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> New to Futures?
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Leverage
Leverage is a powerful tool available in the futures markets. Futures trading provides traders and investors with more leverage than typically allowed with in other securities trading. It is important to note that leverage can be both a benefit and a risk. There is a direct relationship between leverage and risk.
Like any tool, using leverage can be both a benefit and a risk. Leverage is the amount of capital required (margin funds) to trade a financial instrument.
Here's how leverage can work in your favor. Say you believed the S&P 500 would increase. You could purchase 50 shares of the S&P 500 index in the cash market at 1400 for $70,000 and selling at 1420 at $71,000 for a $1000 profit.
Alternatively, you could buy an E-Mini S&P 500 futures contract, valued at $50 x S&P 500. At the time of this writing this requires a $4,000 margin. If you bought this contract at 1400 and sold it at 1420, the profit on this trade is also $1,000. But you were able to produce this profit using $4000, rather than $70,000. In profit and loss, leverage allows you to magnify movement.
If you are a day trader and are allowed more liberal margins then your leverage factor is even greater.
Liquidity
A key strength of the futures markets is liquidity, the volume of contracts traded. Exchanges such as the NYSE have liquidity dispersed among hundreds of individual stocks, but futures markets like the CME and CBOT concentrate liquidity in the markets traded. Just this past year, the CME E-mini S&P 500 futures surpassed the benchmark 10-Year Treasury futures in volume. Volume at the CME in 2006 grew 28% over the previous year.
Note: There are many different futures markets, some of which are not liquid from time to time. Trading in non-liquid markets is risky and can result in poor or no fills on your orders.
Risk
Because of the volatility and leverage characteristics of futures markets, trading these markets are relatively riskier than other traditional market places. In addition, traders can run the risk of losing more money than is funded in their accounts. For these reasons you should only trade futures with risk capital -- money you can afford to lose which would not change your lifestyle.
Futures Trading vs. Stocks
Although futures and stocks have some common characteristics, they are fundamental differences. Futures are contracts with expiration dates, while stocks represent ownership in a company. The below chart outlines some differences.
| Futures | Stocks | |
| Trading | Traded at an organized exchange | Traded at an organized exchange or over-the-counter |
| Represents | A commitment to buy or sell something in the future at an agreed upon price | Ownership of a corporation |
| Issued by | A futures exchange, which writes the terms of each contract and makes it available for trading, but does not specifically issue it Buyers and sellers create an obligation when they enter into futures contracts |
A corporation |
| Maximum number that can be issued | No limit to the number of futures contracts that can be There are, however, position limits and position accountability in stock index futures |
Set by corporate charter
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| Investing | Can be traded in expectation of making a profit, but can be a zero sum game | Long-term positive expectation of return, but no guarantee of profit |
| Cash Flows | In and out flows to traders' accounts are based on daily marking to market-a debiting or crediting of each futures account based on that day's change in the price of the contract(s) held in each account | May receive dividends |
| Leverage | Highly leveraged | May be leveraged if purchased on margin, with a 50 percent margin being the standard (considered a loan from broker with interest required) |
| Ability to Sell Short | Yes, as easily as buying long; no uptick in price necessary | Permitted under special circumstances. A Short sale can only be made on an uptick-when the stock price has gone up "a tick" in price |
| Time | Typically short term Fixed maturity/expiration date, usually less than one year |
Typically, but not always, long term Stocks are perpetual instruments as long as the underlying company remains solvent |
| Money | Buyers and sellers deposit a designated performance bond in an account; the amount is a percentage of the current value of the contract As contracts prices change, the accounts are debited or credited accordingly |
Buyer purchases shares Margin may be paid as a down payment in some cases Broker may ask for a margin call-a request for additional money from the person buying or selling on margin due to additional price changes in the stock |
| Monitoring | Traders must be aware of expiration day and last trading time | |
| Risk | Depending on price change, more than the initial amount invested be lost | If the stock is not bought on margin the most that can be lost is the entire amount invested |
Table Source: CME.com
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