The stock market is volatile. A single fluctuation in the market can ruin your portfolio. Now let’s understand stock futures with an example. You are running an apple juice company. The price of the fruit goes up and down every day. You can make more money by buying the fruit at the lowest possible price.
The current price and the price after six months will not be the same. Now you and the farmer can sign a futures contract. On a certain date in the future, you will buy apples from the farmer at a specific price. However, the farmer does not want to sell apples at the lowest possible price. So, both of you agree to a fair price. As a result, any market fluctuation will neither affect you nor the farmer. This is how stock futures work.
What are stock futures?
In stock futures, two parties sign a contract to trade an agreed amount of stocks on a set future date. Both parties agree on a specific price. Stock futures are not held to the expiration date. Contracts are traded on the basis of their relative values on the future market. In the case of the traditional stock market, you are the owner of the stock.
You don’t own stock in the case of stock futures. Don’t expect invitations to stakeholders’ meetings. Don’t expect dividends. The traditional stock market is profitable when the price of the stock increases. The market going up or down does not affect the price in the case of stock futures.
Stock futures have the following two positions:
In the long position, the stock is purchased when the contract expires. In the short position, the stock is sold when the contract expires. Go for the long position if you expect the stock price to increase in three months. Go for the short position if you expect the price to decrease in three months. When you invest in stock futures, you pay a percentage of the agreed price. You are buying on margin. The margin can be 10 to 20% of the price.
Traditional Stocks vs Stock Futures
Now you know what are stock futures? Let’s see the difference between traditional stocks and stock futures. You can buy stock futures on margin. This is called leveraging. You are leveraging a large amount of stocks using a small amount of money. For example, if you can buy 10 shares by investing $1200. With the same investment, you can buy 50 shares in the case of stock futures. The process of buying traditional stocks on margin is complicated.
You take a loan from the stockholder when you buy a stock on a margin. The purchased stock is used as collateral. Going short on traditional stocks is difficult as compared to stock futures.
However, there are disadvantages of stock futures. Future stocks are both lucrative and risky. You will lose your entire initial investment if the stock loses its value. You don’t get the rights of a stakeholder.