The Arithmetic of Futures Trading and Leverage

To say that gains and losses in futures trading are the result of price changes is an accurate explanation but by no means a complete explanation. Perhaps more so than in any other form of speculation or investment, price changes in futures trading are highly leveraged. An understanding of this leverage and how it can work to either your advantage or disadvantage is absolutely essential to an understanding of futures trading.

As mentioned in the introduction, only a relatively small amount of money (known as margin) is required in order to buy or sell a futures contract. On a particular day, a margin deposit of only $2,500 might enable you to purchase or sell a futures contract on $100,000 worth of U.S. Treasury Bonds. Or for an initial margin deposit of about $15,000 you might buy or sell a contract covering common stocks currently worth $300,000. Or for around $4,000 you may be able to buy or sell a futures contract on 37,000 pounds of coffee currently worth $40,000. The smaller the margin in relation to the underlying value of the futures contract, the greater the leverage.

If you speculate in futures contracts and the price moves in the direction you anticipated, high leverage can yield large profits in relation to your initial margin deposit. But if prices move in the opposite direction, high leverage can produce large losses in relation to your initial margin deposit. Leverage is a two-edged sword.

For example, assume that in anticipation of rising stock prices you buy one June S&P 500 stock index futures contract at a time when the June index is trading at 1200. Also assume your initial margin requirement is $15,000. Since the value of the futures contract is $250 times the index, each one point change in the index represents a $250 gain or loss.

An increase of five percent in the index, from 1200 to 1260, would produce a $15,000 profit (60 X $250). Conversely, a 60 point decline would produce a $15,000 loss. In either case, an increase or decrease of only five percent in the index would, in this example, result in a gain or loss equal to 100 percent of the $15,000 initial margin deposit! That’s the arithmetic of leverage.

Said another way, while buying (or selling) a futures contract provides the same dollars and cents profit potential as owning (or selling short) the actual commodity covered by the contract, low margin requirements sharply increase the percentage profit or loss potential.

Futures trading thus requires not only the necessary financial resources but also the necessary financial and emotional temperament. It can be one thing to have the value of your common stock portfolio decline by five percent but quite another, at least emotionally, to have that same five percent stock price decline wipe out 100 percent of your investment in futures contracts.

An absolute requisite for anyone considering trading in futures contracts whether it’s stock indexes or sugar, pork bellies or petroleum is to clearly understand the concept of leverage. Calculate precisely the gain or loss that would result from any given change in the futures price of the contract you would be trading. If you can’t afford the risk, or even if you’re uncomfortable with the risk, the only sound advice is don’t trade. Futures trading is not for everyone.

Reprinted with permission from the National Futures Association. Copyright 2002.