Stocks and Futures - What is the difference?

Are you new to trading? Perhaps you wonder what the difference is between trading Stocks and trading Futures. Often when I meet someone new who inquires as to what I do, I get a response of "that's like trading stocks, isn't it?"

In some ways they are similar, but only minutely so. So let's consider some of the major differences between the two.

Most individuals have likely traded stocks at one time or another. Usually, it is to buy in order to 'own' a percentage of a particular company or to liquidate such partial ownership. They pick up a phone to call a broker or go online to purchase or sell. The order is facilitated through an 'exchange', such as the New York Stock Exchange for example.

Buying and selling Futures is similar in this respect. You can call a broker or go online to buy or sell Futures contracts. The order is then facilitated througha commodity exchange, such as the Chicago Merchatile Exchange for example. Yet while buying a stock gives you part ownership in a company or portfolio of companies (as in a fund), buying a Futures contract does not give you ownership of a commodity or product. Rather, you are simply entering into a contract to purchase the underlying commodity at a certain price at a future time, noted by the contract. For example, buying one May Wheat at 3.00 simply creates a contract between you and the seller (whom you need not know as this is taken care of via the exchange) that come May you will take delivery of 5000 bushels of Wheat at $3 per bushel, regardless of what the price of Wheat at market happens to be come May. As a speculator simply trading to make a profit from trading itself and with no interest in actually taking delivery of product, you will simply sell your contract prior to delivery at the going market price and the difference between your buy price and sell price is either your profit or loss.

When you buy a stock, you are part owner of a company. When you buy a Futures contract, you simply are entering a contract. With stocks, you will pay for the stock at the time of your purchase plus broker commissions. When buying a futures contract, you are simply entering the buy side of a contract and no monies is paid other than commissions to your broker.

Stock exchanges and commodity exchanges are both membership organizations established to act as middlemen between the buys and sells of all types of traders, from business entities to the individual small trader. The stock exchange act to bring capital from investors to the businesses that need that capital. They facilitate the transfer of property rights (ownership in the various companies offering stock).The commodity exchange act to bring people willing to assume risk for the opportunity to make a substantial amount of money for taking such risk. This helps transfer the price risk associated with ownership of various commodities, such as Soybeans, or a service, like interest rates, from producers.

To buy stocks, you only need enough money in your account to purchase the stock outright plus commissions. Once you make the purchase, the money is removed immediately to make the purchase. With trading futures, since you are not actually purchasing anything but simply entering a contract to do so at a later time (which you will exit prior to avoid delivery), the broker will require a certain amount of margin (good faith deposit to cover any possible losses) in what is called a 'margin account'. Each commodity has a different minimum margin requirement depending on several factors. Your broker may use the exchange calculated margin or require a different margin of their own. If the value of the commodity were to decrease and you are on the buy side of the contract, then your contract has lost value and your broker will notify you if your unrealized losses exceeds have gone beyond your minimum margin requirement. This is called a 'margin call'. Naturally you would want to have more capital than simply the margin amount when trading futures to avoid these broker calls. The broker has the right (and likely will) liquidate your position if you are getting too close to not having enough to cover the losses in order to protect themselves.

With buying stocks outright, there is no potential for a margin call. You simply own the stock outright. So perhaps you may be wondering why anyone would bother buying futures contracts rather than stocks. The major answer is: LEVERAGE.

Leverage gives the trader the ability to control a large amount of money (or commodity worth a lot of money) with very little money. For example, if Live Cattle futures requires a minimum margin of $800 to trade a single contract, and a single contract represents 40,000 lbs at the current market price of say 75, you would be controlling $30,000 worth for a leverage of over 35:1. This is appealing to many traders and justifies the risk. What is that risk? Just as leverage can work in your favor, it can work against you at the very same ratio. Known as a 'two-edged sword'.

You can increase the leverage of trading stocks if you trade with a margin account. This usually allows you to purchase stocks on margin at the usual rate of 50%. So for every dollar you have you can purchase $2 worth of stock. The leverage is 2:1. How this works is that the broker is actually 'lending' you the other 50%. Of course by purchasing stock with margin you can lose more than you have due to the leverage. And in this case you can end up getting a 'margin call' from your broker if your stock losses too much value. But trading stocks comes no where close to the kind of leverage you get trading Futures.

When you look at these two trading vehicles, the bottom line comes to MARGIN and LEVERAGE.