Futures vs stocks: understanding the differences and benefits
Trading stocks and derivatives, such as futures contracts, has long been a significant component of the financial markets. While investors often use both products to gain exposure to specific asset classes, they have distinct differences that should be considered before deciding which is right for you. In this article, we will explore the key differences between futures and stocks, highlighting the advantages and disadvantages of each. We will also discuss why it might make sense to incorporate both into a diversified portfolio.
What are Futures?
Futures contracts in the UK are agreements between two parties to trade an asset or stock at a set price on a particular date. These contracts expose investors to commodities such as energy, agricultural products, and metals. They are typically traded on exchanges that specialise in futures contracts.
What are Stocks?
Stocks represent ownership of a company or entity. When investors purchase stocks, they own a stake in the underlying company and have voting rights regarding significant decisions such as electing board members. Stocks are traded over public exchanges like the New York Stock Exchange (NYSE) or the NASDAQ.
Differences between futures and stocks
The main differences between trading futures and stocks lie in the investments themselves, their risk profiles, and how they can be used within a portfolio.
Futures generally carry higher levels of risk than stocks, as their price movements depend upon a more significant number of variables than stock prices. Additionally, futures contracts have an expiration date which can lead to losses if the contract expires before its expected delivery date. In contrast, stocks do not typically expire and can be held for extended periods.
Futures contracts are traded heavily and often have higher volume and liquidity than stocks. It means investors can quickly enter or exit positions compared to trading stocks.
The time horizon for holding futures contracts tends to be shorter than stocks due to the expiration dates associated with futures contracts. For this reason, many traders prefer using futures to speculate on short-term price movements. On the other hand, stocks are typically held for medium to long-term investments as they are not subject to expiration dates.
Futures contracts typically require margin payments, deposits made to a futures account before trading. These margin requirements can be higher than those for stocks as they are intended to cover potential losses if the market moves in a different position than yours. Stocks do not generally require margin payments and instead may offer investors leverage through borrowing or issuing stock options.
The taxation of profits from trading futures and stocks will vary depending on where you live. Generally speaking, gains from futures contracts in certain countries may benefit from lower capital gains rates than stocks. Additionally, traders should consider whether the taxation structure of the futures exchange supports their investing strategies.
Strategies for combining the two products
Futures and stocks can be combined in various ways to create diversified portfolios. Investors should consider the specific risk tolerance, investment objectives, and time horizon when determining which strategy best suits their needs.
One strategy for combining futures and stocks is actively managing a portfolio with both products. This strategy involves selecting the appropriate securities and regularly monitoring their performance to make necessary adjustments. For example, an investor may buy stocks when markets are rising and sell futures contracts when markets begin to decline. This combination of long-term investing and short-term trading allows investors in the UK to take advantage of market volatility while minimising risk exposure.
Another approach involves using futures as a method of hedging against stocks. This strategy allows investors to reduce their overall portfolio risk by taking offsetting positions on different asset classes or even within the same asset class, such as buying stock index futures to hedge against falling prices of individual stocks within that index. Hedging strategies can also be used when dealing with currency fluctuations by combining futures contracts denominated in different currencies or investing in domestic and foreign equities.
Investors may choose to use options to purchase more shares at a lower price or provide downside protection if the stock decreases in value. Options provide investors with greater flexibility than outright purchases of stocks because they allow investors to set limits on both upside and downside potential losses while allowing them to participate in any potential upside gains.
With that said
When choosing between stocks and futures, there is no one-size-fits-all answer. Each product has unique advantages and disadvantages that should be considered to decide which will best meet your investment goals. Stocks are less risky than futures due to their lack of expiration date but may require a longer time horizon for investors looking for returns. Conversely, futures offer more liquidity than stock markets but carry more significant levels of risk due to their shorter lifespan and the variety of underlying factors that affect their prices. Understanding the differences between these asset classes can help investors determine which is best suited to their needs.