Investing in the futures market is not only riskier, but requires average investors to be more attentive traders.
While the majority of retail investors should avoid trading in futures because it is a more complex market, these contracts allow individuals to hedge against the current holdings in their portfolio, said Kumar Venkataraman, a finance professor at Southern Methodist University's Cox School of Business in Dallas.
"Futures positions have high leverage in that one gets a lot of risk exposure with little capital," he said.
Many individuals invest in popular broad stock market indices such as the S&P 500 index, because it is a low risk, low cost investment. Investing $10,000 into an E-Mini S&P 500 (NQ) futures contract will also have exposure to the same index as investing $10,000 into an S&P 500 mutual fund or ETF, but the risk is five to ten times higher for the same dollar amount of investment, Venkataraman said.
"The investor can make a lot of money if the market moves in their favor, but they can also lose quickly the entire capital if it moves in the other direction," he said.
Advantages of Futures Over Stocks
The futures market gives investors exposure to commodities such as crude oil or natural gas and helps them to diversify their portfolios.
"Note that there is no free lunch - thus the cost of storage will be built into the commodity prices, but it's much easier to obtain exposure than owning a barrel of crude oil," Venkataraman said.
Investors are given access to markets which are open "virtually" 24 hours, although traders have to be prepared to take a speculative position if an economic or political situation arises, said J.B. MacKenzie, director of futures and forex of TD Ameritrade, an Omaha-based online broker.
The futures market also provides investors an opportunity to "express a market opinion" either in favor or against the general market sentiment by investing in choices such as the E-mini Nasdaq futures (QCN), he said.
Another advantage of futures is the capital efficiencies derived from one futures contract, allowing individuals to allocate less capital to take a similar position on a market sentiment, MacKenzie said.
Hedging in futures allows sophisticated investors or institutional players to lower their risk.
"A hedge fund might use a short position in futures contracts to reduce the risk of their overall stock portfolio," Venkataraman said. "Trading desks actively use these contracts to hedge against a market move within a day while they are trying to build or get rid of a position or a bank might purchase interest rate futures contracts to hedge interest rate exposure on the loans that the bank originates."
While futures give average investors additional exposure to energy and commodities that ETFs and stocks can not accomplish, they should only make up 5% to 15% of an individual's portfolio, said Peter Borish, chief strategist with Quad Group, a New York-based financial firm.
"It is not worth the mental anguish, due diligence and discipline if it is less than 5%," he said. "More experienced traders who want diversification in their portfolios can allocate 10% to 15% of their money in futures."
Brokerage firms have different rules about opening a futures account, and many like TD Ameritrade require approval to open one, based on an investor's past experience with trading.
The types of futures contracts investors can trade include energy, interest rates, stock indexes, currency and agricultural, but each of these products has its own set of rules about margin requirements and even trading hours.
Traders who are new to futures should spend time paper trading on TD Ameritrade's simulated platform to experience and understand "how the market reacts differently," said MacKenzie. Companies such as LimitUp offer free futures game simulation games for novice investors to conduct their initial trades.
"Create a strategy to understand the impact and downside risk in order to place the appropriate trade," he said. "This is a different asset class, so buy one contract to see what happens to your overall portfolio."
Trading futures takes a "tremendous amount of discipline," because managing money remains a "very difficult" process, said Borish.
When investors lose money on a trade, they do not want to admit they are wrong, so they tend to lose their discipline and hold onto their bad positions.
"Most people want to be right, but when it comes to trading, it's about making money and it's more important," he said. "You're competing against the pros."
Investors who lack a reasonable time frame, have higher personal liquidity needs and seek instant gratification should shy away from trading futures.
"If you trade futures, you have to understand that while crude can be cheap, it can get cheaper," Borish said. "You are better off going to a managed futures product."
Risks of Futures
Trading futures can be riskier because of the 24-hour market and investors can not be complacent, said MacKenzie.
"It is not something you buy and then not have much concern on whether there will be any volatility," he said. "You have to make sure you are focusing on covering your downside risk and be prepared if the market moves against you. If you bought crude at $48.91 a barrel and it moves to $47, then you need to have the stop loss trade in there when the market moves down."