Margins, Cents, Points & the Power of Leverage

Before entering into either a long or short position, one must post a performance bond or have the initial margin requirement. Because it is only necessary to post a fraction of the underlying value of the worth of the underlying contract, futures are a highly leveraged trading vehicle.

Initial margin requirements vary from market to market, but are generally only 3% to 18% of the value of the underlying contract value.

Example
If March Corn is trading at 211 per bushel ($2.11/bushel), the current initial margin requirement is $405 per contract. Each Corn futures contract represents 5,000 bushels of Corn, so the underlying value of a contract of Corn at 211 is $10,550. In other words, for $405 you can control $10,550 worth of Corn. By putting up just 3.9% of the value of the contract, you can control 5,000 bushels of Corn. (Margin requirements are subject to change without notice.)

In this example, a 1 cent move in the price of Corn ($50.00 before commissions and fees) represents a 12.3% return on the Initial Margin Requirement. This is the power of leverage. A small move in the price of the futures contract can mean a large move in your account.

Because of this kind of leverage, a 3.9% move in the price of Corn could give you a 100% return, double your money, or a loss of it all, if properly or improperly positioned. The power of trading on margin is that a small move in the price of the underlying equates to a large return (either positive or negative) on the money posted.

Just as physical leverage increases the amount of force used, like a pulley lifting very heavy objects, financial leverage increases the amount of money, which can be made or lost in the markets. As they say in Chicago, "The futures markets have made millionaires of more young men than Rock and Roll."

However, we want to point out that leverage is a two-edged sword. Over leveraging your trading is a sure fire way to lose your money. Because of the leverage of a roulette wheel, each bet on a specific number pays off at 35 to 1. If you bet "6" and the ball bounces and lands on "6", every $1 you bet is paid back to you with $35 dollars.

Let’s say you start off with $1 and bet "6" and win. You now have $35 and bet it all on "6", which comes up again. You take your $1,225 winnings and let them ride on "6" again and win, reaping $42,875. Let it ride again, making a phenomenal $1,500,625. You let it ride one more time, and up pops "00." You lose everything.

Though roulette is strictly a game of chance, the above results are possible with futures because of the leverage involved. If you buy 1 Corn futures contract at 210 and the price goes up to 219, you have enough open position profit to post margin for a second contract. Prices then rise another .04 cents, and you buy a third contract. With Corn prices having risen .13 cents, you were able to buy 3 contracts with an initial investment of only $405.00. However, all it takes is a .05 cent decline in the price of Corn and all your profits are gone. If you were lucky enough to see another 5 cent rise, you would yield a $1,450.00 profit or a 358% return on the initial margin.

It is possible to make highly leveraged, and possibly highly profitable, transactions in the futures markets by trading with relatively little financial cushion and pyramiding contracts. However, it has been our experience that those who practice this type of trading generally do not end up making money, but losing it.

Most people are attracted to trading futures because of the leverage involved, and it is the leverage that seems to ruin most traders. Though futures trading should only be done with genuine risk capital, this does not mean you should take undo risk. As a general rule of thumb, traders should learn to diversify their risk, only placing a small percentage of their capital at risk at any given time.

Though this style of trade will reduce the largest "bang for your buck" in the short run, it may prevent you from losing everything. In order to learn this game, you need to be able to stick around to learn all the rules (both written and unwritten), and the only way to stick around is through prudent money management.