Futures are derivatives contracts that derive value from a financial asset such as a traditional stock, bond, or stock index, and thus can be used to gain exposure to various financial instruments including stocks, indexes, currencies, and commodities. Futures are a great vehicle for hedging and managing risk; If someone is already exposed to or earns profits through speculation it is primarily due to their desire to hedge risks. (For a detailed understanding of futures and how they work, read Futures, Derivatives and Liquidity: More or Less Risky?)
Future contracts, because of the way they are structured and traded, have many inherent advantages over trading stocks.
1. Futures are Highly Leveraged Investments
An investor has to put in a margin—a fraction of the total amount (typically 10% of the contract value)—to be invested in futures. The margin is a security that the investor has to keep with the exchange in case the market moves opposite to the position he has taken and he incurs loses. This may be more than the margin amount, in which case the investor has to pay more to bring the margin to a maintenance level.
What trading futures essentially means for the investor is that he can expose himself to a much greater value of stocks than he could when buying the original socks. And thus his profits also multiply if the market moves in his direction (10 times if margin requirement is 10%).
For example, if the investor wants to invest $1250 into Apple Inc. stock (APPL) priced at $125, he can either buy 10 stocks or a future contract holding 100 Apple stocks (10% margin for 100 stocks: $1250). Now assuming a $10 increase in price of Apple, if the investor would have invested in the stock, he would earn a profit of $100, whereas if he took a position in an Apple future contract his profit would be $1000.
2. Future Markets are Very Liquid
Future contracts are traded in huge numbers every day and hence futures are very liquid. The constant presence of buyers and sellers in the future markets ensures market orders can be placed quickly. Also, this entails that the prices do not fluctuate drastically, especially for contracts that are near maturity. Thus, a large position may also be cleared out quite easily without any adverse impact on price.
3. Commissions and Execution Costs are Low
Commissions on future trades are very low and are charged when the position is closed. The total brokerage or commission is usually as low as 0.5% of the contract value. However, it depends on the level of service provided by the broker. An online trading commission may be as low as $5 per side, whereas full-service brokers may charge $50 per trade.
4. Speculators Can Make Fast Money
An investor with good judgment can make quick money in futures because essentially he is trading with 10 times as much exposure than with normal stocks. Also, prices in the future markets tend to move faster than in the cash or spot markets. Similarly, there is also the risk of losing money. However, it could be minimized by using stop-loss orders.
5. Futures are Great for Diversification or Hedging
Futures are very important vehicles for hedging or managing different kinds of risk. Companies engaged in foreign trade use futures to manage foreign exchange risk, interest rate risk by locking in a interest rate in anticipation of a drop in rates if they have a sizeable investment to make, and price risk to lock in prices of commodities such as oil, crops, and metals that serve as inputs. Futures and derivatives help increase the efficiency of the underlying market because they lower unforeseen costs of purchasing an asset outright. For example, it is much cheaper and more efficient to go long in S&P 500 futures than to replicate the index by purchasing every stock.
6. Future Markets are More Efficient and Fair
It is difficult to trade on inside information in future markets. For example, who can predict for certain the next Federal Reserve's policy action, or the weather for that matter?
7. Futures Contracts are Basically Only Paper Investments
The actual stock/commodity being traded is rarely exchanged or delivered, except on the occasion when someone trades to hedge against a price rise and takes delivery of the commodity/stock on expiration. Futures are usually a paper transaction for investors interested solely on speculative profit.
8. Short Selling is Legal
One can get short exposure on a stock by selling a futures contract, and it is completely legal and applies to all kinds of futures contracts. On the contrary, one cannot short sell all stocks, and there are different regulations in different markets, some prohibiting short selling of stocks altogether.
The Bottom Line
Futures have great advantages that make them appealing for all kinds of investors—speculative or not. However, highly-leveraged positions and large contract sizes make the investor vulnerable to huge losses, even for small movements in the market. Thus, one should strategize and do due diligence before trading futures.