The Short Lesson in Leverage in Futures

  • SumoMe

While I have not written about them much lately, for the record, my belief is that commodity futures remain in many cases the best tool available for traders looking to speculate on price movements in many markets.

While I am obviously a huge fan of options and ETF’s, the fact remains that futures contracts offer the purest way to maximize profitability in many cases.  The problem is that far too many traders are “afraid” of futures, due to their reputation as being “risky” and the perception that price action in futures are more “volatile” that the price action in stocks or ETFs.

However, price volatility is not really the key factor.  I debunked this theory in my (WARNING! Shameless self-serving author plugging his book to follow) book “The Four Biggest Mistakes in Futures Trading” (http://tinyurl.com/lsnzhyw not be confused with http://tinyurl.com/lr85xd2) and displayed that in terms of shear price volatility, stocks are actually more volatile than futures. 

The double-edged sword in futures trading is the leverage involved.  A quick example to illustrate: Let’s assume Trader A wants to buy $100,000 worth of IBM stock and Trader B want to buy $100,000 worth of t-bond futures.

For example sake we will assume that IBM is trading at $100 a share and that the current price of a t-bond futures contract is 100.  Trader A would put up $100,000 and buy 1,000 shares of IBM stock.  For Trader B the calculation is a little different.  To buy or sell short one t-bond futures contract a trader must have a minimum of $2,700 of “margin” in his or her trading account.  So let’s review:

-Trader A puts up $100,000 and buys $100,000 worth of IBM stock

-Trader B put up $2,700 and buy 1 t-bond futures contract worth $100,000

Notice the difference?  Let me spell it out.  If both IBM and t-bonds decline 2.7% in value then:

-Trader A will lose $2,700, or 2.7% of his invested capital

-Trader B will lose $2,700, or 100% of his invested capital

Of course of IBM and t-bonds both rally 5% in value then:

-Trader A will gain $5,000, or 5% of his invested capital

-Trader B will gain $5,000, or 185% of his invested capital

Therein lies the difference.  As a result, futures trading is really as much a game of money management and risk management as it is a game of price movement

In the immortal words of Sean Connery as Malone in The Untouchables – “here ends the lesson.”

Jay Kaeppel

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