Advantages and Disadvantages of Trading Futures

Almost everyone is familiar with stocks and the various indices that track the market in general. Nasdaq, Dow and S&P 500 are household names to anyone who even remotely follows financial news. Anyone watching financial news prior to 9:30 am ET may also have heard the word “futures” with some indication on how the market will open. 

What follows assumes a basic understanding of futures contracts. If you think futures and options are the same thing or have never heard of futures before or have never seen the movie Trading Places, then a comprehensive explanation of futures contracts and commodities can be found in a related post.

Why and how would anyone trade a futures contract? Historically, institutional investors use futures contracts on indices such as the S&P 500 (symbol ES) to hedge against large stock portfolios. Speculators use futures contracts to take advantage of short to medium term price movements and provide liquidity to the markets.

Up until the last 10-15 years, futures contracts were limited to professional level traders. Now most retail brokerages (Etrade, Interactive Brokers, Tradestation) offer futures accounts for retail traders.  Opening a futures account is just as easy as opening an equities account.

But just because you can trade something doesn’t mean you should. Futures trading offers many advantages over traditional equity trading, but there are also some serious ramifications when trading futures if not fully educated.  Below are some advantages and disadvantages to trading futures compared to traditional equities.

Advantages

Leverage

The single biggest advantage of futures over equities is leverage. Unlike trading stocks on margin, futures trading does not require borrowing money. What “margin” means in stock trading does not at all mean the same thing in futures trading.

When trading futures, “margin” simply means the amount of money required in your account to enter a position.  It is essentially a “good faith” deposit on your position.  The margin required to enter a position is typically 5-20 times less than the notional value of a position.

Let’s take the e-mini S&P 500 contract (ES) as an example. As of this writing, the notional value to margin ratio is roughly 14:1.  That means that if you are long 1 ES contract, every 1% move up would equate to a 14% return on margin!

But leverage works both ways. Any move against your position would also be multiplied 14x. (More discussion on this in the “disadvantages” section)

Ability to go short

Unlike going short in stock positions, going short in futures does not require borrowing. In fact, shorting a futures contract is exactly the same as going long a futures contract. The margin required is typically the same (although not always) regardless of the direction (long or short). 

Typically retail stock traders are unwilling to go short due to the borrowing aspect and the unlimited loss associated with short selling. Futures contracts remove these shackles as the process is the same for both long and short positions.  When an equities trader suspects a downturn typically the move is to sell and go flat and wait for another buying opportunity.  With futures, the trader can short the market and take advantage of bear conditions just as easily as bull conditions.

Taxes

While leverage and the ability to go short are major advantages of trading futures, taxes are really where futures trading pulls away from equities trading.

First off, futures are not subject to wash sale rules.  Typically if an equities trader sells something like SPY at a loss and then buys SPY back within a 30 day period, that trader will not be able to offset that loss against their gains for the year.  That is not so with futures trading.  Any loss can be offset against gains regardless of trade timing.

More importantly are how futures trading profits are taxed. Futures profits are taxed based on a 60/40 split, with 60% of profits being taxed at the long term capital gains rate (which is typically much lower than the ordinary income rate) and 40% of profits being taxed at the short term gains rate, which would be equal to the ordinary income tax rate of the trader.  It does not matter how long the position is held, the profits will still be taxed on the 60/40 split.

This is a huge advantage for futures traders compared to equities traders as equities traders would pay tax on 100% of profits at the short term gains rate if the position was held for less than one year.

Disadvantages

Leverage

Leverage is a double edged sword. In our earlier ES example, just as a 1% gain can generate a 14% return on margin, a 1% loss can produce a 14% loss on margin. Worse still, the loss on a futures position can easily exceed the margin required to enter a position. If the equity in the account falls below the margin requirement, the broker will issue a “margin call” which will require the trader to immediately deposit enough funds to cover the margin or the broker will liquidate the position. 

A new or undisciplined trader can easily blow out an account on one trade if over leveraged.

Complexity

Let’s face it, stocks and ETFs are much easier to understand than futures. When a retail trader buys 1 share of SPY at $685.69, they spend $685.69 plus commissions.  That is easy to understand. 

But when we start talking about futures, there are terms like margin, notional value, expiration date, tick size, etc. For the typical retail trader that can be overwhelming. And when it comes to investing or trading, if a concept is not fully understood, then it is probably best to stay on the sidelines.

Limited availability

Futures are generally limited to physical commodities, stock indices, treasuries, and foreign exchange. If a trader is interested in a particular company, they will be limited to trading that company’s stock or corporate bonds. While single stock futures are available internationally, they are not currently offered in the United States. 

Taxes

Taxes with regards to futures are only a disadvantage to long term investors as opposed to traders.  The buy-and-hold, “time in the market beats timing the market” crowd will likely not be affected by wash sale or short term gains tax implications.  

Futures are likely not the best vehicles for buy-and-hold investors because the profits are essentially “tax as you go”.  Each year the profits would be taxed on the 60/40 split as described above.  Alternatively, if the buy-and-hold investor were to hold shares in SPY as opposed to ES futures, the profit would be 100% taxed at the capital gains rate assuming that the position would be held for longer than one year.

Overall, for active index traders, futures are clearly the more advantageous vehicle for trading. Higher leverage, ability to short, and preferential tax treatment clearly make futures more attractive.  However, for stock pickers and buy-and-hold investors, stocks and ETFs are the better option.