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How Stock Futures Work

Stock Futures Versus Traditional Stocks
Traders at the Chicago Mercantile Exchange toss confetti to signify the end of the trading year.
Traders at the Chicago Mercantile Exchange toss confetti to signify the end of the trading year.
Scott Olson/Getty Images

The chief advantage of stock futures is the ability to buy on margin. Investing on margin is also called leveraging, since you're using a relatively small amount of money to leverage a large amount of stock. For example, if you have $1,000 to invest, you can by 10 shares of IBM stock. But with the same $1,000, you can buy a futures contract for 50 shares of IBM stock.

It's true that you can also buy traditional stock on margin, but the process is much more complicated. When buying stock on margin, you're essentially taking out a loan from your stockbroker and using the purchased stock as collateral. You also have to pay interest to your broker for the loan [source: Inc.]. The difference with stock futures is that you're not buying any actual stock, so the initial margin payment is more of a good faith deposit to cover possible losses [source: Inc.].

I­t's also much easier to go short on a stock future than to go short on traditional stocks. To go short on a futures contract, you pay the same initial margin as going long. Going short on stocks requires that you sell the stock before you technically own it. To do that, you need to borrow the stock from your broker first. You'll incur broker loan fees and dividend payments [source: Inc.].

Stock futures offer a wider array of creative investments than traditional stocks. Hedging with stock futures, for example, is a relatively inexpensive way to cover your back on risky stock purchases. And for high-risk investors, nothing is as potentially lucrative as speculating on the futures market.

But stock futures also have distinct disadvantages. The high risk factor of a stock future can be just as dangerous as it is lucrative. If you invest in stock, the worst thing that can happen is that the stock loses absolutely all of its value. In that case, you lose the full amount of your initial investment. With stock futures, since you're buying on margin, the potential exists to lose your full initial investment and to end up owing even more money.

What's more, since you don't actually own any of the stock you're trading with futures contracts, you have no stockholder rights with the company. Because you don't own a piece of the company, you're not entitled to dividends or voting rights.

Another disadvantage of stock futures is that their values can change significantly day to day. This isn't the type of security that you can purchase in January and check the price once a month. With such a high-risk security, there's a possibility that the value of your futures contract could drop like a hot potato from one day to the next. In that case, your broker might issue a margin call, which we discussed earlier. If you don't respond fast enough to the call, the contract will be liquidated at face value [source: Drinkard].

In the next section, we'll discuss some of the different methods of buying and selling stock futures.