In times of high volatility in equity markets and low interest rates investors are searching for alternative investment opportunities to improve their return and lower they risk. In this article we will discuss whether futures are a good option to achieve this target.

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What are Futures

Futures are financial derivatives that are publicly traded similar to equity, forex or options. A futures contract allows the owner to buy the underlying asset at a predefined price at a specific time in the futures. With this a farmer can sell his grain long before the harvest and lock in the price. On the other hand a consumer of commodities can buy goods early to secure his supply and lower purchasing risk. Futures exist for stock indices, bonds, energies (oil, gasoline, gas etc.), agricultural products (soybeans, wheat, corn, coffee etc.), metals (gold, silver, copper etc.) or forex.

Why trade futures

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Leverage

When you buy a futures contract you do not need to pay the full purchasing price of the underlying assets, but only a margin. The difference between purchasing price and margin is much higher then in the case of stock. Thus your returns and also your risk can be much higher.

That does not mean that you have to trade with a very high risk. You still have the choice to buy only few contracts with your trading capital. You could put the rest of it on a cash account or invest it somewhere else. The benefit here is that futures give you much more freedom to choose how much leverage you would like to use.

Asset Portfolio

Asset Diversification

Future allow you to become much more diversified. If you trade only stock, stock indices, bonds, private equity, or venture capital the chances are high that in case of a market crash all of them will correlate very much. In such a case all of your assets will lose value at the same time.

Futures are available also for commodities that hardly correlate with stocks and the other asset classes mentioned above. Therefore, such a portfolio will be independent from the rest. When the stock market goes down your futures portfolio may even go up and compensate for some or all the losses. In any case, a diversified futures portfolio will smoothen your equity curve and increase the sharp ratio of your portfolio.

Long and Short Trading

Since futures are a contract between a buyer and a seller of commodities you can always sell short or buy long. This is in stark contrast to stock where you can only sell short on an up-tick. This ability to sell short may enable you to gain from a market crash.

Selling short bears additional risk and should only be done by a knowledgeable investor. Algorithmic trading strategies may sell long or short. They are able to determine when you will have a high likelihood of gaining from selling short and can act accordingly.

High Liquidity

Futures markets are very liquid. The S&P 500 eMini trades several million contracts a day. That may not sound a lot compared to some stock, but when you consider that a futures contract represents much more value than a typical share it is clear that this is a high volume. Even more exotic futures like coffee that trades only several thousand contracts a day. Also they still provide enough liquidity to trade with only little slippage.

Risks of Futures Trading

Futures Trading is associated with risks you should be aware of. If the market moves a lot, a market may be closed any you may not be able to trade. This is similar to the stock market, but since you may have a much higher leverage this could effect you significantly.

Conclusion

Futures trading provides significant advantages but also some risks. Due to higher leverage, the positive effect of diversification and the ability to trade long as well as short a futures portfolio will most likely enhance the overall performance of your investment portfolio. Still, there are also some additional risks associated with futures trading. You should understand them in detail before deciding to trade futures. Some of the risks can be reduced with good trading algorithms and proper money management, but it will not be possible to eliminate it totally.

In case you got interested you can learn more about breakout strategies and why algorithmic trading works in our blog.