Unfortunately, our propensity toward the familiar often holds us back and I feel this is even more true in regards to the world of trading. Despite the human tendency to gravitate to the norm, I would like to challenge your perception of the markets and the way you approach price speculation. Perhaps thinking outside of the box will lead you into alternative arenas and improve the efficiency of your trading ventures.
The futures markets often get a “bad rap” by the investment community thanks to horror stories in regards to traders losing their house along with their shirt. However, losses are possible in any market. It doesn’t seem fair to blame the trading venue, the blame might lie with the participants themselves. That said, there are certainly more temptations in the futures markets than in most other arenas.
If you are going to speculate, do it in the futures markets
I have found that equity traders are reluctant to use the futures markets as a trading vehicle. This is partly because it is more convenient to simply buy a commodity ETF with their stock broker, or their broker might even offer limited access to some futures contracts. Yet, choosing the familiar and convenient road, generally comes with the baggage of inefficiency. In short, ETFs don’t always follow the underlying asset, and stock brokers offering future trading on the side are typically ill equipped to provide proficient service to traders.
Another hesitancy stems from the fact that a futures contract isn’t an asset; instead it is a liability. Specifically, despite the statistic that most speculators sell their obligation before the delivery process, a futures contract is actually an agreement to buy or sell a specific amount of a commodity or financial instrument at a particular price on a stipulated date in the future. To clarify, futures traders are not exchanging the commodity itself, just an agreement to exchange the commodity. Therefore, unlike equities, futures traders have no feeling of ownership.
I’m not convinced this is a valid argument. Let’s face it…aside from a monthly brokerage statement that says so, many stock or ETF holders don’t really own anything either; ask those holding shares of Lumber Liquidators. Shareholders are, in essence, guaranteed the future cash flows, if any, of that particular security but the benefits of ownership seem to end there.
There are some compelling reasons to look toward trading in the futures markets with a true commodity broker. I hope that you are able to open your mind to an unconventional but perhaps more efficient marketplace. We will focus on the most popular stock index futures contract, the e-mini S&P but the same principals can be applied to all commodities. For instance, a silver speculator could buy an ETF, buy a silver mining stock or they could streamline their efforts through the purchase of a silver futures contract.
We all know that leverage goes both ways; in fact, it is possible that this could be a reason not to trade futures. For those on the right side of the market, leverage will supercharge profits but the same can be said of losses for those on the wrong side of the market.
What many traders don’t realize is that leverage is ultimately determined by the trader. In other words, the exchange will set an overnight margin rate and your brokerage firm will set a day-trading margin rate (which is typically much lower) but whether or not the leverage provided is used depends on the funding of the trading account and the position size. Specifically, a trader can eliminate the leverage of a futures contract by depositing the full amount of the contract in question.
For instance, although the exchange overnight margin on the e-mini ranges from $4,000 to $6,000 and day-trading margin can be as little as $500, a trader executing 1 contract in a $100,000 is utilizing little or no leverage. Please note that the $50,000 figure assumes that the S&P index is valued at 2,000 ($50 per point X 2,000), if the index is higher the contract value is higher and vice versa.
Conversely, stock traders must apply for access to margin and are expected to pay interest when using it. The costs of using leverage in equity trading can be substantial and I believe that this shifts the odds of success away from the trader and toward the brokerage firms.
Liquidity and Efficient Execution
E-mini S&P futures are traded electronically in high volumes and with narrow bid/ask spreads. While many stocks and stock indices are also liquid, many of the commodity ETF’s or leveraged stock index ETF’s are not. Naturally, higher bid/ask spreads increase the costs associated with participating in a particular market and, therefore, diminish the odds of successful speculation.
24 hour Futures Markets
The futures markets are open, and relatively liquid, nearly 24 hours per day. Aside from an afternoon pause in most financial futures and commodity markets, it is possible to buy or sell futures contracts, and in some cases even options, around the clock. Not all stock traders have access to extended trading hours, and those that do often complain about liquidity problems.
Buy or Sell in any Order
One of the most persuasive arguments for futures trading is the ability to quickly and efficiently sell a contract in anticipation of the market going lower. The idea is to be able to buy the contract back at a better (lower) price at some point in the future. Unfortunately, things don’t always work out as planned and a short trader may be forced to buy the contract back at a higher price to lock in a loss.
Equity traders can sell ETF’s and stocks short but before they do, the shares must be borrowed. This is much less convenient, not to mention time consuming, and might even be a “deal breaker” if the broker doesn’t have the shares to loan. In addition, they must pay interest to their stock broker.
Low Account Minimums
Many futures brokers have no, or low, account minimums and all applicants are provided leverage if they choose to use it. Stock traders wishing to sell shares short or trade on leverage must first apply for a margin account which often requires a beginning balance of $50,000 or more. To put it into perspective, some brokerage firms will allow you to day trade an e-mini S&P with as little as $1,000. How many stockbrokers would provide you the same courtesy?
No Interest Charges or Borrowing Fees
In addition to the restrictions of borrowing shares and the high barriers to entry, equity brokerage firms charge interest on margined positions. Futures traders, on the other hand, enjoy the luxury of “free” credit provided by the futures exchanges. That said, just because something is free and plentiful doesn’t mean that it is in your best interest to use it to the fullest, but at least you know that it is there if you need it at a moment’s notice.
Unlike futures, in order for a stock trader to turn a profit on a short or leveraged position, he must first be right in the direction enough to overcome the interest charges paid to the brokerage firm. This can be a difficult hurdle to overcome.
While this isn’t the case in all futures contracts, the CME’s e-mini 500 futures are filled on a first come first serve basis regardless of the size of the order or the name of the trader. This is possible due to the lack of human intervention behind the CME’s Globex electronic trade matching platform. In venues in which there are market makers such as equities, this might not necessarily be true.
Favorable Tax Treatment and Ease of Reporting
Here is the nail in the coffin in regards to the equity argument. Futures traders, assuming that they are speculating profitably, face much less of a tax burden than do stock and ETF traders. In futures, there is no distinction between long-term and short-term capital gains. Instead, all trades are taxed at a 60%/40% blend between long and short-term. Even the profit on a trade that has a time span of a minute, will be taxed 60% at the preferable long-term gains rate. This is of course presuming that at the end of the year the cumulative results are positive.
Nearly as attractive as the rate is the manner of reporting; futures traders are provided a lump sum profit or loss reported on a 1099. This figure is simply stated on the schedule K of the traders tax return. Stock traders, on the other hand, are required to list a line-by-line account of each trade and its results. Not only is this time consuming, it is error prone.
No Broker or Counterparty Risk
The NFA and the CFTC require that FCM’s (Futures Commission Merchants), also known as futures brokers, hold client funds in an account segregated from their own capital. This is unlike a stock firm that accepts a client deposit and, aside from stating that it belongs to the client on a statement, is free to put the money to use as it sees fit. Assuming that futures brokers follow fund segregation rules, as nearly all have done since the rule’s inception in the Commodity Exchange Act, a commodity brokerage bankruptcy will not have an impact on funds deposited by the client. This might not always be the case for equity traders; although, if held in certain assets, SIPC or FDIC insurance might come into play in a stock account but no such insurance is available to commodity traders.
Similarly, futures exchanges guarantee the other side of all executed trades. Although there is no ownership, there is a guarantee that the trader will make or lose money based on his speculation alone. This is regardless of the financial ability of the counterparty and the solvency of the brokerage firm. Again, this is assuming that the futures broker is obeying the regulations in regards to customer segregated funds.
Option Selling in Smaller Accounts
Option selling is a strategy that is far more attainable in the futures markets, than it is in the equity markets. This is because stock brokers often require $50,000 to $100,000 in a trading account before they allow option selling. Those with enough trading capital to take on the practice of premium collection, find they are charged interest by their brokerage for use of leverage. Futures traders, on the other hand, can do it in an account as small as $5,000 to $10,000 without any burden of interest. Futures traders of all sizes are also granted portfolio margin; this is in contrast to stock traders who are generally expected to have six figures in their trading account for the privilege of portfolio margins.
Risk Capital Only
Regardless of your intentions in speculation or the market chosen, there is one common rule: Never trade money that you can’t afford to lose. If you are like me, it seems like there is no such thing as money that can be lost without some type of anguish. Nonetheless, risk capital is defined as an amount of money that, if lost, would not alter your current lifestyle.
There is a lot of money to be made or lost in all markets but for those with the willingness and the risk capital to speculate, the futures and options markets offer some glaring advantages over other vehicles.
Carley Garner is the Senior Strategist for DeCarley Trading, a division of Zaner, where she also works as a broker. She authors widely distributed e-newsletters; for your free subscription visit www.DeCarleyTrading.com. Her books, “A Trader’s First Book on Commodities,” “Currency Trading in the FOREX and Futures Markets,” and “Commodity Options,” were published by FT Press.