Q&A
Futures For You
Inside The Futures World
Want to find out how the futures markets really work?
DeCarley Trading senior analyst and broker Carley Garner responds to your questions
about today’s futures markets. To submit a question, post your question
at https://Message-Boards.Traders.com. Answers will be posted there, and selected questions will appear in a future issue of S&C.
Stock index futures vs. equity index products
Are there advantages to trading stock index futures over equity index products such as Spdrs or individual stocks?
There are many more participants in the equity markets than there are in futures, and people tend to gravitate to what they are most familiar with. However, convenience and familiarity aren’t necessarily optimal. The futures markets have been labeled as dangerous due to the ease of gaining leverage and the corresponding horror stories of traders going broke, but in reality, the same risks are evident in active stock speculation. Don’t blame the trading venue, blame the participants.
The most popular stock index futures product is the Standard & Poor’s 500. This is a futures contract written with the S&P 500 as the underlying asset. The most widely traded version of this is the emini S&P, so that will be our focus.
Clearly, there are positive and negative aspects of speculating in each arena, but there are some glaring advantages to trading futures that are often overlooked:
Leverage and margin: This could also be used as a reason why you should not trade futures simply because it goes both ways. The use of leverage will supercharge profits in correct speculative positions but can create seemingly out-of-control losses for those on the wrong side of a move.
Keep in mind that while the exchange sets a minimum overnight margin requirement, and your broker may even increase it, the trader ultimately decides how much leverage to use. Thanks to lenient daytrading margins (as opposed to stringent overnight margins) offered by many firms, intraday margin may require less than $500 per contract traded. That said, just because it is possible to buy 20 mini S&P futures in a $10,000 account doesn’t mean that it should be done. In fact, a trader can eliminate leverage altogether by depositing the entire value of the futures contract being traded. With the emini trading at 900, this is equivalent to $45,000.
Liquidity and efficient execution: In the case of the emini S&P, the volume is extremely high and the bid/ask spread is normally a tick. The bid and ask represent the best available price that a contract can be sold and bought, respectively.
Buy or sell in any order: A futures trader can quickly and efficiently sell an S&P contract in anticipation of the market going lower. The idea is to be able to buy it back at a better (lower) price at some point in the future. Of course, things don’t always work out as planned, and a short trader may be forced to buy the contract back at a loss (a higher price). Equity traders can do this, but they must first borrow shares from their brokerage firm.
Low account minimums: It is possible for an equity trader to sell shares or an exchange traded fund (Etf) that tracks the broad market with the intention of buying them back at a lower price. However, doing so involves a margin account in which applicants must meet certain criteria. Most firms will not approve margin accounts for clients with balances below $20,000. On the contrary, there are some futures brokers who will allow clients to daytrade the emini S&P with balances as low as $1,000.
No interest or borrowing fees: As if the time delay of borrowing shares and overcoming a large minimum account requirement weren’t enough of an obstacle for traders looking to speculate on lower stock prices, equity brokerage firms (as opposed to futures brokers/exchanges) charge clients interest on margined positions. Therefore, in order for a short speculator to be profitable, he or she must first overcome the interest paid to the brokerage firm in return for borrowing shares. Profitable trading is challenging, but paying unnecessary interest charges can make it even more difficult.
Level playing field: Cme emini S&P 500 futures are filled on a first-come, first-served basis with little or no human intervention. In theory, this provides an arena in which a trader swinging 1,000 contracts at a time and one who is trading a single lot will be treated the same in terms of execution. This may not be true in venues that involve market makers, such as equities.
Favorable tax treatment: Equity traders are required by the Irs to list each transaction and the net result of the trade. As you can imagine, this can be time-consuming and error-prone. Futures traders are given a single profit and loss figure, net of commissions and fees, that can be reported to the Irs. In addition, all futures and options on futures market gains are taxed at a 40%/60% blend between long-term and short-term capital gains. Because long-term gains are taxed at a favorable rate, the benefit can be substantial for traders actively trading S&P futures as opposed to stocks or Etfs. That said, this tax benefit only exists for those trading profitably.
There are many reasons to trade futures, but there are also reasons you should not. Because of the leverage and ease of entry into the marketplace as a result of small account minimums and margin requirements, the futures markets too often attract capital that shouldn’t be there. Whether you are actively trading equities, futures, or options on futures, it is important you realize that speculation is a risk and not an investment; only risk capital should be used.