Stocks and Futures

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Futures

A financial contract obligating the buyer to purchase an asset (or the seller to sell an asset), such as a physical commodity or a financial instrument, at a predetermined future date and price. Futures contracts detail the quality and quantity of the underlying asset; they are standardized to facilitate trading on a futures exchange. Some futures contracts may call for physical delivery of the asset, while others are settled in cash. The futures markets are characterized by the ability to use very high leverage relative to stock markets.

Futures can be used either to hedge or to speculate on the price movement of the underlying asset. For example, a producer of corn could use futures to lock in a certain price and reduce risk (hedge). On the other hand, anybody could speculate on the price movement of corn by going long or short using futures.
The primary difference between options and futures is that options give the holder the right to buy or sell the underlying asset at expiration, while the holder of a futures contract is obligated to fulfill the terms of his/her contract.

In real life, the actual delivery rate of the underlying goods specified in futures contracts is very low. This is a result of the fact that the hedging or speculating benefits of the contracts can be had largely without actually holding the contract until expiry and delivering the good(s). For example, if you were long in a futures contract, you could go short in the same type of contract to offset your position. This serves to exit your position, much like selling a stock in the equity markets would close a trade.

STOCK MARKET

The market in which shares of publicly held companies are issued and traded either through exchanges or over-the-counter markets. Also known as the equity market, the stock market is one of the most vital components of a free-market economy, as it provides companies with access to capital in exchange for giving investors a slice of ownership in the company. The stock market makes it possible to grow small initial sums of money into large ones, and to become wealthy without taking the risk of starting a business or making the sacrifices that often accompany a high-paying career.

The stock market lets investors participate in the financial achievements of the companies whose shares they hold. When companies are profitable, stock market investors make money through the dividends the companies pay out and by selling appreciated stocks at a profit called a capital gain. The downside is that investors can lose money if the companies whose stocks they hold lose money, the stocks’ prices goes down and the investor sells the stocks at a loss.

The stock market can be split into two main sections: the primary market and the secondary market. The primary market is where new issues are first sold through initial public offerings. Institutional investors typically purchase most of these shares from investment banks. All subsequent trading goes on in the secondary market where participants include both institutional and individual investors.

Stocks are traded through exchanges. The two biggest stock exchanges in the United States are the New York Stock Exchange, founded in 1792, and the Nasdaq, founded in 1971. Today, most stock market trades are executed electronically, and even the stocks themselves are almost always held in electronic form, not as physical certificates.

If you want to know how the stock market is performing, you can consult an index of stocks for the whole market or for a segment of the market. Examples include the Dow Jones Industrial Average, Nasdaq index, Russell 2000, Standard and Poor’s 500, and Morgan Stanley Europe, Australasia and Far East index.

Many investors have stock accounts and feel comfortable purchasing shares of a particular company or an exchange-traded fund (ETF). However, when it comes to trading, there are some advantages to trading futures contracts instead of equities.

1. Leverage

  • Whether you are buying shares of an individual company or an ETF, one must have an initial minimum deposit of 50% of the total asset being purchased.
    • For example, buying 100 shares of IBM at $30 ($3000 total purchase) would require a minimum of $1500 of available cash.
  • Futures traders that hold a position overnight are required to post a margin deposit (also called a “performance bond”) associated with that specific contract.
    • For example, buying 1 mini-S&P contract (total value of about $50,000) would require approximately $5600 (as of March 31st, 2010). While these overnight margin requirements are subject to change, this example shows a minimum deposit of closer to 10% of the total asset being purchased.
  • Day-trading futures (defined by not having a position when the market closes) requires even less margin.Please consider the implications of leverage can be positive or negative depending on if the trade is a winner or loser.

2. Tax Considerations

  • Securities such as ETFs are taxed on a very different basis than are E-mini stock index futures. Traders should consult their tax attorney for information application to their situation, but as a general rule, gains on ETFs are treated as capital gains.
  • The tax on these capital gains would vary depending on the holding period, but futures fall under Section 1256 of the tax code. This means 60% of the gains are treated as long-term capital gains and 40 percent of the gains are treated as short-term capital gains regardless of the holding period.

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