The strategic advantages of futures for traders

Welcome to Sherwood’s deep dive into futures markets, presented in partnership with

So you know how futures started, what kind of underlying assets underpin futures contracts, and the five specifications of futures contracts, and you’re ready to peer deeper into futures. You’ve proven your mettle by acing our basics futures quiz, too.

In this guide, we’ll go over why futures are useful for active traders and modern markets, the potential for leverage, and other advantages of trading futures. 

Why trade futures?

There are two essential uses for futures: hedging and speculating. 

Just as the futures market can trace its origins back to farmers hedging rice crops, many participants in the futures market are still large institutions that either produce or consume commodities. For example, transportation industries like airlines, cruise lines, and trucking companies may hedge the cost of fuel with futures contracts on products like jet fuel or crude oil.

But for everyday people, hedging needs are a little bit different: instead of hedging commodities, they might want to hedge their portfolios. Traders who fear a short-term downturn may attempt to offset losses in their retirement portfolio by selling an index futures contract. For example, if a trader’s retirement portfolio primarily consists of S&P 500 index funds, a short position in the E-mini S&P 500 Index Futures (/ES) would gain in value as their retirement portfolio drops in value. 

Speculators, on the other hand, aim to capitalize on future price movement with long positions when they think an asset’s price will rise, or short positions when they believe an asset’s price will fall (and, with options on futures, traders can capitalize on horizontal movement or high volatility). Speculators are willing to take on a large amount of risk for potential returns. 

Why are futures appealing for active traders?

There’s a reason I began this with “active” traders: futures, despite their name and that they always have an expiration date set in the future, are not meant to be assets you buy and hold, but, like options, are primarily used with short- to medium-term price movements in mind, especially for speculators. 

Some things traders like about futures:

• Direct exposure to an underlying asset: While traders can buy stocks, they can’t buy commodities like oil or corn via stocks, only stocks of companies whose businesses are affected by the prices of those underlying assets. Sure, Archer Daniels Midland makes a ton of corn syrup and likely would be affected by a plague across all cornfields, but it also makes things out of cocoa and wheat and doesn’t move dollar for dollar with the price of corn, unlike corn futures. 

• Extended trading hours: While many brokerages now offer some trading outside of regular market hours, the volume and liquidity is still limited, if available at all. Sometimes major market-moving news breaks after-hours, such as Russia’s invasion of Ukraine in February 2022. Oil prices shot up overnight, and the only method for traders to wager on how the conflict would affect the commodity was through futures. 

• Day trade without restrictions: Day trading, which is when you open and close the same position in a single day, is subject to certain regulations for margin accounts. If you make four or more day trades within five trading days that represent more than 6% of your total trades in that same five-trading-day period, your margin account will be flagged for pattern day trading. If flagged, you’ll be unable to place any day trades until you bring your portfolio value above $25,000 or switch to a cash account. Futures, however, aren’t subject to the pattern day trading regulations that apply to ETFs, stocks, or stock options. 

• Tax advantages: A profitable short-term trade with futures will pay less in taxes than a stock or ETF. Unlike stocks, ETFs, and equity options, futures are classified as 1256 contracts by the IRS, which means that potential profits may qualify for 60/40 tax treatment:

  • 60% of gains are taxed at the lower long-term capital gains rate, regardless of the holding period.

  • The remaining 40% are taxed at the short-term rate.

Also, unlike stock, ETF, and equity options trades, futures aren’t subject to the wash sale rule. 

• Leverage: As we learned in our basics of futures piece, each futures contract represents a certain amount of the underlying asset. In the case of crude oil, each contract represents 1,000 barrels of oil. So let’s say oil is trading at $60 a barrel; futures allow you to speculate without having to supply the entire $60,000 notional value of one contract. Basically, you get to speculate on a big number with a much smaller amount of your own money. That leverage is very appealing to investors, as it allows them to keep more of their capital liquid or in other positions. And when things move in the direction traders hope, it also amplifies the gains. But, of course, it can also magnify the losses as well.

That said, to use futures, you also have to commit money to fulfill a margin requirement, which is generally between 3% and 12% of the notional value. In the case of the aforementioned oil contract, let’s say the margin requirement is 10% — so you’d also have to commit $6,000 to a margin account. 

As with all derivatives, while futures provide a lot of benefits, they aren’t without risk. In the next piece, we’ll dive into some of the risks associated with futures trading so you’re equipped to manage those risks.

Until then, test your readiness with our fundamentals of futures quiz.