One of the major things that separates trading derivatives, including futures contracts, from trading securities in which one takes possession of an asset, like one would when one buys a stock or bond, is that with derivatives, the trade exists on paper only.
While it is true that futures contracts may be exercised, where one actually takes possession or delivers the asset that the contract is for, most often this is not the case and this is limited to hedgers who actually use or produce the asset. Traders never take possession of assets in fact, as they either will close their positions before the exercise date or settle the contract for cash.
With index futures, it is even rarer for people to take delivery of a basket of stocks upon expiration, and this is once again limited to hedgers. With index futures though, hedgers are unlikely to want to take delivery either as they are just using the contracts to offset risk, such as holding a long position with a basket of stocks and wanting to protect against bigger moves against them where they plan on continuing to hold their positions.
Traders use futures to speculate on the price of the underlying assets changing, and while many may think that this is a disadvantage, and we’d be better off owning something rather than just essentially placing bets on something, the fact that our future trades are just on paper serves an important function that most people don’t consider.
What this serves to do is to greatly increase the amount of liquidity in a market, and in fact, with paper trades, there is unlimited supply from a fundamental standpoint, unrestrained by physical considerations such as the supply of the asset or how many shares there are in the market.
The notional value of futures contracts can and does greatly exceed the supply of the asset, but this all does not matter at all. The benefit here is not all that obvious and this idea even scares some people but what we end up with is a market whose efficiency is unrestrained, and that’s exactly what we should want.
Depending on the level of interest, futures contracts will be opened and closed, as well as traded, where with markets dealing with physical assets, you have a fixed supply that is being traded, where the supply will influence and limit the market.
Futures trading isn’t even a matter of supply and demand, it’s more pure demand, where the demand for long positions and the demand for short positions will compete with each other. While the spot or cash market for the assets certainly does influence price movements, as we may expect given that the contract does track the asset, there are no limitations on the size of the futures market.
A good example of this would be with gold futures, where we can have a notional value that far exceeds the actual supply of gold, but none of this matters, and this allows any amount of participation. The added liquidity of all this is simply tremendous and this is what makes these markets so easy to enter and exit at very efficient pricing and adds a lot to the appeal of futures trading.
Futures Markets aren’t So Tightly Regulated
The battle between futures markets and regulators is a long and drawn out one, mostly due to regulators having a serious problem with paper trading, seeing this more like gambling than actually investing in something. This battle goes back to the 19th Century, and in the end, the futures market ended up winning this fight, opening the door to our current high tolerance with derivatives in general.
By their very nature, futures exchanges take a far less conservative view of the markets than stock or bond markets tend to, and in this sense the futures exchanges have been fighting for the cause of trading freedom rather than against it.
This has all led to a regulatory environment that is clearly focused upon seeking a free market and is only really restrained by efforts to protect participants, which is what regulation is supposed to do. There is no strong bias toward the long side as we see with stock markets, and this bias is so prevalent that a lot of people don’t even notice it, and will even assume that a major goal of markets is to promote price increases and look to avoid price decreases.
Futures markets require equanimity when it comes to the long and the short side and both are equally necessary. Every contract has a long and short side to it in fact, and there are no restrictions on betting on prices going up or down, and one can take a position on either side with the same ease.
When you’re betting against the price of an actual security, a stock or a bond, you have to borrow the asset from someone else to sell it later, but with futures, you are placing your bet so to speak right off the bat, against someone who is taking the bet on the other side. This is certainly a more efficient way to short and there are no inherent restrictions.
This leaves the exchanges to do what they are supposed to, to promote orderly trading and ensure that trades are settled properly.
Futures Trading Offers Much More Leverage
When you buy an asset on margin, you put up the margin, a percentage of the cost of the purchase of the security, and borrow the rest. With futures, nothing is being bought, and you are just putting up a deposit on the position you take, and there isn’t even any borrowing involved here, because the actual transaction has not taken place yet, nothing has changed hands yet.
This is obviously far preferable to having to borrow and buy or sell short something, although the way leveraging works with futures is even better, as positions are settled each day, where traders realize their profits and losses on a day to day basis instead of waiting until the position is closed.
Traders still need to maintain minimum margin requirements though, although these margin requirements are a lot less than what you would need to put up when buying stocks on margin, where for a long time you would only be able to leverage your trade by 2:1.
These days, stock traders may qualify for leverage as high as 4:1, but that’s still pretty tame for a trader. Futures traders can obtain five times that much leverage or more, as futures leverage is not restrained in the same way that stock trading is.
Stock markets are over-regulated though, and these restraints are due to an excessive interest in protecting the interest of traders, where those who decide this don’t really understand the nature of trading and the fact that you can’t just impose risks of longer term trading upon shorter term traders.
If for instance, a 25% move against you would wipe you out with 4:1 leverage, this is certainly something that longer-term investors need to heed, and very seriously at that. Many professional traders never let a trade move against them so that they lose more than 1% of the money they put up before they exit. Applying investing type risk controls to these trades is actually pretty ridiculous.
This of course requires proper risk management by traders, as one could allow oneself to bust their account otherwise, and of course many traders do just that, those who aren’t skilled enough to manage their accounts. The fact that some people mismanage their accounts should never be a reason to restrict one’s ability to trade though, and with futures trading, while there still are restrictions on leverage, they are much more trader friendly and allow for much more latitude.
Leverage is a huge deal with successful trading, and allows traders who have a strong trading advantage to amplify that and receive much higher returns. While this also allows those who are at a trading disadvantage to amplify their losses, since it is their money, the view is that they should be permitted to do so as they see fit, choosing their own style and risks rather than having short sighted regulators participate in these choices too much.
Instead of having to decide between hundreds or even thousands of potential candidates in stock markets, with futures, one can just trade an index such as the S&P 500 and focus on that exclusively if one wishes. This is actually a very good idea for stock traders as it allows them to become intimately familiar with a market as opposed to constantly scanning stocks and basing their trading decisions on more cursory glances.
No matter how good of a trader you are, it is a big advantage to become as familiar as you can with a market, and just trading one market or a few markets is much more ideal than having to spread yourself among countless things to trade.
Indexes are also open virtually 24 hours a day from Monday to Friday, and this is a bigger deal than it may seem to traders. While it’s nice to be able to trade during market hours, what is even more important is the fact that given the market doesn’t close during the week for more than an hour, the risk of gaps during this time is greatly reduced.
Traders protect themselves with stop loss orders, and these orders cannot be executed while the market is closed. If a position gaps against you by 10% for instance, and you set your stop loss at a maximum loss of 1% or 2%, this isn’t going to help you against such a gap.
This is why a lot of traders never hold a position overnight, but being able to hold positions for as long as a week and not having to really worry about gaps does allow more flexibility, where one need not just exit their positions when the trading day is done or risk huge losses.
Futures markets are not for investors, as there is no long-term trend up, and no long-term trend at all, as these contracts are short term. Overall. they certainly can be very beneficial to traders though, in ways that trading stocks simply cannot compete with.
Successful futures trading does require skill of course, but all trading does, and the risks of futures trading can be managed, although not to the same extent that contracts for difference trading can, due to minimum trade sizes with futures being much higher. The futures market does offer a great deal of potential to make simply fabulous rates of return though, provided one is up for it and has the skill and bankroll to achieve these results.