There is a common misconception among people who are not familiar with stock index futures and the commodity markets in general. The misconception is that futures are mysterious and complex trading instruments. While futures trading is not for all traders or investors, there are several key differences between the two. Before an individual begins experimenting or considering the use of a money management trading system in the futures market, they need to understand not only the importance of index futures, which can be used as strong leading indicators of market sentiment, but also how they differ from stocks.
As such, four of the main differences between stocks and futures are outlined below. The more research you do before investing in futures, the better. Even if you are well-acquainted with stocks and the rules and regulations surrounding them, it’s critical to understand these four basic differences between stocks and futures before you begin trading either commodities or futures.
1. Expiration Dates
It is important for those interested in exploring index futures to understand that futures contracts do expire and rollover. A futures contract is basically an agreement between the buyer and seller to exchange money for a precise amount of the underlying product in question. These commodities could include stocks and currencies as well. Usually, these contracts will actually have several expiration dates throughout the year. In total, there will typically be four or more expiration dates per year. Each contract will be active and can be traded for a specific amount of time until it expires and can no longer be traded.
Stock index futures will have a specific expiration date. Expiration dates will fall on the third Friday of each month while other futures and commodity markets have different expiration dates and schedules outlined by the exchange. Therefore, those who are trading futures should know the expiration date of the futures contracts they are trading to ensure that they understand what they are committing to. When futures decline in volume significantly from one day to the next, this is often a sign that the expiration date is nearing. Tracking open interest will also show how many contracts are still being held in that market. Open interest will also rapidly decline when a contract is near expiration.
Expiration dates can also be found on the website of the exchange on which the contract is listed. Those using money management trading systems should make sure that they understand the type of futures contract they are working with how the expiration date will affect their trading decisions. Typically the exchanges list a first notice day (FND) and last trade day (LTD). Most retail brokers will also send out alerts when the futures contract you are trading will expire and actually exit your position for you before the expiration data if you are still in a position. You don’t want to depend on your broker to make sure you exit the trade since broker executed liquidations can include additional trading fees and potentially a warning from your broker. If you are still in a position on the first notice day (FND) and still want to trade that futures market it is important to roll to the next available futures contract with the most volume and open interest.
Many of the financial futures (such as stock indexes, currencies, bonds, etc) are cash settled meaning that if you hold these contracts past the last trade date (LTD), the value would be settled as cash. Commodity markets such as Crude Oil, Soybeans, and Live Hogs are physically deliverable, meaning that if you were to hold a Crude Oil futures contract past the expiration date, then you would owe the entire value of the contract to a supplier. Since Crude Oil trades in fixed contracts sizes of 1000 barrels, at a price of $50 per barrel you would be on the hook for $50,000 plus delivery fees with a scheduled delivery of 1000 barrels of Crude Oil coming to your house.
2. Leverage
Futures offer many benefits to those interested in using money management algorithms in order to trade. One of those benefits is leverage. Futures trading offers traders the ability to have control over futures contracts, who’s contract size is much larger than the amount of capital on deposit at the brokerage firm that will be used for margin. Commodities and futures trading does allow traders to control large futures contracts with only small margin deposits in their trading accounts. Essentially a small investment can ultimately obtain stronger buying power. This is known as leverage. While using leverage can be seen as a benefit, it also has risks involved. For example, a futures contract such as Crude Oil has a fixed contract size. Unlike stocks, which can be purchased in fractional shares or dollar amounts, futures and commodities have set contract sizes.
The exchanges set margins for each market and the brokers are allowed to offer even lower margin rates and often provide day trade margins during the day for many futures contracts. For example, the E-mini S&P at a price of 3800, has a fixed contract size of 50 which is a value of $190,000. If you are familiar with stocks, this means that you would be trading in 50 share increments and trading one E-mini S&P futures contract at a price of 3800 would be similar to trading 50 shares of stock at a price of 3800. One contract would be 50 units, two futures contracts would be 100 units, three futures contracts would be 150 units, etc. You can’t simply trade fractional futures contracts, for example by simply going long $1000 dollars of a futures contract.
Where the real leverage comes into play is based on the minimum required margins. In January 2021, the exchange margin for the E-mini S&P futures worth $190,000 at a price of 3800 is $12,100. Some brokers offer day trade margins as low as $500. This means that you can trade a $190,000 financial futures contract with only $500. While this type of leverage can be seen as a massive benefit and opportunity, it can also serve as an incredible amount of risk. A small 10 point move can either be a gain or loss of $500 on one E-mini S&P contract. If your trade is correct, then that 10 point move can be favorable and a $500 gain and if that 10 point move is against you, then it can be a $500 loss. Average daily ranges at the beginning of 2021 are 30 points in the E-mini S&P while some days can have ranges as high as 100 points. A 100 point move is $5000 per contract. Brokers will typically liquidate your position before your account goes negative but if you are in a fast market or if there were an exchange outage, your brokerage account could hold a negative value if the market re-opens and the market is adversely against your position. Futures trading can have an incredible amount of risk, especially if you a trader does not understand the amount of leverage they employ and if a trader does not include a trading system employ money management.
Unlike stocks, using margin does not require the use of borrowed capital from your broker. Many stock traders employ some leverage as well. Typically there is are borrowing fees such as interest when trading stock on margin. The amount of leverage available to stock traders is typically much smaller. If a stock trader wanted to trade $190,000 worth of stock (current value of the E-mini S&P futures in January 2021), the amount of leverage that could be used is typically 4:1 so a stock trader would be required to have an account size that is 25% or ¼ of the value of the stock being traded. In this case, $47,500 would be required to hold $190,000 worth of stock.
3. Shorting the Market
One of the differences to consider when trading futures is the ability to short the market. Essentially, shorting is the process of first selling a futures contract with the intention of eventually buying it back, to cover your short position at a lower price. If a trader believes that the value of the market is going to decrease in the near future, they may choose to short it. Shorting a futures contract is typically easier than shorting individual stocks. Individual stocks must be borrowed first and then shorted. Interest must be paid for the borrowed stock when shorting and your broker has to approve your account to short stocks. A stock must also be on the “short list”, meaning not all stocks can be shorted. There have been times when shorting the market required an “uptick” (uptick rule) first meaning that stocks could not be shorted at the market but only on limit orders in an uptick. There is more regulation involved when shorting stocks.
Futures contracts are “pure” trading instruments. In futures trading, there is a buyer for every seller so there are as many contracts being shorted as there are being bought on any given trade. Futures contracts can be shorted as easily as they can be bought.
4. Extended Hours
When trading futures with a money management trading system, there are extended hours available. With futures, the market is open virtually 24 hours a day and 5-6 days a week, depending on your timezone. This allows for more flexibility as well as trading opportunities with the ability to plan trades that can not be taken in the equities markets. In the United States, the US futures markets start trading on Sunday night at 5 pm CST. This is considered the beginning of the trading day for Monday. The markets trade around the clock with most futures markets closing by 4 pm CST on Friday. Futures markets trade around the close to serve their original intent as instruments to hedge. If a global event occurred at night that would cause stocks to drop the next day, even though the stock market is closed at night, the futures could be traded to “hedge” stock portfolios. Short term futures traders can take advantage of these opportunities to trade around the clock.
Traders, again, must understand the differences in trading futures versus trading stocks. Although automated trading systems can be used with both, they should be handled with care.
Trading futures offers additional trading opportunities in the financial markets to increase your returns. The use of margin and leverage has to also be considered by measuring the opportunity as well as the risk.
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