Prop Trading Futures

14 Differences Between Stocks & Futures

On the surface buying and selling stocks or futures contracts may look similar: orders are entered pretty much in the same way and profit and prices are calculated in a straightforward manner (contrary to options). But in reality futures contracts and stocks are two completely different instruments.

This difference has its roots in the purpose for which these securities were originally invented. Stocks were created for companies to raise money from investors that wanted to speculate on their growth; futures contracts were created to help producers and merchants to hedge risk.

So let’s dive into this subject, analyzing one by one the key differences between futures contracts and stocks.

1. Ownership

When you own a stock you own – even if in a small part – a share of a company. As an owner, you have a claim on every asset and earnings of that company.

In particular, a common stock entitles you to vote at shareholder meetings and receive dividends while a preferred stock allows you, the holder, to receive dividend payments before a common stockholder does, to have priority over a common stockholder in case of liquidation, but not to vote at sharehoder meetings.

Futures contracts, on the other hand, are just contracts. When you are saying you are buying or selling a futures contract, you are actually NOT buying the underlying commodity, like hogs, wheat or gold: you are merely entering into a contract to be a buyer or a seller of that commodity.

You ‘own’ a stock and you ‘enter’ a futures contract.

The settlement of the contract (that can be done in two ways: physical delivery or a cash settlement, according to the terms fixed by the futures exchange) happens after contract expiration, but in most of the cases it doesn’t occur because the contract is closed before. In most cases brokers don’t even allow traders to take delivery (Anyhow, I I know about some traders that took delivery “by mistake”, but this a story for another post).

Ownership is one the basic differences between stocks and futures.

2. Volume

In stocks the volume is the number of shares that change hands during a given period of time.

On the other hand, you can think of a future market as a multidimensional market where the three dimensions are: time, prices and delivery months. The total trading volume in futures is the aggregate volume of all delivery month contracts in that particular market.

Often in futures markets, especially in intra-day trading, tick volume is used as a substitute of volume. Tick volume is the number of changes in price during any given time interval. Tick volume is used as a proxy of the total volume since, since, as markets become more active, prices change back and forth more often.

Another term used in the futures market is the Open Interest (OI). The open interest is the measurement of the total number of contracts held by buyers or by sellers (the two things are equal since a futures contract is an agreement between two parties: a buyer  and a seller).

From a practical standpoint, the open interest is a measurement of the willingness of longs and shorts to maintain their opposing positions in the marketplace. An increase in open interest shows increasing commitments in a market.

3. Issuing entity

As consequence of what they represent, stocks are issued by a company and it’s the company that decides how many share to issue, etc.

With futures it’s completely another story. Futures contract specifications are created by a futures exchange. Then are the buyers and the sellers that create the contract when they enter a transaction. This explains why there is no limit to the number of futures contracts that can be created in each market. Each time a new contract is created the Open Interest increases. When it is terminated the Open Interest decreases.

4. Trading Hours

The stock market is open less than 12 hours per day.

Most futures markets are open almost 24 hours a day from Sunday to Friday (EST). In futures markets regular time hours (RTH) and extended time hours (ETH) allow to traders from all over the world to participate directly to each market.

5. The exchanges

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 futures exchange sets standardized contract terms, including the contract size, delivery months, the last trading day, the delivery locations, and acceptable qualities or grades of the commodity.

In both cases, the exchange also provides and operates the facilities for trading, enforces the rules for trading and keeps and disseminates trading data.

6. Margins

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 from your account.

With trading futures, since you are not actually purchasing or selling anything but simply entering a contract to buy or sell at a later time, the futures exchange requires a certain amount of initial margin to be paid to make sure that you meet your financial obligations. This deposit is in all aspects a performance bond and is typically between two to ten percent of the value of the futures contract that you want to enter.

Each commodity has a different minimum margin requirement depending on several factors, such as market volatility, contract, liquidity, trading hours, etc.

If the value of your position loses value, your balance in the margin account decreases too, and if this value goes below a level call maintenance margin (that is lower than the initial margin, of course). In such case, you are required to add capital to the account to meet the margin requirements or to close the contract.

Futures commission merchants (FCMs) and introducing brokers often require their customers to maintain funds in their margin accounts that is higher the levels specified by an exchange.

7. Pricing

A stock is always priced at what the market believes the stock is worth today.

A futures contract is always priced based on what the market expects it to be worth in the future, at expiration. Other than that, futures contract prices fluctuate just like the price of a stock.

8. Expiration

Once issued a stock exist for an undetermined amount of time. Surely it is not forever, but generally it is long enough to allow investors to buy and hold it “forever”. As a stockholder, you own a company and until the company exists you its shares.

Futures contracts are contracts for delivery of a commodity in the future. They have a life attached to them that is written in their specification. As the contract gets closer to expiration the market gets thinner: only the few merchants and producers that want to get delivery hold their contracts until expiration.

8. Markets

In the past futures markets had the advantage of giving to speculators a wider spectrum of securities to trade than stocks. Nowadays, most of the commodities are traded also as ETF. Anyway, there are still markets that you can trade only with a futures contract.

9. Leverage

You can trade stocks with leverage if you trade with a margin account.

Most brokers allow retail traders to purchase stocks on margin at the usual rate of 50%. Prop trading firms can get higher leverage than that, but they represent a minority.

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.

Anyway, trading stocks comes no where close to the kind of leverage you get trading futures contracts. In futures markets, leverage gives the speculator and the hedger the ability to control a much larger amount of underlying securities. The leverage ratio in futures can be as high as 1:40.

10. PDT Rule

The SEC describes a stock trader who executes 4 or more day trades in 5 business days, provided the number of day trades are more than six percent of the customer’s total trading activity for that same five-day period, as a Pattern Day Trader (PDT).

As a Pattern Day Trader you are required to have a minimum of $25,000 bankroll and cannot fall below this amount.

Some brokers that are incorporated outside the US (in places like the Bahamas) are exempt from the Pattern Day Trader Rule and allow their traders to day trade with account funded with as little as $2,000.

Futures accounts for Intraday trading can be opened with as little as $500 and do not have any Pattern Day Trader Rules associated with them.

11. Taxation

In many countries futures traders have tax advantages for short term trading since future profit gains are taxed less that short term stock gains.

Each country has its own fiscal rules, so it makes no sense to dive deeper into this issue here.

12. Safety of Funds

If you are merely holding a stock brokerage account, you are probably protected.

If you are trading futures, then you are trading with a CFTC and NFA member firm which is subject to the customer segregated funds rules laid out by the US government. The segregation of customer funds should ensure client funds were safe.  But if there is one thing MF Global and PFG has taught traders, it is not to think that money in a segregated account are safe.

13. Short selling

Most stockbrokers require a margin account for you to be able to short stocks.

Some stocks are not suitable for shorting and others have limited shares that can be shorted.

Also, the uptick rule can be re-enforced and in the past the government has put temporary bans on stocks that can be shorted.

With futures there are no uptick rules against going short and there are no special requirements or privileges you need to ask your futures broker for.

14. Clearing Reliability

During 2010 stock market flash crash, according to the joint study by the SEC and CFTC,  70% of ETFs trades during those few minutes were later canceled, 160 ETFs temporarily lost almost all of their value and 27% of fund companies had securities with trades broken. Had you bought or sold during this event you may have been notified after the market closed that your trade was no longer good and left with potentially dangerous consequences.

On the other hand, during the crash the Emini S&P futures continued to trade within a reasonable price range, reflecting what the cash S&P 500 index was indicating. No trades on the e-mini S&P futures were cancelled and all trades were cleared.

As you can see, while stocks and futures contract are apparently similar, there are substantial differences between the two. It is vital that you recognize these differences so that you can better make informed trading decisions.