Futures and Leverage
This is where it gets confusing. Stay focused, because leverage and margins are the "smoke and mirrors" behind the huge gains and losses of futures trading.
Many traders buy futures for only 10% of the contract's value. That is, they use a small investment to gain access to a larger investment. For example, assuming gold is $700, buying a 100oz gold contract would cost a total of $70,000!! Yikes, few investors could ever risk that kind of money. Instead, investors will typically put in 10% of the contract, or $7,000 in the gold example. That is a much lower barrier to entry!! To further elaborate, buying a $70,000 contract with only $7,000 is an initial investment of $7,000 and leverage of $63,000 ($70,000 - $7,000).
Where did the 100oz in the gold example come from? All futures contracts are traded in set contract sizes. Frequently, their will be several variations for each commodity. For example, 100 oz and 500 oz gold contracts.
So how does leverage create the huge swings?
Using the gold example again, a 100z contract will move $1,000 (14.2% return) for every $10 increase in the underlying price of gold . The math behind that example is as follows:
price move x contract size = futures contract return
eg $10 price move x 100oz = $1,000)
The change to the underlying commodity
(buy price + price move) x contract size = actual change in commodity value
eg ($700 buy price + $10 price move) x 100oz = $71,000
But the exciting metric (if their ever was one) is comparing the commodity price change to futures contract return. It explains the incredible power of leverage. A $10 increase in $700 gold is only, 0.0142% ($10/$700 = 0.0142). But, because of the leveraged contract, that 0.0142% turns into 14.2% profit ($1,000/$7,000 = 14.2%).
That sounds great, sign me up
Not so fast their kimosabe. The great rewards can also be the great achilles of futures trading. If the price of gold drops -$10 instead of rising $10, the investment has now now lost 14.2%. Ouch.
Uh oh, is this where margins come in?
You read my mind! The initial investment of $7,000 is called the opening margin. If the contract has lost $1,000 in value, the investor will be required to deposit enough cash to bring the investment back up to the minimum margin (usually 10%).
Margins are a common place that crushes new futures traders. Don't let that happen to you! Know the minimum margin, keep extra cash beyond the initial investment to cover margin calls, and actively watch the commodity being traded.
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