Trend Followers have made a lot of money over the years, most notably Warren Buffett. Traditionally, those trend followers have made their money trading Futures. Here’s the question: "Why does most Trend Trading use Futures instead of ETFs?"
It’s a good question. Futures are more complex products, and do have more risk. They require a separate futures account, and have only a fraction of the number people trading them compared to the stock market. They’re pretty much off the main-stream investing radar.
Despite that fact, futures have advantages over stocks and ETFs which can make them far better for trend following. In fact, I find it difficult to believe you can be a successful trend trader over the long haul if you use ETFs only. However, that being said, you can have a great trend following strategy that does trade ETFs.
Because of the nature of ETFs, trend trading them can’t bring in the types of returns that a futures system does (numbers like 1200% higher than an average S&P account for example), but trend trading in general can do way more than your average stock account. By tracking trends and being able to make money on down markets you increase your profitability by default.
That’s important because while your system is slowly growing your money, most of all you’re not losing your money. It’s brilliant (if I do say so myself).
But trend trading is traditionally in Futures.
For Trend Followers, the strengths of futures make a huge difference to long term profits. I’d estimate using futures doubles your potential profits over the long run.
Reason #1: Diversification
When I hear people who mostly trade in the stock market talk about diversification, I just laugh. The level of diversification in stocks is probably less than 25% that of the wider futures markets.
You can easily trade international gold, interest rates, stock markets, African commodities, European crude oil, U.S. grains, South American Coffee, 6-10 major currencies, U.S. energy markets, and more from your futures account. All of these have totally different economic exposures, completely different major players in those markets, and completely different delivery cycles.
It’s common for trend traders to choose from 25+ completely different markets.
Reason #2: Risk
It’s so important to only risk a little bit on each trade. I am thinking about putting "Risk only a little bit!" on my business card! If you get only one idea out of the huge number of articles on this blog, have it be "risk only a little bit".
With futures, it’s possible to do this easily. It’s very, very easy to risk a prudent amount of money with futures.
Reason #3: Leverage
One great thing about futures is you can risk the proper, very small amount of money quite easily. But even better, you can do it without eating up your entire account. We talked about diversification before, and how futures markets are the definition of diversification.
What good is that divesification if you can’t use it? to trade well, you need to only risk a little bit per trade. But you also need exposure to many markets. It’s very hard to risk the right amount on many diverse markets without leverage.
Futures markets give you leverage. In fact, futures give you dangerous amounts of leverage. One of the reasons I stress keeping risk very small is because with any trading and futures in particular, it’s easy to let this risk get out of control.
This leverage is one of the major reasons why I think it’s hard to be a successful trend trader just using ETFs. It requires a special kind of trading to make ETFs work as a trend follower.
Reason #4: Easy to Short
Markets trends can go up or down. Of course, markets can go up. But most old time traders will tell you they prefer down markets. Why? The profits tend to be faster or bigger, and sometimes both!
Futures are literally designed to make them easy to short. Futures markets were created to help farmers sell their crops before they harvested them. This is the reason futures markets got started – to help people sell short easily.
This is part of the contract design today. It’s incredibly easy to go short a market in futures. There is no special charges or fees, and you don’t need to find out if you can short this market.
Nope- you just sell a futures contract. This makes it very, very easy to catch massive downtrends like the one in natural gas.
With stocks and ETFs, it requires a special margin account, and most brokers frown on letting people short stocks. Conclusion
Futures markets have difficulties, but they also have strengths too. The goal of trend trading is to make money, and to do this, a trend trading system needs to trade many markets both long and short, but still risk only a little bit!
Meeting these requirements isn’t easy. Futures allow trend traders to trade a huge range of markets easily, cheaply, and with the proper risk.
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