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Time to Graduate to Futures?

Jared Woodard of Condor Options explains how investors can incorporate futures trading into their portfolios.

If you've been trading equity index ETFs for a while, it may be time to graduate to futures. Investors who are familiar with popular exchange-traded products like SPDR S&P 500 ETF (SPY), SPDR Dow Jones Industrial Average (DIA), and iShares Russell 2000 Index (IWM) can track the same benchmark indexes by using mini stock index futures. Here are some things to be aware of when choosing between ETFs and futures contracts.

- Size: The contract size of futures is much larger than for ETF shares. With SPY at $164, for example, a buyer of one share controls $164 worth of fund components. With an E-mini S&P 500 Index futures contract (symbol: ES) at $1640, a buyer of one contract controls a much larger amount of value. The contract multiplier for ES is $50, so the notional value of a contract is the index value times fifty. In this example: $1640 x 50 = $82,000. Each futures product has its own specific contract multiplier, and the futures exchanges provide those multipliers as part of the contract specifications.

The larger product size can be helpful. Consider the case of an investor who wants to allocate 30% of a million dollar portfolio to a position that tracks the Russell 2000. With IWM trading at $100, the investor would need to buy 3,000 shares of the ETF to gain that exposure. Alternatively, with Mini Russell 2000 Index futures (symbol: TF) trading at $1,000 and a contract multiplier of 100, the investor would need to buy only three TF contracts to achieve the same exposure. One advantage in favor of trading the futures is that the commission bill to buy three futures contracts may be much lower than to buy 3,000 ETF shares, depending on your brokerage rates; for options, the commission differences may be even greater.

- Dividends: Equity index ETFs typically entitle investors to receive periodic dividends. Holders of futures contracts do not receive dividends. Does that mean futures traders are missing a key source of income? No: futures contracts are discounted to reflect the lack of dividend payments.

- Tax advantages: For investors who intend to hold positions for less than one year, there may be some tax advantages to trading futures. Gains on ETFs held for less than one year are taxed at the personal income tax rate, which can be much higher than the long-term capital gains rate, depending on your income tax bracket. In comparison, gains or losses on futures contracts are treated according to section 1256 of the tax code, which means that, at the end of the year, 60% of the gains or losses are treated as long-term items, while the remaining 40% are taxed at the short-term rate. Consult your tax advisor for more details.

- Holding period: ETF shares are perpetual instruments, and can be held until an investor is ready to sell them. Futures contracts expire - typically in March, June, September, and December, although some products have expirations in other months as well. To maintain a position in futures, investors must "roll" their positions from one month to the next.

- Regulation: Two important regulatory differences between ETFs and futures are the capital requirements for different assets and the ease of establishing short positions in futures. First, most investors fall under Reg T margin requirements for securities, which means that they must hold capital equal to 50% of the value of the securities in their account, limiting the account to 2:1 margin. For futures, margin requirements vary by contract, but they are generally much lower: initial margin may be 5%-10% of the notional value of the contract or less. Additionally, shorting ETFs requires the broker to find securities to sell, and in 2008 the SEC banned what it called "abusive naked short selling." In futures markets, short positions can be initiated just as easily as long positions.

For more on the differences between equity index ETFs and futures, see "Comparing E-minis and ETFs" from the CME.

OptionsProfits can be followed on Twitter at twitter.com/OptionsProfits

Jared can be followed on Twitter at twitter.com/CondorOptions

At the time of publication, Jared Woodard held positions in SPX, VIX.

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