Page 112 - DCOM510_FINANCIAL_DERIVATIVES

Unit 7: Application of Futures Contracts

7.2 Difference between Trading Securities and Trading Futures on Notes
Individual Securities

Individuals and organisations are always looking for a way to increase revenues. An enticing
concept to do this is to invest in trading securities. While all securities investments pose a risk of
losing the capital investment, trading securities increases the chance of profits and losses. There
are many factors involved when considering trading securities. To understand this, let’s look at
each of the components individually. Securities are equities or debentures of publicly traded
companies that are bought and sold through brokerage firms. They are regulated by the U.S.
Securities and Exchange Commission and offer no guarantee of return on investment. Securities,
even bonds, fluctuate in value and pose a risk to the principal investment. Securities investments
are offered for corporations ranging from large capitalization companies to extremely high risk
penny stock ventures.
Trading is the purchase or sale of a specific security. It can be either an equity or debenture and
is done via a brokerage firm. Individuals can have trades done either through a registered
representative (a licensed Financial Industry Regulatory Authority broker) or make trades
without a broker through an online brokerage trading firm. Trading can be done either in a cash
account or through a margin account. Cash accounts require all transactions to be paid for in full
by the settlement date three days after the trade execution. Margin accounts allow the investor
to borrow money for the purchase of securities in hopes that they will not go down in price and
a margin call for the difference is demanded by the brokerage firm.

Trading securities is the act of buying and selling securities with the intention of making a quick
profit. Brokerage firms and investment advisers recommend buying securities for the anticipated
long-term appreciation of the company. Trading securities involve the same stocks and bonds
available to all investors on public exchanges. The difference is trading securities are timed by
investors to buy low and sell high in short time frames. While all securities can be traded in this
fashion, some securities have a natural ebb and flow that can be traded more regularly.

Example: Retail store chains expect higher fourth-quarter earnings as a result of holiday
shopping that may lead investors to time early fourth quarter buying to be sold in the early first
quarter.
To trade securities, a customer must open a security trading account with a securities broker and
a Demat account with a securities depository Buying security involves putting up all the money
upfront. With the purchase of shares of a company, the holder becomes a part owner of the
company. The shareholder typically receives the rights and privileges associated with the security,
which may include the receipt of dividends, invitation to the annual shareholders’ meeting and
the power to vote. Selling securities involves buying the security before selling it. Even in cases
where short selling is permitted, it is assumed that the securities broker owns the security and
then “lends” it to the trader so that he can sell it. Besides, even if permitted, short sales on
security can only be executed on an up-tick.
To trade futures, a customer must open a futures trading account with a derivatives broker.
Buying futures simply involves putting in the margin money. They enable the futures traders to
take a position in the underlying security without having to open an account with a securities
broker. With the purchase of futures on a security, the holder essentially makes a legally binding
promise or obligation to buy the underlying security at some point in the future (the expiration
date of the contract).
Security futures do not represent ownership in a corporation and the holder is therefore not
regarded as a shareholder. A futures contract represents a promise to transact at some point in
the future. In this light, a promise to sell security is just as easy to make as a promise to buy

LOVELY PROFESSIONAL UNIVERSITY 107