Experienced investors are usually on an ongoing mission to find new ways to expand their portfolios, either by learning new skills that can help them trade more effectively or by investing in new assets to diversify their holdings. As a value investor, you might think about choosing a good futures broker, enabling you to buy and sell futures contracts, which can serve either as a high-risk, high-reward addition to your overall strategy or a way to compensate for the weaknesses of long-term value investing. But is this a good addition to your portfolio?
The premise of value investing
First, let’s recap the big-picture philosophy behind value investing. The idea is to pick stocks that seem to be trading at a price lower than their real value, and sell them when they seem to be trading at a price at or above their real value. This is possible because the market oftentimes overestimates the price of companies when good news emerges, or underestimates the price of companies when bad news emerges, neglecting the real fundamentals of a given company. For example, a single data security concern or a lower-than-expected revenue report could drive a stock price considerably lower, despite it still being a great company in good long-term standing for future growth.
How futures trading works with value investing
Futures trading relies on the exchange of futures contracts, rather than shares of stock or other assets. In a futures contract, you’ll make a pledge to buy or sell a specific asset, at a specific price, on a specific date. For example, if a stock is currently trading at $50 per share, you could arrange to buy 50 shares of the company at $60 in six months. If the share price climbs to $80 per share in that timeframe, you’ll be able to buy those shares at a steep discount, and if you sell them immediately, you’ll reap a significant profit. You can also contract to sell shares (or other assets, like commodities).
This approach has a natural synergy with value investing. The big difference is that instead of merely looking at today’s price and today’s value, you’ll be projecting how that valuation and price could change in the near future. For example, you might predict that the value of the company might remain stable, while public perceptions of the company push the price lower; if that’s the case, a futures contract could help you cash in on the market’s overreaction. You might believe that the market is overinflating the price of a certain company; if that’s the case, you can use a futures contract to bet against it.
Futures contracts can also be valuable to value investors because they allow you to trade on margin, effectively allowing you to trade using more cash than you currently have in your account. This is a risky element to the strategy, but if you’re confident in your predictions, it could lead to a massive payoff.
Key Tips for Success
Trading futures can work well with value investing, but there are some strategies you’ll want to keep in mind for these tactics to complement each other:
- Don’t rely exclusively on futures trading. Futures trading functions best as a complement to your other investment strategies. If it’s your only trading strategy, you could end up exposing yourself to too much risk.
- Stop losses early. It’s tempting to hold onto your contracts until their set expiration date, but it’s usually better for you to use stop losses to prevent further losses when you notice a reversal in price trends.
- Start slow, and scale as you gain more experience. It takes a ton of experience to become a successful futures trader, and in your early days, you’ll probably make a lot of mistakes. Accordingly, it’s in your best interest to start with a small number of low-risk trades, and gradually increase your trading volume as you feel more comfortable.
- Invest only in markets you fully understand. You can trade futures for any number of assets, including commodities, but it’s prudent to only trade futures for assets you feel confident in understanding. Prices evolve according to thousands of complex variables, and if you only know a handful of those variables, you could set yourself up for a massive failure.
- Exercise caution when trading on margin. Trading on margin can help you win bigger profits, but it’s also a major financial risk. Don’t abuse this strategy.
Futures trading isn’t good for every value investor, nor is value investing the underlying philosophy motivating every futures trader. However, every investor can improve their own strategy by branching out and learning more about the intricacies of the market—and diversifying their portfolio with new and different strategies.
Disclosure: I do not own any of the stocks mentioned.Ă‚
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