What’s the best way to Commoditize? The Differences Between Stocks and Futures contracts

The following is a guest article by Nicole Bishop, Financial Analyst, NSBroker

July 31, 2020 - A common dilemma among investors is the question of whether to trade common stocks or futures contracts when the underlying trading theme is related to a commodity. Conventional wisdom says trade the commodity directly via a futures account. It is quite possible, if not common, that an investor can get the story right, but ultimately lose money because the companies in which he or she chose to invest suffer from poor management or uncontrollable input costs. Furthermore, the investor faces geopolitical risks not under the control of management. For example, a silver miner could be running its most profitable mining operation in a country that undergoes political turmoil and thereby lose the mine! Silver contracts traded on a regulated exchange do not face these risks.

Taxes and portfolio size

However, the decision between equities and futures is not so simple. There are other considerations such as taxes and portfolio size. In the United States, all commodity futures contracts are taxed 60% long-term and 40% short-term, no matter how long you hold them. Furthermore, they are marked-to-market at the end of each year, so your gains will not compound tax-free throughout the life of the investment. Equity gains, on the other hand, are taxed 100% long-term if you hold them more than a year, and they are not taxed until you close the position. Therefore, a big consideration between the two forms of investment is your investment horizon.

Along the lines of taxes, equity investment provides one additional huge benefit: unlike futures contracts, equities may be held in a retirement account. Depending on which type of retirement plan you have, you could enjoy your gains tax-free for life!

Active traders will likely prefer futures, especially if the trading strategy involves shorting. Futures contracts, whether traded long or short, are subject to the tax treatment outlined above. Equity shorts are always subject to short-term taxes as are equity longs that are held less than a year.

Size of Investments

A final, important advantage that stocks provide over futures contracts is the ability to size your investment more precisely. For example, if you want to allocate $4,500 to a gold investment, there is no opportunity for you in the futures market. The minimum gold contract size, as provided by a gold mini, is 33.2 ounces... just over $62,200 at the time of this writing. On the other hand, you could buy any number of shares of a gold mining company to fit your investment allocation.

Futures trade on large exchanges and come with large minimum commitments as contracts are used by investment banks and other institutions. Contract sizes are much larger than CFDs or spread bets. A contract for difference (CFD) is a derivative trading tool that covers Forex currency pairs, stock indices, commodities, shares and treasuries. Trading commodities CFDs include precious metals, grains, beef, energy carriers.

Despite all the advantages that stocks provide over futures contracts, an investor may still decide to avoid the business risks of owning equities. These risks can be mitigated through research and diversification, but they can be avoided completely via futures. Many people fear futures due to their reputation of being risky. This perception is irrational and based on old horror stories of people getting wiped out while trading commodities. The truth is that those unfortunate souls simply used too much financial leverage, and any time leverage is used, risk is leveraged, as well. The leverage aspect of commodities can be to a trader's advantage if used carefully.

As always, you should consult a licensed investment advisor before making any investment decision.