Futures and stocks are two of the major classes of financial assets available to retail investors. They each may offer returns on your investments, but for different reasons. Both have significant risks, but futures are generally considered riskier than stocks. Many investors tend to invest primarily in one or the other. They are either stock investors or futures hedgers or speculators. In the futures vs. stock debate, should you invest in one and not the other? We take a look at the risks and rewards of investing in futures vs. stocks to shed light on the question.
Deciding whether to trade futures is best undertaken in consultation with a financial advisor, who understands not just futures but also your goals, risk profile and timeline.
Investing in Futures
Futures, or futures contracts, and shares of stock are very different investment vehicles. Stock is an equity security. When you invest in a stock, you are buying a piece of a company. If the price of the stock goes above what you paid for it and you sell it, you earn a return by taking advantage of its price appreciation. You can lose money, but you can only lose the amount of your investment in the stock, plus your transaction costs.
When you invest in futures, you actually are signing a contract as opposed to buying part of a company. The contract stipulates that, at a point in the future, you will pay a certain price for the asset underlying the contract. In effect, you are placing a bet that the underlying asset will cost a certain price on a certain day, the expiration day of the futures contract. The underlying asset can be a commodity or a currency. But, it may also be a financial asset like a stock or bond. Futures are generally short-term investments with a maturity of one year or less.
Futures are traded on an organized exchange like a stock. Two of the futures exchanges are the Chicago Board of Trade and the New York Mercantile Exchange. A futures exchange writes the terms of the contract and makes it available for trading. There is no limit to the number of futures contracts that can be issued.
Risks of Futures
The biggest, and most obvious, risk when entering into a futures contract is that trades can break against you. For example, let’s say you buy 10,000 gallons of gasoline on a futures contract at a price of $2 per gallon to be delivered in three months. If the price goes up to $2.25 per gallon by the expiration date of the futures contract, then you as the buyer make money. You’ve only paid $2 per gallon. But what if the price of a gallon of gasoline drops to $1.75 per gallon. You still have to pay $2 per gallon to fulfill your contract. So, you lose $0.25 per gallon. You have not only lost your initial investment of $2 per gallon but you have lost an additional $0.25 per gallon due to the depreciation in the price of gasoline versus what you promised to pay for it.
Another risk of trading futures contracts involves the margin requirements. When you buy a futures contract, you typically do not have to pay all the money at that time. Instead, you can use your brokerage account and pay part of the value of the contract and borrow the rest from your broker. Since futures contracts are marked to market daily, you may have to deposit more money to your margin account off and on to meet your margin requirements. Your deposit is called a performance bond. If you lose money on the futures contract, you will also lose the money you had to put up on the margin. You can also sell futures short with no uptick in the market required.
If you trade in the futures market, you have access to more leverage than you do in the stock market. Most brokers will only give you a 50% margin requirement for stocks. For a futures contract, you may be able to get 20-1 leverage, which will magnify your gains but will also magnify your losses. You do have cash flows if you invest in futures based on daily mark to the market, but they could be either cash inflows into your account or cash outflows.
Tax reporting is not as difficult with futures as you might think. Your broker will give you a 1099 B form at the end of the year summarizing your trades. The tax treatment of futures may be more favorable than for stock. Futures returns are subject to the 60/40 rule, which means that 60% of your gains are taxed at the long-term capital gains rate and 40% at the short-term capital gains rate.
Even though the futures market is a more liquid and probably a more efficient market than the stock market, perhaps the biggest risk of all in investing in futures is that you can lose considerably more than your initial investment.
Investing in Stocks
When you invest in a stock, you actually buy a little piece of a company even if what you get in return is a paper certificate. You can diversify a stock portfolio with as few as nine to 13 well-chosen stocks. There does not have to even be brokerage fees. You can invest on your own, even buy fractional shares, if you use one of the many free stock trading apps that have been developed. If you don’t use a broker, what you will spend is your time. Since you are not relying on the advice of a broker, you have to do your own research. That’s only possible if you have above-average knowledge of finance and the stock market.
Discount brokers don’t give advice and the multitude of stock trading apps that exist use robo-advisors at most. It also assumes that you are stoic and will not panic-sell in the event of a market pullback. In reality, and according to Warren Buffett, you need a portfolio of carefully chosen stocks, across market sectors and industries, that are bound to do well in the long run.
You can increase your wealth through stock investing within a tax-advantaged portfolio. Investing through an IRA or 401(k) allows your investments to grow tax-deferred until retirement at which time you may be in a more favorable tax bracket. If you own stock outside a tax-advantaged portfolio, then you will take an income tax hit if you sell your stock. If you sell within a year after you buy it, you will pay the higher short-term capital gains tax on any gains you make. If you sell after a year, you will be subject to the lower capital gains tax rate.
Stocks vs. Futures
To decide whether to stick with stocks or also trade futures one needs to understand the similarities and differences of the two. Among the similarities are the ability to diversify your investments; both stocks and futures can offer investments in a range of industries and sectors. Futher, both types of securities are liquid. You can usually buy and sell stocks at a moment’s notice, so you have easy and quick access to your money. The futures market is also extremely liquid and futures contracts are traded constantly. In addition, both stocks and futures can provide cash. Many stocks generate current income in the form of dividends. Futures contracts generate cash flow as the contracts are marked to market daily, but that cash flow could be positive or negative.
But there are key differences, besides the much greater risk of futures. Cost is one such difference. Stock investing does not require the high transactions costs of futures investing. In addition, the time horizons of the two are quite different. Usually, stock investments are made for the long-term, partly because of the tax consequences. Short-term capital gains are taxed at a higher income tax rate than long-term capital gains. Futures investments are made on a short-term basis with a maturity of less than one year.
The Bottom Line
To evaluate whether you should invest in futures or stocks (or both), you should consider all of these factors. Despite some of the pros regarding trading in futures, it is not a game for small or inexperienced investors. You need a thorough understanding of the futures market and help from your broker or other financial professionals. But, investing is a personal decision and it ultimately comes down to your own preference for risk, your time horizon and your investment goals.
Tips for Investing
- Putting together a portfolio for retirement or any other reason is complex if you want to take the least risk possible but earn maximum rewards. You may want to consult with a financial advisor before making any investment. Finding an advisor doesn’t have to be hard. Start with SmartAsset’s financial advisor matching tool to find an advisor you are comfortable with. All it takes is a few clicks of your mouse. Get started now.
- Would you like to take a try at building a diversified portfolio before you continue to build your real portfolio? Try SmartAsset’s asset allocation tool that allows you to try different assets and different scenarios.
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