Lesson 4: Stocks vs. Futures

What is the difference between owning a share of stock and owning a futures contract? That is a fair question. I think it is best answered in two parts. I will use Lesson Number 4 for the first part and Lesson Number 5 for the second part. To better illustrate the difference between these two parts, let me suggest a supplemental question.

What is the difference between a $100 bill and 400 quarters? I would answer this question in this fashion,

1. From one point of view, there is no difference. All currency is legal tender. If you buy something of value which costs $100, whether you pay with a single $100 bill or with 400 quarters is simply a matter of convenience. In either case, when the clerk rings up your payment the register will show $100 paid. No distinction is made between whether paper money was paid or coin. The same comparison can be made when looking at stocks and futures contracts. From one point of view only, it can be said that there is no difference between the two.

2. But from another point of view, there is a great deal of difference. Suppose you have washed your well used jeans and are now putting them into the dryer to dry. In one pocket there is a $100 bill and in the other 400 quarters. Which $100 in value would get your attention the quickest as the machine started to turn? What if your car happened to run out of gas and there was a single phone booth nearby but nothing else for fifty miles. What would you rather have in your purse or pocket, coin or paper money? What about at the start of a football game when it is decided by a coin flip which team will kick the ball and which team will receive. What is the best medium for making this decision?

When one looks at paper money versus coins in this fashion, there is a great deal of difference between the two. So it is with stocks and futures contracts and I will discuss this difference in the next issue.

Lesson Number 4 states that when looking at stocks and futures contracts from one perspective only, it may be stated that there is no difference between the two.

Let us suppose that you were to buy shares of stock in a corporation and these shares were selling for $25 a share. Suppose you were to give your stock broker these instructions,

1. Buy this stock for me at $25 a share.

2. If prices decline to $20 a share, sell my shares for a loss.

3. If prices rise to $30 a share, sell my shares for a profit.

You want to continue owning these shares until either (2) or (3) happens. Whichever happens first, you will accept.

Now let us suppose that you were able to buy crude oil in 2010 and you could do so for $25 a barrel. You might give your broker these instructions.

1. Buy crude oil for me at $25 a barrel.

2. If prices decline to $20, sell my holdings for a loss.

3. If prices rise to $30, sell my holdings for a profit.

You want to continue owning crude oil until either (2) or (3) happens. Whichever happens first, you will accept.

If you buy something for $25 and you sell that same thing for $20, you lose $5. If you buy something for $25 and you sell that same thing for $30, you make $5. It is the different price levels between the buying and the selling that results in the profit or the loss, not the thing itself. From this one perspective only, it makes absolutely no difference what is being bought and what is being sold as long as you are selling the same thing you bought and the end result is an increase or a decrease in the amount of money in your pocket.

How much money will you make, not considering any commissions that you might have to pay, if you buy some stock at $25 a share and sell the same stock at $30 a share? You will make $5 a share. How much will you make in total? It will depend on how many shares you bought and sold at these levels. If you bought ten shares and sold ten shares, you will make $50. If you bought one thousand shares and sold one thousand shares, you will make $5,000. How much money will you lose, not considering any commissions that you might have to pay, if you buy some stock at $25 a share and sell the same stock at $20 a share? You will lose $5 a share. How much will you lose in total? It will depend upon how many shares you bought and sold at these levels. If you bought ten shares and sold ten shares, you will lose $50. If you bought one thousand shares and sold one thousand shares, you will lose $5,000.

How much money will you make, not considering any commissions that you might have to pay, if you buy crude oil at $25 a barrel and sell the same crude oil for $30 a barrel? You will make $5 a barrel. How much will you make in total? It will depend upon how many barrels you bought and sold at these levels. If you bought ten barrels and sold ten barrels, you will make $50. If you bought one thousand barrels and sold one thousand barrels, you will make $5,000. How much money will you lose, not considering any commissions that you might have to pay, if you buy crude oil at $25 a barrel and sell the same crude for $20 a barrel? You will lose $5 a barrel. How much will you lose in total? It will depend upon how many barrels you bought and sold at these levels. If you bought ten barrels and sold ten barrels, you will lose $50. If you bought one thousand barrels and sold one thousand barrels, you will lose $5,000.

If you are interested in whether prices first go to $30 or to $20 does it really make any difference if you buy shares of stock at $25 or if you buy crude oil at $25? As far as the bottom line is concerned, should it make any difference? Suppose your financial advisor were to tell you, "you bought at $25 and sold at $30". You might ask him what it was you had bought and what it was you had sold. But if he were to call you day after day, month after month, year after year, don't you think you might eventually respond, "I don't care what it was, just give me the price levels".

If you buy a stock at $25 a share and sell it at $30 a share, you have made $5. If you buy crude oil at $25 a barrel and you sell it at $30 a barrel, you have made $5. The five dollar bill that you earn from buying and selling a share of stock for a profit will be identical to the five dollar bill that you will earn from buying and selling a barrel of crude oil at a profit.

This is why it is important to understand at the outset that when someone trades in futures contracts, they are not doing something strange or unusual. They are simply buying and selling. A person trading stocks or bonds or mutual funds is buying and eventually selling. A person trading futures contracts is doing exactly the same thing.

Lesson Number 4 states that when looking at stocks and futures contracts from one perspective only, it may be stated that there is no difference between the two.

What then is the primary difference between trading in stocks and trading in futures? I will explain the difference in the next lesson. It may surprise you.