As an algorithmic trader, I'm often asked about the best markets to trade. Should you focus on stocks, ETFs, options, or forex? In my experience, the answer is none of the above. Instead, I strongly recommend trading futures, and here's why.
The Many Benefits of Futures
Ease Of Going Long or Short
First and foremost, futures offer the ease of going long and short. It's essential to have trading systems that can profit in both rising and falling markets, and futures make this simple. With stocks and ETFs, short selling can be more complicated and restrictive.
Leverage
Another significant advantage of futures is the built-in leverage. This sets them apart from stocks and ETFs, allowing you to control more significant positions with less capital. Of course, leverage is a double-edged sword, but it can significantly enhance your returns when appropriately managed.
Fast Settlement
Fast settlement is another benefit of trading futures. When I was day trading stocks, it sometimes took 24 hours or more for my account to settle before I could use that capital again. With futures, as soon as you sell, you can immediately use those funds for your next trade. This is a considerable advantage for active traders.
Diversification
Diversification is also much easier when trading futures. The futures market offers various uncorrelated markets, from gold and oil to stock indexes and even Bitcoin. This allows you to build a portfolio of trading systems that are performing well across multiple market conditions. At any given time, there's always a bull market and a bear market in the futures universe.
Tax Advantages: Save A Ton Of Money!
However, the most significant advantage is the tax treatment of futures. As traders, our most important expense isn't data feeds or computer-related costs – it's federal taxes. And one of the best ways to reduce those expensive tax bills is to trade futures.
I found this Investopedia article that explains the tax benefit very simply.
"Futures traders benefit from a more favorable tax treatment than equity traders under Section 1256 of the Internal Revenue Code (IRC). 1256 states that any futures contract traded on a U.S. exchange, foreign currency contract, dealer equities option, dealer securities futures contract, or nonequity options contract are taxed at 60% of the long-term capital gains rates and short-term capital gains tax rates at 40%—regardless of how long the trade was opened for.1 As the maximum long-term capital gains rate is 20% and the maximum short-term capital gains rate is 37%, the maximum total tax rate stands at 26.8%."
It's that 60/40 split that saves us. Even if we hold our position for only a few minutes, 60% of our profits are taxed at the lower long-term capital gains rate. That's great!
Save $3,495 - The TurboTax Experiment
In this experiment, I aimed to show the difference in federal taxes owed on the same amount of trading profits generated from futures versus stocks.
First, I set up a new tax return in TurboTax with some basic information: my name, state of residence (Wisconsin), and filing status (single). I kept the scenario simple, assuming that the only reported income was the trading profits.
Next, I created two copies of this basic tax return. I added $50,000 in net profit from trading futures contracts in the first copy. This means that after subtracting all my trading losses from my gains, my total taxable profits from futures trading were $50,000.
In the second copy of the tax return, I added $50,000 in net profit from stock trading. Again, this assumes that after accounting for all my stock trading gains and losses, my total taxable profits were $50,000.
With these two scenarios set up in TurboTax, I could compare the federal tax liability for each. The results were striking:
- With $50,000 in stock trading profits, TurboTax calculated that I would owe $4,311 in federal taxes.
- With $50,000 in futures trading profits, TurboTax calculated that I would owe only $816 in federal taxes.
The difference in taxes owed was significant—$3,495 less in federal taxes for the same amount of trading profits generated through futures instead of stocks.
It's important to note that this was a simplified example. In reality, most people have more complex tax situations with multiple sources of income. However, this experiment aimed to isolate the impact of trading profits on federal taxes and demonstrate the tax efficiency of futures trading.
I encourage you to replicate this experiment using your own tax software, as tax laws and individual circumstances can vary. Create two copies of your tax return, add hypothetical trading profits to each (one for futures and one for stocks), and compare the difference in federal taxes owed.
Remember, tax laws vary by country, so investigate the specific rules in your jurisdiction. But for U.S.-based traders like myself, the tax benefits of futures are hard to ignore.
In Closing
I'm not saying you should never trade forex, options, or other markets if you have a talent or passion for them. But I strongly recommend looking at futures if you have yet to try them.
I prefer futures trading for many reasons, including the ease of going long and short, built-in leverage, fast settlement, and diversification opportunities. The tax advantages are one of the most compelling. As I always say, our most significant expense as traders is federal taxes. By trading futures, we can keep more of our hard-earned profits and save thousands of dollars in taxes each year.