Futures are a way to invest in a market without actually having to invest in that market. For example, you could trade wheat futures if you didn’t have the money to buy a lot of wheat or had no interest in buying a lot of wheat.
While they carry greater risk than cash equities, there is also the potential for higher rewards. Trading futures requires a lot of capital as you need to buy or sell an asset under contract, which is not required when trading cash equities. However, with futures, there are also more restrictions on who can invest in them than regular sharemarkets.
Low entry costs
To invest in the share market, you need a lot of capital, and sometimes you don’t even want to risk that money. As such, it is difficult to get into the share market if you only have a little bit of spare cash to use. On the other hand, because futures require less capital than stocks, it’s easier for people with less money to put towards their investments. It gives more people access to profit-making opportunities on the stock market.
Costs are transparent before you enter into a contract
There are two types of futures contracts, the margin and the cash trade. Cash trade is what it sounds like – both parties pay the total amount of the contract at the time of purchase. The margin trade means that one party deposits an amount with their broker for collateral for them to enter into the transaction. Once again, this deposit will vary depending on how much risk you want to take, but generally speaking, it should be less than half of what you would have to put up for a cash trade to minimise risk exposure.
Higher potential returns
A margin-trading loan allows investors access to potentially higher returns through leveraging their investment. However, this means that you have to be very careful not to take on too much risk as your potential loss is multiplied by the amount of money you’re investing. If the market crashes, you can still lose all of your initial capital in cash trades, but there is no leverage effect on it.
Lower trading costs
The margin-trading loan allows investors access to potentially higher returns through leveraging their investment. The drawback, though, is that not only does this increase their potential losses, but it also increases how much they have to pay in interest every month on the leveraged amount. Due to this, applying for a margin operating account with a broker will probably result in lower total trading costs than buying regular shares, which require zero interest.
When trading cash equities, you can only buy or sell what you currently own. On the other hand, futures contracts are highly liquid due to their ability to be sold at any time before expiration. Meaning that you don’t have to hold the contract until expiry if you want out of it – you could trade them at any time and even benefit from making multiple trades within a single day because there is no expiry date on contracts.
To hedge your portfolio against volatility
One disadvantage of regular sharemarkets is that they carry a degree of risk – which you can reduce by diversifying among different types of assets and increasing the opportunity cost associated with not being able to spend money that could have been invested. In which case, buying up to a certain amount of contracts in index futures can help reduce the risk exposure of a portfolio while also providing returns.
To manage market exposure by quickly taking on multiple positions
It is a lot easier to take a long or short position in futures than it is with other assets because you can always buy or sell an equivalent contract at any time until expiry. It contrasts with assets like spot metals, where if you were bullish, you would either have to wait for an increase or get out earlier and potentially lose money because of that. Additionally, trading commissions are usually lower when trading futures than other assets because there are no restrictions on how many contracts you buy at once, unlike stocks with liquidity issues.
You can find more information on how to trade futures here.
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