Futures Vs. Other Investments

By Lind-Waldock

October, 2004

Have you ever wondered how futures stack up against other investments, not just mainstream instruments but other alternative investments as well? Last month in The Seven Key Benefits of Futures, we explored reasons why people invest in futures. In Part II of this feature, taken from our recent seminar series, well put those benefits into context by comparing futures against instruments you may be more familiar with like stocks, options, mutual funds and exchange-traded funds. You may be surprised by the results.

The Seven Key Benefits of Futures

To review, last months article identified the following Seven Key Benefits of Futures Trading. Each benefit was explored in some detail.

Table 1: The Seven Key Benefits of Futures
1.	Simplicity
2.	Short Positions
3.	Easy to Enter & Exit
4.	Direct Investment in Underlying
5.	Capital Efficient
6.	Price Movement
7.	Tax Benefits

To bring these benefits to life, you may find it helpful to compare futures head-to-head with other investment vehicles. Because of their widespread acceptance, we'll start first with options.

Futures Compared With Options

A key point to take away from this comparison is that futures are simpler to understand and forecast than options. Options involve both calls and puts, deltas and thetas (known as the greeks), implied volatility and different strikes and months. In contrast, futures traders are free to focus on predicting price movements. Whether prices are about to rally or drop is what an investor should be most concerned about; other matters can be an unwelcome distraction.

To complicate the issue with options, the “greeks” are constantly changing. As prices change in the underlying instrument, so too will the statistics of each option. The options may become more or less volatile depending on circumstances. Many of these statistics will change not only with price, but simply with the passing of time. This feature of options can require numerous--and costly--adjustments be made to a portfolio, especially for hedging purposes. Futures, on the other hand, tend to move one-for-one with the underlying instrument.

Some of the most powerful option strategies can involve spreads with the underlying instrument. Unfortunately, popular securities options, such as stock index options, afford little or no opportunity for retail investors to trade the underlying instrument. Futures can have options as well (“options on futures”), which means investors can make use of “covered option” strategies – even in stock index futures trades, and even on short trades.

Perhaps most important of all, futures are not a wasting asset in the same sense that options are. Whether it's from time decay, changing “greeks” or other factors, you can lose money investing in options even if you correctly pick the direction of the market. However, as mentioned earlier, futures tend to move one-for-one with the underlying instrument.

If you're an options trader who agrees that futures are simpler to understand and forecast, perhaps you should be looking a bit further into opportunities available in futures markets.

Futures Compared With Stocks

For lack of a better way to phrase this, investing in futures can mean a lot less homework than what is required with stocks. Both stocks and futures can be affected by the same reports, like GDP, unemployment, inflation, Federal Reserve actions, etc. And certainly, futures have reports unique to specific markets. But consider this: each of these big national reports hits the market all at once, and participants absorb the information together in a kind of “group event.”

On the other hand, stocks involve additional “company-specific” news. Earnings estimates (and revisions) are announced periodically, along with other information such as insider transactions, market share, new products and new competition. Most of this news is discussed or introduced in conference calls with analysts, and the marketplace absorbs them over time.

Individual stocks, and entire sectors for that matter, can be hit with sudden news of scandal or other negative “shocks.” Keeping track of myriad details on industry P/E ratios, industry demand and other important statistics can be a full-time job. And of course, the sheer number of shares to keep track of is daunting.

This “company-specific risk” can have another effect, and that is to distance you from the rationale your investment is based upon. For example, if you buy energy stocks on the belief that crude oil prices are going up, you may be correct in your opinion yet still lose on your stock choice. So, another thing to consider when comparing stocks to futures is that futures provide you a direct link to markets that affect your everyday life. If you have an opinion about the direction of gasoline prices or interest rates, for instance, where better than futures to position yourself?

For many investors just like you, futures are considered to be a mainstream investment tool. If the thought of less homework and more direct investment opportunities appeals to you, perhaps you should be considering whether futures can have a place in your portfolio as well.

Futures Compared With Mutual Funds

Futures can be more powerful than mutual funds. Think of some of the reasons you might wish to invest in mutual funds. You can be a long-term investor, pool costs among many investors, enjoy professional managers or focus on specific sectors or strategies. Perhaps you invest in mutual funds with your Individual Retirement Account (“IRA”) or trust accounts. Clearly, investors can have many valid reasons for investing in mutual funds.

Guess what? You can do all of that and more with futures. You can invest in futures through a commodity pool, where you are grouped together with other investors to enjoy economies of scale. You can evaluate the track records and trading methods of professional, licensed Commodity Trading Advisors (“CTAs”) who run managed futures programs. With many CTAs to choose from, you have access to a wide range of investment strategies. All of these options are available for investment with your IRA.

Interestingly, an investment in mutual funds can be a reason in itself for opening a futures account. With mutual funds you typically wait until the closing price to find out where you entered or exited. But what if you see the beginning of a panic sell-off in stocks? How would you protect yourself from losses if you can't even get out until the end of the day? Well, futures trade throughout the day, and are used as a hedge against adverse price moves. Just like the farmer with crops in the field, you may occasionally need to protect yourself against falling prices. Many investors just like you consider futures to be a valuable part of their investing activity. Hedging potential losses in your mutual funds can be one of those ways.

You may have heard about the benefits of diversifying your investment portfolio. Significantly, futures are a separate investment class and can offer moves unrelated to stocks. For that reason alone many mutual fund investors – again, investors just like you - diversify by allocating a small portion of their overall investment portfolio to futures.

Futures Compared With Exchange-Traded Funds

If you think about it, you may decide that futures have more flexibility than ETFs. Did you know that with futures you can turn the Dow 30 into the Dow 29? Or that you can invest in the S&P 499? In fact, you can take out an entire sector, like bio-tech or retail, from a broader basket of stocks. You do this by simply buying one side (S&P 500, for instance) and selling another (the sector or stock). This strategy is called a “spread trade.”

Why would you do this? First of all, spread trades relieve you of having to pick the direction of the stock market. That's because whether your spread trade makes money or loses can have nothing to do with the direction of the overall market. If you buy S&P 500 futures and sell the retail sector futures, all you're saying is that whichever way prices go, the retail sector is going to under-perform the overall stock market. In other words, stocks could fall dramatically, but as long as the ones you sold dropped more than the ones you own, your “spread trade” will have made money for you.

Spreads can be placed very simply or can be made more complex (with ratios). The point is that spreads afford additional investment opportunities. Some classic spreads you may be familiar with include Pepsi vs. Coke, Intel vs. Microsoft, Corn vs. Soybeans and Crude vs. Natural Gas.

As mentioned earlier, you can also “hedge” with futures. Hedging and spreading afford tremendous flexibility to investors. For instance, a hedge can be used to postpone a taxable event, like selling a stock holding.

Strategies aside, another important issue stands out when comparing futures with ETFs: volume, liquidity and popularity of products. The Chicago Mercantile Exchange reports the S&P futures complex handles six times the volume every day than the SPDR ETFs (Standard & Poor's Depositary Receipts) offered at the American Stock Exchange. CME provides similar comparisons for NASDAQ and other stock indexes. What do those futures traders know that ETF traders don't?

The bottom line is that futures compare quite favorably to ETFs. ETF traders might be well-advised to examine futures trading in more detail.

For More Information

If futures are an investment vehicle you've overlooked, hopefully you now have some reasons to carefully consider what role they might play in your overall investment strategy.

Investors wishing to learn more about futures-related topics should visit the education area on Lind-Waldock's Web site. If you haven't visited the “Education Tab” lately, you may not realize how much of a valuable resource it has become.

Kristina Zurla Landgraf is editor of LindForum. She can be reached at editor@lind-waldock.com.

© 2004 Lind-Waldock, A Division of Man Financial Inc. All Rights Reserved.