While futures are often perceived as tools for short-term trading, hedging, or arbitrage, they can also serve as a viable alternative to traditional stock investments.
This raises several questions regarding the advantages, potential drawbacks, and overall implications of utilizing futures for long-term investment strategies.
Furthermore, it is crucial to examine the suitability of futures for long-term investment, particularly for novice traders seeking to navigate this complex financial instrument. What specific opportunities exist within the futures market for those interested in long-term engagement?
What Is Futures Trading?
Futures contracts are agreements to trade a specific asset—such as a commodity, security, or financial instrument—at a predetermined price on a future date. Both parties, the buyer and the seller, are obligated to fulfill the contract at the agreed-upon price, regardless of market fluctuations at the time of expiration.
The term "futures trading" is often used to describe contracts based on the future value of securities within the stock market. These securities can range from individual company shares to broader market indices like the S&P 500, Dow Jones Industrial Average, or Nasdaq.
However, it's important to note that exchanges like the Chicago Mercantile Exchange facilitate futures trading on a wider range of assets, including physical commodities, bonds, and even weather events.
Futures Market Investing, Why?
Around-the-clock trading opportunities
The near-continuous operation of most futures markets, typically five days a week and almost 24 hours a day, provides investors with unparalleled flexibility. This allows for agile portfolio management, enabling responses to global events, hedging against potential risks, and speculating on diverse assets like indices, commodities, and currencies, even when the U.S. stock market is closed.
Potential tax benefits
The tax treatment of profitable futures trades follows a unique 60/40 split. 60% of the profits are taxed at the lower, long-term capital gains rate, while the remaining 40% are subject to taxation at the short-term capital gains rate, which is equivalent to your ordinary income tax rate.
Direct market exposure
Stock investments inherently tie your financial success to the performance of individual companies. Futures trading, however, provides a different approach. By allowing direct investment in specific indices or commodities, futures offer broader market exposure, empowering investors to act on macroeconomic trends and insights.
Capital efficiency
Compared to the 50% or higher margin requirement for establishing an equity position in a margin account, futures trading offers significantly lower barriers to entry.
Typically, the initial margin requirement for futures falls between a more manageable 3% to 12% of the underlying contract value. This accessibility to leverage presents an opportunity to amplify returns on invested capital. However, it's crucial to remember that leverage is a double-edged sword.
While it can accelerate profits, it also has the potential to magnify losses more rapidly, even with minimal market fluctuations. This inherent risk underscores the importance of careful consideration and risk management when engaging in leveraged trading, as losses could exceed your initial investment.
How Futures Trading Works?
The standardized nature of futures contracts, encompassing quantity, quality, and delivery terms for the underlying asset, forms the bedrock of efficient trading on futures exchanges. This standardization fosters market transparency, enhances liquidity, and contributes to accurate price discovery.
Futures contracts obligate the buyer to purchase and the seller to sell a specified asset, such as stocks or index shares, at a predetermined price and date. This binding agreement ensures market integrity and facilitates smooth transactions.
Futures contracts, including those based on stock indices like the S&P 500, adhere to specific expiration dates, often organized on a quarterly cycle (e.g., March, June, September, December). The contract nearest to expiration is commonly referred to as the "front-month" contract and typically experiences the highest trading volume.
As a contract approaches expiration, traders seeking to maintain their position often "roll over" their holdings into the subsequent contract month. While short-term traders frequently engage with front-month contracts, long-term investors may opt for contracts with later expiration dates.
Illustrating this concept, consider a trader purchasing a futures contract for the S&P 500 index, agreeing to acquire shares at a fixed price six months out. If the index appreciates over that period, the value of their futures contract rises, allowing them to potentially sell it for a profit before expiration. Conversely, if the trader anticipates a market decline and sells a futures contract, a subsequent market downturn would enable them to repurchase the contract at a lower price, profiting from the price differential.
It's important to note that the settlement method for futures contracts varies depending on the underlying asset. Physical delivery is customary for commodities like oil, gold, or wheat. In contrast, futures contracts tied to stocks and stock indices typically settle in cash.
What Are The Best Long-Term Investments For Beginners?
There are 2 ways of using long-term futures investments.
1. Substituting cash long position with long futures
Consider a scenario where you own 1,000 shares of Reliance Industries in the cash market. To optimize your capital utilization, you could consider purchasing one lot (equivalent to 1,000 shares) of Reliance futures.
The key advantage here is that futures trading requires only a margin payment, freeing up a significant portion of the capital that would otherwise be tied up in holding the shares outright. However, it's crucial to maintain sufficient funds to cover potential mark-to-market (MTM) margin calls should the market move against your position.
This freed-up capital can be strategically invested to generate additional returns. For instance, a balanced approach could involve allocating 20% to liquid funds, targeting a 6% annualized return, and the remaining 80% to debt funds aiming for a 10% annualized return. This diversified allocation helps ensure liquidity while aiming for capital appreciation.
Now, let's delve into a comparative analysis of how this strategy would fare in a bullish market scenario.
3-Month Returns7.61%9.61%
By purchasing the asset outright, the trader would have realized a 7.61% return over three months. Conversely, a combined strategy utilizing futures contracts and debt funds would have yielded a 9.61% return over the same period.
This difference highlights the potential of leverage offered by futures contracts. In this scenario, we assume a short, three-month holding period, allowing for the direct purchase of a three-month futures contract.
2. Investing for the long term by rolling over futures
While appealing for short-term gains, using futures contracts for a one-year investment horizon presents challenges. The limited availability of liquid futures contracts, typically only for the first and second month, necessitates rolling over the contracts.
In this case, a one-year investment would require six rollovers within a year (every two months). This begs the question: how would these rollovers impact overall costs, and consequently, the viability of this strategy?
3-Month Returns25.00%33.00%
Roll Cost -3.01%
Net Returns25.00%29.99%
Opting for a futures-based strategy, wherein the trader purchases the asset in the futures market and allocates the remaining capital to a diversified portfolio of liquid and debt funds, presents a compelling advantage. This approach could potentially outperform a traditional cash market purchase by approximately 500 basis points. Such a significant difference underscores the potential of utilizing futures contracts as a powerful tool for long-term investment strategies.
Understanding the differences and similarities between futures options and stock options
Although stock options and futures options share some similarities, it's crucial to recognize their key differences.
One notable distinction lies in the order types available for each. Futures options may have more limitations compared to the broader range of orders typically available for stock options.
Futures Market Investing: Pros and Cons
Futures trading offers a powerful tool for investors and businesses, but it's not without its risks. Here's a balanced look:
Pros
- Leverage: Futures trading allows for magnified returns with a smaller initial investment, known as margin. This margin, set by the broker, is influenced by the contract size, investor creditworthiness, and brokerage terms.
- Hedging: Businesses utilize futures to mitigate risks associated with price fluctuations. By locking in future prices, companies can better plan budgets and protect projected profits from adverse market movements.
Cons
- Potential for amplified losses: While leverage amplifies gains, it also magnifies losses. Due to the leveraged nature of futures, investors can lose more than their initial margin amount if the market moves against their position. This inherent risk underscores the importance of a comprehensive understanding of futures markets and careful risk management.
Which Is More Profitable, Futures or Options?
When comparing the profitability of futures and options, it's important to consider the investor's approach and risk appetite. Futures contracts offer greater leverage, potentially leading to higher returns when market predictions are accurate. However, this leverage also amplifies potential losses. Conversely, options contracts provide a level of security due to their non-binding nature, effectively mitigating downside risk.
Why Trade Futures Instead of Stocks?
Futures trading offers investors a key advantage over stock trading: leverage. This allows traders to control significant asset positions with a relatively small capital outlay, potentially magnifying profits. However, this amplified leverage also increases the potential for losses.
Furthermore, futures markets operate nearly around the clock, providing traders with the flexibility to react to global events and market movements outside of traditional trading hours. This continuous accessibility can be particularly beneficial for active traders seeking to capitalize on emerging opportunities or mitigate risks promptly.
What Happens If Investors Hold a Futures Contract Until Expiration?
For equity futures contracts held until their expiration date, settlement typically occurs in cash rather than through the physical delivery of assets. The trader receives a cash payment if the underlying equity's price increased during the holding period and conversely makes a cash payment if the price decreased.
It's important to note that while cash settlement is the norm for equity futures, certain futures contracts necessitate physical delivery upon expiration. In such instances, the investor holding the contract would be obligated to take physical possession of the underlying asset.
Futures Market Investing: Bottom Line
Futures contracts can be valuable tools for investors, offering the potential for price speculation and hedging against market downturns. However, they also present certain drawbacks that warrant careful consideration.
For instance, if a trader misjudges the market while hedging, their attempt to mitigate risk could actually lead to increased losses. Additionally, the daily mark-to-market process, where futures prices are settled daily, introduces a significant degree of volatility. This means the value of a futures investment can fluctuate considerably from one trading session to the next.