Most people view the futures markets as a dangerous alternative investment that should be avoided altogether. This is due to the amount of leverage available in the futures contracts themselves. For instance, the margin on a Japanese Yen contract is just under $3,000, and this contract controls 12,500,000 yen, which is equivalent to over $100,000. That is a significant amount of leverage, and if misused, can lead to large losses in a short period of time.
What many people don’t realize is that it is quite easy to lose a lot of money in an individual stock in a very short period of time as well. Poor earnings reports or bad news can lead to an instant 10% drop or more in the value of a stock. Occasionally, losses over 50% can happen overnight. If an investor is not properly diversified, this can have a devastating effect on a portfolio.
Professional investment advisors in the futures markets, known as Commodity Trading Advisors (CTAs) approach the markets in a completely different way than the typical mutual fund portfolio manager. Their first focus is on risk management, whereas the first focus of the mutual fund manager is on stock selection. In fact, the concept of risk management is often very secondary to the mutual fund manager. Their idea of risk management is simply to diversify across many stocks.
The CTA on the other hand develops a trading system or strategy with risk management first and foremost in their minds. They understand that the leverage available in the futures markets can wipe them out quickly. In fact, most CTAs trade very conservatively, never risking more than 1% of their portfolio equity on any single trade or position.
One advantage for investing in futures rather than stocks is that there is a constant flow of information available for every market. This includes government statistics and information provided by producers. As a result, market participants are rarely surprised by information that could lead to a huge percentage move similar to what may be seen in individual stocks.
Futures markets, except of course the stock index futures, are largely uncorrelated to the stock market. In other words, most of these markets move independently of the direction of the stock market, whereas during bear markets, three out of four stocks tend to move lower with the market.
It is also easier to establish short positions in the futures markets as there is no extra cost for doing so. In the stock market, investors must first borrow the stock from their broker and then sell it short. Therefore, they must pay interest to the broker when borrowing the stock.
Most CTAs develop mechanical trading systems for trading futures markets. This is easy to do when you are able to focus your attention on 100 markets or less. These systems incorporate entry and exit signals as well as risk management strategies that determine the number of contracts to be traded. In the stock market, this is far more difficult to do, due to the much larger universe of stocks.
One other big advantage that trading futures has over trading stocks is the ability to use unrealized gains in order to trade more contracts. As long as you have enough equity in your account to cover initial margin, you can enter a new position.
In the stock market, you are limited in the amount of shares you can trade while your equity is building to the amount of cash you have on hand. If you don’t have a margin account, and you have already bought as much stock as you can with the cash you have in your account, then you must sell this stock in order to enter a new position in another stock. Also, it takes a couple days for the transaction to settle so that you have the funds in your account to trade again.
If you are an aggressive investor in stocks, you may choose to open up a margin account. Therefore, if you have $10,000 in your account, you can purchase up to $20,000 worth of stock. Unfortunately, you also have to pay interest on those extra shares you decide to purchase, because you are borrowing money from your broker in order to purchase those shares.
In the futures markets, margin is simply a performance bond. Initial margin is usually sufficient to cover the daily maximum price fluctuations in a given market. However, if that market becomes more volatile, the margin requirements may increase to reflect the added risk. The more risk, the higher the required margin deposit.
Futures positions are settled daily. As such, margin account balances will fluctuate on a day to day basis. Losses are debited daily and gains are credited daily. For instance, if a trader is long one corn contract and corn prices rise 10 cents, then his account is marked to reflect the market price…in other words, his account will be credited with $500 (a one cent move in corn futures equates to $50). Conversely, if corn prices fall by 10 cents while the trader is long one contract, his account will be debited $500.
A price movement in favor of a position results in the additional value of the market position added to the account, which increases the account balance. If this increase in the account value is enough to meet the margin requirements for another contract, then the trader may purchase an additional contract without depositing more money into the account. This is one big advantage that investing in futures has over investing in stocks.
Finally, top performing CTAs tend to trounce the S&P 500 over the long run, whereas top mutual funds actually underperform the S&P 500. For instance, some of the top CTAs that employ systematic trend following in their approach to trading futures beat the S&P 500 by a wide margin over the long run, and with even less volatility. This is a fact that escapes most investors. Mutual funds on the other hand demonstrate returns in the long run that tend to underperform the S&P 500 due to the fees they charge.
With all this in mind, many investors should consider investing in futures markets as a way to at least diversify their portfolios to add protection when the stock market heads lower. The best scenario is that an investment in futures can boost returns significantly.
