The Advantages of Trading Futures Contracts Over Direct Stock Trades
Trading futures contracts is a strategic approach that allows traders to capitalize on price movements without directly owning the underlying assets. This method is particularly advantageous when compared to traditional stock trading, offering options like leverage, ease of short selling, and lower transaction costs. In this article, we will explore the benefits of trading futures contracts, supported by a practical example involving Tata Consultancy Services (TCS).
The Difference Between Stock Trading and Futures Trading
Stock trading involves purchasing or selling shares of a publicly traded company. Each share represents a fractional ownership of the company, granting you the right to receive dividends, voting rights, and potentially benefit from capital appreciation. Futures, on the other hand, are derivative contracts that require the buyer to purchase or the seller to sell an underlying asset at a predetermined price on a specified future date. These contracts are standardized, making them more versatile for hedging and speculation purposes.
The Advantages of Trading Futures Over Stocks
Leverage
Futures trading allows you to control a substantial position with only a modest amount of capital, known as the margin. This leverage can amplify both gains and losses. For example, while trading futures at 4170 per share, you need a margin of only 130168 (175 units * 4170) to control a 175-unit futures contract worth 729,750. In contrast, buying 100 shares of TCS stock would require a full payment of 417,000, which is a significantly higher capital outlay.
Easy Short Selling
In futures trading, short selling is a straightforward process. You can immediately sell a futures contract to benefit from a decline in the underlying asset's price. This is particularly advantageous as it eliminates the complexities and associated costs of borrowing shares in traditional stock trading. Short selling stock typically involves borrowing shares, which can be difficult, especially with stocks that are hard to borrow.
Lower Transaction Costs
Futures trading often involves lower transaction costs compared to stock trading. This is because futures are commonly traded in large contracts and on a margin. While the example with TCS demonstrates that the cost of one futures contract is 729,750, compared to the cost of buying 417,000 of TCS stock, you can see how trading futures can save substantial transaction fees.
High Liquidity
Major futures markets such as those for stock indices, commodities, and currencies are highly liquid, meaning you can enter and exit positions quickly with little price slippage. In contrast, smaller or less actively traded stocks may have lower liquidity, making it difficult to trade large positions without affecting the market price.
Standardized Contracts
Futures contracts are standardized, making them easier to trade and compare across different markets. Each contract has a fixed size, price, and expiration date, simplifying the trading process. In contrast, each stock trading involves different quantities and values, making comparison and standardization more complex.
Practical Example: Tata Consultancy Services (TCS)
To illustrate the advantages of futures trading, let's revisit the TCS example:
Stock Trading: The purchase of 100 shares at 4170 per share would cost 417,000. As a shareholder, you own a portion of the company and are entitled to dividends and voting rights. Futures Trading: A single TCS futures contract valued at 4170 per contract and a lot size of 175 units would total 729,750, with a margin requirement of 130,168. This shows how trading futures contracts can be more efficient in terms of capital usage.Overall, futures trading offers higher leverage, greater flexibility in trading directions, and lower transaction costs, making it an attractive option for speculative or hedging purposes in the Indian market. However, as with any leveraged product, futures trading also carries higher risk due to the amplification of both gains and losses.
For those looking to enter the world of futures trading, it's important to understand the risks and benefits fully. If you are interested in leveraging the advantages of futures trading, consider starting with smaller contracts and only increasing your exposure as you gain experience and confidence.