When most people begin investing, they focus on trading stocks. Despite having hundreds of dimensions to consider, they’re relatively approachable, and if all else fails, you can focus on investing in companies you personally know and trust. After dabbling in stocks, they may move on to things like index funds, bonds, exchange-traded funds (ETFs), or real estate investment trusts (REITs) to diversify their investments. But only a handful of investors ever move on to trade futures.
Why is this? And what’s the advantage in trading futures anyway?
Trading Futures in a Nutshell
Rather than buying a “share” of stock, investing in futures requires you to create a contract to buy or sell a given commodity or equity. This contract will require you to buy or sell the commodity at some point in the future — tomorrow or years from now, depending on what’s specified in the contract — for a specific price. This enables you to make money based on your predictions of how the price will change. For example, if you believe the price of corn will rise significantly by next year, you could buy a futures contract that locks in a certain amount of shares of corn for today’s prices.
Advantages of Trading Futures
So what is the advantage to this approach? If you believe the price is going to rise, can’t you just buy the commodity and see the same result?
There are actually several advantages to futures trading:
- Leverage. One of the biggest advantages of trading futures is the ability to gain leverage. When buying a futures contract, you’ll need to provide a kind of down payment, usually amounting to 10 percent of the full value of the contract, but no more than that. This means you’ll be able to expose yourself to assets in far greater value than what you’re actually providing yourself. This is advantageous, because you could potentially trade $10,000 of a stock or commodity by putting only $1,000 down — as long as you protect your bets with a complementary contract should the need arise.
- Diversification. Futures are a different type of investment than stocks, bonds, or mutual funds, giving you another type of asset you can use to diversify your holdings. If you’re concerned about the volatility of a specific equity you recently picked up, you could invest in a futures contract that shields you from a price drop by committing to sell a portion at a specified price in the future.
- Short-selling. If you’re interested in the fast pace and potentially high returns of short-selling, futures trading is the place to do it. If you think a particular market is going to plummet, you can invest your money in a sell contract for that asset, based on a timeline you think is reasonable.
- Reduced commission fees. Futures contracts will require you to pay a commission rate, but they’re generally lower than those you’d find trading stocks and bonds. If you’re day trading these assets, those commission fees can add up quickly, so futures contracts represent an opportunity to do more trading for less money.
- Liquidity. Futures contracts are generally highly liquid investments. There’s no limit to how many futures contracts you can create in a day, and investors create and cash-in futures contracts at an extremely high rate. If you’re interested in day trading, this is one of the best places to operate. If you’re nervous about the contractual obligations of futures trading, try it for yourself — you’ll see how easy it is to pick up new contracts and see them through.
Should You Invest in Futures?
Futures trading is slightly more difficult to learn than trading stocks or bonds, but it’s much simpler than most people realize. It’s a fairly reliable type of investment that can yield potentially high returns — and keep your money safe at the same time. For that reason, it’s a good addition to your portfolio, if for no other reason than to diversify it.
That being said, every investor is different with different goals, different needs, and different preferences. Spend some time learning about futures trading, and if it sounds like it fits your strategy, get yourself involved.