Pros and Cons of Futures Trading for Stock Speculation

Futures contracts were originally designed as hedging or “insurance” tools for trading commodities such as wheat. Since wheat production takes a long time and prices can change for better or worse during that year, the wheat is slow to mature, the buyer of the wheat can reach an agreement with the farmer to buy his wheat at harvest time. at a reasonable price. agreed price right now. This agreement ensured that the buyer would always be able to buy that wheat at exactly the price he wanted and the farmer was also confident that he would be able to sell his wheat at that price even if the price is reduced during harvest. That is the original purpose of future contracts.

However, with the creation of modern futures markets in which similar futures contracts between future traders can be freely traded, as well as the creation of futures contracts on less traditional assets such as stocks and indices, futures trading also became a speculation tool.

Yes, stock futures are a fairly recent innovation that has not yet been as popular as stock options. These stock futures are known as individual stock futures. Individual stock futures are futures contracts with shares as the underlying asset. This means that when you accept delivery of the long-term futures contract, you receive the shares that are covered by the futures contracts.

The beauty of individual stock futures as a speculation tool can be summed up in one word “Leverage.” Leverage means doing more with less, and in this case, it means controlling earnings on more stocks with less money, which in turn means making more money with less money.

Individual stock futures allow you to control the underlying shares using only 25% of the cash that would be paid for the shares themselves. For example, if AAPL is trading at $ 200 and 100 shares cost $ 20,000, you could control those same 100 AAPL shares for just $ 5000! The good news is that the $ 5,000 you “paid” to buy AAPL individual stock futures is still your money and will be used to deduct losses on the position or will be returned to you along with profits if the position is closed improperly. profitable. This is known as the initial margin.

Now, assuming you bought the futures contracts above and the AAPL went up $ 10 on the same day, your account would be credited with $ 1,000 ($ 10 x 100) on the same day! This means that you made $ 1000 using $ 5000 in just one day through futures trading instead of earning that same $ 1000 using $ 20,000 buying the stock itself. That is leverage.

Now, assuming you bought the previous futures contracts and the AAPL was down $ 10 on the same day. The $ 1,000 loss would be deducted from the $ 5,000 you initially paid to fill the position. Do you see how that $ 5000 is still your money?

Now, what if stocks fell a mile in one day?

That brings us to the risk of futures trading, margin calls. If the AAPL is lowered enough to bring your starting $ 5,000 balance below a limit set by the exchange known as “maintenance margin,” the broker will notify you that you must top-up your account up to that initial $ 5,000. If you don’t have the cash to do that, the broker will close your position immediately. Yes, the stock can go up in your favor and it can go down too. In fact, you are not losing any more money than trading the stocks themselves when trading their futures. You will lose exactly the same amount of money as if you had the same number of underlying shares. This means that even though you paid little to put in the position, you must be prepared with more cash than necessary to survive those temporary setbacks that inevitably occur in the stock market.

The problem with most future beginner traders is that they are prepared only to win, not to lose, and usually have little or no cash left on the sidelines to support temporary losses.

In conclusion, trading individual stock futures gives you leverage and the ability to do more with less, but you also need to be prepared with more cash than is necessary to deal with temporary losses. Remember, leverage cuts both ways. Check with your broker to see if they offer individual stock futures trading and definitely get a mentor to guide you through your initial trades.

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