for hedging by businesses, it is also a great market for traders to participate in to express their trade ideas.
In other words, we do not participate in the futures market to exchange for a product in the future.
Instead, our role is simple: to seek value & profit from price changes in the futures market itself (eg. Buy high sell higher/short-selling).
If the price of crude oil rises, the futures contract itself becomes more valuable, and traders could sell it for more in the futures market.
Through the futures market, traders gain access to various types of products, such as:
Energy: Crude Oil, Natural Gas etc.
Metals: Gold, Silver, Copper etc.
Commodities: Soybean, Corn, Wheat, Crude Palm Oil etc.
Indices: S&P 500, NASDAQ, Dow Jones Industrial Average, KLCI Index etc.
As an example, a trader could be anticipating a rise in gold price in the near future.
Instead of buying physical gold (which can be troublesome), the trader can express his/her opinion by buying a gold contract via the futures market.
Soon, if the price of gold does go up, the trader can sell off the contract in the futures market and make a return with the difference in price.
Why Trade Futures?
#1 Futures offer Higher Leverage
Leverage is the buying or selling of an asset by paying only a portion of the price, while the remainder is covered by a lender (ie. Our brokers). While I do not recommend people to invest using leverage, but when it comes to trading, having and knowing leverage well can be very powerful.
Generally, typical retail stock trading brokers offer traders anywhere between 2:1 to 4:1 leverage. So, let’s say a stock trader wants to trade 100 units of Apple shares ($130/share), which sum up to $13,000. With a 2:1 leverage, the trader will need to fork out $6500, which is half the capital needed in order to trade.
On the contrary, the leverage offered in the futures market is more generous.
Futures exchanges normally require a margin between 3% – 12%. So, let’s say I want to trade an E-Mini S&P 500 futures contract that’s worth $205,000 ($50 Multiplier * 4100 Index Price), I’ll only need $10,250 (assuming 3% margin) in my account to execute my trade.
In other words, my leverage is 20:1, where I’ll need only $10,250 capital to trade $205,000 worth of assets.
Through the futures market, traders can have a larger futures exposure with a relatively small amount of capital.
One important thing before we proceed: Leverage is a financial tool that comes with its advantages and risks. Please learn and understand both the upsides and downsides of leverage before using it in trading.
#2 Futures market are more liquid & transparent
The stock market is a relatively fragmented market compared to the futures market. As an example, there are 13 stock exchanges in total in the US.
On the other hand, the futures market is very consolidated. In the US, there are 2 major futures exchanges (The CME Group & Intercontinental Exchange (ICE)).
Hence, all futures transactions must go through these exchanges, leading to concentrated liquidity and volume.
As a result, concentrated futures liquidity allows buyers and sellers of futures contracts to be matched at the desired price easily & accurately.
In addition, important indicators such as volume, open interest, and bid/offer spread are transparent and available readily for traders. Having these data is crucial as they offer better clarity to traders to make better trading decisions.
#3 Less Restriction Compared to Stock Trading
As traders, having the freedom to express our opinions about a trade idea is crucial. Meaning, I’d want to have the least friction on when and how I should long or short the market.
However, the stock market is embedded with rules that may not be best in favor of traders. As an example, the Regulated Short Selling (RSS) program only has limited securities that traders can short. Furthermore, limits are imposed to prevent excessive short-selling activities.
In comparison, there is no such restriction in the futures market and traders are free to express their trade ideas in any direction.
#4 Better Focus Compared to Stock Trading
In stock trading, traders would need to go through hundreds of stocks in search of the ones that’d actually move in accordance with their strategies.
It is common to see stock traders having multiple stocks that they are monitoring. The combined effort of filtering and monitoring multiple stocks can be overwhelming.
On the other hand, most futures traders usually need to focus on only 1 or 2 futures products to trade.
More so, I have seen traders trade only 1 to 2 products, and make a full-time living out of it.
Personally, I am most focused on the E-Mini S&P 500 futures (ES), which gives me enough movement and volatility to execute trades most of the day.
Final words on Futures Trading
As a trader that is working to improve my craft everyday, I can firmly say that trading is not easy.
However, with proper guidance on how futures work, as well as deliberate practice, one can increase his/her odds of succeeding in the markets.
The key here is to treat trading as a serious business that takes time to grow, and not a shortcut to make you rich fast. Learn well, trade well!
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Disclaimers
Leverage is a financial tool that comes with its advantages and risks. Please learn and understand both the upsides and downsides of leverage before using it for trading.
This is so far the best futures introduction! Clear and precise!!!