I get asked often enough about the difference between trading futures and stocks that I thought I’d address and highlight my reasons for trading futures instead of stocks here.

Disclaimer: The following information is not tax advice. Consult a tax professional for more information.

1. Short Term Gains in Futures are Taxed at a Lower Rate than Short Term Gains in Stocks

Simply put this is the single most important reason why I decided to switch to trading futures. I almost never hold my trades over a year and so most of my gains are considered short term (ST) gains and taxed at the ST tax rate. Futures are taxed 60% at the long term (LT) capital gains rate (15% until 2012) and 40% at the ordinary ST rate (up to 35% until 2012). Stocks and stock options held less than a year are taxed 100% at the ordinary ST rate.

2. Easier Tax Reporting

Each and every future trade does not have to be detailed on your schedule D. If you make 100 stock trades on the same stock all year then you will have 100 entries in your schedule D. If you make 100 futures trades in one year on one futures contract then you only have to list your net profit or loss for that futures contract ie 1 line. Nice! However the IRS does expect you to keep a record of all your futures transactions.

3. I can close a futures position at almost any time of the day

Since futures markets are open almost all day during the weekdays, I can close or open a position any time I want. I will admit this causes me to lose more sleep than when I use to solely trade stocks but there have been many times when I have gotten cold feet about a trade and exited it before it turned against me.

4. Futures Sound Great! What’s the catch?

A. More leverage, which is a double edged sword.

With a $5000 futures account an experienced trader can readily (not easily!) make $300-500 per day everyday. Without trading stock options, it’s pretty hard for even an experienced stock trader to make $300-500 day with a $5000 account. Of course an inexperienced trader can easily lose $300 or more dollars per day everyday trading futures while it’s relatively harder (but not impossible) for an inexperienced stock trader to lose $300-500 on a $5000 account in one day.

B. Futures are cash settled daily.

If you buy want to buy XYZ stock for $10, the most you can ever lose is your initial investment ($10 multiplied by the number of shares). If XYZ stock goes up to $20 and you want to invest the profit in some other UVW stock then you have to sell half your XYZ position and then you can buy UVW. When buying stocks, you are buying shares and the share value increases or decreases.

If you want to buy a futures contract, it always costs the same price regardless of what price the underlying commodity is at. So if the S&P500 is trading at 1200, the cost of an ES (the S&P500 futures) contract is $5,625. If the S&P500 is trading at 800 or 1600 the cost of an ES contract is still $5,625.

For every point the S&P500 goes up, you make $50 immediately. That is if you buy ES and it goes up 10 points, then $500 (less commissions) is deposited into your account at the end of the trading day. By the same token if the S&P500 drops 10 points, then $500 (plus commissions, damn middlemen) is deducted from your account at the end of the trading day.

The key is you must always maintain $5,625 worth of cash in your account for every ES contract that you buy. This is called day trading margin and varies from broker to broker. For this example, if you have exactly $5,625 and you buy an ES contract and lose a point ($50) then at the end of the day your cash balance will be $5,575 (assuming no commissions) and if you are still long the ES contract you will get a margin call: either deposit $50 to maintain the contract, or sell the position.

So while you can buy a stock and hold it forever without any consequence to you besides losing your initial investment, you can’t necessarily do the same with a futures contract.

5. So stocks are better for long term investments and futures are better for short term investment?

No. The difference is that with futures you either have to be rich or you have to be right. If you have a $200,000 account and buy a contract of ES, then the stock market would have to drop about 4,000 points for you to be issued a margin call, which is unlikely. So you can essentially hold the contract forever and if over time the stock market continues to go up, then you will continue to make money.

If you’re not rich then use stops! Limit your losses. If you are profiting on a position, use stops to protect your profit.

6. What about trading stock options vs futures?

If futures contracts aren’t leveraged enough, there are options available on futures contracts too. So you can always go that route and still enjoy the tax benefits of futures over stock options. Beware these are usually less liquid than stock options.

7. Well Defined Stops

The big advantage of futures over options trading is that trading futures gives you increased leverage with well defined stops. Options give you leverage too, but how do you set a stop loss on an option? Usually you do so by placing a stop based on the underlying security, not the option price itself because option prices can easily vary 10-100% when the underlying security doesn’t even move in price. So when using a stop loss on an option your potential loss or risk is not well defined and is generally considered to be the option price itself. Futures have the advantage here because you can place an accurate stop loss which accurately defines your risk. For example, if you want to go long the S&P500 at 1325 and are willing to risk $100 on the trade, then you set your stop at 1323. The most you can lose is $100.