Understanding Leverage in Trading 

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Understanding Leverage in Trading



The purpose of the previous example is to illustrate that the key difference between stock trading and futures trading is not the volatility of the underlying tradeables. The key difference between trading stocks and trading futures is the amount of capital required to enter a trade and the resultant percentage return on investment. This can best be illustrated with an example. First let's consider stock trading. In order to buy $100,000 worth of IBM stock Investor A must put up $100,000 in cash (you can buy IBM stock on margin. To do so you would put up $50,000 in cash giving you 2-for-1 leverage. However, for the purposes of our example, we will forego margin buying). If Investor A puts up $100,000 cash to buy $100,000 of IBM stock and IBM stock rises 3%, Investor A will make 3% on his investment. If IBM stock declines 3% he will lose 3% on his investment. Pretty straightforward. Now let's consider a futures trade.

Each futures contract has a standardized contract size. When you buy a Soybean contract you are buying the right to purchase 5,000 bushels of Soybeans. For Soybeans a one cent move ($0.01) is worth $50. Now let's do some math. Let's say Soybeans are presently trading at a price of $5.00 a bushel. With a current price of $5.00 a bushel, the contract is currently trading for the equivalent of 500 cents. 500 cents times $50 a cent means that you would be purchasing $25,000 worth of Soybeans. Thus, if Investor В buys four Soybean contracts at $5.00 a bushel he is buying $100,000 worth of Soybeans. Now here comes the key difference between trading stocks and trading futures: to purchase (or to sell short) a futures contract a trader does not need to put up cash equal to the full value of the contract. Instead, he need only put up an amount of money which is referred to as a "margin".

Minimum margins are set by the futures exchanges and may be raised or lowered based on the current volatility of a given market. In other words, if a particular market becomes extremely volatile, the exchange on which it is traded may raise the minimum margin. As this is written, the amount of margin required to trade one Soybean contract is $750. So in order to buy $100,000 worth of Soybeans, Investor В in our example must buy four contracts at $5.00 a bushel (500 cents x $50/cent x four contracts). However, unlike Investor A who had to pony up $100,000 cash in order to buy his IBM stock, Investor В need only put up $3,000 of margin ($750 per contract x four contracts) in order to make his trade. And therein lies the quality that makes futures trading a highly speculative endeavor—leverage.

If IBM stock rises 3%, Investor A will make 3% on his investment. If Soybeans rise 3%, from $5.00 to $5.15, Investor В will make a 100% return on his investment (15 cents x $50 per cent x four contracts = $3,000). So what we are talking about in this example is the difference between 1-to-1 leverage versus 33-to-1 leverage. When you boil it all down, it is this leverage which gives futures trading its great upside potential as well as its frightening downside risk. If IBM declines 3%, Investor A will lose 3% on his investment. If Soybeans fall 3% from $5.00 to $4.85, Investor В will lose 100% of his investment (-15 cents x $50 per cent x four contracts = -$3,000).

Leverage is the double-edged sword that makes a few people very rich and upon which the majority of futures traders fall.

Very few individuals have the stomach to trade with leverage of 33-to-1. More unfortunately many traders do not clearly understand that they are using this kind of leverage when they trade futures. Those in the greatest danger are the ones who read about "how to make a fortune in Soybeans for just $750!," or "how you can control $25,000 worth of Soybeans for just $750." Also, some traders are unaware that futures trading involves unlimited risk. If you enter the aforementioned Soybean trade, buying four contracts at $5.00/bushel, your initial margin requirement is $750 a contract, or $3,000. Based on their prior experience in stocks or mutual funds or even options, some traders mistakenly assume that this is all they can lose. Not so. If Soybeans happened to trade down lock limit ($0.30/day) just two days in a row, this trader would be sitting with a loss of $12,000 ($0.60 x $50/cent x four contracts) and counting. This illustrates the importance of having a "cushion" and not "trading too big" for your account. The phrase "trading too big" can be defined as the act of trading with more leverage than is prudent given the size of your trading account and your own tolerance for risk.





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Using too much Leverage
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Failure to control Risk
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Lack of Discipline
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