Ever since the movie Trading Places, when Eddie Murphy and Dan Akyroyd’s characters struck it rich overnight trading Orange Juice, the public has been fascinated by the Futures industry. If you do any late night channel surfing you’ll see that Futures (also know as Commodities) are once again at the forefront and gaining popularity.
While the late night TV hucksters try to convince you that “gold is poised for a tremendous move” or that you can make it rich trading the FOREX by watching two lines twist and turn, most people are still very unfamiliar with what Futures are.
A common mistake that people make is assuming that Futures are like stocks. Try explaining the Futures market to any novice and they will undoubtedly try to make a connection between the stock market and the Futures market. While stocks and Futures are both “traded” the similarities pretty much stop there. There are basically three major differences between stocks and the Futures market.
1. You Own Stocks and You Contract for Futures
The principle difference between stocks and Futures is that you “own” a stock and you “enter into a contract” in Futures. When you buy a stock you are literally buying a part of the company you are investing in. This is why stocks are referred to as “shares”, because you own a share of the company. In Futures however, instead of actually “buying” the underlying commodity, like corn or wheat or cotton, you are merely entering into a contract for that particular commodity. This means that you can contract to be a buyer or a seller of a commodity.
For instance, if you thought the price of Silver was going higher you could enter a contract to buy Silver at the current price, hoping that you could sell it later at a higher price and make a profit. While on the surface it may seem that you are really “buying” Silver you are in fact committing to a contract to supply 5000 Troy ounces of Silver at a specific price (5000 Troy ounces is the size of one Silver contract). If you enter your contract when Silver is trading at $498 per ounce and exit your contract when Silver is trading at $512 per ounce you would make a profit of $700 per contract.
The beauty of the Futures markets is that because you are trading contracts, and not the actual commodity, you can make money if the market is moving up or down. Most stock traders traditionally only buy a stock to go higher and most never consider selling a stock they don’t own, but in Futures selling is very common because you don’t actually have to own the commodity to sell it.
For example, if Cocoa was trading at $1446 per ton and you thought prices were going to continue lower you could enter a contract to sell Cocoa at $1446. If the price of Cocoa fell from $1446 to $1360 you would have made a profit of $850 per contract. The important point to bear in mind here is that you do not have to own the Cocoa contract first in order to sell it. Since we are dealing with the future delivery of Cocoa, hence the name Futures – but more on this in a minute, you can enter into a contract to supply Cocoa at a specific price, hoping to buy it at a lower price before the contract comes due. This enables you to profit from a favorable difference in prices.
2. Futures Always Have a Buyer and a Seller
Contracts require a buyer and a seller. It doesn’t matter if you are entering into a contract for a house, a car, or 5000 bushels of Corn, every contract has a buyer and a seller. It is no different in Futures. For every trader that thinks the price of Cotton is going higher there is another trader that thinks the price of Cotton is going lower. This means that Futures are always a zero sum trade. For every trader making money, there is a trader losing money.
With few exceptions, the commodity markets are usually so liquid that it is never a problem to find someone to take the opposite side of your trade. In most cases the fills are nearly instantaneous. On the other hand, in the stock market you can only purchase as many stocks as are available for sale by a particular company. If ABC Company is not issuing any more stocks, and you can not find anyone willing to sell you their shares, you can not buy stock in ABC Company. Simple. While this is not usually a problem, it is a possibility, especially if ABC’s stock becomes particularly popular, or they do not have a large issue of stock, it could be difficult to buy in even if you wanted to.
When you do buy stock in a company, you are investing your money in that company hoping it will become more valuable in the future. However, while the value of the stock is based on the value of the company itself, it is not guaranteed to remain valuable. Remember Enron? In Futures however, since you are entering into a contract where there is always a buyer and seller you can not have an Enron type experience. There is always someone to cover the other side of your contract.
3. Futures Have a Time Limit
I briefly mentioned this earlier, it is the last major difference between stocks and Futures, namely that Futures have a time limit attached. As their name suggests, Futures contracts are contracts for delivery of a commodity in the future. This is why commodity contracts always have a delivery month assigned to them. If you were trading December Corn, then you are trading Corn which has a December delivery. While you would never actually take delivery of a contract, it is nevertheless important to stay aware of when the contract is due to expire. As the contract gets closer to expiration the market gets thinner as only the traders who actually need to take delivery of the commodity (ie. grain mills) remain.
This means you could experience some price slippage if you waited until near the end to exit your contract, but any competent broker will keep you abreast of important first notice and last trading dates. In contrast you can own a stock for as long as the underlying company remains in existence. This is why “buy and hold” is such a popular strategy among stock traders. You can buy into a company and hold onto to the stock for as long as necessary to realize a profit.
“Buy and hold” would not work very well in the Futures markets unless you had VERY deep pockets. Given the extreme leverage that Futures offer, most traders are not able to sustain substantial draw downs against their positions. Again, because Futures trades are contracts with a buyer and a seller, if the market moves against you, you need to “pay” for that loss immediately. Since any profits and losses are automatically adjusted to you account at the end of every trading day, you can only maintain your position for as long as you have enough money in your account. On the other hand, because you actually own the stock when you buy it, you can sit on it for however long you want, or need to.
If the stock loses value you might be upset about it, but it doesn’t actually cost you anything extra. It only means that you have lost part of your original investment if you decided to sell your shares right now. This fact gives you a little better staying power when trading stocks versus commodities.
As you can see, while stocks and Futures are similar, there are substantial differences between the two. It is vital that you recognize these differences so that you can better make informed trading decisions. One is not necessarily better than they other. They’re just different.
For more from Erich, visit the Indicator Warehouse for additional futures resources and NinjaTrader Indicators.