by Darrell Jobman

As an active investor, you probably already know that futures and stocks have some things in common – they are both traded on exchanges, have standardized contracts, can be analyzed technically or fundamentally, etc. However, there are some distinct differences that need to be emphasized so you can understand the role of each in a portfolio.

First and foremost, one widely held misconception must be clarified: futures and options are not the equivalent of gambling. They are legitimate investment choices, and they can be used in a variety of ways to give you as little – or as much – risk as you want.

Every investment area has its risk spectrum, even stocks, and it can even vary widely within an area. The risk spectrum on blue-chip stocks, for example, is not the same as that of a penny stock. An investment in Coca-Cola or General Motors is not the same as putting your money into the latest hot, new initial public offering or into shares in some long-shot, high-flier company.

If you invest in blue-chip stocks, your aversion to risk may keep you away from many other stock possibilities. But even a blue-chip stock has its risk. If Microsoft is at 150 and loses 15 points in a day – and it has happened – that’s a 10% decline in the value of the stock in one day. If you own 100 shares, that’s a loss of $1,500, a sizable blow for almost any pocketbook. And that’s not even mentioning stocks hit by some traumatic event that causes mammoth one-day plunges.

Of course, stocks like IBM or many others in the technology area also make large one-day gains. The risk/reward profile for stocks is like most other investments. If prices go up, you win – the higher the better. If prices go down, you lose – the lower, the more you lose…if you even hang on to the stock. The same risk/reward profile applies to futures and options, but, as you will see, you have many ways to modify this profile by including futures and options in your portfolio. 

One of the primary functions of the stock market is to transfer capital: Those who have capital are willing to invest it in those companies that need it to develop a business that can turn out products or services that they can make at a profit. For your investment, you won a piece of that company and participate in its success when it distributes dividends or when the value of its stock appreciates. You are an owner of property with the right to vote on what happens to it.

The irony of associating risk – and gambling – with futures is that one of the primary functions of the futures market is to transfer risk. Someone who has actual risk but does not want it – a farmer with a field of wheat or a mining company with a copper pit, for example, is willing to transfer its risk of doing business to someone willing to take on that risk with the prospect of profiting from favorable price changes.

The exchanges serve as giant auction places to discover the price at which both parties are willing to transfer this risk. In this market, no property changes hands at the time of the transaction, only a legally binding commitment to fulfill the terms of a contract at a later date.

However, because the purposes of these two investment areas are so different and because they often use the same terms to mean different things, it is important to highlight several key features first before showing you why you might want to incorporate stock-related futures and options into your portfolio.

Nature of the markets – When the price of a stock increases, the total value of the company increases and every stock owner shares in that gain. Therefore, most stock market investors are all smiles when they hear about an up market. The futures market, on the other hand, is a zero-sum game – that is, for every dollar someone wins, someone else loses a dollar – with the amount taken in by brokers and exchanges reducing the total pool of profits that goes to the winners. That’s one reason it often is more difficult to make money in the futures market.

Time – The buy-and-hold strategies that work in stocks do not work with futures or options because futures and options contracts have an expiration date. In many cases, the time period is less than a year and, often only a few months. When you buy a stock, you can think about a long haul of months or years. When someone talks about a September Standard & Poor’s 500 Index futures or options contract, it means that whatever you expect to happen in the market better happen by September because that contract will cease trading at that point. Because of this constant time pressure, involvement in futures and options is usually called “trading” whereas involvement in the stock market is “investing”.

Selling “Short” – Futures, and especially options, require knowledge of some concepts that are different from stock or other “traditional” investments. For many investors, one of the most difficult to comprehend is “How can I sell something I don’t own?” or “How can I buy the right to sell?” But, with futures, it is as easy to sell as to buy, and there is no difference in risk. With options, you have a few more wrinkles to consider, but selling or buying can be done just as easily.

Margins – There really should be different words for each market for this term. “Margin” in stocks is the down payment you make to buy shares; it must be at least 50% of the value of the stock. You owe the rest, and the entire price goes to the seller. “Margin” in futures is more like a security deposit or a bond or earnest money that is deposited with the broker, not the seller, to signify that you will perform your side of the contract. Typically the margin required to open a trade is slightly less than required to maintain a trade. In both cases, however, the margin may amount to no more than 2%-7% of the total value of the contract.

Leverage – Because the margin you put up for futures or options is so low relative to the value of the contract, your leverage is high. You control a contract valued at many thousands of dollars for only a few thousand dollars in margin money. Consequently, a small change in price can cause a huge percentage change in your margin account. It is this feature of futures and options trading that often produces the horror stories you hear…but it is this same feature that provides the opportunities you are seeking as an active investor.

Perception – There seems to be a vast gulf between the public perception of “legitimate” investments in stocks and bonds and the “gunslinger” image that many, including the mainstream media, have of futures and options, despite the flexibility that futures and options can bring to an investment portfolio. You may have been led to believe “The more a market moves, the riskier it is”. That may be true with some investments but, with the power of leverage provided by futures and options, you’ll soon learn, “The more the market moves the more opportunity it offers.”

So why haven’t you heard positive things about futures and options? First and foremost, most brokers are licensed to deal in stocks and mutual funds, not futures or options. There are different tests and different registrations required for brokers in each area, and the vast majority of brokers handle only stock investments because that’s where most of the investment money is.

If you go to the Merrill Lynch site on the Internet and click on the icon for “Investment Dictionary”, you will find a list of investment terms and concepts, some of them a little complicated. But you won’t find a listing for “futures” or “options”. Obviously, that’s by design because the company wants customers in investments perceived to be “safe” and traditional.

If your broker can sell you stocks but can’t do business with you in futures, guess what type of investment they are likely to stress? And guess what type of investment you are likely to hear the horror stories about, even though some of the scandals get tagged with labels such as “derivatives” or “options” or “speculation” when they should be called “fraud” or “scam” or “scheme” because they have nothing to do with legitimate futures and options trading?

The table below compares some of the main features of stocks and futures. Both have options, which have the characteristics of the underlying instrument, so options are not included here.

Stocks vs. Futures

The table below compares some of the main features of stocks and futures. Both have options, which have the characteristics of the underlying instrument, so options are not included here.

Main PurposeCapital formationPrice discovery; risk transfer
Contracts AvailableFixed for each stockUnlimited
Life of ContractIndefinite in most casesLimited to specific month; sometimes very short-term
MarginDown payment; minimum 50% of stock pricePerformance bond/security deposit; typically 2%-7% of contract value
Short SellingPossible but difficult; unlikely for individual investorYes, as easy as going long
Main Risk ConcernCompany viability, performance; market riskHigh leverage due to small margin relative to contract value
Trading LimitsUsually none but depends on circumstancesDaily price limits, position limits for some contracts
CommissionsPer sharePer contract