Futures Trading vs. Stock Trading

Futures Trading is In a Way More Idiot Proof

One of the challenges of trading stocks is deciding which stocks to trade. There are a great deal of different stocks out there and even with using software to select upon them, this task represents one of the biggest challenges to the stock trader.

Futures Trading vs. Stock TradingGiven the fact that some stocks can be more or less volatile than the market, hitting the right stocks does have its benefits, if one can indeed trade the right stocks. Even the most experienced and talented stock traders have to devote a lot of effort and analysis to this task though, and may or may not reap the benefits of this extra effort.

Newer traders can make all sorts of mistakes here, where if you are in the wrong stock, even the best trader isn’t going to do very well, because the wrong stocks by definition do not produce the best results.

There are only so many things you can look at when filtering for stock plays, and many traders just go with a basket of ones that they have either traded successfully before, are popular, have a lot of volume, have a certain amount of volatility that is to their liking, are in the news, and so on.

This certainly does serve to divide the attention of the trader a great deal, and this may also involve taking on smaller positions in several stocks at the same time, further dividing one’s attention.

There are a lot of traders who still trade stocks, either primarily or exclusively, and some of these traders do make money doing this, but this does not mean that they are doing as well or making as much money as they could if, for instance, they were trading index futures.

One of the biggest differences between trading stocks and index futures is that trading the indexes significantly simplifies the trading process, and this is a process where there is a lot to be said for simplicity.

Trading is a very skill driven enterprise, and entirely so. It is an adventure that is very prone to various types of mistakes, and when you can virtually eliminate one major category of these, asset selection, that is a big deal indeed.

This is exactly what index futures trading does, and instead of trying to figure out which stocks to go with, you essentially go with all of them, or at least all of them in a certain index, such as the S&P 500. Buying 500 stocks at the same time is a real advantage to investors and it’s as big or perhaps an even bigger advantage to traders.

This is especially the case with trading as trading is already pretty challenging at the best of times, and making it much more challenging when you don’t need to should never be a goal. On this measure, this presents a huge advantage to futures traders, of a magnitude that many stock traders do not realize.

Futures Trading Offers Much More Leverage than Stock Trading

Even though the U.S. market has loosened up a bit on margin requirements and how much leverage you can get with trading stocks, the maximum is a rather paltry 4:1, and there are conditions attached such as if you trade intraday you need to always maintain a minimum of $25,000 in your account at all times, otherwise you aren’t allowed to day trade on margin at all.

For those who can get it, 4:1 is certainly better than 2:1, twice as good perhaps, but this still isn’t very much leverage in the world of finance. Much of the activity in this world is much more highly leveraged than this, within the vast world of derivatives trading, of which futures trading is part of.

Stock traders tend to not really appreciate the significance of leverage, even the most experienced and successful stock traders, and if they did, they wouldn’t be trading stocks anymore actually.

While risk does need to be managed a little differently with higher leverage, what this leverage does is offer the potential to multiply your trading advantage many times over, and even more than just the nominal multiplier of the leverage, such as 25:1 being over 5 times more leverage than 4:1 and over 12 times more than 2:1.

With smaller multiples of leverage, the cost of borrowing plays a much more significant role, as one must increase one’s returns enough to cover the cost of borrowing before one sees a benefit. With higher leverage, the much higher returns this will produce with a given advantage serves to dilute this cost of borrowing much more, to the point where it isn’t really that meaningful.

This is why 2:1 leverage is a terrible idea actually, whether one is investing or trading, because the cost of borrowing will eat too much of a percentage of one’s returns and limit the upside while adding to the downside. If one gets a nominal average return of 6% and one’s trading costs are 5%, these costs have eaten up almost all of the extra 6% return provided by doubling one’s leverage.

If one trades with a leverage of 25:1 instead, not only are we now seeing triple digit returns, the 5% cost of borrowing will yield a gross return of 150% on the leveraged part of the position and a cost of only 5%, with a net return of 145% rather than just 1%.

There’s also the sheer multiplication of nominal returns of course, which is the main thrust behind highly leveraged trading. Many traders will tell you that, for instance, a 10% return on your trading is good, and perhaps a 20% return is world class. This may be true with trading without leverage, but these returns are pretty pedestrian compared to what can be achieved when your nominal returns get multiplied 10 or 20 times.

In order to make this work, you do need a trading advantage, and also have to be a good trader, and these are separate talents actually, but for traders who have their act together enough, much more leverage means much more profit potential. Futures trading offers this higher leverage and higher potential, stock trading simply does not.

Risks of Futures Trading Versus Stock Trading

Obviously, trading with much more leverage is going to mean a much higher potential for risk, although this does not mean that these risks cannot be properly managed. They must be for a futures trader or any trader who uses high amounts of leverage to trade, but this is certainly something that good traders do and all traders must be vigilant with.

Most new traders fail, for a number of reasons, and poor money management is one of the major reasons to be sure. This is the case with both futures traders and stock traders, and most stock traders go bust as well as most new futures traders, for similar reasons.

The added leverage can indeed accelerate the demise of traders and certainly needs to be given the respect it deserves and requires. Taking on too much risk in a trade may involve either taking too big of a position for the size of one’s account, or allowing a position to move against us too much.

It is generally the latter, letting positions run against us too much, that does most traders in the most, and there is much more potential for this if one is much more leveraged of course. Poor trade management and poor trading never ends well regardless of whether we’re trading with more or less leverage though.

Some proponents of stock trading will portray this as a safer way to go with futures trading being portrayed as rather reckless and quite dangerous, especially if one is not skilled or experienced enough. In the end though, poor traders will simply end up getting decimated regardless.

It is not required that one take advantage of the full leverage offered by futures, by just putting up and maintaining the minimum margin and maintenance requirements by using all of one’s funds, as one can choose to keep more or less cash in one’s future account and dilute this leverage as much as desired.

So it’s not that futures trading is by definition more dangerous, it’s more like one has the means to trade more dangerously if one chooses to. The alternative to this, should the danger be present and significant enough with a given futures strategy, isn’t just to move to trading stocks instead, it also includes trading futures less dangerously.

Futures trading is completely flexible in this regard, should one have the financial means to do so. If one trades a mini futures contract and has the means to trade several full contracts for instance, this certainly dilutes the risk a great deal, and can even lower the leverage below what is offered by stocks if one sees fit.

Therefore, there is nothing fundamental to futures trading that makes this form of trading more risky, and futures traders simply enjoy much more flexibility in how much risk they can take with their positions. One can take on a lot of risk if one is prepared to manage it, or not.

There’s also the matter of coming up with strategies that only expose futures traders to a certain amount of risk per trade, where one comes up with a plan that is both successful and allows for very tight stops.

This can be done with stock trading as well, but the much higher leverage of futures trading allows for even more flexibility, as one can trade much bigger positions with a certain amount of money and take advantage of smaller price movements relative to trading costs in assets in a way that is simply not attainable with stock trading.

If someone is trying to make a living off of a few cents movement in a stock, but only can purchase a certain amount, this average advantage per trade may not amount to all that much. This is especially true when we take commissions into account, as one must expect a return well in excess of the costs of the trade.

If we multiply this by 5 or 6 times though, with similar costs per trade, this can be a real game changer and even may allow futures traders to shoot for even less risk exposure by targeting even smaller moves and make a great deal more money at the same time than the stock trader.

Since the stock market closes at the end of the day, with many futures markets only closing for an hour at a time at most during the trading week, at times of much lower activity, the risk of gaps throughout the trading week are greatly diminished. Some futures markets do close overnight like stock markets do, but if one is concerned about risk of gaps, there are markets such as indexes which stay open overnight and allow stop orders to be executed when needed.

Stock trading is still hugely popular, especially among shorter term traders such as intraday traders and swing traders, who hold their position from a few days to a few weeks, as stock trading is still very much ingrained in our present trading culture.

As more traders become exposed to the many benefits of futures trading, as well as its cousin, contracts for difference trading, where available, we should continue to see an increase in popularity in derivatives trading such as this and more and more movement away from trading individual stocks, and there are a lot of good reasons why trading stocks isn’t the best way to trade.

It all really comes down to traders becoming good enough to trade for a profit overall though, and if a trader isn’t, failure is assured regardless of what you are trading. If one is indeed good enough, futures trading is simply superior.

Eric Baker

Editor, MarketReview.com

Eric has a deep understanding of what moves prices and how we can predict them to take advantage. He also understands why so many traders fail and how they may help themselves.

Contact Eric: eric@marketreview.com

Areas of interest: News & updates from the Commodity Futures Trading Commission, Banking, Futures, Derivatives & more.